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SHORT-TERM FINANCE AND PLANNING

After studying this material you should be able to

Understand why the firm needs to invest in net working capital

Show how long-term financing policy affects short-term financing requirements

Trace

a firms sources and uses of cash and evaluate its need for short-term

borrowing

Develop a short-term financing plan that meets the firms need for cash

FINANCIAL DECISIONS

Long-term financial decisions such as capital budgeting and choice of capital


structure
These decisions usually involve long-lived assets or liabilities
They are not easily reversed and thus may commit the firm for several years

Short-term financial decisions generally involve short-lived assets and liabilities,


and usually they are easily reversed. For example, a 60-day bank loan for 50 million
RON. A bond issue is a long-term decision (10-year maturity)
Cash: RON (cash), bank deposits (deposits), marketable security (shares, bonds)
Account receivable arise because companies do not usually expect customers to pay for
their purchases immediately. Unpaid bills from sales to other companies trade credit
There is a cost to holding idle cash balances rather than putting the money to work earning
interest managers collect and pay out cash and decide on an optimal cash balance

Marketability refers to how easy it is to convert an asset to cash. An asset is marketable if (1) it can be
sold without changing the market price and (2) it can be sold quickly at the existing market price

WORKING CAPITAL

Current assets are cash and other assets that are expected to be converted to cash within the
year / Liquidity is the ease with which assets can be converted to cash at a fair price and the
time it takes to do so

Current liabilities are obligations that are expected to require cash payment within one year or
within the operating cycle (accrued wages, taxes, notes payable, other expenses payable). A
companys principal current liability consist of accounts payable outstanding payments due to
other companies
Current assets:
Cash
Marketable securities
Account receivable
Inventories
Other current assets

Current liabilities:
Short-term loans
Account payable
Accrued wages
Accrued income taxes
Notes payable
Current payments due on long-term debt
Other current liabilities

Example: current assets = 1000 RON; current liabilities = 900 RON; Net working capital = 1000
900 = 100 RON

Net working capital + Fixed assets = Long-term debt + Equity

WORKING CAPITAL

Account receivable are affected by the term of credit the firm offers to its
customers If the firm tries to minimize accounts receivable by restricting credit
sales, it may lose customers

Similarly, the firm can reduce its investment in inventories of raw materials but,
here the risk is that it may one day run out of inventories and production will need
to stopped (it may have to shut down production)

Investment in working capital has both costs and benefits:


The cost of the firms investment in accounts receivable is the interest that could have been
earned if customers had paid their bills earlier
The firm also forgoes interest income when it holds idle cash balances rather than putting
the money to work in marketable securities
The cost of holding inventory includes not only the opportunity cost of capital but also storage and
insurance costs and risk of spoilage or obsolescence

SOURCES AND USES OF CASH


STAR CORPORATION (sources and uses of cash) [thousands RON]
Sources of cash
Cash from operations:
Net income

740

Depreciation

300

Total cash flow from operations

1,040

Decrease in net working capital:


Increase in accounts payable

250

Increase in notes payable

1000

Increase in accrued expenses

25

Increase in taxes payable

25

Total sources of cash

2,340
Uses of cash

Increase in fixed assets

700

Increase in prepayments

100

Dividends

90

Increase in net working capital:


Investment in inventory

1000

Increase in accounts receivable

400

Increase in marketable securities

50

Total uses of cash

Change in cash balance

2,340

THE OPERATING CYCLE AND THE CASH CYCLE

Short-term finance is concerned with the firms short-term operating activities

Operating activities:
Buying raw materials
Paying cash for purchases
Manufacturing the product
Selling the product
Collecting cash

Decisions:
How much inventory to order?
To borrow or draw down cash balance
What choice of production technology?
To offer cash terms or credit terms to customers
How to collect cash?

