Chapter

Short-Term Finance and

Planning

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All

Introduction
Net working capital - short term financial decisions
Current assets minus current liabilities
Working capital management - short-term financial
decisions
3 important questions:
1) What is a reasonable level of cash to keep on
hand (in bank) to pay bills?
2) How much should the firm borrow in the short
term?
3) How much credit should be extended to
customers?
2

Working-Capital
Management
Current Assets
Cash, marketable securities, inventory,
accounts receivable.
Long-Term Assets
Equipment, buildings, land.
Which earn higher rates of return?
Which help avoid risk of illiquidity?
Risk-Return Trade-off:
Current assets earn low returns, but help reduce
the risk of illiquidity.
3

Working-Capital
Management
Current Liabilities
Short-term notes, accrued expenses, accounts
payable.
Long-Term Debt and Equity
Bonds, preferred stock, common stock.
Which are more expensive for the firm?
Which help avoid risk of illiquidity?
Risk-Return Trade-off:
Current liabilities are less expensive, but increase
the risk of illiquidity.
4

The Hedging Principle

Permanent Assets (those held > 1 year)
Should be financed with permanent
and spontaneous sources of
financing.
Temporary Assets (those held < 1 year)
Should be financed with temporary
sources of financing.
5

Balance Sheet
Temporary
Temporary
Current Assets
Short-term financing
Permanent
Permanent
Fixed Assets
Financing
and
Spontaneous
Financing
6

The Hedging Principle

Permanent Financing
Intermediate-term loans, long-term debt,
preferred stock, common stock.
Spontaneous Financing
Accounts payable that arise spontaneously
in day-to-day operations (trade credit, wages
payable, accrued interest and taxes).
Short-term financing
Unsecured bank loans, commercial paper,
loans secured by A/R or inventory.

Figure 15-1

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Sources and Uses of Cash

Balance sheet identity (rearranged)
NWC + fixed assets = long-term debt + equity
NWC = cash + other CA CL
Cash = long-term debt + equity + CL CA other than
cash fixed assets

Sources
Increasing long-term debt, equity or current liabilities
Decreasing current assets other than cash or fixed
assets

Uses
Decreasing long-term debt, equity or current liabilities
Increasing current assets other than cash or fixed assets
9

Cash Conversion Cycle (CCC)

-

to evaluate the effectiveness of the working capital management.

To minimize working capital: speeding up the collection of cash from

sales, increasing inventory turns and slowing down the
disbursement of cash.

CCC = days of sales outstanding (DSO) + days of sales in

inventory (DSI) + days of payable outstanding (DPO)
Where:
DSO = account receivable/(sales/365)
DSI = inventories/(COGS/365)
DPO = account payable/(COGS/365)
*** number of days in 1 year 360 or 365 (depends on the questions)
10

The Operating Cycle

Operating
cycle

time
between
purchasing the inventory and collecting the
cash from selling the inventory
Inventory period time required to
purchase and sell the inventory
Accounts receivable period time required
to collect on credit sales
Operating cycle = inventory period +
accounts receivable period
11

Cash Cycle
Cash cycle
Amount of time we finance our inventory
Difference between when we receive cash
from the sale and when we have to pay for the
inventory

Accounts payable period time between

purchase of inventory and payment for the
inventory
Cash cycle = Operating cycle
accounts payable period
12

Figure 19.1

13

Cash cycles (day) for selected listed

companies
Company Industry Operating

Account Cash
payable cycle
period

Tesco PLC Retail

37
SP Setia
Property 367
develop
ment

69
96

-32
271

Proton

Manufa
cturing

101

81

20

Air Asia

Service

11

cycle

14

Short-Term Financial Policy

Size of investments in current assets
Flexible (conservative) policy maintain a
high ratio of current assets to sales
Restrictive (aggressive) policy maintain a
low ratio of current assets to sales

Financing of current assets

Flexible (conservative) policy less short-term
debt and more long-term debt
Restrictive (aggressive) policy more shortterm debt and less long-term debt
15

Carrying vs. Shortage Costs

Managing short-term assets involves a tradeoff between carrying costs and shortage
costs
Carrying costs increase with increased levels of
current assets, the costs to store and finance the
assets
Shortage costs decrease with increased levels
of current assets
Trading or order costs
Costs related to safety reserves, i.e., lost sales and
customers and production stoppages
16

The optimal investment in

current assets

17

Figure 19.4

18

Financing Policies for Current

Assets (Flexible VS Restrictive)

19

Financing Policies for Current

Assets (Compromise policy)

20

Choosing the Best Policy

Cash reserves

High cash reserves mean that firms will be less likely to experience
financial distress and are better able to handle emergencies or take
advantage of unexpected opportunities
Cash and marketable securities earn a lower return and are zero NPV
investments

