11.2 Short-Term Financial Planning
4 min read•august 15, 2024
Short-term financial planning is crucial for managing a company's cash flows and working capital over a 12-month period. It involves creating cash budgets, optimizing working capital, and analyzing different scenarios to assess risks and opportunities in the near future.
Forecasting financing needs is a key part of short-term planning. Companies use and cash flow forecasting techniques to project their future financial position and identify potential funding requirements. This helps businesses prepare for growth and manage their finances effectively.
Short-Term Financial Planning
Cash Budget and Working Capital Management
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- Short-term financial planning manages cash flows, working capital, and financing needs over 12 months or less
- projects cash inflows and outflows over specific periods (monthly or quarterly)
- Components include beginning cash balance, cash receipts, cash disbursements, net cash flow, and ending cash balance
- Working capital optimization strategies focus on , inventory, and
- and concepts help understand short-term financing requirements
- Operating cycle (time to convert inventory to cash through sales and collections)
- Cash conversion cycle (time between paying for inventory and collecting cash from sales)
- Effective planning requires coordination between sales, production, and finance departments
- Ensures accurate projections and alignment with business objectives
Scenario Analysis and Risk Assessment
- assesses impact of different assumptions on cash flows and financing needs
- Example: Analyzing effects of 10% increase or decrease in sales on cash position
- evaluates how changes in key variables affect financial outcomes
- Example: Testing impact of extending payment terms to customers on cash flow
- Techniques help identify potential risks and opportunities in short-term financial planning
- examines company's ability to withstand adverse economic conditions
- Example: Simulating effects of economic recession on cash flows and financing needs
Forecasting Financing Needs
Pro Forma Financial Statements
- Pro forma statements project future financial position (income statement, balance sheet, cash flow statement)
- forecasts line items assuming direct relationship with sales
- Example: If cost of goods sold is historically 70% of sales, it's projected at 70% of forecasted sales
- Pro forma balance sheets identify potential short-term financing needs
- Projects changes in current assets and current liabilities
- formula calculates additional financing required for sales growth
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- A = assets, S = sales, L = liabilities, RR = retention ratio, PM = profit margin
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- provide insights into projected liquidity and financing requirements
- = Current assets / Current liabilities
- = (Current assets - Inventory) / Current liabilities
Cash Flow Forecasting Techniques
- projects cash receipts and disbursements
- Example: Estimating cash collections from customers and cash payments to suppliers
- adjusts projected net income for non-cash items and changes in working capital
- Example: Adding back depreciation expense and adjusting for changes in accounts receivable
- on pro forma statements assesses impact of assumption changes
- Example: Evaluating effect of 5% change in projected sales growth on cash flow
Sales Growth Impact on Financing
Working Capital and Cash Conversion Cycle
- Sales growth increases working capital requirements
- Higher sales volumes lead to increased inventory and accounts receivable balances
- Cash conversion cycle typically lengthens with rapid sales growth
- Creates need for additional short-term financing to bridge cash flow gaps
- determines maximum sales growth without external financing
-
- ROE = Return on Equity
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- Analyze relationship between sales growth and financial ratios
- = (Accounts Receivable / Annual Sales) * 365
- = Cost of Goods Sold / Average Inventory
Operating Leverage and Cash Flow Management
- influences how sales growth impacts financing needs
- Companies with higher fixed costs experience larger changes in cash flows relative to sales growth
- Scenario analysis comparing different sales growth rates identifies financing "tipping points"
- Example: Analyzing cash flow impacts of 5%, 10%, and 15% annual sales growth
- Managing timing of cash inflows and outflows critical during rapid growth
- Strategies include negotiating favorable payment terms with suppliers and incentivizing early customer payments
Evaluating Short-Term Financing Sources
Types of Short-Term Financing
- (accounts payable financing from suppliers)
- (unsecured short-term debt issued by large corporations)
- (term loans with maturities under one year)
- (flexible borrowing arrangements with banks)
- (selling accounts receivable at a discount)
Cost Comparison and Decision Factors
- compares true cost of financing options
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- r = stated annual rate, m = number of compounding periods per year
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- Trade credit cost calculated when early payment discounts are foregone
- Example: 2/10 net 30 terms have an implicit annual cost of about 37%
- Commercial paper typically offers lower interest rates than bank loans
- Only available to companies with strong credit ratings
- Lines of credit costs include interest on borrowed funds and commitment fees
- Example: 1% commitment fee on unused portion of $1 million credit line
- Factoring costs determined by factoring fee and interest on cash advances
- Example: 2% factoring fee plus 8% annual interest on advanced funds
- Financing source selection considers availability, flexibility, cost, financial ratio impact, and alignment with overall strategy
Key Terms to Review (32)
Accounts payable management: Accounts payable management refers to the process of overseeing and controlling the money that a company owes to its suppliers and creditors for goods and services purchased on credit. This function is crucial for maintaining healthy cash flow, optimizing payment processes, and ensuring that obligations are met in a timely manner, which directly impacts a company's short-term financial stability.
