1. Chapter 8: Cash Flow1 Copyright 2002 Prentice Hall Publishing Company Managing Cash Flow

2. Chapter 8: Cash Flow2 Copyright 2002 Prentice Hall Publishing Company Cash Management n Young, growing companies are “cash sponges.” n A business can be earning a profit and be forced to close because it runs out of cash! n Cash management – forecasting, collecting, disbursing, investing, and planning for the cash a company needs to operate smoothly.

3. Chapter 8: Cash Flow3 Copyright 2002 Prentice Hall Publishing Company Cash Flow Engine

4. Chapter 8: Cash Flow4 Copyright 2002 Prentice Hall Publishing Company Five Cash Management Roles of an Entrepreneur n Cash Finder n Cash Planner n Cash Distributor n Cash Collector n Cash Conserver

5. The Cash Flow Cycle OrderGoods Day1 ReceiveGoods 15 PayInvoice 40 1425 218 178 SellGoods* DeliverGoods 221 3 CustomerPays** SendInvoice 230 9 280 50 Cash Flow Cycle = 240 days * Based on Average Inventory Turnover: 365 days = 178 days 365 days = 178 days 2.05 times/year 2.05 times/year ** Based on Average Collection Period: 365 days = 50 days 365 days = 50 days 7.31 times/year 7.31 times/year

6. Chapter 8: Cash Flow6 Copyright 2002 Prentice Hall Publishing Company The Cash Budget n A “cash map,” showing the amount and the timing of a firm’s cash receipts and cash disbursements over time. n Predicts the amount of cash a company will need to operate smoothly. n A helpful tool for visualizing the firm’s cash receipts and cash disbursements and the resulting cash balance.

7. Chapter 8: Cash Flow7 Copyright 2002 Prentice Hall Publishing Company Preparing a Cash Budget n Determine a Minimum Cash Balance n Forecast Sales n Forecast Cash Receipts n Forecast Cash Disbursements n Estimate End-of-Month Cash Balance

8. Chapter 8: Cash Flow8 Copyright 2002 Prentice Hall Publishing Company n Remember Goldilocks, the Three Bears, and the porridge:  Not too much...  Not too little...  but a cash balance that’s just right... for you! Determine a Minimum Cash Balance

9. Chapter 8: Cash Flow9 Copyright 2002 Prentice Hall Publishing Company n The heart of the cash budget n Sales are ultimately transformed into cash receipts and cash disbursements. n Prepare three sales forecasts: »Most Likely »Pessimistic »Optimistic Forecast Sales

10. Chapter 8: Cash Flow10 Copyright 2002 Prentice Hall Publishing Company Sales Forecast for a Start-Up Example: Number of cars in trading zone 84,000 x Percent of imports x 24% x Percent of imports x 24% = Number of imported cars in trading zone 20,160 Number of imports in trading zone 20,160 x Average expenditure on repairs x $485 x Average expenditure on repairs x $485 = Total import repair sales potential $9,777,600 Total import repair sales potential $9,777,600 x Estimated market share x 9.9% x Estimated market share x 9.9% = Sales estimate $967,982

11. Chapter 8: Cash Flow11 Copyright 2002 Prentice Hall Publishing Company n Record all cash receipts when actually received (i.e., the cash method of accounting). n Determine the collection pattern for credit sales; then add cash sales. Forecast Cash Receipts

12. Chapter 8: Cash Flow12 Copyright 2002 Prentice Hall Publishing Company n Start with those disbursements that are fixed amounts due on certain dates. n Review the business checkbook to ensure accurate estimates. n Add a cushion to the estimate to account for “Murphy's Law.” n Don’t know where to begin? Try making a daily list of the items that generate cash and those that consume it. Forecast Cash Disbursements

13. Chapter 8: Cash Flow13 Copyright 2002 Prentice Hall Publishing Company n Take Beginning Cash Balance... n Add Cash Receipts... n Subtract Cash Disbursements n Result is Cash Surplus or Cash Shortage (Repay or Borrow?) Estimate End-of-Month Balance

14. Chapter 8: Cash Flow14 Copyright 2002 Prentice Hall Publishing Company The “Big Three” of Cash Management n Accounts Receivable n Accounts Payable n Inventory

15. Chapter 8: Cash Flow15 Copyright 2002 Prentice Hall Publishing Company n About 90% of industrial and wholesale sales are on credit, and 40% of retail sales are on account. n Recent survey of small companies across a variety of industries found that 77% extend credit to their customers. n Remember: “A sale is not a sale until you collect the money.” n The goal with accounts receivable is to collect your company’s cash as fast as you can. Accounts Receivable

