Chapter 20

Short-Term
Financial Planning

Prepared by
Tanya Willis
Saint Mary’s University © 2016 McGraw-Hill Education Limited Chapter 20-1
After studying this chapter, you should be able to:
 LO1 Show how long-term financing policy affects short-term financing
requirements.
 LO2 Explain why the firm needs to invest in net working capital.
 LO3 Trace a firm’s sources and uses of cash and evaluate its need for
short-term borrowing.
 LO4 Develop a short-term financing plan that meets the firm’s need for
cash.
 LO5 Determine the costs of various sources of short-term financing.

© 2016 McGraw-Hill Education Limited Chapter 20 -2

  Short term financing issues are conceptually easier than those
involved in capital budgeting.
 They are tied to the firm’s long term decisions.
 Capital refers to a firm’s source of long-term financing.
 The difference between the long-term financing raised and
the total capital requirement determines whether the firm is
a short-term borrower or lender.

LO1
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LO1
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  Some Observations:
◦ Matching Maturities: Financial managers attempt to match the
maturities of their assets and liabilities.
◦ Permanent Working Capital Requirements: Most firms plan to
have a positive net working capital at all times.
◦ Advantages of Liquidity: Most managers would feel comfortable
under the relaxed strategy than the restrictive strategy shown in
figure (a) of the previous slide.

LO1
© 2016 McGraw-Hill Education Limited Chapter 20 -5
 The Components of Working Capital
◦ Some common current assets and liabilities

Current Assets Current Liabilities

Cash and cash equivalents Bank indebtedness
Accounts receivable Accounts payable and
accrued liabilities
Inventories Current portion of long-
term debt
Prepaid expenses

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -6
 Terminology
 Net Working Capital: Current assets minus current liabilities.
Often called working capital.

 Operating cycle: Period of time from the purchase of raw

materials to the collection of cash from the sale of finished
goods.

 Cash Conversion Cycle: Period between firm’s payment for

materials and collection on its sales.

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -7
 A simple cycle of operations:

Cash

Raw materials
Receivables
inventory

Finished goods
Inventory

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -8
 inventory
Inventory period 
annual cost of sales / 365

accounts receivable
Accounts receivable period 
annual sales / 365

accounts payable
Accounts payable period 
annual cost of goods sold / 365

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -9
 The Operating cycle = inventory period + accounts receivables
period

The Cash Conversion Cycle:

= (inventory period + accounts receivables period)– accounts
payable period
OR
= operating cycle – accounts payable period

LO2
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  Example: Brick Brewing Co.:
1. How long on average does it take to produce and sell their product?
2. How long does it take to collect bills?
3. How long does it take to pay bills?
4. What is the operating cycle and cash conversion cycle?
Statement of Comprehensive Statement of Financial Position
Income Data Data
Revenue from sales $69,559,730 Inventory $4,013,375

Cost of sales 26,674,244 Accounts receivables 5,187,785

Accounts payables 5,461,292

Note: Revenue from sales is a measure of the firm’s annual sales and cost of sales is a measure of annual cost of goods
sold.

Source: Statement of comprehensive income ad statement of financial position from Brick Brewing Co. 2013 annual
report.

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -11
 Example: Brick Brewing Co.
inventory 4,013,375
Inventory period    54.9 days
annual cost of sales / 365 26,674,244 / 365

accounts receivable 5,187,785

Accounts receivable period    27.2 days
annual sales / 365 69,559,730 / 365

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -12
 Example: Brick Brewing 2013:

accounts payable 5,461,292

Accounts payable period    74.7 days
annual cost of goods sold / 365 26,674,244 / 365

Operating cycle = Inventory period + receivables period

= 54.9 + 27.2 = 82.1 days

Cash conversion cycle = Operating cycle – payables period

= 82.1 – 74.7 = 7.4 days

LO2
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  The Working Capital Trade-Off

◦ There are costs and benefits associated with the firm’s

investment in working capital
 Carrying costs: Costs of maintaining current assets, including
opportunity cost of capital.

 Shortage costs: Costs incurred from shortages in current assets

◦ An important job of the financial manager is to find the level of

current assets that minimizes the sum of carrying costs and
shortage costs.

LO2
© 2016 McGraw-Hill Education Limited Chapter 20 -14
  Analysts trace the sources and uses of cash in the statement
of cash flows.
◦ Information is organized into 3 sections: cash flow from
operations, cash flow from investments, and cash flow from
financing activities.
◦ Positive entries correspond to activities that generated cash and
negative ones to activities that used cash.

◦ The next 3 slides show year end balance sheets for 2013 and
2014, income statement for 2014 and the statement of cash
flows for 2014 for Dynamic Mattress Company.

LO3
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 Table 20.3: Year end balance sheets for Dynamic
Mattress Company ($ millions)

LO3
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 Table 20.4: Income Statement for
Dynamic Mattress Company, 2014
($ millions)

LO3
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 Table 20.5: Statement of cash flows for Dynamic Mattress
Company, 2014 ($ millions)

LO3
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  Three common steps in creating a cash budget:
1. Forecast the sources of cash.
2. Forecast the uses of cash.
3. Calculate whether the firm is facing a cash shortage or
surplus.

 The financial plan then sets out a strategy for investing a cash
surplus or financing any deficit.

