LOS 10

Management of Short-Term Liabilities

Learning Outcome Statement (LOS)

understand why we need to use short-term financing

why use short-term financing identify the sources of short-term

financing understand cash budgeting summary and conclusion

Introduction

Accounts payable is the Cinderella of the working capital world.

While her more glamorous sister functions demand the bulk of a company’s time and attention, accounts payable often lacks the care and attention it deserves.

That’s a pity - because this Cinderella can account for about 60 percent of a company’s turnover. And when she is dressed up to go to the ball, the results are immediate and can be simply stunning.

Introduction

A payable balance is the result of a company’s need or desire to buy a service, a product, or a commodity.

Purchases can be divided into direct purchases (goods and raw materials) or indirect purchases (pens, stationery, and building maintenance and infrastructure costs, for example).

A/P Management – Why Need the Attention?

Even a small improvement to the accounts payable element of working capital and the cost of purchases can deliver quick results to the bottom line, often well out of proportion to the amounts involved. These improvements can be broadly equivalent to a significant boost in a company’s sales.

For a company facing the reality of static or declining sales, this can spell the difference between collapse and survival, by buying the time needed for rethinking and restructuring.

For a company managing growth, the return will be even healthier key figures than would otherwise be the case.

A/P Management – Why Need the Attention?

As a broad rule of thumb, we would expect the cost of direct purchases to fall by 3 to 5 percent, meaning that for every $1 billion of purchases, $30–$50 million would feed straight through to the bottom line.

A company with a gross margin of 15 percent would need to increase sales by $500 million to generate that much extra net cash.

An increase in creditor days by 15 to 30 percent is also often achieved, giving a further boost to working capital.

Objectives of Current Liabilities

The structure of a firm’s current liabilities should achieve two goals, such as

It should provide the necessary amounts of short-term financing

It should be in keeping with the target level of aggregate liquidity.

The challenge in the management of current liabilities is to achieve these goals at a minimum cost.

The Balance-Sheet Model of the Firm

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm engage in?

The Capital Budgeting Decision

The Balance-Sheet Model of the Firm

How can the firm raise the money for the required investments?

The Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

The Balance-Sheet Model of the Firm

How much short-term cash flow does a company need to pay its bills?

The Net Working Capital Investment Decision

Net Working Capital

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

Types of Short-Term Financing

Short-term financing is a liability that originally scheduled for repayment within one year.

Short-term financing can be classified as temporary short-term financing and permanent short-term financing.

Temporary short-term financing is used to provide funds for transient cash flow shortages, such as those caused by seasonality in sales. When it is cheaper to borrow funds to cover such deficits than to keep a reserve of funds against them, temporary borrowings are attractive to the firm.

Permanent short-term financing are used by firms on a continuing basis and are refinanced with new short-term debt as they mature.

Some Aspects of Short-Term Financial Policy

There are two elements of the policy that a firm adopts for short-term finance.

The size of the firm’s investment in current assets - usually measured relative to the firm’s level of total operating revenues.

Flexible Restrictive

Alternative financing policies for current assets - usually measured as the proportion of short-term debt to long-term debt.

Flexible Restrictive

The Size of the Investment in Current Assets

A flexible short-term finance policy would maintain a high ratio of current assets to sales. Keeping large cash balances and investments in

marketable securities. Large investments in inventory. Liberal credit terms.

A restrictive short-term finance policy would maintain a low ratio of current assets to sales. Keeping low cash balances, no investment in

marketable securities. Making small investments in inventory. Allowing no credit sales (thus no accounts

receivable).

Carrying Costs and Shortage Costs

$

Investment in Current Assets ($)

Shortage costs

Carrying costs

Total costs of holding current assets

CA*

Minimum point

Appropriate Flexible Policy

$

Investment in Current Assets ($)

Shortage costs

Carrying costs

Total costs of holding current assets

CA*

Minimum point

When a Restrictive Policy is Appropriate?

$

Investment in Current Assets ($)

Shortage costs

Carrying costs

Total costs of holding current assets

CA*

Minimum point

Alternative Financing Policies for Current Assets

A flexible short-term financing policy means low proportion of short-term debt relative to long-term financing.

A restrictive short-term financing policy means high proportion of short-term debt relative to long-term financing.

