Short-Term Finance and Planning

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19.1

Sources and Uses of Cash

Balance sheet identity (rearranged)
Net working capital + fixed assets = long-term debt + equity Net working capital = cash + other CA CL Cash = long-term debt + equity + current liabilities current assets 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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19.2

The Operating Cycle

Operating cycle time between purchasing the inventory and collecting the cash Inventory period time required to purchase and sell the inventory Accounts receivable period time to collect on credit sales Operating cycle = inventory period + accounts receivable period

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19.3

Cash Cycle
Cash cycle
time period for which we need to 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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19.4

Figure 19.1

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19.5

Example Information
Inventory:
Beginning = 5000 Ending = 6000

Accounts Receivable:
Beginning = 4000 Ending = 5000

Accounts Payable:
Beginning = 2200 Ending = 3500

Net sales = 30,000 Cost of Goods sold = 12,000

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19.6

Example Operating Cycle

Inventory period
Average inventory = (5000 + 6000)/2 = 5500 Inventory turnover = 12,000 / 5500 = 2.18 times Inventory period = 365 / 2.18 = 167 days

Receivables period
Average receivables = (4000 + 5000)/2 = 4500 Receivables turnover = 30,000/4500 = 6.67 times Receivables period = 365 / 6.67 = 55 days

Operating cycle = 167 + 55 = 222 days

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19.7

Example Cash Cycle

Payables Period
Average payables = (2200 + 3500)/2 = 2850 Payables turnover = 12,000/2850 = 4.21 Payables period = 365 / 4.21 = 87 days

Cash Cycle = 222 87 = 135 days We have to finance our inventory for 135 days We need to be looking more carefully at our receivables and our payables periods they both seem extensive

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19.8

Short-Term Financial Policy

Size of investments in current assets

Flexible policy maintain a high ratio of current assets to sales Restrictive policy maintain a low ratio of current assets to sales

Financing of current assets

Flexible policy less short-term debt and more long-term debt Restrictive policy more short-term debt and less long-term debt
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19.9

Carrying vs. Shortage Costs

Managing short-term assets involves a tradeoff 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, the costs to replenish assets
Trading or order costs Costs related to safety reserves, i.e., lost sales and customers and production stoppages

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19.10

Temporary vs. Permanent Assets

Temporary current assets
Sales or required inventory build-up are often seasonal The additional current assets carried 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 arent sold

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19.11

Figure 19.4

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19.12

Choosing the Best Policy

Cash reserves Pros firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunities Cons 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 your firm
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19.13

Figure 19.6

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19.14

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 costs Allows a company to plan ahead and begin the search for financing before the money is actually needed
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19.15

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 quarters sales Beginning payables = 125 Accounts payable period is 45 days

Other expenses
Wages, taxes and other expense are 25% 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 $100 and the company maintains a minimum balance of $50
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19.16

Example: Cash Budget Cash Collections

ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made and the remaining 1/3 are collected the following quarter Beginning receivables of $250 will be collected in the first quarter Q1 250 500 583 167 Q2 167 600 567 200 Q3 200 650 633 217 Q4 217 800 750 267

Beginning Receivables Sales Cash Collections Ending Receivables

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19.17

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 Payment of accounts 275

Q2 438

Q3 362

Q4 338

Wages, taxes and other expenses

Capital expenditures

125

150
200

163

200

Interest and dividend payments

Total cash disbursements
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50
450

50
838

50
575

50
588

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19.18

Example: Cash Budget Net Cash Flow and Cash Balance

Q1
Total cash collections Total cash disbursements Net cash inflow Beginning Cash Balance Net cash inflow Ending cash balance Minimum cash balance

Q2

Q3

Q4

583 567 633 750 450 838 575 588 133 -271 133 -271 233 -38 58 162 20 58 162 20 182 -50 100 233 -38

-50 -50 -50

Cumulative surplus (deficit)

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183 -88 -30 132

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19.19

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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19.20

Short-Term Financial Plan

Q1
Beginning cash balance Net cash inflow New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term debt Change in short-term debt Ending short-term debt 233 -50 183 0 0 0 88 88 50 -50 0 100 133

Q2
233 -271 88

Q3
50 58

Q4
50 162

3 55 50 -50 0 88 -55 33

1 33 178 -50 128 33 -33 0

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Cash and Liquidity Management

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19.22

Reasons for Holding Cash

Speculative motive hold cash to take advantage of unexpected opportunities Precautionary motive hold cash in case of emergencies Transaction motive hold cash to pay the day-to-day bills Trade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions

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19.23

Understanding Float
Float difference between cash balance recorded in the cash account and the cash balance recorded at the bank Disbursement float
Generated when a firm writes checks Available balance at bank book balance > 0

Collection float
Checks received increase book balance before the bank credits the account Available balance at bank book balance < 0

Net float = disbursement float + collection float

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19.24

Cash Collection

Payment Mailed

Payment Received

Payment Deposited

Cash Available

Mailing Time

Processing Delay Collection Delay

Availability Delay

One of the goals of float management is to try and reduce the collection delay. There are several techniques that can reduce various parts of the delay.

