Chapter 16 introduces you to short-term financial planning. After completing this unit, you should be able to: Be able to compute the operating and cash cycles and understand why they are important, understand the different types of short-term financial policy, understand the essentials of short-term financial planning.
Short-Term Financial Planning Chapter 16 Key Concepts and Skills • Be able to compute the operating and cash cycles and understand why they are important • Understand the different types of short-term financial policy • Understand the essentials of short-term financial planning Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư2 Chapter Outline ã 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 Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư3 Sources and Uses of Cash ã Sources of Cash – Obtaining financing – • Uses of Cash – Increase in long-term debt Increase in equity Increase in current liabilities Paying creditors or shareholders Selling assets Decrease in current assets Decrease in fixed assets – Decrease in long-term debt Decrease in equity Decrease in current liabilities Buying assets Increase in current assets Increase in fixed assets Copyright ª 2007 McGrawHill Australia Pty Ltd 164 The Operating Cycle • The time it takes to receive inventory, sell it and collect on the receivables generated from the sale • 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 Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư5 The Cash Cycle ã 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 Copyright ª 2007 McGrawHill Australia Pty Ltd 166 Table 16.1 Managers who deal with Short Term Financial Problems Copyright ª 2007 McGrawHill Australia Pty Ltd 167 Example Information Item Beginning Ending Average Inventory 200,000 300,000 250,000 Accounts Receivable 160,000 200,000 180,000 75,000 100,000 87,500 Accounts Payable Net Sales = $1,150,000 Cost of Goods Sold = $820,000 Copyright ª 2007 McGrawHill Australia Pty Ltd 168 Example – Operating Cycle • Inventory Period = 365/Inventory Turnover – Inventory Turnover = COGS/Average inventory IT = 820,000 / 250,000 = 3.28 times Inventory Period = 365 / 3.28 = 111 days Accounts Receivable Period = 365/Receivables Turnover – Receivables Turnover = Credit Sales/Average AR – • RT = 1,150,000 / 180,000 = 6.4 times Receivables Period = 365 / 6.4 = 57 days Operating cycle = 111 + 57 = 168 days ã Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư9 Example Cash Cycle • Accounts Payables 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 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 10 Short-Term Financial Policy • Flexible (Conservative) Policy – – – – • • Large amounts of cash and marketable securities Large amounts of inventory Liberal credit policies (large accounts receivable) Relatively low levels of short-term liabilities High liquidity Restrictive (Aggressive) Policy – – – – • Low cash and marketable security balances Low inventory levels Little or no credit sales (low accounts receivable) Relatively high levels of short-term liabilities Low liquidity Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư 11 Carrying vs Shortage Costs ã Carrying costs – – Opportunity cost of owning current assets versus longterm 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 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 12 Temporary vs 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 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 13 Figure 16.4 Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư 14 Choosing the Best Policy ã 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, maintain a cash reserve for emergencies Copyright ª 2007 McGrawHill Australia Pty Ltd 16ư 15 Figure 16.5 Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư 16 Cash Budget ã 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 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 17 Example: Cash Budget Information • Expected Sales for 2000 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 costing $35 million Beginning cash balance = $5 million with minimum cash balance of $2 million Copyright ª 2007 McGrawHill Australia Pty Ltd 16 18 Example: Cash Budget – Cash Collections Q1 Q2 Q3 Q4 Beginning Receivables 30 19 22 22 Sales 57 66 66 90 Cash Collections = Beg Receivables + 2/3(Sales) 68 63 66 82 Ending Receivables = 1/3(Sales) 19 22 22 30 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 19 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 Long-term financing (interest and dividends) Total Disbursements 35.00 5.00 5.00 5.00 5.00 47.75 89.50 54.50 72.50 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 20 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 Disbursements 47.75 89.50 54.50 72.50 Net Cash Flow 20.25 (26.50) 11.50 9.50 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 (deficit) 23.25 (3.25) 8.25 17.75 Beginning Cash Balance Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư 21 Short-Term Borrowing ã ã 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 or inventory or both Copyrightê2007McGrawưHillAustraliaPtyLtd 16ư 22 Example: Factoring ã • • • 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 = 1.0256412 – = 35.502% Copyright ª 2007 McGrawHill Australia Pty Ltd 16 23 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 Copyright ª 2007 McGrawHill Australia Pty Ltd 16 24 Quick Quiz • • • • Suppose your average inventory is $10,000, your average receivables are $9,000 and your average payables are $4,000 Net sales are $100,000 and cost of goods sold is $50,000 – What is the operating cycle and the cash cycle? What are the differences between flexible and restrictive short-term financial policies? What factors we need to consider when choosing a financial policy? What factors go into determining a cash budget and why is it valuable? Copyright ª 2007 McGrawHill Australia Pty Ltd 16 25 ... Understand the different types of short-term financial policy • Understand the essentials of short-term financial planning Copyright ª 2007 McGrawHill Australia Pty Ltd 162 Chapter Outline • Tracing... Some Aspects of Short-Term Financial Policy • The Cash Budget • Short-Term Borrowing • A Short-Term Financial Plan Copyright ª 2007 McGrawHill Australia Pty Ltd 163 Sources and Uses of Cash •... Copyright ª 2007 McGrawHill Australia Pty Ltd 16 16 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