Download SHORT TERM FINANCIAL MANAGEMENT

SHORT TERM
FINANCIAL
MANAGEMENT
M.A. CONSTRUCTION MANAGEMENT GROUP TERM PAPER
COURSE LECTURER
DR.MARGARET GACHURU
DATE OF SUBMISSION
12th May 2009
BY:
CHEBET KATHY KIBOWEN
B50/72257/08
MUINDE EDITH MUENI
B50/72194/08
OTIENO OLIVIA SALLY
B50/72031/08
SHORT TERM FINANCIAL MANAGEMENT
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Contents
I.
INTRODUCTION ............................................................................................................................... 3
II.
THE COMPONENTS OF WORKING CAPITAL ..................................................................................... 3
A.
CURRENT ASSETS ......................................................................................................................... 3
B.
CURRENT LIABILITIES ................................................................................................................... 3
III.
WORKING CAPITAL AND THE CASH CONVERSION CYCLE............................................................ 4
A.
NET WORKING CAPITAL ............................................................................................................... 4
B.
CASH CONVERSION CYCLE ........................................................................................................... 4
IV.
WORKING CAPITAL MANAGEMENT ............................................................................................ 5
V.
TOOLS OF SHORT-TERM FINANCIAL PERFORMANCE ...................................................................... 6
A.
CASH BUDGET .............................................................................................................................. 6
B.
CASH RECEIPTS ............................................................................................................................ 6
C.
CASH DISBURSEMENTS................................................................................................................ 6
VI.
CASH AND LIQUIDITY MANAGEMENT ......................................................................................... 6
A.
REASONS FOR LIQUIDITY ............................................................................................................. 6
1.
Understanding float................................................................................................................. 7
2.
Float management .................................................................................................................. 8
B.
CASH COLLECTION AND CONCENTRATION ................................................................................. 8
1.
Components of collection time ............................................................................................... 8
2.
Types of Collection Systems .................................................................................................... 8
3.
Cash Concentration ................................................................................................................. 9
VII.
CREDIT AND INVENTORY MANAGEMENT ................................................................................... 9
A.
SHORT-TERM BORROWING ......................................................................................................... 9
1.
Unsecured Loans ................................................................................................................... 10
2.
Secured Loans........................................................................................................................ 12
3.
Commercial Paper ................................................................................................................. 13
4.
Trade Credit ........................................................................................................................... 14
5.
Cash Discounts....................................................................................................................... 15
B.
INVENTORY MANAGEMENT ...................................................................................................... 15
VIII.
SUMMARY ................................................................................................................................. 16
IX.
REFERENCES .............................................................................................................................. 17
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I.
INTRODUCTION
Short-term financial decisions generally involve short-lived assets and liabilities, and are usually easily
reversed. Most of short-term financial planning focuses on variation in working capital.
Working capital policy involves the management of the current assets of the firm and the acquisition
of the appropriate financing for those assets. Working capital management involves the financing
and management of the current assets of the firm.
Whereas long term financing decisions concern how the firm finances its assets over several years,
short-term financing decisions concern how the firm can get the money it needs for daily, weekly and
monthly needs. Cash management is paramount, either budgeting the amount on hand, buying
supplies on credit, or borrowing it for short periods of time. Short term funds are also often used for
investments in accounts receivable and inventory (Gallagher and Andrew, 2007).
II.
THE COMPONENTS OF WORKING CAPITAL
Working capital comprises of the short-term or current assets and liabilities.
A.
CURRENT ASSETS
This includes:
1. Current receivables - Arise because companies do not 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 receivables consist of unpaid
bills from sales to other companies, known as trade credit. The remainder arises from the
sales of goods to the final consumer, known as consumer credit.
2. Inventory – This consists of raw materials, work in process or finished goods awaiting sale
and shipment.
3. Cash securities – This consists partly of currency bills but most common is in form of bank
deposits.
4. Market Securities - The principal market security is commercial paper (short-term unsecured
debt sold by other firms). Other securities include Treasury bills (short-term debts sold by
government and state and local government securities.
There are always advantages of holding large amounts of ready cash – there is less risk of running out
of cash and having to borrow money on short notice. On the other hand, there is a cost to holding
idle cash balances rather than putting the money to work earning interest.
