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Suppose that 80 percent of sales are collected in the immediate quarter and the
remaining 20 percent in the next. Table 2.6 shows forecast collections under this as-
sumption.
In the first quarter, for example, collections from current sales are 80 percent of
$87.5 million, or $70 million. But the firm also collects 20 percent of the previous
5 Forsimplicity, we present a quarterly forecast. However, most firms would forecast by month instead of by
quarter. Sometimes weekly or even daily forecasts are made.
178 SECTION TWO


TABLE 2.6
Quarter
Dynamic Mattress™s
collections on accounts First Second Third Fourth
receivable, 2001 (figures in
1. Receivables at start of period $30.0 $ 32.5 $ 30.7 $ 38.2
millions)
2. Sales 87.5 78.5 116.0 131.0
3. Collections
Sales in current period (80%) 70.0 62.8 92.8 104.8
Sales in last period (20%) 15.0a 17.5 15.7 23.2
Total collections $85.0 $ 80.3 $108.5 $128.0
4. Receivables at end of period
(4 = 1 + 2 “ 3) $32.5 $ 30.7 $ 38.2 $ 41.2

aSales in the fourth quarter of the previous year were $75 million.




quarter™s sales, or .20 — $75 million = $15 million. Therefore, total collections are $70
million + $15 million = $85 million.
Dynamic started the first quarter with $30 million of accounts receivable. The quar-
ter™s sales of $87.5 million were added to accounts receivable, but $85 million of col-
lections was subtracted. Therefore, as Table 2.6 shows, Dynamic ended the quarter with
accounts receivable of $30 million + $87.5 million “ $85 million = $32.5 million. The
general formula is
Ending accounts receivable = beginning accounts receivable + sales “ collections
The top section of Table 2.7 shows forecast sources of cash for Dynamic Mattress.
Collection of receivables is the main source but it is not the only one. Perhaps the firm
plans to dispose of some land or expects a tax refund or payment of an insurance claim.
All such items are included as “other” sources. It is also possible that you may raise ad-
ditional capital by borrowing or selling stock, but we don™t want to prejudge that ques-
tion. Therefore, for the moment we just assume that Dynamic will not raise further
long-term finance.


TABLE 2.7
Quarter
Dynamic Mattress™s cash
budget for 2001 (figures in First Second Third Fourth
millions)
Sources of cash
Collections on accounts receivable $ 85.0 $ 80.3 $108.5 $128
Other 1.5 0 12.5 0
Total sources of cash $ 86.5 $ 80.3 $121.0 $128
Uses of cash
Payments of accounts payable $ 65.0 $ 60.0 $ 55.0 $ 50
Labor and administrative expenses 30.0 30.0 30.0 30
Capital expenditures 32.5 1.3 5.5 8
Taxes, interest, and dividends 4.0 4.0 4.5 5
Total uses of cash $131.5 $ 95.3 $ 95.0 $ 93
Net cash inflow equals sources minus uses “$ 45.0 “$ 15.0 +$ 26.0 +$ 35
Working Capital Management and Short-Term Planning 179


FORECAST USES OF CASH
There always seem to be many more uses for cash than there are sources. The second
section of Table 2.7 shows how Dynamic expects to use cash. For simplicity, in Table
2.7 we condense the uses into four categories:
1. Payments of accounts payable. Dynamic has to pay its bills for raw materials, parts,
electricity, and so on. The cash-flow forecast assumes all these bills are paid on time,
although Dynamic could probably delay payment to some extent. Delayed payment
is sometimes called stretching your payables. Stretching is one source of short-term
financing, but for most firms it is an expensive source, because by stretching they
lose discounts given to firms that pay promptly.
2. Labor, administrative, and other expenses. This category includes all other regular
business expenses.
3. Capital expenditures. Note that Dynamic Mattress plans a major outlay of cash in
the first quarter to pay for a long-lived asset.
4. Taxes, interest, and dividend payments. This includes interest on currently outstand-
ing long-term debt and dividend payments to stockholders.


