Short - term Financial Planning

Ending Receivables

= Beginning Receivables + Sales - Total Cash Collections = (0.5)Sales

What are some of the characteristics of a firm with a long operating cycle?

A long operating cycle implies that there is lower accessibility to cash for satisfying liabilities for the short - term. These are firms with relatively long inventory periods and/or relatively long receivables periods. Thus, such firms tend to keep inventory on hand, and they allow customers to purchase on credit and take a relatively long time to pay.

What considerations determine the optimal size of the firm's investment in current assets?

Firm invests the optimal level of money by considering the different costs that are involved in the different short - term financing policies which are available. The important considerable costs are carrying costs and shortage costs.

Will NWC always increase when cash increases?

Nope! The increase in cash an increase NWC some times. Not always as NWC depends on other factors too.

Activities that Decrease Cash (Uses of Cash)

Paying creditors or stockholders: a) Decreasing long - term debt: Paying off a long - term debt b) Decreasing equity: Repurchasing some stock c) Decreasing current liabilities: Paying off a 90 - day loan Buying assets: a) Increasing current assets other than cash: Buying some inventory for cash b) Increasing fixed assets: Buying some property

Operating Cycle

The time period between the acquisition of inventory and the collection of cash from receivables. The time it takes to receive the inventory, sell it and collect on the receivables generated from the sale. Describes how a product moves through the current asset accounts. Consists of: a) Inventory Period: The time it takes to acquire and sell the inventory. b) Accounts Receivable Period/Receivable Period/Days' Sales in Receivables/Average Collection Period: The time between sale of inventory and collection of the receivable. Operating Cycle = Inventory Period + Accounts Receivable Period

Cash flow Timeline

Graphical representation of the operating cycle and the cash cycle

Cash Outflows/Cash Disbursements/Payments

a) Accounts Payable: Payments for goods and services rendered by suppliers, such as, raw materials. b) Wages, taxes and other expenses: Includes all other regular costs of doing business that require actual expenditures. c) Capital Expenditures: Payments of cash for long - lived assets. d) Long - term financing expense: Interest Payments on long - term debt outstanding and dividend payments to shareholders.

Financial ratios for the Operating Cycle

a) Inventory Turnover = COGS/Average Inventory b) Inventory Period = 365 days/Inventory Turnover c) Receivables Turnover = Credit Sales/Average Accounts Receivable d) Receivables Period = 365 days/ Receivables Turnover

Is it possible for a firm's cash cycle to be longer than its operating cycle? Explain why or why not.

Since the cash cycle equals the operating cycle minus the accounts payable period, it is not possible for the cash cycle to be longer than the operating cycle if the accounts payable is positive. Moreover, it is unlikely that the accounts payable period would ever be negative since that implies the firm pays its bills before they are incurred.

Trade-off between carrying costs and shortage costs

x - axis: Amount of Current Assets (CA) y - axis: Cost in dollars: Carrying costs start out as 0 when current assets are 0 and then climb steadily as current assets increases => Upward - sloping. Shortage costs start out very high and then decline as we add current assets => Downward - sloping Total Cost of holding current assets (parabolic shaped curve) = Carrying Cost + Shortage cost *CA = Minimum Total Cost of holding current assets = Optimal level of current assets Flexible Policy: Optimal Current Asset holdings are highest as the carrying costs are perceived to be low relative to shortage costs. Restrictive Policy: Lower Current Asset holdings takes place as the carrying costs are perceived to be high relative to shortage costs.

Net Working Capital (NWC)

= Current assets - Current liabilities = (Cash + Other current assets) - Current liabilities

Explain the connection between a firm's accounting - based profitability and its cash cycle.

A firm's accounting - based profitability is measured by using its Total Asset Turnover. If the (TA) is higher, the greater the firm's accounting Return on Assets (ROA) and Return on Equity (ROE). Thus, all things being the same, the shorter the cash cycle is, the lower is the firm's investment in inventories and receivables. As a result, the firm's total assets are lower, and the total turnover is higher.

Current Assets

Assets which are expected to convert into cash within a year. Listed in the balance sheet in the order of their liquidity: a) Cash and cash equivalents b) Marketable securities c) Accounts receivables d) Inventories

Compromise Financial Policy

Borrow short - term debt (restrictive policy) to meet peak needs and maintain a cash reserve (flexible policy) for emergencies.

Are current assets temporary or permanent?