B.
CURRENT LIABILITIES
As earlier noted, a company’s principlal current asset consists of unpaid bills. One firm’s credit must
be another’s debit.
1. Accounts payable – outstanding payments due to other companies.
2. Short-term borrowing – This is another major current liability.
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III. WORKING CAPITAL AND THE CASH CONVERSION
CYCLE
A.
NET WORKING CAPITAL
Net working capital is the difference between current assets and current liabilities. 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
and current liabilities.
B.
CASH CONVERSION CYCLE
A 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 materials and then sells the finished goods. The delay between the initial
investment in inventories and the sale date is the inventory period
Sometime 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.
CASH
Receivables
Raw materials
inventory
Finished goods
inventory
The figure below shows that the total delays between initial purchase of raw materials and ultimate
payment from customers in the sum of the inventory and accounts receivable periods.
The length of time between the firm’s payment for its raw materials and the collection of payment
from the customer is known as the firm’s cash conversion cycle.
Accounts
receivable
period
Inventory period
Accounts
payable period
Cash conversion cycle
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Raw materials
purchased
Payment for
raw materials
Sale of
finished goods
Cash collected
on sales
The longer the production process, the more cash the firm must keep tied up in inventories.
Similarly, the longer it takes customers to pay their bills, the higher the value of accounts receivable.
On the other hand, if a firm can delay paying for its own materials, it may reduce the amount of cash
it needs. In other words, accounts payable reduce net working capital.
Cash conversion cycle = (inventory period + receivable period) – accounts payable period
Inventory period
=
average inventory
annual cost of goods sold/365
Accounts receivable period =
Accounts payable period
=
average accounts receivable
annual sales/365
average accounts payable
annual cost of goods sold/365
IV. WORKING CAPITAL MANAGEMENT
Cash conversion cycle is not cast in stone. To a large extent, it is within the management control.
Working capital can be managed. For instance:


Accounts receivable are effected by the terms of credit the firm offers to its
customers. Reduce the amount of money tied up in receivables by getting tough on
customers who delay in paying debts. –(risk of customers taking their business
elsewhere)
Reduce investment in inventories of raw materials.-(risk of one day running out of
inventories and production stall)
Above considerations show that investment in working capital has both costs and benefits.
1. Firm’s investment on receivables – is the interest that could have been earned if customers
had paid their bills earlier.
2. Holding idle cash – Firm foregoes interest income by holding cash balances rather than
putting the money in market securities.
3. Costs of holding inventory – includes opportunity cost of capital, storage and insurance costs
and the risk of spoilage or obsolescence. These carrying costs encourage a firm to hold
current assets to a minimum. While carrying costs discourage large investments in current
assets, a low level of current assets makes it more likely that the firm will face shortage costs
e.g run out of inventory of raw materials and shut down production.
A financial manager must always strike a balance between the costs and benefits of current assets i.e
find level of current assets that minimize the sum of carrying costs and shortage costs.
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V. TOOLS OF SHORT-TERM FINANCIAL
PERFORMANCE
A.
CASH BUDGET
This is a statement of the firms planned inflows and outflows of cash. Firms use the cash budget to
ensure they will have enough cash available to meet short term financial obligations. Any surplus
cash resources can be invested quickly and efficiently. It usually spans a one year period, with more
frequent breakdowns provided as components of the budget.
B.
CASH RECEIPTS
Include all the firm’s cash inflows in a given period. The most common components of cash receipts
are cash sales, collections of accounts receivable, and other cash receipts.
C.
CASH DISBURSEMENTS
Include all outlays of cash by the firm in the period. The most common cash disbursements are cash
purchases, fixed-asset outlays, payments of accounts payable, wages, interest payments, taxes and
rent and lease payments. Cash disbursements may also include items such as dividends and share
repurchases. It is important to remember that other depreciation and other non cash expenses are
not included in the cash budget. They are not outlay of cash, but merely represent a schedule writeoff of an earlier cash outflow. Note however that depreciation does have a cash outflow effect
through its impact on tax payments.
VI. CASH AND LIQUIDITY MANAGEMENT
This explains how firms manage cash. However, it is important to know the difference between cash
management and liquidity management.
