ACCA F9 Financial Management - 2010 - Study text

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Chapter 6: Cash management

Sales revenue forecast

The sales revenue forecast should be based on sales revenue in the previous year

will an adjustment for volume growth (and possibly an increase in unit sales prices).

Cost of sales and gross profit

If the ratio of cost of sales: sales and the gross profit margin percentage have been

fairly stable in recent years, it might be assumed that these ratios will apply in the

future. For example, if sales revenue in the previous year was $10 million, gross

profit has been 60% of sales for the past few year and sales revenue should increase

by 5% next year with volume growth the estimate of gross profit for next year will

be $10 million × 1.05 × 60% = $6.3 million.

Other expenses

The estimate for other expenses should be based on reasonable assumptions. For

example it might be assumed that these are fixed costs and so will be unchanged

next year. Alternatively, it might be assumed that these costs will be the same

percentage amount of sales revenue as in previous years.

Other adjustments might be necessary, to allow for known changes in cost (for

example, if an exceptionally large increase in raw material costs is forecast, this will

affect the gross profit margin. Other costs might be affected by an expectation of an

unusually large increase in administrative labour costs, and so on.

Depreciation and amortisation

If the estimates of cost of sales and other expenses include depreciation costs and

amortisation costs, these must be added back in order to obtain an estimate of

EBITDA.

Example

A company wants to make a cash flow forecast for next year. The following

information is available.

Annual sales

$ million

Current year (forecast) 80

Previous year (Year – 1) 75

Year – 2 72

Year – 3 67

Year – 4 64

The company has achieved a gross profit margin of between 57% and 62% in the

past four years. Other costs (distribution and administration costs) in the current

year are expected to be £36 million. Labour costs make up 25% of other costs. These

labour costs are expected to rise by 10% per year for the next two years and then in

line with the general rate of cost inflation. The general rate of annual cost inflation

for the next few years is expected to be 2%.

The company currently has $100 million of freehold land (50% land and 50%

buildings) and $40 million (at cost) of other non-current assets. Buildings are

depreciated by 2% per year and other non-current assets are depreciated over eight

years by the straight-line method to a zero residual value. The investment in

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working capital (trade receivables plus inventory, less trade payables) is currently

$120 million.

Required

Prepare an estimate of cash flows from operations for each of the next two years.

Answer

Sales revenue has grown by a factor of 1.25 (= 80/64) over the past four years. This

gives an average annual growth rate in sales of 5.7% (= fourth root of 1.25, minus 1).

It might therefore be assumed that sales growth will be 6% per year in each of the

next two years.

The gross profit margin has varied between 57% and 62%. It might therefore be

assumed that in the next two years gross profit will be 60% sales.

It might also be assumed that growth in sales and the cost of sales allows for 2% per

annum price inflation.

Other costs are $36 million in the current year, consisting of $9 million of labour

costs and $27 million of other costs. It might be assumed that these are fixed costs,

except that they rise by 10% per year in the case of labour and 2% for other costs.



Current

year

 Year1 Year2

 $m $m $m

Labour9 (+10%p.a.)9.9 10.9

Othercosts 27 (+2%p.a.) 27.5 28.1



–––––

–

–––––

–

–––––

Total 36 37.4 39.0



–––––

–

–––––

–

–––––

Depreciation charges each year are expected to be $1 million (2% × £50 million) for

buildings. For other non-current assets, depreciation will be $5 million (= $40

million/8 years).

If sales increase by 6% per year, it is assumed that working capital will grow at the

same rate, to $127 million in Year 1 and $135 million in Year 2.

Chapter 6: Cash management

An estimate of EBITDA, adjusted for expected working capital changes, can now be

prepared.



Current

year

Year1 Year2

 £m £m £m

Revenue 80.0 84.8 89.9

Costofsales(40%) (32.0) (33.9) (36.0)



–

–––––––

–

––––––– ––––––––

Grossprofit(60%) 48.0 50.9 53.9

Othercosts:seeworkings (36.0) (37.4) (39.0)



–

–––––––

–

––––––– ––––––––

 12.0 13.5 14.9

Depreciation

Buildings1.0 1.0

Othernon‐currentassets5.0 5.0



–

––––––– ––––––––

EBITDA19.5 20.9

Increaseinworkingcapital(7.0) (8.0)



–

––––––– ––––––––

EBITDAadjustedforworkingcapitalchanges 12.5 12.9



–

––––––– ––––––––

2.6 Free cash flow

The concept of free cash flow might also be used in cash flow forecasts. Free cash

flow is the amount of surplus cash flow (or the cash flow deficit) after allowing for

all cash payments that are essential and non-discretionary. Free cash flow is the

amount of cash flow that management are able to use at their discretion for any

purpose.

Free cash flow does not have an exact definition, and there may be differences in

assumptions about essential cash flows. However, a useful definition of free cash

flow is as follows.

EBITDA X

Less:

Payments of interest (X)

Payments of taxation (X)

Changes in working capital X or (X)

(inventory, trade receivables, trade payables)

Essential capital expenditure (replacement of worn-out assets) (X)

Free cash flow

X or (X)

Free cash flow can be used to pay dividends, make discretionary purchases of non-

current assets, repay debt capital to lenders, or retain as a cash surplus.