Both! Temporary: The additional current assets that are added when sales are expected to increase on a seasonal basis. Permanent: The level of current assets that the company retains regardless of any seasonality in sales.

Kane Manufacturing, Inc., has recently installed a just-in-time (JIT) inventory system. Describe the effect this is likely to have on the company's carrying costs, shortage costs, and operating cycle.

Carrying costs will decrease because they are not holding goods in inventory. Shortage costs will probably increase, depending on how close the suppliers are and how well they can estimate need. The operating cycle will decrease because the inventory period is decreased.

Commercial Paper

Consists of short - term (270 days) notes assigned by large and highly rated firms. Used as a source for short - term burrowing.

Carrying costs

Costs that rise with increases in the level of investment in current assets. Opportunity cost of owning current assets v/s long - term assets that pay higher returns. Cost of storing larger amounts of inventory. Includes the costs of maintaining economic value and opportunity costs.

Trade Credit

Increase the accounts payable period, thus, burrowing from suppliers in the form of trade credit. Used as a source for short - term burrowing. Expensive source.

Flexible/Accommodative/Conservative Financial Policy

Maintains a relatively high ratio of current assets to sales. A less proportion of short - term debt relative to long - term financing. Never does any short - term burrowing. a) Keeps large balances of cash and marketable securities. b) Makes large investments in inventory. c) Grants liberal credit terms, which results in a high level of accounts receivables. d) Relatively low levels of short - term liabilities. e) High liquidity.

What is the difference between NWC and cash?

NWC is the amount of difference between current assets and current liabilities. Cash is a current asset which is used as a source of fund.

Activities that Increase Cash (Sources of Cash)

Obtaining finances: a) Increasing long - term debt: Burrowing over long term b) Increasing equity: Selling some stock c) Increasing current liabilities: Getting a 90 - day loan Selling assets: a) Decreasing current assets other than cash: Selling some inventory for cash b) Decreasing fixed assets: Selling some property

Cash Budget

Records the estimates of each cash inflow and cash disbursements, resulting in cash surplus or deficit. Subtracts cash outflows from inflows and determine the investing and financing needs. Primary tool in short - term financial planning. Identifies short - term needs and potential opportunities. Identifies when short - term financing maybe required.

Which financial policy is the best?/What considerations determine the optimal compromise between flexible and restrictive NWC policies?

The best policy will be a combination of flexible and restrictive policies. Depends on: a) Cash reserves: Flexible financial policy consists of surplus cash and little short - term burrowing; satisfying its short - term obligations. It reduces the probability of a firm experiencing financial distress. But, the investments in cash and marketable securities have NPV = 0. b) Maturity hedging: Most firms try matching the maturities of their assets and liabilities. c) Relative interest Rates: Short - term interest rates are usually lower than long - term interest rates. Thus, on average, it is more costly to rely on long - term burrowing as compared to short - term burrowing.

What does it mean to say that a firm has an inventory turnover ratio of 4?

The firm bought and sold off their inventory 4 times during the year. If the inventory turnover ratio is high, it means that the firm is handling their inventories efficiently.

What are some of the characteristics of a firm with a long cash cycle?

The longer the cash cycle, the more financing is required, in the short - run. These are firms that have a relatively long time between the time purchased inventory is paid for and the time that inventory is sold and payment received. Thus, these are firms that have relatively short payables periods and/or relatively long receivable cycles.

Cash - out

The scenario in which a firm runs out of cash and can't readily sell marketable securities and then it has to burrow or default on an obligation.

Cash Cycle

The time between cash disbursement and cash collection. Accounts Payable Period is the time between receipt of inventory and payment for it. Measures how long we need to finance inventory and receivables. Increases as the inventory and receivables periods get longer. Decreases if the company is able to defer payment of payables and thereby, lengthen the payables period. Cash Cycle = Operating Cycle - Accounts Payable Period

Indicate the impact of the following corporate actions on operating cycle: a) Average receivables go up. b) Credit payment times for customers are increased. c) Inventory turnover goes from 3 times to 7 times. d) Payables turnover goes from 6 times to 11 times. e) Receivables turnover goes from 6 times to 11 times. f) Payments to suppliers are accelerated.

a) Increase operating cycle. b) Increase operating cycle. c) Decrease operating cycle. d) No change. e) Decrease operating cycle. f) No change.

