The Cash Budget

The Cash Budget

A cash budget is a detailed statement of the cash inflows and outflows expected in future periods. This budget helps you identify our financing and investment needs. You can also use a cash budget to compare your actual cash flows against planned cash flows so that you can evaluate both your performance and your forecasting ability.

Cash flows in to the firm from:

1. Operations, such as receipts from sales and collections on accounts receivable;

2. The results of financing decisions, such as borrowings, sales of shares of common stock, and sales of preferred stock; and

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3. The results of investment decisions, such as sales of assets and income from marketable securities.

Cash flows out of the firm for:

1. Operations, such as payments on accounts payable, purchases of goods, and the payment of taxes;

2. Financing obligations, such as the payment of dividends and interest, and the repurchase of shares of stock or the redemption of bonds; and

3. Investments, such as the purchase of plant and equipment. As we noted before, the cash budget is driven by the sales forecast.

Consider the following sales forecasts for the Imagined Company for January through June:

Month Forecasted Sales

Month

Forecasted Sales

1,000 Using the forecasted sales, along with a host of assumptions about

June

credit sales, collections on accounts receivable, payments for purchases, and financing, we can construct a cash budget, which tells us about the cash inflows and the cash outflows.

Let’s look at Imagined’s cash budget for January 2005. Sales are expected to be $1,000. Now let’s translate sales into cash flows, focus- ing first on the cash flows from operations.

Let’s assume that an analysis of accounts receivable over the past year reveals that:

■ 10% of a month’s sales are paid in the month of the sale. ■ 60% of a month’s sales are paid in the month following the sale. ■ 30% of a month’s sales are paid in the second month following the sale.

This means that only 10% of the $1,000 sales, or $100 is collected in January. But this also means that in January Imagined collects 60% of 2004’s December sales and 30% of 2004’s November sales. If December 2004 sales were $1,000 and November 2004 sales were $2,000, this means that January collections are:

Collections on January 2005 sales

← 10% of $1,000 Collections on December 2004 sales

← 60% of $1,000 Collections on November 2004 sales

← 30% of $2,000 Total cash inflow from collections

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Now let’s look at the cash flows related to Imagined’s payment for its goods. We first have to make an assumption about how much Imagined buys and when it pays for its goods and services. First, assume that Imagined has

a cost of goods (other than labor) of 50%. This means that for every $1 it sells, it has a cost of 50%. Next, assume that Imagined purchases goods two months in advance of when the firm sells them (this means the number of days of inventory is around 60 days). Finally, let’s assume that Imagined pays 20% of its accounts payable in the month it purchases the goods and 80% of its accounts payable in the month after it purchases the goods.

Putting this all together, we forecast that in January, Imagined will purchase 50% of March’s forecasted sales, or 50% of $3,000 = $1,500. Imagined will pay 20% of these purchases in January, or 20% of $1,500 = $300. In addition, Imagined will be paying 80% of the purchases made in December 2004. And December’s purchases are 50% of Febru- ary’s projected sales. So in January, Imagined will pay 50% of 80% of $2,000, which is 50% of $1,600 or $800.

We assume that Imagined has additional cash outflows for wages (5% of current month’s sales) and selling and administrative expenses (also 10% of current month’s sales). Imagined’s cash outflows related to operations in January consist of:

Payments of current month’s purchases $300 ← 20% of $1,500 Payments for previous month’s purchases

800 ← 80% of $1,600 Wages

50 ← 5% of$1,000 Selling and administrative expenses

100 ← 10% of $1,000 Operating cash outflows

The cash flows pertaining to Imagined Company’s operations are shown in the top portion of Exhibit 29.6. In January, there is a net cash inflow from operations of $50. Extending what we did for January’s cash flows to the next five months as well, we get a projection of cash inflows and outflows from operations. As you can see, there are net outflows from operations in February and March, and net inflows in other months.

But cash flows from operations do not tell us the complete picture. We also need to know about Imagined’s nonoperating cash flows. Does it intend to buy or retire any plant and equipment? Does it intend to retire any debt? Does it need to pay interest on any debt? And so on. These projections are inserted in the lower portion of Exhibit 29.6.