These activities create patterns of cash inflows and cash outflows that are both
unsynchronized and uncertain
Unsynchronized because the payment of cash for raw materials does not
happen at the same time as the receipt of cash form selling the product

Uncertain because future sales and costs are not known with certainty

THE OPERATING CYCLE AND THE CASH CYCLE

Purchasing raw materials, but firm does not pay for them immediately this delay is
the accounts payable period

The firm processes the raw materials and then sells the finished goods the delay
between the initial investment in inventories and the sale date is the inventory
period

Some time after the firm has sold the goods its customers pay their bills the delay
between the date of sale and the date at which the firm is paid is the accounts
receivable (period)

The net time when the company is out of cash is reduced by the time it takes to pay its
own bills

The length of time between the firms payment for its raw materials and the
collection of payment form the customer is known as the firms cash conversion
cycle

THE OPERATING CYCLE AND THE CASH CYCLE


Raw material
purchased
Order
placed

Stock
arrival

Finished
goods
sold
Inventory paid

Cash
received
Accounts
receivable period
Time

Firm received
invoice

Accounts
payable period Cash paid for
materials

Operating cycle

Cash cycle

THE OPERATING CYCLE AND THE CASH CYCLE

The operating cycle is the interval between the arrival of inventory stock and the date
when cash is collected from receivables (sometimes include the time from placement of
the order until arrival of the stock)

The cash cycle begins when is paid for materials and ends when cash is collected from
receivables

The gap between the cash inflows and cash outflows is related to the lengths of the
operating cycle and the accounts payable period - this gap can be filled either by borrowing
or by holding a liquidity reserve. The gap can be shortened by changing the inventory,
receivable, and payable periods

The length of the operating cycle is equal to the sum of the lengths of the inventory and accounts
receivable periods
Operating cycle = Inventory period + Accounts receivable period

Cash conversion cycle = (Inventory period + Receivable period) Accounts payable period
The longer the production process, the more cash the firm must keep tied up in inventories
The longer it takes customers to pay their bills, the higher the value of accounts receivable

THE OPERATING CYCLE AND THE CASH CYCLE

If a firm can delay paying for its own materials, it may reduce the amount of cash
it needs accounts payable reduce net working capital

Financial statements can be used to estimate the inventory period, also called
days sales in inventory the average number of days form the purchase of the
inventories to the final sales
Inventory period = Average inventory / [(Annual costs of goods sold)/365]

The accounts receivable period and the accounts payable period:


Accounts receivable period = Average accounts receivable / [(Annual
sales)/365]
Accounts payable period = Average accounts payable / [(Annual cost of goods
sold)/365]

THE OPERATING CYCLE AND THE CASH CYCLE


Balance Sheet Data [million RON]

Example:

End of 2013

End of 2014

Inventory

470

468

Accounts receivable

471

481

Accounts payable

304

303

Income Statement Data [million RON]


End of 2014
Sales

3968

Cost of goods sold

3518

1.

How long on average does the company to produce and sell their product?
Inventory period = [(470 + 468)/2]/[3518/365] = 48.7 days

2.

How long does company take to collect bills?


Receivables period = [(471 + 481)/2]/[3968/365] = 43.8 days

3.

How long does the company take to pay bills?


Payables period = [(304 + 303)/2]/[3518/365] = 31.5 days

The cash conversion cycle is: Inventory period + Receivable period Accounts payable period =
48.7 +43.8 31.5 = 61 days

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

Any business requires capital money invested in plant, machinery, inventories,


account receivable, and other assets. The total cost of these assets is called the
firms total capital requirement

The firms total capital requirement does not grow smoothly and the company
must be able to meet temporary demands for cash / short-term financial planning

Short-term financial policy:


The size of the firms investment in current assets:
A flexible short-term financial policy would maintain a high ration of current assets to sales
A restrictive short-term financial policy maintain a low ratio of current assets to sales
The financing of current assets (the proportion of short-term debt to long-term debt):
A flexible short-term financial policy means less short-term debt and more long-term debt
A restrictive short-term financial policy means a high proportion of short-term debt relative
to long-term financing

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

The size of the firms investment in current assets

Flexible short-term financial policy include:


Keeping large balances of cash and marketable
securities
Making large investments in inventory
Liberal credit terms (a high level of accounts
receivables

Restrictive short-term financial policy include:


Keeping low cash balances and no investment in
marketable securities
Making small investment in inventory
Allowing no credit sales and no accounts
receivable

Determining the optimal investment level in short-term assets requires an identification of the
different costs of alternative short-term financing policies

Flexible short-term financial


policy is costly in that it
requires
higher
cash
outflows to finance cash and
marketable
securities,
inventory,
and
account
receivable

