Lecture 32

Cash Budget Overview

• Definition: A cash budget is a financial plan that outlines expected cash inflows and outflows over a specific period.

• Purpose: Helps to ensure the organization has enough cash to meet its obligations by projecting cash balance.

Components of the Cash Budget

Cash Inflows

• Sources: Primarily generated from operations such as sales and collections.

• Focus: It's important to remember that cash inflows in the cash budget are always projected, meaning they are estimations of future cash collections.

Cash Outflows

• Nature: Include payments for expenses, inventory purchases, liabilities, etc.

• Impact: Cash outflows must be accurately projected to understand the cash balance.

Expected Cash Balance Calculation

• Cash balance is calculated as:

  • Cash Inflows - Cash Outflows.

Key Characteristics of the Cash Budget

• Forward-Looking: The cash budget is not historical; it is a forecast of future cash flows.

• Estimation: It incorporates estimates, making it crucial for flexibility as not everything will unfold as planned.

Current Liabilities

• Definition: Liabilities that must be settled within one year.

• Examples: Accounts payable and notes payable.

Accounts Payable

• Cost Consideration: Often presents no cost if discounts for early payment are utilized; otherwise, there’s an opportunity cost (implicit cost).

• Implicit Cost: The cost incurred if a discount for early payment is available but not taken.

Notes Payable

• Interest: A primary cost associated with notes payable, incurred over the life of the note.

• Types:

  1. Standard Notes: Interest is paid at the end.

  2. Discounted Notes: Interest is deducted upfront, meaning the borrower receives less cash initially but pays back the full amount later.

• Compensating Balance: An additional cost where a borrower must maintain a minimum balance in their bank account to secure the note. It does not act as collateral but raises the effective cost of borrowing.

Effective Interest Rate

• Definition: The actual rate of interest paid by the borrower due to factors like compensating balances and discounting.

• Stated Rate vs. Effective Rate: The stated rate does not reflect the actual cost if conditions such as compensating balances or upfront discounts are applied.

Impact of Corporate Actions on Cash

• Categories: Transactions may cause cash to increase, decrease, or remain unchanged.

  • For instance:

    • Borrowing cash to pay dividends: No change (increase cash, decrease cash).

    • Paying interest: Decrease cash.

    • Selling on credit: No change in cash.

Operating Cycle and Cash Conversion Cycle

Operating Cycle

• Definition: The duration between purchasing inventory and collecting cash from sales.

• Components:

  1. Days to sell inventory.

  2. Days to collect cash from accounts receivable.

Cash Conversion Cycle

• Definition: The total period required to turn inventory and accounts receivable into cash.

• Calculation:

  • Cash Conversion Cycle = Operating Cycle - Days Deferred.

• Days Deferred: The amount of time a business has before it is obligated to pay its accounts payable.

Calculating Components

• Days to Sell: 365 / Inventory Turnover.

• Days to Collect: 365 / Receivables Turnover.

• Days Deferred: 365 / Payables Turnover.

Problem Assessment in Cash Management

• of factors impacting cash and operating cycles:

  • Increase in receivables: Increases operating cycle.

  • Faster inventory turnover: Decreases operating cycle.

  • Accelerating payments to suppliers: Does not change operating cycle but may affect cash conversion.

Summary and Importance

• Understanding the cash budget alongside current liabilities is essential for effective cash management and ensuring that an organization can meet its financial obligations adequately.