Ch 6

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Chapter 6 MANAGING CASH FLOW FOCUS In this chapter, we focus on short-term financial planning involving projecting monthly financial statements for one year or less. The availability of cash is what drives the entrepreneurial venture. Inadequate cash often constrains the venture’s ability to grow, is a primary cause of financial distress, and can result in bankruptcy even though the venture may be profitable in an accounting sense. The process of preparing short-term projected financial statements also helps the entrepreneur anticipate and estimate additional external financial capital needed to support the business plan during the next year. We also cover a venture’s operating cycle and its cash conversion cycle and their importance in managing cash flow. LEARNING OBJECTIVES Construct a cash budget and determine the timing and amount of any monthly cash needs. Describe how short-term projected statements of cash flows relate to cash budgets. Explain why short-term projected statements of cash flow are important to the entrepreneur. Identify and describe the use and value of conversion period ratios to the entrepreneur.

1. 2. 3. 4.

CHAPTER OUTLINE 6.1 6.2 6.3 6.4 6.5 6.6

FINANCIAL PLANNING THROUGHOUT THE VENTURE’S LIFE CYCLE SURVIVING IN THE SHORT RUN SHORT-TERM CASH-PLANNING TOOLS PROJECTED MONTHLY FINANCIAL STATEMENTS CASH PLANNING FROM A PROJECTED MONTHLY BALANCE SHEET CONVERSION PERIOD RATIOS A. Measuring Conversion Times B. Interpreting Changes in Conversion Times SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. What does short-term financial planning involve?   Short­term financial planning usually involves projecting monthly financial statements and  concentrating on a venture's cash needs. Most initial business plans contain monthly  projected (pro forma) financial statements for at least one year, and sometimes for two or  more years. These short­horizon forecasts directly address whether a venture is expected to  generate—or otherwise obtain—the required cash to meet its coming obligations.

2. Provide a description of the financing cost implications associated with a venture’s need for additional funds. The cost of obtaining additional funds may be explicit, such as additional interest expense associated with debt. Interest expense shows up directly on the projected income statement and, in turn, impacts the AFN shown on the balance sheet. In contrast, added “costs” associated with obtaining equity capital from venture capitalist and other investors are based on the expected rates of return the investors receive when they exit their investments. These implicit costs do not show up on the projected financial statements. 3. What is meant by a cash budget? Describe how a cash budget is prepared. A cash budget is a financial tool showing the inflows and outflows of the firm’s cash balance over a period of time. It is calculated by determining all of the cash-basis expenses and revenues the firm has over a period of time to find out how cash is being built and burned. 4. Besides the cash budget, what additional financial statements are projected monthly in conjunction with short-term financial planning? Additional statements that can be prepared on a monthly basis to provide a clear financial picture of the firm include the income statement, balance sheet and a statement of cash flows. 5. What is meant by a venture’s operating cycle? A venture’s operating cycle is the time it takes to purchase raw materials, assemble a product, book a sale, and collect on it. 6. Describe the cash conversion cycle (C3). The cash conversion cycle is the operating cycle less the days of short-term credit extended by suppliers, employees and government (the purchase-to-payment cycle). 7. What are the three components of the cash conversion cycle (C 3)? How is each component calculated? The three components of the cash conversion cycle are inventory-to-sale conversion period, sales-tocash conversion period, and purchase-to-payment conversion period. The inventory-to-sale conversion period is calculated by dividing average inventories by the venture’s average daily cost of goods sold. The sale-to-cash conversion period is calculated by dividing the average receivables by the net sales per day. The purchase-to-payment conversion period is calculated by dividing the sum of average payables and accrued liabilities by the venture’s cost of goods sold per day. 8. Briefly explain how changes in the conversion times of the components of the C 3 can be interpreted. A lengthening of the inventory-to-sale conversion period indicates less efficient inventory management. A lengthening of the sale-to-cash conversion period indicates less efficient collections or management of receivables. A decrease in the purchase-to-payment period indicates a less efficient use of the credit provided by suppliers, employees and the government.

