Chapter 18

Short-Term Finance and Planning

McGraw-Hill/IrwinCopyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

Learning Objectives• To provide the definition and concept of the working capital

management. • To discuss components and importance of working capital. • To explain the risk and return trade-off from the working

capital management perspective.• To discuss the strategies in working capital management.• To discuss the cash conversion cycle. • To develop a cash budget.• To discuss types of the short-term financing.• To calculate the cost of short-term financing with insertion

of compensation balance, discounted interest rate, and other related features.

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Sources and Uses of Cash

• Balance sheet identity (rearranged)– NWC + fixed assets = long-term debt + equity– NWC = cash + other CA – CL– Cash = long-term debt + equity + CL – CA other than cash –

fixed assets• Sources

– Increasing long-term debt, equity, or current liabilities– Decreasing current assets other than cash, or fixed assets

• Uses– Decreasing long-term debt, equity, or current liabilities– Increasing current assets other than cash, or fixed assets

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The Operating Cycle

• Operating cycle – time between purchasing the inventory and collecting the cash from sale of the inventory

• Inventory period – time required to purchase and sell the inventory

• Accounts receivable period – time required to collect on credit sales

• Operating cycle = inventory period + accounts receivable period

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The Cash Cycle• Cash cycle

– Amount of time we finance our inventory– Difference between when we receive cash from the sale and

when we have to pay for the inventory• Accounts payable period – time between purchase of

inventory and payment for the inventory• Cash cycle = Operating cycle – accounts payable

period

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Figure 18.1

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Example Information• Inventory:

– Beginning = 200,000– Ending = 300,000

• Accounts Receivable:– Beginning = 160,000– Ending = 200,000

• Accounts Payable:– Beginning = 75,000– Ending = 100,000

• Net sales = 1,150,000• Cost of Goods sold = 820,000

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• Inventory period– Average inventory = (200,000+300,000)/2 = 250,000– Inventory turnover = COGS / (Ave inventory) =820,000/250,000 = 3.28 times– Inventory period = 365 / 3.28 = 111 days• Inventory turnover: A ratio showing how many times a company’s inventory

is sold and replaced over a period.• Inventory period: The days required to sell the average inventory on hand.

• Receivables period– Average receivables = (160,000+200,000)/2 = 180,000– Receivables turnover = Net Sales / (Ave receivables) =1,150,000 / 180,000

= 6.39 times– Receivables period = 365 / 6.39 = 57 days

• Operating cycle = 111 + 57 = 168 days• Receivables turnover: A ratio showing how many times a company collects on

its receivables over a period. A high ratio implies more efficient collection of debt.

• Receivables period: The days required to collect the average accounts receivables.

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Example: Cash Cycle

• Payables Period– Average payables = (75,000+100,000)/2 = 87,500– Payables turnover = COGS / (Ave payables) = 820,000 /

87,500 = 9.37 times– Payables period = 365 / 9.37 = 39 days

• Cash Cycle = operating cycle – payables period =168 – 39 = 129 days

• We have to finance our inventory for 129 days• If we want to reduce our financing needs, we need to

look carefully at our receivables and inventory periods – they both seem extensive. A comparison to industry averages would help solidify this assertion.

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Short-Term Financial Policy

• Size of investments in current assets– Flexible (conservative) policy – maintain a high ratio of current

assets to sales– Restrictive (aggressive) policy – maintain a low ratio of current

assets to sales• Financing of current assets

– Flexible (conservative) policy – less short-term debt and more long-term debt

– Restrictive (aggressive) policy – more short-term debt and less long-term debt

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Carrying vs. Shortage Costs

• Managing short-term assets involves a trade-off between carrying costs and shortage costs– Carrying costs – increase with increased levels of

current assets, the costs to store and finance the assets

– Shortage costs – decrease with increased levels of current assets

• Trading or order costs• Costs related to safety reserves, i.e., lost sales and

customers, and production stoppages

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Temporary vs. Permanent Assets• Temporary current assets

– Sales may be seasonal– Additional current assets are needed during the “peak” time– The level of current assets will decrease as sales occur

• Permanent current assets– Firms generally need to carry a minimum level of current assets

at all times– These assets are considered “permanent” because the level is

constant, not because the assets aren’t sold

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Choosing the Best Policy• Cash reserves

