CHAPTER 15

Managing Current Assets

◼ Alternative working capital policies

◼ Cash management
◼ Inventory management
◼ Accounts receivable management
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 Cash budget:
The primary cash management tool
◼ Cash budget shows the firm’s projected cash
inflows and outflows over some specified period.
◼ Purpose: Forecasts cash inflows, outflows, and
ending cash balances. Used to plan loans
needed or funds available to invest.
◼ Timing: Daily, weekly, or monthly, depending
upon purpose of forecast. Monthly for annual
planning, daily for actual cash management.

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 Cash Budget
Cash budget has two sections :
1) Cash collection:
The cash collection is affected by
a) The amount of sales
b) The collection experience of the company
2) Cash payments:
◼ It includes all payments for material, wages, salaries,

interest expenses, taxes, and purchase of new fixed

assets.

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The Key format of Cash Planning
Example: Cash Budget
Coulson Industries, a defense contractor, is developing a cash budget for
October, November, and December.
Coulson’s sales in August and September were $100,000 and $200,000
respectively.
Sales of $400,000, $300,000 and $200,000 have been forecast for October,
November, and December.
Historically, 20% of the firm’s sales have been for cash, 50% have been
collected after 1 month, and the remaining 30% after 2 months. Bad-debt
expenses (uncollectible accounts) have been negligible.
In December, Coulson will receive a $30,000 dividend from stock in a
subsidiary.
Solution

Month Aug. Sep. Oct. Nov. Dec.

Sales 100 200 400 300 200
Collections
Cash Sales (20%) 20 40 80 60 40
Lagged 1 Month (50%) 50 100 200 150
Lagged 2 Month (30%) 30 60 120
Other Receipts
Total Collections
Other Cash Receipts
Other cash receipts:
These are cash receipts expected from sources other than sales.

Examples:
• Interest received,
• dividends received,
• proceeds from the sale of equipment, stock and bond sale proceeds, and lease
receipts may show up here.

In our examples: For Coulson Industries, the only other cash receipt is the
$30,000 dividend due in December.
Solution

Month Aug. Sep. Oct. Nov. Dec.

Sales 100 200 400 300 200
Collections
Cash Sales (20%) 20 40 80 60 40
Lagged 1 Month (50%) 50 100 200 150
Lagged 2 Month (30%) 30 60 120
Other Receipts 30
Total Collections 20 90 210 320 340
Cash Disbursements
• Includes all outlays of cash by the firm during a given financial
period. The most common cash disbursements are (1) Cash purchases,
(2) Fixed-asset outlays, (3) Payments of accounts payable, (4) Interest
payments, (5) Rent (and lease) payments, (6) Cash dividend
payments, (7)Wages and salaries, (8) Principal payments (loans), (9)
Tax payments, (10)Repurchases or retirements of stock
• It is important to recognize that depreciation and other noncash
charges are NOT included in the cash budget.
 Cash Disbursements
Purchases: The firm’s purchases represent 70% of sales. Of this amount, 10% is
paid in cash, 70% is paid in the month immediately following the month of
purchase, and the remaining 20% is paid 2 months following the month of
purchase.
Rent payments: Rent of $5,000 will be paid each month.
Wages and salaries: Fixed salaries for the year are $96,000, or $8,000 per
month. In addition, wages are estimated as 10% of monthly sales.
Tax payments: Taxes of $25,000 must be paid in December.
Fixed-asset outlays: New machinery costing $130,000 will be purchased and
paid for in November.
Interest payments: An interest payment of $10,000 is due in December.
Cash dividend payments: Cash dividends of $20,000 will be paid in October.
Principal payments (loans): A $20,000 principal payment is due in December.
Month Aug. Sep. Oct. Nov. Dec.
Purchases (70% * Sales) 70 140 280 210 140
Payments
Cash Purchases (10%) 7 14 28 21 14
Lagged 1 Month (70%) 49 98 196 147
Lagged 2 Month (20%) 14 28 56
Rent Payments 5 5 5
Wages and Salaries 48 38 28
Tax Payments 25
Fixed Asset Outlays 130
Interest Payments 10
Cash dividends payment 20
Principal Payments 20
Total Cash Disbursements 7 63 213 418 305
Net Cash Flow, Ending Cash, Financing, and Excess Cash

NCF = Cash receipts – Cash disbursements

• Ending Cash flow = Beginning Cash balance + Net cash flow

• Finally, we subtract the desired minimum cash balance from ending cash to
find the required total financing or the excess cash balance.

