Download a cash flow forecast

Paper F9
Financial Management
Cai Ji-fu
Accounting School
1
Chapter 6
Working capital finance
2
Topic list
The management of cash
Cash flow forecasts
Treasury management
Cash management models
Investing surplus cash
Working capital funding strategies
3
Exam guide
The material covered in this chapter is
highly examinable.
Any of the calculation could form part
or all of a question and you need to
also be able to explain the meaning of
your answers.
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1 The management of cash
The term
Cash may be defined as currency held by the firm plus
the firm’s demand deposits
Cash, which can be broadly defined as
encompassing near-cash such as marketable
securities and unused short-term borrowing capacity,
may be held for various reason
Marketable securities are defined as short-term,
highly liquid, interest-bearing financial assets, such as
Treasury bills or high-grade commercial paper
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1.1 Why organization hold cash
(Motives for holding cash)
Transaction motive – to meet current transactions
(paying its A/P, employees’ wages, tax; dividend)
Precautionary motive – this means that there is a need
to maintain a ‘buffer’ of cash for unforeseen
contingencies. The more predictable the inflows and
outflows of cash for a firm, the less cash that needs to
be held for precautionary motive need. Ready borrowing
power (overdrafts)
Speculative motive – take advantage of special
situations (sale price on raw material – buy more now)
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1.1 Why organization hold cash
(Motives for holding cash)
Cash management involves:
determining the cash balances that will adequately
sustain the firm’s operation
efficient payment and collection
investing temporary surplus funds in liquid assets.
objectives:
reduce the opportunity cost of holding idle cash (invest
in ST marketable securities)
ensure all obligations are paid on time/due date (not
early)
collect money owed as soon as it becomes due
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The cash Management Activity
Speeding up
receipts
Slowing down
disbursements
Maintaining
sound banking
relationship
Management of
cash flow
Cash budgeting
Establishing an
optimal cash balance
Short-Term
financing strategies
for cash shortages
Marketable security
investment strategies
for cash surpluses
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Flow of funds
Creditors
Shareholders
Creditors
Shareholders
Governments
purchase
Cash
balance
purchase
Fixed
assets
sale
Marketable
sale
securities
Labor and material
Depreciation
Inventory
cash sales
Credit
sales
Receivable
collections
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1.1 Why organization hold cash
liquidity v profitability
Profitability varies inversely with liquidity. Increased
liquidity generally comes at the expense of reduced
profitability.
There is a trade-off between liquidity with
profitability
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1.2 Cash flow problems
Making losses
Inflation
Growth
Seasonal business
One-off items of expenditure
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2 Cash flow forecasts
Fast forward
Cash flow forecasts show the expected receipts and
payments during a forecast period and are a vital
management control tool, especially during times of
recession.
Key term
a cash flow forecast is a detailed forecast of cash
inflows and outflows incorporating both revenues and
capital items.
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2 Cash flow forecasts
Cash receipts
Cash disbursements
Net cash flow
Cash shortfalls and surpluses
Beginning cash balance + Net cash flow
=Ending cash balance
Minimum cash balance
Short-term financing required or repayment (minimum
cash balance minus ending cash balance).
Or Investment or purchase at marketable securities
(ending cash balance- minimum cash balance )
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2.1 The usefulness of
cash flow forecasts
One of the most important planning tools
Giving management an indication of potential
problems that could arise and allows them the
opportunity to take action to avoid such
problems.
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2.1 The usefulness of
cash flow forecasts
Management will need to take appropriate action depending
on the potential position
Cash position
Appropriate management action
Short term
surplus
Pay A/P early to obtain discount; Attempt to increase sales by
increasing A/R and inventories; Make short term invention
Short term
deficit
Increase A/P; Reduce A/R;
Arrange an overdraft
long term
surplus
Make long term investment; expand; diversify;
Update/replace non-current assets
Long term
deficit
Raising long term finance
Consider shutdown/disinvestment opportunities
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2.2 what to include in
a cash flow forecast
A cash flow forecast is prepared to show the expected receipts, and
payments of cash during a budget period.
Profit v cash flow
Not all cash flow receipts affect income statement income.
Not all cash payment affect income statement expenditure
Some costs in the income statement such as profit or loss on sales
of non-current assets or depreciation are not cash items but are costs
derived from accounting conventions
The timing of cash receipts and payments may not coincide with the
recording of income statement transactions.
To ensure that there is sufficient cash in hand to cope adequately
with planned activities, management should prepare and pay close
attention to a cash flow forecast rather than a income statement.
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2.6 Method of easing cash shortages
Fast forward
Cash shortage can be eased by postponing capital
expenditure, selling assets taking longer to pay A/P and
pressing A/R for earlier payment.
