MBA / FINANCIAL ANALYSIS
Working Capital Management
and cash budget
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Working Capital Management:
Some basic definitions
• What does it mean?
• The company’s policy regarding the use of
current assets (cash, inventories, receivables)
• The day-to-day control of current assets and
current liabilities (accruals and accounts
payable)
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Definitions (Continued)
• The working capital policy deals with two
important issues:
A. The level of each current asset
B. How the current assets are financed
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A. The level of current assets
–The Size of the Firm’s Investment in
Current Assets
–Usually measured relative to the firm’s
level of total operating revenues.
• Flexible
• Restrictive
The Size of the Investment in Current Assets
• A flexible policy short-term finance policy would maintain a
high ratio of current assets to sales.
– Keeping large cash balances and investments in
marketable securities.
– Large investments in inventory.
– Liberal credit terms.
• A restrictive short-term finance policy would maintain a low
ratio of current assets to sales.
– Keeping low cash balances, no investment in marketable
securities.
– Making small investments in inventory.
– Allowing no credit sales (thus no accounts receivable).
How we choose the level of
current assets (flexible or restrictive)
• Current assets (cash, inventory, accounts
receivables)
• What is the cost of keeping them at a very
high level? Carrying costs. Examples?
• What is the cost of keeping them at a very low
level? Shortage costs
• Explain the shortage cost of cash shortage,
Inventory shortage, accounts receivable
shortage.
Carrying Costs and Shortage Costs
Total costs of holding
$ Minimum current assets.
point
Carrying costs
Shortage
costs
CA* Investment in
Current Assets
($)
B. How the current assets are financed
– Alternative Financing Policies for Current
Assets
– Usually measured as the proportion of
short-term debt to long-term debt.
• Moderate
• Aggressive
• Conservative
Current Operating Assets
Financing Policies
• Moderate: Match the maturity of the assets
with the maturity of the financing.
• Aggressive: Use short-term financing to
finance permanent assets.
• Conservative: Use permanent capital for
permanent assets and temporary assets.
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Cash Budget: The Primary Cash
Management Tool
• Purpose: Uses forecasts of cash inflows, outflows,
and ending cash balances to predict loan needs and
funds available for temporary investment.
• Timing: Daily, weekly, or monthly, depending upon
budget’s purpose. Monthly for annual planning,
daily for actual cash management.
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Data Required for Cash Budget
• Sales forecast.
• Information on collections delay.
• Forecast of purchases and payment terms.
• Forecast of cash expenses: wages, taxes,
utilities, and so on.
• Initial cash on hand.
• Target cash balance.
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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 do appear in the cash budget.
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What are some other potential cash
inflows besides collections?
• Proceeds from fixed asset sales.
• Proceeds from stock and bond sales.
• Interest earned.
• Court settlements.
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AN EXAMPLE OF CASH BUDGET
Mr. Smith is selling winter ski equipment.
Sales are made on a cash basis only. Mr. Smith
pays himself a salary of $4,800 per month,
and the rent is $2,000. In addition he must
make a tax payment of $12,000 in December.
The current cash on hand (on December 1) is
$400, but Smith has agreed to maintain an
average bank balance of $6,000.
The estimated sales and purchases for December, January and
February are shown below: Purchases during November were
$140,000. Purchases are paid after one month.
Sales Purchases
Dec $160,000 $40,000
Jan 40,000 40,000
Feb 60,000 40,000
Prepare a cash budget for December, January, and February
Collections and purchases:
Dec Jan Feb
Sales $160,000 $40,000 $60,000
Purchases 40,000 40,000 40,000
Payments *140,000 40,000 40,000
*November purchases = $140,000
Cash Budget Example #2
April May June
Credit Sales $380,000 $396,000 $438,000
Credit purchases 147,000 175,500 200,500
Cash disbursements:
Wages, Taxes, and expenses 39,750 48,210 50,300
Interest 11,400 11,400 11,400
Equipment purchases 83,000 91,000 -
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Example #2 (cont’)
The company predicts that 5% of its credit sales will
never be collected, 35% percent of its sales will be
collected in the month of the sale, and the remaining
60% will be collected in the following month. Credit
purchases will be paid in the month following the
purchase. In March credit sales were $210,000, and
credit purchases were $156,000. The beginning cash
balance in April is $280,000. Prepare a cash budget
for April, May, and June.
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