Chapter 20.pdf

Chapter 20 Short-Term Financial Planning Prepared by Humayun Qadri MacEwan University © 2020 McGraw-Hill Education Limited After studying this chapter, you should be able to: LO1 Show how long-term financing policy affects short-term financin...

Chapter 20 Short-Term Financial Planning Prepared by Humayun Qadri MacEwan University © 2020 McGraw-Hill Education Limited 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. © 2020 McGraw-Hill Education Limited 2  A firm’s short term financing issues are determined by the amount of long-term capital it raises. A firm that issues large amounts of long-term debt or common stock, or that retains a large part of its earnings, may find that it has permanent excess cash. Other firms raise relatively little long-term capital and end up as permanent short-term debtors. Most firms attempts to finance all long-term and part of current assets with long-term financing. © 2020 McGraw-Hill Education Limited 3 © 2020 McGraw-Hill Education Limited 4 © 2020 McGraw-Hill Education Limited 5 Figure 20.2 © 2020 McGraw-Hill Education Limited 6  Some observations: ▪ Matching Maturities: Financial managers generally attempt to match the maturities of their firm’s assets and liabilities. ▪ Permanent Working Capital Requirements: Most firms have a permanent investment in net working capital (current assets less current liabilities). They plan to have a positive net working capital at all times. ▪ Advantages of Liquidity: Current assets can be converted into cash more easily than can long-term assets. So firms with large holdings of current assets enjoy greater liquidity. © 2020 McGraw-Hill Education Limited 7 Working Capital: Short-term or current assets and current liabilities are collectively known as working capital. 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 obligations under finance lease Prepaid expenses Current portion of long- term debt © 2020 McGraw-Hill Education Limited 8  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. Operating Cycle = Inventory period + accounts receivable period © 2020 McGraw-Hill Education Limited 9 Figure 20.3 - A simple cycle of operations: Cash Raw materials Receivables inventory Finished goods Inventory © 2020 McGraw-Hill Education Limited 10  Cash Conversion Cycle: Period of time between firm’s payment for materials and collection on its sales. Cash Conversion Cycle = (Inventory period + accounts receivable period) – accounts payable period = Operating cycle - accounts payable period © 2020 McGraw-Hill Education Limited 11 © 2020 McGraw-Hill Education Limited 12  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 Note: Some firms use the term cost of goods sold rather than cost of sales. © 2020 McGraw-Hill Education Limited 13  Example: Brick Brewing Co. These data can be used to calculate the operating and cash conversion cycles for Brick Brewing in fiscal 2018. Statement of Comprehensive Statement of Financial Position Income Data (for the fiscal year Data (as of January 31, 2019) 2018–2019) Revenue $50,084,490 Inventory $10,316,767 Accounts Costs of sales 37,108,956 4,851,774 receivable Accounts payable 7,303,233 © 2020 McGraw-Hill Education Limited 14  Example: Brick Brewing Co. (Con’t) We are going to use table 20.2 to answer the following four questions: (1) How long on average did it take Brick Brewing to produce and sell their product? (2) How long did it take to collect bills? (3)How long did it take to pay bills? (4) What was the operating cycle and the cash conversion cycle? © 2020 McGraw-Hill Education Limited 15 Example: Brick Brewing Co. inventory 10,316,767 Inventory period = = = 101.47 days annual cost of goods sold / 365 37,108,956/365 accounts receivable 4,851,774 Accounts receivable period = = = 35.36 days annual sales / 365 50,084,490/365 © 2020 McGraw-Hill Education Limited 16  Example: Brick Brewing Co.: accounts payable 7,303,233 Accounts payable period = = = 71.33 days annual cost of goods sold / 365 37,108,956/365 Operating cycle = Inventory period + receivables period = 101.47 + 35.36 = 136.83 days Cash conversion cycle = Operating cycle – payables period = 136.83 – 71.83 = 65 days © 2020 McGraw-Hill Education Limited 17  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. © 2020 McGraw-Hill Education Limited 18 ▪ Table 20.3 and 20.4 (on the next two slides) show 2015 and 2016 year-end balance sheets for Dynamic Mattress Company and the firm’s income statement for 2016. ▪ Dynamic’s cash balance increases from $20 million to $30.4 million in 2016. ▪ What caused this increase? © 2020 McGraw-Hill Education Limited 19 Year-end balance sheets for Dynamic Mattress Company ($ millions) Liabilities and Assets 2015 2016 2015 2016 Shareholders’ Equity Current assets: Current liabilities: Cash $ 20.0 $ 30.4 Bank loans $ 25.0 $ 0 Marketable securities.0 25.0 Accounts payable 110.0 135.0 Inventory 183.0 171.6 Total current liabilities $135.0 $ 135.0 Accounts receivable 124.0 171.6 Long-term debt 60.0 90.0 Net worth (equity and Total current assets $ 327.0 $ 388.0 400.5 427.0 retained earnings) Total liabilities and Non-current assets: $595.5 $ 652.0 owners’ equity Gross Fixed Assets $ 345.0 $ 375.0 Less depreciation 76.5 100.0 Net fixed assets $ 268.5 $ 275.0 Total assets $ 595.5 $652.0 © 2020 McGraw-Hill Education Limited 20 Income statement