Chapter 18

SHORT-TERM FINANCE AND PLANNING

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

18-1

KEY CONCEPTS AND SKILLS

Describe the components of the cash cycle and
why it is important
Define the pros and cons of the various shortterm financing policies
Prepare a cash budget
Outline the various options for short-term
financing

18-2

CHAPTER OUTLINE
18.1 Tracing Cash and Net Working Capital
18.2 The Operating Cycle and the Cash
Cycle
18.3 Some Aspects of Short-Term Financial
Policy
18.4 The Cash Budget
18.5 Short-Term Borrowing
18.6 A Short-Term Financial Plan

18-3

BALANCE SHEET MODEL OF THE FIRM

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity

18-4

18.1 TRACING CASH AND NET

WORKING CAPITAL
Current Assets are cash and other assets that
are expected to be converted to cash within
the year.

Cash
Marketable securities
Accounts receivable
Inventory

Current Liabilities are obligations that are

expected to require cash payment within the
year.
Accounts payable
Accrued wages
Taxes

18-5

DEFINING CASH IN TERMS OF

OTHER ELEMENTS
Net Working
Fixed
+
=
Capital
Assets
Net Working
Capital

= Cash +

LongTerm +
Debt
Other
Current
Assets

Equity

Current
Liabilities

18-6

DEFINING CASH IN TERMS OF

OTHER ELEMENTS
LongNet Working
Fixed
Cash = Term + Equity

Capital
Assets
(excluding cash)
Debt
An increase in long-term debt and or equity
leads to an increase in cashas does a
decrease in fixed assets or a decrease in the
non-cash components of net working capital.
The sources and uses of cash follow from this
reasoning.

18-7

ACTIVITIES THAT INCREASE AND

DECREASE CASH
Increase Cash

Increase Long Term

Debt
Sell Additional Equity
Increase Current
Liabilities
Sell Current Assets
Sell Fixed Assets

Decrease Cash

Pay off Long Term

Debt
Repurchase Equity
Pay off Current
Liabilities
Buy Current Assets
Buy Fixed Assets

18-8

18.2 THE OPERATING CYCLE AND

THE CASH CYCLE
Raw material
purchased

Finished goods sold

Cash
received

Order
Stock
Placed Arrives

Inventory period

Accounts receivable period

Time

Accounts payable period

Firm receives invoice

Cash paid for materials

Operating cycle
Cash cycle

18-9

THE OPERATING CYCLE AND THE

CASH CYCLE
Cash cycle = Operating cycle

Accounts
payable
period

In practice, the inventory period, the accounts

receivable period, and the accounts payable
period are measured by days in inventory, days in
receivables, and days in payables.

18-10

EXAMPLE: OPERATING AND CASH

CYCLE FACTS
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
18-11

EXAMPLE: OPERATING CYCLE

CALCULATIONS
Inventory period

Average inventory = (200,000+300,000)/2 =

250,000
Inventory turnover = 820,000 / 250,000 = 3.28
times
Inventory period = 365 / 3.28 = 111 days

Receivables period

Average receivables = (160,000+200,000)/2 =

180,000
Receivables turnover = 1,150,000 / 180,000 =
6.39 times
Receivables period = 365 / 6.39 = 57 days

Operating cycle = 111 + 57 = 168 days

18-12

EXAMPLE: CASH CYCLE

CALCULATIONS
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

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
excessive.
18-13

INTERPRETATION OF THE CASH CYCLE

Cash cycle increases when:
Inventory and receivable periods get longer

Cash cycle decreases when:

Payables periods are extended and receivables periods
shortened

There is a direct connection between a companys

cash cycle and profitability
Total asset turnover is a useful measure

18-14

18.3 SOME ASPECTS OF SHORTTERM FINANCIAL POLICY

There are two elements of the policy that
a firm adopts for short-term finance.
The size of the firms investment in current
assets, usually measured relative to the
firms level of total operating revenues.
Flexible
Restrictive

Alternative financing policies for current

assets,
usually
measured
as
the
proportion of short-term debt to long-term
debt.
Flexible
Restrictive
18-15

SIZE OF INVESTMENT IN
CURRENT ASSETS
A flexible short-term finance policy would
maintain a high ratio of current assets to sales.
Keeping large cash balances and investments in
marketable securities
Large investments in inventory
Liberal credit terms

A restrictive short-term finance policy would

maintain a low ratio of current assets to sales.
Keeping low cash balances, no investment in marketable
securities
Making small investments in inventory
Allowing no credit sales (thus no accounts receivable)

18-16

CARRYING COSTS AND SHORTAGE

COSTS
$

Minimum
point

Total costs of holding current

assets.
Carrying costs

Shortage costs
CA*

Investment in
Current Assets ($)
18-17

APPROPRIATE FLEXIBLE POLICY

$
Minimum
point

Carrying costs
Total costs of holding
current assets.
Shortage costs

CA*

Investment in
Current Assets ($)
18-18

APPROPRIATE RESTRICTIVE POLICY

$

Minimum
point

Total costs of holding current assets.

Carrying costs

Shortage
costs
CA*

Investment in
Current Assets ($)
18-19

ALTERNATIVE FINANCING
POLICIES
A flexible short-term finance policy means a
low proportion of short-term debt relative to
long-term financing.
A restrictive short-term finance policy means
a high proportion of short-term debt relative
to long-term financing.
Compromise policy meets restrictive and
flexible policies in the middle.
In an ideal world, short-term assets are
always financed with short-term debt, and
long-term assets are always financed with
long-term debt.
In this world, net working capital is zero.

18-20

18.4 THE CASH BUDGET

A cash budget is a primary tool of shortrun financial planning.
The idea is simple: Record the estimates
of cash receipts and disbursements.
Cash Receipts
Arise from sales, but we need to estimate
when we actually collect

Cash Outflow

Payments of Accounts Payable

Wages, Taxes, and other Expenses
Capital Expenditures
Long-Term Financial Planning
18-21

EXAMPLE

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 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
18-22

EXAMPLE: CASH INFLOWS

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.

Beginning Receivables
Sales
Cash Collections
Ending Receivables

Q1
250
500
583
167

Q2
167
600
567
200

Q3
200
650
633
217

Q4
217
800
750
267

18-23

EXAMPLE: CASH OUTFLOWS

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

Q2

Payment of accounts

275

313

362

338

Wages, taxes and other expenses

150

180

195

240

Capital expenditures
Interest and dividend payments
Total cash disbursements

Q3

Q4

200
50

50

50

50

475

743

607

628

18-24

EXAMPLE: CASH BUDGET

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

80

188

12

38

Ending cash balance

188

12

38

160

Minimum cash balance

-50

-50

-50

-50

Cumulative surplus (deficit)

138

-38

-12

110

18-25

18.5 SHORT-TERM BORROWING

The most common way to finance a
temporary cash deficit is to arrange a shortterm loan.
Unsecured Loans
Line of credit (at the bank)
Compensating balances

Secured Loans

Accounts receivable can be either assigned or

factored.
Inventory loans use inventory as collateral.

Commercial Paper
Trade Credit
Cash Discounts

18-26

QUICK QUIZ
How do you compute the operating cycle and the
cash cycle?
What are the differences between a flexible shortterm 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?

18-27