CHAPTER 26: SHORT-TERM FINANCE AND PLANNING

1. Tracing cash and net working capital

Activities increase cash Activities decrease cash

🔹 Increasing long-term debt 🔹 Decreasing long-term debt

🔹
(borrowing over the long-term debt)
Increasing equity 🔹
(paying off a the long-term debt)
Decreasing equity

🔹
(selling some stock)
Increasing current liabilities 🔹
(repurchasing some stock)
Decreasing current liabilities

🔹
(getting a 90-day loan)
Decreasing current assets other than cash 🔹
(paying off a 90-day loan)
Increasing current assets other than cash

🔹
(selling some inventory for cash)
Decreasing fixed asset
(selling some property)
🔹
(buying some inventory for cash)
Increasing fixed asset
(buying some property)
● Activities that increase cash are called sources of cash
● Activities that decrease cash are call uses of cash

2. Operating cycle and the cash cycle

Example: a simple case
● Day 0: we purchase $1,000 worth of inventory on credit
● Day 30: we pay the bill
● Day 60: someone buy the inventory $1,400, but not paid yet
● Day 105: receive the $1,400 payment
The cash effect:

The operating cycle: the entire cycle, from the time we acquire the inventory to the
time we collect the cash takes 105 days. Include two periods:
● Inventory period: the time it takes to acquire and sell the inventory
● Accounts receivable period: the time it takes to collect on the sale
Operating cycle = Inventory period + accounts receivable period
= 60 days + 45 days
The cash cycle: number of days that pass before we collect the cash from a sale,
measured from when we actually pay the inventory. There is a period include in the
cash cycle:
● Account payable period: the time from when we acquire and pay for inventory.
Cash cycle = operating cycle - account payable period = 105 - 30 = 75 days

Calculating the operating and cash cycles: the example above is quite obvious.
In fact, with financial statement information, we will have to do a little more work.

● To calculate operating cycle: we need to know inventory period and account

receivable period.

365
+ Inventory period = = 3.28
= 111.3 days (meaning that
we, on average we hold our inventory for 111.3 days before it was sold)
 8.2
(inventory turnover = = 2.5
= 3.28 times, meaning that we bought and
sold off our inventory 3.28 times during the year)

365
+ Account receivable period = = 6.4
= 57 days
(meaning that, customer take average as 57 days to pay)

11.5
(account receivables turnover = = 1.8
= 6.4 times,
meaning that we turn over our receivable 6.4 times a year))

👉🏽 Operating cycle = Inventory period + Account Receivable period

= 111.3 + 57 = 168.3 days

● To calculate cash cycle: we need to know the payables period

+ Payable period = = 38.95 days

(Payable turnover = = 8200/875 = 9.37

👉🏽 Cash cycle = Operating cycle - Account payable period = 168.3 - 38.95 =

129.35 days.

● Note: each industry and company have a different Operating cycle and cash
cycle.

4. Cash budgeting
- Cash budget is a primary tool of short-run financial planning.
- The idea is simple: record the estimates of
● cash receipts: arise from sales, but we need to estimate when we actually
collect
● Disbursement (cash outflow): payments of accounts payable/wages, taxes,
and other expenses/capital expenditures/long-term financial planning
Example: Company X specialize in pet trea and receives all income from sales.
+ Sales esitimate (millions)
Q1 = 500, Q2 = 600, Q3 = 650, Q4 = 800, Q1 next year = 550
+ Account receivable:
Beginning receivable = $250
Average collection period = 30 days (this mean that 2/3 of sales are collected in
the quarter made, the remaining 1/3 are collected the following quarter)
+ Account payable
Purchases = 50% of next quarter’s sales
Beginning payables = 125
Accounts payable period is 45 days
+ Other expenses
Wages, taxes and other expense are 30% 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.
Ans:
 CHAPTER 28: CREDIT AND INVENTORY MANAGEMENT

1. Credit and Receivables

Why do firms grant credit ? - Because it is an effective way to stimulate sales (give
customer more incentives to buy and shorten the time of payment)

Components of credit policy

● Terms of sale: establish how the firm proposes to sell its goods and services
● Credit analysis: the process of deciding whether or not to extend credit to a
particular customer.
+ Credit information: financial statements, credit reports about the
customer’s payment history with firms, bank
+ Credit evaluation and scoring could based on the classic five Cs of credit:
Character, capacity(operating cash flow), capital(financial reserves),
collateral, conditions
● Collection policy: after credit has been granted, the firm establishes a collection
policy to collect the cash.

