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Tracing Cash and New Working Capital

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					Chapter 16 Short-Term Financial Planning




                          Chapter Outline




  • Tracing Cash and Net Working Capital

  • The Operating Cycle and the Cash Cycle

  • Some Aspects of Short-Term Financial Policy

  • The Cash Budget

  • Short-Term Borrowing

  • A Short-Term Financial Plan
                Sources and Uses of Cash



• Sources of Cash                 • Uses of Cash

     – Obtaining financing:           – Paying creditors or
          • Increase in long-           stockholders
             term debt                     • Decrease in long-
          • Increase in equity               term debt
          • Increase in current            • Decrease in equity
             liabilities                   • Decrease in
     – Selling assets                        current liabilities
          • Decrease in               – Buying assets
             current assets                • Increase in current
          • Decrease in fixed                assets
             assets                        • Increase in fixed
                                             assets
                     The Operating Cycle



• The time it takes to receive inventory, sell it, and collect on the
  receivables generated from the sale of the inventory

• Operating cycle = inventory period + accounts receivable period
    – Inventory period = time inventory sits on the shelf
    – Accounts receivable period = time it takes to collect on
       receivables
                      The Cash Cycle



• The time between payment for inventory and receipt from the sale
  of inventory

• Cash cycle = operating cycle – accounts payable period
    – Accounts payable period = time between receipt of inventory
       and payment for it

• The cash cycle measures how long we need to finance inventory
  and receivables
Table 16.1
                     Example Information



Item             Beginning         Ending           Average

Inventory        200,000           300,000          250,000

Accounts         160,000           200,000          180,000
Receivable

Accounts         75,000            100,000          87,500
Payable

Net Sales = $1,150,000     Cost of Goods Sold = $820,000
                Example: Operating Cycle



• 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
                   Example: Cash Cycle



• Accounts Payable Period = 365 / payables turnover
    – Payables turnover = COGS / Average AP
         • PT = 820,000 / 87,500 = 9.4 times
    – Accounts payables period = 365 / 9.4 = 39 days



• Cash cycle = 168 – 39 = 129 days



• So, we have to finance our inventory and receivables for 129 days
               Short-Term Financial Policy



• Flexible (Conservative)         • Restrictive (Aggressive)
  Policy                            Policy
     – Large amounts of cash          – Low cash and
       and marketable                     marketable security
       securities                         balances
     – Large amounts of               – Low inventory levels
       inventory                      – Little or no credit sales
     – Liberal credit policies            (low accounts
       (large accounts                    receivable)
       receivable)                    – Relatively high levels
     – Relatively low levels of           of short-term liabilities
       short-term liabilities     • Low liquidity
• High liquidity
             Carrying versus Shortage Costs



• Carrying costs
    – Opportunity cost of owning current assets versus long-term
       assets that pay higher returns
    – Cost of storing larger amounts of inventory



• Shortage costs
    – Order costs – the cost of ordering additional inventory or
       transferring cash
    – Stock-out costs – the cost of lost sales due to lack of
       inventory, including lost customers
           Temporary versus Permanent Assets



• Are current assets temporary or permanent?
    – Both!

• Permanent current assets refer to the level of current assets that the
  company retains regardless of any seasonality in sales

• Temporary current assets refer to the additional current assets that
  are added when sales are expected to increase on a seasonal basis
Figure 16.4
                  Choosing the Best Policy



• Best policy will be a combination of flexible and restrictive
  policies

• Things to consider
    – Cash reserves
    – Maturity hedging
    – Relative interest rates

• Compromise policy – borrow short-term to meet peak needs, and
  maintain a cash reserve for emergencies
Figure 16.5
                         Cash Budget



• Primary tool in short-run financial planning
     – Identify short-term needs and potential opportunities
     – Identify when short-term financing may be required



• How it works
    – Identify sales and cash collections
    – Identify various cash outflows
    – Subtract outflows from inflows and determine investing and
      financing needs
           Example: Cash Budget Information



• Expected Sales by quarter (millions)
     Q1: $57; Q2: $66; Q3: $66; Q4: $90

• Beginning Accounts Receivable = $30

• Average collection period = 30 days

• Purchases from suppliers = 50% of next quarter’s estimated sales

• Accounts payable period = 45 days

• Wages, taxes, and other expenses = 25% of sales

• Interest and dividends = $5 million per quarter

• Major expansion planned for quarter 2 costing $35 million

• Beginning cash balance = $5 million with minimum cash balance
  of $2 million
                Example: Cash Budget – Cash Collections




                                 Q1       Q2       Q3     Q4


Beginning Receivables            30       19       22     22


Sales                            57       66       66     90


Cash Collections = Beg.          68       63       66     82
Receivables + 2/3(Sales)


Ending Receivables =             19       22       22     30
1/3(Sales)
           Example: Cash Budget – Cash Disbursements




                                    Q1      Q2      Q3      Q4

Payment of A/P = 50% of sales       28.50   33.00   33.00   45.00



Wages, taxes, other expenses        14.25   16.50   16.50   22.50



Capital Expenditures                        35.00



Long-term financing (interest and   5.00    5.00    5.00    5.00
dividends)


Total Disbursements                 47.75   89.50   54.50   72.50
                       Example:
     Cash Budget – Net Cash Flow and Cash Balance



                         Q1      Q2        Q3       Q4

Total Cash Collections   68.00   63.00     66.00    82.00

Total Cash               47.75   89.50     54.50    72.50
Disbursements
Net Cash Flow            20.25   (26.50)   11.50    9.5

Beginning Cash Balance   5.00    25.25     (1.25)   10.25

Net Cash Inflow          20.25   (26.50)   11.50    9.50

Ending Cash Balance      25.25   (1.25)    10.25    19.75

Minimum Cash Balance     -2.00   -2.00     -2.00    -2.00

Cumulative surplus       23.25   (3.25)    8.25     17.75
(deficit)
                  Short-Term Borrowing


• Unsecured loans
    – Line of credit – prearranged agreement with a bank that
       allows the firm to borrow up to a certain amount on a short-
       term basis

     – Committed – formal legal arrangement that may require a
       commitment fee and generally has a floating interest rate

     – Non-committed – informal agreement with a bank that is
       similar to credit card debt for individuals

     – Revolving credit – non-committed agreement with a longer
       time between evaluations



• Secured loans – loan secured by receivables, inventory, or both
                     Example: Factoring



• Selling receivables to someone else at a discount

• Example: You have an average of $1 million in receivables and
  you borrow money by factoring receivables with a discount of
  2.5%. The receivables turnover is 12 times per year.

• What is the APR?
   – Period rate = .025/.975 = 2.564%
   – APR = 12(2.564%) = 30.769%

• What is the effective rate?
   – EAR = 1.02564 12 – 1 = 35.502%
                   Short-Term Financial Plan


                               Q1      Q2        Q3      Q4

Beginning Cash                 5.00    25.25     2.00    10.05

Net Cash Inflow                20.25   (26.50)   11.50   9.50

New Short-Term Debt            0.00    3.25      0.00    0.00

Interest on Short-Term Debt    0.00    0.00      0.20    0.00

Short-Term Debt Repayment      0.00    0.00      3.25    0.00

Ending Cash Balance            25.25   2.00      10.05   19.55

Minimum Cash Balance           -2.00   -2.00     -2.00   -2.00

Cumulative Surplus (Deficit)   23.25   0.00      8.05    17.55

Beginning Short-Term Debt      0.00    000       3.25    0.00

Change in Short-Term Debt      0.00    3.25      -3.25   0.00

Ending Short-Term Debt         0.00    3.25      0.00    0.00

				
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