Chapter 26

Short-Term Finance and Planning

 Understand the components of the cash cycle and
why it is important
 Understand the pros and cons of the various short-
term financing policies
 Be able to prepare a cash budget
 Understand the various options for short-term
financing

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26-2
26.1 Tracing Cash and Net Working Capital
26.2 The Operating Cycle and the Cash Cycle
26.3 Some Aspects of Short-Term Financial Policy
26.4 Cash Budgeting
26.5 The Short-Term Financial Plan

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26-3
 Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How much short-

Fixed Assets
term cash flow
1. Tangible does a company
need to pay its Shareholders’
2. Intangible bills? Equity

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26-4
 Current Assets are cash and other assets that are
expected to be converted to cash within the year.
◦ Cash
◦ Marketable securities
◦ Accounts receivable
◦ Inventory
 Current Liabilities are obligations that are expected to
require cash payment within the year.
◦ Accounts payable
◦ Accrued wages
◦ Taxes

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26-5
 Long-
Net Working Fixed
+ = Term + Equity
Capital Assets
Debt

Other
Net Working Current
= Cash + Current –
Capital Liabilities
Assets

Long- Net Working

Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash)
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26-6
 Long- Net Working
Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash)

 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.

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26-7
Raw material
Cash
purchased Finished goods sold
received
Order Stock
Placed Arrives

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating cycle

Cash cycle 26-8

 Accounts
Cash cycle = Operating cycle – payable
period

 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, respectively.

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26-9
 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
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26-10
 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 = 111.3 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 = 57.1 days
 Operating cycle = 111.3 + 57.1 = 168.4 days

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26-11
 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 = 38.9 days
 Cash Cycle = 168.4 – 38.9 = 129.5 days
 We have to finance our inventory for 129.5 days.
 If we want to reduce our financing needs, we need to
look carefully at our receivables and inventory
periods – they both seem excessive.

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26-12
 Consider the following financial statement information for the
Rivers Corporation:

Item Beginning Ending

Inventory 17,385 19,108
Accounts Receivables 13,182 13,973
Accounts Payable 15,385 16,676
Net Sales 216,384
Cost of goods sold 165,763

 Calculate the operating and cash cycles. How do you interpret

your answer?

26-13
 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

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26-14
 A flexible 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 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)

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26-15
$ Total costs of holding current
Minimum
assets.
point
Carrying costs

Shortage costs

CA* Investment in
Current Assets ($)

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26-16
 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.

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26-17
Chapter 27
Cash Management
 Speculative motive – hold cash to take advantage of unexpected
opportunities
 Precautionary motive – hold cash in case of emergencies
 Transaction motive – hold cash to pay the day-to-day bills
 Trade-off between opportunity cost of holding cash relative to the
transaction cost of converting marketable securities to cash for transactions

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26-19
 Money market – financial instruments with an original maturity of
one year or less
 Temporary Cash Surpluses

◦ Seasonal or cyclical activities – buy marketable securities with seasonal

surpluses, convert securities back to cash when deficits occur
◦ Planned or possible expenditures – accumulate marketable securities in
anticipation of upcoming expenses

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26-21
 Maturity – firms often limit the maturity of short-term investments to
90 days to avoid loss of principal due to changing interest rates
 Default risk – avoid investing in marketable securities with significant

default risk
 Marketability – ease of converting to cash
 Taxability – consider different tax characteristics when making a

decision

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26-22
 The Litzenberger company has projected the following quarterly
sales amounts for the coming year:

Q1 Q2 Q3 Q4
Sales $740 $840 $910 $970

 Accounts receivable at the beginning of the year are $335. The

company has a 45-day collection period. Calculate cash collections
in each of the four quarter by completing the following:

Q1 Q2 Q3 Q4
Beginning Receivables
Sales
Cash Collections
Ending Receivables 26-23
Receivables Management

26-24
 Granting credit generally increases sales
 Costs of granting credit

◦ Chance that customers will not pay

◦ Financing receivables
 Credit management examines the trade-off between
increased sales and the costs of granting credit

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28-25 26-25
 Terms of sale
◦ Credit period
◦ Cash discount and discount period
◦ Type of credit instrument
 Credit analysis – distinguishing between “good”
customers that will pay and “bad” customers that will
default
 Collection policy – effort expended on collecting

receivables

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28-26 26-26
 Basic Form: 2/10 net 45
◦ 2% discount if paid in 10 days
◦ Total amount due in 45 days if discount not taken
 Buy $500 worth of merchandise with the credit terms
given above
◦ Pay $500(1 - .02) = $490 if you pay in 10 days
◦ Pay $500 if you pay in 45 days

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28-27 26-27
 Revenue Effects
◦ Delay in receiving cash from sales
◦ May be able to increase price
◦ May increase total sales
 Cost Effects
◦ Cost of the sale is still incurred even though the cash from the sale has not been
received
◦ Cost of debt – must finance receivables
◦ Probability of nonpayment – some percentage of customers will not pay for
products purchased
◦ Cash discount – some customers will pay early and pay less than the full sales
price

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28-28 26-28
 Your company is evaluating a switch from a cash
only policy to a net 30 policy. The price per unit is
$100, and the variable cost per unit is $40. The
company currently sells 1,000 units per month. Under
the proposed policy, the company expects to sell
1,050 units per month. The required monthly return is
1.5%.
 What is the NPV of the switch?
 Should the company offer credit terms of net 30?