Cash is used in two different ways, first of all, it has its literal meaning; actual cash on hand. However,
financial managers frequently use the word to describe a firm’s holdings of cash along with its
marketable securities, and marketable securities are sometimes called cash equivalent or near cash.
Liquidity management concerns the optimal quantity of liquid assets a firm should have on hand. It
includes managing cash and accounts payables. Cash management is much more closely related to
optimizing mechanisms for collecting and disbursing cash.
A.
REASONS FOR LIQUIDITY
This explains why people hold cash. There are three motives for liquidity


Speculative motive – this is the need to hold cash to take advantage of additional investment
opportunities, such as bargain purchase that might arise attractive interest rates, and
favourable exchange rate fluctuations in case of international firms.
Precautionary motive – the need to hold cash as a safety margin to act as a financial reserve.
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

Transaction motive- the need to have cash on hand to satisfy normal disbursement and
collection activities associated with a firm’s ongoing operations.
Compensating balances – cash balances are kept at commercial banks to compensate for
banking services the firm receives. A minimum compensating balance requirement may
impose a lower limit on the level o cash a firm holds.
Cash management strategies are based on a firm’s ability to maintain adequate liquidity to preserve
the firm’s solvency.
Megginson et al (2007), state that an international firm can respond to exchange rate risks by
protecting (edging) its undesirable cash and marketable securities exposures or by making certain
adjustments in its operations.


Hedging strategies; these are techniques used to offset or protect against risk, and they are
most applicable to transaction exposure. These strategies include actions such as borrowing
or lending in different currencies; undertaking contracts in the forward, futures, and/ or
options markets; and also swapping assets/liabilities with other parties.
Adjustment in operations; in responding to exchange rate fluctuations, firms can give some
protection to international cash flows through appropriate adjustments in assets and
liabilities.
Many companies employ financial specialists called cash managers. One of their primary roles is to
manage the cash low time line related to collection, concentration and disbursement of the
company’s funds. Their job starts when a customer (payer) initiates payments to the company (the
payee) in any format (cash, check or electronic). Because most business-to-business payments are
still generated by sending a check in the mail, the collection process usually involves trying to reduce
mail, processing, and check-collection delays.
The cash manager is also responsible for concentrating cash from remote collection points into a
central account, and for initiating payments from the company to its suppliers. The final stage of this
process usually involves reconciling the company’s various bank accounts and managing all the
banking relationships. Managing cash flow time line is a vital role, because any delay in timing affects
the low of cash. Delays on either the collection or disbursement side of the cash low process are
generally referred to as float.
1.
Understanding float
Most of the time money that a firm has may be different from that which the bank thinks it has. This
is because some of the written checks may not have been presented for payment.
The cash balance that a firm shows in its books is called the firm’s book or ledger balance. The
balance shown in its bank account as available to spend is called its available or collected balance.
The difference between the available balance and the ledger balance is called float, and represents
the net effect of checks in the process o clearing (moving through the banking system).
They can also be referred to as funds that have been sent by the payer but are not yet usable by the
payee.
We look at two types of float and they include;
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a. Disbursement float; which is created when firms write checks to decrease the book
balance but no change in its available balance.
b. Collection float; are created when firm’s receive checks and it increases book balance
but does not immediately change available balance. The net effect that is the sum of
total collection and disbursement float is the net float. This is simply the overall
difference between the firm’s available balance and its book balance.
2.
Float management
This involves controlling the collection and disbursement of cash. The objective in cash collection is
to speed up collections and reduce the lag between the time customers pay bills and the time the
cash becomes available. The objective in cash disbursement is to control payments and minimize the
firm’s costs associated with making payments. Total collection or disbursement times can be broken
into three parts;




Mailing time is the part of the collection and disbursement process during which checks are
trapped in the postal system. Mail float is the time delay between when payment placed in
the mail and when payment is received.
Processing delay is the time it takes the receiver of a check to process the payment and
deposits it in a bank for collection.
Availability delay refers to the time required to clear a check through the banking system.
Clearing float is the time between deposit of the check and presentation of the check back to
the bank on which it is drawn.
Speeding up collections involves reducing one or more of these components. Slowing up
disbursements involves increasing one of them.
