CASH BUDGETING Breakeven analysis and profit planning dealt with an important aspect of managing a business: that of planning.

The planning process, ideally, begins with some idealistic objective, such as producing the best product at the lowest cost. This objective, in turn, dictates that certain long-term objectives be achieved, such as developing an innovative product that can be produced in an efficient manner. Similarly, the long-term objectives require that certain short-term objectives be realized, such as generating sufficient cash flows to fund the research and development required to come up with the innovative product. Planning Short-term Objectives Intermediate-term Objectives Implementing Conversely, realizing these goals must occur in the reverse order: if a positive cash flow is not generated, there will be no funding for R&D to develop the product that you want to produce. Breakeven analysis and profit planning are short-term planning tools. In fact, many businesses do not breakeven for several years, let alone show a profit (witness many of the Internet companies). There are other tools available for evaluating such endeavors. Undoubtedly, one of the short-term objectives of such companies is to secure the financing sources required to survive until such time as a profit is realized. Critical to the success of any business, is the planning of the cash flows; i.e., cash budgeting. A budget is a plan and budgeting refers to planning. You budget your time just as you budget your cash flows. Planning is an integral part of a managementby-objective style of business management. The alternative is management-by-crisis wherein all of ones time is spent putting out fires a reactive approach to management rather than a proactive approach. The budget provides the framework by which management intends to achieve its short-term goals. For the financial manager, the cash budget aids in the performance of the job of making sure that funds are available when needed as well as planning for the efficient use of any surplus funds that exist. The ability to anticipate the financial needs of the firm allows time to find sources of funds. The complexity of the cash flows can be illustrate by the use of a simple diagram that illustrates the nature of the numerous cash inflows and outflows that confront a firm. Let the Cash Reserve box represent the checking account of the company: Long-term Objectives

Intermittant Inflows (Debt, Equity) Intermittant Outflows (Taxes, Insurance, Wages) Fixed Assets

Near Cash

Cash Reserve Accounts Receivable Cash Sales

Accounts Payable

Credit Sales

Inventory

Into the Cash Reserve go intermittant inflows of funds from lenders and shareholders, and money flows back in the form of interest and principal payments to lenders and dividends to stockholders. There are intermittant outflows of funds to pay wages, taxes and insurance as well. Occasionally, there are tax refunds, payment on insurance claims, etc., that result in cash flows returning to the company. Near Cash (or Near Money) represents investment in short-term marketable securities so that cash surpluses can earn a rate of return. This is a where short-term surpluses of cash are stored. Money is spent to purchase fixed assets, which are later sold when it is time to replace them. Accounts payable must be paid. The accounts payable arise from inventory purchases which are sold to customers on either a cash basis or on credit, in which case the receivables must be collected. There are returns by our customers to us, as well as our returns to suppliers, in which case refunds are paid. As the number of suppliers, customers, lenders, etc., multiplies so does the complexity of the cash flows. Stories abound of companies that are showing a profit (in the accounting sense) but ultimately fail due to the lack of cash flow to make loan payments, pay suppliers, pay wages, taxes, and so on. The Cash Budget A detailed example of a cash budget is presented in your textbook and will not be duplicated here. Rather, a simple two-period example to illustrate the difference between the cash budgeting techniques taught in your accounting course and the cash budget utilized in finance is presented. The cash budget in finance always starts with detailing the receipts of cash. Typically, receipts are comprised of cash sales and the collection of accounts receivable. As indicated in the text, even the collection of receivables may require a separate worksheet. Note also that if there is a 5% bad debt expense anticipated, the collections

should only add up to 95%. That is, bad debt expense is not a cash outflow, it is a receipt that is not collected and, thus, not an item that appears on the cash budget since the budget only represents cash inflows and outflows. Other sources of cash inflows, such as the sale of stock that is anticipated, would also be reflected under the Receipts section of the cash budget. The next category is Disbursements where we list any and all cash payments that are to be made including salaries, rent, interest and principal payments, dividends, purchases of fixed assets, but NOT depreciation (since it is not cash) any cash outflow that is to be made. The difference between the Receipts and Disbursements is the Net Cash Gain (Loss). The various periods for which a cash budget is being prepared can be all be done at the same time up to this point. Beyond this point in the budgeting process, however, the periods must be taken sequentially since each period depends upon the previous one. Receipts Cash Sales Collection of A/R Total Receipts Disbursements Wages Payment of A/P Rent Insurance Debt Payment Dividends Total Disbursements Net Cash Gain (Loss) Plus: Beginning Cash Cumulative Cash Less: Minimum Cash Surplus (Deficit) March 20 75 95 35 50 15 10 0 0 110 (15) 10 (5) (5) (10) April 30 45 75 35 40 15 0 20 5 115 (40) (5) (45) (5) (50)

After calculating the Net Cash Gain (Loss) for each period, the Beginning Cash is added to determine the Cumulative Cash (or Ending Cash) on hand at the end of the period. This amount becomes the Beginning Cash for the following period. From the Cumulative Cash figure, we subtract the Minimimum Cash that we desire to have on hand. This minimum could be a safety stock of cash or it could be a required amount that a lender mandates we keep available (and probably restricted in use). The remaining amount after subtracting the Minimum Cash Required is our Surplus (Deficit). Unlike the cash budgets you have probably seen before, this is a cumulative cash budget. Notice that the Surplus (Deficit) is a cumulative amount that indicates what the total position of the firm is at any point in time. Thus, our cash budget indicates that we will need $10 in financing for March and an additional $40 in April, for a total of $50 in financing requirements. The budget shows us our total financing requirements so that we can go to a bank, for example, and request a line of credit of $50 to cover our financing requirements. (Ideally, of course, the budget will also show how we intend to

repay the loan as well.) The cumulative cash budget allows us to determine our total financial requirements in advance, allowing us time to find a willing supplier of funds. The only thing worse than having to find funding at the last minute, is having to go back and ask for more money at a later date. The lender will know in advance the level of commitment that must be made and, if we are turned down, we have time to line up another source of funds.