A Short-Term Financial Plan

The cash budget is used to determine how a firm will raise the cash to meet any cash deficits
computed in the budget. It is also used to determine when marketable security investment may be
necessary. For temporary imbalances, short-term borrowing and marketable securities are in order.
For long-term short-falls or surpluses, long-term solutions include issuing bonds or equity to meet
cash deficits and paying dividends, repurchasing shares or refunding debt for cash surpluses.

Short-Term Planning Learning Objectives

1. Define the operating and cash cycles. Why are they important?

2. Define the different types of short-term financial policy

3. Understand the essentials of short-term financial planning.

4. Calculate the sources and uses of cash on the balance sheet.

Many view short-term finance generally, and working capital management specifically, as less
important than capital budgeting or the risk-return relationship. This is mistaken. Short-term planning
or working capital management is important.

First, discussions with CFOs quickly lead to the conclusion that, as important as capital budgeting
and capital structure decisions are, they are made less frequently, while the day-to-day
complexities involving the management of net working capital (especially cash and inventory)
consume tremendous amounts of management time. Second, it is clear that while poor long-term
investment and financing decisions will adversely impact firm value, poor short-term financial
decisions will impair the firm’s ability to continue operating. Finally, good working capital decisions
can also have a major impact on firm value.

Short-Term Financial Policy

Size of investments in current assets

This is normally measured relative to the level of operating revenues. A short-term policy is flexible
if the firm maintains a high ratio of current assets to sales. A restrictive policy would have a low
ratio.
In addition to the level of current assets, the method of financing this investment is important. This
measured by the proportion of short-term and long-term debt used finance current assets. A
restrictive policy will use more short-term instead of long-term debt to buy current assets. A flexible
policy will use more long-term debt.
If we take these two areas together, we see that a firm with a flexible policy would have a relatively
large investment in current assets, and it would finance this investment with relatively less short-term
debt. The net effect of a flexible policy is thus a relatively high level of net working capital. Put
another way, with a flexible policy, the firm maintains a higher overall level of liquidity.

Characteristics of a flexible short-term financial

 Keeping large balances of cash and marketable securities.

 Making large investments in inventory.
 Granting liberal credit terms.

 Keeping low cash balances and making little investment in marketable securities.

 Making small investments in inventory.

 Allowing few or no credit sales.

 An optimal plan will balance the costs of a restrictive against the costs of a flexible policy.

What are some of the factors for determining the optimal level of current assets?
Carrying vs. 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

Temporary current assets

Sales or required inventory build-up may be seasonal
Additional current assets are needed during the “peak” time
The level of current assets will decrease as sales occur

Permanent current assets

Firms generally need to carry a minimum level of current assets at all times
These assets are considered “permanent” because the level is constant, not because the assets aren’t
sold
Why we need short term financial Planning

Cash Shortages

There are varied reasons that significant cash shortages occur. For example, a business might be
following an aggressive marketing policy in which it allows its debtors to pay their dues over a
longer period. Such a policy might dent the company’s cash-flows from two perspectives. First,
it locks up money in receivables with debtors, and second, the company might fund additional
inventories for newer sales, without recourse to business-based cash inflows. Enterprises also
face such challenges when they buy new machinery, are assessed heavy court fines or while
fighting natural calamities, such as hurricanes.

Cash-Flow Forecast

When it becomes evident that severe cash shortages will occur, a cash-flow forecast becomes
necessary. The forecast should estimate total cash collections and total cash payments during
each quarter in at least three various scenarios: worst case, most likely and best case. You'll need
to know the difference between the total collections and total payments to ascertain whether
there is a deficit in any quarter of the year. For each cash-inflow and outflow item, you must
account for all relevant increases and decreases. This includes early payment discounts from
creditors, deferred expense payments and cash sales.

Funding Shortages

If the cash-flow forecast shows that shortages are likely to occur during the year, you must make
arrangements to cover them. One way to fund short-term deficits is through other short-term
measures, such as increases in current liabilities, which can include negotiations for longer credit
terms and short-term bank loans. You also can sell certain unwanted assets and offer discounts to
debtors to encourage quicker payments.