TOPIC 7

TEXTBOOK (CHAPTER 18)

S H O RT- T E R M F I N A N C I N G A N D P L A N N I N G
 SUBTOPICS

7.1 Importance of working capital

7.2 Working capital management

7.3 Cash conversion cycle

7.4 Strategies in working capital management

7.5 The cash budget

7.6 Sources of short-term financing

7.7 Cost of short-term financing

18-2
 IMPORTANCE OF WORKING CAPITAL

• Short term financing (STF) is primarily concern with the analysis of decisions
that affect current assets and current liabilities.
 This type of decision is referred to as WORKING CAPITAL MANAGEMENT (WCM).

• Working capital is an example of STF decision that deals with cash inflows
and outflows that occur within a year. This include ordering of raw materials,
payments in cash and sales of finished goods.
• Working capital allows a company to know:
 the reasonable level of cash to keep on hand (in bank) to pay bills.
 the amount to borrow in the short term.
 to determine how much credit should be extended to the customers.

• A good working capital decision can have a major impact on firm value.
• Likewise a poor WCM decision will impair the firm’s ability to continue
operating. 18-3
 WORKING CAPITAL MANAGEMENT

• Managing working capital encompasses decision strategy related to the day-to-

day activities of managing the firm’s current assets and current liabilities.
• Because each financing source comes with advantages and disadvantages, the
financial manager must decide on the sources that are optimal for the firm.

• Examples of working capital decisions include:

 How much inventory should we carry?
 To whom should credit be extended?
 Should the firm purchase items for its inventories on credit or pay cash?
 If credit is used, when should payment be made?
.

18-4
 COMPONENTS OF CASH AND NET WORKING CAPITAL

• Recall that 4 major items in the current assets are cash and cash equivalents,
marketable securities, account receivable and inventories.

• Current liabilities are account payable, expenses payable and note payable.

• Similarly, the basic balance sheet identity (rearranged) can appear as:
 NWC + fixed assets = long-term debt + equity
 NWC = cash + other CA – CL
 Cash = long-term debt + equity + CL – CA other than cash – fixed assets

This indicate that some activities naturally increase cash and some activities
decrease it.

18-5
 SOURCES AND USES OF CASH

• Sources (Activities that increases cash)

 Increasing long-term debt, equity, or current liabilities (90 days
loan)
 Decreasing current assets other than cash (selling some inventory
for cash), or fixed assets (selling some property)

• Uses (Activities that decrease cash)

 Decreasing long-term debt (paying off a long-term debt), equity
(repurchasing some stock), or current liabilities (paying off a 90
days loan)
 Increasing current assets other than cash (buying some inventory
for cash), or fixed assets (buying some property)

18-6
 THE OPERATING CYCLE AND CASH CONVERSION CYCLE

• The primary concern in short-term finance is the firm’s short term

operating and financing activities.

• These activities relates to buying of raw materials, paying and collecting

cash and manufacturing and selling of product.

• Operating cycle and Cash conversion cycle are used to determine how
effectively a firm has managed its working capital.

• The shorter the cycles, the more efficient is the firm’s working-capital
management.

18-7
 OPERATING CYCLE

• The operating cycle measures the time period that elapses from the
date that an item of inventory is purchased to the time the firm
collects the cash from its sale.

• Operating cycle is the length of time it takes to acquire inventory,

sell it, and collect for it.

• OC can be divided into two parts

 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
18-8
 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
18-9
 EXAMPLE: OPERATING CYCLE
• Inventory period
 Average inventory = (200,000 + 300,000)/2 = 250,000
Inventory turnover = cost of good sold/ average inventory
= 820,000 / 250,000 = 3.28 times
Inventory period = 365/inventory turnover
= 365 / 3.28 = 111 days

• Receivables period
 Average receivables = (160,000 + 200,000)/2 = 180,000
 Receivables turnover = credit sales/ average account receivable =
1,150,000 / 180,000 = 6.39 times
 Receivables period = 365/receivable turnover
= 365 / 6.39 = 57 days
Operating cycle = 111 + 57 = 168 days
18-10
• 3.28 times means the firm bought and sold inventories 3.28times
during the year.