9. From the Headlines – Sustainable Northwest: Describe Sustainable Northwest’s short-term inflows and outflows of cash. What would you expect to be the main ingredients of each part of the cash conversion cycle? Sustainable Northwest is a nonprofit organization with a for-profit wholesale lumberyard called Sustainable Northwest Wood which supports its nonprofit parent’s objectives. The wholesale lumberyard provides raw materials gathered by selective harvesting to small lumber mills for processing, with the processed products then being sold to home builders, suppliers of green building products, etc. The inventory-to-sale conversion period would involve gathering raw wood, processing the raw wood into finished products, and carrying the finished products until sales are made. Credit terms may need to be extended to home builders and other customers, who in turn may need to give credit to their retail customers. Thus, Northwest Wood is likely to incur a sale-to-cash conversion period. Furthermore, given that Northwest Wood is a wholesale lumber yard, any purchase-to-payment conversion period to offset the length of the venture’s operating cycle would have to come from the owners of the forests from which the trees are harvested. INTERNET ACTIVITIES 1. Access the U.S. census bureau web site at http://www.census.gov. Find relevant information for trends in U.S. population growth for a specific business idea. Comment on the manufacturing statistics and regional or national statistics relevant for that business. Web-researched results vary due to constant updating of the related web sites. 2. For a specific business idea, find labor wage data for the types of employees that will be involved. Examples of relevant web sites include the Bureau of Labor Statistics web site at http://www.states.bls.gov and career information sites like http://www.wetfeet.com. Web-researched results vary due to constant updating of the related web sites. EXERCISES/PROBLEMS AND ANSWERS 3. [Short-Term Financial Planning] The PDC Company was described during the early part of this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2. PDC’s sales are projected to be $80,000 in September 2017. [Note: An Excel spreadsheet for the PDC Company is available on the authors’ Web site for use by instructors.]

A. Prepare PDC’s sales schedule, purchases schedule, and the wages schedule for August 2017. See the spreadsheet solution for Problem 11. Here we are focusing just on projecting the month of August. Sales Schedule: Schedule 1: Sales Forecast Total sales = $92,000; Credit sales (40%) = $36,800; Cash sales (60%) = $55,200 Schedule 2: Cash Collections Cash sales = $55,200; Collection of July’s credit sales = $46,000; Total collections = $101,200 Purchases Schedule: Ending inventory at end of August is estimated as: Forecasted September sales = $80,000 times .8 of sales coverage times .7 to reflect cost of goods sold. Thus, ($80,000 x .8 x .7) = $44,800. PDC adds a $46,000 inventory cushion to get to the target ending inventory for August of: $90,800. Cost of goods sold for August is $64,400 (i.e., $92,000 x .7). Total inventory needed is $90,800 + $64,400 = $155,200 Schedule 3: Purchases $155,200 total inventory needed minus $97,520 beginning inventory (i.e., ending inventory from July) = $57,680 purchases Schedule 4: Disbursements for Purchases Calculated as 50% of July’s purchases plus 50% of August’s purchases: ($67,620 x .5) + ($57,680 x .5) = $33,810 + $28,840 = $62,650 Wages and Commissions Schedule: Schedule 5: Wages and Commissions Fixed portion = $5,750. Commissions = 15% of August sales ($92,000 x .15) = $13,800. Total wages and commissions = $5,750 + $13,800 = $19,550 Schedule 6: Disbursements (Wages and Commissions) Calculated as 50% of July’s total wages/commissions plus 50% of August’s total wages/commissions: ($23,000 x .5) + ($19,550 x .5) = $11,500 + $9,775 = $21,275 B. Prepare a cash budget for August 2017 for the PDC Company and describe how the forecast affects the end-of-month cash balance. See the spreadsheet solution for August provided in the comprehensive spreadsheet output for Problem 11. The beginning cash balance for August was $29,487. Total cash receipts less total cash disbursements for August were $8,075 ($101,200 - $93,125) resulting in an ending cash balance of $37,562. 4.[Short-Term Financial Planning] The PDC Company was described during the early part of this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2. PDC’s sales are projected to be $80,000 in September 2017. A. Prepare the PDC Company’s projected income statement for August.

