Chapter 18 – Short-Term Finance and Planning
18.3 Some Aspects of Short-Term Financial Policy
A. The Size of the Firm’s Investment in Current Assets
If cash was collected from sales when the bills had to be paid, then
cash balances and net working capital could be zero. The greater
the mismatch between collections and payment, and the
uncertainty surrounding collections, the greater the need to
maintain some cash balances and to have positive net working
capital.
Flexible (conservative) policy – high levels of current assets
relative to sales, relatively more long-term financing
-Keep large cash and securities balances (lower return, but cash
available for emergencies and unexpected opportunities)
-Keep large amounts of inventory (higher carrying costs, but
lower shortage costs including lost customers due to stock-
outs)
-Liberal credit terms, resulting in large receivables (greater
probability of default from customers and usually a longer
receivables period, but leading to an increase in sales)
Restrictive (aggressive) policy – low levels of current assets
relative to sales, relatively more short-term financing
-Keep low cash and securities balances (may be short of cash
in emergencies or unable to take advantage of unexpected
opportunities, but higher return on long-term assets)
-Keep low levels of inventory (high shortage costs, particularly
bad in industries where there are plenty of close substitutes that
customers can turn to, lower carrying costs)
-Strict credit policies, or no credit sales (may substantially cut
sales level, reduce cash cycle, and need for financing)
Carrying costs – costs that increase with investment in current
assets
-Opportunity cost of investing in (and financing) low-yield
assets
-Cost associated with storing inventory
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Chapter 18 – Short-Term Finance and Planning
Shortage costs – costs that decrease with investment in current
assets
-Trading and order costs – commissions, set-up, and paperwork
-Stock-out costs – lost sales, business disruptions, and alienated
customers
Lecture Tip: The just-in-time inventory system is designed to
reduce the inventory period. In essence, companies pay their
suppliers to carry the inventory for them. Reducing the inventory
period reduces the operating cycle and thus the cash cycle. This
reduces the need for financing. Ask the students to consider what
type of cost is being minimized and what costs are likely to
increase. Ask them if JIT inventory policies are appropriate for all
industries. It makes sense for industries that have substantial
carrying costs with relatively low shortage costs, but not for
industries where shortage costs outweigh carrying costs.
B. Alternative Financing Policies for Current Assets
Ideally, we could always finance short-term assets with short-term
debt and long-term assets with long-term debt and equity.
However, this is not always feasible.
Lecture Tip: Some students tend to think permanent assets consist
only of fixed assets. Emphasize that a certain level of current
assets is also “permanent.” Consider the following example:
Januar
y
Februar
y
March April
Current Assets 20,000 30,000 20,000 20,000
Fixed Assets 50,000 50,000 50,000 50,000
Permanent
Assets
70,000 70,000 70,00
0
70,00
0
Temporary Assets 0 10,000 0 0
Ask students to consider what the levels of permanent assets and
temporary assets are for each month.
A flexible policy would finance $80,000 with long-term debt and
have excess cash of $10,000 to invest in marketable securities in
January, March, and April. Overall, the interest expense on the
extra $10,000 borrowed long-term will outweigh the interest
received from the marketable securities.
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Chapter 18 – Short-Term Finance and Planning
A restrictive policy would finance $70,000 with long-term debt. In
February, the firm would borrow $10,000 on a short-term basis to
cover the cost of temporary assets in that month. The short-term
loan would be repaid in March.
C. Which Financing Policy is Best?
Things to consider:
1. Cash reserves – more important when a firm has unexpected
opportunities on a regular basis or where financial distress is a
strong possibility
2. Maturity hedging – match liabilities to assets as closely as
possible, avoid financing long-term assets with short-term
liabilities (risky due to possibility of increase in rates and the risk
of not being able to refinance)
3. Relative interest rates – short-term rates are usually, but not
always, lower; they are almost always more volatile
Lecture Tip: Personal financial situations provide ample examples
of maturity matching. We tend to use 30-year loans when we buy
houses and 4 –5 year loans for cars. Why wouldn’t we finance
these assets with short-term loans? What if you borrowed
$200,000 to buy a house using a 1-year note? In one year, you
either have to pay off the loan with cash or refinance. If you
refinance, you have the transaction costs associated with obtaining
a new loan and the possibility that rates increased substantially
during the year. Adjustable loans adjust annually, the initial rate is
generally lower than a fixed rate loan, and there are limits to how
much the loan rate can increase in any given year and over the life
of the loan. Also, there are no transaction costs associated with the
rate adjustment on an ARM.
D. Current Assets and Liabilities in Practice
The level of current assets and current liabilities depends largely
on the industry involved. The same is true for the cash cycle.
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Chapter 18 – Short-Term Finance and Planning
18.4 The Cash Budget
A. Sales and Cash Collections
Cash budget – a schedule of projected cash receipts and
disbursements
A cash budget requires sales forecasts for a series of periods. The
other cash flows in the cash budget are generally based on the sales
estimates. We also need to know the average collection period on
receivables to determine when the cash inflow from sales actually
occurs.
B. Cash Outflows
Common cash outflows:
-Accounts payable – what is the accounts payables period?
-Wages, taxes and other expenses – usually expressed as a percent
of sales (implies that they are variable costs)
-Fixed expenses, when applicable
-Capital expenditures – determined by the capital budget
-Long-term financing expenses – interest expense, dividends,
sinking fund payments, etc.
