Foundations of Financial Management: An Analysis (part 10)

Under capitalism, man exploits man. Under communism, it's just the opposite.

John Kenneth Galbraith

 Financial Forecasting (Part B)

by

Charles Lamson 

Cash budget

As previously indicated in the last post, the generation of sales and profits does not necessarily ensure there will be adequate cash on hand to meet financial obligations as they come due. A profitable sale may generate accounts receivable in the short run but no immediate cash to meet maturing obligations. For this reason, we must translate the pro forma income statement from the last post into cash flows. In this process we divide the longer-term pro forma income statement into smaller and more precise time frames to anticipate the seasonal and monthly patterns of cash inflows and outflows. Some months may represent particularly high or low sales volume or may require dividends, taxes, or capital expenditures.

Cash Receipts

In the case of the Lamson Corporation, we break down the pro forma income statement from the last post for the first half of the Year 2021 into a series of monthly cash budgets. In Table 1 from the last post, we showed anticipated sales of $100,000 over this time. We shall now assume these sales can be divided into monthly projections, as indicated in Table 9.

Table 9 Monthly sales pattern (for first half of 2021)

A careful analysis of past sales and collection records indicates 20 percent of sales is collected in the month of sales and 80 percent in the following month. The cash receipt pattern related to monthly sales is shown in table 10. It is assumed that sales for December 2020 will be $12,000.

Table 10 Monthly cash receipts

The cash inflow will vary between $11,000 and $23,000 with the high point in receipts coming in May.

We now examine the monthly outflows.

Cash Payments

The primary considerations for cash payments are monthly costs associated with inventory manufactured during the period (material, labor, and overhead) and disbursements for general and administrative expenses, interest payments, taxes, and dividends. We must also consider cash payments for any new plant and equipment, an item that does not show up on our pro forma income statement. Costs associated with units manufactured during the period may be taken from the data provided in Table 5 from last post. In Table 11, we simply recast these data in terms of material, labor, and overhead.

Table 11 Component costs of manufactured goods

We see that the total costs for components in the two products in Table 11 are materials, $34,390; labor, $17,195; and overhead, $11,125. We shall assume all these costs are incurred on an equal monthly basis over the six-month period. Even though the sales volume varies from month to month, we assume we are employing level monthly production to ensure maximum efficiency in the use of various productive resources. Average monthly costs for materials, labor, and overhead are as shown in Table 12.

Table 12 Average monthly manufacturing costs

We hall pay for materials one month after the purchase has been made. Labor and overhead represent direct monthly cash outlays, as is true of interest, taxes, dividends, and the purchases of $8,000 in new equipment in February and $10,000 in June. We summarize all of our cash payments in Table 13. Past records indicate that $4,500 in materials was purchased in December.

Table 13 Summary of all monthly cash payments

Actual Budget

We are now in a position to bring together our monthly cash receipts and payments into a cash flow statement, illustrated in Table 14. The difference between monthly receipts and payments is net cash flow for the month.

Table 14 Monthly cash flow

The primary purpose of the cash budget is to allow the firm to anticipate the need for outstanding funding at the end of each month. In the present case, we shall assume the Lamson Corporation wishes to have a minimum cash balance of $5,000 at all times. If it goes below this amount, the firm will borrow funds from the bank. If it goes above $5,000 and the firm has a loan outstanding, it will use the excess funds to reduce the loan. This pattern of financing is demonstrated in Table 15---a fully developed cash budget with borrowing and repayment provisions.

Table 15 Cash budget with borrowing and repayment provisions

The first line in table 15 shows net cash flow from table 14, which is added to the beginning balance to arrive at the cumulative cash balance. The fourth entry in the additional monthly loan or loan repayment, if any, required to maintain a minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry represents cumulative loans outstanding for all months. Finally, we show the cash balance at the end of the month, which becomes the beginning cash balance for the next month.

At the end of January the firm has $6,380 in cash, but by the end of February the cumulative cash position of the firm is negative, necessitating a loan of $5,072 to maintain a $5,000 cash balance. The firm has a loan on the books until May, at which time there is an ending cash balance of $11,069. During the month of April and May the cumulative cash balance is greater than the required minimum cash balance of $5,000, so loan repayments of $4,548 and $4,479 are made to retire the loans completely in May. In June the firm is once again required to borrow $5,884 to maintain a $5,000 cash balance. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 92-96*

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