See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11. B. Prepare the PDC Company’s projected balance sheet for August. See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11. C. Prepare the PDC Company’s projected statement of cash flow for August. See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11. D. Compare your balance sheet at the end of August with the balance sheet in Table 6.1 in the chapter and apply the balance sheet method to determine cash flows over the MarchAugust time period. See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11.

7. [Short-Term Financial Planning] Artero Corporation is a traditional toy products retailer that recently also started an Internet-based subsidiary that sells toys online. A markup is added on goods the company purchases from manufacturers for resale. Swen Artero, the company president, is preparing for a meeting with Jennifer Brown, a loan officer with First Banco Corporation, to review year end financing requirements. After discussions with the company’s marketing manager, Rolf Eriksson, and finance manager, Lisa Erdinger, sales over the last three months of 2017 are forecasted to be: ____________________________________________________________________ Month Sales Forecast __________________________________________________($000)_____________ October 2017 $1,000 November 1,500 December 3,000 ____________________________________________________________________ Artero’s balance sheet as of the end of September, 2017 was as follows. ____________________________________________________________________ Artero Corporation Balance Sheet as of September 30, 2017 (in $ Thousands) ____________________________________________________________________

Cash Accounts receivable Inventories Net fixed assets

$ 50 700 500 750

Accounts payable $ 0 Notes payable 800 Long-term debt 400 Total liabilities 1,200 Equity 800 Total assets $2,000 Total $2,000 ____________________________________________________________________ All sales are made on credit terms of net 30 days and are collected the following month and no bad debts are anticipated. The accounts receivable on the balance sheet at the end of September thus will be collected in October. The October sales will be collected in November, and so on. Inventory on hand represents a minimum operating level (or “safety” stock), which the company intends to maintain. Cost of goods sold average 80 percent of sales. Inventory is purchased in the month of sale and paid for in cash. Other cash expenses average 7 percent of sales. Depreciation is $10,000 per month. Assume taxes are paid monthly and the effective income tax rate is 40 percent for planning purposes. The annual interest rate on outstanding long-term debt and bank loans (notes payable) is 12%. There are no capital expenditures planned during the period, and no dividends will be paid. The company’s desired end-of-month cash balance is $80,000. The president hopes to meet any cash shortages during the period by increasing the firm’s notes payable to the bank. The interest rate on new loans will be 12 percent. A. Prepare monthly pro forma income statements for October, November, and December, and for the quarter ending December 31, 2017.

B. Prepare monthly pro forma balance sheets at the end of October, November, and December, 2017.

C. Prepare both a monthly cash budget and pro forma statements of cash flows for October, November, and December 2017.

D. Describe your findings and indicate the maximum amount of bank borrowing that is needed. Based on the financial projection above, a maximum of $1,916,000 is needed. 8. Cash Conversion Cycle] Two years of financial statement data for the Munich Export Corporation are shown below. MUNICH EXPORTS CORPORATION Balance Sheet Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets

2015 $50,000 200,000 450,000 700,000 300,000 $1,000,000

2016 $50,000 300,000 570,000 920,000 380,000 $1,300,000

Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($.05 par) Additional Paid-in-Capital Retained Earnings Total Liab. & Equity

130,000 50,000 90,000 270,000 400,000 50,000 200,000 80,000 $1,000,000

$180,000 70,000 90,000 340,000 550,000 50,000 200,000 160,000 $1,300,000

Income Statement Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40% rate) Net Income

2015 2016 $1,600,000 960,000 640,000 160,000 150,000 55,000 275,000 45,000 55,000 155,000 220,000 62,000 88,000 $93,000 $132,000