16. Chapter 8: Cash Flow16 Copyright 2002 Prentice Hall Publishing Company n Establish a firm credit-granting policy. n Screen credit customers carefully. n When an account becomes overdue, take action immediately. n Add finance charges to overdue accounts (check the law first!). n Develop a system of collecting accounts. n Send invoices promptly. Accounts Receivable Beating the Cash Crisis

17. Chapter 8: Cash Flow17 Copyright 2002 Prentice Hall Publishing Company n Stretch out payment times as long as possible without damaging your credit rating. n Verify all invoices before paying them. n Take advantage of cash discounts. n Negotiate the best possible terms with your suppliers. n Be honest with creditors; avoid the “the check is in the mail” syndrome. n Schedule controllable cash disbursements to come due at different times. n Use credit cards wisely. Accounts Payable Beating the Cash Crisis

18. Chapter 8: Cash Flow18 Copyright 2002 Prentice Hall Publishing Company n Monitor it closely; it can drain a company's cash. n Avoid inventory “overbuying.” It ties up valuable cash at a zero rate of return. n Arrange for inventory deliveries at the latest possible date. n Negotiate quantity discounts with suppliers when possible. Inventory Beating the Cash Crisis

19. Chapter 8: Cash Flow19 Copyright 2002 Prentice Hall Publishing Company Avoiding the Cash Crunch n Consider bartering. That means exchanging goods and services for other goods and services, to conserve cash. n Trim overhead costs. For example:  Lease rather than buy  Avoid nonessential cash outlays  Negotiate fixed loan payments to coincide with your company’s cash flow

20. Chapter 8: Cash Flow20 Copyright 2002 Prentice Hall Publishing Company Avoiding the Cash Crunch n Trim overhead costs. For example:  Buy used equipment  Hire part-time employees and freelancers  Develop an internal security system  Devise a method for fighting check fraud  Change shipping terms  Switch to zero-based budgeting n Keep your business plan current n Invest surplus cash (continued)

21. Chapter 8: Cash Flow21 Copyright 2002 Prentice Hall Publishing Company Creating a Successful Financial Plan

22. Chapter 8: Cash Flow22 Copyright 2002 Prentice Hall Publishing Company Basic Financial Reports n Balance Sheet - Estimates the firm’s worth on a given date; built on the accounting equation: Assets = Liabilities + Owner’s Equity Assets = Liabilities + Owner’s Equity n Income Statement - Compares the firm’s expenses against its revenue over a period of time to show its net profit (or loss): Net Profit = Sales Revenue - Expenses Net Profit = Sales Revenue - Expenses n Statement of Cash Flows - Shows the change in the firm’s working capital over a period of time by listing the sources of funds and the uses of these funds.

23. Chapter 8: Cash Flow23 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Liquidity Ratios - Tells whether or not the small business will be able to meet its maturing obligations as they come due. 1. Current Ratio - Measures solvency by showing the firm's ability to pay current liabilities out of current assets. Current Ratio = Current Assets = $686,985 = 1.87:1 Current Liabilities $367,850 2. Quick Ratio - Shows the extent to which the firm’s most liquid assets cover its current liabilities. Quick Ratio = Quick Assets = $231,530 =.63:1 Current Liabilities $367,850

24. Chapter 8: Cash Flow24 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Leverage Ratios - Measure the financing provided by the firm’s owners against that supplied by its creditors; a gauge of the depth of the company’s debt. 3. Debt Ratio - Measures the percentage of total assets financed by creditors rather than owners. Debt Ratio = Total Debt = $580,000 =.68:1 Total Assets $847,655 4. Debt to Net Worth Ratio - Compares what the business “owes” to what it “owns.” Debt to Net = Total Debt = $580,000 = 2.20:1 Worth Ratio Tangible Net Worth $264,155

25. Chapter 8: Cash Flow25 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Leverage Ratios ( Continued) 5. Times Interest Earned - Measures the firm’s ability to make the interest payments on its debt. Times Interest = EBIT* = $80,479 = 4.05:1 Earned Total Interest Expense $19,850 *Earnings Before Interest and Taxes

26. Chapter 8: Cash Flow26 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Operating Ratios - Evaluate the firm’s overall performance and show how effectively it is putting its resources to work. 6. Average Inventory Turnover Ratio - Tells the average number of times the firm’s inventory is “turned over” or sold out during the accounting period. Average Inventory = Cost of Goods Sold = $1,290.117 = 2.05 times Turnover RatioAverage Inventory* $630,600 a year *Average Inventory = Beginning Inventory + Ending Inventory 2