Example

Suppose that in the previous example the company expects to have interest costs of

$500,000 each year for the next two years, and that taxation will be 25% of EBITDA.

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It might be assumed that essential capital expenditure is equal to the depreciation

charge on non-current assets.

Free cash flow might therefore be estimated as follows.

 Year1 Year2

 £m £m

Revenue 84.8 89.9

Costofsales(40%) (33.9) (36.0)

Grossprofit(60%) 50.9 53.9

Othercosts:seeworkings (37.4) (39.0)

 13.5 14.9

Depreciation

Buildings 1.0 1.0

Othernon‐currentassets 5.0 5.0

EBITDA 19.5 20.9

Interestpayments (0.5) (0.5)

Taxpayments(25%of19.5and20.9) (4.9) (5.2)

Increaseinworkingcapital (7.0) (8.0)

Essentialcapitalexpenditure (6.0) (6.0)

Freecashflow 1.1 1.2

This forecast suggests that after making essential cash payments, the remaining free

cash flow will be just over $1 million in each year, which might be insufficient to

pay for proposed equity dividends or discretionary new capital expenditure

projects.

In this example, if the company is hoping to expand it will need to consider ways of

raising finance from sources other than operational cash flows.

Chapter 6: Cash management

Cash models: Baumol model and Miller-Orr model

 Purpose of cash models

 Baumol model

 Miller-Orr model

3 Cash models: Baumol model and Miller-Orr model

3.1 Purpose of cash models

Cash models might be used when an entity has periods of surplus cash and periods

when cash is needed. A model can be used to decide:

 how much cash to hold and how much to invest short-term to earn interest

 when cash is needed, how many investments to sell (how much cash to obtain).

Two such cash models are the Baumol model and the Miller-Orr model

3.2 Baumol model

The Baumol cash model is based on similar principles to the Economic Order

Quantity (EOQ) model for inventory control. It assumes that a company spends

cash regularly on expenses and that to obtain the cash it has to sell short-term

investments. The company therefore makes regular sales of investments in order to

obtain cash to pay its operational expenses.

The purpose of the Baumol cash model is to calculate the optimal amount of cash

that should be obtained each time that short-term investments are sold.

The assumptions used in the model are as follows:

 The company uses cash at a constant rate throughout each year (the same

amount of cash every day).

 The company can replenish its cash immediately, as soon as it runs out of the

cash it has.

 Cash is replenished by selling short-term investments. These investments earn

interest. The amount of investments sold, and the amount of cash from selling

the investments, is $X.

 Holding cash has a cost. This is the opportunity cost of not investing the cash to

earn interest. The opportunity cost, C

, can be expressed as an interest rate. For

example, if investments earn interest at 4% per year, the annual cost of holding

cash is 0.04.

 Selling securities or investments to obtain cash has a transaction cost (similar to

the cost of placing an order with the EOQ inventory model). In the model, this is

shown as C

The maximum amount of cash is therefore X. The average cash holding is

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The annual cost of holding cash is therefore

⎛

⎝

⎜

⎞

⎠

⎟

× C

If the annual demand for cash is $D, the annual transaction costs of selling securities

(short-term investments) is

⎛

⎝

⎜

⎞

⎠

⎟

× C

The model identifies the optimal amount of cash to obtain by selling securities, X. It

is the amount of cash that minimises the total opportunity costs of holding cash and

the transaction costs of selling securities.

The total of

⎛

⎝

⎜

⎞

⎠

⎟

× C

⎡

⎣

⎢

⎤

⎦

⎥

⎛

⎝

⎜

⎞

⎠

⎟

× C

⎡

⎣

⎢

⎤

⎦

⎥

is minimised where

X =

Example

Entity KL makes payments to its creditors of $3 million a year, at an equal rate each

day.

Each time it converts investments into cash, it pays transaction charges of $150.

The opportunity cost of holding cash rather than investing it is 6% per year.

Using the Baumol model, calculate what quantity of investments should be sold

whenever more cash is needed by Entity KL.

Answer

X =

× 150 × 3,000,000

()

0.06

⎛

⎝

⎜

⎞

⎠

⎟

= $122,474

This might be rounded to $122,500.

There would then be

$3,000, 000

$122,500

= between 24 and 25 transfers of cash during the year.

Exercise 1

Entity GF invests all cash as soon as it is received, to earn interest at 5%. It incurs

cash expenditures of $16,000,000 each year, and pays for these at a constant rate

each day. The cost of converting a batch of investments into cash is $250, regardless

of the size of the transaction.

Required

Use the Baumol model to decide how much cash should be obtained each time

investments are sold.

Chapter 6: Cash management

3.3 Miller-Orr model

The Baumol model assumes that cash payments are evenly spread over time, and

are a constant amount each period. In reality, this is unlikely to happen. There will

be much more uncertainty over the timing of cash payments and receipts.

The Miller-Orr model recognises this uncertainty in cash flows, which are measured

statistically. Daily cash flows might be positive or negative. The net daily cash flows

are then assumed to be normally distributed around the daily average net cash flow.