• Excess (Required) Cash = Ending cash balance – Minimum cash balance

• If negative: financing is required.
• If positive: there is a surplus or excess cash.
Example
▪ The Cash Budget for Coulson Industries can be derived by combining the
receipts budget with the disbursements budget.

▪ At the end of September, Coulson’s cash balance was $50,000, notes payable
was $0, and marketable securities balance was $0.

▪ Coulson also wishes to maintain a minimum cash balance of $25,000.

▪ As a result, it will have excess cash of $22,000 in October, and a deficit of cash
in November and December.
Month Oct. Nov. Dec.
Total Cash Receipts 210 320 340
Total Disbursements 213 418 305
Net Cash Flows (3) (98) 35
Add: Beg. Cash 50 47 (51)
Ending Cash 47 (51) (16)
Less: Minimum Cash 25 25 25
Surplus (Deficit) 22 (76) (41)
Table 4.10 A Cash Budget for Coulson
Industries ($000)
Evaluating the Cash Budget

• Cash budgets indicate the extent to which cash shortages or surpluses

are expected in the months covered by the forecast.

• The excess cash of $22,000 in October should be invested in

marketable securities. The deficits in November and December need
to be financed.
 Cash Collection
Example :Suppose that the monthly sales from January to
April are as follows
Month January February March April
Sales 300 400 500 350

Company can collect 20% of dollar sales during the month in which
the sale is made , on 70% of sales, payment is made during the
month immediately following the month of sales, and on 10% of
sales payment is made in the second month following the month of
sales.
Compute cash collections for each month.

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 Solution
Month Jan. Feb. March April
Sales 300 400 500 350
Collections
20% current month 60 80 100 20
70% after one month 210 280 350
10% after 2 months 30 40
Total Collections 60 290 410 460

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 Cash Payments
◼ The company should compute the total
payments during each month.
◼ Then, it should compute the net cash flow
which is the difference between cash
receipts (collections) minus total payments
of each month.
◼ NCF = Collections – Total Payments

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SKI’s cash budget:
For January and February
Net Cash Inflows
Jan Feb
Collections $67,651.95 $62,755.40
Purchases 44,603.75 36,472.65
Wages 6,690.56 5,470.90
Rent 2,500.00 2,500.00
Total payments $53,794.31 $44,443.55
Net CF $13,857.64 $18,311.85
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 Preparing the complete cash
budget

◼ In order to complete the cash budget;

◼ We first determine the cash balance at the start of each
month, assuming no borrowing is done.
◼ Referring to the pervious example, assume that the
company will have $3,000 on hand at the start of
January.
◼ The cumulative cash balance will equal to = NCF+
cash on hand.
◼ Cumulative cash = 3,000 + 13,857.64 = 16,857.64

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◼ The target cash balance (which is in our
example = 1500) is then subtracted
from the cumulative cash flow to
determine the firm’s borrowing
requirement.

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SKI’s cash budget
Net Cash Inflows
Jan Feb
Cash at start if
no borrowing $ 3,000.00 $16,857.64
Net CF 13,857.64 18,311.85
Cumulative cash 16,857.64 35,169.49
Less: target cash 1,500.00 1,500.00
Surplus $15,357.64 $33,669.49

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◼ When a target cash balance is deducted
from cumulative cash, the value may be
negative or positive.
◼ Negative – represents a required loan
◼ Positive – represents surplus cash

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Should depreciation be explicitly
included in the cash budget?
◼ No. Depreciation is a noncash
charge. Only cash payments and
receipts appear on cash budget.
◼ However, depreciation does affect
taxes, which appear in the cash
budget.

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What are some other potential
cash inflows besides collections?
◼ Proceeds from the sale of fixed
assets.
◼ Proceeds from stock and bond
sales.
◼ Interest earned.
◼ Court settlements.