B.
CASH COLLECTION AND CONCENTRATION
The primary objective of the collections process is to quickly and efficiently collect funds from
customers and others. This process includes gathering and disseminating information related to the
collections. Collection delays usually work against the firm. If all things are constant, a firm will adopt
ways of speeding up collections and thereby decrease collection times.
1.
Components of collection time
The basic parts of cash collection process can be depicted using the times involved namely; mailing
time, check processing delay and the banks availability delay.
2.
Types of Collection Systems
How a firm collects from its customers depends largely on the nature of business. For example, in a
restaurant, most customers will pay using cash, check or credit card. This is known as over the
counter collection, so there is no problem with mailing delay.
When some or all of the payments a company receives are checks that arrive through the mail all
three component of collection time become relevant. Another way is preauthorized payment
arrangement. This involves payment amounts and payment dates being fixed in advance. When the
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agreed upon date arrives, the amount is automatically transferred from the customers bank account
to the firms bank account, which sharply reduces or even eliminates collection delays. In summary
the systems include;
1. Field banking system – companies make most collections either over the counter (retail
store) or at a collection office. These systems are characterized by many collection points as
opposed to a centralized location.
2. Mail- based collection system-the company typically has one or more collection points that
process the incoming mail payments.
3. Electronic system – in this system, companies send electronic bills to customers, who then
can pay them electronically.
4. Lock boxes; these are special post office boxes set up to intercept and speed up accounts
receivable payments. It is a popular technique for speeding up collections because it affects
all the components of float. It works like this; instead o mailing payments to the company,
customers mail payments to a post office box, which the firm’s bank empties regularly. The
bank processes each payment and deposits the payments into the firm’s account. The bank
sends (or transmits electronically) deposit slips and enclosures to the firm so the firm can
properly credit its customers accounts.
3.
Cash Concentration
Even after cash is collected firms need procedures to funnel or concentrate, that cash where it can be
best used.
Cash concentration is the practice of and procedures of moving cash from multiple banks into the
firm’s main accounts. By routinely pulling its cash, the firm greatly simplifies its cash management by
reducing the number of accounts that must be tracked. Also by having a large pool of funds available,
a firm may be able to negotiate or otherwise obtain a better rate on any short term investments.
There are three types of funds transfer mechanisms;
1. Depository transfer checks – this is an unsigned check drawn on one of the firm’s bank
accounts and deposited in another of the firm’s bank accounts.
2. Automated clearinghouse Debit Transfer- this is a preauthorized electronic withdrawal from
the payer’s accounts. It is generally known as electronic depository transfer (EDT).
3. Wire transfers- this is an electronic communication that removes funds from the payer’s
bank and deposits the funds in the payee’s bank on a same day basis via book keeping
entries.
VII. CREDIT AND INVENTORY MANAGEMENT
A.
SHORT-TERM BORROWING
There are four short-term borrowing options:
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1. unsecured borrowing,
2. secured borrowing,
3. commercial paper, and
4. trade credit.
1.
Unsecured Loans
The most common way to finance a temporary cash deficit is to arrange a short-term
unsecured bank loan (Ross et al 2008). This kind of loan is recommended if the company has
an excellent credit rating. It is usually used to finance projects having quick cash flows and is
appropriate if the company has immediate cash and can either repay the loan in the near
future or quickly obtain longer term financing (Shim & Siegel, 2000).
Seasonal cash short falls and desired inventory build-ups are among the reasons to use an
unsecured loan. The disadvantages of this king of loan are that it carries a higher interest
rate than a secured loan since there is no collateral and that a lump-sum payment is
required (Shim & Siegel, 2000).
Firms that use short-term bank loans often arrange for a line of credit. A line of credit is an
agreement under which a firm is authorized to borrow up to a specified amount on a
recurring basis. To ensure that the line is used for short-term purposes, the lender will
sometimes require the borrower to pay the line down to zero and keep it there for some
period during the year, typically 60 days (called a cleanup period) (Ross et al 2008). This
payment shows the bank that the loan is actually seasonal rather than permanent (Shim &
Siegel, 2000).
The advantages of a line of credit are that it offers easy and immediate access to funds
during tight money market conditions and it enables the company to borrow only as much as
it needs and to repay immediately when cash is available (Shim & Siegel, 2000).
