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Chapter 16
Short-Term Financial
Planning

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 Key Concepts and Skills
After studying this chapter, you should be able to:
• Discuss operating and cash cycles and why they are
important.
• Differentiate between the types of short-term financial
policies.
• Identify the essentials of short-term financial planning.

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 Chapter Outline
16-1 Tracing Cash and Net Working Capital.
16-2 The Operating Cycle and the Cash Cycle.
16-3 Some Aspects of Short-Term Financial Policy.
16-4 The Cash Budget.
16-5 Short-Term Borrowing.
16-6 A Short-Term Financial Plan.

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 NWC Review
(16.1) NWC + Fixed assets = L/T Debt + Equity.

(16.2) NWC = (Cash + Other current assets) − Current

Liabilities.
(16.3) Cash  L/T Debt  Equity  Current
Liabilities  Current Assets other
than cash  Fixed assets.

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 Sources and Uses of Cash
Sources of Cash Uses of Cash
• Increase long-term debt. • Decrease long-term debt.
• Increase equity. • Decrease equity.
• Increase current liabilities. • Decrease current
• Decrease current assets. liabilities.
• Decrease fixed assets. • Increase current assets.
• Increase fixed assets.

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 The Operating Cycle
Time required to receive inventory, sell it, and collect on the
receivables generated from the sale of the inventory.
Operating cycle = Inventory period + Accounts receivable
period.
• Inventory period = Time inventory sits on the shelf.
• Accounts receivable period = Time it takes to collect on
receivables.

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 Operating Cycle Equations
Operating cycle = Inventory period + Accounts receivable
period.
Inventory period = 365/Inventory turnover.
• Inventory turnover = COGS* ÷ Average Inventory.

Accounts receivable period = 365/Receivables turnover.

• Equals the average collection period.
• Accounts receivable turnover = Credit sales/Average
accounts receivable.

*COGS = Cost of Goods Sold.

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 The Cash Cycle
The time between payment for inventory and receipt from the
sale of inventory.
Cash cycle = Operating cycle − Accounts payable period.
• Accounts payable period = Time between receipt of
inventory and payment for it.

The cash cycle measures how long we need to finance

inventory and receivables.

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 Cash Cycle Equations
Cash cycle = Operating cycle − Accounts payable period.
Accounts payable period = 365/Payables turnover.
Payables turnover = COGS/Average account payable.

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 The Operating & Cash Cycles
FIGURE 16.1 Cash flow time line and the short-term operating activities
of a typical manufacturing firm

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 Corporate Management & Short-term
Financial Planning Table 16.1
TABLE 16.1 Managers Who Deal with Short-Term Financial Problems.

Duties Related to Short-Term Financial

Title of Manager Management Assets/Liabilities Influenced
Cash manager Collection, concentration, disbursement; Cash, marketable securities,
short-term investments; short-term borrowing; short-term loans
banking relations
Credit manager Monitoring and control of accounts Accounts receivable
receivable; credit policy decisions
Marketing manager Credit policy decisions Accounts receivable

Purchasing manager Decisions on purchases, suppliers; may Inventory, accounts payable

negotiate payment terms
Production manager Setting of production schedules and materials Inventory, accounts payable
requirements
Payables manager Decisions on payment policies and on Accounts payable
whether to take discounts
Controller Accounting information on cash flows; Accounts receivable, accounts
reconciliation of accounts payable; payable
application of payments to accounts
receivable

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 Example Data
Item Beginning Ending Average
Inventory $2,000,000 $3,000,000 $2,500,000
Accounts Receivable 1,600,000 2,000,000 1,800,000
Accounts Payable 750,000 1,000,000 875,000
Net Sales $11,500,000
Cost of Goods Sold 8,200,000

Operating cycle = Inventory period + Accounts receivables period.

Inventory period = 365/Inventory turnover.
Accounts receivables period = 365/Receivables turnover.
= Average collection period.
Cash cycle = Operating cycle − Accounts payable period.
Accounts payable period = 365/Payables turnover.
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 Example: Operating Cycle
Inventory period.
• Average inventory  $200,000,000  300,000,000  / 2  $250,000,000.