2. Term of the sale

Basic form of term of sale:
Example: 2/10,net 30.
Means that the customer has 30 days from the invoice date to pay the full amount. If
payment is made within 10 days, a 2% cash discount can be taken.
 ● Net credit period: length of time the customer has to pay (30 days)
● Cash discount period: the time during which the discount is available (10 days)

Made up of three elements:

● The credit period: length of time for which credit is granted. It is almost always
between 30 and 120 days.
● The cash discount: the % discount when paying in the cash discount period.
● Type of credit instrument: basic evidence of indebtedness (invoice,...)

Cost of the credit: support the order is for $1,000. In 10 days, the buyer can pay $980,
or wait 20 days and pay $1,000. In other words, the buyer is borrowing $980 for 20 days
and pays $20 in interest. So what’s the interest rate?

With $20 in interest on $980 borrowed, the rate is $20/$980 = 2.0408%. This is quite
low, but remember that this is just the rate for a 20-day period. There are 365/20 =
18.25 this kind of period in a year. If not taking the discount, the buyer is paying an
effective annual rate (EAR) of:

7. Inventory Management
Inventory takes a large proportion in the total asset. Hence the management of
inventory is very important.

Inventory types:
● Raw materials (iron, steel,..): higher liquidity
● Work-in-progresss (unfinished product): less liquidity
● Finished goods: ready to sell: liquidity depend

Inventory costs
+ Carrying cost
● Storage and tracking costs
● Insurance and taxes
● Losses due to obsolescence, deterioration or theft
● The opportunity cost
+ Shortage costs: having inadequate inventory on hand.
There is a tradeoff between carrying cost and shortage costs.

EXCERCISE
5. Calculating Cash Collections The Litzenberger Company has
projected the following quarterly sales amounts for the coming year:

a. Accounts receivable at the beginning of the year are $335. The company
has a 45-day collection period. Calculate cash collections in each of the
four quarters by completing the following

b. Rework (a) assuming a collection period of 60 days.

a. 45-day collection period implies all receivables outstanding from the

previous quarter are collected in the current quarter, and: (90 – 45)/90 = 1/2
of current sales are collected. So:
(90 – 45)/90 = 1/2 of current sales are collected. So:
b. A 60-day collection period implies all receivables outstanding from the
previous quarter are collected in the current quarter, and:(90 – 60)/90 = 1/3
of current sales are collected.

6. Calculating Cycles Consider the following financial statement

information for the Rivers Corporation:

Calculate the operating and cash cycles. How do you interpret your
answer?
Inventory turnover
= COGS / Average inventory Inventory turnover
= $165,763 / [($17,385 + 19,108) / 2]
= 9.09 times

Inventory period
= 365 days / Inventory turnover Inventory period
= 365 days / 9.09 Inventory period
= 40.18 days
Receivables turnover = Credit sales / Average receivables Receivables
turnover = $216,384 / [($13,182 + 13,973) / 2] Receivables turnover =
15.9370 times

Receivables period
= 365 days / Receivables turnover Receivables period
= 365 days / 15.9370 Receivables period
= 22.90 days

So, the operating cycle is:

Operating cycle = 40.18 days + 22.90 days
Operating cycle = 63.08 days

Payables turnover
= COGS / Average payables Payables turnover
= $165,763 / [($15,385 + 16,676) / 2] Payables turnover
= 10.3405 times

Payables period
= 365 days / Payables turnover Payables period
= 365 days / 10.3405 Payables period = 35.30 days

Cash cycle = 63.08 days – 35.30 days Cash cycle = 27.78 days

7. Terms of Sale A firm offers terms of 1/10, net 30. What effective annual
interest rate (EAR) does the firm earn when a customer does not take the
discount? Calculate EAR when
a. The discount is changed to 2 percent.
b. The credit period is increased to 60 days.
c. The discount period is increased to 15 days.

Initial EAR = (1+1/99)^365/20 - 1 = 20.13%

a. When discount changed to 2%
EAR = (1+2/98)^365/20 - 1 = 44.59%
b. EAR = (1+1/99)^365/50 - 1 = 7.61%

c. EAR = (1+1/99)^365/15 - 1 = 27.71%

EAR at the present = (1+1/99)^(365/20) - 1 = 20.13%

a. When discount changed to 2%
EAR = (1+2/98)^(365/20) - 1 = 44.59%
b. When credit period increased to 60 days:
EAR = (1+1/99)^(365/50) - 1 = 7.61%
c. the discount period is increased to 15 days.
EAR = (1+1/99)^(365/15) - 1 = 27.71%