• 111 days means an average inventory spend 111 days in the store
before it was sold.

• 57 days indicates that customers took an average of 57 days

before making payment.

• 168 days indicates that 168 days elapse between the time of
acquiring the inventory and selling it, as well as collecting for
sale.
18-11
 CASH CYCLE

• Cash conversion cycle is shorter than the operating cycle because the firm
does not have to pay for the items in its inventory for a period equal to the
length of the account payable deferral period.

• Therefore, cash cycle indicates the amount of time we finance our

inventory, and the difference between when we receive cash from the sale
and when we have to pay for the inventory.
• This is simply refers to as the time between cash disbursement and cash
collection.
Cash cycle = Operating cycle – Accounts payable period

• Accounts payable period is the time between purchase of inventory and

payment for the inventory or the time between receipt of inventory and
payment for it.. It provide us days on average the firm has to pay its
suppliers who have provided the firm with the trade credit?
APP = 365/ (Cost of goods sold/account payable)
18-12
 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
18-13
 EXAMPLE: CASH CYCLE
• Payables Period
 Average payables = (75,000 + 100,000)/2 = 87,500
 Payables turnover = 820,000 / 87,500 = 9.37 times
Payables period = 365 / 9.37 = 39 days
Cash Cycle = 168 – 39 = 129 days
• This means that on average, there is a 129 days delay between the time the
firm pays for goods and the time of collection on the sale.
Therefore, we have to finance our inventory for 129 days.

• However, if we want to reduce our financing needs, there is need to look

carefully at our receivables and inventory periods.
• A comparison to industry averages would help solidify this assertion.

• Note that cash cycle increases as inventory and receivable periods get longer,
while it decreases if company defer payments of payables and increase the
payable period. 18-14
 FIGURE 18.1: CASH FLOW TIME LINE: A GRAPHICAL
REPRESENTATION OF THE OPERATING CYCLE AND THE CASH
CYCLE

18-15
 SHORT-TERM FINANCIAL POLICY
• The STFP that a firm adopts appears in at least two ways:
• Size of the firm’s investment in current assets: this is usually measured
relative to firm’s level of total operating revenues.
 Flexible (conservative) policy – maintain a high ratio of current assets to
sales (e.g., keeping large balances of cash and marketable securities, making
large investments in inventory, granting discount to increase investment in
marketable securities).
 Restrictive (aggressive) policy – maintain a low ratio of current assets to
sales (opposite of earlier examples).

• Financing of current assets: measured in proportion of short term debt

(current liabilities) and long term debt used to finance the 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
18-16
 • Based on these two explanations, it can be concluded that a
company with a flexible policy would have a relatively large
investment in current assets and it would finance this investment
with relatively less short term debt.

• With a flexible policy, the firm maintains a higher overall level

of liquidity.

18-17
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 CARRYING VS. SHORTAGE COSTS

• Managing short-term assets involves a trade-off between costs that rise

(carrying costs) and costs that fall (shortage costs) with level of
investment.

 Carrying costs – the cost that increase with increased in the levels of
investment in current assets, the costs to store and finance the assets.
 Shortage costs – the cost that decrease with increased levels of current
assets. These costs are incurred when investment in current assets is low.
 If a firm runs out of cash, it will be forced to sell marketable securities.
 However, if such firm cannot readily sell marketable securities, it may
have to borrow or default on an obligation. This situation is referred to as
cash-out.
 A situation whereby a firm may lose customers if it runs out of inventory
or cannot extend credit to customer is called a stockout.
18-18
  There are two types of shortage:
• Trading or order costs: cost of placing an order for more cash
(brokerage costs) or more inventory (production set up cost).
• Costs related to safety reserves, i.e., lost sales and customers, and
production stoppages

18-19
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 TEMPORARY VS. PERMANENT ASSETS

• Temporary current assets

 Sales or required inventory build-up 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.

