Financial Forecasting and the Monthly Cash Budget

The two previously-discussed forecasting methods target the financial planning needs necessary to expand and increase sales. The monthly cash budget is much more short-sighted and for that reason just as important in terms of planning for financial resources. Many companies may appear healthy going-concerns.  However if their monthly cash budgets do not produce a current string of cash surpluses, insolvency can quickly result. This possibility is less likely for larger, established firms that have large stores of idle cash or have quick access to short-term financial capital (e.g., short-term bank loans, issuance of commercial paper, etc.). However smaller companies usually do not have this access. Sudden and unexpected cash deficits can be particularly devastating for small growing businesses that have huge cash needs. Many  so-called early-stage companies grow by relying on pre-planned cash injections by venture capitalists. Getting from one cash injection to the next can be problematic when the company is not producing systematic flows of cash. These smaller up-starts are particularly vulnerable to cash crunches, an outcome that can quickly result in insolvency and bankruptcy.

The cash budget: The cash budget is defined as a financial statement showing the firm's planned cash inflows and cash outflows per time period and the resulting per period cash surplus or deficit. 

A cash budget follows the matching principle as described in Part 4 —cash inflows are matched with cash outflows per period of time. The cash budget gets to the nitty-gritty of cash management damage control since it is concerned with highlighting any pending cash deficits with enough lead time so that management can deal with the projected imbalance(s). Without a cash budget management has no lead time and the company can crash and burn.

 

Some particulars about the cash budget: To be useful for management's short-term financial planning task, the cash budget is critical. The more seasonal and uncertain a firm's sales-generated cash inflows and outflows, the greater the number of forecasted intervals needed per year.  Because many firms experience a seasonal sales pattern, the typical cash budget is usually most useful when presented on a monthly basis. Cash budgets with intervals longer than one or two months are probably useless in terms of proper cash management.

A forecast: Understand that the cash budget is a forecast.  Planning for adequate cash is synonymous with planning for adequate short-term solvency. While an after-the-fact analysis of a cash budget might be useful in analyzing what went right or what went wrong, it has its greatest use as a prediction device showing projected cash inflows and cash outflows. 

Cash, not accrual based: The cash budget is not accrual-based; it is compiled using the cash basis method discussed in the 'Probability' module. However the cash budget is not quite synonymous with the statement of cash flows as described in Part 4 of the 'Money Flow' module . 

The chief distinctions are that the cash budget:

1. is typically based upon monthly, not annual data

2. it does not distinguish between operating, investing, and financing cash flows

3. it does not "adjust" the accrual-based net income amount for non-cash items or for accounts that do not appear on the income statement. The only requirement for a business activity to be part of a cash budget is whether or not it will produce or use cash during a given time period.   

 

What accounts might appear in a forecasted cash budget? 

The forecasted cash budget can be general or extremely detailed. Management must decide based upon experience. Clearly a more detailed listing of projected inflows and outflows is required if the short-term operating environment is uncertain.  If the firm is operating in a stable environment where historical analysis shows cash inflows and outflows are reasonably predictable, a more general and less specific format can be used.

 

The monthly sales forecast: Since many items are related to the level of sales a key input in cash budget forecasts will be the monthly sales forecast.  As previously discussed, a yearly sales forecast can come from historical data and/or internal and external sources. For cash budgeting purposes it is critical to accurately break up the yearly forecast into monthly intervals. This task may best be handled by the marketing department and/or those employees actually dealing with customers in the field. They can often see trends before  higher levels of management. They will also be aware of any systematic seasonal trends in sales. 

 

Cash inflow forecasts: From sales forecasts management must distill projected cash inflows and the timing of these inflows. To a large extent cash receipts from sales will depend upon the firm's collection policies and the paying practices of its customers.  Some percent of sales may be collected in cash in the month of the sales event and some percent from sales in the previous months. That is the dollar amount of accounts receivable will be a function of both the percentage collection percentage and time.

