CASH FLOWS MANAGEMENT Q&A

Lecturer: Dr. Tran Tat Thanh

PROFIT OR CASH FLOWS ???
Tel: 0904282440

Email: trantatthanh@gmail.com KEEP YOUR EYE ON THE CASH, NOT ON

School: Banking and Finance RECORDED PROFITS.

Web: www.sbf.neu.edu.vn

1 2

CASH FLOWS MANAGEMENT TIMETABLE

EXERCISE
CHAPTER CONTENT HOURS THEORY
PRESENT

1 Chapter 1: Introduction 4.5 3 1.5

CASH IS KING!
Recepts and disbursements
2 Chapter 2: 9 5 4
management
Cash availability is the lifeblood of the organization.
3 Chapter 3: Planning cash flow 6 4 2
Rob Reider The models of cash flow
4 Chapter 4: forecasting 9 5 4
Mid-term test
The model of cash balance
5 Chapter 5: management and analyzing 6 4 2
cash balance
Cash flow management in
6 Chapter 6 3 2 1
multinational company

3
Total 37.5 23 14.5 4

Exam and group assignment CHAPTER 1

INTRODUCTION TO CASH FLOWS MANAGEMENT

CHAPTER 1
Attendance: 10% INTRODUCTION CASH FLOWS MANAGEMENT
Mid-term test 1: 10%

Mid-term test 2 : 30%

Final test: 50%

5 6
 CHAPTER 1 What is cash flow management?
INTRODUCTION CASH FLOWS MANAGEMENT

Cash flows basic Cash flow management is the process of tracking how
much money is coming into and going out of your
Target and process of cash flows planning
business.
Content of cash flows management This helps you spot trends, prepare for the future, and tackle any
problems with your cash flow.
Financial ratios and cash flows analysis It pays to practice cash flow management often to make sure your
business has enough money to keep running.
This helps you predict how much money will be available to your
business in the future. It also helps you identify how much money
your business needs to cover debts, like paying staff and suppliers.

7 8

Cash flow or Cash OBJECTIVES

Control and track the cash flows

Maximize capacity and use cash
Maximize revenue and minimize expense
Collect sales as quickly as possible
Use cash if necessary
Pay the creditors no earlier than the due date
Forecast fluctuations of cash flow;
Reserve an amount for daily payments.
Provide appropriate external funding sources
Efficient use of excess cash.

9 10

IMPORTANCE OF CASH FLOW MANAGEMENT OBJECTIVES

Cash Flow From Operations $

Receipts
Business fail Bankuptcy Customer Invoices $80,500
Other $1,500
Avoid extended cash High advertising cost
Disbursements
shortages More investment capital Employee Salaries -$45,000
for new Suppliers -$25,500
Other -$5,000
projects/facilities
Net Cash Flow From Operations $6,500
High level inventory Cash Flow From Investments
Equipment and Software Purchases -$5,500
Lasting sales collected Net Cash Flow From Investments -$5,500
Cash Flow From Financing
Loan Payments -$3,300
Shareholder Dividends -$5,000
Net Cash Flow From Financing -$8,300
Net Change in Cash Balance -$7,300
11 12
Acme, Inc. – Cash Flow Statement for the Year Ended Dec. 31, 2018
 CASH FLOWS AND BUSINESS PROFIT versus NET CASH FLOW
EXAMPLE
IS A MANAGEABLE ACTIVITY

Revenue versus Cash inflows (CIF)

ITEMS REVENUE CASH INFLOWS
1. RECEIVABLES (Excluding VAT) YES NO
2. CIF FROM BORROWING NO YES
3. CIF FROM ISSUING SHARES NO YES
MANAGING CASH FLOW

4. OUTPUT VAT COLLECTED NO YES

Expenses versus Cash outflows (COF)
ITEMS EXPENSES CASH OUTFLOWS
1. DEPRECIATION YES NO
2. COF FROM BUYING FIXED ASSETS NO YES
3. COF TO PAY PRINCIPALS NO YES
13
3. INPUT VAT PAID NO YES 14

PROFIT VERSUS CASH FLOW PROFIT VERSUS CASH FLOW

EXAMPLE EXAMPLE

Income statement of 123 company: The statement of cash flow of 123 company:
Beginning cash in bank $ 208,000
Prior Current Next Year Collections 13,110,000
($$ in 000s) Year Year (projected) Addition to long-term debt 500,000
Sales $ 12,002 $ 15,073 $ 20,292 Inventory purchases (5,029,000)
Cost of goods sold 8,436 10,290 13,877 Payroll (1,975,000)
Other expenses 2,474 2,480 2,875 Other manufacturing expenses (2,101,000)
________ ________ ________
Selling & administrative expenses (2,257,000)
Operating profit $ 1,092 $ 2,303 $ 3,540
Capital equipment purchases (1,608,000)
________ ________ ________
Taxes, interest and debt principal (940,000)
% of Sales 9.1% 15.3% 17.4% ___________
________ ________ ________
Cash position at end of year $ (92,000)
___________

15 16

PROCESS PROCESS
CASH FLOWS MANAGEMENT CASH FLOWS MANAGEMENT

Planning
Purpose → Business activities Cash
Purchasing
Personel Collection
Timetable
→ Record and manage

Content → Financial Account Purchased

Estimate cash flows transactions receivable material
Managment model
Apply corporate governance model → Purpose: Budget
optimization and
Performance evaluation and limited budget handling Sales Manufacturing
Inventory
Solution for limited issues
Evaluate management performance
As slowly As quickly
as possible as possible
18
17
 CONTENT CONTENT
CASH FLOWS MANAGEMENT CASH FLOWS MANAGEMENT

Cash flows and the statement of cash flows

The statement of cash flows
Cash inflow
Estimate CASH INFLOWS
Cash outflow

CASH Cash flow planning and forecasting

FLOWS Estimate CASH OUTFLOWS Forecast cash flows
MANAGEMENT Plan cash flows

FORCAST cash flows Model of money management and budget

Build up BUDGETING optimization
handling
Model
Budget handling
19
20

CASH INFLOWS CASH INFLOWS

Forecasting of Cash Flows is one of the most complex and difficult tasks in cash
and treasury management. It requires commitment of the whole company to
achieve cost-effective and accurate forecasts in the four types of cash flow.

In-house Banking is an internal treasury function, typically used by large multi-

national corporations, where the treasury department provides foreign exchange,
intra-group lending and cash flow management services for the group.

Multi-lateral Netting systems and services minimize the number of payments and
the cost of FX between subsidiaries and companies within a group. Also for some
external payments by making one payment, at the end of a given period, for the net
cash flow between either intra-group or with trading partners.

Payment Factories minimize the cost of external payment flows as well as the
internal cost of processing payments by centralizing all payments in a dedicated
processing centre. Payment factories can also be used to optimize liquidity by
managing the timing of payments. Some well established payment factories also
21
provide payment collection services. 22

CASH INFLOWS CASH OUTFLOWS

Expenses for purchase of goods, raw materials in stock, tools,

fixed assets.
Receivables from the sale of goods and services
Payment for staff salaries
Interest on deposits from banks and investments
Payment of taxes
Investments by shareholders Expenditures on other purchases incurred.

23 24
 RATIOS RATIOS
CASH FLOWS MANAGEMENT CASH FLOWS MANAGEMENT

Sources of Cash Uses of Cash

The ability to meet payment through a group of
financial indicators that reflect cash flow and Profits from operations Losses from operations
solvency Repayment of debt
Borrowing
Solvency ratios
Cash flows ratios Sale of equity Payment of dividends
Sale of assets Invetment/Acquistion of assets
Expenses incurred when the enterprise cannot
Decrease in working capital Increase in working capital
ensure the solvency, thereby assessing the risk of
(except cash) (except cash)
enterprise bankruptcy
Expense incurred
Bankruptcy ability

25 26

Sources and Uses of Cash Sources and Uses of Cash

Sources
Cash inflow – occurs when we “sell” Uses
something and we add to the cash account Cash outflow – occurs when we
“buy” something
• Decrease in asset account
• Accounts receivable, inventory, and net
fixed assets
• Increase in asset account
• Cash and other current assets. Fixed
• Increase in liability or equity account assets
• Accounts payable, other current liabilities,
long-term liability and common stock • Decrease in liability or equity
account
• Notes payable and long-term debt

3-27 3-28

Sample Balance Sheet Sample Income Statement

XYZ Corporation XYZ Corporation
December 31, 202X January 1 – December 31, 202X
(Figures in millions of dollars) ( Figures in millions of dollars)
Revenues $5,000
2021 2020 2021 2020
Cost of Goods Sold (2,006)
Cash 696 58 A/P 307 303
Expenses (1,740)
A/R 956 992 N/P 26 119
Depreciation (116)
Inventory 301 361 Other CL 1,662 1,353 EBIT 1,138
Other CA 303 264 Total CL 1,995 1,775 Interest Expense (7)
Total CA 2,256 1,675 LT Debt 843 1,091 Taxable Income 1,131
Taxes (442)
Net FA 3,138 3,358 C/S 2,556 2,167
Net Income $689
Total Assets 5,394 5,033 Total Liab. & Equity 5,394 5,033
EPS $3.61