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19.25

Cash Disbursements

Slowing down payments can increase disbursement float but it may not be ethical or optimal to do this Controlling disbursements
Zero-balance account Controlled disbursement account

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19.26

Investing Cash

Money market financial instruments with an original maturity of one-year or less Temporary Cash Surpluses
Seasonal or cyclical activities buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occur Planned or possible expenditures accumulate marketable securities in anticipation of upcoming expenses

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19.27

Figure 20.6

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19.28

Characteristics of Short-Term Securities

Maturity firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest rates Default risk avoid investing in marketable securities with significant default risk Marketability ease of converting to cash Taxability consider different tax characteristics when making a decision

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19.29

Target Cash Balances

Target cash balance desired cash level determined by trade-off between carrying costs and shortage costs Flexible policy - If a firm maintains a marketable securities account, the primary shortage cost is the trading cost from buying and selling securities Restrictive policy Generally borrow shortterm, so the shortage costs will be the fees and interest associated with arranging a loan
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19.30

Figure 20A.1

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19.31

BAT Model
Assumptions
Cash is spent at the same rate every day Cash expenditures are known with certainty

Optimal cash balance is where opportunity cost of holding cash = trading cost
Opportunity cost = (C/2)*R Trading cost = (T/C)*F Total cost = (C/2)*R + (T/C)*F

C*
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2TF R
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19.32

Example: BAT Model

Your firm will have $5 million in cash expenditures over the next year. The interest rate is 4% and the fixed trading cost is $25 per transaction.
What is the optimal cash balance? What is the average cash balance? What is the opportunity cost? What is the shortage cost? What is the total cost?

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19.33

Miller-Orr Model

Model for cash inflows and outflows that fluctuate randomly Define an upper limit, a lower limit and a target balance
Management sets lower limit, L C* = L + [(3/4)F2/R]1/3 (target balance) U* = 3C* - 2L (upper limit) Average cash balance = (4C* - L)/3

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19.34

Figure 20A.3

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19.35

Example: Miller-Orr Model

Suppose that we wish to maintain a minimum cash balance of $50,000. Our fixed trading cost is $250 per trade, the interest rate is .5% per month and the standard deviation of monthly cash flows is $10,000.
What is the target cash balance? What is the upper limit? What is the average cash balance?

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19.36

Conclusions

The greater the interest rate, the lower the target cash balance The greater the fixed order cost, the higher the target cash balance It is generally more expensive to borrow needed funds than it is to sell marketable securities Trading costs are usually very small relative to opportunity costs for large firms
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Credit and Inventory Management

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19.38

Credit Management: Key Issues

Granting credit increases sales Costs of granting credit

Chance that customers wont pay Financing receivables

Credit management examines the trade-off between increased sales and the costs of granting credit

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19.39

Components of Credit Policy

Terms of sale
Credit period Cash discount and discount period Type of credit instrument

Credit analysis distinguishing between good customers that will pay and bad customers that will default Collection policy effort expended on collecting on receivables

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19.40

The Cash Flows from Granting Credit

Credit Sale

Check Mailed

Check Deposited

Cash Available

Cash Collection
Accounts Receivable

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19.41

Terms of Sale

Basic Form: 2/10 net 45

2% discount if paid in 10 days Total amount due in 45 days if discount not taken

Buy $500 worth of merchandise with the credit terms given above
Pay $500(1 - .02) = $490 if you pay in 10 days Pay $500 if you pay in 45 days

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19.42

Example: Cash Discounts

Finding the implied interest rate when customers do not take the discount Credit terms of 2/10 net 45 and $500 loan
$10 interest (.02*500) Period rate = 10 / 490 = 2.0408% Period = (45 10) = 35 days 365 / 35 = 10.4286 periods per year

EAR = (1.020408)10.4286 1 = 23.45% The company benefits when customers choose to forego discounts