THE CASH BALANCE
The forecast net inflow of cash (sources minus uses) is shown on the bottom row of
Table 2.7. Note the large negative figure for the first quarter: a $45 million forecast out-
flow. There is a smaller forecast outflow in the second quarter, and then substantial cash
inflows in the second half of the year.
Table 2.8 calculates how much financing Dynamic will have to raise if its cash-flow
forecasts are right. It starts the year with $5 million in cash. There is a $45 million cash
outflow in the first quarter, and so Dynamic will have to obtain at least $45 million “
$5 million = $40 million of additional financing. This would leave the firm with a fore-
cast cash balance of exactly zero at the start of the second quarter.
Most financial managers regard a planned cash balance of zero as driving too close
to the edge of the cliff. They establish a minimum operating cash balance to absorb un-
expected cash inflows and outflows. We will assume that Dynamic™s minimum operat-
ing cash balance is $5 million. That means it will have to raise $45 million instead of
$40 million in the first quarter, and $15 million more in the second quarter. Thus its cu-
mulative financing requirement is $60 million in the second quarter. Fortunately, this is
the peak; the cumulative requirement declines in the third quarter when its $26 million



TABLE 2.8
Cash at start of period $5 “$ 40 “$55 “$29
Short-term financing
+ Net cash inflow (from Table 19.7) “ 45 “ 15 + 26 + 35
requirements for Dynamic
= Cash at end of perioda “ 40 “ 55 “ 29 +6
Mattress (figures in millions)
Minimum operating cash balance 5 5 5 5
Cumulative short-term financing $ 45 $ 60 $34 “$ 1
required (minimum cash balance
minus cash at end of period)b

aOf course firms cannot literally hold a negative amount of cash. This line shows the amount of cash the
firm will have to raise to pay its bills.
bA negative sign indicates that no short-term financing is required. Instead the firm has a cash surplus.
180 SECTION TWO


net cash inflow reduces its cumulative financing requirement to $34 million. (Notice
that the change in cumulative short-term financing in Table 2.8 equals the net cash in-
flow in that quarter from Table 2.7.) In the final quarter Dynamic is out of the woods.
Its $35 million net cash inflow is enough to eliminate short-term financing and actually
increase cash balances above the $5 million minimum acceptable balance.
Before moving on, we offer two general observations about this example:
1. The large cash outflows in the first two quarters do not necessarily spell trouble for
Dynamic Mattress. In part they reflect the capital investment made in the first quar-
ter: Dynamic is spending $32.5 million, but it should be acquiring an asset worth
that much or more. The cash outflows also reflect low sales in the first half of the
year; sales recover in the second half.6 If this is a predictable seasonal pattern, the
firm should have no trouble borrowing to help it get through the slow months.
2. Table 2.7 is only a best guess about future cash flows. It is a good idea to think about
the uncertainty in your estimates. For example, you could undertake a sensitivity
analysis, in which you inspect how Dynamic™s cash requirements would be affected
by a shortfall in sales or by a delay in collections.


Calculate Dynamic Mattress™s quarterly cash receipts, net cash inflow, and cumulative
Self-Test 4
short-term financing required if customers pay for only 60 percent of purchases in the
current quarter and pay the remaining 40 percent in the following quarter.


Our next step will be to develop a short-term financing plan that covers the forecast
requirements in the most economical way possible. Before presenting such a plan, how-
ever, we should pause briefly to point out that short-term financial planning, like long-
term planning, is best done on a computer. The nearby box presents the spreadsheet un-
derlying Tables 2.6 to 2.8. The spreadsheet on the left presents the data appearing in the
tables; the one on the right presents the underlying formulas. Examine those formulas
and note which items are inputs (for example, rows 15“18) and which are calculated
from equations. The formulas also indicate the links from one table to another. For ex-
ample, collections of receivables are calculated in Table 2.6 (row 6), and passed through
as inputs in Table 2.7 (row 11). Similarly, net cash inflow in Table 2.7 (row 20) is passed
along to Table 2.8 (row 24).
Once the spreadsheet is set up, it becomes easy to explore the consequences of many
“what-if ” questions. For example, Self-Test 4 asks you to recalculate the quarterly cash
receipts, net cash inflow, and cumulative short-term financing required if the firm™s col-
lections on accounts receivable slow down. You can obviously do this by hand, but it is
quicker and easier to do it in a spreadsheet”especially when there might be dozens of
scenarios that you are responsible to work through!



