Short-Term Financing

Finance Essentials I

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Course: Finance Essentials I

Lesson 3: Short-Term Financing

In the course of doing business, N-Style progresses through the operating cycle depicted above. Throughout the cycle, the company experiences a series of cash inflows and outflows. These cash inflows and outflows are both unsynchronized and uncertain.

The cash flows are unsynchronized because payment for the clothing and shoes purchased from the manufacturers does not occur simultaneously with the collection of cash from customers purchasing those items. The cash flows are uncertain because clothing sales and the cost of acquiring inventory cannot be predicted with complete certainty.

For N-Style, as with all other companies, the purpose of short-term financing decisions is ensuring that the company has enough cash on hand to operate and maximizing the return on any short-term cash surpluses through short-term investments.

cash flow A measure of all money that is received or paid out by an entity over a period of time What is the difference between short-term and long-term finance?

The most important difference is the timing of the cash flows. Short-term finance involves cash inflows and outflows that occur within 12 months. For example, a short-term financial decision is one where a company purchases raw materials for cash and anticipates selling the finished goods for cash within 12 months.

In contrast, a long-term financial decision involves cash flows occurring beyond 12 months, or assets and liabilities whose lives extend beyond 12 months. An example of a long-term financial decision is a company purchasing new operating equipment that will reduce production costs over the next 5 years.

In order to operate in the face of uncertain and unsynchronized short-term cash flows, N-Style must keep a certain amount of cash and short-term investments. Further, N-Style needs sufficient inventory on hand to fulfill its short-term sales needs.

In order to track its "investment" in current assets needed to support short-term (day-to-day) operations, N-Style watches their level of Net Working Capital. Net Working Capital is the difference between the company's current assets and current liabilities and represents the resources needed to operate the business.

The general rule for minimizing short-term financing costs is to reduce the level of short-term assets that must be carried, earn as much return as possible on excess cash, and keep the costs of borrowing and shortage as low as possible.

The level of short-term assets should be kept as low as possible because those assets (e.g., inventory, non-interest earning cash) use up funds that could otherwise be deployed to earn money in long-term investments. Even when short-term assets earn interest, as is the case with marketable securities, the amount of interest earned will almost always be less than the funding cost of borrowing the money to fund such investments.

Shortage costs are the costs of running out of needed short-term assets. It could be quite costly to N-Style if they unexpectedly run out of short-term cash and need to quickly arrange additional financing. Likewise, running out of inventory would carry significant costs in the form of lost sales revenue and higher expenses associated with emergency purchases of goods to replenish inventory.

Laura looks to the financial markets to find the investment that provides the best return over the next 9-12 months on the USD 400,000 in excess cash.

In the equity capital markets, equity securities, commonly known as shares of stock, are traded. Most equity securities are common stock, which does not oblige the issuer to pay dividends or to make any other payments. Equity securities are very long-term in nature and represent ongoing, perpetual ownership interest.

Long-term debt securities are traded in the debt capital markets. A debt security, such as a bond or note, is a long-term contractual obligation whereby the issuer promises to pay interest and repay the face amount of principal in total on one maturity date or in installments over various dates. Bonds, in particular, can be very long-term in nature, with some bonds maturing up to 30 years in the future.

In the foreign exchange markets, the currencies of the world are traded for one another. These markets facilitate currency transactions that allow companies in different countries to do business with each other.

The money markets are where short-term funds are bought, sold, borrowed, and lent on a wholesale basis. In contrast to the much longer maturities in the capital markets, the instruments traded in the money markets have maturities of one year or less.

money markets Marketplace for short-term financing, or investment of short term surpluses. Money market instruments are sometimes called cash equivalents.

What are the foreign exchange markets used for?

International trade is the most fundamental use of the foreign exchange (FX) markets, as the buying and selling of goods between countries also requires the buying and selling of currencies. However, the FX markets are used for other purposes as well.

Speculators take advantage of the opportunities presented by exchange rate differentials. Even banks occasionally speculate in the FX market by going long or short a currency. A Central Bank, such as the Bank of Japan, may participate in the FX market, not to speculate, but in an attempt to stabilize its domestic currency.

Finally, the FX market is utilized when a loan of foreign currency must be repaid.

Even though the USD 400,000 in excess cash is being used to fund a long-term investment rather than meet short-term operating needs, the appropriate investment will still be found in the money markets. The use of the funds does not matter. The short-term nature of the needed investment is the key factor.

Where are the money markets located?

The money markets do not exist in any specific geographic location. Instead, a network of computers and telephones link participants in this market.

Do any money market instruments have maturities of greater than one year?

Yes. Term CDs and floating-rate CDs may have longer maturities. You will learn about these later in the course.

Several instruments traded in the money markets may be appropriate for Laura's 9-12 month investment of the excess cash of N-Style.

Money market instruments, such as the ones listed above, do more than just provide good investment opportunities for companies. These instruments also provide a mechanism for the following:

• Transfer of money between banks who have a surplus or deficit of funds • Source of short-term investments for pools of funds such as mutual funds • Transfer of short-term money from banks and mutual funds to corporations that need

short-term funding • Implementation of monetary policy by the central bank

Banks are core participants in the money markets and utlize the various instruments to manage mismatches between the maturities of their assets and liabilities. As a corporation, N-Style typically participates in the money markets through its banks.

Institutional investors include mutual funds, pension funds, and insurance companies.

Dealers buy and sell for their accounts or on behalf of customers. Banks may be dealers as well. Brokers are entities who do not buy and sell for their own account, but instead serve as intermediaries for other participants. While some organizations act as either a broker or dealer, many organizations are empowered to act in both capacities. These latter organizations are often referred to as broker/dealers.

The government plays a major role in the money markets as well.

What is the role of the government in the money markets?

The money markets serve as a vehicle for governments and central banks to carry out fiscal and monetary policy. Fiscal policy involves the use of government's taxation and spending policies to achieve macroeconomic goals, such as sustainable growth rates, price stability, and high employment.

In the United States, the president and Congress carry out fiscal policy. Each year, the president proposes a budget to Congress. To execute the fiscal policy contained in the budget, the U.S.

Treasury Department may need to raise funds from the financial markets to finance budgeted activities. When short-term funds are needed, Treasury bills are issued in the money markets.

Monetary policy can be defined as the actions that alter money supply. A nation's monetary policy is carried out by the central bank. In the United States, the central bank is the Federal Reserve System.

A frequent goal of monetary policy is to maintain price stability (commonly referred to as controlling inflation). The central bank tries to achieve price stability by conducting open market operations (i.e., buying/selling Treasury instruments including Treasury bills) and setting the Discount Rate and level of reserve requirements for banks. These actions affect the level of short-term interest rates.