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19.43

Credit Policy Effects

Revenue Effects
Delay in receiving cash from sale May be able to increase price May increase total sales

Cost Effects
Cost of sale is still incurred even though the cash from the sale has not been received Cost of debt must finance receivables Probability of nonpayment some percentage customers will not pay for products purchased Cash discount some customers will pay early and pay less than the full sales price
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19.44

Example: Evaluating a Proposed Policy Part I

Your company is evaluating a switch from a cash only policy to a net 30 policy. The price per unit is $100 and the variable cost per unit is $40. The company currently sells 1000 units per month. Under the proposed policy the company will sell 1050 units per month. The required monthly return is 1.5%. What is the NPV of the switch? Should the company offer credit terms of net 30?
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19.45

Example: Evaluating a Proposed Policy Part II

Incremental cash inflow

(100 40)(1050 1000) = 3000

Present value of incremental cash inflow

3000/.015 = 200,000

Cost of switching
100(1000) + 40(1050 1000) = 102,000

NPV of switching
200,000 102,000 = 98,000

Yes the company should switch

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19.46

Total Cost of Granting Credit

Carrying costs
Required return on receivables Losses from bad debts Costs of managing credit and collections

Shortage costs
Lost sales due to a restrictive credit policy

Total cost curve

Sum of carrying costs and shortage costs Optimal credit policy is where the total cost curve is minimized
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19.47

Credit Analysis

Process of deciding which customers receive credit Gathering information

Financial statements Credit reports Banks Payment history with the firm

Determining Creditworthiness
5 Cs of Credit Credit Scoring
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19.48

Credit Information

Financial statements Credit reports with customers payment history to other firms Banks Payment history with the company

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19.49

Five Cs of Credit

Character willingness to meet financial obligations Capacity ability to meet financial obligations out of operating cash flows Capital financial reserves Collateral assets pledged as security Conditions general economic conditions related to customers business

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19.50

Collection Policy

Monitoring receivables
Keep an eye on average collection period relative to your credit terms Use an aging schedule to determine percentage of payments that are being made late

Collection policy
Delinquency letter Telephone call Collection agency Legal action
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19.51

Inventory Management

Inventory can be a large percentage of a firms assets Costs associated with carrying too much inventory Costs associated with not carrying enough inventory Inventory management tries to find the optimal trade-off between carrying too much inventory versus not enough

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19.52

Types of Inventory

Manufacturing firm
Raw material starting point in production process Work-in-progress Finished goods products ready to ship or sell

Remember that one firms raw material may be another companys finished good Different types of inventory can vary dramatically in terms of liquidity
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19.53

Inventory Costs
Carrying costs range from 20 40% of inventory value per year
Storage and tracking Insurance and taxes Losses due to obsolescence, deterioration or theft Opportunity cost of capital

Shortage costs
Restocking costs Lost sales or lost customers

Consider both types of costs and minimize the total cost

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19.54

Inventory Management - ABC

Classify inventory by cost, demand and need Those items that have substantial shortage costs should be maintained in larger quantities than those with lower shortage costs Generally maintain smaller quantities of expensive items Maintain a substantial supply of less expensive basic materials

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19.55

EOQ Model
The EOQ model minimizes the total inventory cost Total carrying cost = (average inventory) x (carrying cost per unit) = (Q/2)(CC) Total restocking cost = (fixed cost per order) x (number of orders) = F(T/Q) Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) + F(T/Q)
*

2TF CC
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19.56

Extensions

Safety stocks
Minimum level of inventory kept on hand Increases carrying costs

Reorder points
At what inventory level should you place an order? Need to account for delivery time

Derived-Demand Inventories
Materials Requirements Planning (MRP) Just-in-Time Inventory

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19.57

Alternative Credit Policy Analysis

One-Shot Approach
Determine if you would be better off with the cash (with lower sales) this month or the cash (with higher sales) next month Find the NPV of the investment as a one shot deal Then determine the PV if this is repeated each month indefinitely

Accounts Receivable Approach

Incremental investment in receivables = PQ + v(Q Q) Carrying cost = [PQ + v(Q - Q)]R Compute present value of monthly benefit

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19.58

Discounts and Default

Cash discounts and default affect the benefits received

Net incremental cash flow = PQ(d - ) NPV = -PQ + PQ(d - )/R

Break-even Point
= d R(1 d) d is percent discount for cash is percent of credit sales uncollected P is credit price (no discount price)
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