Accounts receivable: Accounts receivable refers to the money owed to a company by its customers for goods or services that have been delivered but not yet paid for. This term plays a crucial role in understanding a company's financial health, as it reflects the expected inflow of cash and impacts liquidity. Monitoring accounts receivable is essential for managing cash flow and ensuring that the business can meet its short-term obligations.
Cash budget: A cash budget is a financial plan that estimates cash inflows and outflows over a specific period, helping organizations manage their liquidity and ensure they have enough cash to meet obligations. It plays a critical role in short-term financial planning, as it allows businesses to anticipate cash shortages and surpluses, enabling proactive decision-making to avoid financial distress.
Cash Conversion Cycle: The cash conversion cycle (CCC) is a metric that indicates the time it takes for a company to convert its investments in inventory and accounts receivable into cash flow from sales. It reflects the efficiency of a company's operations in managing its working capital and highlights the relationship between cash flow, financial planning, and liquidity management.
Commercial paper: Commercial paper is an unsecured, short-term debt instrument issued by corporations to finance their immediate cash flow needs, usually with maturities ranging from a few days to up to 270 days. This financial tool allows companies to raise funds quickly and efficiently, typically at lower interest rates compared to bank loans, thus serving as a critical component of short-term financial planning and cash management strategies.
Current Ratio: The current ratio is a financial metric that measures a company's ability to cover its short-term obligations with its short-term assets. It is calculated by dividing current assets by current liabilities, providing insights into a company's liquidity and overall financial health. A higher current ratio indicates better capability to meet short-term debts, linking directly to aspects of balance sheets, financial analysis, short-term planning, cash management, and inventory control.
Days Sales Outstanding (DSO): Days Sales Outstanding (DSO) is a financial metric that measures the average number of days a company takes to collect payment after a sale has been made. A lower DSO indicates that a company is efficient at collecting its receivables, which is crucial for maintaining cash flow and ensuring short-term financial health. Understanding DSO helps companies evaluate their credit policies and customer payment behaviors, making it an essential component of short-term financial planning.
Direct Method: The direct method is a way of preparing the cash flow statement that focuses on the actual cash inflows and outflows from operating activities during a specific period. This method provides a clear and straightforward view of how cash is generated and used in the company's operations, making it easier to assess liquidity and financial health. It contrasts with the indirect method, which starts with net income and adjusts for non-cash items and changes in working capital.
Effective Annual Rate (EAR): The effective annual rate (EAR) is the interest rate on an investment or loan that is adjusted for compounding over a specific period of time, allowing for a more accurate comparison of financial products. It reflects the total amount of interest that will be earned or paid in one year, taking into account the effect of compounding, which can significantly impact short-term financial decisions. Understanding EAR is essential for making informed choices about savings, investments, and borrowing in the context of financial planning.