For the year just ended, you have gathered the following information on the Holly Corporation: a) A $200 dividend was paid. b) Accounts Payable increased by $500. c) Fixed Assets purchases were $900. d) Inventories increased by $625. e) Long - term debt decreased by $1,200. Label each item as a source or use of cash and describe its effect on the firm's cash balance.

a) Use of cash: Decreasing equity = Decreasing cash b) Source of cash: Increasing current liabilities = Increasing cash c) Use of cash: Increasing fixed assets = Decreasing cash d) Use of cash: Increasing current assets = Decreasing cash e) Use of cash: Decreasing long - term debt = Decreasing cash

Cash

= (Long - term) debt + Equity + Current liabilities - Current Assets other than cash - Fixed Assets

Total Cash Collections

= Beginning Accounts Receivables + (0.5)(Sales)

Total Asset Turnover (TA)

= Sales / Total Assets

Net Cash Inflow

= Total Cash Collection - Cash Disbursement

Shortage Costs

Costs that fall with increases in the level of investment in current assets. Incurred when the investment in current assets is really low. Consists of: a) Trading or order costs: Cost of placing an order for more cash, such as, brokerage costs, or more inventory, such as, production setup costs. b) Costs related to lack of safety reserves: Costs of lost sales, lost customer goodwill and disruption of production schedules: i. Stock - Out: When a firm loses customers because it has ran out of inventories.

Restrictive (Aggressive) Financial Policy

Maintains a relatively low ratio of current assets to sales. A high proportion of short - term debt relative to long - term financing. Doesn't have a cash reserve (an investment in marketable securities). a) Keeps low cash balances and little investment in marketable securities. b) Makes small investments in inventory. c) Allows few or no credit sales, thereby, minimizing accounts receivables. d) Relatively high levels of short - term liabilities. e) Low liquidity.

Balance Sheet Identity

Net Working Capital (NWC) + Fixed Assets = (Long - term) debt + Equity

Current Liabilities (Short - term debt)

Obligations that are expected to require cash payment within 1 year. a) Accounts payable b) Expenses payable, including accrued wages and taxes c) Notes payable

Indicate the impact of the following corporate actions on cash and operating cycles: a) The terms of cash discounts offered to customers are made less favorable. b) The cash discounts offered by suppliers are decreased; thus, payments are made earlier. c) An increased number of customers begin to pay in cash instead of with credit. d) Fewer raw materials than usual are purchased. e) A greater percentage of raw material purchases are paid for with credit. f) More finished goods are produced for inventory instead of for order.

a) Cash cycle: Increase Operating cycle: Increase If the terms of the cash discount are made less favorable to customers, the accounts receivable period will lengthen. This will increase both the cash cycle and the operating cycle. b) Cash Cycle: Increase Operating cycle: No change This will shorten the accounts payable period, which will increase the cash cycle. It will have no effect on the operating cycle since the length of the operating cycle is not affected by the payables period. c) Cash Cycle: Decrease Operating cycle: Decrease If more customers pay in cash, the accounts receivable period will decrease. This will decrease both the cash cycle and the operating cycle. d) Cash Cycle: Decrease Operating cycle: Decrease Fewer raw materials purchased will reduce the inventory period, which will decrease both the cash cycle and the operating cycle. e) Cash Cycle: Decrease Operating cycle: No change If more raw materials are purchased on credit, the accounts payable period will tend to increase, which would decrease the cash cycle. We should say that this may not be the case. The accounts payable period is a decision made by the company's management. The company could increase the accounts payable account and still make the payments in the same number of days. This would leave the accounts payable period unchanged, which would leave the cash cycle unchanged. The change in credit purchases made on credit will not affect the inventory period or the accounts receivable period, so the operating cycle will not change. f) Cash Cycle: Increase Operating cycle: Increase If more goods are produced for inventory, the inventory period will increase. This will increase both the cash cycle and operating cycle.

Indicate the impact of the following corporate actions on cash: a) A dividend is paid with funds received from a sale of debt. b) Real estate is purchased and paid for with short term debt. c) Inventory is bought on credit. d) A short term bank loan is repaid. e) Next year's taxes are prepaid. f) Preferred stock is redeemed. g) Sales are made on credit. h) Interest on long term debt is paid. i) Payments for previous sales are collected. j) The accounts payable balance is reduced. k) A dividend is paid. l) Production supplies are purchased and paid for with a short term note. m) Utility bills are paid. n) Cash is paid for raw materials purchased for inventory. o) Marketable securities are sold.

a) No change. b) No change. c) No change. d) Decrease cash. e) Decrease cash. f) Decrease cash. g) No change. h) Decrease cash. i) Increase cash. j) Decrease cash. k) Decrease cash. l) No change. m) Decrease cash. n) Decrease cash. o) Increase cash.

