ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 5: Management of receivables and payables
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The value of the settlement discount is:
1 +
2
98
⎛
⎝
⎜
⎞
⎠
⎟
365
30
−10
()
⎛
⎝
⎜
⎜
⎞
⎠
⎟
⎟
⎡
⎣
⎢
⎢
⎤
⎦
⎥
⎥
− 1 = 0.446 =
44.6%
The value of the settlement discount is much higher than the cost of a bank
overdraft.
Purple should take the discount and pay invoices on day 10.
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Paper F9
Financial management
CHAPTER
6
Cash management
Contents
1 Thenatureofcashmanagement
2 Cashbudgetsandcashflowforecasts
3 Cashmodels:BaumolmodelandMiller‐Orr
model
4 Otheraspectsofcashmanagement
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The nature of cash management
Reasons for holding cash
Objective of good cash management
Aspects of cash management
1 The nature of cash management
The importance of cash and liquidity for a business was explained in the earlier
section on liquidity ratios. If a company is unable to pay what it owes at the
required time, a creditor might take legal action to recover the unpaid amount. Even
if such extreme action is not taken, but a company is slow in paying invoices,
creditors will be reluctant to provide additional credit.
It is therefore essential for a business to ensure that its cash flows are well managed
and that it has sufficient liquidity.
1.1 Reasons for holding cash
There are several reasons why a business entity might choose to hold cash.
To settle transactions. Cash is needed to pay expenses, and to settle debts.
As a precaution against unexpected requirements for cash. A business might
hold some additional cash in the event that there is a need to make an
unexpected and unforeseen payment.
For speculative reasons. A company might hold some cash that can be used if a
business opportunity arises. Some investment opportunities, such as the
opportunity to purchase a rival business, might require some element of cash.
Holding a ‘war chest’ of cash might therefore be a strategic measure taken by a
company, to take opportunities for developing the business whenever an
attractive opportunity arises.
However, cash does not earn a high return. Cash in a normal business bank account
earns no interest at all. Holding cash therefore provides a company with liquidity
(an ability to pay), but reduces profitability (the lost income resulting from holding
cash rather than investing it in business development).
1.2 Objective of good cash management
The objective of good cash management is to hold sufficient cash to meet liabilities
as they fall due, whilst making sure that not too much cash is held. Money held as
cash is not being invested in the wealth-creating assets of the organisation – thereby
affecting profitability.
If a business entity wants to maintain sufficient liquidity, but does not want to hold
too much cash, it might consider investing cash that is surplus to short-term
requirements. Surplus cash can be invested in short-term financial instruments or
even savings accounts, and so can earn some interest (although possibly not much)
Chapter 6: Cash management
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until it is needed. When the cash is eventually needed, the investments can be sold,
or cash can be withdrawn from the savings accounts.
1.3 Aspects of cash management
You might be required to consider any of the following three aspects of cash
management.
Forecasting cash flow requirements and operational cash flows. This is done by
means of cash budgeting or cash flow forecasting. In your examination it is more
likely that you will be required to prepare a cash flow forecast rather than a
detailed cash budget.
Deciding how to invest surplus cash in short-term investments.
Deciding how much cash to keep and how much to invest in short-term
investments. In addition, if money is invested in short-term investments,
deciding how many investments to sell in exchange for cash when some cash is
eventually needed for operational requirements.
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Cash budgets and cash flow forecasts
Cash budgets
Preparing a cash budget
Cash flow forecasts
2 Cash budgets and cash flow forecasts
2.1 Cash budgets
A cash budget is a detailed plan of cash receipts and cash payments during a
planning period. The planning period is sub-divided into shorter periods, and the
cash receipts and payments are forecast/planned for each of the sub-divisions of
time.
For an annual master budget, the cash budget might be prepared on a monthly
basis, or possibly a quarterly basis. Some business entities prepare new cash
budgets regularly, possibly forecasting daily cash flows for the next week, or weekly
cash flows for the next month.