However:
1. Future inflows are highest
2. Sales are stimulated by the use of a credit policy
3. A large amount of inventory provides a quick delivery
service to customers and increases in sales
4. Firm can probably charge higher prices for the quick
delivery service and credit terms
5. A fewer production stoppages because of inventory
shortages

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

The size of the firms investment in current assets

A trade-off between costs that rise with the level of investment in current assets (carrying costs) and
costs that fall with the level of investment in current assets (shortage costs)

Carrying costs increase with the level of investment in current assets and include:
There is an opportunity cost because the rate of return on current assets in low compared
with that of other assets
Cost of maintaining the economic value of the items, for example, the cost of warehousing
inventory
Shortage costs are incurred when the investment in current assets is low decrease with
increases in the level of investment in current assets and include:
Trading costs - the costs of placing an order for more cash or more inventory (order costs)
Costs related to safety reserves these are costs of lost sales, lost customer goodwill, and
disruption of production schedule

Situation: If a firm runs out of cash, it will be forced to sell marketable securities. If a firm runs out of cash
and cannot readily sell marketable securities, it may need to borrow or default on an obligation (cash out).
If a firm has no inventory (stock-out) or if it cannot extend credit to its customers, it will lose customers

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING


The size of the firms investment in current assets

Total cost of holding


current assets

Carrying costs and Shortage costs


RON

Carrying costs

The total costs of investing in


current assets are determining by
adding the carrying costs and the
shortage costs

Shortage costs
CA*
The optimal amount of
current assets

Flexible policy the optimal


policy calls for substantial
current assets

Restrictive policy

RON

RON

Carrying costs

Carrying costs
Shortage costs
CA*

Amount of current
assets (CA)

Amount of current
assets (CA)

Shortage costs
CA*

Amount of current
assets (CA)

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

Alternative financing policies for current assets

We examine the level of current liabilities, assuming the investment in current assets is optimal !
Example: A grain elevator operator buys
crops after harvest, store them, and sell
them during the year. It has high inventory of
Current assets =
short-term debt
grain after the harvest and end with low
Total
inventory just before the next harvest. The requirement
capital
Long-term
purchase of grain is financed by bank loan
debt plus
with maturity of less than one year. Longcurrent assets
Fixed
term assets are assumed to grow over time,
assets
whereas current assets increase at the end
of the harvest and then decline during the
Time
year. Short-term assets end at zero just
before the next harvest. These assets are
An ideal model: Rule Short-term assets
financed by short-term debt, and long-term
can always be financed with short-term debt, and
assets are financed with long-term with longlong-term assets can be financed with long-term
term debt and equity / Net working capital is
debt and equity / net working capital is always
always zero
zero

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

Alternative financing policies for current assets

Current assets cannot be expected to drop to zero in the real world because a long-term rising of sales will
result in some permanent investment in current assets !!!
The total asset requirement will exhibit balances over time reflecting: a growth trend, a seasonal
variation around the trend and unpredictable fluctuations
Total requirement
capital
When long-term
financing does not
cover the
total
capital requirement,
the firm must raise
short-term capital to
make
up
the
difference

Seasonal component
of required assets

The base level of fixed


assets and current assets

The growth in the firms capital requirements

The upward-sloping line shows that as the


business grows, it is likely to need additional
fixed assets and current assets the base
capital requirement

Total asset
requirement

Time

In addition to this base capital requirement,


there may be seasonal fluctuations in the
business that require an additional investment in
current assets

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

Alternative financing policies for current assets


How this assets requirement is financed !!!!

1. Flexible strategy the long-term financing covers more than the total asset requirement, even at
seasonal peaks in this case, the firm is always a short-term lender - the firm has surplus cash
available for short-term investment - this surplus will be invested in marketable securities

Total
requirement
capital

Excess capital = investment in


cash and marketable securities

Asset
requirements

Long-term financing

Time

The firm will have excess cash available for investment in marketable securities when the total asset
requirement falls from peaks. This policy implies chronic short-term cash surplus and a large investment in net
working capital, it is considered a flexible strategy

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

Alternative financing policies for current assets

2.