But there is one catch here: Cash inflows must equal cash outflows (unless Imagined has found a way to create cash!). So we have to decide where Imagined is going to get its cash if its inflows are less than its out- flows. And we have to decide where it is going to invest its cash if its outflows are less than its inflows.

EXHIBIT 29.6 Imagined Company Monthly Cash Budget, January–June 2005

May June

$3,000 $2,000 $1,000 $1,000 Operating Cash Flows Cash Inflows

Collections on accounts receivables: Collections on current month’s sales

$100 $100 Collections from previous month’s sales

1,200 600 Collections from two months’ previous sales

900 600 Operating cash inflows

$2,200 $1,300 Cash Outflows

Payments of purchases on account: Payments for current month’s purchases

$100 $100 Payments for previous month’s purchases

50 50 Selling and administrative expenses

100 100 Operating cash outflows

$650 $650 Operating net cash flow

$1,550 $650 Nonoperating Cash Flows

Cash Inflows Retirements of plant and equipment

$0 $0 Issuance of long-term debt

0 0 0 0 Issuance of common stock

0 0 0 0 0 0 Nonoperating cash inflows

May June

Cash Outflows Acquisitions of plant and equipment

$3,500 $0 Payment of cash dividends

0 0 100 Retirement of long-term debt

0 0 0 0 0 1,000 Retirement of common stock

0 0 0 0 0 0 Interest on long-term debt

10 10 10 10 10 10 Taxes

53 53 Nonoperating cash outflows

$3,563 $1,163 Nonoperating cash flows

Analysis of cash and marketable securities

Balance, beginning of month

$2,000.00 $1,000.00 Net cash flows for the month

(2,012.55) (513.05) Balance without any change in bank loans

($12.55) $486.95 Bank loans to maintain minimum balance

0.00 0.00 1,012.55 513.05 Available to pay off bank loans

0.00 0.00 Balance, end of month

(1) Cash sales are 10% of current month’s sales (2) Collections on accounts receivables are 60% of previous month’s sales and 30% of the two months previous’ sales (3) Purchases are 50% of two months ahead sales (4) Payments on accounts are 20% of current month’s purchases, plus 80% of previous month’s purchases (5) Wages are 5% of current month’s sales (6) Selling and administrative expenses are 5% of current month’s sales (7) July and August sales are forecasted to be $1,000 each month

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Let’s assume that Imagined will borrow from the bank when it needs short-term financing and it will pay off its bank loans or invest in marketable securities (if it has no outstanding bank loans) if it has more cash than needed. In our example, let’s group cash and marketable secu- rities and cash into one item, referred to as “cash.”

The bank loan-marketable securities decision is a residual decision: We make decisions about such things as when we pay out accounts, but we use the bank loan or marketable securities investment as a “plug” figure to help balance our cash inflows and outflows. But this “plug” is very important—it tells us what financing arrangement we need to have in place (such as a line of credit) or that we need to make decisions regarding short-term investments (such as U.S. Treasury bills).

Comparing inflows with outflows from operations, we see that if Imagined requires a minimum cash balance of $1,000, it needs to use bank financing in January, February, May, and June. We also see that if Imagined does not need to maintain a cash balance above $2,000, it can pay off some of its bank loans in April.

We’ve forecasted cash inflows and outflows for several months into the future. But these are forecasts and lots of things can happen between now and then. The actual cash flows can easily differ from the fore- casted cash flows. Furthermore, we’ve made a host of assumptions and decisions along the way, some that we have control over, such as divi- dend payments, and some that we have no control over, such as how long customers take to pay. Economic conditions, market conditions, and other factors will affect actual cash flows.

Two methods to help us look as the uncertainty of cash flows are sensitivity analysis and simulation analysis. Sensitivity analysis involves changing one of the variables in our analysis, such as the number of units sold, and looking at its affect on the cash flows. This gives us an idea of what cash flows may be under certain circumstances. We can pose differ- ent scenarios: What if customers take 60 days to pay instead of 30? What if we sales are actually $1,000 in February instead of $2,000?