3-29 Dividends per share $1.08 3-30

 Sources and Uses of Cash Sources and Uses of Cash
XYZ Corporation - December 31, 202X XYZ Corporation - December 31, 202X
ASSETS 2020 2021 Change
Current assets
SOURCES OF CASH
Cash 58 696 638
A/R 992 956 -36
Decrease in account receivables 36
Inventory 361 301 -60 Decrease in inventories 60
Other CA 264 303 39 Decrease in Net fixed assets 220
Total CA 1,675 2,256 581 Increase in account payables 4
Net FA 3,358 3,138 -220
Increase in other CL 309
TOTAL ASSETS 5,033 5,394 361
Increase in common stock 389
LIABILITIES AND OWNERS' EQUITY
CURRENT LIABILITES 2020 2021
TOTAL SOURCES 1,018
A/P 303 307 4 USES OF CASH
N/P 119 26 -93 Increase in cash 638
Other CL 1,353 1,662 309
Increase in other CA 39
Total CL 1,775 1,995 220
Decrease in Note payables 93
LT Debt 1,091 843 -248
C/S 2,167 2,556 389 Decrease in Long-term debt 248
TOTAL LIAB. & EQUITY 5,033 5,394 361 3-31
TOTAL USES 1,018 3-32

Sources and Uses of Cash Sources and Uses of Cash

XYZ Corporation - December 31, 202X XYZ Corporation - December 31, 202X
Looking over the balance sheets for XYZ, we see that quite a few things changed Looking again at XYZ, we see that Cash balance rose by $638. This is a net use
during the year. For example, XYZ increased its cash balance by $638 and its because XYZ effectively paid out $638 to increase the amount in its checking
other current assets by $39. (Note that, throughout, all figures are in millions of account. XYZ also paid out $39 to increase the amount in its other Current
dollars.). It also pays account payables by $93 and its long-term debt by $248. Assets. It also paid out $93 to decrease Note payables and $248 to decrease
Where did the money come from? To answer this and related questions, we need Long-term debt.
to first identify those changes that used up cash (uses) and those that brought cash Accounts receivables decreased by $36 and inventories decreased by 60. This is a
in (sources). A little common sense is useful here. A firm uses cash by either source of cash because XYZ effectively has collected $36 from account
buying assets or making payments. So, loosely speaking, an increase in an asset receivables by the end of the year. It also effectively has borrowed an additional
account means the firm, on a net basis, bought some assets—a use of cash. If an $4 payable by the end of the year. Increase in other Current liabilities and
asset account went down, then on a net basis, the firm sold some assets. This common stock by 309 and 389 respectively are also sources of cash.
would be a net source. Similarly, if a liability account goes down, then the firm
has made a net payment—a use of cash. This simple statement tells us much of what happened during the year, but it
doesn’t tell the whole story. For example, the increase in retained earnings is net
Given this reasoning, there is a simple, albeit mechanical, definition you may income (a source of funds) less dividends (a use of funds). It would be more
find useful. An increase in a left-side (asset) account or a decrease in a right-side enlightening to have these reported separately so we could see the breakdown.
(liability or equity) account is a use of cash. Likewise, a decrease in an asset Also, we have considered only net fixed asset acquisitions. Total or gross
account or an increase in a liability (or equity) account is a source of cash. spending would be more interesting to know.
33 34

Example of sources and uses of cash

sources of cash The Concept of Cash Flow

decrease in cash 138,7
decrease in inventory 90
decrease in fa 78 • Cash flow is one of the most important
increase in payable 294
increase in taxes 42,84
pieces of information that a financial
increase in accrued exp 1,8 manager can derive from financial
increase in equity 26,16 statements
total 671,5

uses of cash • The “Statement of Cash Flows” does not

increase in acc receivable 644 provide us with the same information that
increase in other ca 7,5
decrease in short term debt 20 we are looking at here
total 671,5
• We will look at how cash is generated
from utilizing assets and how it is paid to
those that finance the purchase of the
35
assets. 2-36
 Cash Flow Summary Table 2.6
Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash Flow to
Creditors + Cash Flow to Stockholders

CFFA = CF to creditors + CF to
Stockholders
The first equation is how the cash flow from the firm is divided among the
investors who financed the assets.

The second equation is the cash flow that the firm receives from its assets. This
is an important equation to remember. We will come back to it and use it again
when we do our capital budgeting analysis. We want to base our decisions on
the timing and risk of the cash flows we expect to receive from a project.
2-37 2-38

Example of CCFA: Part I Cash Flow From Assets

• CF to Creditors (B/S and I/S) = interest paid – net new • Cash Flow From Assets = Operating Cash Flow
borrowing = 7 + 248 = $255 – Net Capital Spending – Changes in NWC
• Net New Borrowing = ending LT debt – beginning LT OCF: dòng tiền hoạt động kinh doanh
debt = 843 – 1091 = -248 NCS: chi tiêu vốn ròng
NWC: vốn lưu động ròng
• CF to Stockholders (B/S and I/S) = dividends paid –
net new equity raised = 206,128 +93,872 = $300 CFFA = OCF – NCS - ∆NWC
• Net New Equity=(2556-482.872) – 2167 = -93.872 (Be The first equation is how the cash flow from the firm is divided among the
sure to point out that we want equity raised in the investors who financed the assets.
capital markets, not retained earnings). The second equation is the cash flow that the firm receives from its assets.
CFFA = CF to creditors + CF to Stockholders This is an important equation to remember. We will come back to it and use
it again when we do our capital budgeting analysis. We want to base our
• CFFA = 255 + 300 = $555 decisions on the timing and risk of the cash flows we expect to receive from
a project.
2-39 2-40

The Big Picture Problem: Balance Sheet and

Example of CCFA: Part II Income Statement Information
• Current Accounts
 OCF (I/S) = EBIT + depreciation – taxes = 1.138 + 116 –
442 = $812 – 2009: CA = 3625; CL = 1787
– 2008: CA = 3596; CL = 2140
 NCS ( B/S and I/S) = ending net fixed assets – beginning
net fixed assets + depreciation =3138 – 3358 + 116= -$104 • Fixed Assets and Depreciation
– 2009: NFA = 2194; 2008: NFA = 2261
 Changes in NWC (B/S) = ending NWC – beginning NWC
= 261 – (-100) =$361 – Depreciation Expense = 500
• Ending NWC = 2256 – 1995 = 261 • Long-term Debt and Equity
• Beginning NWC = 1675 – 1775 = -100 – 2009: LTD = 538; Common stock & APIC = 462
 CFFA = OCF – NCS - ∆NWC – 2008: LTD = 581; Common stock & APIC = 372
 CFFA = 812 + 104 – 361 = $555 (APIC: Additional paid-in capital)
 (EBIT: earnings before interests and taxes – Thu • Income Statement
nhập trước lãi vay và thuế) – EBIT = 1014; Taxes = 368
– Interest Expense = 93; Dividends = 285
2-41 2-42
 Task: use the information on the previous
slide to compute the following: Cash Flow Problem Answers:
1. OCF • OCF = 1,014 + 500 – 368 = 1,146
2. NCS • NCS = 2,194 – 2,261 + 500 = 433
3. Changes in NWC • Changes in NWC = (3,625 – 1,787) – (3,596 –
2,140) = 382
4. CFFA • CFFA = 1,146 – 433 – 382 = 331
5. CF to Creditors • CF to Creditors = 93 – (538 – 581) = 136
6. CF to Stockholders • CF to Stockholders = 285 – (462 – 372) = 195
7. CFFA • CFFA = 136 + 195 = 331
8. Does the CF identity hold? • The CF identity holds!
2-43 2-44

Comprehensive Problem Comprehensive Problem

• Current Accounts
– 2009: CA = 4,400; CL = 1,500 OCF = EBIT + depreciation – taxes = $2000 + 400 – 300 = $2100
– 2008: CA = 3,500; CL = 1,200 NCS = ending net fixed assets – beginning net fixed assets + depreciation
• Fixed Assets and Depreciation = 3400 – 3100 + 400 = $700
Changes in NWC = ending NWC – beginning NWC
– 2009: NFA = 3,400; 2008: NFA = 3,100
= (4400 – 1500) – (3500 – 1200) = $600
– Depreciation Expense = 400
CFFA = OCF – NCS – Changes in NWC
• Long-term Debt and Equity (R.E. not given) = 2100 – 700 – 600 = $800
– 2009: LTD = 4,000; Common stock & APIC = 400 CF to creditors = interest paid – net new borrowing
– 2008: LTD = 3,950; Common stock & APIC = 400 = 350 – (4000 – 3950) = $300
• Income Statement CF to Stockholders = dividends paid – net new equity raised
= 500 – (400 – 400) = $500
– EBIT = 2,000; Taxes = 300
CFFA = 300 + 500 = $800
– Interest Expense = 350; Dividends = 500
• Task: Compute the CFFA
2-45 46

CHAPTER 2
CONCLUSION Receipts and Disbursements

SALES ARE GOOD.

