CHAPTER TWO

1. FINANCIAL ANALYSIS AND PLANNING

1.1 Financial Analysis

Financial statements are summaries of the operating, financing, and investment activities of a
business that provide information useful to both investors and creditors in making credit,
investment, and other business decisions.

Financial analysis is the selection, evaluation and interpretation of financial data, along with
other pertinent information. Analysis of financial statement refers to the art of applying various
tools to know the behavior of the accounting information. It is defined by Metcalf as the
“Process of evaluating the relationship between component parts of a financial statement to
obtain a better understanding of a firm's position and performance.” According to Kennedy and
Muller, “Analysis and interpretation of financial statements are an attempt to determine the
significance and meaning of the financial statements data so the forecast may be made of the
prospects for future earnings, ability to pay interest and debt maturities and profitability of a
sound dividend policy.” Interpretation of financial statements refers to evaluating the
performance of the business. According to F. Wood, “To interpret means to put the meaning of a
statement in simple terms for the benefit of a person.”

The need for financial Analysis:

A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information and
understand the financial aspects of the firm. The type of financial analysis varies according to the
specific interests of the party involved. Trade creditors are interested primarily in the liquidity of
a firm. The claims of bond holders interested in the cash-flow ability of the company to service
debt over the long-run. Investors in a company's common stock might concentrate their analysis
on a company's profitability. Financial analysis assists in investment and financial decision
making. Financial analysis may be used internally to evaluate issues such as employee
performance, the efficiency of operations, and credit policies and externally to evaluate potential
investments and the credit-worthiness of borrowers, among other things. Management employs

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financial analysis for purposes of internal control. In particular, it is concerned with profitability
on investment in the various assets of the company and in the efficiency of asset management.

We can use financial analysis to try to tell us whether the business is profitable, has enough
money to pay its bills, could be paying its employees higher wages, is paying its share of tax, is
using its assets efficiently, has a gearing problem, is a candidate for being bought by another
company or investor.

Source of financial data:

The analyst draws the financial data needed in financial analysis from many sources. The
primary source is the data provided by the firm itself in its annual report and required
disclosures. The annual report comprises the income statement, the balance sheet, owner's equity
statement and the statement of cash flows, as well as footnotes to these statements. Government
agencies, bulletins, research centers and others might provide financial data of a firm.

1.2 Approaches to Financial Analysis and Interpretation

Financial analysis may be used internally to evaluate issues such as employee performance, the
efficiency of operations, and credit policies and externally to evaluate potential investments and
the credit-worthiness of borrowers, among other things.
The following are the common methods or tools/techniques widely used by the business concern.
 Trend /Time-Serious Analysis/Horizontal analysis: Trend analysis is the evaluation of the
firm’s financial performance over time to help determine or predict the improvement or
deterioration in its financial situation. Trend analysis helps to understand the trend
relationship with various items. Percentages may also be taken as index number showing
relative changes in the financial information resulting with the various period of time.
 Common Size Analysis/Vertical analysis: It provides comparative statements that give only
the percentages for financial data. Figures reported are converted into percentage to some
common base.
 Ratio Analysis: Ratio is a mathematical relationship between one numbers to another. Ratio
is used as an index for evaluating the financial performance of the business concern. An
accounting ratio shows the mathematical relationship between two figures, which have
meaningful relation with each other.

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2.2.1 Ratio Analysis

Ratio analysis might be trend/time serious analysis or Cross-sectional analysis. In trend analysis,
we can evaluate firm’s performance over time. In cross-sectional analysis different firms’
performance is compared at the same time. There are as many different financial ratios as there
are possible combinations of items appearing on the income statement, balance sheet, and
statement of cash flows. In general financial ratios can be grouped into 5: Liquidity ratio, Activity
ratios, Leverage ratio, Profitability ratio, and Market value ratio.

A. Liquidity Ratios

Liquidity reflects a firm's ability to meet its short-term financial obligations on time using assets
that are most readily converted into cash. Current assets are used to satisfy short-term
obligations, or current liabilities. The amount by which current assets exceed current liabilities is
referred to as the net working capital. The two liquidity ratios, current ratio and acid test ratio are
the most important ratios.

1. Current Ratio: Current ratio is an indicator of short-term debt-paying ability. It is

determined by dividing current assets by current liabilities; the higher the ratio, the more
liquid the company.