(However, you do not need to know the statistical details of the model.)

The model is used as follows:

 The model has a minimum cash holding. This is called the lower limit. This is

usually decided by management.

 If the cash balance falls to the lower limit, then investments will be converted

into cash, to take the balance back to a predetermined amount, known as the

return point.

 There is also a maximum cash holding limit, the upper limit.

 The difference between the lower limit and the upper limit is called the spread.

 If the cash balance reaches the upper limit, cash is used to buy investments. The

amount of cash used to buy investments is sufficient to return the cash balance

to the return point.

 The cash balance should therefore fluctuate between the upper and lower limits,

and should not exceed these limits.

 The distance between the lower limit and the return point is usually

of the

total spread.

 The distance between the upper limit and the return point is usually

of the

total spread.

Paper F9: Financial management

The Miller-Orr model formula for the size of the spread

The Miller-Orr model formula for the size of the spread is as follows:

Spread =

¾ × Transaction cost × Variance of cash flows

1/3

Interest rate as a proportion

Notes

(a) The transaction cost is the cost of the sale and purchase of securities

(b) The variance of cash flows is a statistical measure of the variation in the

amount of daily net cash flows.. The variance should relate to the same period

of time as the interest rate. For example, if the variance is a variance of daily

cash flows, the interest rate (expressed as a proportion) must be a daily

interest rate. If in doubt, to calculate a daily interest rate from an annual

interest rate, divide the annual interest rate by 365. Alternatively, if you prefer

to be more exact, take the 365

root (1 + interest rate), then subtract 1 to get

the daily interest rate.

(d) Remember also that the variance is the square of the standard deviation (and

the standard deviation is the square root of the variance).

(e) A value to the power of one-third means the cube root. Make sure that you

have a calculator that can calculate a cube root.

Example

Entity ASD decides that it needs a minimum cash balance of $15,000.

It estimates that it has transaction costs of $50 for each purchase or sale of short-

term investments.

Based on its measured historical observations, the standard deviation of daily cash

flows is $1,400.

The annual market interest rate on short-term investments is 8%.

Required

Calculate the upper cash limit and the return point using the Miller-Orr model.

Answer

The variance of daily cash flows = (1,400)

= 1,960,000.

The daily interest rate =

0.08

365

= 0.000219

Chapter 6: Cash management

Using the formula to calculate the difference between the limits

Spread =

¾ × 50 × 1,960,000

1/3

0.000219

= $20,848

Lower limit (decided by management) = $15,000

Upper limit = $15,000 + $20,848 = $35,848

Return point = $15,000 + (

× $20,848) = $21,949.

Alternative calculation of daily interest rate

Daily interest rate =

365

1.08

()

= 0.000211

Spread =

¾ × 50 × 1,960,000

1/3

0.000211

= $21,108

Lower limit (decided by management) = $15,000

Upper limit = $15,000 + $21,108 = $36,108

Exercise 2

Entity Green decides that it needs a minimum cash balance of $40,000.

It estimates that it has transaction costs of $120 for each purchase or sale of short-

term investments.

Based on its measured historical observations, the standard deviation of daily cash

flows is $1,800.

The annual market interest rate on short-term investments is 7%.

Required

Using the Miller-Orr model, calculate:

 the upper cash limit, and

 the return point.

Paper F9: Financial management

Other aspects of cash management

 Use of surplus cash: investing short term

 Ways of investing short term

 Dealing with shortfalls of cash

 Cash management in larger organisations

 Functions of a treasury department

4 Other aspects of cash management

4.1 Use of surplus cash: investing short term

Surplus cash arises when a business entity has cash that it does not need

immediately for its day-to-day operations. Surpluses may be short-term

(temporary).

When a surplus is identified, the entity should plan how to use it. Holding it as cash

is wasteful, because cash in a business bank account earns no interest.

If the surplus is likely to be

long-term, the cash should be invested long-term in

wealth-producing assets of the business – perhaps through a plan of market

expansion. Alternatively, if no suitable wealth-producing project is available, the

entity should consider returning cash as dividends to its owners – the shareholders.

If the surplus is likely to be

temporary, it would be more appropriate to invest it for

the short term, and then cash in the investments when the cash is eventually

needed.

When deciding on how to use temporary surplus cash, the following considerations

are important:

 Liquidity – Short-term investments should ideally be liquid. This means that

they should be convertible into cash fairly quickly, at a fair price and without

difficulty. The more liquid the investment, the easier it is to convert it back into

cash. Market securities can be sold immediately on the market, but at some risk

of obtaining a poor price. Money in a savings account can be withdrawn without

loss (except perhaps there might be some loss of interest if the money is

withdrawn without providing the required minimum notice period).

 Safety – The level of investment risk should be acceptable. There is a risk of

losing money on the investment, due to a fall in its market value. With

investments such as a savings account, there would be no risk of capital loss, but

the interest on the savings might be very low. On the other hand investing in

shares of other companies is much more risky since share prices fluctuate.

 Profitability – The aim should be to earn the highest possible return on the

surplus cash, consistent with the objectives of liquidity and safety.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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