Chapter 6 Short Term Finance and Planning.pptx

Short term Finance

1. Short-Term Finance and Planning Chapter 6

2. Chapter Outline 6.1 Tracing Cash and Net Working Capital 6.2 The Operating Cycle and the Cash Cycle 6.3 Some Aspects of Short-Term Financial Policy 6.4 The Cash Budget 6.5 Short-Term Borrowing

3. Balance Sheet Model of the Firm How much short-term cash flow does a company need to pay its bills? Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

4. 6.1 Tracing Cash and Net Working Capital Current Assets are cash and other assets that are expected to be converted in to cash within a year. Cash Marketable securities Accounts receivable Inventory Cash Equivalent(e.g bank ertificate of deposit, treasury bill, commercial paper, bankers acceptance and other money market instruments) Pre-paid liablity(e.g prepaid bill, rent, salary, insurance premium)

5. Continued... Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payable Accrued wages Taxes (payroll tax, income tax) Short term note payable Interest payable Other Short term Debts.

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

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

8. Activities That Increase Cash Increasing long-term debt (borrowing over the long term). Increasing equity (selling some stock). Increasing current liabilities (getting a 90-day loan). Decreasing current assets other than cash (selling some inventory for cash). Decreasing fixed assets (selling some property). Activities That Decrease Cash Decreasing long-term debt (paying off a long-term debt). Decreasing equity (repurchasing some stock). Decreasing current liabilities (paying off a 90-day loan). Increasing current assets other than cash (buying some inventory for cash). Increasing fixed assets (buying some property).

9. Activities that increase cash are called sources of cash . Those activities that decrease cash are called uses of cash. Example : If accounts payable go up by $100, is this a source or a use? If accounts receivable go up by $100, is this a source or a use? Accounts payable are what we owe our suppliers. This is a short-term debt. If it rises by $100, we have effectively borrowed the money, so this is a source of cash . Receivables are what our customers owe to us, so an increase of $100 in accounts receivable means that we have loaned the money; this is a use of cash .

10. 6.2 The Operating Cycle and the Cash Cycle Time Accounts payable period Cash cycle Operating cycle Cash received Accounts receivable period Inventory period Finished goods sold Firm receives invoice Cash paid for materials Order Placed Stock Arrives Raw material purchased

11. The Operating Cycle and the Cash Cycle 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. Cash cycle = Operating cycle – Accounts payable period

12. 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

13. 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 = 112 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 = 112 + 57 = 169 days

14. 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 = 169 – 39 = 130 days We have to finance our inventory for 130 days. If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem excessive.

15. 6.3 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

16. Size of Investment in Current Assets A flexible (Conservative) 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 (Aggressive) 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)

17. Carrying vs. Shortage Costs Managing short-term assets involves a trade-off between carrying costs and shortage costs Carrying costs – increase with increased levels of current assets, the costs to store and finance the assets Shortage costs – decrease with increased levels of current assets Trading or order costs Costs related to safety reserves, i.e., lost sales and customers, and production stoppages 18-

18. Carrying Costs and Shortage Costs $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA * Minimum point

19. Appropriate Flexible Policy $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA * Minimum point

20. Appropriate Restrictive Policy $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA * Minimum point

21. Alternative Financing Policies A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing. A restrictive short-term finance policy means a high proportion of short-term debt relative to long-term financing. In an ideal world, short-term assets are always financed with short-term debt, and long-term assets are always financed with long-term debt. In this world, net working capital is zero.

22. Temporary vs. Permanent Assets Temporary current assets Sales or required inventory build-up may be seasonal Additional current assets are needed during the “peak” time The level of current assets will decrease as sales occur Permanent current assets Firms generally need to carry a minimum level of current assets at all times These assets are considered “permanent” because the level is constant, not because the assets aren’t sold 18-

23. Figure 18.4 Total Asset Requirement Over Time 18- Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

24. Choosing the Best Policy Cash reserves High cash reserves mean that firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunities Cash and marketable securities earn a lower return and are zero NPV investments Maturity hedging Try to match financing maturities with asset maturities Finance temporary current assets with short-term debt Finance permanent current assets and fixed assets with long-term debt and equity Interest Rates Short-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debt Firms can get into trouble if rates increase quickly or if it begins to have difficulty making payments – may not be able to refinance the short-term loans Have to consider all these factors and determine a compromise policy that fits the needs of the firm 18-

25. Figure 18.6 A Compromise Financing Policy 18-

26. 6.4 The Cash Budget A cash budget is a primary tool of short-run financial planning. The idea is simple: Record the estimates of cash receipts and disbursements. Cash Receipts Arise from sales, but we need to estimate when we actually collect Cash Outflow Payments of Accounts Payable Wages, Taxes, and other Expenses Capital Expenditures Long-Term Financial Planning

27. Example Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales Sales estimates (in millions) Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550 Accounts receivable Beginning receivables = $250 Average collection period = 30 days Accounts payable Purchases = 50% of next quarter’s sales Beginning payables = 125 Accounts payable period is 45 days Other expenses Wages, taxes and other expense are 30% of sales Interest and dividend payments are $50 A major capital expenditure of $200 is expected in the second quarter The initial cash balance is $80 and the company maintains a minimum balance of $50

28. Example ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made, and the remaining 1/3 are collected the following quarter. Beginning receivables of $250 will be collected in the first quarter. Q1 Q2 Q3 Q4 Beginning Receivables 250 167 200 217 Sales 500 600 650 800 Cash Collections 583 567 633 750 Ending Receivables 167 200 217 267

29. Example Payables period is 45 days, so half of the purchases will be paid for each quarter, and the remaining will be paid the following quarter. Beginning payables = $125 Q1 Q2 Q3 Q4 Payment of accounts 275 313 362 338 Wages, taxes and other expenses 150 180 195 240 Capital expenditures 200 Interest and dividend payments 50 50 50 50 Total cash disbursements 475 743 607 628

30. Example Q1 Q2 Q3 Q4 Total cash collections 583 567 633 750 Total cash disbursements 475 743 607 628 Net cash inflow 108 -176 26 122 Beginning Cash Balance 80 188 12 38 Net cash inflow 108 -176 26 122 Ending cash balance 188 12 38 160 Minimum cash balance -50 -50 -50 -50 Cumulative surplus (deficit) 138 -39 -12 110

31. 6.5 Short-Term Borrowing Unsecured Loans Line of credit Committed vs. noncommitted Revolving credit arrangement Letter of credit Secured Loans Accounts receivable financing Assigning Factoring Purchase order (PO) financing A popular form of factoring used by small/midsized companies Inventory loans Blanket inventory lien Trust receipt Field warehouse financing Commercial Paper Trade Credit 18-

32. Example: Compensating Balance We have a $500,000 line of credit with a 15% compensating balance requirement. The quoted interest rate is 9%. We need to borrow $150,000 for inventory for one year. How much do we need to borrow? 150,000 / (1 – 0.15) = 176,471 What interest rate are we effectively paying? Interest paid = 176,471 (.09) = 15,882 Effective rate = 15,882 / 150,000 = 0.1059 or 10.59%

33. Example: Factoring Last year your company had average accounts receivable of $2 million. Credit sales were $24 million. You factor receivables by discounting them 2%. What is the effective rate of interest? Receivables turnover = 24 / 2 = 12 times APR = 12(.02/.98) = 0.2449 or 24.49% EAR = (1+.02/.98) 12 – 1 = 0.2743 or 27.43% 18-

34. The of Chapter 6