December 2000 December 2001 December 2002
The total capital requirement can be met through either long- or short-term financ-
ing. When long-term financing does not cover the total capital requirement, the firm
must raise short-term capital to make up the difference. When long-term financing
more than covers the total capital requirement, the firm has surplus cash available for
short-term investment. Thus the amount of long-term financing raised, given the total
capital requirement, determines whether the firm is a short-term borrower or lender.
The three panels in Figure 2.4 illustrate this. Each depicts a different long-term fi-
nancing strategy. The ÔÇťrelaxed strategyÔÇŁ in panel a always implies a short-term cash sur-
plus. This surplus will be invested in marketable securities. The ÔÇťrestrictiveÔÇŁ policy il-
lustrated in panel c implies a permanent need for short-term borrowing. Finally, panel
b illustrates an intermediate strategy: the firm has spare cash which it can lend out dur-
ing the part of the year when total capital requirements are relatively low, but it is a bor-
rower during the rest of the year when capital requirements are relatively high.
What is the best level of long-term financing relative to the total capital require-
ment? It is hard to say. We can make several practical observations, however.
1. Matching maturities. Most financial managers attempt to ÔÇťmatch maturitiesÔÇŁ of as-
sets and liabilities. That is, they finance long-lived assets like plant and machinery
with long-term borrowing and equity. Short-term assets like inventory and accounts
receivable are financed with short-term bank loans or by issuing short-term debt like
2. Permanent working-capital requirements. Most firms have a permanent investment
in net working capital (current assets less current liabilities). By this we mean that
they plan to have at all times a positive amount of working capital. This is financed
from long-term sources. This is an extension of the maturity-matching principle.
Since the working capital is permanent, it is funded with long-term sources of fi-
3. The comforts of surplus cash. Many financial managers would feel more comfort-
able under the relaxed strategy illustrated in Figure 2.4a than the restrictive strategy
in panel c. Consider, for example, General Motors. At the end of 1998 it was
sitting on a cash mountain of over $10 billion, almost certainly far more than it
needed to meet any seasonal fluctuations in its capital requirements. Such firms with
174 SECTION TWO
Alternative approaches to Long-term
long- versus short-term financing
(a) Relaxed strategy, where requirements
the firm is always a short-
term lender. Excess capital
(b) Middle-of-the-road investment in cash
and market securities
(c) Restrictive policy, where
the firm is always a short-
Firm is a short-term
borrower in this region Long-term
a surplus of long-term financing never have to worry about borrowing to pay next
monthÔÇ™s bills. But is the financial manager paid to be comfortable? Firms usually put
surplus cash to work in Treasury bills or other marketable securities. This is at best
a zero-NPV investment for a tax-paying firm.4 Thus we think that firms with a per-
4 Why do we say at best zero NPV? Not because we worry that the Treasury bills may be overpriced. Instead,
we worry that when the firm holds Treasury bills, the interest income is subject to double taxation, first at the
corporate level, and then again at the personal level when the income is passed through to investors as divi-
dends. The extra layer of taxation can make corporate holdings of Treasury bills a negative-NPV investment
even if the bills would provide a fair rate of interest to an individual investor.
Working Capital Management and Short-Term Planning 175
manent cash surplus ought to go on a diet, retiring long-term securities to reduce
long-term financing to a level at or below the firmÔÇ™s total capital requirement. That
is, if the firm is described by panel a, it ought to move down to panel b, or perhaps
Tracing Changes in Cash
and Working Capital
Table 2.3 compares 1999 and 2000 year-end balance sheets for Dynamic Mattress Com-
pany. Table 2.4 shows the firmÔÇ™s income statement for 2000. Note that DynamicÔÇ™s cash
balance increases from $4 million to $5 million in 2000. What caused this increase? Did
the extra cash come from Dynamic Mattress CompanyÔÇ™s additional long-term borrow-
ing? From reinvested earnings? From cash released by reducing inventory? Or perhaps
it came from extra credit extended by DynamicÔÇ™s suppliers. (Note the increase in ac-
The correct answer? All of the above. There is rarely any point in linking a particu-
lar source of funds with a particular use. Instead financial analysts list the various
sources and uses of cash in a statement like the one shown in Table 2.5. The statement
shows that Dynamic generated cash from the following sources:
1. It issued $7 million of long-term debt.
2. It reduced inventory, releasing $1 million.
3. It increased its accounts payable, in effect borrowing an additional $7 million from
4. By far the largest source of cash was DynamicÔÇ™s operations, which generated $16
million. Note that the $12 million net income reported in Table 2.4 understates cash
flow because depreciation is deducted in calculating income. Depreciation is not a
cash outlay. Thus it must be added back in order to obtain operating cash flow.
