Building a Cash Budget

Forecasting cash receipts requires an intimate knowledge of the internal and external sources of this revenue.

TERM

• lien

  A legal claim; a charge upon real or personal property for the satisfaction of some debt or duty.

Cash Receipts

A cash receipt is a term used to describe cash flowing into a business . In terms of cash flow forecasting, we typically think of cash receipts as:

• Cash from cash sales (received in the month of sale)
• Cash from debtors who are paying for a past month's credit sale
• Sales of capital assets
• Short-term bank financing
• Accounts receivable financing
• Inventory financing
• Unsecured financing

External Cash Receipts

Bank Financing

Having a good banking relationship can be essential for a company when short-term cash solutions are needed. There are a couple of methods for obtaining short-term bank financing. A company can obtain a line of credit in order to address recurring cash deficits. It could also arrange a revolving loan, where the company borrows as deficits occur up to a maximum amount. The bank may require the firm to put up collateral, such as account receivables, inventory, etc. Key points to remember when obtaining bank financing include:

• Make arrangements to borrow when you least need it.
• Borrow more than you think you will need.
• The moment you think you will need short term financing, begin preparing immediately.
• Borrow to meet your strategic plans, not to avoid possible bankruptcy.

Receivables Financing

In addition to bank financing, a company can borrow against its assets from a financing company. Accounts receivable is a liquid asset that provides a form of financing. In order to obtain receivables financing, a company must meet the following criteria:

1. Receivables are related to the sale of merchandise and not services.
2. Receivable customers are financially sound and there is a high probability of payment.
3. Receivable customers obtain title to merchandise when it is shipped.
4. Your overall receivable balance is at least $ 50,000 with sales that are substantially higher than your receivable balance.

There are two forms of receivable financing, factoring and assignments. Under the forcing form, a company sells its receivables to the financing company, who in turn assumes all responsibility for collecting the receivable. Under the assignments form, a company retains ownership of the receivables. The company assigns the receivable to the financing company in exchange for an advance of 60% to 80% of the balance.

Inventory Financing

Similar to receivables financing, inventory financing has the following requirements:

1. Inventory must be highly marketable.
2. Inventory is non-perishable and not subject to obsolescence.
3. Inventory prices are relatively stable.

There are three forms of inventory financing. A financing company can place a floating or blanket lien on a firm's inventory, meaning they obtain a security interest in it, in exchange for lending cash. A financing company may also look to obtain interest in a certain part of a firm's inventory. This form is known as warehouse receipts. Finally, a financing company may lend a firm money for a specific item in its inventory until the firm is able to sell it. When cash is received for the sale, the firm pays the financing company. This form is known as trust receipts.

Unsecured Financing

For large corporations with financially sound operations, cash can be obtained on the credit worthiness of the corporation - known as unsecured financing. In the United States, commercial paper is perhaps the most popular form of unsecured financing. Commercial paper is sold at a discount in the form of a promissory note.

Receipt Cycle

A company needs to understand the timing involved with cash-producing or cash-depleting activities before it can properly plan for cash flows. The receipt cycle is the total time between when products or services are delivered and when payment from the customer clears the bank. The overall objective within the receipt cycle is to decrease the cycle or shorten the time necessary to collect and have use of cash. We can shorten the receipt cycle by:

• Invoicing customers as quickly as possible.
• Taking immediate action when a customer becomes delinquent.
• Rewarding customers for making early payment by offering a discount.
• Imposing a finance charge on customers that are seriously delinquent.
• Evaluating the financial soundness of customers before extending credit.
• Accepting credit cards for payment.
• Issuing monthly statements to remind customers of amounts owed.
• Placing collection centers near customers and/or having banks control deposits.

Cash payments describe cash flowing out of a business resulting from operating activities, investment activities and financing activities.

TERM

• disbursement

  Money paid out or spent.

Why is cash flow forecasting important? If a business runs out of cash and is not able to obtain new financing, it will become insolvent. It is no excuse for management to claim that they didn't see a cash flow crisis coming. So in business, "cash is king".

Cash Payments

Cash payments describe cash flowing out of a business. These cash payments can result from operating activities, investment activities and financing activities.

