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financial statements for The Hobby Horse Company, Inc. (HH).
openings coinciding with a poor Christmas season had pushed
“Hobby Horse,” she said, “has got a $45 million loan from us due
the company into loss. Management had halted all new construc-
at the end of September and it is likely to ask us to roll it over.
tion and put 15 of its existing stores up for sale.
The company seems to have run into some rough weather re-
Burchetts decided to start with the 6-year summary of HH™s
cently and I have asked Furze Platt to go down there this after-
balance sheet and income statement (Table A.18). Then he turned
noon and see what is happening. It might do you good to go along
to examine in more detail the latest position (Tables A.19 and
with her. Before you go, take a look at these financial statements
and see what you think the problems are. Here™s a chance for you
Financial Statement Analysis 161

2000 1999 1998 1997 1996 1995
Financial highlights for The
Hobby Horse Company, Inc., Net sales 3,351 3,314 2,845 2,796 2,493 2,160
year ending March 31 EBIT “9 312 256 243 212 156
Interest 37 63 65 58 48 46
Taxes 3 60 46 43 39 34
Net profit “49 189 145 142 125 76
Earnings per share “0.15 0.55 0.44 0.42 0.37 0.25
Current assets 669 469 491 435 392 423
Net fixed assets 923 780 753 680 610 536
Total assets 1,573 1,249 1,244 1,115 1,002 959
Current liabilities 680 365 348 302 276 320
Long-term debt 217 159 159 311 319 315
Stockholders™ equity 676 725 599 502 407 324
Number of stores 240 221 211 184 170 157
Employees 13,057 11,835 9,810 9,790 9,075 7,825

(all items in millions of dollars)
Net sales 3,351
Cost of goods sold 1,990
Selling, general, and administrative expenses 1,211
Depreciation expense 159
Earnings before interest and taxes (EBIT) “9
Net interest expense 37
Taxable income “46
Income taxes 3
Net income “49
Allocation of net income
Addition to retained earnings “49
Dividends 0

Note: Column sums subject to rounding error.

(figures in millions of dollars)

Assets Mar. 31, 2000 Mar. 31, 1999
Current assets
Cash and marketable securities 14 72
Receivables 176 194
Inventories 479 203
Total current assets 669 469
Fixed assets
Property, plant, and equipment (net of depreciation) 1,077 910
Less accumulated depreciation 154 130
Net fixed assets 923 780
Total assets 1,592 1,249
Liabilities and Shareholders™ Equity Mar. 31, 2000 Mar. 31, 1999
Current Liabilities
Debt due for repayment 484 222
Accounts payable 94 58
Other current liabilities 102 85
Total current liabilities 680 365
Long-term debt 236 159
Stockholders™ equity
Common stock and other paid-in capital 155 155
Retained earnings 521 570
Total stockholders™ equity 676 725
Total liabilities and stockholders™ equity 1,592 1,249

Note: Column sums subject to rounding error.
Section 2
Working Capital Management and
Short-Term Planning

Cash and Inventory Management

Credit management and Collection
A Short-Term Financing Plan
Working Capital
Options for Short-Term Financing
The Components of Working Capital
Evaluating the Plan
Working Capital and the Cash
Conversion Cycle
Sources of Short-Term
The Working Capital Trade-off
Links between Bank Loans
Long-Term and Commercial Paper
Short-Term Financing
Secured Loans
Tracing Changes in Cash
The Cost of Bank Loans
and Working Capital
Simple Interest
Cash Budgeting Discount Interest
Forecast Sources of Cash
Interest with Compensating Balances
Forecast Uses of Cash
The Cash Balance

A warehouse of finished-goods inventory.
Inventory is a major part of working capital. Investment in working capital has to be planned
and managed.
John Lund/Tony Stone Images

uch of this material is devoted to long-term financial decisions such as

M capital budgeting and the choice of capital structure. These decisions
are called long-term for two reasons. First, they usually involve long-
lived assets or liabilities. Second, they are not easily reversed and thus may
commit the firm to a particular course of action for several years.
Short-term financial decisions generally involve short-lived assets and liabilities,
and usually they are easily reversed. Compare, for example, a 60-day bank loan for $50
million with a $50 million issue of 20-year bonds. The bank loan is clearly a short-term
decision. The firm can repay it 2 months later and be right back where it started. A firm
might conceivably issue a 20-year bond in January and retire it in March, but it would
be extremely inconvenient and expensive to do so. In practice, such a bond issue is a
long-term decision, not only because of the bond™s 20-year maturity, but because the de-
cision to issue it cannot be reversed on short notice.
A financial manager responsible for short-term financial decisions does not have to
look far into the future. The decision to take the 60-day bank loan could properly be
based on cash-flow forecasts for the next few months only. The bond issue decision will
normally reflect forecast cash requirements 5, 10, or more years into the future.
Short-term financial decisions do not involve many of the difficult conceptual issues
encountered elsewhere in this book. In a sense, short-term decisions are easier than
long-term decisions”but they are not less important. A firm can identify extremely
valuable capital investment opportunities, find the precise optimal debt ratio, follow the
perfect dividend policy, and yet founder because no one bothers to raise the cash to pay
this year™s bills. Hence the need for short-term planning.
We will review the major classes of short-term assets and liabilities, show how long-
term financing decisions affect the firm™s short-term financial planning problem, and
describe how financial managers trace changes in cash and working
capital. We will also describe how managers forecast month-by-month cash re-
quirements or surpluses and how they develop short-term investment and financing
After studying this material you should be able to
Understand why the firm needs to invest in net working capital.
Show how long-term financing policy affects short-term financing requirements.
Trace a firm™s sources and uses of cash and evaluate its need for short-term
Develop a short-term financing plan that meets the firm™s need for cash.

