Corporate Finance

Short-Term Financial Planning

Short-term financial planningShort-term financial planning is important for virtually all businesses – from small startups to large established businesses. Even large businesses with seemingly healthy income statements have gone bankrupt, simply because they couldn’t meet their current obligations.

Short term planning helps answer important questions like:

  • How much cash should you have available in the bank to pay bills?
  • How much inventory should you keep on hand?
  • How much credit should you extend to customers?

Short-Term Finance Defined

The main difference between short-term and long-term finance is the timing of cash flows. Usually, short-term financial decisions are defined as those that involve cash flows within the next 12 months. The long-term is usually defined as longer than one year.

Operating Cycle and Cash Cycle – Unsynchronized!

A common reason firms get into cash flow problems is because of the timing of cash flows during short-term operating activities.

To illustrate, we can look at some typical short-run operating activities of a manufacturing firm:

  1. Buying raw materials
  2. Paying for raw materials → cash out
  3. Manufacturing the product.
  4. Selling the product
  5. Collecting cash → cash in

The operating cycle is the time between the arrival of inventory and the date when cash is collected from receivables. As we can see, cash is usually paid out before it is collected.

The cash cycle starts when cash is paid out for materials and ends when cash is collected from accounts receivable.

Imagine a company could buy inventory, sell its product, collect payment, and pay suppliers all in one day. The company would have a cash cycle of zero days. It’s hard to think of many examples of this type of firm because most companies have a positive cash cycle. The longer the cash cycle, the more the need for financing.

Strategies for Reducing Cash Flow Problems

Decrease cash cycle time

Decreasing cash cycle time can help significantly reduce the chances of cash flow problems. This is why companies frequently try to decrease their inventory and receivables time periods. Cash cycle time can be decreased further if payments to suppliers can be delayed.

Cash reserves

Keeping cash reserves and few short-term liabilities can go a long way to help avoid financial distress. However, this comes at a cost. Having idle cash that is not put to work or invested means future revenue is foregone.

Maturity hedging

Maturity hedging is a fancy term that simply means paying for short-term costs, like inventory, with short-term loans. It is usually better to avoid financing long-lived assets (such as machinery) with short-term borrowing. That type of maturity mismatching requires frequent refinancing, and is riskier because short-term interest rates are more volatile than long-term rates. Maturity mismatching also increases risk because short-term financing may not always be available.

It’s important to note that short-term interest rates are normally lower than long-term rates. This means that it’s generally more expensive to use long-term borrowing than short-term borrowing.

Cash Budgeting

The primary tool for short-term financial planning is the cash budget. It gives managers a “heads-up” about when short-term financing may be needed. A cash budget simply records estimates of cash receipts and payments.

Cash budgeting starts with a sales forecast, usually by the quarter, for the upcoming year. By using the sales forecast and factoring in the receivables period, we can get an estimate of the timing of cash collections by quarter.

Next, cash payments are taken into account. Cash payments are often put into four categories:

  • Payments of accounts payable
  • Capital expenditures (cash payments for long-term assets)
  • Long-term financing costs (interest, dividends etc.)
  • Salaries, taxes and other expenses

Finally, the quarterly cash balance is found by subtracting the quarterly cash inflows with the cash outflows. Financing arrangements have to be made for quarters with a net cash outflow.

Larger companies often go beyond the “best guess” outlined above and use multiple “what if” scenario analysis, and sensitivity analysis.

For more details, see our article that covers cash budgeting in depth.

Common sources of short-term borrowing

Operating loans

Operating loans from banks are the most common way to finance temporary cash deficits. It’s an agreement where the company can borrow up to a certain amount for a given period – almost like a credit card. Operating loans can be unsecured or secured by collateral.

Interest is charged on the loan and is set by the bank. It’s usually the bank’s prime lending rate plus an additional percentage. The bank may increase the rate over time as it assesses the borrower’s risk.

Banks lend mainly to low-risk borrowers. This is why they often decline risky business loans. Many loan requests that banks turn down come from small businesses, particularly startups. These startups then often turn to alternative financing sources.

Financial institutions may require collateral (called security) for a loan, such as property, accounts receivable, or equipment. These are called secured loans. For secured loans, the interest rate charged is often less than with unsecured loans.

Letter of credit

Letters of credit allow borrowers to pay off a balance and borrow funds as needed. This differs from a short-term loan where the borrower receives a lump sum of cash and can borrow more only after the short-term loan is repaid.

Other sources

Larger companies use a variety of other sources of short-term funds. Commercial paper are short-term notes issued by highly rated firms. Banker’s acceptances are similar to commercial paper except that they are guaranteed by a bank in exchange for a fee charged by the bank.