$1,300,000 780,000 520,000 130,000 150,000 40,000 200,000

A. Calculate the inventory-to-sale, sale-to-cash, and purchase-to-payment conversion periods for Munich Exports for 2016. Inventory-to-Sale Conversion Period = Average Inventories / (Cost of Goods Sold/365) = [($450,000 + $570,000)/2]/$960,000/365 = $510,000/$2,630.14 = 193.91 days Sale-to-Cash Conversion Period = Average Receivables / (Net Sales/365) = [($200,000 + $300,000)/2]/ ($1,600,000/365) = $250,000/$4,383.56 = 57.03 days Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued Liabilities) / (Cost of Goods Sold/365) = [(($130,000 + $180,000)/2) + (($50,000 + $70,000)/2) / ($960,000/365) = ($155,000 + $60,000)/$2,630.14 = $215,000/$2,630.14 = 81.74 days B. Calculate the length of Munich Exports’ cash conversion cycle for 2016. Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash Conversion Period – Purchase-to-Payment Conversion Period Cash Conversion Cycle = 193.91 days + 57.03 days – 81.74 days = 163.20 days 9. [Cash Conversion Cycle] Castillo Products Company improved its operations from a net loss in 2015 to a net profit in 2016. While the founders, Cindy and Rob Castillo, are happy about these developments, they are concerned with trying to understand how long the firm takes to complete its cash conversion cycle in 2016. Use the following financial statements to make your calculations. Balance sheet items should reflect the averages of the 2015 and 2016 accounts.

CASTILLO PRODUCTS COMPANY

INCOME STATEMENT Net sales Cost of goods sold Gross profit Marketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss)

2015 $900,000 540,000 360,000 90,000 250,000 40,000 –20,000 45,000 –65,000 0 –$65,000

2016 $1,500,000 900,000 600,000 150,000 250,000 40,000 160,000 60,000 100,000 25,000 $ 75,000

BALANCE SHEET  Cash Accounts receivable Inventories Total current assets Gross fixed assets Accumulated depreciation Net fixed assets Total assets

2015 $ 50,000 200,000 400,000 650,000 450,000  – 100,000 350,000 $1,000,000

2016 $ 20,000 280,000 500,000 800,000 540,000  – 140,000 400,000 $1,200,000

Accounts payable Accruals Bank loan Total current liabilities Long­term debt Common stock (0.05 par) Additional paid­in­capital Retained earnings Total liabilities and equity

$ 130,000 50,000 90,000 270,000 300,000 150,000 200,000 80,000 $1,000,000

$160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000

A. Calculate the inventory-to-sale conversion period for 2016. Inventory-to-Sale Conversion Period = Avg. Inventory/Avg. Daily COGS = (($400,000 + $500,000)/2)/($900,000/365) = 182.50 days B. Calculate the sale-to-cash conversion period for 2016.

Sale-to-Cash Conversion Period = Avg. Receivables/Avg. Daily Sales = (($200,000 + $280,000)/2)/($1,500,000/365) = 58.40 days C. Calculate the purchase-to-payment conversion period for 2016. Purchase-to-Payment Conversion Period = (Avg. Payables + Avg. Accruals)/Avg. Daily CGS = (($130,000 + $160,000)/2 + ($50,000 + $70,000)/2)/($900,000/365) = 83.14 days D. Determine the length of the Castillo Product’s cash conversion cycle for 2016. Length of the Cash Conversion Cycle = (Inventory-to-Sale Conversion Period) + (Salesto-cash Conversion Period) – (Purchase-to-Payment Conversion Period) = 182.50 days + 58.40 days – 83.14 days = 157.76 days 10. [Cash Conversion Cycle] Safety-First, Inc. makes portable ladders that can be used to exit second floor levels of homes in the event of fire. Each ladder consists of fire resistant rope and high strength plastic steps. A lightweight fire resistant cape with a smoke filter is included with Safety-First ladder. Each ladder and cape, when not in use, are rolled up and stored in a pouch the size of a back pack and can easily be taken on trips and vacations. Jan Smithson founded Safety-First as soon as she graduated from a private liberal arts college in the northwest three years ago. After struggling for the first year, the venture seemed to be growing and producing profits. Following are the two most recent years of financial statements, expressed in thousands of dollars, for the Safety-First, Inc.

SAFETY-FIRST, INC.