18-20
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 FIGURE 18.4: TOTAL ASSET REQUIREMENT OVER
TIME

18-21
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 CHOOSING THE BEST FINANCING POLICY
• What is the most appropriate amount of short term borrowing?
• Cash reserves: surplus cash and a little short term borrowing.
 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.
 However, 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.

• Relative 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. 18-22
 FIGURE 18.6: A COMPROMISE FINANCING POLICY

18-23
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 CASH BUDGET

• The cash budget is a primary tool in short-term financial planning.

• It allows for short-term financial needs and opportunities.
• It assist manager to explore the need for short-term borrowing.

• It display the forecast of cash inflows (cash receipts) and outflows (cash
disbursements) over the next short-term planning period.

• It helps to determine when the firm should experience cash surpluses or

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

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

18-24
• We can prepare a quarterly, monthly, or weekly cash budget.
 EXAMPLE: CASH BUDGET INFORMATION

• Pet Treats, Inc. specializes in gourmet pet treats and receives all income from sales.
• Sales estimates (in millions)
 Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
• Accounts receivable
 Beginning receivables = $250
 Average collection period = 30 days
• Accounts payable
 Purchases = 50% of next quarter’s sales
 Beginning payables = 125
 Accounts payable period is 45 days.
• Other expenses
 Wages, taxes, and other expense are 30% of sales.
 Interest and dividend payments are $50.
 A major capital expenditure of $200 is expected in the second quarter.

• The initial cash balance is $80, and the company maintains a minimum balance of $50.
18-25
EXAMPLE: CASH BUDGET – CASH COLLECTIONS

• ACP = 30 days; this implies that 60/90 (2/3) of sales are collected in the
quarter made and the remaining 30/90 (1/3) are collected the following
quarter.
• Beginning receivables of $250 will be collected in the first quarter.
250 + 500 – 583 = 167

Q1 Q2 Q3 Q4

Beginning Receivables 250 167 200 217

Sales 500 600 650 800

Cash Collections (BR + (2/3 *sales) 583 567 633 750

Ending Receivables (1/3 * sales) 167 200 217 267

18-26
 EXAMPLE: CASH BUDGET – CASH
DISBURSEMENTS
• Payables period is 45 days, so half of the purchases will be paid for each
quarter and the remaining will be paid the following quarter.

• Beginning payables = $125

• Q1 = 125 + (50/100 *next quarter sales *45/90) = 275
• Q2 = 275-125 = 150 +(50/100 *next quarter sales *45/90) = 313

Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 150 180 195 240

Capital expenditures 200

Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628
18-27
 EXAMPLE: CASH BUDGET – NET CASH FLOW AND
CASH BALANCE

Q1 Q2 Q3 Q4

Total cash collections 583 567 633 750

Total cash disbursements 475 743 607 628

Net cash inflow 108 -176 26 122

Beginning Cash Balance (A) 80 188 12 38

Net cash inflow brought forward (B) 108 -176 26 122

Ending cash balance (A + B) = C 188 12 38 160

Minimum cash balance (D) -50 -50 -50 -50

Cumulative surplus (deficit) (C-D) 138 -38 -12 110

18-28
• The company will need to access a line of credit or borrow short-term
to pay for the short-fall in quarter 2, but it should be able to clear
up the line of credit in quarter 4.

• The most common way to finance a temporary cash deficit is to

arrange a short-term unsecured loan (e.g., line of credit).
• A line of credit is an agreement under which a firm is authorized to
borrow up a specified amount.

• In short, all depends on the firm financing policy.

• With a flexibly policy, the company might seek up for the 38

million in short term financing.

18-29
 SHORT-TERM BORROWING: HOW TO FINANCE
CASH DEFICIT
• It can be financed through secured and unsecured loans
• Unsecured Loans
 Line of credit: A line of credit is an agreement under which a firm is
authorized to borrow up to a specified amount.

Line of credit can be committed vs. noncommitted

 Revolving credit arrangement is similar to a line of credit, but it is open
for 2 or more years.