Short-term lines of credit are classified as either committed or noncommitted. The latter
type is an informal arrangement that allows firms to borrow up to a previously specified limit
without going through the normal paperwork (much as they would with a credit card). A
revolving credit arrangement (or just revolver) is similar to a line of credit, but it is usually
open for two or more years, whereas a line of credit would usually be evaluated on an
annual basis (Ross et al 2008).
Committed lines of credit are more formal legal arrangements and usually involve a
commitment fee paid by the firm to the bank (usually the fee is on the order of .25 percent
of the total committed funds per year). The interest rate on the line of credit is usually set
equal to the bank's prime lending rate plus an additional percentage, and the rate will
usually float. A firm that pays a commitment fee for a committed line of credit is essentially
buying insurance to guarantee that the bank can't back out of the agreement (absent some
material change in the borrower's status) (Ross et al 2008).
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
compensating balances
When a company borrows under a line of credit, it may be required to maintain a
compensating balance (a non interest bearing account ) with the bank (Shim & Siegel, 2000).
By leaving these funds with the bank and receiving little or no interest, the firm further
increases the effective interest rate earned by the bank on the line of credit, thereby
"compensating" the bank. A compensating balance might be on the order of 2 to 5 percent
of the amount borrowed (Ross et al 2008).
Firms also use compensating balances to pay for non-credit bank services such as cash
management services. A traditionally contentious issue is whether the firm should pay for
bank credit and non-credit services with fees or with compensating balances. Most major
firms have now negotiated for banks to use the corporation's collected funds for
compensation and use fees to cover any shortfall (Ross et al 2008).

cost of a compensating balance
A compensating balance requirement has an obvious opportunity cost because the money
often must be deposited in an account with a zero or low interest rate.
Suppose that we have a $100,000 line of credit with a 10 percent compensating balance
requirement. This means that 10 percent of the amount actually used must be left on deposit in a
noninterest-bearing account. The quoted interest rate on the credit line is 16 percent. Suppose we
need $54,000 to purchase some inventory. How much do we have to borrow? What interest rate
are we effectively paying?
If we need $54,000, we have to borrow enough so that $54,000 is left over after we take out the 10
percent compensating balance:
$54,000 = (1 - .1 O) x Amount borrowed
$60,000 = $54,000/.90 = Amount borrowed
The interest on the $60,000 for one year at 16 percent is $60,000 X .16 = $9,600. We're actually
only getting $54,000 to use, so the effective interest rate is:
Effective interest rate
= Interest paid/Amount available
= $9,600/54,000
= 17.78%
Notice that what effectively happens here is that we pay 16 cents in interest on every 90
cents we borrow because we don't get to use the 10 cents tied up in the compensating
balance. The interest rate is thus .16/.90 = 17.78 percent, as we calculated.
Several points bear mentioning:
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o First, compensating balances are usually computed as a monthly average of the daily
balances. This means that the effective interest rate may be lower than our example
illustrates.
o Second, it has become common for compensating balances to be based on the
unused amount of the credit line. The requirement of such a balance amounts to an
implicit commitment fee.
o Third, and most important, the details of short-term business lending arrangements
are highly negotiable. Banks will generally work with firms to design a package of fees
and interest.

letters of credit
A letter of credit is a common arrangement in international finance. It is a document issued
by a bank guaranteeing the payment of a customer’s drafts up to a specified amount for a
designated time period (Shim & Siegel, 2000). With a letter of credit, the bank issuing the
letter promises to make a loan if certain conditions are met. Typically, the letter guarantees
payment on a shipment of goods provided that the goods arrive as promised. A letter of
credit can be revocable (subject to cancellation) or irrevocable (not subject to cancellation if
the specified conditions are met) (Ross et al 2008). The advantages of letters of credit are
that the company doesn’t have to pay cash in advance of shipment, using funds that could
be used elsewhere in business (Shim & Siegel, 2000).
2.
Secured Loans
Banks and other finance companies often require security for a short-term loan just as they
do for a long-term loan. Security for short-term loans usually consists of accounts receivable,
inventories, or both.

