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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26-1
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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26-2
 Current
Liabilities
Current Assets
Net
Working
Long-Term
Capital Debt

How much short-

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

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26-3
 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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 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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 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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26-6
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
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 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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 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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 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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 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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26-11
 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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26-12
 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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26-13
$ Total costs of holding current
Minimum
point assets.
Carrying costs

Shortage costs

CA* Investment in
Current Assets ($)

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26-14
$

Carrying costs
Minimum
point
Total costs of holding
current assets.

Shortage costs

CA* Investment in
Current Assets ($)

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26-15
$ Minimum Total costs of holding current 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
 A cash budget is a primary tool of short-run
financial planning.
 The idea is simple: Record the estimates of cash
receipts and disbursements.
 Cash Receipts
◦ Arise from sales, but we need to estimate when we
actually collect
 Cash Outflow
◦ Payments of Accounts Payable
◦ Wages, Taxes, and other Expenses
◦ Capital Expenditures
◦ Long-Term Financial Planning
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 Pet Treats Inc. specializes in gourmet pet treats and receives all income
from sales
 Sales estimates (in millions)
◦ Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
 Accounts receivable
◦ Beginning receivables = $250
◦ Average collection period = 30 days
 Accounts payable
◦ Purchases = 50% of next quarter’s sales
◦ Beginning payables = 125
◦ Accounts payable period is 45 days
 Other expenses
◦ Wages, taxes and other expense are 30% of sales
◦ Interest and dividend payments are $50
◦ A major capital expenditure of $200 is expected in the second quarter
 The initial cash balance is $80 and the company maintains a minimum
balance of $50

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 ACP = 30 days, this implies that 2/3 of sales are
collected in the quarter made, and the remaining 1/3 are
collected the following quarter.
 Beginning receivables of $250 will be collected in the
first quarter.
Q1 Q2 Q3 Q4
Beginning Receivables 250 167 200 217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267
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 Payables period is 45 days, so half of the purchases will
be paid for each quarter, and the remaining will be paid
the following quarter.
 Beginning payables = $125

Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 150 180 195 240
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628

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 Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
Total cash disbursements 475 743 607 628
Net cash inflow 108 -176 26 122
Beginning Cash Balance 80 188 12 38
Net cash inflow 108 -176 26 122
Ending cash balance 188 12 38 160
Minimum cash balance -50 -50 -50 -50
Cumulative surplus (deficit) 138 -39 -12 110

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26-22
 The most common way to finance a temporary cash
deficit is to arrange a short-term loan.
 Unsecured Loans
◦ Line of credit (at the bank)
 Secured Loans
◦ Accounts receivable can be either assigned or factored.
◦ Inventory loans use inventory as collateral.
 Other Sources
◦ Banker’s acceptance
◦ Commercial paper

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 How do you compute the operating cycle and the cash
cycle?
 What are the differences between a flexible short-
term financing policy and a restrictive one? What are
the pros and cons of each?
 What are the key components of a cash budget?
 What are the major forms of short-term borrowing?

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26-24