Chapter 18 – Short-Term Finance and Planning
Chapter 18
SHORT-TERM FINANCE AND PLANNING
CHAPTER WEB SITES
Section Web Address
18.1 www.treasury-management.com
18.4 www.toolkit.com
18.5 www.receivablesxchange.com
CHAPTER ORGANIZATION
18.1 Tracing Cash and Net Working Capital
18.2 The Operating Cycle and the Cash Cycle
Defining the Operating and Cash Cycles
The Operating Cycle and the Firm’s Organizational Chart
Calculating the Operating and Cash Cycles
Interpreting the Cash Cycle
18.3 Some Aspects of Short-Term Financial Policy
The Size of the Firm’s Investment in Current Assets
Alternative Financing Policies for Current Assets
Which Financing Policy is Best?
Current Assets and Liabilities in Practice
18.4 The Cash Budget
Sales and Cash Collections
Cash Outflows
The Cash Balance
18.5 Short-Term Borrowing
Unsecured Loans
Secured Loans
Other Sources
18.6 A Short-Term Financial Plan
18.7 Summary and Conclusions
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Chapter 18 – Short-Term Finance and Planning
ANNOTATED CHAPTER OUTLINE
Lecture Tip: For some reason, many students (and some faculty)
view short-term finance generally, and working capital
management specifically, as less important than capital budgeting
or the risk-return relationship. You may find it useful to emphasize
the importance of short-term finance in introducing the current
chapter.
First, discussions with CFOs quickly lead to the conclusion that,
as important as capital budgeting and capital structure decisions
are, they are made less frequently, while the day-to-day
complexities involving the management of net working capital
(especially cash and inventory) consume tremendous amounts of
management time. Second, it is clear that while poor long-term
investment and financing decisions will adversely impact firm
value, poor short-term financial decisions will impair the firm’s
ability to continue operating. Finally, good working capital
decisions can also have a major impact on firm value.
18.1 Tracing Cash and Net Working Capital
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
Substituting NWC into the first equation and rearranging;
Cash = Long-term debt + Equity + Current Liabilities – Other
current assets – Fixed assets
Sources of Cash (Activities that increase cash)
Increase in long-term debt account (borrowed money)
Increase in equity accounts (sold stock)
Increase in current liability accounts (borrowed money)
Decrease in current asset accounts, other than cash (sold
current assets)
Decrease in fixed assets (sold fixed assets)
Uses of Cash (Activities that decrease cash)
Decrease in long-term debt account (repaid loans)
Decrease in equity accounts (repurchased stock or paid
dividends)
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Chapter 18 – Short-Term Finance and Planning
Decrease in current liability accounts (repaid suppliers or short-
term creditors)
Increase in current asset accounts, other than cash (purchased
current assets)
Increase in fixed assets (purchased fixed assets)
Lecture Tip: Concept question 18.1b asks students to consider
whether net working capital always increases when cash
increases. The best way to illustrate why the answer to this is “no”
is to work an example: Suppose a firm currently has $50,000 in
current assets and $20,000 in current liabilities; so NWC =
$50,000 – 20,000 = 30,000. Management decides to borrow
$10,000 using long-term debt. What happens to cash and NWC?
Cash increases by $10,000 and NWC = (50,000 + 10,000) –
20,000 = 40,000. So, both cash and NWC increase by 10,000.
Suppose, on the other hand, management borrowed the $10,000
from a bank as a short-term loan. Cash still increases by $10,000,
but net working capital doesn’t change ( NWC = (50,000 +
10,000) – (20,000 + 10,000) = 30,000). The effect of an increase
in cash on NWC depends on where the increase comes from; if the
increase comes from a change in long-term liabilities, equity or
fixed assets, then there will be an increase in NWC. On the other
hand, if the increase comes from a change in current liabilities or
current assets, then there will be no impact on NWC.
18.2 The Operating Cycle and the Cash Cycle
A. Defining the Operating and Cash Cycles
The operating cycle is the average time required to acquire
inventory, sell it, and collect for it.
Operating cycle = inventory period + accounts receivable
period
The inventory period is the time to acquire and sell inventory.
