Chapter 26
SHORT-TERM FINANCE AND PLANNING
SLIDES
CHAPTER WEB SITES
Section Web Address
Introduction www.afponline.org
26.2 www.businessdebts.com
www.opiglobal.com
CHAPTER ORGANIZATION
26.1 Key Concepts and Skills
26.2 Chapter Outline
26.3 Balance Sheet Model of the Firm
26.4 Tracing Cash and Net Working Capital
26.5 Defining Cash in Terms of Other Elements
26.6 Defining Cash in Terms of Other Elements
26.7 The Operating Cycle and the Cash Cycle
26.8 The Operating Cycle and the Cash Cycle
26.9 Example
26.10 Example
26.11 Example
26.12 Some Aspects of Short-Term Financial Policy
26.13 Size of Investment in Current Assets
26.14 Carrying Costs and Shortage Costs
26.15 Appropriate Flexible Policy
26.16 Appropriate Restrictive Policy
26.17 Alternative Financing Policies
26.18 Cash Budgeting
26.19 Example
26.20 Example
26.21 Example
26.22 Example
26.23 The Short-Term Financial Plan
26.24 Quick Quiz
26.1 Tracing Cash and Net Working Capital
26.2 The Operating Cycle and the Cash Cycle
Defining the Operating and Cash Cycles
The Operating Cycle and the Firm’s Organization Chart
Calculating the Operating and Cash Cycles
Interpreting the Cash Cycle
A Look at Operating and Cash Cycles
26.3 Some Aspects of Short-Term Financial Policy
The Size of the Firm’s Investment in Current Assets
Alternative Financing Policies for Current Assets
Which is Best?
26.4 Cash Budgeting
Cash Outflow
The Cash Balance
26.5 The Short-Term Financial Plan
Unsecured Loans
Secured Loans
Other Sources
ANNOTATED CHAPTER OUTLINE
Slide 26.0 Chapter 26 Title Slide
Slide 26.1 Key Concepts and Skills
Slide 26.2 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 remain operating. Finally, good
working capital decisions can also have a major impact on firm value.
Slide 26.3 Balance Sheet Model of the Firm
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
Slide 26.4 Tracing Cash and Net Working Capital
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)
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)
Slide 26.5 –
Slide 26.6 Defining Cash in Terms of Other Elements
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
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
Slide 26.7 –
Slide 26.8 The Operating Cycle and the Cash Cycle
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 (receipt of goods), and the cash
cycle begins with the payment of accounts payable.
B. The Operating Cycle and the Firm’s Organization 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
Slide 26.9 –
Slide 26.11 Example
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 “snapshot”
value by a “flow” value (income statement numbers that represent what
has happened over a period of time) is to use the average “snapshot”
value computed over the same period.
Consider the example in the PowerPoint Slides (similar to the one in the
book):
Item Beginnin
g
Ending Average
Inventory 200,000 300,00
0
250,000
Accounts
Receivable
160,000 200,00
0
180,000
Accounts Payable 75,000 100,00
0
87,500
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 = 111.3 days
Finding accounts receivables period:
Receivables turnover = 1,150,000 / 180,000 = 6.39 times
Accounts receivables period = 365 / 6.39 = 57.1 days
Operating cycle = 111.3 + 57.1 = 168.4 days
Finding accounts payables period:
Payables turnover = 820,000 / 87,500 = 9.37 times
Accounts payables period = 365 / 9.37 = 38.9 days
Cash cycle = 168.4 – 38.9 = 129.5 days
Lecture Tip: It may be beneficial to have the students consider Example
26.2. Students may feel that the main demand on funds for Slowpay comes
from the inventory period of 73 days. 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.
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: 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 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 would otherwise have to hold. As a result, the firm’s financing
needs are lessened.
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.
E. A Look at Operating and Cash Cycles
When you review operating and cash cycles, remember that they are
essentially financial ratios. Thus, interpretation is dependent on firm and
industry characteristics. For example, restaurants have short cycles due to
the nature of their sales (mostly in cash) and inventory (perishable);
however, the health care equipment industry is the exact opposite.
2. Some Aspects of Short-Term Financial Policy
Slide 26.12 Some Aspects of Short-Term Financial Policy
A. The Size of the Firm’s Investment in Current Assets
If cash were 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 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 and receivables)
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)
Slide 26.13 Size of Investment in Current Assets
Carrying costs – costs that increase with investment in current assets
-Opportunity cost of investing (and financing) low-yield assets
-Cost associated with storing inventory
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