Financial Planning – Part II.

Lecture 03b

1 Lecture 03b Short-Term Financial Planning

 Contents
̶ Short-Term Financial Planning
̶ Tracing Cash and Net Working Capital
̶ Operating Cycle and Cash Cycle (Revision)
̶ Cash Budget
̶ Cash Management
̶ Inventories
̶ Accounts Receivable Management and Credit Decision

2 Lecture 03b Short-Term Financial Planning

 Managers Dealing with Short-term Financial Issues

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 645.
(Originally in: Hill, N. C. and Sartoris, W. L. 1992. Short-Term Financial Management, 2nd ed. New York: Macmillian, p. 15).

3 Lecture 03b Short-Term Financial Planning

 Short-Term Financial Planning (1)
̶ Short-term financial planning = working capital management
̶ Short-term financial decisions:
▪ Involve short-lived assets and liabilities -> short-run operating and
financing activities.
▪ Are easily reversed.
▪ Timing of cash inflows and outflows is within a year or less.

̶ The following questions should be answered among others:

▪ Should the company borrow in the short-term? If yes, how much?
▪ Should the company extend credits to customers?
▪ How much cash should be kept to pay bills?
4 Lecture 03b Short-Term Financial Planning
 Current Assets in Different U.S. Industries
(% of Total Assets, 4th Q 2020)

BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate finance. 14th ed. New York:
McGraw-Hill Education, p. 890.

5 Lecture 03b Short-Term Financial Planning

 Tracing Cash and Net Working Capital
Cash = Long-term debt + Equity + Current liabilities – Current Assets other
than cash – Fixed assets

▪ Sources of cash: ▪ Uses of cash:

↑ debt ↓ debt
↑ equity ↓ equity
↑ current liabilites ↓ current liabilites
↓ current assets other than cash ↑ current assets other than cash
↓ fixed assets ↑ fixed assets
̶ Cash inflows and cash outflows are unsychronized and uncertain.
6 Lecture 03b Short-Term Financial Planning
 Operating Cycle and Cash Cycle (1)
̶ Operating cycle.
▪ It represents the time period between purchase of inventory and the
collection of cash from receivables.
▪ It describes a product motion through the current asset accounts.
▪ With each step, the asset is closer to cash.

Operating cycle = Inventory period + Accounts receivable period

7 Lecture 03b Short-Term Financial Planning

 Operating Cycle and Cash Cycle (2)
̶ Cash Cycle.
▪ Represents unsynchronization of cash flows.
▪ Number of days that pass before the cash is collected from a sale,
calculated from when we paid for inventory.

Cash cycle = Operating cycle – Accounts payable period

8 Lecture 03b Short-Term Financial Planning

 Operating Cycle and Cash Cycle (3)

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 643.

9 Lecture 03b Short-Term Financial Planning

 Operating Cycle and Cash Cycle (4)
̶ The cash cycle points out the need for short-term financial
management.
̶ The cash cycle ↑ when the inventory and receivable periods get
longer and when the payables period gets shorter and vice versa.
̶ The gap can be filled by:
▪ Borrowing.
▪ Holding a liquidity reserve (cash or marketable securities).
▪ Or it can be adjusted by changing inventory, payable and receivable
periods (if possible).

10 Lecture 03b Short-Term Financial Planning

 Link Between Cash Cycle and Profitability
̶ Total asset turnover (Revenues/Total assets).
▪ ! Determinant of profitability and growth.
▪ The higher the total asset turnover, the greater ROA and ROE.
▪ The shorter cash cycle, the lower company‘s investment in inventories and
receivables → totals asset are lower → increase in total asset turnover.

11 Lecture 03b Short-Term Financial Planning

 Different Asset Financing Policies

BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate finance. 14th ed. New York:
McGraw-Hill Education, p. 858.

12 Lecture 03b Short-Term Financial Planning

 Selected Aspects of Short-term Financial
Policy (1)
̶ The adopted policy is reflected in:
a) The size of the company‘s investment in current assets.
b) The financing of current assets.

̶ Conservative short-term fin. policy: ̶ Restrictive short-term fin. policy:

▪ Large balances of cash and marketable
securities.
▪ Large investments in inventory.
▪ Liberal credit terms → high level of
accounts receivables.
▪ Low level of cash and marketable
securities.
▪ Small inventory investments.
▪ Minimazing accounts receivables.

13 Lecture 03b Short-Term Financial Planning

 Selected Aspects of Short-term Financial
Policy (2)
̶ The optimal level of short-term investment in current assets is associated
with identification of different costs of alternative short-term financing
policies.
̶ Carrying costs: ̶ Shortage costs:
▪ ↑ when the level of investment in current ▪ ↓ when the level of investment in current
assets rises. assets increases.
▪ Opportunity costs associated with ▪ Cash-out x stock out
current assets. ▪ Trading (order) costs x cost related to
lack of safety reserves.

14 Lecture 03b Short-Term Financial Planning

 Selected Aspects of Short-term Financial
Policy (3)
Conservative policy

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance. Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, p. 677.

15 Lecture 03b Short-Term Financial Planning

 Selected Aspects of Short-term Financial
Policy (4)
̶ The adopted policy is reflected in:
a) The size of the company‘s investment in current assets.
b) The financing of current assets.
̶ Three possibilites:
▪ NWC = 0
▪ NWC > 0
▪ NWC < 0
̶ Other criteria for consideration:
▪ Cash reserves.
▪ Maturity hedging.
▪ Relative interest rates.