Current Ratio = Current Assets/Current Liabilities

Example: Here is the information for Carphone Warehouse to help us work out its current ratio.

Consolidated Balance Sheet 31-Mar-2001 25-Mar-2000

Total Current Assets £315,528,000 £171,160,000
Creditors: Amounts falling due within one year £222,348,000 £173,820,000
(current liabilities)

The current ratio is calculated as:

Current Ratio = Current Assets/Current Liabilities = £315,528,000/£222,348,000 = 1.42:1

Interpretation: for every 1 pound of current liabilities there is 1.42 pound of current assets.

Creditors like to see a high current ratio. If a company is getting into financial difficulty, it will
begin paying its bills (accounts payable) more slowly, borrowing from its bank, and so on, so its
current liabilities will be increasing. In the perspective of shareholders, high current ratio could

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mean that the company has a lot of money tied up in nonproductive assets, such as excess cash or
marketable securities or due to large inventory holdings. Thus, shareholders might not want a
high current ratio.

2. Acid Test Ratio/Liquid or the Quick ratio: It is a stricter indication of a company's

financial strength (or weakness). A liquid asset is one that trades in an active market and
hence can be converted quickly to cash at the going market price. Inventories are typically
the least liquid of a firm’s current assets. Inventories are sometimes might be difficult to sell
or use. Therefore, a measure of the firm’s ability to pay off short-term obligations without
relying on the sale of inventories is important. It is calculated as follows:

Acid Test Ratio = (Current Assets – inventories)/Current Liabilities

If acid-test ratio is 0.69 for the year 2000 and 1.18 for the year 2001, the acid-test ratio has
increased from 2000 to 2001. This implies that the firm has stronger liquidity position that it had
before.

The ideal current ratio being 2:1 and the ideal acid test ratio being 1:1

B. Asset Management Ratios or Usage/Activity Ratio

Asset management ratios measure how effectively a firm is managing its assets. If a company
has excessive investments in assets, then its operating capital will be unduly high which will
reduce its free cash flow and ultimately its stock price. On the other hand, if a company does not
have enough assets then it will lose sales, which will hurt profitability, free cash flow, and the
stock price.

Activity ratios measure the speed with which various accounts are converted into sales or cash
—inflows or outflows. It is important to look beyond measures of overall liquidity and to assess
the activity (liquidity) of specific current accounts.

1. Inventory Turnover: commonly measures the activity, or liquidity, of a firm’s

inventory. It indicates how many times inventory is created and sold during the period.
In principle, the lower the investment in stocks the better. Low turnover is an unhealthy
sign, indicating excess stocks and/or poor sales. The ideal stock turnover ratio is 8 times
a year. It indicates the operational and marketing efficiency of the business.

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 Cost of goods sold
Inventory turnover = Average Inventory
Example: CW has cost of goods sold amounting £830,126,000 and average inventory
[(Beginning inventory + Ending Inventory)/2] £52,437,000 for the year 2001.

Therefore, the inventory turnover is calculated as follows.

£830,126,000
ITO =
£52,437,000 = 15.8 times
Interpretation: This ratio tells us that the firm turns over its inventory 15.8 times per year. On
average, cash is invested in inventory, goods and services are produced, and these goods and
services are sold 15.8 times a year. Inventory turnover can be easily converted into an average
age of inventory by dividing it into 360- assumed number of days in a year. For CW, the
average age of inventory in 2001 is 23 days (360/15.8). This value can also be viewed as average
number of days’ sales in inventory.

2. Accounts Receivable (A/R) Turnover Ratio: a measure of how effectively a firm is using
credit extended to customers. When we do provide credit, we must do so as optimally as
possible. A/R turnover indicates rate at which cash is generated by turnover of receivables
from regular debtors.
Annual Credit Sales
A/R Turnover =
Annual A/R
Example: Gross profit ratio 20% on sales; Total gross profit Br. 100,000; Cash sales Br.
120,000; Average debtors (A/R) Br. 95,000; and calculate debtors (Accounts Receivable (A/R) )
turnover ratio.
Solution: Gross profit on sales = 20%
Gross profit = Br. 100,000
Total sales = 100,000 X 100/20 = 500,000
Credit sales = Total sales – Cash sales = 500,000 – 120,000 = 380,000
A/R Turnover Ratio = 380,000/95,000 = 4 times
Therefore, there are 4 cycles of sales to credit to cash during the year.
The average collection period (ACP) or Days Sales outstanding is useful in evaluating credit
& collection policies. It is arrived at by dividing average daily sales into the accounts receivable
balance: Accounts recievable Br 95,000
ACP =
Average sales per day =
Br 380,000 /360 Days = 90 Days

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On the average, it takes the firm 90 days to collect an account receivable. If a company extends
45-day credit terms to customers, an average collection period of 90 days may indicate a poorly
managed credit or collection department, or both.

