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CHAPTER ORGANIZATION 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. Also, 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 firms ability to remain operating. Finally, working capital decisions can also have a major impact on firm value. 16.1 Tracing Cash and Net Working Capital Current assets are assets expected to be converted into cash within one year. The major categories of current assets include cash, marketable securities, accounts receivable, and inventory. Current assets are listed on the balance in the order of their liquidity, with the most liquid assets appearing first. Current liabilities are shortterm obligations which come due within one year. The major categories of current liabilities include accounts payable, accrued wages and taxes, other expenses, and notes payable. 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 Current assets other than cash Fixed assets Sources of Cash (Activities that increase cash) Increase in long-term debt account (borrowed money) Increase in equity accounts (issued stock) Increase in current liability accounts (borrowed money) Decrease in current asset accounts, other than cash (sold C/A) Decrease in fixed assets (sold fixed assets) Prepared by Jim Keys 1

Uses of Cash (Activities that decrease cash) Decrease in long-term debt account (repaid loans) Decrease in equity accounts (bought stock or paid dividends) Decrease in current liability accounts (repaid suppliers or short-term creditors) Increase in current asset accounts, other than cash (bought C/A) Increase in fixed assets (purchased fixed assets) 16.2 The Operating Cycle and the Cash Cycle

The primary concerns in short-term finance are the firm's short-run operating and financing activities. For a typical manufacturing firm, these short-run activities might consist of the following sequence of events and decisions:

Defining the Operating and Cash Cycles Operating cycle the average time required acquiring inventory, selling it and collecting 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 sales. Receivables turnover = credit sales / average receivables Accounts receivable period = 365 / receivables turnover Cash cycle the average time between cash disbursement and cash received from collections. Cash cycle = operating cycle accounts payable period

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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

Companies would prefer to take as long as possible before paying bills. Accounts payable are 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. The Operating Cycle and the Firms Organizational Chart

Short-term financial management in a large firm involves coordination between the credit manager, marketing manager, and controller. Potential for conflict may exist if particular managers concentrate on individual objectives as opposed to overall firm objectives.

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Calculating the Operating and Cash Cycles (example): Item Inventory Accounts Receivable Accounts Payable Net sales = 1,150,000 COGS = $820,000 Finding inventory period: Inventory turnover = COGS / Average inventory = $820,000 / $250,000 = 3.28 times Inventory period = 365 / 3.28 = 111.28 days Finding accounts receivables period: Receivables turnover = Credit sales / Average accounts receivable = $1,150,000 / $180,000 = 6.389 times Accounts receivables period = 365 / 6.389 = 57.13 days Operating cycle = 111.28 + 57.13 = 168.41 days Finding accounts payables period: Payables turnover = COGS / Average accounts payable = $820,000 / $87,500 = 9.37 times Accounts payables period = 365 / 9.37 = 38.95 days Cash cycle = 168.41 38.95 = 129.46 days Article: Dell Manages Profitability, Not Inventory Beginning $200,000 160,000 75,000 Ending Average $300,00 $250,000 0 200,000 180,000 100,000 87,500

Interpreting the Cash Cycle

The example above shows that the cash cycle depends on the inventory, receivables, and payables periods. The cash cycle increases as the inventory and receivables periods get longer. It decreases if the company is able to defer payment of payables and thereby lengthen the payables period. Most firms have a positive cash cycle, and they thus require financing for inventories and receivables. The longer the cash cycle, the more financing is required. Also, changes in the firm's cash cycle are often monitored as an early-warning measure. A lengthening cycle can indicate that the firm is having trouble moving inventory or collecting on its receivables. Such problems can be masked, at least partially, by an increased payables cycle, so both should be monitored. We can easily see the link between the firm's cash cycle and its profitability by recalling that one of the basic determinants of profitability and growth for a firm is its total asset turnover, which is defined as Sales/Total assets. The higher this ratio is, the greater are the firm's accounting return on assets, ROA, and return on equity, ROE. Thus, all other things being the same, the shorter the cash cycle is, the lower is the firm's investment in inventories and receivables. As a result, the firm's total assets are lower, and total turnover is higher. 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. Cash cycles also depend on the industry. They tend to be long in the retail jewelry industry and short in the grocery industry. This has obvious implications for the different types of financing needs in the two industries. Prepared by Jim Keys 4


