SHORT-TERM FINANCE

Trang Nguyen
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What do you want to be in
next 10 years ?
What do you want to do in
next 1 or 2 months ?
Course
objectives

Short-term financial decisions

Short-term financing instruments

Reading Materials:
Textbook:
Hillier, D., Ross, S., Westerfield, R., Jaffe, J. and
Jordan, B., 2013. Corporate finance (No. 2nd Eu).
McGraw Hill.

Optional Readings:
• Damodaran, A., 1996. Corporate finance.
Wiley
• Brealey, R.A., Myers, S.C., Allen, F. and
Mohanty, P., 2012. Principles of corporate
finance. Tata McGraw-Hill Education.
Course Contents

Chapter 1 (5 Lectures) Chapter 2 (5 Lectures) Chapter 3 (5 Lectures)

Short-term Finance Cash and Liquidity Credit and Inventory

and Planning management management
Course Attendance: 10%

Assessmen The number of attendances and participation in lesson (minimum

of 5 times)

t Midterm exam: 30%

Written exam (60 mins, 20 MCQs and 2 problem-solving questions)

Final exam: 60%

Written exam (60 mins, 40 MCQs, and 2 essay questions)

 Tracing cash and net working
capital
Chapter 1: Short-term
Finance and Planning The operating cycle and the cash
cycle

Some aspects of short-term financial

policy

Cash budget

Short-term borrowing

Short-term financing plan

1.1 Current assets
Current assets: are cash and other assets that are expected to be converted to cash
within the year.

Current liabilities: are obligations that are expected to require cash payment within
one year or within the operating cycle, whichever is shorter.
Working capital
Working capital (net working capital): represents the difference between a company’s
current assets and current liabilities.

• It is a measure of a company’s liquidity and short-term financial health.

• A company has negative working capital if its ratio of current assets to liabilities is
less than one
• Positive working capital indicates that a company can fund its current operations
and invest in future activities and growth.
• High working capital isn’t always a good thing. It might indicate that the business
has too much inventory, not investing its excess cash, or not capitalizing on low-
expense debt opportunities.
Cash in terms of other elements
The balance sheet equation is:
Net working capital + Non-current assets = Non-current liabilities + Equity (1)

Net working capital is cash plus the other elements of net working capital:
Net working capital = Cash + Other Current assets - Current Liabilities
(2)

Substituting Equation (2) into (1) yields

Cash + Other Current assets - Current Liabilities
= Non-current liabilities + Equity - Non-current assets.
(3)

and rearranging, we find that:

Cash = Non-current liabilities + Equity
- Working Capital (excluding cash) - Non-current assets. (4)
CAS • increase non-current liabilities

H • Increase equity

• Decrease non - current assets

• Decrease Working capital

(exclusing cash)
 The sources and Uses of Cash
Statement of cash flows: describes the sources and uses of of cash

(+) Cash (-) Cash

(+) Non-current liabilities (+) Working capital (excluding cash)

(+) Equity (+) Non-current assets

(+) Net Income+depreciation (+) dividend payments

Tracing the changes in cash
P1. For the last year, you have gathered the following information
about Rock Spring plc:
(a) The company undertook a £200 million share buyback programme.
(b) £300 million was invested in property, plant and equipment.
(c) Deferred revenue increased by £400 million.
(d) Corporation tax payments were £500 million.
(e) Staff redundancy payments of £50 million were made.
Label each as a source or use of cash and describe its effect on the
firm’s cash balance.
P2. Changes in the Cash Account Indicate the impact of the following corporate actions on cash,
using the letter I for an increase, D for a decrease or N when no change occurs.
(a) A dividend is paid with funds received from a sale of debt.
(b) Property is purchased and paid for with short-term debt.
(c) Inventory is bought on credit.
(d)A short-term bank loan is repaid.
(e) Next year’s taxes are prepaid.
(f) Preference shares are redeemed.
(g) Sales are made on credit.
(h) Interest on long-term debt is paid.
(i) Payments for previous sales are collected.
(j) The trade payables balance is reduced.
(k) A dividend is paid.
(l) Production supplies are purchased and paid with a short-term note.
(m) Utility bills are paid.
(n) Cash is paid for raw materials purchased for inventory.
(o) Marketable securities are sold.
1.2 The operating cycle and the cash
cycle
Short-term finance is concerned with the firm’s short-term operating activities.
Operating cycle and Cash cycle
Operating cycle: refers to the time it takes a company to buy goods, sell them and
receive cash.