External Funds Needed (EFN): External funds needed (EFN) refers to the additional financing a company requires from outside sources to support its projected growth and operational activities. This concept is crucial for businesses as it helps determine the gap between their internal funding capacity and the financial resources necessary for achieving their strategic objectives, especially in short-term financial planning where immediate cash flow needs must be addressed.
Factoring: Factoring refers to the financial transaction where a business sells its accounts receivable to a third party, known as a factor, at a discount in exchange for immediate cash. This practice helps businesses manage their cash flow by converting future sales into present liquidity, allowing them to meet operational needs without waiting for customers to pay their invoices.
Indirect method: The indirect method is a way of preparing the cash flow statement by adjusting net income for changes in non-cash items and working capital accounts to arrive at cash flows from operating activities. This method starts with net income and reconciles it to cash flow by considering factors such as depreciation, changes in inventory, and accounts receivable. It's particularly useful because it provides insights into how non-cash transactions and working capital changes impact cash flows, which is vital for understanding liquidity.
Inventory management: Inventory management is the process of overseeing and controlling the ordering, storage, and use of products that a company holds in stock. Effective inventory management ensures that businesses have the right amount of stock on hand to meet customer demand while minimizing costs associated with overstocking or stockouts. It plays a crucial role in short-term financial planning by affecting cash flow, operational efficiency, and overall profitability.
Inventory turnover: Inventory turnover is a financial ratio that measures how many times a company sells and replaces its stock of goods during a specific period, typically a year. A higher inventory turnover indicates efficient management of inventory and a strong sales performance, while a lower turnover can signal overstocking or weak sales. This metric connects to financial planning models and short-term financial planning by providing insights into inventory management, cash flow, and operational efficiency.
Lines of Credit: A line of credit is a flexible loan option that allows borrowers to access funds up to a specified limit, as needed, rather than receiving a lump sum. This financial tool is particularly valuable for managing short-term cash needs and liquidity requirements, enabling businesses to cover operational expenses and unexpected costs without having to take out multiple loans or deplete cash reserves.
Operating Cycle: The operating cycle refers to the time it takes for a company to purchase inventory, sell it, and receive cash from the sale. This cycle is crucial for understanding how efficiently a business manages its resources, as it connects inventory management, accounts receivable, and cash flow. A shorter operating cycle indicates a more efficient use of working capital, while a longer cycle can signal potential cash flow issues that may affect overall financial health.
Operating Leverage: Operating leverage refers to the degree to which a firm can increase its operating income by increasing revenue. It highlights the relationship between fixed and variable costs in a company, indicating how changes in sales volume can lead to disproportionate changes in profits. Understanding operating leverage is crucial when assessing risk, cost of capital, and making capital budgeting decisions, as it impacts how sensitive a company's profitability is to changes in sales. Additionally, operating leverage plays an important role in short-term financial planning, as companies must manage their cost structures effectively to navigate cash flow fluctuations.
Percent of sales method: The percent of sales method is a financial planning technique used to project future financial statements by estimating expenses and other line items as a percentage of total sales. This approach allows businesses to create budgets and forecasts that are closely aligned with expected revenue, making it easier to manage costs and resources effectively. It is commonly applied in both long-term financial models and short-term financial planning, helping firms maintain a clear overview of their financial health as sales fluctuate.
Pro forma financial ratios: Pro forma financial ratios are estimates of a company's financial performance based on projected figures rather than historical data. These ratios are useful in short-term financial planning as they allow businesses to forecast their financial health under various scenarios, helping to make informed decisions about budgeting, investment, and cash flow management.
Pro forma financial statements: Pro forma financial statements are projected financial documents that forecast a company's future financial performance, often based on certain assumptions or hypothetical scenarios. These statements help businesses in budgeting and financial planning by providing insights into potential revenues, expenses, and cash flows under different conditions, thereby playing a vital role in short-term financial planning.