PROFITS ARE BETTER. CHAPTER 2
CASH IS BEST!
Receipts and Disbursements

Cash flow management is the process from arising transactions,

recording, money arises, and processing the arising money.
The content of cash flow management includes determining
cash inflow and cash outflow, budget and cash flows
management models.
Evaluate cash flows management through solvency indicators
and making money from the business.
47 48
 CHAPTER 2
Receipts and Disbursements Receipts and Disbursements

The statement of cash flows (Cash flow statement_CFS)

Cash flows of business MAXIMIZE CASH IN,

Working capital and demand of working capital MINIMIZE CASH OUT
Cash cycle and business cycle

Case study

49
50

1 ROLES OF STATEMENTS OF CASH FLOWS Purpose of Cash flow statement

51

1 2 3

Assess the Assess debt Explain the

affordability, reasons for the
ability to
dividend difference
generate cash between profit
flows in the payment and
additional and cash flow
future increase
capital needs
(decrease)
Master the meaning of the statement of cash flows. Understand the requirements
of Vietnamese accounting standards and current regulations on presenting the
statement of cash flows

IAS07 and VAS24

CFS & Relationships with Financial Statements

Usefulness and Format

Usefulness of the Statement of Cash Flows Statement of cash flows

▪Business activities
Provides information to help assess:
▪Investment activities
Financial activities
Cash Debts ▪ Hoạt động tài chính
1. Entity’s ability to generate future cash flows. Cash Debts

2. Entity’s ability to pay dividends and obligations. other

Equity
Other
Equity
assets assets

3. Reasons for the difference between net income and net

cash provided (used) by operating activities. Undistributed Undistributed
profit profit

4. Cash investing and financing transactions during the

Balance Sheet Balance
period. Income Statement sheet
Factors that make the
Inventory management policy
difference between
income statement and Manage Receivables / Payables
statement of cash flows Investment plan; Capital mobilization policy
 Statement of Cash flows 2 CASH FLOW STATEMENT FORMAT
56
CFS
XYZ Company
Statement of cash flows
Information How does the cash of the business change in a 202X
users
financial period?(How much does it come from,
where does it come from and what is it used for?) I. Net cash flow from business activities $ XXX
Cash flow in
3 types of II. Net cash flow from invesment activities XXX
Managers: Investors Lenders activities III. Net cash flow from financial activities XXX
Do businesses have The ability of business to generate money in Is the business Net cash flow in the period $ XXX
enough money to repay the future? Does it need to be further able to pay?
debts/pay dividends? funded? can dividends be paid?
Plus: Backlog of CF at the beginning of period XXX

Backlog of CF at the end of period $ XXX

CASH FLOW FROM OPERATING ACTIVITIES

Usefulness and Format
58
Classification of Cash Flows
Is cash flow Cash inflows
Operating Investing Financing related to daily
business Collect from customers
Activities Activities Activities
activities and
generates the
Income Changes in Changes in
main revenue
Statement Items Investments and Long-Term Cash outflows
of the
Long-Term Liabilities and
business. • Salary and wages
Assets Stockholders’ • Pay for suppliers
Equity • Tax payment
• Loan Interest

CASH FLOW FROM INVESTING ACTIVITIES CASH FLOW FROM FINANCING ACTIVITIES
59 60

Cash inflows
Is cash flow Is cash Cash inflows
• Sell fixed assets
related to flow related
• Sell long-term investment stocks fixed asset to activities • Issuance of stocks
• Loan recovery (principal) trading and that • Issuance of bonds
• change the • Short-term and long-term loans
Received dividends long-term
• Loan interest size and
investment structure of
activities. the equity Cash outflows
Cash outflows and loans
of the • Dividend payment
• Buy fixed assets enterprise. • Buy treasury stocks
• Buy long-term investment stocks • Repayment of loans
• Buying bonds, lending • owners withdraw capital
 Usefulness and Format Net income and Net cash
provided by operating activities
Significant Noncash Activities
1. Direct issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Direct issuance of debt to purchase assets.
4. Exchanges of plant assets.

Companies report noncash activities in either a

◆ separate schedule (bottom of the statement) or
◆ separate note to the financial statements. In general, why do difference exist between net income
and net cash flow provided from operating activities?

Presentation of cash flow statement

Format of the Statement of Cash Flows
2 Methods

Direct Indirect
(not use for current exam)

Net profit or loss is adjusted for

the effects of transactions of a
Disclose major classes of gross cash
receipts and gross cash payments non-cash nature, any deferrals or
accruals, items of income or
(Rarely used in practice as costly expense associated with
to prepare) investing or financing cash flows

Indirect method: Neu doanh nghiep chi co cash sale va expense cung thanh toan luon =>
Sale – Expense = Profit = net CF
Tuy nhien, thuc te co bien dong tu working capital, non-cash items co anh huong den
profit => Profit khac CF

Example: EFFECT OF PRODUCT LIFE CYCLE ON CASH FLOWS

Classify each of these transactions by type of cash flow activity.

1. Issued 100,000 shares of $5 par value

Financing
common stock for $800,000 cash.
plus

2. Borrowed $200,000, signing a 5-year note Finance

Cash flows

Financing
bearing 8% interest.
3. Purchased two semi-trailer trucks for
Investing
$170,000 cash. Business
minus

4. Paid employees $12,000 for salaries and

wages.
Operating

5. Collected $20,000 cash for services Investment

Operating
provided.
Introduction growth Saturation Recession
STAGES
 3-68

Investor Insight
Operating with negative cash Cash flow statement-Vietnam

• Direct method

• Indirect method

Why do companies have negative net cash provided by operating activities

during the introductory phrase?
68

3-69 3-70

I. Cash flows from operating activities

1. Gains from sales of goods and service provisions and other gains
2. Payments to suppliers III.Cash flows from financing activities
3. Payments to employees
1. Gains from stock issuance and capital contributions from shareholders
4. Loan interests already paid
2. Repayments for capital contributions and repurchases of stocks already
5. Payments for corporate income tax
issued
6. Other gains
3. Short-term and long-term loan received
7. Other disbursements
Net cash flows from operating activities 4. Loan principal amounts repaid
II. Cash flows from investing activities 5. Payments for financial leasehold assets
1. Purchases and construction of fixed assets and other long-term assets 6. Dividend and profit already paid to the owners
2. Gains from disposal and liquidation of fixed assets and other long-term assets Net cash flows from financing activities
3. Loan given and purchases of debt instruments of other entities Net cash flows during the year
4. Recovery of loan given and disposals of debt instruments of other entities Cash and cash equivalent at the beginning of the period
5. Investments into other entities Effects of fluctuations in foreign exchange rates
6. Withdrawals of investments in other entities Cash and cash equivalent at the end of the period
7. Receipts of loan interests, dividend and profit shared
Net cash flows from investing activities

McGraw-Hill/Irwin McGraw-Hill/Irwin
Corporate Finance, 7/e Corporate Finance, 7/e

3-71 3-72

CASH FLOWS STATEMENT (Indirect method) The relationship between financial statements
I. Cash flows from operating activities
1. Profit/ (loss) before tax Beginning balance sheet
2. Adjustments It provides the beginning data
Depreciation of fixed asset
Provisions
Gain/ (loss) from foreign exchange differences
Gain/ (loss) from investing activities Income statement Cash flow statement
Loan interest expenses Ending Cash balance
3. Operating profit before changes of working capital Profit after tax Account receivables
Increase/ (decrease) of accounts receivable Dividend Account payables
Increase/ (decrease) of inventories
Increase/ (decrease) of accounts payable
Increase/ (decrease) of prepaid expenses
Loan interests already paid
Corporate income tax already paid Ending balance sheet
Other gains Ending Cash balance
Other disbursements Account receivables, Account payables
Net cash flows from operating activities Changes in account balances
(Other parts are the same as those of the direct method)
McGraw-Hill/Irwin McGraw-Hill/Irwin
Corporate Finance, 7/e Corporate Finance, 7/e
 Notes for the preparation of the cash flow statement Notes for the preparation of the cash flow statement
In particular:
• When preparing the cash flow statement (indirect • For the direct method: “Other gains/ disbursements” are
method), the changes in account receivables and gains/disbursements from operating activities apart from the 5 items
account payables caused by interest, corporate income mentioned above.
tax, provisions, and indirect taxes from non-operating • Other gains: Gains from tax refund, Mortgage, collateral & deposits,
activities (Such as accrued expenses, corporate income Budget resources, Bonus, aids,…
tax payables) must be eliminated. • Other disbursements: Payments for charges, land rental charges,
Mortgage, collateral & short term deposits, VAT, SCT…
• The items “Other gains” and “Other disbursements” • For the indirect method: “Other gains/ disbursements” are
have the same name in both methods but they are gains/disbursements from operating activities which are not included in
different. calculations of revenues, costs and net working capital such as
Mortgage, collateral & deposits, Budget resources of projects, bonus
from outsiders… (Payments for VAT and SCT which relate to operating
activities are excluded. This is the difference compared to direct
method).
3-74