• Inventory  $820,000,000 / $250,000,000  3.28 times.

turnover
• Inventory period  365 / 3.28  111 days.

Receivables period.
• Average receivables  $160,000,000  200,000,000  / 2  $180,000,000.

• Receivables turnover  $11,500,000 / $1,800,000  6.39 times.

• Receivables period  365 / 6.39  57 days.

Operating cycle = 111 + 57 = 168 days.

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 Example: Cash Cycle
Accounts payable period = 365/Payables turnover.
Payables turnover = COGS/Average accounts payable.
• PT  $8, 200,000 / $875,000  9.4 times.

Accounts payables period  365 / 9.4  39 days.

Cash cycle = 168 − 39 = 129 days.

→ Inventory and receivables must be financed for 129 days.

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 Short-Term Financial Policy
Flexible Policy Restrictive Policy
• Large amounts of cash and • Low cash and marketable
marketable securities. security balances.
• Large amounts of • Low inventory levels.
inventory. • Little or no credit sales
• Liberal credit policies (large (low accounts receivable).
accounts receivable). • Relatively high levels of
• Relatively low levels of short-term liabilities.
short-term liabilities.
→ Low liquidity.
→ High liquidity.
Return to Quiz

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 Flexible Financial Policy
Advantages Disadvantages
• No difficulty meeting short- • Liquid securities = lower
term obligations. return.
• Cash available for • Financing S/T assets with
emergencies. L/T debt risky.
• Lower storage costs.

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 Restrictive Financial Policy
Advantages Disadvantages
• Higher returns on long- • Less liquidity for
term assets. emergencies.
• Lower carrying costs. • Higher storage costs.
• S/T liabilities can be
decreased more easily in
case of economic
downturn.

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 Carrying versus Shortage Costs
Carrying costs.
• Opportunity cost of owning current assets versus long-term
assets that pay higher returns.
• Cost of storing larger amounts of inventory.

Shortage costs.
• Order costs – the cost of ordering additional inventory or
transferring cash.
• Stock-out costs – the cost of lost sales due to lack of
inventory, including lost customers.

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 Temporary versus Permanent Assets
Permanent current assets.
• The level of current assets the company retains regardless
of any seasonality in sales.

Temporary current assets.

• Additional current assets added when sales are expected
to increase on a seasonal basis.

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 Alternative Asset Financing Policies
FIGURE 16.4 Alternative asset financing policies

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 Choosing the Best Policy
Consider:
• Cash reserves.
• Maturity hedging.
• Relative interest rates.

Compromise policy = Borrow short-term to meet peak needs, and

maintain a cash reserve for emergencies.

Return to Quiz

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 A Compromise Financing Policy Figure 16.5

FIGURE 16.5 A compromise financing policy

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 Cash Budget
Primary tool in short-run financial planning.
• Identify short-term needs and opportunities.
• Identify when short-term financing may be required.

How it works.
• Identify sales and cash collections.
• Identify various cash outflows.
• Subtract outflows from inflows and determine investing and
financing needs.

Return to Quiz

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 Cash Budget Example Fun Toys
Expected sales by quarter (millions).
• Q1: $200; Q2: $300; Q3: $250; Q4: $400.

Beginning accounts receivable = $120.

Collections  Beginning receivables  ½  Sales.
Accounts payable = 60 percent of sales.
Wages, taxes, and other expenses = 20 percent of sales.
Interest and dividends = $20 million per quarter.
Major expansion planned for Q2 costing $100 million.
Beginning cash balance = $20 million with minimum cash
balance of $10 million.