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2.6 Method of easing cash shortages
Measures
Postponing capital expenditure
Accelerating cash inflows
Reversing past investment decisions by selling assets
previously acquired
Negotiating a reduction in cash outflows , to postpone or
reduce payment.
Longer credit
Loan repayments
Deferral corporate tax
Reducing dividend payment
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2.7 Deviations from expected cash flow
A cash flow forecast model
Sensitivity
Probability distribution
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Board of directors
Chief Executive
officer
Vice president
operations
Chief finance offer
Treasurer
Vice president
marketing
Controllers
•Capital budget
•Cost accounting
•Cash management
•Cost management
•Credit management
•Data processing
•Dividend disbursement
•General processing
•Finance analysis &
planning
•Internal control
•Investor relation
•Preparing financial
statements
•Pensions management
•Preparing budgets
•Risk management
•Preparing forecast
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3 Treasury management
Fast forward
A large organization will have a treasury department to
manage liquidity, short term investment, borrowings,
foreign exchange risk and other, specialized, areas such
as forward contracts and future etc.
Key term
Treasury management can be defined as: ‘the corporate
handing of all financial matters, the generation of
external and internal funds for business, the
management of currencies and cash flows and the
complex strategies, policies and procedure of finance.’
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3.1 Centralization on the
treasury department
Advantage of centralization :
Centralized liquidity management
Avoid having a mix of cash surpluses and overdrafts in different
localized bank accounts
Facilitates bull cash flows, so that lower bank charges can be
negotiated.
Larger volumes of cash flow are available to invest ,
giving better short term investment opportunity.
Any borrowing can be arranged in bulk, at lower interest
rates than for smaller borrowings, and perhaps on the
Eurocurrency or Eurobond markets.
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3.1 Centralization on the
treasury department
Advantage of centralization :
Foreign risk management is likely to be improved in a
group of company.
Employing experts
Reducing the cash need of precautionary purpose.
Through having a separate profit centre, attention will
be focused on the contribution to group profit
performance that can be achieved by good cash,
funding, investment and foreign currency management.
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3.1 Centralization on the
treasury department
Advantage of decentralized:
Source of finance can be diversified and can match local
assets.
Greater autonomy
More responsive
More limited opportunities to invest such balances on a
short term basis.
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4 Cash management models
Fast forward
Optimum cash holding levels can be calculated from
formal models, such as the Baumol model and MillerOrr model.
Cash management models attempt to minimizing the
total costs associated with cash movements between a
current account and short term investment – the
‘opportunity’ cost of lost interest plus transaction costs by determining when, and how much, cash flow should
be transferred each time.
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4.1 The Baumol model
The Baumol model assumes that cash is steadily consumed
over time and a firm holds a stock of marketable securities
that can be sold when cash is needed.
The cost of holding cash is the opportunity cost, i.e.
foregone from not investing that cash. The cost of placing
an order is the administration (conversion) cost incurred
when selling the securities.
Q
cos t of holding cash 
i
2
Q
S
total cos t 
i  C
Q
2
S
transferre d cos t 
C
Q
Q
2SC
i
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4.1 The Baumol model
Drawbacks of the Baumol model
In reality, it is unlikely to be possible to predict
amounts required over future period with much
certainty.
No buffer inventory of cash is allowed for. There may
be costs associated with running out of cash.
There may be other normal costs of holding cost which
increase with the average amount held.
The problem with the Maumol model is its unrealistic
assumption that firms face a constant demand for cash.
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4.2 The Miller-Orr model
A
Cash
balance
Upper limit
The firm buys
securities
Return point
The firm sells
securities
B
Lower limit
time
The Miller-Orr model controls irregular movements of cash by uses of
upper and lower limits on cash balance.
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4.2 The Miller-Orr model
The formula of Miller-Orr model
1
 3 tranaction cos t  var iance of cashflows  3
spread  3   

int erest rate
4
1
return po int  lower lim it  (  spread )
3
Where transaction costs= transferred costs for each buying and
selling securities
variance of cash flow= expected daily variance of cash flow
balance
interest rate = daily interest rate of security
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5 Investing surplus cash
Fast forward
Temporary surpluses of cash can be invested in
a variety of financial instruments.
Long term surpluses should be returned to
shareholders if there is a lack of investment
opportunities.
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5 Investing surplus cash
The objectives of investing surplus cash
Liquidity: the cash must be available for use
when needed
Safety: no risk of capital loss must be taken
Profitability: subject to the above, the aim is to
earn the highest possible after tax returns.
