Ch.

27 Short Term Finance and Planning

Apple Video
- Companies that have an excess amount of cash dont know what to do
with it
o Apple has $250B excess cash
- The FANG: Facebook, Amazon, Netflix, Google
o Dont really have any tangible assets or physical capital needs
- Oil and Energy companies
o Enbridge just made a huge acquisition of an American company
o Industry is very capital intensive require much tangible assets
o Good for dividends
- You should invest in the components that go into the devices, rather than the
devices
o Because there is so much competition between devices, and they will
obsolete quickly
o But chips and parts inside the phone will always be needed.
o Broadcom chip-maker

Intro
- Short term finance is concerned with decisions that affect current assets and
current liabilities.
o Involve cash flows that occur within a year

Tracing Cash and Net Working Capital

- Current Assets: Cash and other assets that are expected to be converted to
cash within the year.
o Cash
o Marketable securities
o Accounts Receivable: When the services are provided on account (an
outstanding balance of sales you made on credit)
o Inventory (expected to be sold for cash within a year)
- Current Liabilities: Obligations that are expected to require cash payment
within the year.
o Accounts Payable
o Unearned Revenue (You have received cash, but have not yet performed
the service)
o Accrued Wages
o Taxes
o Notes Payable
- Net Working Capital (NWC): Current Assets Current Liabilities

Identities
- NWC + fixed assets = Long term Debt + Equity
- NWC = (Cash + other current assets) Current Liabilities
- Cash + other current assets Current Liabilities + fixed assets = Long term
Debt + Equity
 - Cash = Long term Debt + Equity other current assets + Current
Liabilities fixed assets
- Cash = Long term Debt + Equity NWC(excluding cash) fixed assets

Activities that Increase Cash Activities that Decrease Cash

(Sources of cash) (Uses of cash)
long term debt (borrowing over long long term debt (paying off a long
term) term debt)
equity (selling stock) equity (repurchase stock)
current liabilities (getting a month current liabilities (pay off the
loan) month loan)
current assets (selling some current assets (purchase some
inventory) inventory)
fixed assets (selling some property fixed assets (purchase some
like machinery) property like machinery)
- To increase cash, a liability account is always increased, or asset account is
decreased
- To decrease cash, a liability account is decreased, or asset account is increased.

Operating and Cash Cycle

Buying raw materials pay cash manufacture product sell product collect
cash

Operating cycle:
- The entire cycle; from the time inventory/raw materials are acquired, to the
time the cash is collected from the sale of the product.
o The length of time it takes to acquire inventory, sell it, and collect the
cash for it.
- 2 periods
o Inventory period: From acquiring selling
o Accounts receivable period: time sold cash received
 - Operating cycle = Inventory period + A/R period
- Unit of time: days
o On average, a year or less.

Cash Cycle:
- The time from when you paid for your materials, to when you collect the cash
from your sale (tracks cash out, to cash in)
- Cash cycle = Operating cycle Accounts Payable period
- Cash cycle increases as the inventory and receivables periods get longer
- Cash cycle decreases if the payable period gets longer.
- The longer the cycle, the more financing is required.
o Long means more assets are tied up in inventory or receivablesso firm
is less efficientas a result, more financing is required
o Total asset turnover also lowerso less profitable
o **TAT is directly linked to sustainable growth
- The shorter the cycle, the lower the investment in inventories and receivable
o total assets are lower and total; turnover is higher.

Short-Term Financial Policy

A firms short-term financial policy has 2 elements
1. Size of investment in current assets
- Relative to firms level of total operating revenues.
- Flexible/accommodative: High ratio of current assets to sales
o Large cash balances; investments in marketable securities and inventory
o Grant liberal credit terms (large A/R)
o Flexible policies are costly b/c they require higher cash outflows to
finance cash, securities, inventory and A/R. But future cash flows will also
be highest with flexible policies.
o Stimulates large sales; generous credit policy, lots of inventory on hand,
so quick delivery to customers (so they can charge higher prices)
- Restrictive: Low ratio of current assets to sales
o Low cash balances; no investment in marketable securities
o Only small investments in inventory
o Dont allow credit sales (so no A/R)
- Managing current assets is a trade-off btwn carrying costs and shortage costs
o Carrying costs: Costs that rise with the level of investment (Costs
incurred by overinvesting in short-term assets such as cash)
Opportunity cost, since the rate of return on current assets is low
compared to other assets
Costs of maintaining economic value of the item (ie. Warehouse,
storage)
o Shortage costs: Costs that are incurred when the level of investment in
current assets is low; the costs of running out of short-term assets. If a
firm runs out of cash, it will have to sell marketable secs. If it cant it, may
need to borrow or default (cash-out). If a firm has no inventory (stockout),
it will lose its customers
 Trading/order costs: Costs of placing an order for more cash
(brokerage fees) or more inventory.
Safety Reserve costs: Costs of lost sales, lost customer
goodwill/loyalty, and disruption of production.
- Cost Curve:
o The total costs of investing in current assets are determined by adding
carrying costs and shortage costs.
o The minimum pt on the curve reflects the optimal balance of current
assets.
o If carrying costs are low
and shortage costs are high, then flexible policy (lots of
current assets)
o If carrying costs are high and shortage costs are low, then
restrictive policy (less current
asset)

2. Alternative Financing Policies

for Current Assets (dealing
with current liabilities)
- Ideally, short-term assets can always
be financed with short-term debt,
and same thing goes for long- term. So, net working capital would
always be 0.
o Grain elevator example: Inventories increase at beginning of year, and
reduce as they are sold during the year, then it increases again form the
harvest next year, and so on.
o Short-term bank loans are used to purchase the grainand then paid off
by the sale of these grains.
- But in the real world, a growing firms has a permanent requirement for both
current assets and long-term assets. Net working capital provides a buffer to let
the firm meet its ongoing obligations.
o Secular growth trend
o Seasonal variations
o Unpredictable fluctuations

- Flexible: Low proportion of short-term

debt relative to long-term debt.
o Long-term financing covers more than the
total asset requirement, even at
seasonal peaks
o Firm has excess cash to invest in marketable securities when the total
asset reqment falls from the peaks
o Chronic short-term cash surplus and large investment in NWC
 - Restrictive: High proportion of short-term debt relative to long-term debt.
o When long-term financing does not cover total asset reqment, firm has
to borrow short term to make up.