Other monthly cash receipts must be identified. For example, the firm may own marketable securities and receive interest income. It may have an equity stake in subsidiaries and receive dividend income. It may own bonds and receive interest income. The firm may receive monthly rental income. These and other cash receipts need to be forecasted both in terms of the amount and month of receipt. Collectively they will be added to give total expected cash inflow for the month. 

 

Cash disbursement forecasts: There can be many forms of monthly cash disbursements. Perhaps the most important one for cash planning purposes will be related to accounts payable. From Part 3 we learned that an accounts payable constitutes a source of funds in that the firm is temporarily paying for its purchases via an (implicit) short-term loan from its vendors. Like accounts receivable, a portion of purchases may be paid in cash in the month of purchase with remaining percentages paid in  lagged sequence.  

 In determining cash disbursements it is probably best for management to separate variable from fixed monthly expenses. A variable expense is a direct function of sales (e.g., cost of goods sold or sales commissions). A fixed expense is independent of sales. Given its constant recurring nature, fixed expenses are usually easier to forecast than variable expenses.

 Other cash disbursements might include interest payments on the firm's debt, the planned repayment of outstanding debt, pending tax and dividend payments, or the planned repurchase of stock. Any pending exercise of stock options should be worked into the monthly budget since the firm will be required to pay cash for any exercised stock options.  Many other types of cash disbursements can be considered and would be dependent upon the nature of the business.   

 Collectively these amounts will be added to give total expected cash outflows for the month. Adding algebraically total expected inflows and outflows will produce a net monthly positive or negative dollar amount. Positive amounts represent cash surpluses and negative amounts cash deficits. 

 

The minimum desired cash balance: An important type of "outflow" is the firm's desired monthly minimum cash balance. The size of this balance is discretionary and is a function of the uncertainty surrounding cash inflows and outflows and the availability of ready short-term credit.  It's sort of like an insurance premium to insure against the firm running out of cash unexpectedly.  Firms that have unstable sales or have a penchant for random large cash outflows and the inability to quickly borrow on a short-term basis will tend to choose larger minimum cash balances than firms with stable sales and a ready access to credit. As described in our discussion of the statement of cash flows in Part 3 regarding the balance sheet account "cash,"  the minimum cash balance account is a residual amount intended to receive cash surpluses and cover cash shortfalls. Before-the-fact the minimum cash floor is expected to cover any shortfalls.  If this floor, ex post, turns out to be insufficient for any shortfalls management should have in place a means for quick, short-term borrowing at reasonable interest rates. In practice management would hope that the floor is never reached.  If it is routinely exceeded then it needs to be increased or better coordination of operating inflows and outflows needs to be achieved. This coordination is the essence of good cash planning.

 

The cumulative cash balance: The final component of a cash budget is the "running" cumulative cash balance. This dollar amount is just what it says—the aggregate algebraic addition of each month's net cash balance after allowing for the minimum cash balance. This moving window of the forecasted incremental monthly net balances is particularly important in cash planning since it reveals the month when cash shortfall are expected to occur. Management can then plan accordingly. Positive cumulative amounts can be targeted for short-term investments; negative amounts can be "headed off at the pass" via the arrangement of short-term financing (e.g., a bank line of credit or the issuance of commercial paper or a short term bank loan).

 

A problem: XYZ Industries is a small manufacturer of summer wear and summer related products. The company has been in business for five years as a sole proprietorship and later as a partnership. Given XYZ's growth over this period of time they have recently "gone public" with an Initial Public Offering (IPO). Using sales and cost data from the previous five years management is in the process of preparing a cash budget. At this time management feels that a six-month monthly cash budget is appropriate (at the end of its first six months of operations a revised six-month budget will be forthcoming).

The historical record over the past five years of operations shows that sales are seasonal with the winter months showing a decline in sales followed by an upturn during the summer months. The record shows that 20 percent of monthly sales are collected in cash with a remaining 50 percent and 30 percent collected in months t + 1 and t + 2, respectively. The record shows that bad debts are negligible and management has chosen to omit them  from the calculations. The firm also receives monthly interest, dividend, and rental income. A one-time initial start-up cash flow is expected to be made by the firm's major stockholders (the original owners of the business prior to going public) in the first month of incorporation.