accounts receivable financing
This involves either assigning receivables or factoring receivables. Under assignment, the
lender has the receivables as security, but the borrower is still responsible if a receivable
can't be collected. With conventional factoring, the receivable is discounted and sold to the
lender (the factor). Once it is sold, collection is the factor's problem, and the factor assumes
the full risk of default on bad accounts. With maturity factoring, the factor forwards the
money on an agreed-upon future date.
Factors play a particularly important role in the retail industry. Retailers in the clothing
business, for example, must buy large amounts of new clothes at the beginning of the
season. Because this is typically a long time before they have sold anything, they wait to pay
their suppliers, sometimes 30 to 60 days. If an apparel maker can't wait that long, it turns to
factors, who buy the receivables and take over collection.
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Factoring is a relatively expensive source of money in this case. We should note that, if the
factor takes on the risk of default by a buyer, then the factor is providing insurance as well as
immediate cash. More generally, the factor essentially takes over the firm's credit
operations. This can result in a significant savings. The interest rate we calculated is
therefore overstated, particularly if default is a significant possibility.

inventory loans
According to Ross et al (2008), these are short-term loans to purchase inventory, come in
three basic forms: blanket inventory liens, trust receipts, and field warehouse financing:
a. Blanket Inventory Lien. A blanket lien gives the lender a lien against all the borrower's
inventories (the blanket "covers" everything).
b. Trust Receipt. A trust receipt is a device by which the borrower holds specific
inventory in "trust" for the lender. Automobile dealer financing, for example, is done
by use of trust receipts. This type of secured financing is also called floor planning; in
reference to inventory on the showroom floor. However, it is somewhat
cumbersome to use trust receipts for, say, wheat grain.
c. Field Warehouse Financing. In field warehouse financing, a public warehouse company (an
independent company that specializes in inventory management) acts as a control agent to
supervise the inventory for the lender.
3.
Commercial Paper
There are a variety of other sources of short-term funds employed by corporations. One of
the most important, especially for certain very large corporations is commercial paper.
Commercial paper consists of short-term notes issued by large and highly rated firms.
Typically, these notes are of short maturity, ranging up to 270 days (Ross et al 2008).
Commercial paper can be issued only if the company possesses a high credit rating;
therefore, the interest rate is less than that of a bank loan (Shim & Siegel, 2000). This is
because the firm issues these directly and because it usually backs the issue with a special
bank line of credit.
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Cost of Factoring
For the year just ended, LuLu's Pies had an average of $50,000 in accounts receivable. Credit
sales were $500,000. Lulu’s factors its receivables by discounting them 3 percent, in other
words, by selling them for 97 cents on the dollar. What is the effective interest rate on this
source of short-term financing?
To determine the interest rate, we first have to know the accounts receivable, or average
collection, period. During the year, Lulu’s turned over its receivables $500,000/50,000 = 10
times. The average collection period is therefore 365/10 = 36.5 days.
The interest paid here is a form of discount interest (discussed in Chapter 4). In this case, Lulu’s
is paying 3 cents in interest on every 97 cents of financing. The interest rate per 36.5 days is thus
.03/.97 = 3.09 percent. The APR is 10 x 3.09 percent = 30.9 percent, but the effective annual rate
is:
EAR = 1.030910 - 1 = 35.6%
4.
Trade Credit
Another very important source of short-term financing for firms of all sizes is trade credit,
meaning accounts payable. Such payables amount to money borrowed from suppliers, and
small firms in particular rely heavily on suppliers for short-term credit. Trade credit is
important for large firms as well; retailing giant Wal-Mart uses more trade credit than it does
money borrowed from banks.

understanding trade credit terms
The easiest way to understand trade credit terms is to consider an example. For bulk candy,
terms of2/10, net 60, might be quoted.
This means that customers have 60 days from the invoice date (discussed next) to pay the
full amount. However, if payment is made within 10 days, a 2 percent cash discount can be
taken.
Consider a buyer who places an order for $1,000, and assume that the terms of the sale are
2/10, net 60. The buyer has the option of paying:
$1,000 X (1 - .02) = $980 in 10 days, or paying the full $1,000 in 60 days.
If the terms were stated as just net 30, then the customer would have 30 days from the
invoice date to pay the entire $1,000, and no discount would be offered for early payment.