What is the best amount of short-term borrowing?

- Cash Reserves
o Flexible financing strategy implies surplus cash and little to no short-term
borrowing
o Reduces the chance of financial distress for the firm
o But investments in cash and marketable securities are 0 NPV, at best.

- Maturity Hedging
o Most firms finance inventory with short-term debt and capital assets with
long-term debt.
o If they mistakenly match long-lived assets with short-term borrowing, it
will require frequent financing, and so, increase interest rate risk (short-
term rates are more volatile than long-term)
- Term Structure
o Short-term interest rates are lower than long-term rates
o So, it is more costly to rely on long-term borrowing than short-term
borrowing.

Real World
- Advances in technology
o Just-in-time systems, B2B sales
o Firms are moving away from flexible, and towards restrictive policies.
o If you are able to accurately forecast stock demands, then restrictive
policies are more efficient.

Cash Budgeting

- Cash budget: Primary tool of short-term financial planning

o Lets the manager identify short-term financial needs and opportunities;
tell them what the required borrowing is.
o Cash budget records estimates of cash receipts and disbursements
- Starts with a sales forecast for the year (by quarter)
o Then Purchases
o Then Uses
- Cash Receipts: Arise from sales, but need to estimate actual collections (ie.
Not all sales will fall under the specific collection period, because
of credit sales)
o Ending A/R = Starting A/R +
Sales Collections
o If 90 day collection period,
collections = starting balance
 o If 45 day collection period, collections = starting balance + half
of current sales
o If 60 day collection period, collections = starting balance + third
of current sales
- Cash Outflow (Disbursements):
o Payments of Accounts Payable
o Wages, taxes, and other expenses: Normal costs of business that require
expenditures
o Capital expenditures: Payments of cash for long-lived assets.
o Long-term financing: Interest and principal payments on long-term debt;
dividends to shareholders.
- Cash Balance
o Tells the manager what borrowing is required, or what investing will be
possible in the short run.
o Minimum cash balances are established to facilitate transactions and act
as a contingency plan (just in case they need it)
 Short-term Financial Plan

- Firms must properly forecast their cash needs (take into account the variability
of cash flow in your industry)
- To finance a temporary cash deficit, most common way is a
Unsecured Loans
- The most common way to finance a temporary cash deficit is a short-term
unsecured bank loan.
- Firms will ask their bank for a noncommitted or committed line of credit.
o Noncommitted LoC: informal arrangement that allows firms to borrow up
to a previously specified limit; no need for paperwork. The interest rate
on the loc is set equal to the banks prime lending rate, plus an extra
percentage
o Committed LoC: Formal legal arrangements; firm pays a commitment fee
to the bank
- Compensating Balance: Deposits the firm keeps with the bank in low-interest
or no-interest accounts.
o Usually 2-5% of the amount used.
o By leaving these funds at the bank without getting interest, the firm
increases the effective interest earned by the bank on the LoC.
o So the bank is actually getting more than the agreed upon rate of 10%

Secured Loans
- Security for loans consist of accounts receivable or inventories.
- Accounts Receivable financing: Receivables are assigned or factored.
o Assigned: Lender has a lien on receivables, and recourse (legal right to
demand payment) from borrower.
o Factoring: The sale of accounts receivablethe factor (one purchasing
a/r) will collect the receivables, but also assumes full risk of default on
those.
- Inventory Loans: Uses inventory as collateral
o Blanket inventory lien: Gives the lender a lien against all inventories
o Trust receipt: Borrower holds inventory in trust for lender. Proceeds from
the sale of inventory immediately go to the lender.
o Field Warehouse Financing: A public warehouse company supervises the
inventory for the lender.

Other Sources
- Commercial Paper:
o Short-term notes issued by large, highly rated firms.
o Usually short maturity; interest rate is lower than what bank would
charge.
o Firms issuing commercial paper in Canada generally have borrowing
needs over $20 million.
o Dominion Bond Rating Service rates commercial paper similarly to bonds.
- Bankers Acceptances:
o Agreement by a bank to pay a sum of money.
 o These arise when a seller sends a bill to a customer; customers bank
accepts the bill and pays it.
o Bank charges a fee for this service to the customer.
o More commonly used than commercial paper in Canada, b/c Canadian
chartered banks enjoy stronger credit ratings.

In the Absence of Short-term Borrowing

- Short-term borrowing allows companies to meet their obligations right away
provides liquidity
- Financial crisis 07-08: what happens when this liquidity is no longer available in
market.
Bonus question
- 1 question on op/cash cycle
- 1 question on credit as well
- Inventory turnover: # of inventory cycles per year
- For any turnover ratios, first find the ratio, then find the number of days by
dividing from 365.
- Short-term assets should be financed with short-term debt; likewise with long-
term

o Hold very low balances of current assets; finance them with short-term
debt
o Dell