3. Total Asset Turnover:It compares the sales with the assets that the business has used to
generate that sale. In its simplest terms, we are just saying that for every Br1 of assets, the
turnover is Br x. Total asset turnover matches the turnover of a business with all of the
assets it has used to generate that turnover - the bigger the value of the ratio the better. The
formula for total asset turnover is:
Total Asset Turnover = Sales
Total Assets

If the total sale during the year is £1,110,678,000 and total assets is a £711,703,000 = 1.56 time

When a firm has low total asset turnover the company is not generating a sufficient volume of
business given its total assets investment. Sales should be increased, some assets should be
disposed of, or a combination of these steps should be taken.

4. Fixed Asset Turnover:The fixed assets turnover ratio measures how effectively the firm
uses its plant and equipment. It is the ratio of sales to net fixed assets:

Fixed Asset Turnover = Sales

Fixed Assets
Example: Carphone Warehouse's total sales for the year 2001 is£1,110,678,000 and fixed
assets are £396,175,000; the total asset turnover is 2.8 times.

C. Debt Management Ratios

The debt position of a firm indicates the amount of other people’s money being used to generate
profits. In general, the financial analyst is most concerned with long-term debts, because these
commit the firm to a stream of payments over the long run. Because creditors’ claims must be
satisfied before the earnings can be distributed to shareholders, present and prospective
shareholders pay close attention to the firm’s ability to repay debts. Lenders are also concerned
about the firm’s indebtedness. Management obviously must be concerned with indebtedness. In
general, the more debt a firm uses in relation to its total assets, the greater its financial leverage.

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Financial leverage is the magnification of risk and return introduced through the use of fixed-
cost financing, such as debt and preferred stock. The more fixed-cost debt a firm uses, the greater
will be its expected risk and return.

1. Debt Ratio: measures the proportion of total assets financed by the firm’s creditors. The
higher this ratio, the greater the amount of other people’s money being used to generate
profits. The ratio is calculated as follows:
Debt ratio = Total liabilities
Total assets
Total debt includes both current liabilities and long-term debt. Creditors prefer low debt.
Stockholders, on the other hand, may want more leverage because it magnifies expected
earnings.
Example: A company with total liabilities of $1,643,000 & total assets of $3,597,000, the debt
ratio is (45.7%).This value indicates that the company has financed close to half of its assets with
debt. The higher this ratio, the greater the firm’s degree of indebtedness & the more financial
leverage it has.
2. Debt-equity ratio: It expresses the relationship between debt & equity. Debt here is taken to
mean long-term and short-term debt and equity means owners or shareholders funds.
Debt-equity ratio = Debt/Equity
3. Gearing ratio: Gearing is concerned with the relationship between the long term liabilities
that a business has and its capital employed. The idea is that this relationship ought to be in
balance, with the shareholders' funds being significantly larger than the long term liabilities.

Gearing = Long Term Liabilities

Equity Shareholders' Funds
Carphone Warehouse 31-Mar-01 25-Mar-00
Creditors: Amounts falling due after more than one year (long term £14,107,000 £21,033,000
liabilities)
Equity shareholders' funds 436,758 44,190
Gearing Ratio for the Carphone Warehouse:
31-Mar-01 14,107: 436,758 0.032: 1
25-Mar-00 21,033: 44,190 0.476: 1

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In the year 2000 when the ratio was relatively high at 0.476 or 47.6% they probably were not too
worried because their other ratios were fine too. In 2001 the gearing ratio fell to almost zero
indicating that the business much prefers equity funding to debt funding.

4. Times Interest Earned Ratio (TIER): measures the firm’s ability to make contractual
interest payments. The higher its value, the better able the firm is to fulfill its interest
obligations.
TIER = Profit before Interest &Tax
Interest Charges

The ideal Debt-Service cover is 6 or 7 times. If the ratio is high it means there is higher margin
of safety for lenders & it is not difficult for the business to obtain further long term funds.
Unable to meet its annual interest costs can bring legal action by firm’s creditors, possibly
resulting in bankruptcy.