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How could bad debts be worked
into the cash budget?
◼ Collections would be reduced by the
amount of the bad debt losses.
◼ For example, if the firm had 3% bad
debt losses, collections would total
only 97% of sales.
◼ Lower collections would lead to
higher borrowing requirements.

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 Comprehensive Example
XYZ company’s sales are made on cash basis only. Purchases must be paid
during the following month. The company pays a salary $4,800 per month, and
the rent is $2,000 per month . In addition, it makes tax payment of $12,000 in
December. The current cash on hand (on December 1) is $400, but it has agreed
to maintain an average bank balance of $6000- this is the target cash balance. The
estimated sales and purchases for December, January, and February are shown
below. Purchases during November amounted to $140,000.
Month December Jan. Feb.
Sales 160,000 40,000 60,000
Purchases 40,000 40,000 40,000

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 Solution
Month Dec. Jan. Feb
Sales 160,000 40,000 60,000
Collections 160,000 40,000 60,000
Payments
Purchases 40,000 40,000
Salary 4,800 4,800 4,800
Rent 2,000 2000 2000
Tax Payment 12,000
Total Payments 18,800 46,800 46,800
NCF 141,200 -6,800 13,200

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 Solution
Month Dec. Jan. Feb
Cash at the start 400 141,600 134,800
NCF 141,200 -6,800 13,200
Cumulative CF 141,600 134,800 148,000
Less: Target Cash 6,000 6,000 6,000
Surplus (Deficit) 135,600 128,800 142,000

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Types of inventory costs
◼ Carrying costs – storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
◼ Ordering costs – cost of placing orders,
shipping, and handling costs.
◼ Costs of running short – loss of sales or
customer goodwill, and the disruption of
production schedules.
Reducing the average amount of inventory
generally reduces carrying costs, increases
ordering costs, and may increase the costs of
running short. 15-31
 Effect of improving Inventory
turnover
◼ improvements in inventory management can free up
considerable amounts of cash.
Example:
▪ Suppose a company has sales of $120 million and an
inventory turnover ratio of 3. Then,
Inventory = Sales / Inventory Turnover
Inv. = 120 / 3 = 40 million
◼ If the company can improve its inventory turnover
ratio to 4, then its inventory will fall to
Inventory = 120/4 = 30 million
this 10 million reduction will free cash flow by 10
million 15-32
Is SKI holding too much
inventory?
◼ SKI’s inventory turnover (4.82) is
considerably lower than the industry
average (7.00). The firm is carrying a lot of
inventory per dollar of sales.
◼ By holding excessive inventory, the firm is
increasing its costs, which reduces its ROE.

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 Receivables Management

◼ Receivables management begins with the firm’s

credit policy, but a monitoring system is also
important to keep tabs on whether the terms of
credit are being observed.

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 Elements of credit policy
1. Credit Period – How long to pay? Shorter period
reduces DSO and average A/R, but it may discourage
sales. (Example: net 30)
2. Cash Discounts – Lowers price. Attracts new customers
and reduces DSO. (2/10, net 30)
3. Credit Standards –How much financial strength must a
customer show to qualify for credit? Tighter standards
tend to reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
4. Collection Policy – How tough the company in collecting
its sales? Tougher policy will reduce DSO but may
damage customer relationships.

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Do SKI’s customers pay more or less
promptly than those of its competitors?

◼ SKI’s DSO (45.6 days) is well above the

industry average (32 days).
◼ SKI’s customers are paying less
promptly.
◼ SKI should consider tightening its credit
policy in order to reduce its DSO.

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Does SKI face any risk if it
tightens its credit policy?
◼ Yes, a tighter credit policy may
discourage sales. Some customers
may choose to go elsewhere if they
are pressured to pay their bills sooner.

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If SKI succeeds in reducing DSO without
adversely affecting sales, what effect
would this have on its cash position?

◼ Short run: If customers pay sooner,

this increases cash holdings.
◼ Long run: Over time, the company
would hopefully invest the cash in
more productive assets, or pay it out
to shareholders. Both of these actions
would increase EVA.

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