for Dynamic Mattress Company, 2016 ($ millions) Sales $ 2,200.0 Operating costs 2,024.0 Depreciation 23.5 EBIT $ 152.5 Interest 6.0 Pretax income $ 146.5 Tax at 50% 73.3 Net income $ 73.3 Note: Dividends = $46.8 million; addition to retained earnings = $26.5 million. © 2020 McGraw-Hill Education Limited 21  Financial analysts trace the sources and uses of cash in the statement of cash flows like the one shown in Table 20.5 (on next slide) Information is organized into 3 sections: cash flow from operations, cash flow from investments, and cash flow from financing activities. The positive entries in that table correspond to activities that generated cash and the negative ones to activities that used cash. © 2020 McGraw-Hill Education Limited 22 Statement of cash flows for Dynamic Mattress Company, 2016 ($ millions) Cash flows from operating activities: Net income $73.3 Depreciation 23.5 Decrease (increase) in accounts receivable −26.0 Decrease (increase) in inventories 11.4 Increase (decrease) in accounts payable 25.0 Net cash flow from operating activities $107.2 Cash flows from investing activities: Investment in fixed assets −$30.0 Cash flows from financing activities: Dividends −$46.8 Sale (purchase) of marketable securities −25.0 Increase (decrease) in long-term debt 30.0 Increase (decrease) in bank loans −25.0 Net cash flow from financing activities −$66.8 Increase in cash balance $10.4 © 2020 McGraw-Hill Education Limited 23  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 company then uses these forecasts to draw up a plan for investing cash surpluses or financing any deficit. © 2020 McGraw-Hill Education Limited 24 Forecast Sources of Cash Dynamic Mattress Example: Sales forecast by quarter for 2017: Quarter: First Second Third Fourth Sales, $millions 560 502 742 836 ▪ Assume 70% of sales are collected in the immediate quarter and the remaining 30% in the next quarter. © 2020 McGraw-Hill Education Limited 25  Dynamic Mattress forecasted collections for 2017 (figures taken from Table 20.6) a. Sales in 4th quarter of previous year were $396.7 million © 2020 McGraw-Hill Education Limited 26  Dynamic Mattress forecasted Sources and Uses of Cash for 2017 (figures taken from Table 20.6) © 2020 McGraw-Hill Education Limited 27  Dynamic Mattress forecasted Short-Term Financing requirements for 2017 (figures taken from Table 20.6) © 2020 McGraw-Hill Education Limited 28 Dynamic’s financial manager must find short-term financing to cover the firm’s forecasted cash requirements. For simplicity we will assume that Dynamic has just two short-term financing options: Bank loan. Dynamic has an existing arrangement with its bank, allowing it to borrow up to $100 million at an interest rate of 10% per year. It can borrow and repay the loan whenever it chooses, but the company may not exceed its credit limit. Stretching payables. Dynamic can also raise capital by putting off payment of its bills. The financial manager believes that Dynamic can defer up to $100 million in each quarter. © 2020 McGraw-Hill Education Limited 29 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. © 2020 McGraw-Hill Education Limited 30 © 2020 McGraw-Hill Education Limited 31  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. © 2020 McGraw-Hill Education Limited 32  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 the unused portion of a line of credit © 2020 McGraw-Hill Education Limited 33 ▪ 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. © 2020 McGraw-Hill Education Limited 34  Secured Loans ▪ Banks do not make loans without assessing the firm’s credit risk because the riskiness of the borrower affects the bank’s risk. ▪ 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 – Typical maximum loan amounts are between 50% and 75% of accounts receivable, 50% of finished goods inventories, and zero for raw material and work-in-progress inventories. © 2020 McGraw-Hill Education Limited 35  A/R financing – When loans are secured by receivables, the firm assigns or pledges them as collateral for the loan. ▪ If the firm fails to repay the loan, the bank can collect the pledged accounts receivable from the firm’s customers and use the cash to pay off the debt. Inventory financing – Banks also lend on the security of inventory, but they are choosy about what they will accept. Factoring – When the firm sells the receivables at a discount for the purpose of obtaining short –term financing © 2020 McGraw-Hill Education Limited 36  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. © 2020 McGraw-Hill Education Limited 37  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  where m is the number of compounding periods in a year. © 2020 McGraw-Hill Education Limited 38 Discount Interest : With a discount interest loan, 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, you are paying $12,000 on $88,000 loan. Thus, the interest is 12,000/88,000 = 13.64% © 2020 McGraw-Hill Education Limited 39  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. © 2020 McGraw-Hill Education Limited 40  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. © 2020 McGraw-Hill Education Limited 41  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. © 2020 McGraw-Hill Education Limited 42  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. © 2020 McGraw-Hill Education Limited 43