Income Statements (in $ Thousands) Net sales Cost of goods sold Gross profit Operating expenses Interest Income before taxes Income taxes Net income

2015 3,750 2,250 1,500 670 30 800 250 550

2016 4,500 2,700 1,800 860 40 900 300 600

2015 400 500 1,450 2,350

2016 150 800 2,000 2,950

Balance Sheets (in $ Thousands) Cash Accounts receivable Inventories Total current assets

Gross fixed assets Less accumulated depreciation Net fixed assets Total assets Accounts payable Bank loan Accrued liabilities Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

2,000 -950 1,050 3,400 2015 300 150 100 550 150 850 1,850 3,400

2,800 -1,250 1,550 4,500 2016 400 250 150 800 150 1,100 2,450 4,500

A. Using yearend data, calculate the inventory-to-sale conversion period, the sale-to-cash conversion period, and the purchase-to-payment conversion period for 2015 and 2016. Note: because inventories, accounts receivable, accounts payable, and accrued liabilities are not available for 2014, averages of these accounts cannot be calculated for 2015. So for 2015 versus 2016 comparative purposes, we use yearend data for these accounts. Inventory-to-Sale Conversion Period = (Yearend Inventories) / (COGS / 365) 2015: 1450 / (2250 / 365) = 1450/6.1644 = 235.22 2016: 2000 / (2700 / 365) = 2000/7.3973 = 270.37 Note: the calculation for 2016 using average inventories would be: Inventory-to-Sale Conversion Period = (Average Inventories) / (COGS / 365) 2016: ((1450 + 2000) / 2) / (2700 / 365) = 1725/7.3973 = 233.19 Sale-to-Cash Conversion Period = (Yearend Receivables) / (Net Sales / 365) 2015: 500 / (3750 / 365) = 500/10.2740 = 48.67 2016: 800 / (4500 / 365) = 800/12.3288 = 64.89 Note: the calculation for 2016 using average receivables would be: Sale-to-Cash Conversion Period = (Average Receivables) / (Net Sales / 365) 2016: [(500 + 800) / 2] / (4500 / 365) = 650/12.3288 = 52.72 Purchase-to-Payment Conversion Period = (Yearend Payables + Yearend Accrued Liabilities) / (COGS / 365)

2015 (300 + 100) / (2250 / 365) = 400/6.1644 = 64.89 2016: (400 + 150) / (2700 / 365) = 550/7.3973 = 74.35 Note: the calculation for 2016 using average payables and average accruals would be: Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued Liabilities) / (COGS / 365) 2016: ((300 + 400)/2) + ((100 + 150)/2) = 350 + 125 = 475 475 / (2700 / 365) = 475/7.3973 = 64.21

B. Determine the cash conversion cycle for each year and discuss the changes that took place, if any. Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash Conversion Period – Purchase-to-Payment Conversion Period 2015: 235.22 + 48.67 – 64.89 = 219.00 2016: 270.37 + 64.89 – 74.35 = 260.91 Note: using average (2015 and 2016) balance sheet accounts for 2016 results in the following cash conversion cycle: 2016: 233.19 + 52.72 – 64.21 = 221.70 11. Short-term financial planning for the PDC Company was described during the early part of this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2. PDC’s monthly sales for the remainder of 2017 are expected to be: September October November December A.

$80,000 $100,000 $130,000 $160,000

Prepare PDC’s sales schedule, purchases schedule, and the wages schedule for each of the last four months of 2017. See spreadsheet solution below.

B. Prepare cash budgets for each of the last four months of 2017 for the PDC Company and describe how the forecast affects the end of month cash balances. See spreadsheet solution below. C.

Prepare the PDC Company’s projected monthly income statements for the August through December period. See spreadsheet solution below.

D.

Prepare the PDC Company’s projected monthly balance sheets for the August through December period. See spreadsheet solution below.

E.Prepare the PDC Company’s projected monthly statements of cash flow for the August through December period.

See spreadsheet solution below. F.Compare your balance sheet at the end of December with the balance sheet in Table 6.1 in the chapter and apply the balance sheet method to determine cash flows over the MarchDecember period. See spreadsheet solution below.

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