XYZ cash purchases equal 20 percent of sales paid in the month of purchase. The remaining 60 and 20 percent of sales are paid in two accounts payable installments in periods t + 1 and t + 2, respectively. 

The firm estimates fixed expenses at $5 per month and variable expenses will be 10 percent of sales per month.  Base (fixed) sales are estimated to be $10 per month and commission sales will be 30 percent of sales. The firm expects to make quarterly dividend payments of $4. It will make a quarterly sinking fund and tax payments of $5 and $10, respectively. The firm is committed to retiring $10 in outstanding debt every six months.  XYZ's management has decided on a minimum cash balance of $100 per month.

Objective: Beginning in January 2011 compute the monthly cash budget for XYZ Industries and interpret the results with attention paid to the cumulative cash balance over the first six months of operations.

Solution: Table 6- 3A displays the forecasted cash budget for the Zeos Corporation for the first six months of operations as a publicly-traded corporation.           

Table 6-3A  The cash budget for XYZ Industries for Jan – June, 2011 (the numbers represent 0.10% of $1,000,000)

 

Comments, analysis, and evaluation: Line 3 shows the seasonal nature of sales. Lines 7, 8, and 9 show the projected cash receipts per month including the amounts collected from accounts receivable. Lines 10 – 12 are self explanatory. Line 13 shows the one-time cash injection of $1000. If the firm was still a sole proprietorship or partnership then this injection  would be called venture capital. Line 15 shows total expected cash inflows from January through June. The seasonal nature of sales is reflected in these inflows.

Lines 19, 20, and 21 show the pattern of cash outflows related to purchases. Line 22 shows that fixed expense equals $5 per month and variable expenses constitute 10 percent of sales per month. Total wages are paid in two forms:  Line 23 shows base fixed salaries to be $10 per month. Line 24 shows commission sales are 30 percent of sales for a given month.  Again, notice the seasonal nature of commissions. Lines 25 though 28 are self-explanatory. Line 30 summarizes the cash outflows. You can see that cash outflows are being impacted both by the seasonal nature of sales and the quarterly payment of certain fixed financial obligations.

Line 32 shows the net monthly inflows. This is a very instructive string of numbers for management's financial planning task. We see that after February the net inflows decline steadily, turning negative in May and June. Subtracting Line 34, (the desired minimum cash balance), only exacerbates this projected decline and causes the April balance to become negative as well (Line 36). 

However, it's the cumulative cash balance, shown in Line 38, that really tells the story.  The cumulative balances sequence carries forward the previous ending cash balance so that it becomes the beginning cash balance of the subsequent month.  Line 38 shows the cash build-up months of January, February, and March carrying forward to "fund" the negative monthly balances in April, May, and, to some extent, June. Thus the meaningful cash crunch month is projected to be June with a negative cumulative balance of $68. 

 

Damage control: Based upon these forecasts made in January, management should have adequate short-term funding ready to go for June. It's better to know this outcome in January than in the month of the cash shortfall. That's the beneficial outcome of cash budgeting. 

Of course, seeing this June shortfall management could take other steps. The most obvious step would be to increase the receipt of accounts receivable. Perhaps eliminating accounts payable in period t + 2 might help assuming such a request does not alienate customers. Since most of the other accounts are reasonably set, this seems like the only account that might be altered.

 

Short-term external funds policy: Note that XYZ has a policy of first liquidating its marketable securities to meet deficits and then borrowing with notes payable if additional financing is needed. Since  XYZ is not expected to let the cumulative cash balance sit around in petty cash the company is expected to invest these funds in short-term earning assets that provide a minimal rate of return and instant liquidity. 

We have excluded the earned interest on these balances for convenience and because the after-tax interest would be negligible. Had the problem allowed for these invested balances the cumulative balance would be a bit higher. As Table 6-3A is constructed XYZ will be issuing notes payable of $68 in June of 2011.

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