Maturity hedging

Try to match financing maturities with asset maturities

Finance temporary current assets with short-term debt
Finance permanent current assets and fixed assets with long-term debt
and equity

Interest Rates

Short-term rates are normally lower than long-term rates, so it may be

cheaper to finance with short-term debt
Firms can get into trouble if rates increase quickly or if it begins to have
difficulty making payments may not be able to refinance the short-term
loans

Have to consider all these factors and determine a compromise policy

that fits the needs of the firm
21

Cash Budget
Forecast of cash inflows and outflows over
the next short-term planning period
Primary tool in short-term financial planning
Helps determine when the firm should
experience cash surpluses and when it will
need to borrow to cover working-capital costs
Allows a company to plan ahead and begin
the search for financing before the money is
actually needed
22

Example of cash budget

The following is the sales budget for ABC Inc:

Year

Sales ( in thousand)

Feb 2013

RM150

Mar 2013

RM170

Apr 2013

RM190

May 2013

RM220

June 2013

RM250

Credit sales are collected as follows:

20% in the month of the sale
30% in the month after sale
50% in the second month after sale.
23

Cash Budget Information

Other expenses
Wages, taxes and other expense are 30% of
sales
Cash purchases of RM50,000 , RM25,000 and
35,000 respectively in Apr, May and June 2013.
A major capital expenditure of $100,000 is
expected in May 2013
The initial cash balance is $80,000 and the
company maintains a minimum balance of
$500,000
Interest on accumulated loan is at 12% annual
interest and is paid in the following month.
24

ABC Incs Cash budget for Apr-June

2013 (in thousand)
Feb Mar
Sales

Apr

May June

150

170

190

220

250

30

34

38

44

50

45

51

57

66

75

85

95

164

186

211

Cash Collection:
Cash sales (20%)
2nd collection (30%)
3rd collection (50%)
Total cash collection

25

ABC Incs Cash budget for Apr-June

2013 (in thousand)
Feb Mar

Apr

May June

Cash disbursement:
Wages, taxes & other
expenses

57

66

75

Cash purchases

50

25

35

Capital expenditure
Total cash
disbursement

100
107

191

110

26

ABC Incs Cash budget for Apr-June

2013 (in thousand)
Feb Mar

Apr

May

June

Change in net cash

(cash collectioncash disbursement)

57

-5

101

Beginning balance

80

500

500

(3.63)

(3.71)

Additional financing

363

8.63

(97.29)

Ending balance

500

500

500

Accumulated financing

363 371.63

274.34

Interest expenses

27

Cost of Short-term Credit

Interest = principal rate time
Cost of short-term financing = annual percentage
rate (APR)
APR = (interest / principal) * (1 / time)
A company plans to borrow $1,000 for 180 days.
At maturity, the company will repay the $1,000
principal amount plus $40 interest. What is the
APR?
APR = ($40/$1,000) [1/(180/360)]
= .04 (180/90)
= .08 or 8%
28

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Annual Percentage Yield (APY)

APR does not consider compound interest. To account for the influence of
compounding, we must calculate APY or annual percentage yield
APY = (1 + i/m)m 1
Where:
i is the nominal rate of interest per year;
m is number of compounding period within a year
In the previous example,
# of compounding periods 360/180 = 2
Rate = 8%
APY = (1 + .08/2)2 1
= .0816 or 8.16%

APR or APY ?
-Because the differences between APR and APY are usually small,
we can use the simple interest values of APR to compute the cost of
short-term credit.
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27

Sources and Costs of Short-term

Credit
Short-term credit sources can be classified into two basic
groups:
Unsecured sources
-Unsecured loans include all of those sources that have as
their security only the lenders faith in the ability of the
borrower to repay the funds when due.
-Major sources-accrued wages and taxes, trade credit,
unsecured bank loans, and commercial paper
-Since employees are paid periodically (biweekly or
monthly), firms accrue a wage payable account that is, in
essence, a loan from their employees.
- Similarly, if taxes are deferred or paid periodically, the
firm has the use of the tax money.
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30

Unsecured source: Trade credit arises spontaneously with

the firms purchases. Often, the credit terms offered with
trade credit involve a cash discount for early payment.
Terms such as 2/10 net 30 means a 2% discount is offered
for payment within 10 days, or the full amount is due in 30
days
A 2% penalty is involved for not paying within 10 days.
Effective Cost of Passing Up a Discount
-Terms 2/10 net 30
-The equivalent APR of this discount is:
APR = $.02/$.98 [1/(20/360)]
= .3673 or 36.73%
-The effective cost of delaying payment for 20 days is 36.73%

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31

Unsecured source: bank credit

Commercial banks provide unsecured short-term credit in two forms:
1) Lines of credit
-Informal agreement between a borrower and a bank about the maximum
amount of credit the bank will provide the borrower at any one time.
-There is no legal commitment on the part of the bank to provide the stated
credit.
-Banks usually require that the borrower maintain a minimum balance in the
bank throughout the loan period (known as compensating balance).
-Interest rate on line of credit tends to be floating.
-Revolving Credit- is a variant of the line of credit form of financing, a legal
obligation is involved
2) Transaction loans (notes payable)
-Transaction loan is made for a specific purpose. This is the type of loan
that most individuals associate with bank credit and is obtained by signing
a promissory note.

