Lecture 8 - Short-term Financial Planning

Lucas S. Macoris

Financing Short-term needs

  • In our previous lecture, we saw that firms need not only long-term, but also short-term investments

  • These, in general, are referred to as net working capital:

    1. If a firm is growing, it is likely the case that its net working capital needs are also trending upwards
    2. In order to foster such growth, the firm needs to firm about how to fund it!

  • Firms may also present seasonal sales patterns:

    1. A firm can generate surpluses in some given quarters…
    2. But it might demand capital in other quarters

  • Question: how does a company manage its short-term needs within the year?

Financing Short-term needs - ARRZ3

Breaking Down Short-Term Financing Needs - ARRZ3

Breaking Down Debt Trends - ARRZ3

Overview

  • Overall, it seems that both Sales and Net Working Capital are trending upwards

    1. High demand for products \(\rightarrow\) higher working capital needs
    2. Higher need to extend funding to foster increased activity

  • Looking at the specifics of Arezzo’s working capital accounts, it seems it is being fueled mainly by Inventories, although Receivables have also increased significantly

  • Payables have substantially increased to sustain the firm’s growth. However, overall net capital needs have increased.

  • How to finance the remaining part?

  • In the next slides, we’ll study a step-by-step guide in short-term financing, following (Berk and DeMarzo 2019)

Step 1: Forecasting Short-term Financing Needs

  • The first step in short-term financial planning is to forecast the company’s future cash flows

    1. A company forecasts its cash flows to determine whether it will have surplus cash or a cash deficit for each period
    2. The management needs to decide whether that surplus or deficit is temporary or permanent

  • Within short-term financing planning, we are interested in analyzing the types of cash surpluses or deficits that are temporary and, therefore, short-term in nature

  • Typically, firmsrequire short-term financing for three reasons:

  1. Seasonalities
  2. Negative Cash-Flow shocks
  3. Positive Cash-Flow shocks

Seasonalities

  • When sales are concentrated during a few months, sources and uses of cash are also likely to be seasonal.

    1. Firms in this position may find themselves with a surplus of cash during some months that is sufficient to compensate for a shortfall during other months
    2. However, because of timing differences, such firms often have short-term financing needs.

  • The introduction of seasonal sales creates some dramatic swings in short-term cash flows:

    1. While Cost of Goods Sold generally fluctuates proportionally with sales, other costs (such as administrative overhead and depreciation) do not, leading to large changes in the firm’s net income by quarter

    2. Net working capital changes are more pronounced

  • Seasonal sales create large short-term cash flow deficits and surpluses: because of this, a firm may opt to invest surpluses in short-term investment options and use it during downturns

Negative and Positive Cash-Flows

Negative Cash-Flow Shocks

  • Occasionally, a company will encounter circumstances in which cash flows are temporarily negative for an unexpected reason (e.g, higher costs, legal actions, widespread events, such as COVID-19, among others)

  • Such unexpected hits in the firm’s cash flow expectations might induce to an increase in financing needs

  • Example: what happened to delivery food chains during the onset of the pandemic in Brazil?

Positive Cash-Flow Shocks

  • Increases in firm’s expected sales can leader to increases in short-term financing needs. Going back to the example that we saw, ARZZ’s growth in sales was accompained by a surge in working capital needs!

  • A firm may have a temporary deficit before it actually reaps out the benefitis of positive cash-flow shocks (e.g, Marketing investments)

An example of projected financial statements

Step 2: Financing Short-term Financing Needs

  • Right after forecasting the need for short-term financing, it is time to decide how it will be financed

  1. On the one hand, there is an opportunity cost of holding cash in accounts that pay little or no interest

  2. On the other hand, firms also face high transaction costs if they need to negotiate a loan on short notice to cover a cash shortfall

  • The Matching Principle firms can increase their value by adopting a policy that minimizes these kinds of costs:

  1. Short-term needs should be financed with Short-term debt

  2. Long-term needs should be financed with Long-term sources of funds

Matching Principle in practice - Permanent Working Capital

  • We saw that we can distinguish permanent and short-term working capital needs. The permanent portion of working capital]{.blue} is the amount that a firm must keep invested in its shortterm assets to support its continuing operations.

  • Because this investment in working capital is required so long as the firm remains in business

  • The matching principle indicates that the firm should finance this permanent investment in working capital with long-term sources of funds

  • In general, such sources have lower transaction costs than short-term sources of funds, which would have to be replaced more often.

Example: after forecasting permanent working capital needs, if funding using short-term sourcers (say, 1 year), firms are exposed to interest rate risk – in other words, you may have to refinance at a higher rate in the future! During, COVID-19, interest rate risk made smaller firms to shut-down its operations

Matching Principle in practice - Temporary Working Capital

  • Another portion of a firm’s investment in its accounts receivable and inventory is temporary and results from seasonal fluctuations in the firm’s business or unanticipated shocks

  • This temporary working capital need is the difference between the actual level of investment in short-term assets and the permanent working capital investment. Following the Matching Principle, it should be financed with short-term sources!

  • Using our previous example, we can use the minimum net working capital of a given quarter and fix it as our permanent component (\(X-\$2,125\))

Financing Policies - Aggresive Policy

  • What if we depart from the Matching Principle whenever financing firm’s activity? An Aggresive Policy is the case if we financed permanent working capital needs with short-term debt:

    1. When the short-term debt comes due, the firm will have to negotiate a new loan
    2. This new loan will involve additional transaction costs, and it will carry whatever market interest rate exists at the time

  • When firms can benefit from this policy? As short-term debt is less sensitive to the firm’s credit quality than long-term debt, firms can benefit from it whenever market imperfects are more acute

  • Furthermore, when the yield curve is upward sloping, the interest rate on short-term debt is lower than the rate on long-term debt

  • However, shareholders incur in funding risk, which is the risk of incurring financial distress costs if firm is not able to refinance its debt in a timely manner or at a reasonable rate

Financing Policies - Conservative Policy

  • Alternatively, a firm could finance its short-term needs with long-term debt, a practice known as a Conservative Financing policy: use long-term sources of funds to finance its fixed assets, permanent working capital, and some of its seasonal needs

  • Whenever implementing such policy, there will be periods where there is excess cash - i.e, those periods when the firm requires little or no investment in temporary working capital

  • While such policy significantly reduces funding risks, it has its drawbacks:

    1. Excess cash may earn below-average interest rates
    2. Holding higher cash levels can also distort managers incentives - i.e, pay perks for themselves or use it non-productively

Analyzing Arezzo

References

Presented by Lucas S. Macoris

Berk, J., and P. DeMarzo. 2019. Corporate Finance, Global Edition. Global Edition / English Textbooks. Pearson. https://books.google.com.br/books?id=m78oEAAAQBAJ.