5. Fixed-Payment Coverage Ratio: Fixed-payment coverage ratio measures the firm’s ability
to meet all fixed payment obligations, such as loan interest and principal, lease payments,
and preferred stock dividends. The higher this value, the better. The formula for the fixed-
payment coverage ratio is
Earnings before interest and taxes + Lease payments
Fixed payment
Coverage ratio = Interest + Lease payments +{(Principal payments + Preferred stock dividends )x [ 1/(1-T )]}
Where, T is the corporate tax rate applicable to the firm’s income. The term 1/(1-T) is included to
adjust the after-tax principal and preferred stock dividend payments back to a before-tax
equivalent that is consistent with the before-tax values of all other terms.The lower the ratio, the
greater the risk to both lenders and owners; the greater the ratio, the lower the risk.
D. Profitability Ratios
There are many measures of profitability. These measures enable the analyst to evaluate the
firm’s profits with respect to a given level of sales, a certain level of assets, or the owners’
investment. Owners, creditors, and management pay close attention to boosting profits because
of the great importance placed on earnings in the market place. Each item on income statement is
expressed as a percentage of sales in common-size income statement analysis. Common-size
income statements are especially useful in comparing performance across years. Three frequently
cited ratios of profitability that can be read directly from the common-size income statement are
(1) the gross profit margin, (2) the operating profit margin, and (3) the net profit margin.

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6. Gross Profit Ratio: The gross profit margin measures the percentage of each sales dollar
remaining after the firm has paid for its goods. The higher the gross profit margin the better,
the lower the relative cost of merchandise sold. The gross profit margin is calculated as
follows:
Gross Profit Ratio =Gross Profit X 100 Gross Profit = Sales - Cost of Sales
Sales
A profit margin tells us how much profit, on average, our business has earned per Birr 1 of
turnover. Gross profit is the profit we earn before we take off any administration costs, selling
costs and so on. A low gross profit may indicate unfavorable purchasing, the instability of
management to develop sales volume thereby making it impossible to buy goods in large
volume, excessive competition etc. An increase in the gross profit ratio may reflect an increase in
sales price of goods sold without any corresponding increase in costs; a decrease in cost without
its impact on sales price of goods, opening stock valued at a figure lower than it should have
been, etc. Normally 25% to 30% margin is anticipated.

7. Net profit ratio: It expresses the relationship between net profit after taxes to sales. The
following formula is used:
Net Profit Ratio = Net Profit after Tax X 100
Net Sales
It measures over-all profitability and is very useful to proprietors.

8. Operating profit ratio: This ratio establishes the relationship between operating profit & net
sales and is calculated as follows:

Operating Profit Ratio = Operating Profit X 100

Net Sales
This ratio indicates the portion remaining out of every birr worth of sales after all operating costs
and expenses have been met.

9. Earnings per Share (EPS): The firm’s earnings per share (EPS) is generally of interest to
present or prospective stockholders and management. As we noted earlier, EPS represents the
number of dollars earned during the period on behalf of each outstanding share of common
stock. It measure average amount of profits earned per ordinarxy share issued. Earnings-per
share is calculated as follows:

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EPS = Profit available to common equity shareholders
Average number of issued common equity shares
The Carphone Warehouse 31-Mar-01 25-Mar-00
Consolidated Profit & Loss Account
Profit for the financial period (£) 38,159,000 16,327,000
Weighted average no of issued shares 833,000,000 600,000,000
31-Mar-01 25-Mar-00
EPS 38,159,000 £0.04648 16,327,000 £0.02721
600,000,000
833,000,000

The good news for investors here is that the average earnings per issued ordinary share has
almost doubled over the two years. Number of shares issued has increased from 600 million to
833 million, so this really is a good result as profits available for shareholders must have
increased significantly too from £16,327,000 to £38,159,000.

10. Return on Total Assets (ROA): often called the return on investment (ROI), measures the
overall effectiveness of management in generating profits with its available assets. The
higher the firm’s return on total assets the better. The return on total assets is calculated as
follows:

The ratio of net income to total assets measures the return on total assets (ROA) after interest and
taxes:
Return on Total Assets (ROA) = Earnings available for common stockholdersx 100
Total Assets
For example, a company has $221,000 earnings available for common stockholders and
total assets of $3,597,000 the ROA of the company is 6.1%. This value indicates that the firm
earned 6.1 cents on each dollar of asset investment.