27. Chapter 8: Cash Flow27 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Operating Ratios - Evaluate the firm’s overall performance and show how effectively it is putting its resources to work. 7. Average Collection Period Ratio - Tells the average number of days required to collect accounts receivable. Two Steps: Receivables Turnover = Credit Sales = $1,309,589 = 7.31 times Ratio Accounts Receivable $179,225 a year Average Collection = Days in Accounting Period = 365 = 50.0 Period Ratio Receivables Turnover Ratio 7.31 days

28. Chapter 8: Cash Flow28 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Operating Ratios (Continued) 8. Average Payable Period Ratio - Tells the average number of days required to pay accounts payable. Two Steps: Payables Turnover = Purchases = $939,827 = 6.16 times Ratio Accounts Payable $152,580 a year Average Payable = Days in Accounting Period = 365 = 59.3 Period Ratio Payables Turnover Ratio 6.16 days

29. Chapter 8: Cash Flow29 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Operating Ratios (Continued) 9. Net Sales to Total Assets Ratio - Measures the firm’s ability to generate sales given its asset base. Net Sales to = Net Sales = $1,870,841 = 2.21:1 Total Assets Total Assets $847,655

30. Chapter 8: Cash Flow30 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Operating Ratios (Continued) 10. Net Sales to Working Capital Ratio - Measures how many dollars in sales the company generates for every dollar of working capital. Net Sales to = Net Sales = $1,870,841 = 5.86:1 Total Assets Working Capital* $847,655 *Working Capital = Current Assets - Current Liabilities

31. Chapter 8: Cash Flow31 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Profitability Ratios - Measure how efficiently the firm is operating; offer information about the firm’s “bottom line.” 11. Net Profit on Sales Ratio - Measures the firm’s profit per dollar of sales revenue. Net Profit on = Net Income = $60,629 = 3.24% Sales Net Sales $1,870,841

32. Chapter 8: Cash Flow32 Copyright 2002 Prentice Hall Publishing Company Twelve Key Ratios Profitability Ratios (Continued) 12. Net Profit to Equity Ratio - Measures the owner’s rate of return on the investment in the business. Net Profit to = Net Income = $60,629 = 22.65% Equity Owner’s Equity* $267,655 * Also called net worth

33. Chapter 8: Cash Flow33 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Current ratio = 1.87:1 n Industry Median Current ratio = 1.50:1 Although Sam’s falls short of the rule of thumb of 2:1, its current ratio is above the industry median by a significant amount. Sam’s should have no problem meeting short-term debts as they come due. Current Ratio - Measures solvency by showing the firm's ability to pay current liabilities out of current assets.

34. Chapter 8: Cash Flow34 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Quick ratio = 0.63:1 n Industry Median Quick ratio = 0.50:1 Again, Sam is below the rule of thumb of 1:1, but the company passes this test of liquidity when measured against industry standards. Sam relies on selling inventory to satisfy short-term debt (as do most appliance shops). If sales slump, the result could be liquidity problems for Sam’s. Quick Ratio - Shows the extent to which the firm’s most liquid assets cover its current liabilities.

35. Chapter 8: Cash Flow35 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Debt ratio = 0.68:1 n Industry Median Debt ratio = 0.64:1 Creditors provide 68% of Sam’s total assets. very close to the industry median of 64%. Although the company does not appear to be overburdened with debt, Sam’s might have difficulty borrowing, especially from conservative lenders. Debt Ratio - Measures the percentage of total assets financed by creditors rather than owners.

36. Chapter 8: Cash Flow36 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Debt to net worth ratio = 2.20:1 Industry Median Debt to net worth ratio =1.90:1 Sam’s owes $2.20 to creditors for every $1.00 the owner has invested in the business (compared to $1.90 to every $1.00 in equity for the typical business. Many lenders will see Sam’s as “borrowed up,” having reached its borrowing capacity. Creditor’s claims are more than twice those of the owners. Debt to Net Worth Ratio - Compares what the business “owes” to what it “owns.”

37. Chapter 8: Cash Flow37 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Times interest earned ratio = 2.52:1 n Industry Median Times interest earned ratio =2.0:1 Sam’s earnings are high enough to cover the interest payments on its debt by a factor of 2.52:1, slightly better than the typical firm in the industry. Sam’s has a cushion (although a small one) in meeting its interest payments. Times Interest Earned - Measures the firm’s ability to make the interest payments on its debt.

38. Chapter 8: Cash Flow38 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Average inventory turnover ratio = 2.05 times per year Industry Median Average inventory turnover ratio = 4.0 times per year Inventory is moving through Sam’s at a very slow pace. What could be causing such a low turnover in the business? Average Inventory Turnover Ratio - Tells the average number of times the firm’s inventory is “turned over” or sold out during the accounting period.

