Building a Cash Budget
This section emphasizes the importance of cash and good cash management to a business. You will learn how to analyze cash inflows and outflows to better forecast a firm's cash budget. When you have completed this section, you will be able to describe the direct and indirect methods of cash flow forecasting. Cash flow is often used as a determinant providing financing to firms. A cash budget is used along with pro forma financial statements to assess the result of financial transactions.
Forecasting cash receipts requires an intimate knowledge of the internal and external sources of this revenue.
Describe how a company can use its cash receipts to receive short-term financing
- Cash receipts come from internal sources, such as cash from sales and accounts receivable, and external sources, such as bank loans or accounts receivable financing.
- 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 for a company should be to decrease the receipt cycle.
A legal claim; a charge upon real or personal property for the satisfaction of some debt or duty.
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
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.
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:
- Receivables are related to the sale of merchandise and not services.
- Receivable customers are financially sound and there is a high probability of payment.
- Receivable customers obtain title to merchandise when it is shipped.
- 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.
Similar to receivables financing, inventory financing has the following requirements:
- Inventory must be highly marketable.
- Inventory is non-perishable and not subject to obsolescence.
- 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.
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.
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.
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