11. Return on Capital Employed Ratio (ROCE): The Return on Capital Employed ratio
(ROE) tells us how much profit we earn from the investments the shareholders have made in
their company. Assume the profit for the year and its capital employed had been £25 and
£500 respectively then the ROE for that company would be 5% too.
ROCE = Profit for the Year x 100% = 25 x 100 = 5%
Equity Shareholders' Funds 500

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 E. Market Ratio

Market ratios relate the firm’s market value, as measured by its current share price, to certain
accounting values. These ratios give insight into how well investors in the marketplace feel the
firm are doing in terms of risk and return. They tend to reflect, on a relative basis, the common
stockholders’ assessment of all aspects of the firm’s past and expected future performance.

12. Price/Earning (P/E) Ratio:commonly used to assess the owners’ appraisal of share value.The
P/E ratio measures the amount that investors are willing to pay for each dollar of a firm’s
earnings. The level of the price/earnings ratio indicates the degree of confidence that investors
have in the firm’s future performance. The higher the P/E ratio, the greater is investor
confidence.

P/E Ratio = Market price per share / Earnings per Share

Example: If Bartlett Company’s common stock at the end of 2003 was selling at $32.25, using
the EPS of $2.90, the P/E ratio at year-end 2003 is
$32.25 ÷ $2.90 = 11.1

This figure indicates that investors were paying $11.10 for each $1.00 of earnings. The P/E ratio
is most informative when applied in cross-sectional analysis using an industry average P/E ratio
or the P/E ratio of a benchmark firm.

13. Market/Book (M/B) Ratio:This ratio provides an assessment of how investors view the
firm’s performance. It relates the market value of the firm’s shares to their book - strict
accounting - value. To calculate the firm’s M/B ratio, we first need to find book value per
share:
Book value per share = Common stock equity
No of shares outstanding
Example: Book value per share of common stock = $1,754,000/76,262 = $23.00
M/B ratio = Market price per share
Book value per share
Example: Bartlett Company’s end of 2003 common stock price of $32.25 and its $23.00 book
value per share of common stock, the M/B ratio is:
Market/book (M/B) ratio = $32.25/$23.00 = 1.40

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This M/B ratio means that investors are currently paying $1.40 for each $1.00 of book value of
Bartlett Company’s stock. The stocks of firms that are expected to perform well—improve
profits, increase their market share, or launch successful products—typically sell at higher M/B
ratios than the stocks of firms with less attractive outlooks. Bartlett’s future prospects are being
viewed favorably by investors, who are willing to pay more than its book value for the firm’s
shares.

2.2.2 The DuPont System of Analysis

The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its
financial condition. It merges the income statement and balance sheet into two summary
measures of profitability: return on total assets (ROA) and return on common equity (ROE). The
DuPont system first brings together the net profit margin, which measures the firm’s profitability
on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets
to generate sales. In the DuPont formula, the product of these two ratios results in the return on
total assets (ROA):

The DuPont Equation

ROA = Net Profit Margin on Sales x Total Assets Turnover
ROA = Net Income/Sales x Sales/Total Assets

Extended DuPont Equation

ROE = Net Profit Margin x Total Assets Turnover x Equity Multiplier
ROE = NI/Sales x Sales/Total Assets x Total Assets/Common Equity

Note:- Total Debt Ratio = Total Debt/Total Assets = [1 - (1 / Equity Multiplier)]

- Equity Multiplier = 1 / [1 - (Total Debt/Total Assets)]

Use of the financial leverage multiplier (FLM) to convert the ROA into the ROE reflects the
impact of financial leverage on owners’ return. Substituting the values for Bartlett Company’s
ROA of 6.1% and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock
equity) into the modified DuPont formula yields:

ROE = 6.1% x 2.06 = 12.6%

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The 12.6 percent ROE calculated by using the modified DuPont formula is the same as that
calculated directly. The advantage of the DuPont system is that it allows the firm to break its
return on equity into a profit-on-sales component (net profit margin), an efficiency-of asset- use
component (total asset turnover), and a use-of-financial-leverage component (financial leverage
multiplier). The total return to owners therefore can be analyzed in these important dimensions.

