2 LEARNING OBJECTIVES1. 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.5. Prepare a pro forma income statement and a pro forma balance sheet.
3 12.1 Sources and Uses of Cash Cash is considered to be the life-blood of a business. Cash shortages can be stifling and expensive while excesses can lead to poor returns.Since most businesses do not function on a pure 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.
4 12.1 Sources and Uses of Cash Despite setting up a cash reserve, the firm is projected to have cashshortfalls in 3 months and surpluses in 2 after all cash receipts anddisbursements have been forecasted for the first half of 2010.
5 12.1 Sources and Uses of Cash 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.
6 12.2 Cash Budgeting and the Sales Forecast Sales revenue: Base variable driving almost all other items in the cash budget. A company 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. A company must keep track of all future collections. To forecast: Need internal data (information that is proprietary or unique to the firm) as well as external data (publicly available information) sources for objective sales forecasts.
8 12.2 Cash Inflow from SalesFirms 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. It is quite common for firms to collect some of their receivables in the months following the sale, i.e. November 2008’s credit sales will be partially collected in December and January.
9 12.2 Cash Inflow from SalesManagers often figure in a small percentage of the forecasted sales as bad debts when preparing a cash budget.
10 12.2 Other Cash ReceiptsBesides sales, which are the main contributors to a firm’s cash inflow, need to forecast the timing and magnitude of other occasional sources of cash such asasset sales,funds raised through issuance and sale of securities, andincome earned on investments (dividends, interest, etc.)
11 12.3 Cash Outflow from Production The magnitude and timing of the various cash disbursements of a firm depends 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 various costs, and when it actually makes the payment for them.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 budget.
12 12.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses The main objective of developing a cash budget is to determine if a 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, other operating expenses;3. Capital expenditures for plant, equipment, and machinery; and4. Dividends, interest and floatation cost payments related to raising and servicing of capital.Over a short planning cycle, the total periodic cash inflow rarely matches the total periodic outflow, due to seasonal fluctuations and time lags. Forecasted cash deficits and surpluses in specific periods can be managed for the betterment of the firm.
13 12.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses
14 12.4 Funding Cash Deficits Cash shortfalls can be handled in 4 ways: Cash from savingsUnsecured loans (letters of credit).Secured loans (using accounts receivable, inventories or other company assets).Other sources (commercial paper, trade credit, or banker’s acceptance).
15 12.4 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 (add new projects that grow the company by accepting positive net present value projects).
16 12.5 Planning with Pro Forma Financial Statements Cash budgeting, is only one aspect of short-term financial planning. Equally important for firms is to forecast their operating cash flow and net income for the forthcoming period by developing pro forma financial statements. There are a variety of ways to produce pro forma statements, but the statements usually rely on two primary inputs: The prior year’s financial statements and the relationship of the account balances to each other, andThe projected sales for the coming year.
17 12.5 Planning with Pro Forma Financial Statements The percentage of each item either to sales (income statement) or to total assets (balance sheet) is computed for the prior year and then multiplied by the projected sales (income statement) or total assets (balance sheet) for the coming year to develop pro forma financial statements. For example, let’s say that the cash balance for the prior year is $2 million and the total assets is $100m. So cash is 2% of total assets.For the Pro Forma Balance Sheet, we would forecast cash as 2% of the forecasted total assets as well, i.e. if total assets are forecasted to increase by 20% to $120m the cash would be forecasted to be .02 x 120m = $24m.
19 12.5 Pro Forma Income Statement This approach, a good first step, is often too simplistic in reality because many financial statement items do not vary proportionately with sales. In particular, depreciation decreases over time and cost of goods sold often declines due to economies of scale. The manager would have to fine-tune the forecasted values to make them more in line with reality.
20 12.5 Pro Forma Balance Sheet Each prior year’s balance sheet item is expressed as a percent of total assets, and then multiplied by the forecasted total assets figure for the next period. Items which are obviously either constant each period, or which vary at a different rate (for whatever reason) are accordingly adjusted for by the financial manager. If total assets exceed total liabilities and owner’s equity, external financing is allocated according to some pre-determined ratio to serve as the plug variable.
26 12.5 Pro Forma Cash Flow Statement Finally, the pro forma cash flow statement (Figure 12.7) is prepared to tie together all the changes in operating, investment, and financing cash flows.It helps the company see where funds will be generated in the coming period and where funds will be used.If operations is insufficient in generating cash inflow and borrowing is needed (from either lenders or owners) it must be a temporary situation or the company will not be sustainable. Here the $200,000 from borrowing needs to be for expanding the business and not maintaining the business.