Quick Ratio: The quick ratio, also known as the acid-test ratio, measures a company's ability to meet its short-term obligations using its most liquid assets. This ratio focuses on the assets that can be quickly converted into cash, such as cash and cash equivalents, accounts receivable, and short-term investments, while excluding inventory from the calculation. This makes it a more stringent indicator of liquidity compared to the current ratio, providing insights into financial health and risk management in business operations.
Return on Equity (ROE): Return on Equity (ROE) is a financial ratio that measures a company's profitability by revealing how much profit a company generates with the money shareholders have invested. This key metric helps assess the effectiveness of a firm's management in utilizing equity financing to generate earnings, making it essential for evaluating company performance, strategic planning, investment opportunities, and dividend policies.
Risk assessment: Risk assessment is the systematic process of identifying, analyzing, and evaluating potential risks that could negatively impact an organization's assets, operations, or profitability. This process is crucial for informed decision-making, allowing companies to anticipate uncertainties and allocate resources effectively to mitigate potential losses. Understanding risk assessment helps organizations navigate financial decisions, project evaluations, and short-term financial planning.
Sales Growth Impact: Sales growth impact refers to the effect that changes in sales revenue have on a company's financial performance and overall strategy. This concept is crucial for short-term financial planning, as understanding how sales fluctuations affect cash flow, working capital, and profitability helps businesses make informed operational and financial decisions.
Scenario Analysis: Scenario analysis is a process used to evaluate and assess the potential future outcomes of various financial situations by considering different hypothetical scenarios. This method helps organizations understand the impact of varying assumptions, such as changes in cash flow, costs, or market conditions, enabling better financial planning and decision-making.
Sensitivity Analysis: Sensitivity analysis is a financial modeling technique used to predict how different variables impact a specific outcome, such as cash flows or investment returns. By adjusting key assumptions in a model, this method helps assess risk and uncertainty, providing insights into how changes in inputs can affect financial decisions and outcomes.
Sensitivity testing: Sensitivity testing is a financial analysis technique used to assess how different values of an independent variable affect a specific dependent variable under a given set of assumptions. This method helps in understanding the impact of changes in key inputs on financial outcomes, which is crucial for short-term financial planning as it enables decision-makers to identify risks and make informed choices.
Short-term bank loans: Short-term bank loans are financial borrowings from banks that are typically due for repayment within one year. These loans are often used to cover immediate operational expenses, manage cash flow, or finance inventory purchases, providing businesses with quick access to capital. They are crucial in short-term financial planning as they help organizations bridge the gap between cash inflows and outflows.
Stress Testing: Stress testing is a simulation technique used to evaluate how a financial institution or organization can handle extreme economic scenarios. This method helps in understanding the potential impacts on cash flows, liquidity, and overall financial health during adverse conditions, making it crucial for short-term financial planning and effective management of credit and inventory.
Sustainable growth rate (SGR): The sustainable growth rate (SGR) is the maximum rate at which a company can grow its sales, earnings, and dividends without having to increase debt or equity financing. This rate reflects the balance between the company’s internal financing capacity and its operational efficiency, emphasizing the importance of maintaining a stable capital structure while pursuing growth. Understanding SGR helps companies plan their growth strategies in a financially sustainable manner, ensuring they don't overextend themselves.
Trade Credit: Trade credit is a financial arrangement where a buyer is allowed to purchase goods or services and defer payment for a specified period of time. This type of credit is crucial for short-term financial planning as it allows businesses to manage cash flow effectively while taking advantage of purchasing opportunities without immediate cash outflow.
Working Capital Management: Working capital management involves the processes and strategies that companies use to manage their short-term assets and liabilities to ensure operational efficiency and financial health. This concept focuses on maintaining adequate cash flow to meet obligations and invest in growth opportunities, while optimizing the use of current assets like inventory and receivables. Effective working capital management is crucial for balancing liquidity needs with profitability, making it a key aspect of financial management.