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 Fun Toys Cash Collections & Cash
Disbursements
Cash Collections Q1 Q2 Q3 Q4
Beginning Receivables $120 $100 $150 $125
Sales (m) 200 300 250 400
Cash Collections −220 −250 −275 −325
Ending Receivables $100 $150 $125 $200

Cash Disbursements Q1 Q2 Q3 Q4
Payment of Accounts (60% of $120 $180 $150 $240
sales)
Wages, Taxes, other expenses 40 60 50 80
Capital expenditures 0 100 0 0
Long-term financing expenses
(Interest and dividends) 20 20 20 20
Total Cash Disbursements $180 $360 $220 $340

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 Fun Toys Net Cash Flow and Cash Balance

Net Cash Flow Q1 Q2 Q3 Q4

Total Cash Collections $220 $250 $275 $325
Total Cash Disbursements 180 360 220 340
Net Cash Flow $40 −$110 $55 −$15
Cash Balance Q1 Q2 Q3 Q4
Beginning Cash Balance $20 $60 −$50 $5
Net Cash Inflow 40 −110 55 −15
Ending Cash Balance $60 −$50 $5 −$10
Minimum Cash Balance −10 −10 −10 −10
Cumulative Surplus (deficit) $50 −$60 −$5 −$20

Comments on Fun Toys’ Cash Budget:

• Beginning in Q2, Fun Toys will have a cash deficit which must
be covered.
• Sales are forecasts and could be much better or worse.

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 Short-Term Borrowing Unsecured Loans 1

Line of credit.
• Prearranged agreement with a bank that allows the firm to
borrow up to a certain amount on a short-term basis.
• May require a “Cleanup period.”

Committed.
• Formal legal arrangement that may require a commitment
fee and generally has a floating interest rate.

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 Short-Term Borrowing Unsecured Loans 2

Noncommitted.
• Informal agreement with a bank that is similar to credit
card debt for individuals.

Revolving credit.
• Non-committed agreement with a longer time between
evaluations.

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 Short-Term Borrowing Secured Loans 1

Accounts Receivable Financing.

Assigning receivables.
• Lender has A/R as security but borrower still responsible
for collection.

Factoring receivables.
• A/R discounted and sold to a factor.
• Collection = Factor’s problem.

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 Short-Term Borrowing Secured Loans 2

Inventory Loans.
Blanket inventory lien.
• Lender has lien against all inventories.

Trust receipt.
• Borrower holds specific inventory in “trust” for the lender.
• Auto dealer “floor plans.”

Field warehouse financing.

• Public warehouse acts as control agent to supervise
inventory for lender.

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 Fun Toys Short-Term Financial Plan
S/T Financial Plan Q1 Q2 Q3 Q4
Beginning Cash Balance $20 $60 $10 $10
Net Cash Flow 40 −110 55 −15
Net short term borrowing 0 60 0 15.4
Interest on S/T borrowing 0 0 −3 −.4
S/T Borrowing repaid 0 0 −52 0
Ending Cash Balance $60 $10 $10 $10
Minimum Cash Balance −10 −10 −10 −10
Cumulative Surplus (deficit) $50 $0 $0 $0
Beginning Short-term 0 0 60 8
borrowing
Change in short-term 0 60 −52 15.4
borrowing
Ending short-term borrowing $0 $60 $8 $23.4

Deficit covered with S/T borrowing at 20 percent A PR

calculated quarterly.

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 Quick Quiz - 1
1. What are the differences between flexible and restrictive
short-term financial policies? (Slide 16.15).
2. What factors do we need to consider when choosing a
financial policy?
(Slide 16.21).
3. What factors go into determining a cash budget and why
is it valuable? (Slide 16.23).

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 Quick Quiz - 2
4. Suppose your average inventory is $10,000, your average
receivables balance is $9,000, and your average payables
balance is $4,000. Net sales are $100,000 and cost of
goods sold is $50,000.What are the operating cycle and
cash cycle?

What are the operating cycle and cash cycle?

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 Quick Quiz – Problem 4 Solution
Inventory turnover  $50,000/$10,000  5x
Inventory period  365 / 5  73 days

Receivables turnover  $100,000/$9,000  11.11x

Average collection period  365 /11.11  33 days

Payables turnover  $50,000/$4,000  12.5x

Payables period  365 /12.5  29 days

Operating Cycle = 73 + 33 = 106 days
Cash Cycle = 106 days − 29 days
= 77 days
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