But sensitivity analysis can become unmanageable if we start chang- ing two or more things at a time. A manageable approach to doing this is with computer simulation. Simulation analysis allows you to develop

a probability distribution of possible outcomes, given a probability dis- tribution for each variable that may change. Suppose you can develop a probability distribution—that is, a list of possible outcomes and their related likelihood of occurring—for sales. (A probability distribution is the set of possible outcomes and their likelihood of occurrence.) And suppose you can develop a probability distribution for costs of the raw materials that are needed in producing the product. Using simulation, a probability distribution of cash flows

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can be produced, providing information on the uncertainty of the firm’s future cash flows, as shown in Exhibit 29.7.

Once we produce the probability distribution of future cash flows, we have an idea of the possible cash flows and can plan accordingly. The cash budget produced using the possible cash flows is a flexible budget. With this information, we can then determine the more appropriate short-term financing and short-term investments to consider.

Pro Forma Financial Statements

A pro forma balance sheet is a projected balance sheet for a future period—

a month, quarter, or year—that summarizes assets, liabilities, and equity.

A pro forma income statement is the projected income statement for a future period—a month, quarter, or year—that summarizes revenues and expenses. Together both projections help you identify your firm’s invest- ment and financing needs.

The analysis of accounts and the percent-of-sales method are two ways of projecting financial statements.

Analysis of Accounts The analysis of accounts method starts with the cash budget. Before put-

ting together the pro forma income statement and balance sheet, we need to see how the various asset, liability, and equity accounts change from month to month, based on the information provided in the cash budget. The analysis of accounts is shown in Exhibit 29.8, where each account is analyzed starting with the beginning balance and making any necessary adjustments to arrive at the ending balance.

EXHIBIT 29.7 Simulation and Cash Flow Uncertainty Probability distribution

of future period’s sales

Computer Probability distribution of simulation

future cash flows

Probability distribution of future period’s raw materials

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EXHIBIT 29.8 Imagined Company Analysis of Monthly Changes in Accounts,

January through June 2005

January February March April May June

Accounts receivable Month’s beginning balance

$2,000 $1,700 $2,600 $3,800 $3,200 $2,000 plus, credit sales during the month

900 1,800 2,700 1,800 900 900 less, collections on accounts

1,200 900 1,500 2,400 2,100 1,200 Month’s ending balance

$1,700 $2,600 $3,800 $3,200 $2,000 $1,700 Inventory Month’s beginning balance

$2,500 $3,500 $3,500 $2,500 $2,000 $2,000 plus, purchases

1,500 1,000 500 500 500 500 plus, wages and other production expenses 50 100 150 100 50 50 less, goods sold

550 1,100 1,650 1,100 550 550 Month’s ending balance

$3,500 $3,500 $2,500 $2,000 $2,000 $2,000 Accounts payable Month’s beginning balance

$2,000 $2,400 $2,000 $1,600 $1,600 $1,600 plus, purchases on account

1,200 800 400 400 400 400 less, payments on account

800 1,200 800 400 400 400 Month’s ending balance

$2,400 $2,000 $1,600 $1,600 $1,600 $1,600 Bank loans Month’s beginning balance

$1,000 $1,529 $2,304 $2,304 $1,113 $2,125 plus, borrowings

529 775 0 0 1,013 513 less, repayment of loans

0 0 0 1,192 0 0 Month’s ending balance

$1,529 $2,304 $2,304 $1,113 $2,125 $2,638 Plant and equipment Month’s beginning balance

$10,000 $10,890 $13,751 $13,614 $12,982 $16,318 plus, acquisitions

1,000 3,000 $0 0 3,500 0 less, retirements

0 0 0 500 0 0 less, depreciation*

110 139 137 131 165 163 Month’s ending balance

$10,890 $13,751 $13,614 $12,982 $16,318 $16,154 Long-term debt Month’s beginning balance

$5,000 $5,000 $8,000 $8,000 $8,000 $8,000 plus, issuances of long-term debt

0 3,000 0 0 0 0 less, retirements of long-term debt

0 0 0 0 0 1,000 Month’s ending balance

$5,000 $8,000 $8,000 $8,000 $8,000 $7,000 Common equity Month’s beginning balance

$8,000 $8,161 $8,547 $9,079 $9,470 $9,592 plus, earnings retained during the month

161 386 532 391 123 24 plus, issuances of common stock

0 0 0 0 0 0 less, retirements of common stock

0 0 0 0 0 0 Month’s ending balance

*1% of gross plant and equipment

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We can see how the cash budget interacts with the pro forma income statement and balance sheet by looking at the change in accounts receivable. Consider what happens in January:

The analysis of . . . affects financial planning accounts receivable . . .

through the . . .)

