Chapter 27 – Short-Term Finance and Planning
LO 27.1 - Tracing Cash and Net Working Capital
● Current liabilities – obligations expected to require cash payment within one
year or within the OPERATING CYCLE (whichever is shorter)
LO 27.2 - Defining Cash in Terms of Other Elements
The Sources and Uses of a Cash Statement
● Increase in long-term debt or equity leads to an increase in cash
● Increase in NWC or fixed assets leads to decrease in cash
● Sum of net income and depreciation increases cash, and dividend payments
decrease cash
LO 27.3 - The Operating Cycle and the Cash Cycle
● Short-run operating activities – events and decisions concerning the
short-term finance of a firm, such as how much inventory to order and
whether to offer cash terms or credit terms to customers
● Operating cycle = inventory + accounts receivable periods
○ Inventory period – length of time required to order, produce, and
sell a product
○ Accounts receivable period – length of time required to collect cash
receipts
● Cash cycle = operating cycle – accounts payable period
○ Time between cash disbursement and cash collection
○ Accounts payable period – length of time firm is able to delay
payment on the purchase of various resources (wages, raw
materials)
Interpreting the Cash Cycle
● Cash cycle increases as inventory and receivables periods get longer
○ Decreases if company stalls payment of payables
● Most firms have POSITIVE cash cycle
● ROA – return on assets
LO 27.4 - Some Aspects of the Short-Term Financial Policy
The Size of the Firm's Investment in Current Assets
● Measured relative to the firm's level of total operating revenues
● Flexible short-term financial policies maintain a high ratio of current assets to
sales:
1. Keeping large balances of cash and marketable securities
2. Making large investments in inventory
3. Granting liberal credit terms, which result in a high level of accounts
receivable
● Restrictive short-term financial policies entail a low ratio of current assets to
sales:
1. Keeping low cash balances and no investment in marketable
securities
2. Making small investments in inventory
3. Allowing no credit sales and no accounts receivable
● Future cash flows are highest with flexible policy
● Carrying costs – costs that increase with increases in the level of investment
in current assets
1. Opportunity cost since the rate of return on current assets is low
compared with that of other assets
2. Cost of maintaining economic value such as warehousing inventory
● Shortage costs – costs that fall with increases in the level of investment in
current assets
1. Trading or order costs – costs of placing an order for more cash
(brokerage costs) or more inventory (production set-up costs)
2. Costs related to safety reserves – costs of lost sales, lost customer
goodwill, and disruption of production schedules
● If carrying costs are low or shortage costs are high, the optimal policy calls for
substantial current assets (FLEXIBLE)
● If carrying costs are high or shortage costs are low, the optimal policy calls for
modest current assets (RESTRICTIVE)
Alternative Financing Policies for Current Assets
● Ideal economy: short-term assets are financed by short-term debt, and
long-term assets financed with long-term debt and equity, net working capital
(NWC) is always zero
Current Assets and Liabilities in Practice
● Different inventories have different cash cycles
○ EX) aircraft industry carries a lot of inventory, because building
planes takes a lot of time
LO 27.5 - Cash Budgeting
● Cash budgeting – forecast of cash receipts and disbursements expected by a
firm in the coming year
○ Short-term financial planning tool
Cash Outflow
● Four basic categories:
1. Payments of accounts payable – payments for goods/services,
made after purchases, purchases depend on sales forecast
■ Payments = last quarter's purchases
■ Purchases = ½ of next quarter's sales forecast
2. Wages, taxes, and other expenses – all other normal costs of doing
business that require actual expenditures
■ EX) depreciation
3. Capital expenditures – payments of cash for long-lived assets
4. Long-term financing – interest and principal payments on long-term
outstanding debt and dividend payments to shareholders
The Cash Balance
LO 27.6 - The Short-Term Financial Plan
Short-Term Planning and Risk
Short-Term Borrowing
● Operating loan – most common way to finance a temporary cash deficit
○ Agreement under which a firm is authorized to borrow up to a
specified amount for a given period, usually one year (like a credit
card)
○ Short-term lines of credit are either committed or non-committed
1. Committed – formal legal arrangement
2. Non-committed – informal arrangement
● Letters of credit – common arrangement in international finance, where the
bank issuing the letter promises to make a loan if certain conditions are met
○ Revocable – subject to cancellation
○ Irrevocable – not subject to cancellations
● Secured loans:
○ Covenant - written agreement or promise usually under seal
between two or more parties especially for the performance of a
particular action
○ Accounts receivable financing – involves either the assigning of
receivables or the factoring of receivables
1. Under assignment, the lender has a lien on the
receivables and recourse to the borrower
2. Factoring involves the sale of accounts receivable
○ Inventory loan – 3 basic forms are a blanket inventory lien, a trust
receipt, and field warehouse financing
1. Blanket inventory lien – gives the lender a lien against all
the borrower's inventories
2. Trust receipt – borrower holds the inventory in trust for
the lender, and proceeds from sale of inventory are
remitted immediately to the lender
3. Field warehouse financing – a public warehouse
company supervises the inventory for the lender
○ Trade credit – credit granted to other firms
● Other Sources:
○ Commercial paper – unsecured promissory notes issued by
corporations with a high credit standing, and maturity ranges up to
270 days
○ Banker's acceptance – agreement by a bank to pay a given sum of
money at a future date