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Why it is important to identify cash shortages and surpluses

Technology Application Financial Forecasting and the Monthly Cash Budget The two previously-discussed forecasting methods target the financial planning needs necessary to expand and why it is important to identify cash shortages and surpluses sales. The monthly cash budget is much more short-sighted and for that reason just as important in terms of planning for financial resources. Many companies may appear healthy going-concerns. However if their monthly cash budgets do not produce a current string of cash surpluses, insolvency can quickly result.

This possibility is less likely for larger, established firms that have large stores of idle cash or have quick access to short-term financial capital e. However smaller companies usually do not have this access. Sudden and unexpected cash deficits can be particularly devastating for small growing businesses that have huge cash needs.

Getting from one cash injection to the next can be problematic when the company is not producing systematic flows of cash. These smaller up-starts are particularly vulnerable to cash crunches, an outcome that can quickly result in insolvency and bankruptcy. The cash budget is defined as a financial statement showing the firm's planned cash inflows and cash outflows per time period and the resulting per period cash surplus or deficit. A cash budget follows the matching principle as described in Part 4 why it is important to identify cash shortages and surpluses inflows are matched with cash outflows per period of time.

The cash budget gets to the nitty-gritty of cash management damage control since it is concerned with highlighting any pending cash deficits with enough lead time so that management can deal with the projected imbalance s. Without a cash budget management has no lead time and the company can crash and burn. Some particulars about the cash budget: To be useful for management's short-term financial planning task, the cash budget is critical.

The more seasonal and uncertain a firm's sales-generated cash inflows and outflows, the greater the number of forecasted intervals needed per year. Because many firms experience a seasonal sales pattern, the typical cash budget is usually most useful when presented on a monthly basis. Cash budgets with intervals longer than one or two months are probably useless in terms of proper cash management. Understand that the cash budget is a forecast. Planning for adequate cash is synonymous with planning for adequate short-term solvency.

While an after-the-fact analysis of a cash budget might be useful in analyzing what went right or what went wrong, it has its greatest use as a prediction device showing projected cash inflows and cash outflows.

Cash, not accrual based: The cash budget is not accrual-based; it is compiled using the cash basis method discussed in the 'Probability' module. However the cash budget is not quite synonymous with the statement of cash flows as described in Part 4 of the 'Money Flow' module.

The chief distinctions are that the cash budget: The only requirement for a business activity to be part of a cash budget is whether or not it will produce or use cash during a given time period.

What accounts might appear in a forecasted cash budget? The forecasted cash budget can be general or extremely detailed. Management must decide based upon experience. Clearly a more detailed listing of projected inflows and outflows is required if the short-term operating environment is uncertain.

If the firm is operating in a stable environment where historical analysis shows cash inflows and outflows are reasonably predictable, a more general and less specific format can be used. The monthly sales forecast: Since many items are related to the level of sales a key input in cash budget forecasts will be the monthly sales forecast.

For cash budgeting purposes it is critical to accurately break up the yearly forecast into monthly intervals. They will also be aware of any systematic seasonal trends in sales. From sales forecasts management must distill projected cash inflows and the timing of these inflows.

To a large extent cash receipts from sales will depend upon the firm's collection policies and the paying practices of its customers. Some percent of sales may be collected in cash in the month of the sales event and some percent from sales in the previous months.

That is the dollar amount of accounts receivable will be a function of both the percentage collection percentage and time. Other monthly cash receipts must be identified. For example, the firm may own marketable securities and receive interest income. It may have an equity stake in subsidiaries and receive dividend income.

  • The chief distinctions are that the cash budget;
  • The chief distinctions are that the cash budget:

It may own bonds and receive interest income. The firm may receive monthly rental income. These and other cash receipts need to be forecasted both in terms of the amount and month of receipt.

  • Lines 25 though 28 are self-explanatory;
  • Subtract your total cash paid out step 3 from your total cash on hand step 2;
  • Positive amounts represent cash surpluses and negative amounts cash deficits;
  • The final component of a cash budget is the "running" cumulative cash balance.

Collectively they will be added to give total expected cash inflow for the month. There can be many forms of monthly cash disbursements.

  • The monthly sales forecast;
  • The firm may receive monthly rental income;
  • The cumulative balances sequence carries forward the previous ending cash balance so that it becomes the beginning cash balance of the subsequent month.