Some Aspects of Short-Term Financial Policy The short-term financial policy that a firm adopts will be reflected in at least two ways: 1. The size of the firm's investment in current assets. This is usually measured relative to the firm's level of total operating revenues. A flexible, or accommodative, short-term financial policy would maintain a relatively high ratio of current assets to sales. A restrictive short-term financial policy would entail a low ratio of current assets to sales. 2. The financing of current assets. This is measured as the proportion of short-term debt (that is, current liabilities) and long-term debt used to finance current assets. A restrictive short-term financial policy means a high proportion of short-term debt relative to long-term financing, and a flexible policy means less short-term debt and more long-term debt. If we take these two areas together, we see that a firm with a flexible policy would have a relatively large investment in current assets. It would finance this investment with relatively less in short-term debt. The net effect of a flexible policy is thus a relatively high level of net working capital. Put another way, with a flexible policy, the firm maintains a larger overall level of liquidity.

The Size of the Firms 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 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 is 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; leads 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; 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; reduces cash cycle and need for financing) o 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 o Shortage costs costs that decrease with investment in current assets - Trading and order costs commissions, set-up, paperwork Prepared by Jim Keys

Stock-out costs lost sales, business disruptions, alienated customers

The optimal investment in current assets is that which minimizes the sum of carrying and shortage costs, i.e., total cost.

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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.

Which Financing Policy is Best? What is the most appropriate amount of short-term borrowing? There is no definitive answer. Several considerations must be included in a proper analysis: 1. Cash reserves. The flexible financing policy implies surplus cash and little short-term borrowing. This policy reduces the probability that a firm will experience financial distress. Firms may not have to worry as much about meeting recurring short-run obligations. However, investments in cash and marketable securities are zero net present value investments at best. 2. Maturity hedging. Most firms attempt to match the maturities of assets and liabilities. They finance inventories with short-term bank loans and fixed assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent refinancing and is inherently risky because short-term interest rates are more volatile than longerterm rates.

Personal financial situations provide ample examples of maturity matching. We tend to use 30-year loans when we buy houses (expectation that a house has a long useful life) and 4 5 year loans for cars. Why wouldnt we finance these Prepared by Jim Keys 7

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 may adjust annually, but 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. 3. Relative interest rates. Short-term interest rates are usually lower than long-term rates. This implies that it is, on the average, more costly to rely on long-term borrowing as compared to short-term borrowing.

Current Assets and Liabilities in Practice Short-term assets represent a significant portion of a typical firm's overall assets. For U.S. manufacturing, mining, and trade corporations, current assets were about 50 percent of total assets in the 1960s. Today, this figure is closer to 40 percent. Most of the decline is due to more efficient cash and inventory management. Over this same period, current liabilities rose from about 20 percent of total liabilities and equity to almost 30 percent. The result is that liquidity (as measured by the ratio of net working capital to total assets) has declined, signaling a move to more restrictive short-term policies.

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The Cash Budget - The cash budget is a primary tool in short-run financial planning. It allows the financial manager to identify short-term financial needs and opportunities. Importantly, the cash budget will help the manager explore the need for short-term borrowing. The idea of the cash budget is simple: It records estimates of cash receipts (cash in) and disbursements (cash out). The result is an estimate of the cash surplus or deficit. Sales and Cash Collections 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. Cash Collection Example (Excel)

Cash Outflows Common cash outflows: - Accounts payable what is the accounts payable period? - Wages, taxes, and other expenses usually expressed as a percent of sales (implies that these costs are variable) - Fixed expenses, when applicable - Capital expenditures determined by the capital budget - Long-term financing expenses interest expense, dividends, and sinking fund payments - Short-term borrowing based on the other information