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5 Investing surplus cash
Other factors needed to be considered:
fixed or floating interest rates
Term to maturity
Marketability
Minimum amount
Whether to invest on international markets
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5 Investing surplus cash
Surplus cash lack of investment opportunity may
be returned to shareholders by:
increasing the usual level of the annual dividend
Making a one-off special dividend payment
Buying back its own shares
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5.1 short term investments
Deposit
Bank deposit
Money market lending
Local authority deposit
Finance house deposits
Short term debt instrument
Certificate of deposits
Treasury bills
Longer term debt instrument
Share of listed companies
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5.1 short term investments
Certificates of deposits
A CD is a security that is issued by a bank, acknowledging that
a certain amount of money has been deposited with it for a
certain period of time (usually, a short term)
CDs are negotiable and traded on the CD market (a money
market), so if a CD holder wishes to obtain immediate cash, he
can sell the CD on the market at any time.
Treasury bills
Treasury bills are issued weekly by the government to finance
short term cash deficiencies in the government’s expenditure
program.
Treasury bills have a term of 91 days to maturity, after which
the holder is paid full value of the bill.
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6 Working capital funding strategies
Fast forward
Working capital can be funded by a mixture of
short and long term funding. Business should be
aware of the distinction between fluctuating and
permanent assets.
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6.1 The working capital requirement
Working capital (over a one year period)
= current assets – current liabilities
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6.3 The level of working capital
A conservative approach
A conservative working capital management policy aims
to reduce the risk of system breakdown by holding high
levels of working capital.
The cumulative effect on these policies can be that the
firm carries a high burden of unproductive assets,
resulting a financing cost that can destroy profitability. A
period of rapid expansion may also cause severe cash
flow problems as working capital requirements outstrip
available finance. Further problems may arise from
inventory obsolescence and lack of flexibility to
customer demands.
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6.3 The level of working capital
An aggressive approach
An aggressive working capital management policy aims
to reduce this financing cost and increase profitability
by cutting inventories, speeding up collection from
customer, and delaying payment to suppliers.
The potential disadvantage of this policy is an increase
in the chances of system breakdown through running out
of inventory or loss of goodwill with customers and
suppliers.
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6.3 The level of working capital
An moderate approach
An moderate working capital management policy is a
middle way between the aggressive and conservative
approaches.
The decision regarding the level of overall
investment in working capital is a risk/return trade-off:
-liquidity v profitability;
Liquidity-the ability of an asset
to be converted into cash without
a significant price concession
- profitability v risk
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6.3 The level of working capital
liquidity v profitability
Profitability varies inversely with liquidity.
Increased liquidity generally comes at the expense
of reduced profitability.
profitability v risk
Profitability moves together with risk (i.e. there is a
trade-off between risk and return). In search of
higher profitability, we must expect to take greater
risks.
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6.3 The level of working capital
Asset level
Policy A
Policy B
Policy C
Current assets
0
Output unit
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6.3 The level of working capital
Net profit
Net profit
ROI 

total assets (cash  receivable  invertory)  fixed assests
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6.4 Permanent and fluctuating
current assets
Non-current (fixed) assets are long term assets
from which an organization expects to derive
benefit over a number of periods
Permanent current asset are the amount
required to meet long term minimum needs and
sustain normal trading activity.
Fluctuating current assets are the current
assets which vary according to normal business
activity. For example due to seasonal variations.
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6.4 Permanent and fluctuating
current assets
Permanent current asset together with
Fluctuating current assets form part of the
working capital of the business, which may be
financed by either long term funding or by
current liabilities (short term funding)
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6.5 Working capital financing
Short term sources of funding are usually cheaper
and more flexible than long term. However short
term sources are riskier as interest rates are more
volatile in the short term and they may be not be
renewed.
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Links between long-term and short-term
financing decisions
Short-term Long-term
debt
debt
Liquidity risk
higher
lower
costs
lower
middle
Equity
no
higher
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Spontaneous, Temporary,
and Permanent sources of Financing
Spontaneous financing - Trade credit, and other
payables and accruals, that arises spontaneously
in the firm’s day-to-day operations.
Spontaneous current liabilities required at the
seasonal low are called the spontaneous
permanent liabilities.
The difference between the highest level of
current liabilities and the spontaneous permanent
liabilities is called the seasonal liabilities.
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Working capital financing
Conservative financing policy ensures all longterm assets are financed through long-term liabilities as
well as seasonal and permanent portions of net working
capital
Hedging (maturity matching) financing policy
finances some seasonal net working capital with longterm and some with short-term
Aggressive financing policy uses long-term debt to
finance only some long-term assets and the permanent
net working capital.The balance is financed with shortterm financing.
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Conservative financing policy
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maturity matching (Hedging)
financing policy
51
Aggressive financing policy
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6.6 Other factors
Industry norms
Products
Management issues
The size of the organization
The degree of centralization
Management attitudes to risk
Previous funding decisions
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