Working Capital Management and Short-Term Planning 167

Working Capital
Short-term, or current, assets and liabilities are collectively known as working capital.
Table 2.1 gives a breakdown of current assets and liabilities for all manufacturing cor-
porations in the United States in 1999. Total current assets were $1,352 billion and total
current liabilities were $1,046 billion.

Current Assets. One important current asset is accounts receivable. Accounts receiv-
able arise because companies do not usually expect customers to pay for their purchases
immediately. These unpaid bills are a valuable asset that companies expect to be able to
turn into cash in the near future. The bulk of accounts receivable consists of unpaid bills
from sales to other companies and are known as trade credit. The remainder arises from
the sale of goods to the final consumer. These are known as consumer credit.
Another important current asset is inventory. Inventories may consist of raw materi-
als, work in process, or finished goods awaiting sale and shipment. Table 2.1 shows that
firms in the United States have about the same amount invested in inventories as in ac-
counts receivable.
The remaining current assets are cash and marketable securities. The cash consists
partly of dollar bills, but most of the cash is in the form of bank deposits. These may be
demand deposits (money in checking accounts that the firm can pay out immediately)
and time deposits (money in savings accounts that can be paid out only with a delay).
The principal marketable security is commercial paper (short-term unsecured debt sold
by other firms). Other securities include Treasury bills, which are short-term debts sold
by the United States government, and state and local government securities.
In managing their cash companies face much the same problem you do. There are al-
ways advantages to holding large amounts of ready cash”they reduce the risk of run-
ning out of cash and having to borrow more on short notice. On the other hand, there is
a cost to holding idle cash balances rather than putting the money to work earning in-
terest. In later we will tell you how the financial manager collects and pays out cash and
decides on an optimal cash balance.

Current Liabilities. We have seen that a company™s principal current asset consists
of unpaid bills. One firm™s credit must be another™s debit. Therefore, it is not surprising

Current Assets Current Liabilities
Current assets and liabilities,
U.S. manufacturing Cash $ 114 Short-term loans $ 203
corporations, first quarter Marketable securities 89 Accounts payable 303
1999 (figures in billions) Accounts receivable 481 Accrued income taxes 46
Inventories 468 Current payments due on long-term debt 68
Other current assets 201 Other current liabilities 427
Total 1,352 Total 1,046

Notes: Net working capital (current assets “ current liabilities) = $1,352 “ $1,046 = $306 billion. Column
sums subject to rounding error.
Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade
Corporations, First Quarter 1999, Table 1.0.

that a company™s principal current liability consists of accounts payable”that is, out-
standing payments due to other companies.
The other major current liability consists of short-term borrowing. We will have
more to say about this later in this material.

The difference between current assets and current liabilities is known as net working
CAPITAL Current assets capital, but financial managers often refer to the difference simply (but imprecisely) as
minus current liabilities. Often working capital. Usually current assets exceed current liabilities”that is, firms have
called working capital. positive net working capital. For United States manufacturing companies, current assets
are on average 30 percent higher than current liabilities.
To see why firms need net working capital, imagine a small company, Simple Sou-
venirs, that makes small novelty items for sale at gift shops. It buys raw materials such
as leather, beads, and rhinestones for cash, processes them into finished goods like wal-
lets or costume jewelry, and then sells these goods on credit. Figure 2.1 shows the whole
cycle of operations.
If you prepare the firm™s balance sheet at the beginning of the process, you see cash
(a current asset). If you delay a little, you find the cash replaced first by inventories of
raw materials and then by inventories of finished goods (also current assets). When the
goods are sold, the inventories give way to accounts receivable (another current asset)
and finally, when the customers pay their bills, the firm takes out its profit and replen-
ishes the cash balance.
The components of working capital constantly change with the cycle of operations,
but the amount of working capital is fixed. This is one reason why net working capital
is a useful summary measure of current assets or liabilities.
Figure 2.2 depicts four key dates in the production cycle that influence the firm™s in-
vestment in working capital. The firm starts the cycle by purchasing raw materials, but
it does not pay for them immediately. This delay is the accounts payable period. The
firm processes the raw material and then sells the finished goods. The delay between
the initial investment in inventories and the sale date is the inventory period. Some time
after the firm has sold the goods its customers pay their bills. The delay between the
date of sale and the date at which the firm is paid is the accounts receivable period.
The top part of Figure 2.2 shows that the total delay between initial purchase of raw


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