A Short-Term Financing Plan
OPTIONS FOR SHORT-TERM FINANCING
Suppose that Dynamic can borrow up to $40 million from the bank at an interest cost
of 8 percent per year or 2 percent per quarter. Dynamic can also raise capital by putting
off paying its bills and thus increasing its accounts payable. In effect, this is taking a
6 Maybe people buy more mattresses late in the year when the nights are longer.
Working Capital Management and Short-Term Planning 181


loan from its suppliers. The financial manager believes that Dynamic can defer the fol-
lowing amounts in each quarter:
Quarter: First Second Third Fourth
Amount deferrable, millions of dollars 52 48 44 40

That is, $52 million can be saved in the first quarter by not paying bills in that quarter.
(Note that Table 2.7 was prepared assuming these bills are paid in the first quarter.) If
deferred, these payments must be made in the second quarter. Similarly, $48 million of
the second quarter™s bills can be deferred to the third quarter and so on.
Stretching payables is often costly, however, even if no ill will is incurred.7 This is
because many suppliers offer discounts for prompt payment, so that Dynamic loses the
discount if it pays late. In this example we assume the lost discount is 5 percent of the
amount deferred. In other words, if a $52 million payment is delayed in the first quar-
ter, the firm must pay 5 percent more, or $54.6 million in the next quarter. This is like
borrowing at an annual interest rate of over 20 percent (1.054 “ 1 = .216, or 21.6%).
With these two options, the short-term financing strategy is obvious: use the lower
cost bank loan first. Stretch payables only if you can™t borrow enough from the bank.
Table 2.9 shows the resulting plan. The first panel (cash requirements) sets out the
cash that needs to be raised in each quarter. The second panel (cash raised) describes

TABLE 2.9
Quarter
Dynamic Mattress™s
financing plan (figures in First Second Third Fourth
millions)
Cash requirements
1. Cash required for operationsa $45 $15 “$ 26 “$35
2. Interest on bank loanb 0 0.8 0.8 0.6
3. Interest on stretched payablesc 0 0 0.8 0
4. Total cash required $45 $15.8 “$ 24.4 “$34.4
Cash raised
5. Bank loan $40 $0 $0 $0
6. Stretched payables 0 15.8 0 0
7. Securities sold 5 0 0 0
8. Total cash raised $45 $15.8 $0 $0
Repayments
9. Of stretched payables 0 0 $ 15.8 $0
10. Of bank loan 0 0 8.6 $31.4
Increase in cash balances
11. Addition to cash balances $0 $0 $0 $3
Line of credit
12. Beginning of quarter $0 $40 $ 40 $31.4
13. End of quarter 40 40 31.4 0

a From Table 2.7, bottom line. A negative cash requirement implies positive cash flow from operations.
b The interest rate on the bank loan is 2 percent per quarter applied to the bank loan outstanding at the start
of the quarter. Thus the interest due in the second quarter is .02 — $40 million = $.8 million.
c The “interest” cost of the stretched payables is 5 percent of the amount of payment deferred. For example,

in the third quarter, 5 percent of the $15.8 million stretched in the second quarter is about $.8 million.

7 In fact, ill will is likely to be incurred. Firms that stretch payments risk being labeled as credit risks. Since
stretching is so expensive, suppliers reason that only customers that cannot obtain credit at reasonable rates
elsewhere will resort to it. Suppliers naturally are reluctant to act as the lender of last resort.
EXCEL SPREADSHEET




182
183
184 SECTION TWO


the various sources of financing the firm plans to use. The third and fourth panels de-
scribe how the firm will use net cash inflows when they turn positive.
In the first quarter the plan calls for borrowing the full amount available from the
bank ($40 million). In addition, the firm sells the $5 million of marketable securities it
held at the end of 2000. Thus under this plan it raises the necessary $45 million in the
first quarter.
In the second quarter, an additional $15 million must be raised to cover the net cash
outflow predicted in Table 2.7. In addition, $.8 million must be raised to pay interest on
the bank loan. Therefore, the plan calls for Dynamic to maintain its bank borrowing and
to stretch $15.8 million in payables. Notice that in the first two quarters, when net cash
flow from operations is negative, the firm maintains its cash balance at the minimum
acceptable level. Additions to cash balances are zero. Similarly, repayments of out-
standing debt are zero. In fact outstanding debt rises in each of these quarters.
In the third and fourth quarters, the firm generates a cash-flow surplus, so the plan
calls for Dynamic to pay off its debt. First it pays off stretched payables, as it is required
to do, and then it uses any remaining cash-flow surplus to pay down its bank loan. In
the third quarter, all of the net cash inflow is used to reduce outstanding short-term bor-
rowing. In the fourth quarter, the firm pays off its remaining short-term borrowing and
uses the extra $3 million to increase its cash balances.


Revise Dynamic Mattress™s short-term financial plan assuming it can borrow up to $45
Self-Test 5
million through its line of credit. Assume that the firm will still sell its $5 million of
short-term securities in the first quarter.



EVALUATING THE PLAN
Does the plan shown in Table 2.9 solve Dynamic™s short-term financing problem? No”
the plan is feasible, but Dynamic can probably do better. The most glaring weakness of

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