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Cash Budgeting

The financial manager`s task is to forecast future sources and uses of cash. These forecasts serve two purposes. First, they alert the financial manager to future cash needs. Second, the cash-flow forecasts provide a standard, or budget, against which subsequent performance can be judged.

There are several ways to produce a quarterly cash budget. Many large firms have developed elaborate ¬corporate models ­; others use a spreadsheet program to plan their cash needs. The procedures of smaller firms may be less formal. But no matter what method is chosen, there are three common steps to preparing a cash budget: Step 1. Forecast the sources of cash. The largest inflow of cash comes from payments by the firm`s customers.

Step 2. Forecast uses of cash.

Step 3. Calculate whether the firm is facing a cash shortage or surplus.

The financial plan sets out a strategy for investing cash surpluses or financing any deficit. We will illustrate these issues by continuing the example of Dynamic Mattress.

FORECAST SOURCES OF CASH

Most of Dynamic`s cash inflow comes from the sale of mattresses. We therefore start with a sales forecast by quarter for 2001:5

But unless customers pay cash on delivery, sales become accounts receivable before they become cash. Cash flow comes from collections on accounts receivable. Most firms keep track of the average time it takes customers to pay their bills. From this they can forecast what proportion of a quarter`s sales is likely to be converted into cash in that quarter and what proportion is likely to be carried over to the next quarter as accounts receivable. This proportion depends on the lags with which customers pay their bills. For example, if customers wait 1 month to pay their bills, then on average one-third of each quarter`s bills will not be paid until the following quarter. If the payment delay is 2 months, then two-thirds of quarterly sales will be collected in the following quarter.

Suppose that 80 percent of sales are collected in the immediate quarter and the remaining 20 percent in the next. Table 2.6 shows forecast collections under this assumption. In the first quarter, for example, collections from current sales are 80 percent of $87.5 million, or $70 million. But the firm also collects 20 percent of the previous quarter`s sales, or .20 $75 million = $15 million. Therefore, total collections are $70

million + $15 million = $85 million.

Dynamic started the first quarter with $30 million of accounts receivable. The quarter`s sales of $87.5 million were added to accounts receivable, but $85 million of collections was subtracted. Therefore, as Table 2.6 shows, Dynamic ended the quarter with accounts receivable of $30 million + $87.5 million Ј $85 million = $32.5 million. The general formula is

Ending accounts receivable = beginning accounts receivable + sales Ј collections

The top section of Table 2.7 shows forecast sources of cash for Dynamic Mattress. Collection of receivables is the main source but it is not the only one. Perhaps the firm plans to dispose of some land or expects a tax refund or payment of an insurance claim. All such items are included as ¬other ­ sources. It is also possible that you may raise additional capital by borrowing or selling stock, but we don`t want to prejudge that question. Therefore, for the moment we just assume that Dynamic will not raise further long-term finance.

FORECAST USES OF CASH

There always seem to be many more uses for cash than there are sources. The second section of Table 2.7 shows how Dynamic expects to use cash. For simplicity, in Table 2.7 we condense the uses into four categories:

1. Payments of accounts payable. Dynamic has to pay its bills for raw materials, parts, electricity, and so on. The cash-flow forecast assumes all these bills are paid on time, although Dynamic could probably delay payment to some extent. Delayed payment is sometimes called stretching your payables. Stretching is one source of short-term financing, but for most firms it is an expensive source, because by stretching they lose discounts given to firms that pay promptly.

2. Labor, administrative, and other expenses. This category includes all other regular business expenses.

3. Capital expenditures. Note that Dynamic Mattress plans a major outlay of cash in the first quarter to pay for a long-lived asset.

4. Taxes, interest, and dividend payments. This includes interest on currently outstanding long-term debt and dividend payments to stockholders.

5 For simplicity, we present a quarterly forecast. However, most firms would forecast by month instead of by quarter. Sometimes weekly or even daily forecasts are made.