Return on Equity 12.7%

Return on Assets Assets/Equity = $2,000/$896

5.7% X = 2.23

Profit Margin:
Earnings as a Total Assets
Percent of Sales Turnover 1.5
3.8% X

Sales Net Sales Total

$3,000 $3,000
Income Assets
Divided Divided
into
$113.5 by
$2,000

Total
Costs Sale Fixed Curre
Assets nt
$2,886.
5 s $1,00 Assets
$3, 0 $1,00
Plus 0
Minus
from 000

2.2.3 Limitations of Ratio Analysis

• Difficult to develop a meaningful set of industry average ratios for comparative purposes.

• Striving for “average” performance is not a target for most firms.

• Inflation can distort firms’ balance sheets.

• Seasonal factors can distort a ratio analysis.

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 2.3 Financial Planning

Financial planning is an important aspect of the firm’s operations because it provides road maps
for guiding, coordinating, and controlling the firm’s actions to achieve its objectives.The
financial planning process begins with long-term, or strategic, financial plans. These in turn
guide the formulation of short-term, or operating, plans and budgets. Generally, the short-term
plans and budgets implement the firm’s long-term strategic objectives.

Long-Term (Strategic) Financial Plans:lay out a company’s planned financial actions and the
anticipated impact of those actions over periods ranging from 2 to 10 years. Five-year strategic
plans, which are revised as significant new information becomes available, are common.
Generally, firms that are subject to high degrees of operating uncertainty, relatively short
production cycles, or both, tend to use shorter planning horizons.

Long-term financial plans are part of an integrated strategy that, along with production and
marketing plans, guides the firm toward strategic goals. Those long-term plans consider
proposed outlays for fixed assets, research and development activities, marketing and product
development actions, capital structure, and major sources of financing. Also included would be
termination of existing projects, product lines, or lines of business; repayment or retirement of
outstanding debts; and any planned acquisitions. Such plans tend to be supported by a series of
annual budgets and profit plans.

Short-term (operating) financial plans:specify short-term financial actions and the anticipated
impact of those actions. These plans most often cover a 1- to 2-year period. Key inputs include
the sales forecast and various forms of operating and financial data. Key outputs include a
number of operating budgets, the cash budget, and pro forma financial statements. Short-term
financial planning begins with the sales forecast. From it, production plans are developed that
take into account lead (preparation) times and include estimates of the required raw materials.
Using the production plans, the firm can estimate direct labor requirements, factory overhead
outlays, and operating expenses. Once these estimates have been made, the firm’s pro forma
income statement and cash budget can be prepared. With the basic inputs (pro forma income
statement, cash budget, fixed asset outlay plan, long-term financingplan, and current-period
balance sheet), the pro forma balance sheet can finally be developed.

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The short-term (operating) financial planning process

Cash Planning: Cash Budgets

The cash budget, or cash forecast, is a statement of the firm’s planned inflows and outflows of
cash. It is used by the firm to estimate its short-term cash requirements, with particular attention
to planning for surplus cash and for cash shortages. Typically, the cash budget is designed to
cover a 1-year period, divided into smaller time intervals. The more seasonal and uncertain a
firm’s cash flows, the greater the number of intervals.

The Sales Forecast: The key input to the short-term financial planning process is the firm’s
sales forecast. On the basis of the sales forecast, the financial manager estimates the monthly
cash flows that will result from projected sales receipts and from outlays related to production,
inventory, and sales. The manager also determines the level of fixed assets required and the
amount of financing, if any, needed to support the forecast level of sales and production. The
sales forecast may be based on an external forecast which is based on the relationships observed
between the firm’s sales and certain key external economic indicators (GDP, new housing starts,

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consumer confidence, and disposable personal income). Additionally, internal forecasts are
made based on a buildup, or consensus, of sales forecasts through the firm’s own sales channels.

The General Format of the Cash Budget:

Preparing the Cash Budget

Cash receipts:include all of a firm’s inflows of cash in a given financial period. The most
common components of cash receipts are cash sales, collections of accounts receivable, and
other cash receipts.

