Chapter 26

Short-Term Finance and

Planning
26.1 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
Balance Sheet Model of the
Firm
Current
Liabilities
Current Assets
Net
Working
Long-Term
Capital Debt

How much short-

Fixed Assets
term cash flow
1. Tangible does a company
Shareholders’
need to pay its
2. Intangible bills? Equity
26.2 Defining Cash in Terms of Other
Elements
Long-
Net Working Fixed
+ = Term + Equity
Capital Assets
Debt

Other
Net Working Current
= Cash + Current –
Capital Liabilities
Assets

Long- Net Working

Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash)
 Defining Cash in Terms of Other
Elements
Long- Net Working
Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash)

• An increase in long-term debt and or

equity leads to an increase in cash—as
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.
26.3 The Operating Cycle and the Cash
Cycle
Raw material
Cash
purchased Finished goods sold
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
The Operating Cycle and the Cash
Cycle
Accounts
Cash cycle = Operating cycle – 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.
 Example
• 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
 Example
• 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 = 111.3 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 = 57.1 days
• Operating cycle = 111.3 + 57.1 = 168.4 days
 Example
• 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 = 168.4 – 39 = 129.4 days
• We have to finance our inventory for 129.4 days.
• If we want to reduce our financing needs, we
need to look carefully at our receivables and
inventory periods – they both seem excessive.
 26.4 Some Aspects of Short-Term
Financial Policy
• There are two elements of the policy that a firm
adopts for short-term finance.
– The size of the firm’s investment in current
assets, usually measured relative to the firm’s
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
 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)
Carrying Costs and Shortage
Costs
$ Minimum Total costs of holding current
assets.
point
Carrying costs

Shortage costs

CA* Investment in
Current Assets ($)
Appropriate Flexible Policy
$

Carrying costs
Minimum
point
Total costs of holding
current assets.

Shortage costs

CA* Investment in
Current Assets ($)
Appropriate Restrictive Policy

$ Minimum Total costs of holding current assets.

point

Carrying costs

Shortage
costs

CA* Investment in
Current Assets ($)
 26.5 The Short-Term Financial
Plan
• The most common way to finance a temporary
cash deficit is to arrange a short-term loan.
• Unsecured Loans
– Line of credit (at the bank)
• Secured Loans
– Accounts receivable can be either assigned or
factored.
– Inventory loans use inventory as collateral.
• Other Sources
– Banker’s acceptance
– Commercial paper