Chapter 18

Short-Term Finance
and Planning
McGraw-Hill/Irwin
Copyright 2012 by McGraw-Hill Education (Asia). All rights reserved.
Learning Objectives
To provide the definition and concept of the working capital
management.
To discuss components and importance of working capital.
To explain the risk and return trade-off from the working
capital management perspective.
To discuss the strategies in working capital management.
To discuss the cash conversion cycle.
To develop a cash budget.
To discuss types of the short-term financing.
To calculate the cost of short-term financing with insertion
of compensation balance, discounted interest rate, and
other related features.
18-1
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
18-2
The Operating Cycle
Operating cycle time between purchasing the inventory
and collecting the cash from sale of 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
18-3
The 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
18-4
Figure 18.1
18-5
Example Information
Inventory:
Beginning = 200,000
Ending = 300,000
Accounts Receivable:
Beginning = 160,000
Ending = 200,000
Accounts Payable:
Beginning = 75,000
Ending = 100,000
Net sales = 1,150,000
Cost of Goods sold = 820,000
18-6
Inventory period
Average inventory = (200,000+300,000)/2 = 250,000
Inventory turnover = COGS / (Ave inventory) =820,000/250,000 = 3.28
times
Inventory period = 365 / 3.28 = 111 days
Inventory turnover: A ratio showing how many times a companys
inventory is sold and replaced over a period.
Inventory period: The days required to sell the average inventory on hand.
Receivables period
Average receivables = (160,000+200,000)/2 = 180,000
Receivables turnover = Net Sales / (Ave receivables) =1,150,000 /
180,000 = 6.39 times
Receivables period = 365 / 6.39 = 57 days
Operating cycle = 111 + 57 = 168 days
Receivables turnover: A ratio showing how many times a company
collects on its receivables over a period. A high ratio implies more efficient
collection of debt.
Receivables period: The days required to collect the average accounts
receivables.


18-7
Example: Cash Cycle
Payables Period
Average payables = (75,000+100,000)/2 = 87,500
Payables turnover = COGS / (Ave payables) = 820,000 /
87,500 = 9.37 times
Payables period = 365 / 9.37 = 39 days
Cash Cycle = operating cycle payables period =168 39 =
129 days
We have to finance our inventory for 129 days
If we want to reduce our financing needs, we need to
look carefully at our receivables and inventory periods
they both seem extensive. A comparison to industry
averages would help solidify this assertion.
18-8
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 short-term debt and less
long-term debt
18-9
Carrying vs. Shortage Costs
Managing short-term assets involves a trade-off
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
18-10
Temporary vs. Permanent Assets
Temporary current assets
Sales 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 arent sold
18-11
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
18-12
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 requirements
Allows a company to plan ahead and begin the search for
financing before the money is actually needed
18-13
Cash Budget
14
Exercise 1
As a cash manager, you are required to prepare a cash budget for May to
August 2013. The sales in March and April were RM62,000 and
RM50,000, respectively. The operation manager projected that 30% of
Nanny Nuggets sales are collected one month after the sale and the
balance two month after the sales. The estimated sales for May
through August 2013 are given below.

Month May June July August
Projected Sales(RM) 60,000 80,000 85,000 70,000
Projected Purchases (RM) 48,000 51,000 42,000 40,000

The purchase in April was RM36,000. These purchases are paid in the
following month.

15
Wages and salaries, rent and other expenses are as follows (RM):
May June July August
Wages and salaries 4,000 5,000 6,000 4,000
Rent 3,000 3,000 3,000 3,000
Other expenses 1,000 500 1,200 1,500
Depreciation 500 500 500 500

Nanny Nugget needs to pay RM4,000 interest on long-term debt in May
2013.
Principal amount of short-term debt amounting RM8,000, and its
interest amounting RM200 will be due in July 2013.
A tax payment will also be due in July amounting RM5,200.
Nanny needs to purchase equipment costing RM10,000 in May 2013.

Cash Budget
16
The ending cash balance in April was RM10,000 and will
continue to maintain the minimum cash balance in the near
future.
Additional borrowing is allowed to maintain the minimum
cash balance. Interest on short-term fund is 12% p.a. or 1%
per month. Interest will be paid the following month after the
fund was borrowed.

Construct a cash budget for month May to August.
Cash Budget
17
Constructing a cash budget
Salco company wants to prepare cash budget for upcoming 6 months.
30% of sales are collected 1 month after sales, 50% 2 months after
sale, and the reminder during the third month following the sales.
Purchase equal 75% of sales and are made 2 months in advance of
anticipated sales. Payments are made in the month follwoing
purchases.
Equipment purchased on February of $14,000 and the repayment of a
$12,000 loan in May. In June, Salco will pay interest of $7,500 on its
$150,000. interest of 12,000 short term repaid in May is $600.
Salco has a cash balance of $20,000 and wants to maintain a minimum
balance of $10,000.
Interest on the borrowed funds equals 12% per annum or 1% per month
and is paid in the month following the one in which funds are borrowed.

18
19
Short-Term Borrowing
Unsecured Loans
Line of credit
Committed vs. noncommitted
Revolving credit arrangement
Letter of credit
Secured Loans
Accounts receivable financing
Assigning
Factoring
Inventory loans
Blanket inventory lien
Trust receipt
Field warehouse financing
Commercial Paper
Trade Credit
18-20
Example: Compensating Balance
1. We have a $500,000 line of credit with a 15% compensating
balance requirement. The quoted interest rate is 9%. We
need to borrow $150,000 for inventory for one year.
How much do we need to borrow?
150,000/(1-.15) = 176,471
What interest rate are we effectively paying?
Interest paid = 176,471(.09) = 15,882
Effective rate = 15,882/150,000 = .1059 or 10.59%
2. With a quoted interest rate of 5% and a 10% compensating
balance, what is the effective rate of interest (use a $200,000
loan proceeds amount)?
Borrow $200,000 / (1 - 0.1) = $222,222 Pay interest of .05 x $222,222 = $11,111
Effective rate of interest = $11,111/$200,000 = .05555 = 5.56%
18-21
End of Chapter
18-22