Premium Course Notes[Session 5 and 6]
Chapter 10 Cash and Funding Strategies
SYLLABUS1.Explain the various reasons for holding cash, and discuss and apply the use of relevant techniques in managing cash, including:
(a)preparing cash flow forecasts to determine future cash flows and cash balances
(b)assessing the benefits of centralized treasury management and cash control
(c)cash management models, such as the Baumol model and Miller-Orr model
(d)investing short-term
2.Describe and discuss the key factors in determining working capital funding strategies, including:
(a)the distinction between permanent and fluctuating current assets
(b)the relative cost and risk of short-term and long-term finance
(c)the matching principle
(d)the relative costs and benefits of aggressive, conservative and matching funding policies
(e)management attitudes to risk, previous funding decisions and organization size
Prepared by Patrick LuiP. 1Copyright @ Kaplan Financial 2015
Premium Course Notes[Session 5 and 6]
Chapter Summary
Patrick LuiP. 1Copyright @ Kaplan Financial 2015
Premium Course Notes[Session 5 and 6]
1.Reasons for Holding Cash
(Dec 12)
1.1Although cash needs to be invested to earn returns, businesses need to keep a certain amount readily available.
1.2 / Motives of Holding Cash(a)Transaction motive–cash required to meet day-to-day expenses, e.g. payroll, payment of suppliers, etc.
(b)Finance motive – cash required to cover major items such as the repayment of loans and the purchase of non-current assets.
(c)Precautionary motive – cash held to give a cushion against unplanned expenditure (the cash equivalent of buffer inventory).
(d)Speculative motive – cash kept available to take advantage of market investment opportunities.
1.3Failure to carry sufficient cash levels can lead to:
(a)loss of settlement discounts
(b)loss of supplier goodwill
(c)poor industrial relations
(d)potential liquidation.
1.4Once again therefore the firm faces a balancing act:
Multiple Choice Questions1.Although cash needs to be invested to earn returns, businesses need to keep a certain amount readily available.
Which of the following is not a reason for holding cash?
AMovement motive
BTransactions motive
CPrecautionary motive
DInvestment motive
2.Cash Budgets and Cash Flow Forecasts
2.1The usefulness of cash flow forecasts
2.1.1Acash forecast is an estimate of cash receipts and payments for a future period under existing conditions.
2.1.2Acash budget is a commitment to a plan for cash receipts and payments for a future period after taking any action necessary to bring the forecast into line with the overall business plan.
2.1.3The cash flow forecast is one of the most important planning tools that an organization can use. It shows the cash effect of all plans made within the flow forecastary process and hence its operation can lead to a modification of flow forecasts if it shows that there are insufficient cash resources to finance the planned operations.
2.1.4It can also give management an indication of potential problems that could arise and allows them the opportunity to take action to avoid such problems.
2.1.5A cash flow forecast can show four positions. Management will need to take appropriate action depending on the potential position.
Cash Position / Appropriate Management ActionShort-term surplus / Pay accounts payable early to obtain discount
Attempt to increase sales by increasing accounts receivable and inventories
Make short-term investments
Short-term deficit / Increase accounts payable
Reduce accounts receivable
Arrange an overdraft
Long-term surplus / Make long-term investments
Expand
Diversify
Replace/update non-current assets
Long-term deficit / Raise long-term finance (such as via issue of share capital)
Consider shutdown/disinvestment opportunities
2.2Preparing cash flow forecast
2.2.1Forecasts can be prepared from any of the following:
(a)planned receipts and payments
(b)statement of financial position predictions
(c)working capital ratios.
(a)Preparing a cash flow forecast from planned receipts and payments
(Jun 09, Dec 14)
2.2.2Every type of cash inflow and receipt, along with their timings, must be forecast. Note that cash receipts and payments differ from sales and cost of sales in the income statement because:
(a)not all cash items affect the income statement
(b)some income statement items are not cash flows
(c)actual timing of cash flows may not correspond with the accounting period in which they are recorded.
2.2.3Proforma of cash budget
2.2.4 / Example 1You are presented with the following forecasted cash flow data for your organization for the period November 2010 to June 2011. It has been extracted from functional flow forecasts that have already been prepared.
Nov 10 / Dec 10 / Jan 11 / Feb 11 / Mar 11 / Apr 11 / May 11 / Jun 11
$ / $ / $ / $ / $ / $ / $ / $
Sales / 80,000 / 100,000 / 110,000 / 130,000 / 140,000 / 150,000 / 160,000 / 180,000
Purchases / 40,000 / 60,000 / 80,000 / 90,000 / 110,000 / 130,000 / 140,000 / 150,000
Wages / 10,000 / 12,000 / 16,000 / 20,000 / 24,000 / 28,000 / 32,000 / 36,000
Overheads / 10,000 / 10,000 / 15,000 / 15,000 / 15,000 / 20,000 / 20,000 / 20,000
Dividends / 20,000 / 40,000
Capital expenditure / 30,000 / 40,000
You are also told the following.