Notes for the preparation of the cash flow statement

Usefulness and Format
- Gain/ (loss) from investing activities: eliminate the gain, add back the loss
- Provisions: Add back the provision
- Increase/ (decrease) of accounts receivable, inventory: Provisions exclusive
Preparing the Statement of Cash Flows
value
Three Sources of Information:
Rule of adjustment:
- Increase in assets → Decrease in cash 1. Comparative balance sheets
- Decrease in assets→ Increase in cash
2. Current income statement
So, changes in assets: Beginning assets – Ending assets
3. Additional information
- Increase in liability → Increase in cash
- Decrease in liability → Decrease in cash
So, changes in liability: Ending liability – Beginning liability

3-75

Usefulness and Format Usefulness and Format

Preparing the Statement of Cash Flows Preparing the Statement of Cash Flows
Three Major Steps: Three Major Steps:
 CASH FLOW STATEMENT
Usefulness and Format
Basic principles for prepare CF
Preparing the Statement of Cash Flows
Opening balance – Cash & Cash
Three Major Steps: equivalent

Operating CF
Cash Flows in the period
(Movement) Investing CF

Financing CF

Ending balance – Cash &

Cash equivalent

Usefulness and Format Preparing the Statement of Cash Flows

Indirect and Direct Methods Indirect Method

Companies favor the indirect

method for two reasons:
1. Easier and less costly to
prepare.

2. Focuses on differences
between net income and net
cash flow from operating
activities.

Preparing the Statement of Cash Flows Preparing the Statement of Cash Flows

Additional information for 2014:

1. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.
2. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated
depreciation $1,000) for $4,000 cash.
3. Issued $110,000 of long-term bonds in direct exchange for land.
4. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also
purchased for cash.
5. Issued common stock for $20,000 cash.
6. The company declared and paid a $29,000 cash dividend.
LO 4
Preparation of the Statement of Cash Flows Step 1: Operating Activities
Indirect Method
Question
Step 1: Operating Activities
Which is an example of a cash flow from an operating
Determine net cash provided/used by operating activities by activity?
converting net income from accrual basis to cash basis.
a. Payment of cash to lenders for interest.
Common adjustments to Net Income (Loss): b. Receipt of cash from the sale of capital stock.
◆ Add back noncash expenses (depreciation, amortization, or
c. Payment of cash dividends to the company’s
depletion expense).
stockholders.
◆ Deduct gains and add losses.
d. None of the above.
◆ Changes in noncash current asset and current liability
accounts.

Step 1: Operating Activities Operating Activities

Depreciation Expense Loss on Disposal of Plant Assets

Although depreciation expense reduces net income, it does not Companies report as a source of cash in the investing
reduce cash. The company must add it back to net income. activities section the actual amount of cash received from the
sale.

Cash flows from operating activities: ◆ Any loss on sale is added to net income in the operating
Net income $ 145,000 section.
Adjustments to reconcile net income to net cash
provided by operating activities: ◆ Any gain on sale is deducted from net income in the
Depreciation expense 9,000 operating section.
Net cash provided by operating activities $ 154,000

Operating Activities Operating Activities

Loss on Disposal of Plant Assets Changes to Noncash Current Asset Accounts

When the Accounts Receivable balance decreases, cash
Cash flows from operating activities:
receipts are higher than revenue earned under the accrual basis.
Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities: Accounts Receivable

Depreciation expense 9,000 1/1/14 Balance 30,000 Receipts from customers 517,000
Loss on disposal of plant assets 3,000 Sales revenue 507,000

Net cash provided by operating activities $ 157,000 12/31/14 Balance 20,000

Company adds to net income the amount of the decrease in

accounts receivable.
Operating Activities Operating Activities

Changes to Noncash Current Asset Accounts Changes to Noncash Current Asset Accounts
When the Inventory balance increases, the cost of merchandise
Cash flows from operating activities:
purchased exceeds the cost of goods sold.
Net income $ 145,000
Adjustments to reconcile net income to net cash Inventory
provided by operating activities:
1/1/14 Balance 10,000 Cost of goods sold 150,000
Depreciation expense 9,000 Purchases 155,000
Loss on disposal of plant assets 3,000
12/31/14 Balance 15,000
Decrease in accounts receivable 10,000
Net cash provided by operating activities $ 167,000
Cost of goods sold does not reflect cash payments made for
merchandise. The company deducts from net income this
inventory increase.

Operating Activities Operating Activities

Changes to Noncash Current Asset Accounts Changes to Noncash Current Asset Accounts

When the Prepaid Expenses balance increases, cash paid for

Cash flows from operating activities:
Net income $ 145,000 expenses is higher than expenses reported on an accrual basis.
Adjustments to reconcile net income to net cash The company deducts the decrease from net income to arrive at
provided by operating activities: net cash provided by operating activities.
Depreciation expense 9,000
Loss on disposal of plant assets 3,000 If prepaid expenses decrease, reported expenses are higher
Decrease in accounts receivable 10,000 than the expenses paid.
Increase in inventory (5,000)
Net cash provided by operating activities $ 162,000

Operating Activities Operating Activities

Changes to Noncash Current Asset Accounts Changes to Noncash Current Liability Accounts
When Accounts Payable increases, the company received more
Cash flows from operating activities:
in goods than it actually paid for. The increase is added to net
Net income $ 145,000
Adjustments to reconcile net income to net cash income to determine net cash provided by operating activities.
provided by operating activities:
When Income Taxes Payable decreases, the income tax
Depreciation expense 9,000
Loss on disposal of plant assets 3,000
expense reported on the income statement was less than the
Decrease in accounts receivable 10,000 amount of taxes paid during the period. The decrease is
Increase in inventory (5,000) subtracted from net income to determine net cash provided by
Increase in prepaid expenses (4,000) operating activities.
Net cash provided by operating activities $ 158,000
Operating Activities Operating Activities

Changes to Noncash Current Liability Accounts Summary of Conversion to

Cash flows from operating activities:
Net Cash Provided by
Net income $ 145,000 Operating Activities
Adjustments to reconcile net income to net cash
Indirect Method
provided by operating activities:
Depreciation expense 9,000
Loss on disposal of plant assets 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
Decrease in income taxes payable (2,000)
Net cash provided by operating activities $ 172,000

Step 2: Investing and Financing Activities Investing and Financing Activities

Partial statement
Company purchased land of $110,000 by exchanging bonds for
Net cash provided by operating activities 172,000
land. This is a significant noncash investing and financing activity
Cash flows from investing activities:
that merits disclosure in a separate schedule. Purchase of building (120,000)
Purchase of equipment (25,000)
Land Sale of equipment 4,000
1/1/14 Balance 20,000 Net cash used by investing activities (141,000)
Issued bonds 110,000 Cash flows from financing activities:
Issuance of common stock 20,000
12/31/14 Balance 130,000 Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Bonds Payable Net increase in cash 22,000
Cash at beginning of period 33,000
1/1/14 Balance 20,000
Cash at end of period $ 55,000
For land 110,000
12/31/14 Balance 130,000 Disclosure: Issuance of bonds to purchase land $ 110,000

Investing and Financing Activities Investing and Financing Activities

Partial statement
From the additional information, the company acquired an
Net cash provided by operating activities 172,000
office building for $120,000 cash. This is a cash outflow Cash flows from investing activities:
reported in the investing section. Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Building Cash flows from financing activities:
1/1/14 Balance 40,000 Issuance of common stock 20,000
Office building 120,000 Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
12/31/14 Balance 160,000 Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000

Disclosure: Issuance of bonds to purchase land $ 110,000

 Cash flows from operating activities:

Investing and Financing Activities Statement Net income

Adjustments to reconcile net income to net cash
$ 145,000

of Cash provided by operating activities:

Depreciation expense 9,000
The additional information explains that the equipment increase Flows Loss on disposal of plant assets 3,000
Decrease in accounts receivable 10,000
resulted from two transactions: (1) a purchase of equipment of Increase in inventory (5,000)
$25,000, and (2) the sale for $4,000 of equipment costing $8,000. Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
Indirect Decrease in income taxes payable (2,000)
Equipment Net cash provided by operating activities 172,000
Method Cash flows from investing activities:
1/1/14 Balance 10,000 Cost of equipment sold 8,000 Purchase of building (120,000)
Purchase 25,000 Purchase of equipment (25,000)
Sale of equipment 4,000
12/31/14 Balance 27,000 Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Cash 4,000 Payment of cash dividends (29,000)
Journal
Accumulated Depreciation 1,000 Net cash used by financing activities (9,000)
Entry Net increase in cash 22,000
Loss on Disposal of Plant Assets 3,000
Cash at beginning of period 33,000
Equipment 8,000 Cash at end of period $ 55,000