In an ideal world, short-term assets are always financed with short-term debt and long-term assets are always financed with long-term debt.

In this world, net working capital is always zero.

Financing Policy for an Idealized Economy

Long-term debt plus common stock

$

Time0 1 2 3 4 5

Current assets = Short-term debt

Fixed assets: a growing firm

Grain elevator operators buy crops after harvest, store them, and sell them during the year. Inventory is financed with short-term debt. Net working capital is always zero.

Alternative Asset-Financing Strategies

$

Time

Long Term Financing

Short Term

Financing

Total Asset Requiremen

t $

Time

Long Term Financing

Marketable

Securities

Total Asset Requireme

nt

Why Use Short-Term Financing?

There are at least three reasons for the use of permanent short-term financing, such as

There are minimum amounts of accounts payable and of accruals. It is uneconomical for the firm to reduce short-term debt below those levels.

As long as the yield curve is upsloping, the expected interest expense of short-term debt is less than that on long-term debt, though the use of short-term debt is riskier.

Financing with permanent short-term debt allows the firm substantial flexibility in its package of permanent financing.

Sources of Short-Term Financing

Nine common sources of short-term financing are:

Commercial paper Bankers’ acceptance Accounts payable Accruals Unsecured credit line borrowings Unsecured notes and term loan borrowings Secured borrowings with marketable securities as

collateral Secured borrowings with accounts receivable as

collateral Secured borrowings with inventory as collateral

The first six of these are unsecured borrowings, while the last three involves secured transactions.

Characteristics of Sources of Short-Term Financing

Sources Users Maturity

Commercial paper

Large firms and small firms with bank guarantee

270 days; most common is 30 days

Bankers’ acceptance

Firms importing goods 30-180 days; most common 90 days

Accounts payable

Any purchaser of goods or services

30 days most common

Accruals Firms who may defer labor, taxes etc.

Depends on specific accruals

Unsecured credit line

Firms with strong financial position

Can be drawn down or paid off any time

Unsecured short-term notes

Firms with strong financial position

Most common 90 days

Characteristics of Sources of Short-Term Financing

Sources Users Maturity

Secured borrowing using marketable securities

Firms holding marketable securities

Typically of very short maturities

Secured borrowings using accounts receivable

Firms with liquid and substantial accounts receivable

Loans are due when invoices are paid

Secured borrowings using inventory

Firms with liquid and substantial inventory

Loans are made when inventory is acquired and are due when inventory is used

Cash Budgeting

A cash budget is a primary tool of short-run financial planning.

The idea is simple: Record the estimates of cash receipts and disbursements.

Cash Receipts Arise from sales, but we need to estimate when we

actually collect.

Cash Outflow Payments of Accounts Payable Wages, Taxes, and other Expenses Capital Expenditures Long-Term Financial Planning

Cash Budgeting

The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

The Short-Term Financial Plan

The most common way to finance a temporary cash deficit to arrange a short-term loan.

Unsecured Loans Line of credit down at the bank

Secured Loans Accounts receivable financing can be either assigned

or factored. Inventory loans use inventory as collateral.

Other Sources Banker’s acceptances Commercial paper.

Summary & Conclusions

This chapter introduces the management of short-term finance.

We examine the short-term uses and sources of cash as they appear on the firm’s financial statements.

We see how current assets and current liabilities arise in the short-term operating activities and the cash cycle of the firm.

From an accounting perspective, short-term finance involves net working capital.

Summary & Conclusions

Managing short-term cash flows involves the minimization of costs.

The two major costs are: Carrying costs - the interest and related costs

incurred by overinvesting in short-term assets such as cash

Shortage costs - the cost of running out of short-term assets.

The objective of managing short-term finance and short-term financial planning is to find the optimal tradeoff between these two costs.

Summary & Conclusions

In an ideal economy, the firm could perfectly predict its short-term uses and sources of cash and net working capital could be kept at zero.

In the real world, net working capital provides a buffer that lets the firm meet its ongoing obligations.

The financial manager seeks the optimal level of each of the current assets.

The financial manager can use the cash budget to identify short-term financial needs.

The cash budget tells the manager what borrowing is required or what lending will be possible in the short run.