1. Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 12 Forecasting and Short-Term Financial Planning

2. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-2 Learning Objectives 1.Understand the sources and uses of cash that are used in building a cash budget. 2.Explain how sales forecasts are used to predict cash inflow. 3.Understand how production costs vary in terms of cash flow timing. 4.Explain possible ways to cover cash deficits and invest cash surplus.

3. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-3 Forecasting One of the main tasks of finance manager is to forecast for the coming period. The forecast is the foundation for short-term financial action plan. Two tools to forecast : -Cash forecast (cash budget) -Pro forma financial statements (cash budget projections)

4. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-4 12.1 Sources and Uses of Cash Cash is considered to be the life-blood of a business. Cash shortages can be problematic while cash excesses can lead to poor returns. Since most businesses do not function on a purely cash basis, it is critical for them to forecast their needs for cash in advance. The cash budget is the analytical tool that estimates the future timing of cash inflow and cash outflow and projects potential shortfalls and surpluses.

5. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-5 Despite setting up a cash reserve, the firm is projected to have cash shortfalls in 3 months and surpluses in 2 after all cash receipts and disbursements have been forecasted for the first half of 2010. 12.1 Sources and Uses of Cash (continued) TABLE 12.1 Bridge Water Pumps and Filters, Cash Budget for First Six Months of 2010 ($ in thousands)

6. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-6 Identifying all possible sources and uses of cash is essential for preparing a useful cash budget. This list can serve as a guide when preparing a cash budget. 12.1 Sources and Uses of Cash (continued) FIGURE 12.1 Cash inflows and cash outflows for a company.

7. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-7 Example Which of the following is a source of cash and which one is a use of fund? - Accounts receivables - Wages and salaries - Interest payments - Cash sales of equipments

8. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-8 Example If ABC company will have in December cash receipts of $470,000 and cash disbursements/payments of $ 490,000.If its beginning balance of cash is $5,000 and its reserves are $7,000,what will be the shortfall/surplus in cash for the month?

9. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-9 12.2 Cash Budgeting and the Sales Forecast The first step to prepare a cash budget is to predict the cash inflows from future sales(sales forecasts). Sales revenue  base variable driving almost all other items in the cash budget,  Must forecast sales as objectively as possible. There is usually a time lag between when a sale is made and when the cash receipts come in  Must keep track of collections time-line. Two types of data used as sources for objective sales forecasts: -internal data: information that is proprietary or unique to the firm - external data: publicly available information

10. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-10 12.2 (A) Cash Inflow from Sales Firms typically sell products and services partially for cash and partially on credit. An analysis of a firm’s collection policy can help project cash inflow from sales. Once the sales estimate is in, finance manager must estimate the cash flow from these sales in terms of timing. It is quite common for firms to collect some of their receivables in the 2 months following the sale, i.e., November 2008’s credit sales will be partially collected in December 2008 and January 2009.

11. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-11 Example The sales for October, November, and December are $12,000,$13,000 and $20,000 respectively. For any particular months of sales, the following percentages are received over time in cash: 20% in cash from that same month of sales, 40% in cash from the previous month’s sales, and 40% in cash from the sales from the two months ago. What amount of cash will be received during December?

12. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-12 12.2 (B) Other Cash Receipts Besides sales, which are the main contributor to a firm’s cash inflow, need to forecast the timing and magnitude of other occasional sources of cash such as – asset sales, –funds raised through issuance and sale of securities, and –income earned on investments (dividends, interest, etc.)

13. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-13 12.3 Cash Outflow from Production The magnitude and timing of the various cash disbursements of a firm depend mainly on forecasted sales. –Payments for raw materials, labor costs, overheads such as utilities and rent, shipping costs, etc. Like sales, there is often a time lag between when the firm receives and records the benefit, and when it actually makes the payment for it. The cash budget can be used as a handy planning document to keep track of the projected disbursements. Depreciation is merely a tax write-off, not a cash disbursement, so should not be included in a cash budgetDepreciation is merely a tax write-off, not a cash disbursement, so should not be included in a cash budget.

14. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-14 12.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses The main objective of developing a cash budget  Firm has sufficient cash available from its revenues and other receipts to cover its periodic cash disbursements such as: 1.Accounts payables for materials and supplies 2.Salaries, wages, taxes, and other operating expenses 3.Capital expenditures for plant, equipment, and machinery 4.Dividends, interest, and flotation cost payments related to the raising and servicing of capital Over a short planning cycle, the total periodic cash inflow rarely matches the total periodic outflow,  seasonal fluctuations and time lags.  This results in forecasted cash deficits and cash surpluses in certain periods.  Therefore, cash budget can help us to determine whether we need short term borrowing or not (i.e. when we have deficit).

15. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-15 12.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses (continued) TABLE 12.3 Monthly Cash Budget for Bridge Water Pumps and Filters

16. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-16 Example The Heather firm has cash sales of $550,000 in October, its accounts receivable payments in that month are $340,000, it has a beginning cash in October of $20,000, and there are no other cash inflows in October. Heather has accounts payable of $250,000 in October, its wages and salaries payments in October are $130,000, its interest payments in October are $70,000, and there are no other outflows for October. What is the ending cash balance of Heather in October?

17. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-17 12.4 (A) Funding Cash Deficits Cash shortfalls can be handled in 4 ways: 1.Cash from savings 2.Unsecured loans (letters of credit) 3.Secured loans (using accounts receivable or inventories) 4.Other sources (commercial paper, trade credit, or banker’s acceptance).

18. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-18 12.4 (B) Investing Cash Surpluses When a company has excess funds, it has 4 options: 1.Put the surplus in a savings account or invest it in marketable securities. 2.Repay lenders and owners (retire debt early or pay extra dividends). 3.Replace aging assets. 4.Invest in the company, accepting positive net present value projects