-Short-term borrowing – determined based on the other
information
C. The Cash Balance
Net cash inflow is the difference between cash collections and cash
disbursements
18.5 Short-Term Borrowing
A. Unsecured Loans
Line of credit – formal or informal prearranged short-term loans
Commitment fee – charge to secure a committed line of credit
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Chapter 18 – Short-Term Finance and Planning
Compensating balance – deposit in a low (or no) interest account
as part of a loan agreement
Cost of a compensating balance – if the compensating balance
requirement is on the used portion, less money than what is
borrowed is actually available for use. If it is on the unused
portion, the requirement becomes a commitment fee.
Example: Consider a $50,000 line of credit with a 5%
compensating balance requirement. The quoted rate on the line is
prime + 5%, and the prime rate is currently 8%. Suppose the firm
wants to borrow $28,500. How much do they have to borrow?
What is the effective annual rate?
Loan Amount: 28,500 = (1 – .05)L
L = 28,500 / .95 = 30,000
Effective rate: Interest paid = 30,000(.13) = 3,900. Effective rate =
3,900/28,500 = .1368 = 13.68%
Lecture Tip: Credit cards are an excellent way to illustrate the
concept of a “personal” line of credit. The consumer can use the
line of credit on the credit card to purchase goods or services. The
line of credit remains active until we abuse the privilege (i.e., late
payments). There is often a cost for this line of credit in the form of
annual fees. This is in addition to the often high rates of interest.
College students are targeted by credit card companies and can
end up holding several cards at one time. The cost of the annual
fees can add up – especially if they don’t need the additional credit
to begin with. Students also have the habit of charging to their
limits and then just making the minimum payment.
Lecture Tip: Trade credit represents another source of unsecured
financing. However, the cost of this form of borrowing is largely
implicit, since it is represented by the opportunity cost of not
taking the discount offered, if any. To compute the effective annual
cost of trade credit, we first use the credit terms to determine a
periodic opportunity cost. For example, if the terms are 2/10 net
30, rational managers will either pay $.98 per dollar of goods
ordered on the 10th day, or the full invoice cost on the 30th day. In
the latter case, the firm is actually paying $.02 to borrow $0.98 for
20 days. In one year, there are 365 / 20 = 18.25 such periods.
Therefore, the annualized cost is (1 + .02/.98)18.25 – 1 = 44.58%.
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Chapter 18 – Short-Term Finance and Planning
B. Secured Loans
Accounts Receivable Financing
-Assigning receivables – receivables are security for a loan, but
the borrower retains the risk of uncollected receivables
-Factoring – receivables are sold at a discount
Inventory Loans
-Blanket inventory lien – all inventory acts as security for the
loan
-Trust receipt – borrower holds specific inventory in trust for
the lender (e.g., automobile dealer financing)
-Field warehouse financing – public warehouse acts as a
control agent to supervise inventory for the lender
Lecture Tip: Inventory needs to be non-perishable, marketable,
and not subject to obsolescence in order to be useful for inventory
loans. Some view inventory financing as a means of raising
additional short-term funds after receivables financing has been
exhausted; however, it is standard practice in some industries,
such as auto sales.
Real-World Tip: An interesting discussion of inventory financing is
the story of Tino De Angelis, who has come to be known as the
“salad oil king.” Mr. De Angelis, a former butcher, constructed an
empire with a reported value of $100 million (in 1963) based
largely on his supposed acumen in buying and selling vegetable
oil. The magnitude of his operation is apparent when you consider
that at one point, he had contracted to purchase 600 million
pounds of the product, or one-third of the total amount produced
domestically.
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Chapter 18 – Short-Term Finance and Planning
Unfortunately, Mr. De Angelis’ business acumen was greatly
exaggerated. He resorted to borrowing against his inventory,
which supposedly consisted of millions of gallons of vegetable oil
held in steel vats spread across New Jersey. Unfortunately for his
creditors, the vats were largely empty. The resulting default caused
millions of dollars in losses to banks, insurance companies,
brokerage firms, and the New York Stock Exchange. Mr. De
Angelis was paroled in 1972 after serving seven years of a 20-year
prison sentence.
C. Other Sources
-Commercial paper – short-term publicly traded loans
-Trade credit – accounts payable
Lecture Tip: In Corporate Liquidity, by Kenneth Parkinson and
Jarl Kallberg, commercial paper is called “the most important
source of short-term borrowing for large U.S. companies.” The
commercial paper market has grown dramatically over the last few
years. Parkinson and Kallberg describe a typical commercial
paper transaction:
–The issuer sells a note to an investor for an agreed-upon rate,
principal (usually in $1 million increments), and maturity date
(270 days or less).
–The issuer contracts with the issuing bank to prepare the note
and deliver it to the investor’s custodial bank.
–The investor instructs her bank to wire funds to the
commercial paper issuer upon delivery and verification of the
note. Since commercial paper is sold on a discounted basis, the
amount of funds wired is less than the face amount of the note.
–On the maturity date, the note is returned to the issuer’s
paying agent and the face amount of the note is transferred to
the investor. The note is marked paid and returned to the
issuer.
18.6 A Short-Term Financial Plan
The cash budget is used to determine how a firm will raise the cash
to meet any cash deficits computed in the budget. It is also used to
determine when marketable security investments may be
necessary. For temporary imbalances, short-term borrowing and
marketable securities are in order. For long-term short-falls,
solutions include issuing bonds or equity. For long-term cash
surpluses, solutions include paying dividends, repurchasing shares,
or refunding debt
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Chapter 18 – Short-Term Finance and Planning
18.7 Summary and Conclusions
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