(a)Sales are 40% cash 60% credit. Credit sales are paid two months after the month of sale.
(b)Purchases are paid the month following purchase.
(c)75% of wages are paid in the current month and 25% the following month.
(d)Overheads are paid the month after they are incurred.
(e)Dividends are paid three months after they are declared.
(f)Capital expenditure is paid two months after it is incurred.
(g)The opening cash balance is $15,000.
The managing director is pleased with the above figures as they show sales will have increased by more than 100% in the period under review. In order to achieve this he has arranged a bank overdraft with a ceiling of $50,000 to accommodate the increased inventory sales and wage bill for overtime worked.
Required:
(a)Prepare a cash flow forecast for the six-month January to June 2011.
(b)Comment on your results in the light of the managing director’s comments and offer advice.
Solution:
(a)
Jan / Feb / Mar / Apr / May / Jun
Cash receipts / $ / $ / $ / $ / $ / $
Cash sales / 44,000 / 52,000 / 56,000 / 60,000 / 64,000 / 72,000
Credit sales / 48,000 / 60,000 / 66,000 / 78,000 / 84,000 / 90,000
92,000 / 112,000 / 122,000 / 138,000 / 148,000 / 162,000
Cash payments
Purchases / 60,000 / 80,000 / 90,000 / 110,000 / 130,000 / 140,000
Wages: 75% / 12,000 / 15,000 / 18,000 / 21,000 / 24,000 / 27,000
Wages: 25% / 3,000 / 4,000 / 5,000 / 6,000 / 7,000 / 8,000
Overheads / 10,000 / 15,000 / 15,000 / 15,000 / 20,000 / 20,000
Dividends / 20,000
Capital expenditure / 30,000 / 40,000
85,000 / 114,000 / 178,000 / 152,000 / 181,000 / 235,000
Net cash flow / 7,000 / (2,000) / (56,000) / (14,000) / (33,000) / (73,000)
Bal. b/f / 15,000 / 22,000 / 20,000 / (36,000) / (50,000) / (83,000)
Net / 22,000 / 20,000 / (36,000) / (50,000) / (83,000) / (156,000)
(b)
The overdraft arrangements are quite inadequate to service the cash needs of the business over the six-month period. If the figures are realistic then action should be taken now to avoid difficulties in the near future. The following are possible courses of action.
(i)Activities could be curtailed.
(ii)Other sources of cash could be explored, for example a long-term loan to finance the capital expenditure and a factoring arrangement to provide cash due from accounts receivable more quickly.
(iii)Efforts to increase the speed of debt collection could be made.
(iv)Payments to accounts payable could be delayed.
(v)The dividend payments could be postponed (the figures indicate that this is a small company, possibly owner-managed).
(vi)Staff might be persuaded to work at a lower rate in return for, say, an annual bonus or a profit-sharing agreement.
(vii)Extra staff might be taken on to reduce the amount of overtime paid.
(viii)The stock holding policy should be reviewed; it may be possible to meet demand from current production and minimize cash tied up in inventories.
Question 1 – Cash Budgets, overdraft and Baumol Model
Thorne Co values, advertises and sells residential property on behalf of its customers. The company has been in business for only a short time and is preparing a cash budget for the first four months of 2006. Expected sales of residential properties are as follows.
2005 / 2006 / 2006 / 2006 / 2006
Month / December / January / February / March / April
Units sold / 10 / 10 / 15 / 25 / 30
The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the value of each property sold. Thorne Co receives 1% in the month of sale and the remaining 2% in the month after sale. The company has nine employees who are paid on a monthly basis. The average salary per employee is £35,000 per year. If more than 20 properties are sold in a given month, each employee is paid in that month a bonus of £140 for each additional property sold.
Variable expenses are incurred at the rate of 0·5% of the value of each property sold and these expenses are paid in the month of sale. Fixed overheads of £4,300 per month are paid in the month in which they arise. Thorne Co pays interest every three months on a loan of £200,000 at a rate of 6% per year. The last interest payment in each year is paid in December.
An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne Co intends to dispose of surplus vehicles, with a net book value of £15,000, for £20,000. The cash balance at the start of January 2006 is expected to be a deficit of £40,000.