Investing and Financing Activities Investing and Financing Activities

The increase in common stock resulted from the issuance of Partial statement
Net cash provided by operating activities 172,000
new shares.
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Common Stock
Sale of equipment 4,000
1/1/14 Balance 50,000 Net cash used by investing activities (141,000)
Shares sold 20,000 Cash flows from financing activities:
Issuance of common stock 20,000
12/31/14 Balance 70,000 Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000

Disclosure: Issuance of bonds to purchase land $ 110,000

Cash flows from operating activities:

Investing and Financing Activities Statement Net income

Adjustments to reconcile net income to net cash
$ 145,000

of Cash provided by operating activities:

Depreciation expense 9,000
Retained earnings increased $116,000 during the year. This Flows Loss on disposal of plant assets 3,000
Decrease in accounts receivable 10,000
increase can be explained by two factors: (1) Net income of Increase in inventory (5,000)
$145,000 increased retained earnings, and (2) Dividends of Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
$29,000 decreased retained earnings. Indirect Decrease in income taxes payable (2,000)
Net cash provided by operating activities 172,000
Method Cash flows from investing activities:
Retained Earnings Purchase of building (120,000)
Purchase of equipment (25,000)
1/1/14 Balance 48,000 Sale of equipment 4,000
Dividends 29,000 Net income 145,000 Net cash used by investing activities (141,000)
Cash flows from financing activities:
12/31/14 Balance 164,000 Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000
Step 3: Net Change in Cash Investing and Financing Activities
Compare the net change in cash on the Statement of Cash Review Question
Flows with the change in the cash account reported on the
Balance Sheet to make sure the amounts agree. Which is an example of a cash flow from an investing
activity?
a. Receipt of cash from the issuance of bonds payable.
b. Payment of cash to repurchase outstanding capital
stock.
c. Receipt of cash from the sale of equipment.
d. Payment of cash to suppliers for inventory.

Using Cash Flows to Evaluate a Company Using Cash Flows to Evaluate a Company

Free Cash Flow

Required:
Calculate
Microsoft’s
free cash flow.
Free cash flow describes the cash remaining from
operations after adjustment for capital expenditures and
dividends. Net cash provided by operating activities $37,529
Less: Expenditures on PP&E and intangibles 7,452
Dividends paid 0
Free cash flow $30,077

Using Cash Flows to Evaluate a Company Using Cash Flows to Evaluate a Company

Assessing Liquidity and Solvency Assessing Liquidity and Solvency

Liquidity is the ability to pay obligations expected to become Solvency is the ability of a company to survive over the long
due within the next year. term.

A value below .40 times is cause for additional investigation. A ratio below .20 times is cause for additional investigation.
 Format of Cash Flow Statement
Direct
Direct method Cash Flow Statement
$ $ method
Cash flows from operating activities
Cash receipts from customers xxxxxxx
Cash paid to supplier and employees xxxxxxx
Cash generated from operations xxxxxxx
Interest paid xxxxxxx
Income taxes paid xxxxxxx
1. Compute net cash provided by operating activities by
Net cash from operating activities xxxxxxx
adjusting each item in the income statement from the
Cash flows from investing activities
Purchase of property, plant and equipment xxxxxxx accrual basis to the cash basis.
Proceeds from sale of equipment xxxxxxx
Interest received xxxxxxx
Dividend received xxxxxxx 2. Companies report only major classes of operating cash
Net cash used in investing activities xxxxxxx
Cash flows from financing activities
Proceeds from issuance of share capital xxxxxxx
receipts and cash payments.
Proceeds from long-term borrowings xxxxxxx
Dividends paid * xxxxxxx
3. For these major classes, the difference between cash
Net cash used in investing activities xxxxxxx
Cash flows from financing activities xxxxxxx receipts and cash payments is the net cash provided by
Cash receipts from shares issued xxxxxxx
operating activities.
Long term loan paid xxxxxxx
Net cash from financing activities

Net increase in cash and cash equivalent xxxxxxx

Cash and cash equivalent at beginning of period xxxxxxx
Cash and cash equivalent at end of period xxxxxxx

Net profit & net cash flow from business activities ADVANTAGES OF DIRECT METHOD

117 118

Eliminate non-cash revenue

Revenue ❑Consistent with the objectives of the statement of
cash flows
❑Specify the sources of cash creation and the
Profit Net cash flow from
business activities purposes of spending the cash.

Expense
Eliminate non-cash expense

CHAPTER 3
Cash Flow Statement Direct PLANNING AND BUDGETING
Method
Step 1: Operating Activities
CHAPTER 3
PLANNING AND BUDGETING

120
 CHAPTER 3
OBJECTIVES
PLANNING AND BUDGETING

Cash inflows Determine when the business's cash flow appears

Cash outflows
Determine cash flow in, cash out flow based on
business short-term operation plan.
Planning and budgeting: long-term and short-term Planning process
Contents of planning process and budgeting
Cash flow forecast
How to handle the budget in case of surplus or deficit

121
122

CASH FLOW STATEMENT

Cash and cash equivalents
Basic principles for prepare CF Cash Not held for investment or other long-term purposes,
equivalent but rather to meet short-term cash commitments
Opening balance – Cash & Cash Example: Term deposit (2 months)
equivalent
An investment’s (loan, borrowing, bank overdraft…)
maturity date should normally be three months from its
Operating CF acquisition date (noted: equity investment like shares in
Cash Flows in the period other companies ➔ NOT cash equivalent)
(Movement) Investing CF
Note for CF Movements between different types of cash and cash
Financing CF presentation equivalent ➔ not included in cash flows
i.e. Term deposits matured → transfer to bank accounts

Ending balance – Cash &

Cash equivalent

Presentation of cash flow statement Advantages and criticism of cash flow

Advantages Criticism of preparing cash flow
• Survival in business depends on the ability to generate cash.
2 Methods Cash flow accounting directs attention towards this critical
issue • Cash equivalent ➔ not easy to
• Cash flow is more comprehensive than “profit” which is distinguish and unrealistic (like an
dependent on accounting conventions and concepts investment has to be within three
• Creditors (long and short-term) are more interested in an
enterprise’s ability to repay them than in its profitability months of maturity)
Direct Indirect • Cash flows reporting provides better mean of comparing the • No interpretation of the CFS is
result of different companies rather than traditional profit
provided within the accounts
reporting
• Management: information for decision making (relevant cost, • Non-cash transactions (bonus issue)
future cash…) are not highlighted, they are of
Net profit or loss is •
Disclose major classes of Shareholder/auditor: provide satisfactory basis for stewardship
interest to users as they will impact
adjusted for the effects of accounting
gross cash receipts and • Cash flow forecasts are easier to prepare and more useful than future cash flows
transactions of a non-cash profit forecasts
gross cash payments •
nature, any deferrals or Accruals concept is confusing and cash flows are more easily
understood
accruals, items of income or • Forecast can subsequently be monitored by compare actual
(Rarely used in practice as cash flow against the forecast.
expense associated with
costly to prepare)
investing or financing
cash flows
 Questions Questions 1
Exercise 1
A company made a loss on the disposal of a company motor
vehicle of $8,000. The vehicle originally cost $50,000 and
accumulated depreciation of the vehicle at the date of
(a) In the adjustment to get from operating profit to CF
disposal was $20,000.
from operations:
Loss on disposal of the vehicle: +$8,000
Required:
(b) Under the heading “CF from investing activities”:
What are the items that should be included for the disposal
Proceed from disposal: $50,000 – 2,000 – 8,000 = $22,000
of the vehicle in the statement of cash flows for the year:
(a) in the adjustments to get from operating profit to cash
flow from operations?
(b) under the heading: ‘Cash flows from investing
activities’?

Questions Questions 2
Exercise 2
A company made an total profit before tax of $16,000 in the year just ended.
Depreciation charges were $15,000. There was a gain of $5,000 on disposals Total profit: $16000
of non-current assets and there were no interest charges. Values of working
Add: depreciation: 15000
capital items at the beginning and end of the year were:
Receivables Inventory Trade payables Deduct: gain on disposals: (5000)
Beginning of the year $9,000 $3,000 $4,000 Add: dec in AR: 3000
End of the year $6,000 $5,000 $6,500 Deduct: inc in inventory: (2000)
Corporate income tax was $4,800. Add: inc in trade payables: 2500
Required: Calculate the amount of cash generated from operations, as it
Deduct: CIT paid: (4800)
would be shown in a statement of cash flows using the indirect method. Cash generated from operations: 24700