Perhaps the most important one for cash planning purposes will be related to accounts payable. From Part 3 we learned that an accounts payable constitutes a source of funds in that the firm is temporarily paying for its purchases via an implicit short-term loan from its vendors.

In determining cash disbursements it is probably best for management to separate variable from fixed monthly expenses. A variable expense is a direct function of sales e. A fixed expense is independent of sales.

Given its constant recurring nature, fixed expenses are usually easier to forecast than variable expenses. Other cash disbursements might include interest payments on the firm's debt, the planned repayment of outstanding debt, pending tax and dividend payments, or the planned repurchase of stock. Any pending exercise of stock options should be worked into the monthly budget since the firm will be required to pay cash for any exercised stock options.

Many other types of cash disbursements can be considered and would be dependent upon the nature of the business. Collectively these amounts will be added to give total expected cash outflows for the month. Adding algebraically total expected inflows and outflows will produce a net monthly positive or negative dollar amount.

Positive amounts represent cash surpluses and negative amounts cash deficits. The minimum desired cash balance: An important type of "outflow" is the firm's desired monthly minimum cash balance. The size of this balance is discretionary and is a function of the uncertainty surrounding cash inflows and outflows and the availability of ready short-term credit.

It's sort of like an insurance premium to insure against the firm running out of cash unexpectedly. Firms that have unstable sales or have a penchant for random large cash outflows and the inability to quickly borrow on a short-term basis will tend to choose larger minimum cash balances than firms with stable sales and a ready access to credit.

Before-the-fact the minimum cash floor is expected to cover any shortfalls. If this floor, ex post, turns out to be insufficient for any shortfalls management should have in place a means for quick, short-term borrowing at reasonable interest rates.

Market equilibrium

In practice management would hope that the floor is never reached. If it is routinely exceeded then it needs to be increased or better coordination of operating inflows and outflows needs to be achieved. This coordination is the essence of good cash planning. The cumulative cash balance: The final component of a cash budget is the "running" cumulative cash balance. This dollar amount is just what it says—the aggregate algebraic addition of each month's net cash balance after allowing for the minimum cash balance.

This moving window of the forecasted incremental monthly net balances is particularly important in cash planning since it reveals the month when cash shortfall are expected to occur. Management can then plan accordingly. Positive cumulative amounts can be targeted for short-term investments; negative amounts can be "headed off at the pass" via the arrangement of short-term financing e. XYZ Industries is a small manufacturer of summer wear and summer related products. The company has been in business for five years as a sole proprietorship and later as a partnership.

Using sales and cost data from the previous five years management is in the process of preparing a cash budget.

Why it is important to identify cash shortages and surpluses

At this time management feels that a six-month monthly cash budget is appropriate at the end of its first six months of operations a revised six-month budget will be forthcoming. The historical record over the past five years of operations shows that sales are seasonal with the winter months showing a decline in sales followed by an upturn during the summer months.

The firm also receives monthly interest, dividend, and rental income. A one-time initial start-up cash flow is expected to be made by the firm's major stockholders the original owners of the business prior to going public in the first month of incorporation.

XYZ cash purchases equal 20 percent of sales paid in the month of purchase. Beginning in January 2011 compute the monthly cash budget for XYZ Industries and interpret the results with attention paid to the cumulative cash balance over the first six months of operations.

Table 6- 3A displays the forecasted cash budget for the Zeos Corporation for the first six months of operations as a publicly-traded corporation. Line 3 shows the seasonal nature of sales. Lines 7, 8, and 9 show the projected cash receipts per month including the amounts collected from accounts receivable. Lines 10 — 12 are self explanatory. Line 15 shows total expected cash inflows from January through June. The seasonal nature of sales is reflected in these inflows. Lines 19, 20, and 21 show the pattern of cash outflows related to purchases.

Why it is important to identify cash shortages and surpluses

Total wages are paid in two forms: Line 24 shows commission sales are 30 percent of sales for a given month. Again, notice the seasonal nature of commissions. Lines 25 though 28 are self-explanatory.

Line 30 summarizes the cash outflows. You can see that cash outflows are being impacted both by the seasonal nature of sales and the quarterly payment of certain fixed financial obligations. Line 32 shows the net monthly inflows. This is a very instructive string of numbers for management's financial planning task.