Cash cycle: begins when cash is paid for materials and ends when cash is collected
from receivables.

The cash flow timeline: consists of an operating cycle and a cash cycle

=> The need for short-term financial decision making is suggested by the gap
between cash inflows and outflows.
 Operating cycle and Cash cycle
Operating cycle = Inventory period + Accounts receivable period

Cash cycle = Operating cycle - Accounts payable period

Where:
• The inventory period is the length of time required to order raw materials, and
produce and sell a product (days in inventory).
• The accounts receivable period is the length of time required to collect cash receipts
(days in receivables).
• The accounts payable period is the length of time the firm is able to delay payment
on the purchase of various resources, such as labour and raw materials (days in
payables).
P1: Consider the following financial statement information for Bulldog Ice plc.
Calculate
the operating and cash cycles. How do you interpret your answer?
1.3 Some aspects of short-term financial
policy

• The size of the firm’s investment in current assets: the firm’s level of total
operating revenues.
+) A flexible (accommodative) short-term financial policy: maintain a high ratio of
current assets to sales.
+) A restrictive short-term financial policy: entail a low ratio of current assets to sales.
• The financing of current assets: the proportion of short-term debt to long-term
debt.
+) A restrictive short-term financial policy: a high proportion of short-term debt
relative to long-term financing,
+) A flexible policy: less short-term debt and more long-term debt.
The size of the firm’s investment in
current assets
Flexible short-term financial policies include:
• Keeping large balances of cash and marketable securities.
• Making large investments in inventory.
• Granting liberal credit terms, which results in a high level of accounts receivable.

Restrictive short-term financial policies are:

• Keeping low cash balances and no investment in marketable securities.
• Making small investments in inventory.
• Allowing no credit sales and no accounts receivable.
 Which policy is better?

• Current asset holdings are highest with a flexible short-term financial policy and lowest
with a restrictive policy
• flexible short-term financial policies are costly
• future cash inflows are highest with a flexible policy
• A large amount of inventory on hand (‘on the shelf’) provides a quick delivery service to
customers and increases in sales
• the firm can probably charge higher prices for the quick delivery service and the liberal
credit terms of flexible policies
• A flexible policy also may result in fewer production stoppages because of inventory
shortages
 Carrying costs vs. shortage costs

• Carrying costs: Costs that rise with the level of investment in current assets
+) The rate of return on current assets is low compared with that of other assets (an opportunity
cost)
+) There is the cost of maintaining the economic value of the item (cost of warehousing
inventory)

• Shortage costs: Costs that fall with increases in the level of investment in current assets
+) Trading or order costs: are the costs of placing an order for more cash (brokerage costs) or
more inventory (production set-up costs)
+) Costs related to safety reserves: costs of lost sales, lost customer goodwill and disruption of
production schedules.
 1.4 Cash budgeting

• Cash budget is a primary tool of short-term financial planning

• allow the financial manager to identify short-term financial needs (and
opportunities)
• show the manager the required borrowing for the short term
• identify the cash flow gap in the cash flow timeline
• record estimates of cash receipts and disbursements
 1.4 Cash budgeting
Example: All of Fun Toys’ cash inflows come from the sale of toys. Cash budgeting for
Fun Toys starts with a sales forecast for the next year, by quarter:

1st quarter 2nd quarter 3rd quarter 4th quarter

Sales ($ millions) 100 200 150 100

• Fun Toys’ fiscal year starts on 1 July

• Fun Toys’ sales are seasonal and are usually very high in the second quarter due to
holiday sales
• It sells to department stores on credit, and sales do not generate cash immediately
• Cash comes later from collections on accounts receivable.
• It has a 90-day collection period, and 100 per cent of sales are collected in the
following quarter
• Sales in the fourth quarter of the previous fiscal year were €100 million
 Cash Inflow
Sources of Cash (Cash inflow) (in $ millions)

1st quarter 2nd quarter 3rd quarter 4th quarter

Sales ($ millions) 100 200 150 100

Cash collections

Starting receivables

Ending Receivables
 Cash outflow – cash disbursement

• Payments of accounts payable: payments for goods or services, such as raw

materials that be made after purchases.