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30

Unsecured source: Commercial Paper

The largest and most credit worthy companies are able to use commercial
papera short-term promise to pay that is sold in the market for short-term
debt securities.
Maturity: Usually 6 months or less.
Interest Rate: Slightly lower (1/2 to 1%) than the prime rate on commercial
loans.
New issues of commercial paper are placed directly or dealer placed.
Advantages:
1) Interest rates
Rates are generally lower than rates on bank loans
2)Compensating-balance requirement
No minimum balance requirements are associated with commercial
paper
3)Amount of credit
Offers the firm with very large credit needs a single source for all its
short-term financing
4)Prestige
Signifies credit status
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31

 Secured sources
-Involve the pledge of specific assets as collateral in the event the
borrower defaults in payment of principal or interest
-Primary Suppliers: Commercial banks, finance companies, and factors
-Principal sources of collateral: Accounts receivable and inventories
-Secured Sources of Loans
* Secured loans have assets of firm pledged as collateral. If there is a
default, the lender has first claim to the pledged assets. Because of its
liquidity, accounts receivable is regarded as the prime source for collateral.
*Accounts Receivable loans
Pledging Accounts Receivable
Factoring Accounts Receivable
* Inventory loans

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34

Pledging Accounts Receivable

Borrower pledges accounts receivable as collateral for a loan
obtained from either a commercial bank or a finance company
The amount of the loan is stated as a percentage of the face
value of the receivables pledged
If the firm pledges a general line, then all of the accounts are
pledged as security. (Simple and inexpensive)
If the firm pledges specific invoices each invoice must be
evaluated for creditworthiness. (more expensive)
Credit Terms: Interest rate is 25% higher than the banks prime
rate. In addition, handling fee of 12% of the face value of
receivables is charged.
While pledging has the attraction of offering considerable
flexibility to the borrower and providing financing on a continuous
basis, the cost of using pledging as a source of short-term
financing is relatively higher compared to other sources.

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35

Factoring Accounts Receivable

Factoring accounts receivable involves the
outright sale of a firms accounts to a financial
institution called a factor.
A factor is a firm (such as commercial
financing firm or a commercial bank) that
acquires the receivables of other firms. The
factor bears the risk of collection in exchange
for a fee of 13 percent of the value of all
receivables factored.
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36

Secured Sources: Inventory Loans

These are loans secured by inventories
The amount of the loan that can be obtained
depends on the marketability and perishability of
the inventory
Types:
Floating lien agreement
Chattel Mortgage agreement
Field warehouse-financing agreement
Terminal warehouse agreement
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37

Types of Inventory Loans

Floating or blanket Lien Agreement
The borrower gives the lender a lien against all its inventories.

Chattel Mortgage Agreement

The inventory is identified and the borrower retains title to the
inventory but cannot sell the items without the lenders
consent.

Field warehouse-financing agreement

Inventories used as collateral are physically separated from

the firms other inventories and are placed under the control of
a third-party field-warehousing firm.

Terminal warehouse agreement

inventories pledged as collateral are transported to a public
warehouse that is physically removed from the borrowers
premises.
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38

EXERCISES:
Calculate the effective cost of the following trade credit terms when
payment is made on the net due date (360 days in 1 year)
a) 2/10, net 30
b) 3/15, net 30
a) (0.02/0.98) x [1/(20/360)]= 0.36734 or 36.73%
b) (0.03/0.97) x [1/(15/360)] = 0.74226 or 74.23%
Compute the EAR for a & b.
a) [1+(0.3673/18)]^18 - 1 = 43.85%
b) [1+(0.7423/24)]^24 - 1 = 107.73%

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39

The Rosewood Corporation established a line of credit with a local bank.