The main uses of a cash budget are as follows:
To forecast how much cash receipts and payments are expected to be over the
planning period.
To learn whether there will be a shortage of cash at any time during the period,
or possibly a cash surplus.
If there is a forecast shortage of cash, to consider measures in advance for
dealing with the problem - for example by planning to defer some purchases of
non-current assets, or approaching the bank for a larger bank overdraft facility.
To monitor actual cash flows during the planning period, by comparing actual
cash flows with the budget.
2.2 Preparing a cash budget
A cash budget can be prepared by producing a table for the cash receipts and cash
payments, containing each item of cash receipt and each item of cash payment. The
cash receipts and then the cash payments should be listed in rows of the table, and
each column of the table represents a time period, such as one month.
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A typical format for a monthly cash budget is shown below.
January February March
Cashreceipts $ $ $
Cashsales 5,000 6,000 5,000
Cashfromcreditsales
Creditsalesthepreviousmonth(monthM‐1) 22,000 20,000 24,000
Creditsalesintwomonthsago(monthM‐2) 50,000 44,000 40,000
Creditsalesinthreemonthsago(monthM‐3)
Othercashreceipts 4,000 2,000 2,000
–
–––––––
–
––––––– ––––––––
Totalcashreceipts 81,000 72,000 71,000
–
–––––––
–
––––––– ––––––––
Cashpayments
Paymentsforpurchasesincurrentmonth 6,000 6,600 6,200
Paymentsforpurchasesinpreviousmonth 8,400 9,000 9,900
Paymentsofrent‐30,000‐
Paymentsofwagesandsalaries 23,000 23,000 23,000
Dividendpayments‐‐40,000
Paymentsfornon‐currentassets70,000 10,000
Otherpayments 3,000 3,000 3,000
–
–––––––
–
––––––– ––––––––
Totalcashpayments 40,400 141,600 92,100
–
–––––––
–
––––––– ––––––––
Receiptsminuspayments(netcashflow) 40,600 (69,600) (21,100)
Cashbalanceatthebeginningofthemonth 45,000 85,600 16,000
–
–––––––
–
––––––– ––––––––
Cashbalanceattheendofthemonth 85,600 16,000 (5,100)
–
–––––––
–
––––––– ––––––––
2.3 Cash flow forecasts
Cash flow forecasts, like cash budgets, are used to predict future cash requirements,
or future cash surpluses. However, unlike cash budgets:
they are prepared throughout the financial year, and are not a part of a formal
budget plan
they are often prepared in much less detail than a cash budget.
The main objectives of cash flow forecasting, like the purposes of a cash budget, are
to:
make sure that the entity is still expected to have sufficient cash to meet its
payment commitments as they fall due
identify periods when there will be a shortfall in cash resources, so that
financing can be arranged
identify whether there will be a surplus of cash, so that the surplus can be
invested
assess whether operating activities are generating the cash that is expected from
them.
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The main focus of cash flow forecasting is likely to be operating cash flows,
although some investing and financing cash flows might also be significant.
Techniques for preparing a cash flow forecast
There are no rules about how to prepare a cash flow forecast. A forecast need not be
in the same amount of detail as a cash budget. However there are two basic
approaches that might be used:
producing a cash flow forecast similar to a statement of cash flows prepared
using the indirect method
forecasting cash flows by estimating revenues and costs to arrive at an estimate
of earnings before interest, tax and depreciation (EBITDA).