In general, credit terms are interpreted in the following way: (Take this discount off the
invoice price if you pay in this many days). (or else pay the full invoice amount in this many
days)
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Thus, 5110, net 45, means take a 5 percent discount from the full price if you pay within 10
days, or else pay the full amount in 45 days.
5.
Cash Discounts
As we have seen, cash discounts are often part of the terms of sale. One reason discounts are
offered is to speed up the collection of receivables and reduce the amount of credit being offered
(and the potential losses from defaults) (Ross et al, 2008).
Notice that when a cash discount is offered, the credit is essentially free during the discount period.
The buyer pays for the credit only after the discount expires. With 2/10, net 30, a rational buyer
either pays in 10 days to make the greatest possible use of the free credit or pays in 30 days to get
the longest possible use of the money in exchange for giving up the discount. So, by giving up the
discount, the buyer effectively gets 3O - 10 = 20 days' credit.
Another reason for cash discounts is that they provide a way of charging higher prices to customers
who have had credit extended to them. In this sense, cash discounts are a convenient way of
charging for the credit granted to customers
EXAMPLE: What's the Rate?
Ordinary tiles are often sold with terms of 3/30, net 60. What effective
annual rate does a buyer pay by not taking the discount? What would the
APR be if one were quoted? Here we have 3 percent discount interest on
60 - 30 = 30 days' credit. The rate per 30 days is .03/.97 = 3.093%. There
are 365/30 = 12.17 such periods in a year, so the effective annual rate is:
EAR = 1.030931W - 1 = 44.9% The APR, as always, would be calculated by
multiplying the rate per period by the number of periods: APR = .03093 x
12.17 = 37.6% An interest rate calculated like this APR is often quoted as
the cost of the trade credit and, as this example illustrates, can seriously
understate the true cost.
B.
INVENTORY MANAGEMENT
According to Baker and Powell (2005), effective inventory management involves turning over
inventory as quickly as possible without losing sales from inventory stock outs. Inventory
management is important for two major reasons:
1. It represents a sizable investment for some firms and affects their profitability
2. It is the firm’s least liquid current asset
According to (Megginson et al 2005) a firm may also borrow against inventory to acquire funds. The
extent to which inventory financing may be employed is based on the marketability of the pledged
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goods, their associated price stability, and the perishability of the product. Another significant factor
is the degree of physical control that can be exercised over the product by the lender. We can relate
some of these factors to the stages of inventory production and the nature of lender control.
VIII.
SUMMARY
1. Short-term finance involves short-lived assets and liabilities. We trade and examine the
short-term sources and uses 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.
2. Managing short-term cash flows involves the minimizing of costs. The two major costs are
carrying costs, the return forgone by keeping too much invested in short-term assets such as
cash, and shortage costs, the cost of running out of short-term assets. The objective of
managing short-term finance and doing short-term financial planning is to find the optimal
trade-off between these two costs.
3. 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, cash and net working
capital provide a buffer that lets the firm meet its ongoing obligations. The financial manager
seeks the optimal level of each of the current assets.
4. 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. The firm has available to it a number of possible ways of acquiring funds to
meet short-term shortfalls, including unsecured and secured loans, commercial paper, and
trade credit.
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IX. REFERENCES
1. Stanley B. Block and Geoffrey A. Hirt (1992): Foundations of Financial Management, 6th ed.
Irwin Homewood, Boston.
2. Richard A. Brealey, Sterwart C. Myers and Alan J. Marcus (2007): Fundamentals of Corporate
Finance, 5th ed. MC-Grawhill International
3. Jae K. Shim and Joel g. Siegel Barron’s (2000): Financial Management 2nd Edition Educational
Series
4. Harold K. Baker and Gary E. Powell (2005): Understanding Financial Management; A practical
guide, Wiley Blackwell
5. Timothy Gallagher and Joseph Andrew (2003): Financial Management Principles and Practice,
Freeload Press
6. Megginson W. L. Gitman L.J. and Smart B.S. (2005): Corporate Finance 2nd edition, Thomson
Press
7. Stephen Ross, Randolph Westerfield, Bradford Jordan (2008): Fundamentals of Corporate
Finance, Mc Graw Hill Publications
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