Questions Questions 3
Exercise 3 1. Interest payments
A company had liabilities in its statement of financial position at the beginning and
at the end of Year 1, as follows:
= Beginning interest payable – Ending interest
Interest charges payables Corporate income tax payables payable + Interest expense
Beginning of Year 1 $4,000 $53,000 = $4,000 – 3,000 + 22,000 = $23,000
End of Year 1 $3,000 $61,000
2. Tax payments
During the year, interest charges in the income statement were $22,000 and taxation
on profits were $77,000.
= Beginning tax payable – Ending tax payable +
Tax expense
Required: Calculate the amounts of interest payments and Corporate income tax = $61,000 – 53,000 + 77,000 = $69,000
payments (cash flows) for inclusion in the statement of cash flows
 Questions Questions 4
• PP&E:
Ending PP&E = Beginning – Historical cost + Historical purchase
Exercise 4
of PP&E
180000 = 150000 – 60000 + Historical purchase of PP&E
Historical purchase = 90000
• Depreciation of disposal asset
Ending dep = Beginning dep – Sold dep + New dep
88000 = 105000 – Sold dep + 40000
Sold dep = 57000
During the year a vehicle was disposed of for a gain of $3,000. The original cost of this asset
was $60,000. Assume that the Depreciation of Fixed assets of the year was $40,000. • Net book value of disposal asset = 60000 – 57000 = 3000
Required: Calculate the net cash flow from investing activities related to disposal of PPE
and PPE acquired. • Sale price of asset sold = 3000 + 3000 = 6000
• Net cash paid for PPE acquired = 90000 – 6000 = 84000
• Nếu là net CF from investing activities: -90000 + 6000 = -84000

Questions Questions 5
Exercise 5

The statements of the financial position of Grand Company at the beginning and end of Year + Carrying amount of the disposal assets:
1 include the following information:
260000 – 240000 = 20000
Property, plant , and equipment Beginning of Year 1 End of Year 1
cost/re‐valued amount 1,400,000 1,900,000 + Profit from disposal of FA:
Accumulated depreciation 350,000 375,000 = Net selling price – Carrying amount = 25000
Carrying value 1,050,000 1,525,000 => Net selling price = 25000 + 20000 = 45000
During the year, some property was re-valued upwards by $200,000. An item of equipment
was disposed of during the year at a profit of $25,000. This equipment had an original cost of
+ Cash outflow to acquire new PPE:
$260,000 and accumulated depreciation of $240,000 at the date of disposal. 1900000 – 1400000 – 200000 + 260000 = 560000
+ Net cash flow from investing activities:
Required: Calculate net cash flow from investing activities related to disposal of PPE and
PPE acquired
-560000 + 45000 = -515000

Questions Questions
Exercise 6 Exercise 7
The statements of financial position of Entity PLM at 1 January and 31 December included The statements of financial position of Entity PLM at 1 January and 31 December included
the following items: the following items:
1 January Year 1 31 December Year 1 1 January Year 1 31 December Year 1
$ $ $ $
Equity shares of $1 each 600,000 750,000 Loans repayable within 12 months 760,000 400,000
Share premium 800,000 1,100,000 Loans repayable after 12 months 1,400,000 1,650,000

Required: Calculate the cash generated from issuing new shares. Required: Calculate the net CF relating to loans during the year.

Cash generated from issuing new shares = ($750,000 – 600,000) + Change in short-term loans = $400,000 – 760,000 = -$360,000 (outflow)
($1,100,000 – 800,000) = $450,000 Change in long-term loans = $1,650,000 – 1,400,000 = $250,000 (inflow)
Net CF relating to loans during the year = $250,000 – 360,000 = -$110,000
 Questions Questions 8
Exercise 8
From the following information, calculate the cash flows from investing activities for Penron (a)CF from issuing new shares = (500,000 – 400,000) +
Company in Year 1. (615,000 – 275,000) = 440,000
Beginning of Year 1 End of Year 1
$ $ (b)CF paid for loans = (520,000 – 600,000) + (55,000 –
Share capital (ordinary shares) 400,000 500,000
Share premium 275,000 615,000 80,000) = -105,000
Retained earnings 390,000 570,000
1,065,000 1,685,000 (c)Ending RE = Beginning RE + Profit – Dividend paid
Loans repayable after more than 12 months 600,000 520,000
Loans repayable within 12 months or less 80,000 55,000 =>Payment of dividend to ordinary shareholders =
The company made a profit of $420,000 for the year after taxation. beginning RE + profit – ending RE
Required: Calculate for year 1, for inclusion in the statement of cash flows:
(a) the cash from issuing new shares
= 390000 + 420000 – 570000 = 240,000
(b) the cash flows received or paid for loans
(c) the payment of dividend to ordinary shareholders.

Question 9 Question 10
• An extract from a statement of cash flows prepared by a trainee
accountant is shown below. • Which of the following items could appear in a
• Cash flows from operating activities company’s statement of cash flows?
$m
Net profit before taxation 28 A. Surplus on revaluation of non-current assets
Adjustments for Depreciation (9)
Operating profit before working capital changes 19 B. Proceeds of issue of shares
Decrease in inventories 13
Increase in receivables (4) C. Proposed dividend
Increase in payables (8)
Cash generated from operations 10 D. Irrecoverable debts written off
• Which TWO of the following criticisms of this extract are correct? E. Dividends received
A. Depreciation charges should have been added, not deducted
B. Decrease in inventories should have been deducted, not added.
C. Increase in receivables should have been added, not deducted.
D. Increase in payables should have been added, not deducted

Questions 9, 10 Question 11
9.
A. True
Explanation: Depreciation is a non-cash expense because the company • Which of the following assertions about statement of cash flows is/are
does not have actual cash outflow for those expense. So, the correct?
depreciation should be added to the net income to find the net cash flow A. A statement of cash flows prepared using the direct method produces a
from operating activities under the indirect method. different figure for operating cash flow from that produced if the indirect
D. True method is used.
Explanation: Increase in payables raises current liabilities and must be B. Rights issues of shares do not feature in statements of cash flows.
added to find the net cash flow from operating activities.
C. A surplus on revaluation of a non-current asset will not appear as an item
in a statement of cash flows. (A revolution surplus is a non-cash item and
10. does not affect cash flow. It is not included in the statement of cash flow)
Correct answers: B & E
B. Proceeds of issue of shares recorded in cash flow from financing D. A profit on the sale of a non-current asset will appear as an item under
activities Cash Flows from Investing Activities in a statement of cash flows.
E. Dividend received is recorded in cash flow from operating activities
While A, C and D are recorded in balance sheet
 Question 12 Question 13
• The following extract is from the financial statements of Pompeii, a limited • Part of a company’s draft statement of cash flows is shown below:
liability company at 31 October: $’000
20X9 20X8 Net profit before tax 8,640
$’000 $’000 Depreciation charges (2,160)
Proceeds of sale of non-current assets 360
Equity and liabilities
Increase in inventory (330)
Share capital 120 80
Increase in accounts payable 440
Share premium 60 40
Retained earnings 85 68 • Which TWO of the following criticisms of the above extract are valid?
265 188
Non-current liabilities
A. Depreciation charges should have been added, not deducted.
Bank loan 100 150 B. Increase in inventory should have been added, not deducted.
365 338 C. Increase in accounts payable should have been deducted, not added.
• What is the cash inflow from financing activities to be disclosed in the D. Proceeds of sale of non-current assets should not appear in this part of
statement of cash flows for the year ended 31 October 20X9? the statement of cash flows.

Question 12, 13 Question 6

12.
• Issue of share capital
= (120000 + 60000) – (80000 + 40000) = 60000
• Which TWO of the following items could appear ¡n
• Repayment of bank loan a company’s statement of cash flows?
= 100000 – 150000 = -50000
Cash inflow from financing activities = 60000 – 50000 =
10000 A. Proposed dividends
B. Rights issue of shares (cash inflow)
13.
Correct answers are A and D. C. Bonus issue of shares
A. Depreciation is a non-cash item, so it should be added back to
D. Repayment of loan (cash outflow)
the net profit before tax to find the net CFO.
D. Proceeds of sale of non-current assets should appear in
investing activities.

PLANNING PROCESS
Question 7 Short-term planning

• In the course of preparing a company’s statement of cash flows, the

Preparation
following figures are to be included in the calculation of net cash from
operating activities.
$
Depreciation charges 980,000 Cash
Profit on sale of non-current assets 40,000 Forecast
Increase in inventories 130,000
Decrease in receivables 100,000
Increase in payables 80,000
Cash
• What will the net effect of these items be in the statement of cash planning
flows?

$
A Addition to operating profit 890,000 Cash budgeting
B Subtraction from operating profit 890,000
C Addition to operating profit 1,070,000
D Addition to operating profit 990,000

980000 – 40000 – 130000 + 100000 + 80000 = 990000

Planning cash flow for the purpose of short-term
 Addition to operating profit = 990000 operations.
150
 PLANNING PROCESS PLANNING PROCESS
Short-term planning Short-term planning

Step 3: Cash flow planning

Step 1: Prepare the cash flow planning
To make an effective cash flow plan, businesses need to collect Attempt to smooth out cash flow. Cash flow typically
information about past cash flows. Cash flow history needs to be fluctuates significantly from period to period. Receipts can
collected at least in the last 12 months. On that basis, perform a perhaps be accelerated, or selected disbursements deferred in
classification of cash inflows and outflows and make decisions order to smooth out shortfalls and avoid borrowing money or
about planned cash flows. delaying payments to important vendors or suppliers.
Step 2: Cash flow forecasting Make investments as early as possible. Idle cash is a lazy
Planning helps businesses find the most relevant results, while also asset, and the opportunity to put cash to work for the
pointing out data for each specific activity of the business. Plan to company in an interest-bearing account will help to improve
make decisions for forecasting, test options, fix times, from which overall return to the company.
results the company will run business.