Balance at the beginning of the $2,000 → pro forma balance sheet (accounts month

receivable)

Plus credit sales during January +900 → pro forma income statement (sales) and pro forma balance sheet (accounts receivable)

Less collections on accounts –1,200 → cash budget (cash flow from opera- during January

tions)

Balance at the end of the month $1,700 → pro forma balance sheet (accounts

receivable)

As you can see, the balances in these accounts are all interrelated with the cash budget.

In doing our cash budget, we have begun to make projections based on the following information:

■ Changes in the cash account are determined by the difference between our cash inflows and outflows. ■ Changes in accounts receivables are determined by our sales and collec- tions projections. ■ Changes in inventory are determined by our purchase and sales projec- tions. ■ Changes in plant and equipment are determined by our capital budgeting. ■ Changes in long-term debt are determined by our financing projections. ■ Changes in common equity are determined by both the financing pro-

jections and the projected retained earnings. ■ Changes in retained earnings are determined by the projected income.

If we put together all these pieces, we have a pro forma balance sheet for Imagined Company, as shown in Exhibit 29.9. Looking at the cash budget in Exhibit 29.7, the analysis of accounts in Exhibit 29.8, and the balance sheet in Exhibit 29.9, we can follow through to see the interactions among the various assets, liabilities, equity accounts, and cash flows as we did for accounts receivable.

The pro forma income statement for Imagined Company is shown in the lower part of Exhibit 29.9. Though our interest is ultimately on cash flows, the income statement provides useful summary information on the expected performance of the firm in months to come. As you can see in Exhibit 29.9, net income tends to increase in March, which accompanies the increased revenues in that month.

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EXHIBIT 29.9 Imagined Company Monthly Pro Forma Balance Sheet and Income

Statement, January through June 2005 Pro Forma Balance Sheet

January February

March

April May June

Assets Cash and marketable securities

$2,000 $1,000 $1,000 Accounts receivable

2,000 2,000 2,000 Plant and Equipment

12,982 16,318 16,154 Total Assets

$17,090 $20,851 $20,983 $20,182 $21,318 $20,854 Liabilities and Equity Accounts payable

$1,600 $1,600 $1,600 Bank loans

1,113 2,125 2,638 Long-term debt

8,000 8,000 7,000 Common equity

9,470 9,592 9,616 Total Liabilities and Equity

Pro Forma Income Statement

January February March April May June

Sales $1,000 $2,000 $3,000 $2,000 $1,000 $1,000 less, Cost of goods sold

1,650 1,100 550 550 less, Depreciation

138 131 165 163 Gross profit

$1,212 $769 $285 $287 less, Selling and administrative expenses

300 200 100 100 Earnings before interest and taxes

$912 $569 $185 $187 less, Interest

10 10 10 10 10 10 Earnings before taxes

$902 $559 $175 $177 less, Taxes

271 168 53 53 Net income

$632 $391 $123 $124 less, Cash dividends

0 0 100 0 0 100 Retained earnings

We are interested in the pro forma balance sheet and income state- ment not just as a product of our cash flow analysis. Suppose the bank financing is secured financing, limited to 80% of accounts receivable. If this is the case, we may be limited in how much we can borrow from the bank in any particular month. We are also interested in the balance sheet since some of our short-term or long-term debt may have covenants that prescribe the firm to maintain specific relations among its accounts; for example, a current ratio of 2:1. In addition, we may be concerned about the firm’s perceived riskiness. If we must borrow heavily at certain times within a year, does this affect the riskiness of our debt securities, increas- ing the cost of financing?

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These considerations point out the importance of reviewing the pro- jected balance sheet. In fact, these considerations may point out the need for the financial manager to explicitly build constraints into the budget to ensure that, say, a current ratio of 2 is maintained each month. These constraints add complexity to an already complex system of relationships, the detail of which is beyond the scope of this text.