Financial ratios for the Cash Cycle

a) Payables Turnover = COGS/Average Payables b) Payables Period = 365 Days/Payables Turnover

Short - term Financial Policy

a) Size of the firm's investment in current assets: Measured relative to the firm's level of total operating revenues. b) Financing of current assets: Measured as the proportion of short - term debt (current liabilities) and long - term debt used to finance current assets.

Last month, BlueSky Airline announced that it would stretch out its bill payments to 45 days from 30 days, due to "control costs and optimize cash flow". The increased payables period will be in effect for all of the company's 4,000 suppliers. a) What impact did this change in payables policy have on BlueSky's operating cycle? Cash cycle? b) What impact did the announcement have on BlueSky's suppliers? c) Is it ethical for large firms to unilaterally lengthen their payables periods, particularly when dealing with smaller suppliers? d) Why don't all firms simply increase their payables periods to shorten their cash cycles? e) BlueSky lengthened its payables period to "control costs and optimize cash flow." Exactly what is the cash benefit to BlueSky from this change?

a) The increase in payables period will lead to shortening of the cash cycle. b) Their receivables period increased, thereby increasing their operating and cash cycles. c) It is sometimes argued that large firms "take advantage of" smaller firms by threatening to take their business elsewhere. However, considering a move to another supplier to get better terms is the nature of competitive free enterprise. d) Although, firms would like to do so, it is important to note that the payables period is a subject of much negotiation, and it is one aspect of the price a firm pays its suppliers. A firm will generally negotiate the best possible combination of payables period and price. Typically, suppliers provide strong financial incentives for rapid payment. e) BlueSky will need less financing because it is essentially borrowing more from its suppliers. Among other things, BlueSky will likely need less short-term borrowing from other sources, so it will save on interest expense.

Short - term Burrowing/ What factors go into determining a cash budget and why is it valuable?

a) Unsecured Loans: Firms that use short - term bank loans often arrange a line of credit, which is a formal (committed) or informal (noncommitted) arrangement under which a firm is authorized to burrow up to a specified amount, on annual basis. Noncommited line of credits don't require going through the normal paperwork. Committed line of credits are more formal legal arrangements and often involve a commitment fee paid by the firm to the bank. Its like the bak is buying insurance to guarantee that it doesn't bank out of the agreement. Revolving credit arrangement (Revolver): Similar to line of credit, but, it is usually open for 2+ years. Usually, employs floating interest rates. b) Secured Loans: i. Accounts Receivable Financing: Involves either the assignment or factoring of receivables. Under assigning, the lender has the receivables as security, but the burrower is still responsible if a receivable can't be collected. With conventional factoring, the receivable is discounted and sold to the lender (the factor). Once its sold, the collection is the factor's problem and factor assumes the full risk of default on bad accounts. With maturity factoring, the factor forwards the money on an agreed - upon future date. ii. Inventory Loans: Short - term loans to purchase inventories. Blanket Inventory Lien: Allows the lender a lien against all burrower's inventories. Trust Receipt (Floor Planning): The burrower holds specific inventory in "trust" for the lender. Eg: Automobile dealer financing Field Warehouse Financing: A public warehouse company (an independent company that specializes in inventory management) acts as a control agent to supervise the inventory for the lender.

Total asset requirement

x - axis: Time y - axis: Dollars Varying: a) General growth trend b) Seasonal variation around the trend (Cyclical needs) c) Unpredictable day - to - day and month - to - month fluctuations. In order to meet a firm's cyclical needs: Flexible Policy: Keep a relatively large pool of marketable securities. As the need for inventory and other current assets begin to rise, the firm sells off marketable securities and uses the cash to purchase whatever is needed. Once the inventory is sold and inventory holdings begin to decline, the firm reinvests in marketable securities. Thus, the firm essentially uses a pool of marketable securities as a buffer against changing current asset needs. The firm finances internally, using its own cash and marketable securities. Restrictive Policy: Keep a limited supply of marketable securities. As the need for inventory and other assets begin to rise, the firm burrows the needed cash on a short - term basis. The firm repays the loans as the need for assets cycles back down. The firm finances externally, burrowing the needed funds on a short - term basis. All else being the same, a firm with a flexible policy will have a greater investment in NWC.