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 shortterm financial policy • Understand the essentials of short-term financial planning Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-2 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 ã A short-term financial plan Copyright â 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-3 Net working capital (NWC) review NWC + Fixed assets = L/T debt + Equity NWC = (Cash + Other current assets) – Current liabilities Cash = L/T debt + Equity + Current liabilities – Current assets other than cash – Fixed assets Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-4 Sources and uses of cash Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-5 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 = the time inventory sits on the shelf – Accounts receivable period = the time it takes to collect on receivables Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-6 Operating cycle equations • Operating cycle = Inventory period + Accounts receivable period • Inventory period = 365/Inventory turnover – Inventory turnover = Cost of goods sold/Average inventory • Accounts receivable period = 365/Receivables turnover – Average collection period – Accounts receivable turnover = Credit sales/Average accounts receivable Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-7 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 16-8 receivables Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Cash cycle equations • Cash cycle = Operating Cycle – Accounts payable period • Accounts payable period = 365/Payables turnover • Payables turnover = Cost of goods sold/Average accounts payable Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-9 The operating and cash cycles Figure 16.1 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-10 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 a16-19 seasonal basis Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Alternative asset financing policies Figure 16.4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-20 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; maintain a cash reserve for emergencies Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-21 A compromise financing policy Figure 16.5 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-22 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 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-23 Cash budget example Fun Toys Corporation • Expected sales by quarter (millions) Q1: $200; Q2: $300; Q3: $250; Q4: $400 • • • • • • Beginning accounts receivable = $120 Collections = Beginning receivables + ½ x Sales Accounts payable = 60% of sales Wages, taxes and other expenses = 20% of sales Interest and dividends = $20 million per quarter Major expansion planned for quarter costing $100 million • Beginning cash balance = $20 million with minimum cash balance of $10 million Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-24 Fun Toys Corporation Cash collections and cash disbursements Cash Collections Beginning Receivables Sales (m) Cash collections Ending Receivables Q1 $120 200 220 100 Q2 $100 300 250 150 Q3 $150 250 275 125 Q4 $125 400 325 200 Cash Disbursements Payment of Accounts (60% of sales) Wages, taxes, other expenses Capital expenditures Long-term financing expenses (Interest and dividends) Total Cash Disbursements Q1 $120 40 Q2 $180 60 100 Q3 $150 50 Q4 $240 80 20 $180 20 $360 20 $220 20 $340 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-25 Fun Toys Corporation Net cash flow and cash balance Net Cash Flow Toal Cash Collections Total Cash Disbursements Net Cash Flow Cash Balance Beginning Cash Balance Net Cash Flow Ending Cash Balance Minimum Cash Balance Cumulative Surplus (deficit) Q1 $220 180 $40 Q2 $250 360 ($110) Q3 $275 220 $55 Q4 $325 340 ($15) Q1 $20 40 $60 (10) $50 Q2 $60 (110) ($50) (10) ($60) Q3 ($50) 55 $5 (10) ($5) Q4 $5 (15) ($10) (10) ($20) Comments on Fun Toys cash budget •Beginning in Q2, Fun Toys will have a cash deficit which must be covered •Sales are forecasts and reality could be much better or worse Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-26 Short-term borrowing Unsecured loans • 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© 2011 a longer timePtybetween evaluations Copyright McGraw-Hill Australia Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-27 Short-term borrowing Secured loans • Secured loans—loan secured by receivables or inventory or both • Accounts receivable financing – Assigning receivables • Lender has A/R as security but borrower still responsible for collection – Factoring receivables • A/R discounted and sold to a factor • Collection = factor’s problem Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-28 Short-term borrowing Secured loans (cont.) • Inventory loans – Blanket inventory lien • Lender has lien against all inventories – Trust receipt • Borrower holds specific inventory in ‘trust’ for the lender • Auto dealer ‘floor plans’ – Field warehouse financing • Public warehouse acts as control agent to supervise inventory for lender Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-29 Fun Toys Corporation Short-term financial plan S/T Financial Plan Beginning Cash Balance Net Cash Flow Net short term borrowing Interest on S/T borrowing S/T Borrowing repaid Ending Cash Balance Minimum Cash Balance Cumulative Surplus (deficit) Beginning Short-term borrowing Change in short-term borrowing Ending short-term borrowing Q1 $20 40 0 $60 (10) $50 0 $0 Q2 $60 (110) 60 0 $10 (10) $0 60 $60 Q3 $10 55 (3) (52) $10 (10) $0 60 (52) $8 Q4 $10 (15) 15.4 (0.4) $10 (10) $0 15.4 $23.4 •Deficit covered with S/T borrowing at 20% APR calculated quarterly Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-30 Quick quiz • Suppose your average inventory is $10 000, your average receivables are $9000 and your average payables are $4000 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 shortterm 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 © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-31 Quick quiz—Solution Q1 Inventory turnover = 50 000 / 10 000 =5x Inventory period = 365 / = 73 days Receivables turnover = 100 000 / 9000 = 11.11x Average collection period = 365 / 11.11 = 33 days Payables turnover = 50 000 / 4000 = 12.5 x Payables period = 365 / 12.5 = 29 days Operating cycle = 73 + 33 = 106 days Cash Copyrightcycle © 2011 McGraw-Hill Australia Pty Ltd = 106 days – 29 days PPTs t/a Essentials of Corporate Finance 2e by Ross et al 16-32 Slides prepared by David E Allen and Abhay K Singh = 77 days Chapter 16 END 16-33 ... different types of shortterm financial policy • Understand the essentials of short-term financial planning Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e... PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 16-22 Cash budget • Primary tool in short-run financial planning – Identify short-term. .. 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