Ross et al.: Fundamentals VII. Short−Term Financial 19.

Short−Term Finance © The McGraw−Hill 683

of Corporate Finance, Sixth Planning and Management and Planning Companies, 2002
Edition, Alternate Edition

656 PART SEVEN Short-Term Financial Planning and Management

TA BLE 19.3 Q1 Q2 Q3 Q4
Cash Collection for Fun
Beginning receivables $120 $100 $150 $125
Toys (in Millions)
Sales 200 300 250 400
Cash collections 220 250 275 325
Ending receivables 100 150 125 200

Collections " Beginning receivables ! 1/2 $ Sales

Ending receivables " Beginning receivables ! Sales # Collections
" 1/2 $ Sales

choose quarters for convenience and also because a quarter is a common short-term
business planning period. (Note that, throughout this example, all figures are in millions
of dollars.)
All of Fun Toys’s cash inflows come from the sale of toys. Cash budgeting for Fun
Toys must therefore start with a sales forecast for the coming year, by quarter:

Q1 Q2 Q3 Q4

Sales (in millions) $200 $300 $250 $400

Note that these are predicted sales, so there is forecasting risk here, and actual sales
could be more or less. Fun Toys started the year with accounts receivable equal to $120.
Fun Toys has a 45-day receivables, or average collection, period. This means that
half of the sales in a given quarter will be collected the following quarter. This happens
because sales made during the first 45 days of a quarter will be collected in that quarter,
whereas sales made in the second 45 days will be collected in the next quarter. Note that
we are assuming that each quarter has 90 days, so the 45-day collection period is the
same as a half-quarter collection period.
Based on the sales forecasts, we now need to estimate Fun Toys’s projected cash col-
lections. First, any receivables that we have at the beginning of a quarter will be col-
lected within 45 days, so all of them will be collected sometime during the quarter.
Second, as we discussed, any sales made in the first half of the quarter will be collected,
so total cash collections are:
Cash collections " Beginning accounts receivable ! 1/2 $ Sales [19.6]
For example, in the first quarter, cash collections would be the beginning receivables of
$120 plus half of sales, 1/2 $ $200 " $100, for a total of $220.
See the Finance Tools Because beginning receivables are all collected along with half of sales, ending re-
section of ceivables for a particular quarter will be the other half of sales. First-quarter sales are
http://business.lycos.com projected at $200, so ending receivables will be $100. This will be the beginning re-
for several useful
templates including a ceivables in the second quarter. Cash collections in the second quarter will thus be $100
cash flow budget. plus half of the projected $300 in sales, or $250 total.
Continuing this process, we can summarize Fun Toys’s projected cash collections as
shown in Table 19.3.
In Table 19.3, collections are shown as the only source of cash. Of course, this need
not be the case. Other sources of cash could include asset sales, investment income, and
receipts from planned long-term financing.
684 Ross et al.: Fundamentals VII. Short−Term Financial 19. Short−Term Finance © The McGraw−Hill
of Corporate Finance, Sixth Planning and Management and Planning Companies, 2002
Edition, Alternate Edition

CHAPTER 19 Short-Term Finance and Planning 657

Q1 Q2 Q3 Q4 TA BL E 19.4
Cash Disbursements
Payment of accounts (60% of sales) $120 $180 $150 $240
for Fun Toys (in Millions)
Wages, taxes, other expenses 40 60 50 80
Capital expenditures 0 100 0 0
Long-term financing expenses
(interest and dividends) 20 20 20 20
Total cash disbursements $180 $360 $220 $340

Q1 Q2 Q3 Q4 TA BL E 19.5
Net Cash Inflow for Fun
Total cash collections $220 $250 $275 $325
Toys (in Millions)
Total cash disbursements 180 360 220 340
Net cash inflow $ 40 !$110 $ 55 !$ 15

Cash Outflows
Next, we consider the cash disbursements, or payments. These come in four basic
categories:
1. Payments of accounts payable. These are payments for goods or services rendered
by suppliers, such as raw materials. Generally, these payments will be made
sometime after purchases.
2. Wages, taxes, and other expenses. This category includes all other regular costs of
doing business that require actual expenditures. Depreciation, for example, is often
thought of as a regular cost of business, but it requires no cash outflow and is not
included.
3. Capital expenditures. These are payments of cash for long-lived assets.
4. Long-term financing expenses. This category includes, for example, interest
payments on long-term debt outstanding and dividend payments to shareholders.
Fun Toys’s purchases from suppliers (in dollars) in a quarter are equal to 60 percent
of the next quarter’s predicted sales. Fun Toys’s payments to suppliers are equal to the
previous quarter’s purchases, so the accounts payable period is 90 days. For example, in
the quarter just ended, Fun Toys ordered .60 $ $200 " $120 in supplies. This will ac-
tually be paid in the first quarter (Q1) of the coming year.
Wages, taxes, and other expenses are routinely 20 percent of sales; interest and divi-
dends are currently $20 per quarter. In addition, Fun Toys plans a major plant expansion
(a capital expenditure) costing $100 in the second quarter. If we put all this information
together, the cash outflows are as shown in Table 19.4.