 Letter of credit: is mostly used in international finance. The bank issuing

the letter promises to make a loan if certain conditions are met. This letter
would guarantees payment on a shipment of goods provided that the goods
arrive as promised.
 Compensating balances

18-30
 COMPENSATING BALANCE

• Compensating balance is the money kept by the firm with a bank in low
interest or non-interest bearing accounts as part of a loan agreement.
• Because the money is deposited with low or non-interest attached to the
balance, there is an obvious opportunity cost.
• Example : cost of compensating balance
• If a firm has a $500,000 line of credit with a 15% compensating balance
requirement. The quoted interest rate is 9% and suppose we need to borrow
$150,000 for inventory for one year.
 How much do we need to borrow?
150,000 = (1 - 0.15) * amount borrowed
Amount borrowed = 150,000 / (1 – 0.15) = 176,471
 What interest rate are we effectively paying?
• Interest paid = 176,471 (.09) = 15,882
• Effective rate = 15,882 / 150,000 = 0.1059 or 10.59%. 18-31
 SECURED LOANS

 Accounts receivable financing: it involves assigning or factoring

receivables.
 Purchase order (PO) financing
• A popular form of factoring used by small/midsized companies. The
factor pays the supplier.
 Inventory loans: these are short term loans to purchase inventory.
• Blanket inventory lien: it gives the lender a lien against all the
borrower’s inventories
• Trust receipt: is a device by which the borrower holds specific
inventory in trust for the lender.
• Field warehouse financing: a public warehouse company acts as a
control agent to supervise the inventory for the lender.
• Commercial Paper: short term notes issued by large, highly rated firms.
• Trade Credit: it involves increasing the account payable period through
borrowing from supplier. 18-32
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 ACCOUNT RECEIVABLE FINANCING: FACTORING

• Account receivable financing is a secured short term loan that involves either
assigning receivables or factoring receivables. In this case, the lender has the
receivables as security, but the borrower is still responsible in case of
uncollectable receivables. A typical example is credit card receivable funding
or business cash advances.
• Example on how receivable is being factor (Cost of Factoring)
• Last year your company had average accounts receivable of $2 million. Credit
sales were $24 million. You factor receivables by discounting them 2%. In other
words, by selling them for 98cents on a dollar. What is the effective rate of
interest on the source of short term financing?
 Receivables turnover = 24 / 2 = 12 times
 Average collection period = 365/12 = 30.42 days.
Annual Percentage Rate = Receivable turnover (discount rate/1 – discount rate)
 Annual Percentage Rate = 12(.02/.98) = 0.2449 or 24.49%
EAR = (1+.02/.98)12 – 1 = 0.2743 or 27.43% 18-33
 SHORT TERM FINANCIAL PLAN

• Let us assume that Short-term funds are borrowed at 12%, and interest is
compounded quarterly = (12/4 = 3%)
• Short-term surpluses are invested at 2%, and interest is compounded
quarterly.
• Q1 interest received = .15 rounds to 0 (i.e., 80-50 = excess cash =
30; 30 × .02/4 = .15)
Q2 interest received = .69 rounds to 1
Q3 interest paid = 1.14 rounds to 1
Q4 interest paid = .39 rounds to 0

18-34
 SHORT-TERM FINANCIAL PLAN

Q1 Q2 Q3 Q4

Beginning cash balance 80 188 50 50

Net cash inflow 108 (176) 26 122

New short-term borrowing (188 – 176 = - 12) 38

Interest on short-term investment (loan) 1 (1)

Short-term borrowing repaid 25 13

Ending cash balance 188 50 50 159

Minimum cash balance (50) (50) (50) (50)

Cumulative surplus (deficit) 138 0 0 109

Beginning short-term debt 0 0 38 13

Change in short-term debt 0 38 (25) (13)

Ending short-term debt 0 38 13 0

18-35
 QUICK QUIZ

• How do you compute the operating cycle and the cash cycle?

• What are the differences between a flexible short-term financing

policy and a restrictive one? What are the pros and cons of each?

• What are the key components of a cash budget?

• What are the major forms of short-term borrowing?

18-36
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 COMPREHENSIVE PROBLEM

• 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)?

• With average accounts receivable of $5 million and credit

sales of $24 million, you factor receivables by discounting
them 2%. What is the effective rate of interest?

18-37
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