151 152

PLANNING PROCESS PLANNING PROCESS

Short-term planning Short-term planning

Step 3: Cash flow planning

Looking into the future to see where problems are coming up also provides the Delay borrowing as long as possible. The cash flow plan will
opportunity to take action to do something about those potential problems.
show prospective shortfalls for which borrowing may have to
The look into the future provided by a solid cash planning system may alert the
company to opportunities to make investments earlier than would otherwise be be incurred.
the case. Larger dollar investments can generate more earnings than equiva-lent Get early information. The advantage of having early
amounts in smaller pieces, and knowing that cash will continue to be generated in
increasing amounts in the future may allow investment of more dollars earlier.
information so as to preclude the chaos of dealing with
This kind of anticipatory action is not feasible with-out good cash planning in unexpected cash excesses or shortfalls should be obvious to
place. any businessperson who has had to put out a fire or otherwise
However, the plan may also show ways to cover the shortfalls by means other deal with an emergency.
than bor-rowing, or may enable the company to defer borrowing until a later time.
This means savings in interest expense, the benefit of which is obvious to However, the plan may also show ways to cover the shortfalls by means other
everyone—except, perhaps, the company’s banker. than bor-rowing, or may enable the company to defer borrowing until a later
time. This means savings in interest expense, the benefit of which is obvious
to everyone—except, perhaps, the company’s banker.

153 154

PLANNING PROCESS
State the essentials of effective budgeting and
Step 4 STEP 1
the components of the master budget.

Budget: a formal written statement of management’s plans for

Step 4: Budgeting management/Cash management a specified future time period, expressed in financial terms.

◆ Primary method of communicating agreed-upon objectives

Forecasting sales
throughout the organization.
Projecting cash receipts
◆ Promotes efficiency.
Projecting cash disbursements
Projecting cash balances ◆ Control device - important basis for performance evaluation
once adopted.

155
The Benefits of Budgeting Essentials of Effective Budgeting

Primary benefits of budgeting: ◆ Depends on a sound organizational structure with

authority and responsibility for all phases of operations
1. Requires all levels of management to plan ahead.
clearly defined.
2. Provides definite objectives for evaluating performance.
◆ Based on research and analysis with realistic goals.
3. Creates an early warning system for potential problems.
◆ Accepted by all levels of management.
4. Facilitates coordination of activities within the business.

5. Results in greater management awareness of the entity’s

overall operations.

6. It motivates personnel throughout organization to meet

planned objectives.

Essentials of Effective Budgeting STEP 2

Prepare budgets for sales, production, and
direct materials.

LENGTH OF THE BUDGET PERIOD Sales Budget

◆ May be prepared for any period of time.
◆ First budget prepared.
► Most common - one year (~ 12 months).
◆ Derived from the sales forecast.
► Supplement with monthly and quarterly budgets.
► Management’s best estimate of sales revenue for the
► Different budgets may cover different time periods. budget period.

◆ Long enough to provide an attainable goal and ◆ Every other budget depends on the sales budget.
minimize seasonal or cyclical fluctuations.
◆ Prepared by multiplying expected unit sales volume for
◆ Short enough for reliable estimates. each product times anticipated unit selling price.

Sales Budget Production Budget

CASE STUDY: Hayes Company ◆ Shows units that must be produced to meet anticipated
sales.
◆ Expected sales volume: 3,000 units in the first quarter with
500-unit increases in each succeeding quarter. ◆ Derived from sales budget plus the desired change in
◆ Sales price: $60 per unit. ending finished goods inventory.

◆ Essential to have a realistic estimate of ending inventory.

 Production Budget Direct Materials Budget
CASE STUDY: Hayes Company
◆ Shows both the quantity and cost of direct materials to be
Hayes Co. believes it can meet future sales needs with an ending purchased.
inventory of 20% of next quarter’s budgeted sales volume.
◆ Formula for direct materials quantities.

Illustration 9-6

◆ Budgeted cost of direct materials to be purchased = required

units of direct materials x anticipated cost per unit.
◆ Inadequate inventories could result in temporary shutdowns
of production.

Direct Materials Budget Direct Materials Budget

CASE STUDY: Hayes Company

Because of its close proximity to suppliers,
◆ Hayes Company maintains an ending inventory of raw
materials equal to 10% of the next quarter’s production
requirements.
◆ The manufacture of each Rightride requires 2 pounds of
raw materials, and the expected cost per pound is $4.
◆ Assume that the desired ending direct materials amount is
1,020 pounds for the fourth quarter of 2017.
◆ Prepare a Direct Materials Budget.

Example 2 Sales, Production, and Direct Materials Budget Example 2 Sales, Production, and Direct Materials Budget

Prepare the sales, production, and direct materials budgets by

Soriano Company is preparing its master budget for 2017. Relevant data
pertaining to its sales, production, and direct materials budgets are as follows: quarters for 2017.
Sales: Sales for the year are expected to total 1,200,000 units. Quarterly sales
are 20%, 25%, 30%, and 25% respectively. The sales price is expected to be
$50 per unit for the first three quarters and $55 per unit beginning in the fourth
quarter. Sales in the first quarter of 2018 are expected to be 10% higher than
the budgeted sales for the first quarter of 2017.
Production: Management desires to maintain ending finished goods
inventories at 25% of next quarter’s budgeted sales volume.
Direct materials: Each unit requires 3 pounds of raw materials at a cost of $5
per pound. Management desires to maintain raw materials inventories at 5% of
the next quarter’s production requirements. Assume the production
requirements for the first quarter of 2018 are 810,000 pounds.
Example Sales, Production, and Direct Materials Budget Example 2 Sales, Production, and Direct Materials Budget
2
Prepare the sales, production, and direct materials budgets by Prepare the sales, production, and direct materials budgets by
quarters for 2017. quarters for 2017.

CASH PLANNING
Example 2 Sales, Production, and Direct Materials Budget
Direct method: Cash Receipts and Disbursements

Prepare the sales, production, and direct materials budgets. Cash receipts

Cash sales
Accounts receivable collections
Sales of assets
Interest and dividends received
Proceeds from borrowing
Proceeds from new equity
Other cash receipts

172

CASH PLANNING CASH PLANNING

Direct method: Cash Receipts and Disbursements Direct method: Cash Receipts and Disbursements
Bài tập: Doanh nghiệp A có doanh thu lịch sử 3 tháng cuối năm N-1 và
Cash disbursements doanh thu dự kiến 6 tháng đầu năm N như sau:
Cash sales Dividend payments Đơn vị: triệu USD
Debt amortization THỰC TẾ DỰ KIẾN
Accounts payable Tháng 10/N-1 11/N-1 12/N-1 1/N 2/N 3/N 4/N 5/N 6/N
Payroll costs (net) Capital expenditures Doanh thu 196 207 203 200 250 400 500 300 200

Payroll taxes Rents, royalties, etc. Cho biết:

Income taxes 1. 5% doanh thu được trả ngay lập tức, 10% doanh thu được trả sau đó
Fringe benefits payments nhưng vẫn trong tháng phát sinh, 60% doanh thu được trả sau 1 tháng, 15%
Manufacturing/service Property taxes doanh thu được trả sau 2 tháng, 10% doanh thu được trả sau 3 tháng.
expenses Insurance premiums 2. Tiền thu khác từ hoạt động kinh doanh như sau:
Other cash disbursements THỰC TẾ DỰ KIẾN
Marketing/administrative Tháng 10/N-1 11/N-1 12/N-1 1/N 2/N 3/N 4/N 5/N 6/N
expenses Thu khác từ kinh doanh Thực Thực Thực 11 2 4 8 10 5
Interest expense 3. Dự kiến dòng tiền cho các chi phí và mua sắm tài sản như sau:
- Chi phí nguyên vật liệu trực tiếp bằng 24% doanh thu.
173 - Chi phí nhân công trực tiếp bằng 6% doanh thu 174
 CASH PLANNING CASH PLANNING
Direct method: Cash Receipts
Direct method: Cash Receipts and Disbursements
Cash Flow Planning
- Chi phí sản xuất chung là 25
ACTUAL (Act.) PROJECTED
- Thuế và các khoản liên quan: 1% doanh thu
OCT NOV DEC JAN FEB MAR APR MAY JUN
- Chi phí sản xuất khác dự kiến như sau:
Sales (actual for first three months; then forecasted
THỰC TẾ DỰ KIẾN 196 207 203 200 250 400 500 300 200
Tháng 10/N-1 11/N-1 12/N-1 1/N 2/N 3/N 4/N 5/N 6/N Collections:
Chi phí sản xuất khác Thực Thực Thực 33 47 91 120 61 33 Cash sales—5% Act. Act. Act. 10 12 20 25 15 10
Current month -10% Act. Act. Act. 20 25 40 50 30 20
- Chi phí hoa hồng bằng 5% doanh thu
Prior month -60% Act. Act. Act. 122 120 150 240 300 180
- Chi phí bán hàng và quản lý doanh nghiệp bằng 25% doanh thu
Second prior -15% Act. Act. Act. 31 30 30 37 60 75
- Doanh nghiệp dự kiến có khoản chi mua sắm công cụ dụng cụ vào tháng 3 và tháng
Third prior -10% Act. Act. Act. 20 21 20 20 25 40
6 lần lượt là 20 và 30.
Total Cash Inflow from Collections
- Lãi vay trả hàng tháng: 10
Act. Act. Act. 203 208 260 372 430 325
- Chi phí khác mỗi tháng: 5
Other cash receipts Act. Act. Act. 11 2 4 8 10 5
Yêu cầu
Total Inflow-Month Act. Act. Act. 214 210 264 380 440 330
1. Lập bảng tính tổng thu, tổng chi và chênh lệch thu chi mỗi tháng
Total Inflow-Cum. 214 424 688 1,068 1,508 1,838
2. Cho biết tiền và các khoản tương đương tiền ngày 1/1/N là 100, tính tiền mặt cuối
mỗi tháng nếu không có hoạt động tài trợ cho thâm hụt ngân quỹ
3. Cho biết số dư tiền mặt tối thiểu yêu cầu là 100, xác định số tiền cần vay hàng
tháng để tài trợ cho thâm hụt ngân quỹ và số dư ngân quỹ cuối mỗi tháng khi có hoạt
động tài trợ đó. 175 176

