Short Term Finance and Planning. Sources and Uses of Cash

Short Term Finance and Planning

(Text reference: Chapter 27)

Topics

sources and uses of cash

operating cycle and cash cycle

short term financial policy

cash budgeting

short term financial planning

AFM 271 - Short Term Finance and Planning Slide 1

Sources and Uses of Cash

much of short term finance revolves around net working

capital. Since

net working capital = current assets− current liabilities net working capital+ fixed assets = long term debt+ equity

net working capital excl. cash+ cash + fixed assets = long term debt+ equity,

we have

cash = long term debt+ equity− net working capital excl. cash − fixed assets

sources of cash:

Cont’d

example:

Balance Sheet ($ millions) Income Statement ($ millions) 2000 2001 2001 Current assets: Sales 700 Cash 8 10 Operating costs −642 Marketable securities 0 10 58 Inventory 52 50 Depreciation −8 Accounts receivable 50 60 50 Total current assets 110 130 Interest −2 Fixed assets: Pre-tax income 48 Gross investment 112 140 Tax (50%) −24 Depreciation −32 −40 Net income 24 Net fixed assets 80 100 Dividend 2 Total assets 190 230 Retained earnings 22 Current liabilities:

Bank loans 10 0 Accounts payable 40 54 Total current liabilities 50 54 Long term debt 10 24 Net worth 130 152 Total liabilities and net worth 190 230

AFM 271 - Short Term Finance and Planning Slide 3

Cont’d

what are the sources and uses of cash? Why did

cash increase by 2?

sources of cash

Operating Cycle and Cash Cycle

Time Raw material bought Finished goods sold

Order

placed Material_arrives

Invoice received Inventory period Cash paid for material Accounts payable period Cash received Accounts receivable period

operating cycle:

time period from arrival of raw materials

inventory to receipt of cash

cash cycle:

time period from payment of cash for materials to

receipt of cash

the need for short term finance is due to the gap between cash

outflows and inflows

AFM 271 - Short Term Finance and Planning Slide 5

Cont’d

some common ratios:

Inventory turnover = Cost of goods sold_{Average inventory} Receivables turnover =_{Average receivables}Credit sales

Payables turnover =Cost of goods sold_{Average payables}

e.g.: refer back to slide 3 and assume that cost of goods sold

for 2001 was $250 million and that half of sales were on credit:

Short Term Financial Policy

the main features are:

1. size of firm’s investment in current assets

flexible (high ratio of current assets/sales) vs. restrictive

(low ratio)

optimal choice is a tradeoff between

carrying costs

(costs

that rise with the level of current assets) and

shortage

costs

(costs that fall with the level of current assets)

Amount of current assets $ Flexible Policy Amount of current assets $ Restrictive Policy

AFM 271 - Short Term Finance and Planning Slide 7

Cont’d

2. two general possibilities for the financing of current assets:

Time $ No Short Term Borrowing

Time $ Short Term Borrowing

Cont’d

factors to consider:

importance of cash reserves:

without short term borrowing, the firm must

maintain investments in cash and marketable

securities. This provides flexibility, and reduces

the chance of financial distress, but ties up money

in zero NPV investments.

maturity hedging

firms often try to finance assets with debt of

similar maturity (e.g. inventory with short term

debt). Mismatched maturities (e.g. short term debt

for long term assets) can be risky (“rollover risk”).

term structure

the yield curve usually slopes upward, so it is

typically more expensive to borrow using long

term debt

AFM 271 - Short Term Finance and Planning Slide 9

Cash Budgeting

the

cash budget

provides forecasts of future cash receipts and

payments

it allows managers to identify possibilities for short term

investments and financing

example: start with cash inflows. Suppose we have the

following forecasts for sales/collections:

Q.1 Q.2 Q.3 Q.4 Receivables at start of quarter 30 32.5 30.7 38.2 Sales 87.5 78.5 116.0 131.0 Collections:

Cont’d

now consider cash outflows; here we assume

payments on accounts payable are $65, $60, $55, and $50 million in quarters 1-4 labour and administrative expenses are $30 million per quarter

capital expenditures are $32.5, $1.3, $5.5, and $8 million in quarters 1-4 taxes, interest, and dividends are $4, $4, $4.5, and $5 million in quarters 1-4 then:

Q.1 Q.2 Q.3 Q.4 Sources of cash

Collections on accounts receivable 85.0 80.3 108.5 128.0 Other 0.0 0.0 12.5 0.0 Total sources 85.0 80.3 121.0 128.0 Uses of cash

Payments on accounts payable 65.0 60.0 55.0 50.0 Labour & admin. expenses 30.0 30.0 30.0 30.0 Capital expenditures 32.5 1.3 5.5 8.0 Taxes, interest, & dividends 4.0 4.0 4.5 5.0 Total uses 131.5 95.3 95.0 93.0 Sources minus uses -46.5 -15.0 26.0 35.0

AFM 271 - Short Term Finance and Planning Slide 11

Cont’d

we can determine the short term financing requirements as

follows:

Q.1 Q.2 Q.3 Q.4 Cash at start of period 5.0 -41.5 -56.5 -30.5 Change in cash balance -46.5 -15.0 26.0 35.0 Cash at end of period -41.5 -56.5 -30.5 4.5 Minimum operating cash balance 5 5 5 5 Cumulative short term financing req’d 46.5 61.5 35.5 0.5

notes:

minimum operating cash balance is a contingency reserve

if cumulative short term financing required were negative,

this would indicate a surplus

in practice, one would want to do sensitivity/scenario

analyses to assess the uncertainty in cash requirements

before developing a short term financial plan

Short Term Financial Planning

having estimated cash requirements, the next step is planning

how to borrow/invest appropriately

in the previous example, the firm must raise cash in every

period

there are many alternative ways of short term borrowing:

operating loans/lines of credit

accounts receivable financing

inventory loans

commercial paper/banker’s acceptances

short term investing is usually in items such as Treasury bills,

bank accounts, etc.

in the previous example, other possibilities include long term

financing for the capital expenditures or “stretching payables”