• Wages, taxes and other expenses: includes all other normal costs of doing
business that require actual expenditures

• Capital expenditures: payments of cash for long-lived assets

• Long-term financing: includes interest and principal payments on long-term

outstanding debt and dividend payments to shareholders.
 Cash outflow - Uses of Cash (Cash outflow) (in $ millions)

Assume:
- Payments = Last quarter’s purchases
- Purchases = ½ next quarter’s sales forcast
- Fun Toys plans no major capital expenditure in the fourth quarter.
- It pay $10m for interest on long-term debt each quarter.
- Wages, taxes and other expenses = 1/5 current sales
- Fun Toys had established a minimum operating cash balance equal to €5 million to facilitate
transactions, protect against unexpected contingencies and maintain compensating balances at
its banks
Cash outflow - Uses of Cash (Cash outflow) (in $ millions)

1st quarter 2nd quarter 3rd quarter 4th quarter

Sales ($ millions) 100 200 150 100

Purchases

Uses of cash

Payments of AP

Wages, taxes and other expenses

Capital expenditures

Long-term financing expenses

Total uses of cash

Cash Balance

1st quarter 2nd quarter 3rd quarter 4th quarter

Total cash receipts

Total cash disbursements

Net cash flow

Cumulative excess cash balance

Minimum cash balance

Cumulative finance surplus (deficit)

Requirement
 1.5 Short-term borrowing and the short-
term plan
• Short-term borrowing
• Short-term plan
 Short-term borrowing

• Unsecured bank borrowing

• Secured borrowing
• Other sources
 Unsecured bank borrowing (Unsecured loans)

• The most common way to finance a temporary cash deficit is to arrange a short-term unsecured
bank loan
• Firms ask their banks for either a non-committed or a committed line of credit:
- A non-committed line is an informal arrangement that allows firms to borrow up to a previously
specified limit without going through the normal paperwork. The interest rate is usually set
equal to the bank’s prime lending rate plus an additional percentage.
- A committed line is a formal legal arrangement and usually involves a commitment fee paid by
the firm to the bank (≈ 0.25%)
 A committed line of credit

• For larger firms:

Interest rate = floating interest rate benchmark/the bank’s cost of funds
• For mid-sized and smaller firms:
- Stated interest rate # effective interest rate
- Compensating balances: are deposits a firm keeps with the bank in low-interest or non-interest-
bearing accounts (2-5% of the amount used).
Example:
if a firm borrows £100,000 (with a stated interest rate of 10%) and must keep 5% of the amount
used in a non-interest-bearing account.
Þ A compensating balance = ???
Þ Firm effectively receives:
Þ Yearly interest payments:
Þ The effective interest rate:
 Secured borrowing (secured loans)

• Security for short-term loans usually consists of accounts receivable or inventories.

Under AR financing: receivables are either assigned or factored
- Assignment: the lender not only has a lien on the receivables but also has recourse to the
borrower
- Factoring (the sale of accounts receivable): The purchaser (a factor) must collect on the
receivables. The factor assumes the full risk of default on bad accounts.
Under inventory financing: uses inventory as collateral
- Blanket inventory lien: gives the lender a lien against all the borrower’s inventories
- Trust receipt:
The borrower holds the inventory in trust for the lender.
The document acknowledging the loan is called the trust receipt.
Proceeds from the sale of inventory are remitted immediately to the lender.
- Field warehouse financing: a public warehouse company supervises the inventory for the
lender.
 Other Sources

• Commercial paper: consists of short-term notes issued by large, highly rated firms
• Banker’s acceptance: is an agreement by a bank to pay a sum of money.
 Summary and Conclusions

• Short-term finance involves short-lived assets and liabilities. We traced and examined the short-
term sources and uses of cash as they appear on the firm’s financial statements. We saw how
current assets and current liabilities arise in the short-term operating activities and the cash
cycle of the firm. From an accounting perspective, short-term finance involves net working
capital.
• Managing short-term cash flows involves the minimization of costs. The two major costs are
carrying costs and shortage costs. The objective of managing short-term finance and short-term
financial planning is to find the optimal trade-off between these costs.
- In an ideal economy, a firm could perfectly predict its short-term uses and sources of cash, and
net working capital could be kept at zero. In the real world, net working capital provides a
buffer that lets the firm meet its ongoing obligations. The financial manager seeks the optimal
level of each of the current assets.
- The financial manager can use the cash budget to identify short-term financial needs. The firm
has a number of possible ways of acquiring funds to meet short-term shortfalls, including
unsecured and secured loans.