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28-29 26-29
 Incremental cash inflow
◦ (100 – 40)(1,050 – 1,000) = 3,000
 Present value of incremental cash inflow
◦ 3,000/.015 = 200,000
 Cost of switching
◦ 100(1,000) + 40(1,050 – 1,000) = 102,000
 NPV of switching
◦ 200,000 – 102,000 = 98,000
 Yes, the company should switch

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28-30 26-30
 Carrying costs
◦ Required return on receivables
◦ Losses from bad debts
◦ Costs of managing credit and collections
 Shortage costs
◦ Lost sales due to a restrictive credit policy
 Total cost curve
◦ Sum of carrying costs and shortage costs
◦ Optimal credit policy is where the total cost curve is
minimized

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28-31 26-31
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 Process of deciding which customers receive credit
 Gathering information
 Determining Creditworthiness
◦ 5 Cs of Credit
◦ Credit Scoring

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28-33 26-33
 Financial statements
 Credit reports with customer’s payment history to

other firms
 Banks
 Payment history with the company

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28-34 26-34
 Character – willingness to meet financial obligations
 Capacity – ability to meet financial obligations out of

operating cash flows

 Capital – financial reserves
 Collateral – assets pledged as security
 Conditions – general economic conditions related to

customer’s business

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28-35 26-35
Chapter 28
Inventory Management
 Inventory can be a large percentage of a firm’s assets
 There can be significant costs associated with carrying too
much inventory
 There can also be significant costs associated with not carrying
enough inventory
 Inventory management tries to find the optimal trade-off
between carrying too much inventory versus not enough

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28-37 26-37
 Manufacturing firm
◦ Raw material – starting point in production process
◦ Work-in-progress
◦ Finished goods – products ready to ship or sell
 Remember that one firm’s “raw material” may be another firm’s

“finished goods”

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28-38 26-38
 Carrying costs – range from 20 – 40% of inventory value per
year
◦ Storage and tracking
◦ Insurance and taxes
◦ Losses due to obsolescence, deterioration, or theft
◦ Opportunity cost of capital
 Shortage costs
◦ Restocking costs
◦ Lost sales or lost customers
 Consider both types of costs, and minimize the total cost

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28-39 26-39
 Classify inventory by cost, demand, and need
 Those items that have substantial shortage costs should be
maintained in larger quantities than those with lower shortage
costs
 Generally maintain smaller quantities of expensive items
 Maintain a substantial supply of less expensive basic materials

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28-40 26-40
 Economic order quantity (EOQ) is the ideal order quantity a
company should purchase to minimize inventory costs such as
holding costs, shortage costs, and order costs.
 The formula assumes that demand, ordering, and holding costs

all remain constant.

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28-41 26-41
 The goal of the EOQ formula is to identify the optimal number of product
units to order. If achieved, a company can minimize its costs for buying,
delivery, and storing units.

 EOQ is an important cash flow tool. The formula can help a company
control the amount of cash tied up in the inventory balance.

 For many companies, inventory is its largest asset other than its human
resources, and these businesses must carry sufficient inventory to meet the
needs of customers.

 If EOQ can help minimize the level of inventory, the cash savings can be
used for some other business purpose or investment.
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 The EOQ model minimizes the total inventory cost
 Total carrying cost = (average inventory) x (carrying

cost per unit) = (Q/2)(CC)

 Total restocking cost = (fixed cost per order) x

(number of orders) = F(T/Q)

 Total Cost = Total carrying cost + total restocking

cost = (Q/2)(CC) + F(T/Q)

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28-44 26-44
 Consider an inventory item that has carrying cost =
$1.50 per unit. The fixed order cost is $50 per order,
and the firm sells 100,000 units per year.
◦ What is the economic order quantity?

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28-45 26-45
 Safety stocks
◦ Minimum level of inventory kept on hand
◦ Increases carrying costs
 Reorder points
◦ At what inventory level should you place an order?
◦ Need to account for delivery time
 Derived-Demand Inventories
◦ Materials Requirements Planning (MRP)
◦ Just-in-Time Inventory

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28-46 26-46