The Cash Balance

The predicted net cash inflow is the difference between cash collections and cash dis-
bursements. The net cash inflow for Fun Toys is shown in Table 19.5. What we see im-
mediately is that there is a cash surplus in the first and third quarters and a cash deficit
in the second and fourth.
 Ross et al.: Fundamentals VII. Short−Term Financial 19. Short−Term Finance © The McGraw−Hill 685
of Corporate Finance, Sixth Planning and Management and Planning Companies, 2002
Edition, Alternate Edition

658 PART SEVEN Short-Term Financial Planning and Management

TA BLE 19.6 Q1 Q2 Q3 Q4
Cash Balance for Fun
Beginning cash balance $20 $ 60 !$50 $ 5
Toys (in Millions)
Net cash inflow 40 ! 110 55 ! 15
Ending cash balance $60 !$ 50 $ 5 !$10
Minimum cash balance ! 10 ! 10 ! 10 ! 10
Cumulative surplus (deficit) $50 !$ 60 !$ 5 !$20

We will assume that Fun Toys starts the year with a $20 cash balance. Furthermore,
Fun Toys maintains a $10 minimum cash balance to guard against unforeseen contin-
gencies and forecasting errors. So, the company starts the first quarter with $20 in cash.
This amount rises by $40 during the quarter, and the ending balance is $60. Of this, $10
is reserved as a minimum, so we subtract it out and find that the first quarter surplus is
$60 # 10 " $50.
Fun Toys starts the second quarter with $60 in cash (the ending balance from the pre-
vious quarter). There is a net cash inflow of #$110, so the ending balance is $60 # 110
" #$50. We need another $10 as a buffer, so the total deficit is #$60. These calcula-
tions and those for the last two quarters are summarized in Table 19.6.
At the beginning of the second quarter, Fun Toys has a cash shortfall of $60. This oc-
curs because of the seasonal pattern of sales (higher towards the end of the second quar-
ter), the delay in collections, and the planned capital expenditure.
The cash situation at Fun Toys is projected to improve to a $5 deficit in the third
quarter, but, by year’s end, Fun Toys still has a $20 deficit. Without some sort of fi-
nancing, this deficit will carry over into the next year. We explore this subject in the next
section.
For now, we can make the following general comments on Fun Toys’s cash needs:
1. Fun Toys’s large outflow in the second quarter is not necessarily a sign of trouble.
It results from delayed collections on sales and a planned capital expenditure
(presumably a worthwhile one).
2. The figures in our example are based on a forecast. Sales could be much worse (or
better) than the forecasted figures.

CONCEPT QUESTIONS
19.4a How would you do a sensitivity analysis (discussed in Chapter 11) for Fun Toys’s
net cash balance?
19.4b What could you learn from such an analysis?

19.5 SHORT-TERM BORROWING

Fun Toys has a short-term financing problem. It cannot meet the forecasted cash out-
flows in the second quarter using internal sources. How it will finance that shortfall de-
pends on its financial policy. With a very flexible policy, Fun Toys might seek up to $60
million in long-term debt financing.
 Ross et al.: Fundamentals VII. Short−Term Financial 19. Short−Term Finance © The McGraw−Hill 689
of Corporate Finance, Sixth Planning and Management and Planning Companies, 2002
Edition, Alternate Edition

662 PART SEVEN Short-Term Financial Planning and Management

the interest rate the firm obtains is often significantly below the rate a bank would
charge for a direct loan.
Another option available to a firm is to increase the accounts payable period; in other
words, the firm may take longer to pay its bills. This amounts to borrowing from sup-
pliers in the form of trade credit. This is an extremely important form of financing for
smaller businesses in particular. As we discuss in Chapter 21, a firm using trade credit
may end up paying a much higher price for what it purchases, so this can be a very ex-
pensive source of financing.

CONCEPT QUESTIONS
19.5a What are the two basic forms of short-term financing?
19.5b Describe two types of secured loans.

19.6 A SHORT-TERM FINANCIAL PLAN

To illustrate a completed short-term financial plan, we will assume that Fun Toys
arranges to borrow any needed funds on a short-term basis. The interest rate is a 20 per-
cent APR, and it is calculated on a quarterly basis. From Chapter 5, we know that the
rate is 20%/4 " 5% per quarter. We will assume that Fun Toys starts the year with no
short-term debt.
From Table 19.6, we know that Fun Toys has a second-quarter deficit of $60 million.
The firm will have to borrow this amount. Net cash inflow in the following quarter is
$55 million. The firm will now have to pay $60 million $ .05 " $3 million in interest
out of that, leaving $52 million to reduce the borrowing.
Fun Toys still owes $60 million # 52 million " $8 million at the end of the third
quarter. Interest in the last quarter will thus be $8 million $ .05 " $.4 million. In addi-
tion, net inflows in the last quarter are #$15 million, so the company will have to bor-
row a total of $15.4 million, bringing total borrowing up to $15.4 million ! 8 million "
$23.4 million. Table 19.7 extends Table 19.6 to include these calculations.

TA BLE 19.7 Q1 Q2 Q3 Q4
Short-Term Financial
Beginning cash balance $20 $ 60 $10 $10.0
Plan for Fun Toys
(in Millions) Net cash inflow 40 ! 110 55 ! 15.0
New short-term borrowing — 60 — 15.4
Interest on short-term borrowing — — ! 3 ! .4
Short-term borrowing repaid — — ! 52 —
Ending cash balance $60 $ 10 $10 $10.0
Minimum cash balance ! 10 ! 10 ! 10 ! 10.0
Cumulative surplus (deficit) $50 $ 0 $ 0 $ 0.0
Beginning short-term borrowing 0 0 60 8.0
Change in short-term debt 0 60 ! 52 15.4
Ending short-term debt $ 0 $ 60 $ 8 $23.4