Because learning changes everything.

Corporate Finance
Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 26

Short-Term Finance and Planning

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 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
26.1 Tracing Cash and Net Working Capital
26.2 The Operating Cycle and the Cash Cycle
26.3 Some Aspects of Short-Term Financial Policy
26.4 Cash Budgeting
26.5 The Short-Term Financial Plan

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 Balance Sheet Model of the Firm

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 26.1 Tracing Cash and Net Working Capital

Current assets are cash and other assets that are expected to
convert to cash within the year.
• Cash and cash equivalents.
• Marketable securities.
• Accounts receivable.
• Inventory.

Current liabilities are obligations that are expected to require cash

payment within one year.
• Accounts payable.
• Expenses payable (including accrued wages and taxes).
• Notes payable.

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 Defining Cash in Terms of Other Elements of
the Balance Sheet - I
Net Working Capital + Fixed Assets = Long-Term Debt +
Equity

Net Working Capital = Cash + Other Current Assets −

Current Liabilities

Cash = Long-Term Debt + Equity − Current liabilities −

Current assets other than cash − Fixed assets

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 Defining Cash in Terms of Other Elements of
the Balance Sheet - II
Cash = Long-Term Debt + Equity − Current liabilities −
Current assets other than cash − Fixed assets

An increase in long-term debt, equity, or current liabilities

leads to an increase in cash—as does a decrease in fixed
assets or a decrease in noncash current assets.
The sources and uses of cash follow from this reasoning.

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 26.2 The Operating Cycle and the Cash Cycle

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 The Operating Cycle and the Cash Cycle

Cash cycle = Operating cycle − Accounts payable period

In practice, the inventory period, the accounts receivable

period, and the accounts payable period are measured by
days in inventory, days in receivables, and days in payables,
respectively.

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 Cash Cycle Example – I
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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 Cash Cycle Example – II
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 = 111.3 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 = 57.1 days

Operating cycle = 111.3 days + 57.1 days = 168.4 days

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 Cash Cycle Example – III
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 = 38.9 days

Cash Cycle = 168.4 days − 38.9 days = 129.5 days

We have to finance our inventory for 129.5 days.
If we want to reduce our financing needs, we need to look
carefully at our receivables and inventory periods—they
both may be excessive.

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 26.3 Some Aspects of Short-Term Financial Policy

There are two elements of the policy that a firm adopts for short-
term finance.
The size of the firm’s investment in current assets, usually
measured relative to the firm’s level of total operating revenues.
• Flexible.
• Restrictive.

Financing of current assets, usually measured as the proportion of

short-term debt to long-term debt.
• Flexible.
• Restrictive.

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 Size of Investment in Current Assets
A flexible short-term finance policy includes,
• Keeping large balances of cash and marketable securities.
• Making large investments in inventory.
• Granting liberal credit terms.
A restrictive short-term finance policy includes.
• Keeping low cash balances, no investment in marketable
securities.
• Making small investments in inventory.
• Allowing no credit sales and no accounts receivable.

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 Carrying Costs and Shortage Costs

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 Appropriate Flexible Policy

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 Appropriate Restrictive Policy

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 Alternative Financing Policies
A flexible short-term finance policy means a low proportion
of short-term debt relative to long-term financing.
A restrictive short-term finance policy means a high
proportion of short-term debt relative to long-term
financing.
In an ideal world, short-term assets are always financed
with short-term debt, and long-term assets are always
financed with long-term debt.
• In this world, net working capital is zero.

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 26.4 Cash Budgeting
A cash budget is a primary tool of short-term financial planning.
The idea is simple: Record the estimates of cash receipts and
disbursements.
Cash Receipts
• Arise from sales, but we need to estimate when we actually
collect.

Cash Outflow,
• Payments of accounts payable.
• Wages, taxes, and other expenses.
• Capital expenditures.
• Long-term financing.

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 Cash Budgeting Example – I
Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales
Sales estimates (in millions)
• Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550.

Accounts receivable
• Beginning receivables = $250.
• Average collection period = 30 days.

Accounts payable
• Purchases = 50 percent of next quarter’s sales.
• Beginning payables = 125.
• Accounts payable period is 45 days.

Other expenses
• Wages, taxes, and other expense are 30 percent of sales.
• Interest and dividend payments are $50.
• A major capital expenditure of $200 is expected in the second quarter.

The initial cash balance is $80 and the company maintains a minimum balance of $50

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 Cash Budgeting Example – II

Beginning receivables of $250 will be collected in the

first quarter.
Q1 Q2 Q3 Q4

Beginning Receivables $250 $167 $200 $217

Sales 500 600 650 800

Cash Collections 583 567 633 750

Ending Receivables $167 $200 $217 $267

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 Cash Budgeting Example – III
Payables period is 45 days, so half of the purchases will be
paid for each quarter, and the remaining will be paid the
following quarter.
Beginning payables = $125
Q1 Q2 Q3 Q4

Payment of accounts $275 $313 $363 $338

Wages, taxes, and other expenses 150 180 195 240

Capital expenditures 200

Interest and dividend payments 50 50 50 50

Total cash disbursements $475 $743 $608 $628

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 Cash Budgeting Example – IV
Q1 Q2 Q3 Q4
Total cash receipts $583 $567 $633 $750
Total cash disbursements 475 743 608 628
Net cash inflow $108 –$176 $26 $123
Beginning cash balance $80 $188 $12 $38
Net cash inflow 108 –176 26 123
Ending cash balance $188 $12 $38 $161
Minimum cash balance –50 –50 –50 –50
Cumulative surplus (deficit) $138 –$38 –$12 $111

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 26.5 The Short-Term Financial Plan
The most common way to finance a temporary cash deficit is to
arrange a short-term loan.
Unsecured Loans
• Line of credit (at the bank).

Secured Loans
• Accounts receivable can be either assigned or factored.
• Inventory loans use inventory as collateral.

Other Sources
• Banker’s acceptance.
• Commercial paper.

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 Quick Quiz
How do you compute the operating cycle and the
cash cycle?
What are the differences between a flexible short-
term financing policy and a restrictive one? What are
the pros and cons of each?
What are the key components of a cash budget?
What are the major forms of short-term borrowing?

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