Required:
(a)Prepare a monthly cash budget for the period from January to April 2006. Your budget must clearly indicate each item of income and expenditure, and the opening and closing monthly cash balances. (10 marks)
(b)Discuss the factors to be considered by Thorne Co when planning ways to invest any cash surplus forecast by its cash budgets. (5 marks)
(c)Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to fund any cash shortages forecast by its cash budgets. (5 marks)
(d)Explain how the Baumol model can be employed to reduce the costs of cash management and discuss whether the Baumol cash management model may be of assistance to Thorne Co for this purpose. (5 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2005 Q5)
(b)Preparing a cash flow forecast from a statement of financial position
(Dec 09)
2.2.5Used to predict the cash balance at the end of a given period, this method will typically require forecasts of:
(a)changes to non-current assets (acquisitions and disposals)
(b)future inventory levels
(c)future receivable levels
(d)future payables levels
(e)changes to share capital and other long-term funding (e.g. bank loans)
2.2.6 / Example 2ABC Co has the following statement of financial position at 30 June 2014:
$ / $
Non-current assets
Plant and machinery / 192,000
Current assets
Inventory / 16,000
Receivables / 80,000
Bank / 2,000
98,000
Total assets / 290,000
Equity and liabilities
Issued share capital / 216,000
Retained profits / 34,000
250,000
Current liabilities
Trade payables / 10,000
Dividend payable / 30,000
40,000
Total equity and liabilities / 290,000
(a)The company expects to acquire further plant and machinery costing $8,000 during the year to 30 June 2015.
(b)The levels of inventories and receivables are expected to be increase by 5% and 10% respectively by 30 June 2015, due to business growth.
(c)Trade payables and dividend liabilities are expected to be the same at 30 June 2015.
(d)No share issue is planned, and net profits for the year to 30 June 2015 are expected to be $42,000.
(e)Plant and machinery is depreciated on a reducing balance basis, at the rate of 20% pa, for all assets held at the statement of financial position date.
Required:
Produce a balance sheet forecast as at 30 June 2015, and predict what the cash balance or bank overdraft will be at that date.
Solution:
Statement of financial position at 30 June 2015
$ / $
Non-current assets
Plant and machinery [(192,000 + 8,000) × 80%] / 160,000
Current assets
Inventory (16,000 × 105%) / 16,800
Receivables (80,000 × 110%) / 88,000
Bank (balancing figure) / 67,200
172,000
Total assets / 332,000
Equity and liabilities
Issued share capital / 216,000
Retained profits (34,000 + 42,000) / 76,000
292,000
Current liabilities
Trade payables / 10,000
Dividend payable / 30,000
40,000
Total equity and liabilities / 332,000
The forecast is that the bank balance will increase by $65,200 (i.e. $67,200 – $2,000). This can be reconciled as follows:
$ / $
Retained profit / 42,000
Add: Depreciation [20% of $(192,000 + 8,000)] / 40,000
82,000
Less: non-current asset acquired / (8,000)
74,000
Increase in inventory / 800
Increase in receivables / 8,000
(8,800)
Increase in cash balance / 65,200
(c)Preparing a cash flow forecast from working capital ratios
2.2.7Working capital ratios can also be used to forecast future cash requirements. The first stage is to use the ratios to work out the working capital requirement, as we have already seen in Chapter 8.
2.2.8 / Example 3X Co had the following results for last year.
Income statement / $m
Sales / 200
Cost of sales (including $20m depreciation) / 120
Operating profit / 80
Interest / 5
Profit before tax / 75
Tax / 22
Profit after tax / 53
Dividend proposed / 10
Retained earnings / 43
Statement of financial position / $m
Non-current assets / 400
Current assets
Inventory / 25
Receivables / 33
Cash / 40
98
Current liabilities
Trade payables / 20
Dividend payable / 10
Tax payable / 22
52
Long term loan @ 10% / 50
X Co expects the following for the forthcoming year.
Sales will increase by / 10%
Plant and machinery will be purchased costing / $12m
Inventory days / 80 days
Receivable days / 75 days
Trade payables days / 50 days
Depreciation will be / $15m
Required:
Prepare a cash flow projection for the forthcoming period.
Solution:
Here we will assume that the gross profit percentage will remain unaltered in cash terms.
$m
Last year
Sales / 200
Cost of sales less depreciation / 100
Operating cash flow / 100
Gross profit percentage / 50%
This year / $m
Sales $200m× 110% / 220
Cost of sales $220m× 50% / 110
Operating cash flow / 110
Next we calculate the working capital requirements (to the nearest $m)
$m
Inventory (80/365 × $110m) / 24
Receivables (75/365 × $220m) / 45
Trade payables (50/365 × $110m) / 15
Now we assemble the information in the pro forma given earlier.
Note / $m
1 / Operating cash flow / 110
2 / Interest / (5)
3 / Tax / (22)
3 / Dividend / (10)
4 / Purchase of plant and machinery / (12)
5 / Reduction in inventory ($24m– $25m) / 1
5 / Increase in receivables ($45m– $33m) / (12)
5 / Reduction in trade payables ($15m– $20m) / (5)
Net cash flow / 45
Notes
(1)We have already calculated operating cash flow so do not need to adjust for depreciation of $15m.