39. Chapter 8: Cash Flow39 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Average collection period ratio = 50.0 days n Industry Median Average collection period ratio = 19.3 days Sam’s collects the average account receivable after 50 days compared to the industry median of 19 days – more than 2.5 times longer. What is a more meaningful comparison for this ratio? Average Collection Period Ratio - Tells the average number of days required to collect accounts receivable.

40. Chapter 8: Cash Flow40 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Average payable period ratio = 59.3 days n Industry Median Average payable period ratio = 43 days Sam’s payables are nearly 40 percent slower than those of the typical firm in the industry. Stretching payables too far could seriously damage the company’s credit rating. What are the possible causes of this discrepancy? Average Payable Period Ratio - Tells the average number of days required to pay accounts payable.

41. Chapter 8: Cash Flow41 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Net sales to total assets ratio = 2.21:1 n Industry Median Net Sales to total assets ratio = 2.7:1 Sam’s Appliance Shop is not generating enough sales, given the size of its asset base. What could cause this? Net Sales to Total Assets Ratio - Measures the firm’s ability to generate sales given its asset base.

42. Chapter 8: Cash Flow42 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Net sales to working capital ratio = 5.86:1 n Industry Median Net Sales to working capital ratio = 10.8:1 Sam’s generates just $5.86 in sales for every $1 of working capital, just over half of what the typical firm in the industry does. The message is clear: Sam’s is not producing an adequate volume of sales. Possible causes... ? Net Sales to Working Capital Ratio - Measures how many dollars in sales the company generates for every dollar of working capital.

43. Chapter 8: Cash Flow43 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Net profit on sales ratio = 3.24% n Industry Median Net profit on sale ratio = 7.6% After deducting all expenses, Sam’s has just 3.24 cents of every sales dollar left as profit – less than half the industry average. Sam may discover that some of his operating expenses are out of balance. Net Profit on Sales Ratio - Measures the firm’s profit per dollar of sales revenue.

44. Chapter 8: Cash Flow44 Copyright 2002 Prentice Hall Publishing Company Interpreting Ratios n Sam’s Appliance Shop Net profit on equity ratio = 22.65% n Industry Median Net profit on equity ratio = 12.6% Sam’s return on his investment in the business is an impressive 22.65%, compared to an industry median of just 12.6%. Is this the result of high profitability or is there another explanation? Net Profit to Equity Ratio - Measures the owner’s rate of return on the investment in the business.

45. Chapter 8: Cash Flow45 Copyright 2002 Prentice Hall Publishing Company Breakeven Analysis n The breakeven point is the level of operation at which a business neither earns a profit nor incurs a loss. n It is a useful planning tool because it shows entrepreneurs the minimum level of activity required to stay in business. n The breakeven point may be calculated in dollars and in units. n Adding desired profit, markdowns, and theft when computing the breakeven point provides a more significant insight into the financial analysis.

46. Chapter 8: Cash Flow46 Copyright 2002 Prentice Hall Publishing Company Break-Even Analysis n Break-even point: That quantity of output at which total revenue equals total cost, assuming a certain selling price. n Mark-up = Unit contribution to fixed costs/overhead = Selling price - Variable cost.  Create an “Average Mark-up” if you’re selling a variety of products at different prices and costs. n Definitions:  Variable costs vary with the level of production.  Fixed costs/overhead remain constant regardless of the level of production. of production. n Breakeven Formulas:  B.E. in Units Sales = Total fixed costs/overhead Selling price - Variable cost  B.E. in $ Sales=B.E. in units x Selling price

47. Chapter 8: Cash Flow47 Copyright 2002 Prentice Hall Publishing Company Assume a store sells bubble gum machines for $100 that cost $75 to make. Monthly overhead is $10,000. Breakeven Analysis Mark-up B.E. in Units = Fixed/Overhead Costs B.E. in $ =B.E. in Units x Selling Price Fixed/Overhead Costs = Price - Variable Cost B.E. in Units = $10,000 $100 - $75 = $10,000 $25 = 400 units B.E. in $ =40 units x $100 = $40,000

48. Chapter 8: Cash Flow48 Copyright 2002 Prentice Hall Publishing Company Profit Analysis Mark-up B.E. in Units = Fixed/Overhead Costs + Profit + Markdowns/Theft B.E. in $ =B.E. in Units x Selling Price B.E. in Units = $10,000 + $5,000 + $2,500$17,500 $25 = 700 units B.E. in $ =700 units x $100 = $70,000 Each month, assume the owner needs to breakeven, make $5,000 profit to live on, and cover expected markdowns/theft. = $25 Desired