The Cash Balance - Net cash inflow is the difference between cash collections and cash disbursements. Short-Term Borrowing Unsecured Loans The most common way to finance a temporary cash deficit is to arrange a short-term, unsecured bank loan. Firms that use short-term bank loans often arrange a line of credit. A line of credit is an agreement under which a firm is authorized to borrow up to a specified amount. To ensure that the line is used for short-term purposes, the borrower will sometimes be required to pay the line down to zero and keep it there for some period during the year, typically 60 days (called a cleanup period). Prepared by Jim Keys 9

Short-term lines of credit are classified as either committed or noncommitted. The latter is an informal arrangement that allows firms to borrow up to a previously specified limit without going through the normal paperwork (much as you would with a credit card). A revolving credit arrangement (or just revolver) is similar to a line of credit, but it is usually open for two or more years, whereas a line of credit would usually be evaluated on an annual basis. Committed lines of credit are more formal legal arrangements and often involve a commitment fee paid by the firm to the bank. The interest rate on the line of credit will usually float. A firm that pays a commitment fee for a committed line of credit is essentially buying insurance to guarantee that the bank can't back out of the agreement (absent some material change in the borrower's status). Secured Loans - Banks and other finance companies often require security for a short-term loan just as they do for a long-term loan. Security for short-term loans usually consists of accounts receivable, inventories, or both. Accounts receivable financing involves either assigning receivables or factoring receivables. Under assignment, the lender has the receivables as security, but the borrower is still responsible if a receivable can't be collected. With conventional factoring, the receivable is discounted and sold to the lender (the factor). Once it is sold, collection is the factor's problem, and the factor assumes the full risk of default on bad accounts. With maturity factoring, the factor forwards the money on an agreed-upon future date. Inventory loans, short-term loans to purchase inventory, come in three basic forms: blanket inventory liens, trust receipts, and field warehouse financing: 1. Blanket inventory lien. A blanket lien gives the lender a lien against all the borrower's inventories (the blanket covers everything). 2. Trust receipt. A trust receipt is a device by which the borrower holds specific inventory in trust for the lender. Automobile dealer financing, for example, is done by use of trust receipts. This type of secured financing is also called floor planning, in reference to inventory on the showroom floor. However, it is somewhat cumbersome to use trust receipts for, say, wheat grain. 3. Field warehouse financing. In field warehouse financing, a public warehouse company (an independent company that specializes in inventory management) acts as a control agent to supervise the inventory for the lender. Other Sources Commercial paper consists of short-term notes issued by large and highly rated firms. Typically, these notes are of short maturity, ranging up to 270 days (beyond that limit, the firm must file a registration statement with the SEC). Because the firm issues these directly, the interest rate the borrowing firm obtains can be significantly below the rate a bank would charge for a direct loan. 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 recent 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 investors custodial bank. - The investor instructs its bank to wire funds to the commercial paper issuer upon delivery and verification of the note. Prepared by Jim Keys 10

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 issuers paying agent and the face amount of the note is transferred to the investor. The note is marked paid and returned to the issuer. Adapted from Parkinson and Kallberg, Corporate Liquidity, published by Business One, Richard D. Irwin, Inc. page 256. Another option available to a firm is to increase the accounts payable period; in other words, it may take longer to pay its bills. This amounts to borrowing from suppliers in the form of trade credit. This is an extremely important form of financing for smaller businesses in particular. A firm using trade credit may end up paying a much higher price for what it purchases, so this can be a very expensive source of financing. Cost of foregoing the cash discount (cost of trade credit): 365 Discount % Nominal annual cost of trade credit (APR) = 1 - Discount % Total Credit Period - Discount Period = (Interest Rate Per Period)(Number of Interest Periods) .02 365 .02 365 = = = (.0204081633)(7.3) = 14.90% 1 - .02 60 - 10 .98 50 Discount % 365 Effective annual cost of trade credit (EAR) = 1 + ^ -1 1 - Discount % Total Credit Period - Discount Period

.02 365 = 1 + ^ 1 = [( 1.0204081633) ^ (7.3)] 1 = 15.89% 1 - .02 60 - 10 Link to Sample Exam questions: https://www.eztestonline.com/190704/13524091042391100.tp4

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