LO4
© 2016 McGraw-Hill Education Limited Chapter 20 -19
 Dynamic Mattress cash budgeting example:

Forecasted quarterly sales for 2015 will be:

Quarter: First Second Third Fourth

Sales, $millions 87.5 78.5 116 131

◦ Assume 80% of sales are collected in the immediate quarter

and the remaining 20% in the next quarter.

LO4
© 2016 McGraw-Hill Education Limited Chapter 20 -20
 Dynamic Mattress forecast collections (figures taken from Table
20.6)

a. Sales in 4th quarter of previous year were $75 million

LO4
© 2016 McGraw-Hill Education Limited Chapter 20 -21
 Dynamic Mattress forecast sources and uses of cash (figures
taken from Table 20.6)

LO4
© 2016 McGraw-Hill Education Limited Chapter 20 -22
 Dynamic Mattress forecast short term financing requirements (figures
taken from Table 20.6)

b. Firms cannot literally hold a negative amount of cash. This line shows the amount of cash the
firm will have to raise to pay its bills.
c. A negative sign indicates that no short-term financing is required. Instead the firm has a cash
surplus.

LO4
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 The next slide shows Dynamic Mattress’s financing plan.

• Panel A (cash requirements) sets out the cash that needs to be

raised in each quarter.

• Panel B (cash raised in quarter) describes the various sources of

financing the firm plans to use.

• Panels C and D describe how the firm will use net cash inflows
when they turn positive.

• Panel E keeps track of the bank loan.

LO4
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Table 20.7:
A spreadsheet
for Dynamic
Mattress’s
financing plan
($ million)

LO4
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  Evaluating the Plan

◦ Short-term financial plans must be developed by trial and error.

◦ You lay out one plan, think about it then try again with different
assumptions about the financing and investment alternatives.

◦ You continue until you can think of no further improvements.

LO4
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  Bank Loans are the simplest and the most common form of
short term financing.
◦ A line of credit is an agreement by a bank that a company
may borrow at any time up to an established limit.
◦ Typically reviewed annually and may be cancelled.

◦ Revolving credit agreement: usually last a few years and

formally commit he bank to lending up to the agreed limit
◦ Firm pays a commitment fee – fee charged by lender on
unused portion of a line of credit

LO5
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 ◦ An alternative to a line of credit is a term loan that provides
all the money at the start of the loan and has a specified
repayment schedule (more than one year).

◦ Some lines of credit and term loans are too large for a single
lender. A syndicated loan is a loan provided by a group of
banks that combine to provide the loan amount.

LO5
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  Secured Loans
◦ Sometimes a company must offer assets as security, depending
on the assessment of the credit risk by the bank.
◦ The amount a bank will lend against security varies - typically,
75% of good quality, under 90 day receivables and 50% of
finished goods inventory.
◦ A/R financing – When loans are secured by receivables, the firm
assigns or pledges them as collateral for the loan.
◦ Inventory financing – When loans are secured by inventories

 Factoring – When the firm sells the receivables at a discount

for the purpose of obtaining short –term financing

LO5
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  Commercial Paper
◦ Commercial paper is a short-term unsecured note issued by
large, well-known corporations that regularly need to raise large
amounts of cash.
◦ Commercial paper is backed by the quality of the corporations
assets and its operating cash flows.

 Banker’s Acceptance
◦ Firm’s time draft that has been accepted by a bank and may be
sold to investors as a short-term unsecured note issued by the
firm and guaranteed by the bank.

LO5
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 Comparing the rates:

Simple Interest =
annual interest rate
Amount of loan  
number of periods in the year

Effective Annual Rate =

m
 quoted annual interest rate 
1   1
 m 

LO5
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 Discount Interest
 The bank deducts the interest up front. Example: you borrow
$100,000 on a discount basis at 12% for 1 year. This means
the bank will charge the $12,000 interest up front and give
you $88,000. After a year, you will have to pay back $100,000
face value.

 Thus, effectively, they are paying $12,000 on $88,000 loan.

Thus, the interest is 12,000/88,000 = 13.64%

LO5
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 Most firms attempt to finance all long-term assets with equity
and long-term debt, and invest cash surpluses during part of
the year and borrow during the rest of the year.

 Short-term financial planning is concerned with the

management of the firm’s short-term or current assets and
liabilities.

 The difference between current assets and current liabilities

is called net working capital.

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 The cash conversion cycle is the length of time between the
firm’s payment for materials and the date it gets paid by its
customers.

 Higher investment in current assets entails higher carrying

costs but lower expected shortage costs.

 The starting point for short-term financial planning is

forecasting the sources and uses of cash.

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 Firms forecast their collection of accounts receivables and
other cash inflows and subtract all forecast cash outflows. If
the balance is insufficient to cover day-to-day operations, the
company will require financing.

 A short-term financial plan is developed by trial and error .

Companies look at the consequences of different assumptions
about cash requirements, interest rates, limits on financing,
etc.

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 Many sources and ways to finance short-term needs
◦ Bank loans – line of credit, term loan, syndicated loan
◦ Secured loans – A/R financing, inventory financing
◦ Factoring
◦ Commercial paper
◦ Banker’s acceptance
◦ The interest rate on short-term bank loans is usually quoted as a
simple interest rate (or APR) but sometimes quoted on a discount
basis.

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