(2)It is assumed that this is the same as last period, as the loans have not changed.
(3)The tax and dividend payables in last year’s statement of financial position will be paid in the forthcoming period.
(4)This was given in the question.
(5)Increase in current assets are an outflow, reductions are an inflow. The reverse is the case for trade payables.
Question 2 – Overdraft and Cash Flows Forecast
CPA is a manufacturing company in the furniture trade. Its sales have risen sharply over the past six months as a result of an improvement in the economy and a strong housing market. The company is now showing signs of ‘overtrading’ and the financial manager, Ms Smith, is concerned about its liquidity. The company is one month from its year end. Estimated figures for the full 12 months of the current year and forecasts for next year, on present cash management policies, are shown below.
Next year / Current year
Income statement / $000 / $000
Revenues / 5,200 / 4,200
Less: Cost of sales (Note 1) / 3,224 / 2,520
Operating expenses / 650 / 500
Operating profit / 1,326 / 1,180
Interest paid / 54 / 48
Profit before tax / 1,272 / 1,132
Tax payable / 305 / 283
Profit after tax / 967 / 849
Dividends declared / 387 / 339
Current assets and liabilities as at the end of the year
Inventory/work-in-progress / 625 / 350
Receivables / 750 / 520
Cash / 0 / 25
Trade payables / 464 / 320
Other payables (tax and dividends) / 692 / 622
Overdraft / 11 / 0
Net current assets/(liabilities) / 208 / (47)
Note 1: Cost of sales includes depreciation of / 225 / 175
Ms Smith is considering methods of improving the cash position. A number of actions are being discussed.
Debtors
Offer a 2% discount to customers who pay within 10 days of despatch of invoices. It is estimated 50% of customers will take advantage of the new discount scheme. The other 50% will continue to take the current average credit period.
Trade payables and inventory
Reduce the number of suppliers currently being used and negotiate better terms with those that remain by introducing a just-in-time policy. The aim will be to reduce the end-of-year forecast cost of sales (excluding depreciation) by 5% and inventory/WIP by 10%. However, the number of days credit taken by the company will have to fall to 30 days to help persuade suppliers to improve their prices.
Other information
All trade is on credit. Official terms of sale at present require payment within 30 days. Interest is not charged on late payments.
All purchases are made on credit.
Operating expenses will be $650,000 with the existing or proposed policies.
Interest payments would be $45,000 if the new policies are implemented.
Capital expenditure of $550,000 is planned for next year.
Required:
(a)Explain the main uses of overdraft facilities as part of a company’s working capital management policy. (5 marks)
(b)Prepare a cash flow forecast for next year, assuming:
(i)The company does not change its policies
(ii)The company’s proposals for managing customers, suppliers and inventory are implemented
In both cases, assume a full twelve-month period, that is the changes will be effective from day 1 of next year. (14 marks)
(c)As assistance to Ms Smith, write a short report to her discussing the proposed actions. Include comments on the factors, financial and non-financial, that the company should take into account before implementing the new policies. (6 marks)
(Total 25 marks)
Multiple Choice Questions
2.Which of the following should NOT be included in a cash flowforecast?
AFunds from the issue of share capital
BRepayment of a bank loan
CReceipts of dividends from outside the business
DRevaluation of a noncurrentasset
3.Roger plc's projected revenue for 20X4 is $350,000. It is forecast that12% of sales will occur in January and remaining sales will be equallyspread among the other eleven months. All sales are on credit.Receivables accounts are settled 50% in the month of sale, 45% in thefollowing month, and 5% are written off as bad debts after two months.
Which of the following amounts represents the budgeted cashcollections for March?
A$24,500
B$26,600
C$28,000
D$32,900
4.JP Co has budgeted that sales will be $300,100 in January 20X2, $501,500 in February, $150,000 in Marchand $320,500 in April. Half of sales will be credit sales. 80% of receivables are expected to pay in the monthafter sale, 15% in the second month after sale, while the remaining 5% are expected to be bad debts.Receivables who pay in the month after sale can claim a 4% early settlement discount.
What level of sales receipts should be shown in the cash budget for March 20X2 (to the nearest $)?
A290,084
B298,108
C580,168
D596,216
5.ABC Co’s cash budget highlights a short-term surplus in the near future.
Which of the following actions would be appropriate to make use of the surplus?
APay suppliers earlier to take advantage of any prompt payment discounts
BBuy back the company’s shares
CIncrease payables by delaying payment to suppliers
DInvest in a long term deposit bank account
6.Which of the following actions would be appropriate if the cashbudget identified a shorttermcash deficit?
AIssue shares
BPay suppliers early
CArrange an overdraft
DInvest in a shorttermdeposit account
3.Treasury Management (資金管理)