Inventory turnover = Cost of goods sold / average inventory
Inventory period = 365 / inventory turnover
The accounts receivable period (average collection period) is
the time to collect on the sale.
Receivables turnover = credit sales / average receivables
Accounts receivable period = 365 / receivables turnover
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Chapter 18 – Short-Term Finance and Planning
The cash cycle is the average time between cash disbursement for
purchases and cash received from collections.
Cash cycle = operating cycle – accounts payable period
The accounts payable period is the time between receipt of
inventory and payment for it.
Payables turnover = Cost of goods sold / average payables
Payables period = 365 / payables turnover
Lecture Tip: Students should recognize that a company would
prefer to take as long as possible before paying bills. You might
mention that accounts payable is often viewed as “free credit;”
however, the cost of granting credit is built into the cost of the
product. Note that the operating cycle begins when inventory is
purchased and the cash cycle begins with the payment of accounts
payable.
B. The Operating Cycle and the Firm’s Organizational Chart
Short-term financial management in a large firm involves
coordination between the credit manager, the marketing manager,
and the controller. Potential for conflict may exist if particular
managers concentrate on individual objectives as opposed to
overall firm objectives.
C. Calculating the Operating and Cash Cycles
Lecture Tip: In this chapter, we use average values of inventory,
accounts receivable, and accounts payable to compute values of
inventory turnover, accounts receivable turnover and accounts
payable turnover, respectively. Remind students that the balance
sheet represents a financial “snapshot” of the firm and, as such,
balance sheet values literally change on a daily basis. One way to
reduce the distortions caused by dividing a “flow” value (income
statement numbers that represent what has happened over a period
of time) by a “snapshot” value is to use the average “snapshot”
value computed over the same period.
Consider this example (similar to the one in the book):
Item Beginning Ending Average
Inventory 200,000 300,000 250,000
Accounts
Receivable
160,000 200,000 180,000
Accounts Payable 75,000 100,000 87,500
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Chapter 18 – Short-Term Finance and Planning
Net sales = 1,150,000; COGS = $820,000
Finding inventory period:
Inventory turnover = 820,000 / 250,000 = 3.28 times
Inventory period = 365 / 3.28 = 111 days
Finding accounts receivables period:
Receivables turnover = 1,150,000 / 180,000 = 6.39 times
Accounts receivables period = 365 / 6.39 = 57 days
Operating cycle = 111 + 57 = 168 days
Finding accounts payables period:
Payables turnover = 820,000 / 87,500 = 9.37 times
Accounts payables period = 365 / 9.37 = 39 days
Cash cycle = 168 – 39 = 129 days
D. Interpreting the Cash Cycle
A positive cash cycle means that inventory is paid for before it is
sold and the cash from the sale is collected. In this situation, a firm
must finance the current assets until the cash is collected. The next
section addresses the issue of how to finance the cash cycle.
Lecture Tip: It may be beneficial to have students consider the
interactions imbedded in the cash cycle. For example, students
may feel that the main demand on funds, for example, comes from
the inventory period. However, the students should consider the
interactions involved when trying to speed up the inventory
turnover. Increasing inventory turnover may involve relaxing
credit terms, which will result in a lower receivables turnover. The
ultimate effect will depend on the trade-off between the two and
the cash flows that are generated.
Real-World Tip: This discussion suggests that, depending on
inventory needs and financing costs, some firms will find it useful
to hire others to “store inventory” for them. In fact,
Boeing/McDonnell-Douglas Aircraft in St. Louis does exactly that
– small firms are paid to guarantee the delivery of raw materials
(copper, sheet steel, etc.) to the firm at a moment’s notice. And
while these firms also do some preliminary cutting and machining,
their primary role is to hold inventory that Boeing/McDonnell-
Douglas would otherwise have to hold. As a result, the firm’s
financing needs are lessened.
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Chapter 18 – Short-Term Finance and Planning
The relationship between inventory turnover and financing
needs is also apparent in industries with extremely long or short cash cycles. For
example, cash cycles are relatively long in the jewelry retailing industry, and
particularly short in the grocery industry.
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