Example: 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, respectively. Historically, 20% of the firm’s sales have been
for cash, 50% have generated accounts receivable collected after 1 month, and the remaining
30% have generated accounts receivable collected after 2 months. Bad-debt expenses
(uncollectible accounts) have been negligible. In December, the firm will receive a $30,000
dividend from stock in a subsidiary. The schedule of expected cash receipts for the company
contains the following items:
 Forecast sales:It is provided as an aid in calculating other sales-related items.
 Cash sales:shown for each month represent 20% of the total sales forecast for that month.
 Collections of A/R:collection of accounts receivable resulting from sales in earlier months.
o Lagged 1 month:These figures represent sales made in the preceding month that
generated accounts receivable collected in the current month.

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 o Lagged 2 months:These figures represent sales made 2 months earlier that generated
accounts receivable collected in the current month.
 Other cash receipts:Interest received, dividends received, proceeds from the sale of
equipment, stock and bond sale proceeds, and lease receipts may show up here.
 Total cash receipts:represents the total of all the cash receipts listed for each month.

Cash disbursements:include all outlays of cash by the firm during a given financial period. The
most common cash disbursements are: cash purchases, fixed-asset outlays, payments of accounts
payable, interest payments, rent (and lease) payments, cash dividend payments, wages and
salaries, principal payments (loans), tax payments, repurchases or retirements of stock. It is
important to recognize that depreciation and other noncash charges are NOT included in the
cash budget, because they merely represent a scheduled write-off of an earlier cash outflow. The
impact of depreciation is reflected in the reduced cash outflow for tax payments.

Example: Coulson Industries has gathered the following data needed for the preparation of a cash
disbursements schedule for October, November, and December.
 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 salary cost for the year is $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.

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  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.
 Repurchases or retirements of stock:No repurchase or retirement of stock is expected
between October and December.
 Purchases:The figures represent 70% of the forecast sales for each month. They have been
included to facilitate calculation of the cash purchases and related payments.
 Cash purchases:The cash purchases for each month represent 10% of the month’s
purchases.
 Payments of A/P:These entries represent the payment of accounts payable (A/P) resulting
from purchases in earlier months.
o Lagged 1 month:purchases made in the preceding month that are paid for in the current
month. Because 70% of the firm’s purchases are paid for 1 month later, the payments
with a 1-month lag shown for September represent 70% of the August purchases,
payments for October represent 70% of September purchases, and so on.
o Lagged 2 months:purchases made 2 months earlier that are paid for in the current
month. Because 20% of the firm’s purchases are paid for 2 months later, the payments
with a 2-month lag for October represent 20% of the August purchases, and so on.
 Wages and salaries:These amounts were obtained by adding $8,000 to 10% of the sales in
each month. The $8,000 represents the salary component; the rest represents wages. The
remaining items on the cash disbursements schedule are self-explanatory.

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Net Cash Flow, Ending Cash, Financing, and Excess Cash: The firm’s net cash flow is found
by subtracting the cash disbursements from cash receipts in each period. Then we add beginning
cash to the firm’s net cash flow to determine the ending cash for each period. Finally, we
subtract the desired minimum cash balance from ending cash to find the required total
financing or the excess cash balance. If the ending cash is less than the minimum cash balance,
financing is required, which is viewed as short-term and represented by notes payable. If the
ending cash is greater than the minimum cash balance, excess cash exists. Any excess cash is
assumed to be invested in a liquid, short-term, interest-paying vehicle - that is, in marketable
securities.

Example: At the end of September, Coulson’s cash balance was $50,000, and its notes payable
and marketable securities equaled $0.7 The Company wishes to maintain, as a reserve for
unexpected needs, a minimum cash balance of $25,000.

For Coulson Industries to maintain its required $25,000 ending cash balance, it will need total
borrowing of $76,000 in November and $41,000 in December. In October the firm will have an
excess cash balance of $22,000, which can be held in an interest-earning marketable security.
The required total financing figures in the cash budget refer to how much will be owed at the end
of the month. The monthly changes in borrowing and in excess cash can be found by further
analyzing the cash budget. In October the $50,000 beginning cash, which becomes $47,000 after
the $3,000 net cash outflow, results in a $22,000 excess cash balance once the $25,000 minimum
cash is deducted. In November the $76,000 of required total financing resulted from the $98,000
net cash outflow less the $22,000 of excess cash from October. The $41,000 of required total
financing in December resulted from reducing November’s $76,000 of required total financing
by the $35,000 of net cash inflow during December.

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