Year-end balance sheets for Dynamic Mattress Company (figures in millions)
Assets 1999 2000 Liabilities and ShareholdersÔÇ™ Equity 1999 2000
Current assets Current liabilities
Cash $4 $ 5 Bank loans $5 $ 0
Marketable securities 0 5 Accounts payable 20 27
Inventory 26 25 Total current liabilities $ 25 $ 27
Accounts receivable 25 30 Long-term debt 5 12
Total current assets $55 $ 65 Net worth (equity and retained earnings) 65 76
Fixed assets Total liabilities and ownersÔÇ™ equity $ 95 $115
Gross investment $56 $ 70
Less depreciation 16 20
Net fixed assets $40 $ 50
Total assets $95 $115
176 SECTION TWO
Income statement for
Operating costs 321
Dynamic Mattress Company,
2000 (figures in millions)
Pretax income 24
Tax at 50 percent 12
Net income $ 12
Note: Dividend = $1 million; retained earnings = $11 million.
Sources and uses of cash for
Issued long-term debt $7
Dynamic Mattress Company
Reduced inventories 1
(figures in millions)
Increased accounts payable 7
Cash from operations
Net income 12
Total sources $31
Repaid short-term bank loan $5
Invested in fixed assets 14
Purchased marketable securities 5
Increased accounts receivable 5
Total uses $30
Increase in cash balance $1
Dynamic used cash for the following purposes:
1. It paid a $1 million dividend. (Note: The $11 million increase in DynamicÔÇ™s equity
is due to retained earnings: $12 million of equity income, less the $1 million divi-
2. It repaid a $5 million short-term bank loan.
3. It invested $14 million. This shows up as the increase in gross fixed assets in Table
4. It purchased $5 million of marketable securities.
5. It allowed accounts receivable to expand by $5 million. In effect, it lent this addi-
tional amount to its customers.
How will the following affect cash and net working capital?
a. The firm takes out a short-term bank loan and uses the funds to pay off some of its
b. The firm uses cash on hand to buy raw materials.
Working Capital Management and Short-Term Planning 177
c. The firm repurchases outstanding shares of stock.
d. The firm sells long-term bonds and puts the proceeds in its bank account.
The financial managerÔÇ™s task is to forecast future sources and uses of cash. These fore-
casts serve two purposes. First, they alert the financial manager to future cash needs.
Second, the cash-flow forecasts provide a standard, or budget, against which subsequent
performance can be judged.
There are several ways to produce a quarterly cash budget. Many large firms have
developed elaborate ÔÇťcorporate modelsÔÇŁ; others use a spreadsheet program to plan their
cash needs. The procedures of smaller firms may be less formal. But no matter what
method is chosen, there are three common steps to preparing a cash budget:
Step 1. Forecast the sources of cash. The largest inflow of cash comes from payments
by the firmÔÇ™s customers.
Step 2. Forecast uses of cash.
Step 3. Calculate whether the firm is facing a cash shortage or surplus.
The financial plan sets out a strategy for investing cash surpluses or financing any
We will illustrate these issues by continuing the example of Dynamic Mattress.
FORECAST SOURCES OF CASH
Most of DynamicÔÇ™s cash inflow comes from the sale of mattresses. We therefore start
with a sales forecast by quarter for 2001:5
Quarter: First Second Third Fourth
Sales, millions of dollars 87.5 78.5 116 131
But unless customers pay cash on delivery, sales become accounts receivable before
they become cash. Cash flow comes from collections on accounts receivable.
Most firms keep track of the average time it takes customers to pay their bills. From
this they can forecast what proportion of a quarterÔÇ™s sales is likely to be converted into
cash in that quarter and what proportion is likely to be carried over to the next quarter
as accounts receivable. This proportion depends on the lags with which customers pay
their bills. For example, if customers wait 1 month to pay their bills, then on average
one-third of each quarterÔÇ™s bills will not be paid until the following quarter. If the pay-
ment delay is 2 months, then two-thirds of quarterly sales will be collected in the fol-