– High cash reserves mean that firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunities

– Cash and marketable securities earn a lower return and are zero NPV investments

• Maturity hedging– Try to match financing maturities with asset maturities– Finance temporary current assets with short-term debt– Finance permanent current assets and fixed assets with long-term debt

and equity• Interest Rates

– Short-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debt

– Firms can get into trouble if rates increase quickly or if it begins to have difficulty making payments. May not be able to refinance the short-term loans

• Have to consider all these factors and determine a compromise policy that fits the needs of the firm

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Cash Budget• Forecast of cash inflows and outflows over the next short-

term planning period• Primary tool in short-term financial planning• Helps determine when the firm should experience cash

surpluses and when it will need to borrow to cover working-capital requirements

• Allows a company to plan ahead and begin the search for financing before the money is actually needed

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Cash Budget

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Exercise 1As a cash manager, you are required to prepare a cash budget for May to August 2013. The sales in March and April were RM62,000 and RM50,000, respectively. The operation manager projected that 30% of Nanny Nugget’s sales are collected one month after the sale and the balance two month after the sales. The estimated sales for May through August 2013 are given below.

Month May June July AugustProjected Sales(RM) 60,000 80,000 85,000 70,000Projected Purchases (RM) 48,000 51,000 42,000 40,000

The purchase in April was RM36,000. These purchases are paid in the following month.

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• Wages and salaries, rent and other expenses are as follows (RM):May June July August

Wages and salaries 4,000 5,000 6,000 4,000Rent 3,000 3,000 3,000 3,000Other expenses 1,000 500 1,200 1,500 Depreciation 500 500 500 500

• Nanny Nugget needs to pay RM4,000 interest on long-term debt in May 2013.

• Principal amount of short-term debt amounting RM8,000, and its interest amounting RM200 will be due in July 2013.

• A tax payment will also be due in July amounting RM5,200.• Nanny needs to purchase equipment costing RM10,000 in May 2013.

Cash Budget

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• The ending cash balance in April was RM10,000 and will continue to maintain the minimum cash balance in the near future.

• Additional borrowing is allowed to maintain the minimum cash balance. Interest on short-term fund is 12% p.a. or 1% per month. Interest will be paid the following month after the fund was borrowed.

Construct a cash budget for month May to August.

Cash Budget

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Constructing a cash budget

• Salco company wants to prepare cash budget for upcoming 6 months. • 30% of sales are collected 1 month after sales, 50% 2 months after

sale, and the reminder during the third month following the sales.• Purchase equal 75% of sales and are made 2 months in advance of

anticipated sales. Payments are made in the month follwoing purchases.

• Equipment purchased on February of $14,000 and the repayment of a $12,000 loan in May. In June, Salco will pay interest of $7,500 on its $150,000. interest of 12,000 short term repaid in May is $600.

• Salco has a cash balance of $20,000 and wants to maintain a minimum balance of $10,000.

• Interest on the borrowed funds equals 12% per annum or 1% per month and is paid in the month following the one in which funds are borrowed.

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Short-Term Borrowing• Unsecured Loans

– Line of credit– Committed vs. noncommitted– Revolving credit arrangement– Letter of credit

• Secured Loans– Accounts receivable financing

• Assigning• Factoring

– Inventory loans• Blanket inventory lien• Trust receipt• Field warehouse financing

• Commercial Paper• Trade Credit

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Example: Compensating Balance1. We have a $500,000 line of credit with a 15% compensating

balance requirement. The quoted interest rate is 9%. We need to borrow $150,000 for inventory for one year.– How much do we need to borrow?

• 150,000/(1-.15) = 176,471

– What interest rate are we effectively paying?• Interest paid = 176,471(.09) = 15,882• Effective rate = 15,882/150,000 = .1059 or 10.59%

2. With a quoted interest rate of 5% and a 10% compensating balance, what is the effective rate of interest (use a $200,000 loan proceeds amount)?

Borrow $200,000 / (1 - 0.1) = $222,222 Pay interest of .05 x $222,222 = $11,111Effective rate of interest = $11,111/$200,000 = .05555 = 5.56%

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End of Chapter

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