The maximum amount that can be borrowed under the terms of the
agreement is $500,000 at a rate of 10 percent. A compensating balance
averaging 15 percent of the loan is required. Prior to the agreement,
Rosewood had maintained an account at the bank averaging $25,000. Any
additional funds needed for the compensating balance will also have to be
borrowed at the 10 percent rate. If the firm needs $280,000 for 6 months,
what is the annual cost of the loan?
Borrowed Funds = $280,000 - $25,000
0.85
Borrowed Funds = $304,411.8
Rate = $304,411.80 (.10/2)
1
$280,000
(180/360)
Rate = .1087 per year

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40

MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells directly to large
retail firms on terms of net 60 and has average monthly sales of $350,000. It has recently
decided to pledge all of its accounts receivable to its bank. The bank advances up to 80
percent of the face value of these receivables at a rate of 4 percent over the prime rate,
while charging 2.5 percent on all receivables pledged for processing to cover billing and
collection services. Prior to this arrangement MovieTone was spending $50,000 a year on
its credit department. The prime rate is 6 percent.
a.
What is the average level of accounts receivable?
b.
What is the effective cost of using this short-term credit for one year?
a. 2 $350,000 = $700,000
b. Rate = $56,000 + $105,000 - $50,000
1
560,000
(360/360)

= 0.1982

Annual interest expense = 0.10 0.80 $700,000 = $56,000

Processing fee = .025 $350,000 x12 = $105,000
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41

The EPG manufacturing Company uses

commercial paper regular to support its needs
for short-term financing. The firm plan to sell
$100 million in 270-day-maturity paper, on which
it expects to pay discounted interest at a rate of
12% per annum. In addition, EPG expects to
incur a cost of approximately $100,000 in dealer
placement fees an other expenses of issuing
paper. What is the effective cost of credit to
EPG?
41

The Burlington Western Company plans to issue

a commercial paper of $20 million. The
commercial paper will carry a 270-day maturity
and require interest based on a rate of 11% per
annum. In addition, the firm will have to pay fees
totaling $200,000 to bring the issue to market and
place it. What is the effective cost of the
commercial paper to Burlington Western?
42

Calculate the effective cost of the following

trade credit terms when payment is made on
the net due date.
a) 3/15 net 45
b) 2/15 net 60
Calculate the EAR for (a) and (b).
43

Penn Inc. needs to borrow $250,000 for the next 6 months. The
company has a line of credit with a bank that allows the company to
borrow funds with an 8% interest rate subject to a 20% of loan
compensating balance. Currently, Penn Inc. has no funds on deposit
with the bank and will need the loan to cover the compensating balance
as well as their other financing needs.
a)

How much will Penn Inc. need to borrow?

b)

What will be the annual percentage rate, or APR, for this financing?

c) If the company maintains $20,000 in its bank account, recalculate

APR.
44

A project for Jevon and Aaron, Inc. results

in additional accounts receivable of
RM400,000,
additional
inventory
of
RM180,000, and additional accounts
payable of RM70,000. What is the
additional investment in net working
capital?
45

A company collects 25 percent of its sales

during the month of sale, 65 percent one
month after the sale, and 10 percent two
months after the sale. The company
expects sales of RM50,000 in August,
RM80,000 in September, RM90,000 in
October, and RM60,000 in November.
How much money is expected to be
collected in October?
46

Syarikat Untung Rugi Sdn. Bhd has projected the following budget for the
second quarter of 2012:

ITEMS

APRIL (RM)

MAY (RM)

JUNE (RM)

Credit sales

380,000

396,000

438,000

Credit purchases

147,000

175,500

200,500

Wages, taxes &

expenses

39,750

48,210

50,300

Interest on existing
debt

11,400

11,400

11,400

Equipment
purchases

83,000

91,000

Cash
disbursement:

The company predicts that 5 percent of its credit sales will

never be collected. 40 percents of its sales will be
collected in the month of sale, and the remaining 55
percent will be collected in the following month. Credit
purchases will be paid in the month following the
purchase. In March 2012, credit sales were RM210,000
and credit purchases were RM156,000. Using this
information,
a) What is Syarikat Untung Rugis projected total
disbursement for May 2012?
b) What is Syarikat Untung Rugis projected total cash
receipts for April 2012?
48

The Carmel Corporations projected sales for the first eight months
of 2001 are as follows:
January: $100,000
May:$275,000
February:$110,000
June:$250,000
March:$130,000
July:$235,000
April:$250,000
August:$160,000

Of Carmels sales, 20% is for cash, another 60% is collected in the

month following sale, and 20 percent is collected in the second
month following sale. November and December sales for 2000 were
$220,000 and $175,000, respectively.
Carmel purchases its raw materials two months in advance of its
sales equal to 70% of its final sales price. The supplier is paid one
month after it makes delivery.
49

 In addition, Carmel pays $10,000 per month for rent and $20,000
each month for other expenditures. Tax prepayments for $23,000
are made in March and June.
The companys cash balance at December 31, 2000, was
$22,000; a minimum balance of $20,000 must be maintained at
all times.
Assume that any short-term financing needed to maintain that
cash balance would be paid off in the month following the month
of financing, if sufficient funds are available.
Interest on short-term loans (12% annually) is paid monthly.
Borrowing to meet estimated monthly cash needs takes place at
the beginning of the month.
Prepare a cash budget for Carmel covering the first seven
months of 2001.
50