Generally speaking, normal operating activities refer to the cash effects of transactions involving revenues and expenses that impact net income. Cash payments must be made for relevant expenses. Typical payments include those to:

• Suppliers for inventory or other supplies
• Employees for wages
• Government for taxes
• Lenders for interest on borrowed money

Typical cash outflows from investing activities include:

• Purchase of capital assets
• Purchase of bonds/notes or shares of other entities
• Loans to other entities

Typical cash outflows from financing activities include:

• Payments of dividends to the company's own shareholders
• Redemption (repurchase) of company's own shares
• Repayment of principal and interest on company's own bonds or notes

Disbursement Cycle

The cash disbursement cycle is important to consider when analyzing cash payments. This is the total time between when an obligation occurs and when the payment clears the bank. A company's objective regarding the cash disbursement cycle should be to increase the cycle time, or delay making payments until they are due. A firm may delay payments by:

1. Mailing checks from locations not close to customers. This will increase the mail time, or mail float, within the disbursement cycle.
2. Disbursing checks from a remote bank. This will increase the time required for the payment to clear the bank.
3. Purchasing with credit cards so that the time required for making payment is much longer. By using a credit card, you will receive a bill at the end of the month payable in 30 days. This creates more processing time or processing float.

Therefore, when a company manages cash flow cycles, it tries to control three types of float times:

1. Mail float, or the time spent for a payment in the mail.
2. Clearance float, or the time spent for a payment to clear the bank.
3. Processing float, or the time required to process cash flow transactions.

In order to determine the optical cash balance for a company, cash flows are estimated and a forecast is prepared.

TERM

• insolvent

  Unable to pay one's bills as they fall due.

Building a Cash Budget

There is a saying in business that "cash is king". Cash is the most liquid of assets, and it represents the lifeblood for growth and investment, particularly for start-ups and small enterprises. One of the worst things that can happen to a company is to run short of cash unexpectedly. This can make it difficult to pay suppliers and employees without scurrying around to raise needed cash quickly. When cash must be raised quickly, it is often a difficult and expensive task. If a business runs out of cash and is not able to obtain new financing, it will become insolvent. In order to generate cash, businesses must efficiently and effectively manage the activities that provide cash. These activities include billing customers as quickly as possible, disbursing payments only when they come due, collecting cash on overdue accounts, and investing idle cash. Managing cash flow involves several objectives:

• Accelerating cash inflows wherever possible.
• Delaying cash outflows until they come due.
• Investing surplus cash to earn a rate of return.
• Borrowing cash at the best possible terms.
• Maintaining an optimal level of cash that is neither excessive nor deficient.

This last objective is of vital importance. If a business hold too much cash, it loses the opportunity to earn a return on idle cash. If it holds too little cash, it runs the risk of not making timely payments to suppliers, banks, and other parties. The optimal cash balance is determined by looking at the four reasons for holding cash:

• Transactions: A company must hold enough cash to cover their outstanding payments or transactions.
• Precautionary measures: A company needs to maintain cash for unexpected disbursements.
• Speculative measures: If a company is anticipating making an investment, it will hold a speculative amount to take advantage of opportunities in the marketplace.
• Financial measures: In order to acquire assets, retire debt, or meet some major event, a company must accumulate and hold a certain amount of cash.

The Cash Flow Forecast

One of the best ways to determine the optimal cash balance is to fully understand cash flow patterns. This requires that we plot cash flows and prepare a forecast. What a cash flow forecast does is estimate cash inputs and outputs over a period of time, usually at least 90 days, in order to give you assurance that your business will have the cash necessary to meet its obligations to others. Think of the cash flow forecast as an "early warning system. " A cash flow forecast also answers several questions, such as how long can we invest idle cash, when will it be necessary to borrow cash, and when can we purchase new capital assets? A typical cash flow forecast will include: cash on hand, expected receipts, and expected disbursements.

Direct and Indirect Methods

The direct method of cash flow forecasting schedules the company's cash receipts and disbursements (R&D). This direct R&D method is best suited to the short-term forecasting horizon of 30 days or so because this is the period for which actual, as opposed to projected, data is available. Three indirect methods are based on the company's projected income statements and balance sheets.

1. The adjusted net income method starts with operating income and adds or subtracts changes in balance sheet accounts, such as receivables, payables, and inventories to project cash flow.
2. The pro-forma balance sheet method looks straight at the projected book cash account; if all the other balance sheet accounts have been correctly forecast, cash will be correct, too.
3. The accrual reversal method is similar to the adjusted net income method, but instead of using projected balance sheet accounts, large accruals are reversed and cash effects are calculated based upon statistical distributions and algorithms. This allows the forecasting period to be weekly or even daily.

The adjusted net income and pro-forma balance sheet methods are best suited for medium-term and long-term forecasting horizons. Both need to be adjusted for the difference between book cash and bank balances, which are often significantly different. The accrual reversal method is more complicated and best suited for medium-term forecasting. Consider the following points when preparing forecasts

• Prepare forecasts for shorter periods of time (weekly or daily) if cash flows are tight.
• Use available data as much as possible.
• If necessary, prepare two forecasts: an early warning forecast for longer periods of time and a targeted forecast for shorter periods.
• Forecasting is extremely difficult in periods of rapid growth.