16 Lecture 03b Short-Term Financial Planning

 Cash Bugdeting (1)

̶ Main tool in short-term financial planning.

̶ It helps to identify short-term financial needs and opportunities.
̶ It represents a forecast of disbursements and cash receipts for the
planning period.
̶ 1st step: Calculate cash inflows:
▪ Sales and cash collections.
Ending accounts receivable = beginning accounts receivable + sales − collections

▪ Other cash inflows.

17 Lecture 03b Short-Term Financial Planning

 Cash Budgeting (2)
̶ 2nd step: Calculate cash outflows:
▪ Payments of account payables.
▪ Wages, administration, other expenses.
▪ Increase in inventories.
▪ Capital expenditures.
▪ Financing expenses that a firm already bears.
▪ Taxes, divident payments.
̶ 3rd step: Calculate whether the firm is facing a cash shortage or
surplus.

18 Lecture 03b Short-Term Financial Planning

 Cash Management (1)
̶ Cashpool.
̶ Open credit line, etc.

̶ Cash does not pay interest.

▪ Move money from cash accounts into interest bearing accounts or short-
term securities.
▪ In case of a significant cash surplus, long-term securities can also be
considered.

19 Lecture 03b Short-Term Financial Planning

 Cash Management (2)
Example: Apple 2021 cash investments
Fixed-Income Investments Value at Cost ($ billions)
Money market and mutual funds $9.7
U.S. Treasury and agency securities 30.1
Non-U.S. government securities 20.0
Certificates of deposit and times deposits 7.1
Commercial paper 2.1
Corporate debt securities 85.2
Municipal securities 1.0
Mortgage-and asset-backed securities 22.2
Total $177.4
BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate finance. 14th ed. New York: McGraw-Hill Education,
p. 858.

20 Lecture 03b Short-Term Financial Planning

 Inventories (1)
̶ Goal = Minimize amount of cash tied up in inventory.
̶ Tools used to minimize inventory.
▪ Just-in-time and other methods.
̶ ! As the firm increases its order size, the number of orders falls
and therefore the order costs decline.
̶ ! However, an increase in order size also increases the average
amount in inventory, so that the carrying cost of inventory rises.
̶ A balance should be found between these two costs.

21 Lecture 03b Short-Term Financial Planning

 Determination of Optimal Order Size

BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate finance. 14th ed. New York:
McGraw-Hill Education, p. 893.

22 Lecture 03b Short-Term Financial Planning

 Inventories (2)
̶ Economic Order Quantity: Order size that minimizes total
inventory costs, that is the optimal order size.

cost per order

Economic order quantity = 2  sales 
carrying cost

̶ It is useful when the company uses up materials at a constant

rate.

23 Lecture 03b Short-Term Financial Planning

 Accounts Receivable Management
̶ Trade Credit – receivables from one company to another.
̶ Consumer Credit – receivables from consumers.

̶ Management of trade credit requires answers to 4 questions:

a) How long are you going to give customers to pay their bills? Are you
prepared to offer a cash discount for prompt payment?
b) How do you determine which customers are likely to pay their bills?
c) How much credit are you prepared to extend to each customer? (play it
safe versus risk acceptance)
d) How do you collect the money when it becomes due? What is the
approach to reluctant payers?

24 Lecture 03b Short-Term Financial Planning

 Terms of Sale
̶ Terms of sale: Credit, discount, and payment terms offered on a sale.

Example: 2/10, net 30.

▪ 2: percent discount for early payment.
▪ 10: number of days that the discount is available.
▪ net 30: number of days before payment is due.

25 Lecture 03b Short-Term Financial Planning

 Credit Analysis
̶ Procedure to determine the likelihood a customer will pay its bills.
̶ Credit agencies provide reports on the creditworthiness of a
potential customer.
̶ Financial ratios can be calculated to help determine an ability to
pay.

26 Lecture 03b Short-Term Financial Planning

 The Credit Decision (2)

BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate finance. 14th ed.
New York: McGraw-Hill Education, p. 896.

27 Lecture 03b Short-Term Financial Planning

 The Credit Decision (3)
̶ Based on the probability of payoffs, the expected profit from
transaction can be expressed in following form:
p  PV (REV − COST) − (1 − p)  PV (COST)

̶ The break-even probability of collection is:

PV(COST)
p=
PV(REV)

28 Lecture 03b Short-Term Financial Planning

 The Credit Decision – Example Illustration

BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate finance. 14th
ed. New York: McGraw-Hill Education, p. 830.
29 Lecture 03b Short-Term Financial Planning
 Collection Policy
̶ Collection Policy:
▪ Procedures to collect and monitor receivables.
̶ Factoring:
▪ Arrangement whereby a financial institution buys a company's accounts
receivable and collects the debt.

30 Lecture 03b Short-Term Financial Planning

 Literature
BREALEY, R. A., S. C. MYERS and F. ALLEN. 2023. Principles of corporate
finance. 14th ed. New York: McGraw-Hill Education, chapter 30.

WESTERFIELD, Randolph a Jeffrey F. JAFFE. 2005. Corporate finance.

Edited by Stephen A. Ross. 7th ed. Boston: McGraw-Hill, chapter 4.

31 Lecture 03b Short-Term Financial Planning

Thank you for your attention.
Questions? Remarks? Impulses to discussion?

32 Lecture 03b Short-Term Financial Planning