Chapter 18
Short-Term
Finance and
Planning

McGraw­Hill/Irwin

Copyright © 2010 by The McGraw­Hill Companies, Inc. All rights reserved.

Key Concepts and Skills
• Understand the components of the cash cycle and why it is important
• Understand the pros and cons of the various short-term financing policies
• Be able to prepare a cash budget
• Understand the various options for short-term financing

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Chapter Outline
• Tracing Cash and Net Working Capital
• The Operating Cycle and the Cash Cycle
• Some Aspects of Short-Term Financial
Policy
• The Cash Budget
• Short-Term Borrowing
• A Short-Term Financial Plan

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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 18-4

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

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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

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Figure 18.1

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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

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Example – Operating Cycle
• Inventory period
– Average inventory = (200,000+300,000)/2 = 250,000
– Inventory turnover = 820,000 / 250,000 = 3.28 times
– Inventory period = 365 / 3.28 = 111 days

• Receivables period
– Average receivables = (160,000+200,000)/2 = 180,000
– Receivables turnover = 1,150,000 / 180,000 = 6.39 times
– Receivables period = 365 / 6.39 = 57 days

• Operating cycle = 111 + 57 = 168 days

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Example – Cash Cycle
• Payables Period
– Average payables = (75,000+100,000)/2 = 87,500
– Payables turnover = 820,000 / 87,500 = 9.37 times
– Payables period = 365 / 9.37 = 39 days

• Cash Cycle = 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.

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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 shortterm debt and more long-term debt
– Restrictive (aggressive) policy – more shortterm debt and less long-term debt

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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
18-12

Temporary vs. Permanent
Assets
• Temporary current assets
– Sales or required inventory build-up may be seasonal
– Additional current assets are needed during the “peak”