Short-Term Finance

Overview
Net Working Capital and Cash

Operating cycle and cash cycle

Models for optimal cash balance (BAT, Miller-Orr)

Understanding float
 Balance Sheet of the Firm
What is Net Working Capital?
Current
Liabilities
Current
Net
Assets Working
Long-Term
Capital Debt

How much
Fixed Assets
short-term cash
1. Tangible flow does a
Shareholder
company need
2. Intangible to pay its bills? s Equity
 Defining Cash in Terms of Other
Elements

Long- Net Working

Fixed
Cash = Term + Equity Capital
Assets
Debt (excluding cash)

An increase in long-term debt and or equity (i.e.,

new financing by issuing debt or equity) leads to
an increase in cash, while a increase in fixed
assets or the non-cash components of net
working capital (e.g., use cash to purchase fixed
assets or additional raw materials) leads to an
decrease in cash.
The sources and uses of cash follow from this
reasoning.
 Tracing Cash and Net Working Capital
Sources of Cash (Activities that increase cash)
Increase in long-term debt account (borrowed money)
Increase in equity accounts (sold stock)
Increase in current liability accounts (borrowed money)
Decrease in current asset accounts, other than cash (sold current
assets)
Decrease in fixed assets (sold fixed assets)
Uses of Cash (Activities that decrease cash)
Decrease in long-term debt account (repaid loans)
Decrease in equity accounts (repurchased stock or paid
dividends)
Decrease in current liability accounts (repaid suppliers or short-
term creditors)
Increase in current asset accounts, other than cash (purchased
current assets)
Increase in fixed assets (purchased fixed assets)
26.2 The Operating Cycle and the Cash
Cycle
Raw material
purchased
Cash
Finished goods sold
received
Order Stock
Placed Arrives

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating
cycle
Cash cycle
The Operating Cycle and the Cash Cycle

Accounts
Cash cycle = Operating cycle payable
period
Where Operating cycle = Inventory period +
Account receivable period (see the previous slide)

In practice, the inventory period, the accounts

receivable period, and the accounts payable period
are measured by days in inventory, days in
receivables, and days in payables, respectively.
 More detailed formulas
Inventory period
Average inventory = (Beginning inventory + Ending inventory)/2
Inventory turnover = (Annual) Cost of Goods Sold / Average
inventory
Inventory period = 365 days / Inventory turnover
Receivables period
Average account receivables = (Beginning receivables + Ending
receivables)/2
Receivables turnover = Credit sale / Average account receivables
Receivables period = 365 days / Receivables turnover
Account Payables Period
Average payables = (Beginning payable + Ending payable)/2
Payables turnover = (Annual) Cost of Goods Sold / Average
payables
Payables period = 365 days / Payable turnover
Operating cycle = Inventory period + Receivables period
Cash Cycle = Operating cycle Account Payables Period
 Costs of Holding Cash:
BAT models view
Costs in dollars of
holding cash Trading costs increase when the firm
must sell securities to meet cash needs.
Total cost of holding cash
Opportunity Costs

The investment income

foregone when holding cash.

Trading costs
C* Size of cash balance
The BAT (Baumol-Allais-Tobin) Model

F = The fixed cost of selling securities to raise cash

T = The total amount of new cash needed
R = The opportunity cost of holding cash, i.e., the
interest rate. If we start with $C (cash
holding amount), spend at a
C constant rate each period and
replace our cash with $C
when we run out of cash, our
C C
2 average cash balance will be
2
The opportunity cost
of holding C is C R
2 2
1 2 3 Time
The BAT (Baumol-Allais-Tobin) Model
As we transfer $C each
period we incur a
trading cost of F.

C
If we need $T in total
over the planning
C T
2 period we will pay $F
C
times, where T/C is
the number of times
we raise cash.
1 2 3 Time
T F
The trading cost is
C
 The BAT (Baumol-Allais-Tobin) Model
C T
Total cost = R + F
2 C
C
Opportunity Costs = R
2

T
Trading costs = F
C
C* Size of cash balance

2T
optimal cash =
*
C F
balance C* R
The BAT Model: the derivation of C*
(optimal cash balance)
The optimal cash balance is found where the opportunity
costs equals the trading costs.
When C is at Optimal level, Opportunity Costs = Trading
Costs C T
R = F
2 C
Multiply both sides by C
C2 T F 2TF
R =T F C =2
2
C =
*

2 R R
BAT Model implication: Optimal cash holding C* is negative
related to opportunity cost (i.e., interest rate R) and positive
related to T (the total amount of new cash needed). Since higher
F means greater transaction cost, it reduce the number of times
we want to raise cash. Thus, F is also positive related to C*.
 The Miller-Orr Model
The firm allows its cash balance to wander
randomly between upper and lower control limits.
When the cash balance reaches the upper control
$ limit U, cash is spent/invested elsewhere to get us
to the target cash balance C.
U When the cash
balance reaches the
lower control
limit, L,
C investments are
sold to raise cash
L to get us up to the
target cash balance.
Time
 The Miller - Orr Model
Upper Limit Buy Securities
H

L
Lower Limit Sell Securities

Days of the Month

 The Miller-Orr Model Math
Given L (lower control limit for cash balance), which is
set by the firm, the Miller-Orr model solves for C* and U

1
2
3FF 3 2 3
C *= 3 + L= + L;
U *
= 3C *
2L
4R 4R
where s2 is the variance of net daily cash flows.
NOTE: Since the s2 is the variance of daily cash flow. If
we plug in this formula, the R should be daily rate of
return.
F = transaction cost of buying or selling (marketable)
securities.
Implications of the Miller-Orr Model

To use the Miller-Orr model, the

manager must do four things:
1. Set the lower control limit (i.e., L) for the
cash balance.
2. Estimate the standard deviation of daily
cash flows (i.e., s - sigma).
3. Determine the (daily) interest rate (i.e., R).
4. Estimate the trading costs of buying and
selling securities (i.e., F ).
 Example question
Example: Suppose that short-term securities
yield 5% per year and it costs the organization
$50 each time it buys or sells securities. The
variance of daily cash flows is $1000 and your
bank requires $1,000 minimum checking account
balance. Given the information above, how much
should be the optimal cash balance C* and
upper limit U* (that is corresponding to C*)?
Implications of the Miller-Orr Model
The model clarifies the issues of cash
management:
The optimal cash position, C*, is positively
related to trading costs, F, and negatively
related to the interest rate R.
C* is positively related to the variability (i.e.,
standard deviation) of cash flows (s2). This is
an intuitive new insight we gain from Miller-Orr
model, compared to BAT model.
1
2
3FF 3 2 3
=
C* 3 =
+L + L;
4R 4R
Short-Term Financial Plan: Short-Term Borrowing
The most common way to finance a temporary
cash deficit is to borrow a short-term loan.
Unsecured Loans
Line of credit (at the bank)
Secured Loans
Accounts receivable financing can be either
assigned or factored.
(i) Under assignment, the lender not only has a lien on
the receivables but also has recourse to the borrower.
(ii) Factoring involves the sale of accounts receivable.
The purchaser of the receivables, called factor, must
then collect on the receivables. The factors assumes
the full risk of default on bad account.
Inventory loans use inventory as collateral.
Other Sources: Commercial paper ( for large firms)