2.4 Cash flow statement approach
One way of preparing a cash flow forecast for a period of time is to produce a
statement similar to a statement of cash flows in financial reporting. The general
structure of the forecast will therefore be as follows:
Cashflowforecast
$ $
Expectedtradingprofitintheperiod34,000
Adjustmentsfornon‐cashitems:
Depreciation22,000
–
–––––––
56,000
Adjustmentsforworkingcapital
Increaseininventory (15,000)
Increaseintradereceivables (18,000)
Increaseintradepayables 10,000
–
–––––––
(23,000)
–
–––––––
Operationalcashflows33,000
Interestpayments(10,000)
Taxpayments(onprofits)(7,000)
–
–––––––
Cashflowsfromoperatingactivities
16,000
Cashflowsfrominvestingactivities
Saleofnon‐currentasset 4,000
Purchaseofnon‐currentasset (25,000)
–
–––––––
(21,000)
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Cashflowsfromfinancingactivities
Repaymentofloan (12,000)
Paymentofdividend (15,000) (27,000)
–
–––––––
–
–––––––
Netchangeincashposition(32,000)
Cashatbeginningofforecastperiod40,000
–
–––––––
Cashatendofforecastperiod8,000
–
–––––––
Trading profit (profit before interest and tax)
The expected trading profit might be estimated by projecting the current year’s
trading profit (profit before interest and tax). For example, if trading profits have
been increasing by about 5% per year and were $300,000 in the year just ended, it
might be assumed for the purpose of the cash forecast that trading profit will be
$315,000 next year.
Depreciation (and amortisation)
Depreciation is not a cash flow; therefore it must be added back to profit in order to
calculate cash flows. Detailed information might be available about non-current
assets to enable an accurate estimate of future depreciation charges (and
amortisation charges, if there are any intangible assets). Alternatively, it might be
assumed that the depreciation charge in the next year will be about the same as in
the current year.
An assumption has to be made about depreciation charges, and alternative
assumptions might be more appropriate. If you have to make an estimate of
depreciation for the purpose of cash flow forecasting in your examination, you
should make the most reasonable assumption available on the basis of the
information provided in the question.
Changes in inventory, trade receivables and trade payables
The figure for profit must also be adjusted for changes in working capital in order to
estimate cash flows from operational activities. The most appropriate assumptions
about working capital changes might be one of the following:
that there will be no changes in working capital
that inventory, trade receivables and trade payables will increase by the same
percentage amount as the growth in sales. For example, if sales are expected to
increase by 5%, it might be reasonable to assume that inventory, trade
receivables and trade payables will also increase by 5% above their amount at
the beginning of the year.
Interest payments and tax payments
Assumptions might be needed about interest and tax payments in the cash flow
forecast.
It might be assumed that interest payments will be the same as interest costs in
the current year’s income statement, on the assumption that the company’s total
borrowings will not change significantly and interest rates will remain stable.
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It might be assumed that tax payments will be a percentage of the figure for
trading profit.
However, other assumptions might be more appropriate, given the information
provided in an examination question.
Investing cash flows
Investing cash flows might be included in a cash flow forecast if:
it is expected that additional non-current assets will be purchased in the period
it is expected that some non-current assets will be sold/disposed of
it is assumed that some essential replacement of ageing and worn-out non-
current assets will be necessary. For example it might be assumed that purchases
of replacement non-current assets will be necessary, and the amount of
replacements required will be equal approximately to the annual depreciation
charge for those assets.
Financing cash flows
It might also be appropriate to include some financing cash flows in the cash flow
forecast, where these are expected. In particular, if the company intends to pay an
equity dividend, this should be included I n the forecast as a cash outflow.
2.5 Revenue and cost estimation approach
Another approach to preparing a cash flow statement is to estimate earnings before
interest, tax, depreciation and amortisation (EBITDA) using estimates of revenues
and costs.
Cashflowforecast
$
Salesrevenueforecast 300,000
Costofsales(%ofsalesrevenue) (180,000)
Grossprofit 120,000
Otherexpenses(possiblyfixed,possiblya%ofsalesrevenue) (90,000)
Netprofit 30,000
Add
Depreciationandamortisation 26,000
EBITDA 56,000
The figure for EBITDA is equivalent to the figure in the cash flow statement for
operational cash flows before working capital adjustments. Adjustments can be
made to EBITDA for working capital changes, interest and tax payments, investing
cash flows and financing cash flows, in order to arrive at an estimate of the net cash
flow surplus or deficit for the period.