Restrictive policy when


long-term financing does not
cover the total asset requirement,
the firm must borrow short-term
to make up the deficit - the firm is
always a short-term borrower.
This policy denotes a permanent
need for short-term borrowing

3. Moderate policy the firm


has available cash which it can
lend out during the part of the
year when total capital
requirements are relatively low,
but it is a borrower during the
rest of the year when capital
requirements are relatively high

Total
requirement
capital

Short-term
borrowing

Total asset
requirements

Long-term financing
Time

Total
requirement
capital

Firm is a
short-term
borrower in
this period

Long-term
financing
Asset
requirements
Firm holds
marketable securities
Time

LINKS BETWEEN LONG-TERM AND SHORT-TERM FINANCING

What is the best level of long-term financing relative to the total capital requirement?

a) Matching maturities (match maturities) managers finance long-lived assets like plant and
machinery with long-term borrowing and equity. Also, short-term assets like inventory and
accounts receivable are financed with short-term bank loans or by issuing short-term debt like
bonds. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of
maturity mismatching would necessitate frequent financing and is inherently risky because shortterm interest rates are more volatile than longer rates

b) Permanent working-capital requirements managers plan to have at all times a positive


amount of working capital. This is financed from long-term sources. Short-term interest rates are
normally lower than long-term interest rates. It is more costly to rely on long-term borrowing
than on short-term borrowing (on average)

c)The comforts of surplus cash (relaxed strategy) such firms with a surplus of long-term
financing never have to worry about borrowing to pay next bills. Firms usually put surplus cash to
work in marketable securities. However, investment in cash and marketable securities are zero net
present value investment at best
Short-term securities entail little interest rate risk

Short-term financial assets (securities in the money market) are highly marketable or liquidity
(ease and cheap to sell the asset for cash

CASH BUDGETING

Managers need to forecast future sources and uses of cash for:


It allows to identify short-term financial needs and opportunities. It denotes the required borrowing
for the short term (to identify the future cash needs)

It is the way of identifying the cash flow gap on the cash flow time line. It records estimates of cash
receipts and disbursements

Steps to preparing a cash budget:


1. Forecast the sources of cash (the largest inflow of cash comes from payments by the firms
customers) - cash budgeting stats with a sales forecast
2. Forecast uses of cash
3. Calculate whether the firm is facing a cash shortage or surplus

The financial plan sets a strategy for investing cash surpluses or financing any deficit

Unless customers pay on delivery, sales become accounts receivable before they become
cash. Cash flow comes form collections on accounts receivable
Managers can forecast what proportion of a quarters sales is likely to be converted into cash in
that quarter and what proportion is likely to be carried over to the next quarter as account
receivable suppose that 80 percent of sales are collected in this period and the remaining 20
percent in the next

CASH BUDGETING
Example, cash budget STAR Company
Quarters

First

Second

Third

Fourth

Collections on accounts receivable

85

80.3

108.5

128

Other

1.5

12.5

86.5

80.3

121

128

Source of cash:

Total sources of cash

Uses of cash (cash outflow cash disbursements):

Payments of accounts payable

65

60

55

50

Labor and administrative expenses

30

30

30

30

32.5

1.3

5.5

4.5

131.5

95.3

95

93

-45

-15

+26

+35

Capital expenditures
Taxes, interest, and dividends
Total uses of cash
Net cash inflow equals sources minus uses

The forecast net inflow of cash is shown on the bottom row of table. Note the large negative figure
For the first quarter forecast outflow.There is a substantial cash inflows in third and fourth quarters

CASH BUDGETING

Payments of accounts payable pay bills for raw materials, parts, electricity, and so on.
Delayed payment is called stretching payables. Stretching is one source of short-term
financing, but for most firms it is an expensive source, because by stretching they lose discounts
given to firms that pay promptly

The cash balance Managers establish a minimum operating cash balance to absorb unexpected
cash inflows and outflows

Short-term financing requirements (example)


Cash at start of period

-40

-55

-29

+ Net cash inflow

-45

-15

+26

+35

= Cash at end of period

-40

-55

-29

+6

Minimum operating cash balance

Cumulative short-term financing required (minimum cash


balance minus cash at end of period)

45

60

34

-1

Of course firms cannot hold a negative amount of cash - this line shows the amount of cash the
firm will have to raise to pay its bills