CASH PLANNING CASH PLANNING

Direct method: Disbursements Direct method: Disbursements

ACTUAL PROJECTED
ACTUAL (Act.) PROJECTED
OCT NOV DEC JAN FEB MAR APR MAY JUN OCT NOV DEC JAN FEB MAR APR MAY JUN
Sales (actual for first three months; then forecasted) Sales (actual for first three months; then forecasted)
196 207 203 200 250 400 500 300 200 196 207 203 200 250 400 500 300 200
Cash Expenditures (Some expenses are calculated as the percentage of Revenue (Rev.) Beginning Cash without borrowing
Material purchases Act. Act. Act. 48 60 96 120 72 48 Act. Act. Act. 100 119 94 (37) (122) 33
Payroll direct labour cost Act. Act. Act. 12 15 24 30 18 12
NET CASH FLOW -MONTH
Payroll general expenses Act. Act. Act. 25 25 25 25 25 25
Act. Act. Act. 19 (25) (131) (85) 155 105
Payroll taxes and fringe benefits Act. Act. Act. 2 2.5 4 5 3 2
Ending Cash without Borrowing
Other manufacturing expenses Act. Act. Act. 33 47 91 120 61 33
Commissions Act. Act. Act. 10 12 20 25 15 10 Act. Act. Act. 119 94 (37) (122) 33 138
Other SG&A expenses Act. Act. Act. 50 63 100 125 75 50 Borrowing required
Capital equipment Act. Act. Act. 0 0 20 0 0 30 Act. Act. Act. 0 6 137 222 67 0
Debt service Act. Act. Act. 10 10 10 10 10 10 ENDING CASH BALANCE
Other expenditures Act. Act. Act. 5 5 5 5 5 5 Act. Act. Act. $119 $100 $100 $100 $100 $138
Total Cash Payments - Month Act. Act. Act. 195 239.5 395 465 284 225
Total Cash Payments -Cum. 195 434.5 829.5 1294.5 1578.5 1803.5
177 178

Prepare budgets for direct labor, manufacturing

STEP 3 overhead, and selling and administrative expenses, Direct Labor Budget
and a budgeted income statement.

Case study: Direct labor hours are determined from the

Direct Labor Budget
production budget. At Hayes Company, two hours of direct
◆ Shows both the quantity of hours and cost of direct labor labor are required to produce each unit of finished goods. The
necessary to meet production requirements. anticipated hourly wage rate is $10.

◆ Critical in maintaining a labor force that can meet

expected production.

◆ Total direct labor cost formula:

Manufacturing Overhead Budget Manufacturing Overhead Budget

◆ Shows the expected manufacturing overhead costs for Case study: Hayes Company expects variable costs to
the budget period. fluctuate with production volume on the basis of the following
◆ Distinguishes between fixed and variable overhead rates per direct labor hour: indirect materials $1.00, indirect
costs. labor $1.40, utilities $0.40, and maintenance $0.20. Thus, for
the 6,200 direct labor hours to produce 3,100 units, budgeted
indirect materials are $6,200 (6,200 x $1), and budgeted
indirect labor is $8,680 (6,200 x $1.40). Hayes also recognizes
that some maintenance is fixed. The amounts reported for fixed
costs are assumed.

Prepare a Manufacturing Overhead Budget.

Selling and Administrative Expense

Budget

◆ Projection of anticipated operating expenses.

◆ Distinguishes between fixed and variable costs.

Case study: Variable expense rates per unit of sales are sales
commissions $3 and freight-out $1. Variable expenses per
quarter are based on the unit sales from the sales budget. Hayes
expects sales in the first quarter to be 3,000 units. Fixed
expenses are based on assumed data.

Prepare a selling and administrative expense budget.

Budgeted Income Statement

◆ Important end-product of the operating budgets.

◆ Indicates expected profitability of operations.
◆ Provides a basis for evaluating company performance.
◆ Prepared from the operating budgets:
► Sales ► Manufacturing Overhead
► Direct Materials ► Selling and Administrative Expense
► Direct Labor
Budgeted Income Statement Budgeted Income Statement

Case study: To find the cost of goods sold, it is first Case study: All data for the income statement come from the
necessary to determine the total unit cost of producing one individual operating budgets except the following: (1) interest
Rightride, as follows. expense is expected to be $100, and (2) income taxes are
estimated to be $12,000.

Second, determine Cost of Goods Sold by multiplying units

sold times unit cost: 15,000 units x $44 = $660,000

Budgeted Income Statement Example 3 Budgeted Income Statement

Question Soriano Company is preparing its budgeted income statement

for 2017. Relevant data pertaining to its sales, production, and
Each of the following budgets is used in preparing the budgeted
direct materials budgets can be found on the following slide.
income statement except the:
Soriano budgets 0.5 hours of direct labor per unit, labor costs at
a. Sales budget. $15 per hour, and manufacturing overhead at $25 per direct
labor hour. Its budgeted selling and administrative expenses for
b. Selling and administrative budget.
2017are $12,000,000.
c. Capital expenditure budget.

d. Direct labor budget. (a) Calculate the budgeted total unit cost.
(b) Prepare the budgeted income statement for 2017.

Example 3 Budgeted Income Statement Example 3 Budgeted Income Statement

Soriano Company is preparing its master budget for 2017. Relevant data
Calculate the budgeted total unit cost and prepare the budgeted
pertaining to its sales, production, and direct materials budgets are as
follows: income statement for 2017.
Sales: Sales for the year are expected to total 1,200,000 units. Quarterly (a)
sales are 20%, 25%, 30%, and 25% respectively. The sales price is
expected to be $50 per unit for the first three quarters and $55 per unit
beginning in the fourth quarter. Sales in the first quarter of 2018 are
expected to be 10% higher than the budgeted sales for the first quarter of
2017.
Production: Management desires to maintain ending finished goods
inventories at 25% of next quarter’s budgeted sales volume.
Direct materials: Each unit requires 3 pounds of raw materials at a cost
of $5 per pound. Management desires to maintain raw materials
inventories at 5% of the next quarter’s production requirements. Assume
the production requirements for the first quarter of 2018 are 810,000
pounds.
Example 3 Budgeted Income Statement STEP 4 Prepare a cash budget and a budgeted balance sheet.

Calculate the budgeted total unit cost and prepare the budgeted
Cash Budget
income statement for 2017.
◆ Shows anticipated cash flows.
(b)
◆ Often considered to be the most important output in
preparing financial budgets.

◆ Contains three sections:

(b)
► Cash Receipts

► Cash Disbursements

► Financing

◆ Shows beginning and ending cash balances.

Cash Budget Cash Budget

◆ Cash Receipts Section

► Expected receipts from the principal sources of revenue.
► Expected interest and dividends receipts, proceeds from
planned sales of investments, plant assets, and the
company’s capital stock.
◆ Cash Disbursements Section
► Expected cash payments for direct materials, direct labor,
manufacturing overhead, and selling and administrative
expenses.
◆ Financing Section
► Expected borrowings and repayments of borrowed funds
plus interest.

Cash Budget Cash Budget

◆ Must prepare in sequence. Case study: Hayes Company Assumptions

◆ Ending cash balance of one period is the beginning cash 1. The January 1, 2017, cash balance is expected to be $38,000.
balance for the next. Hayes wishes to maintain a balance of at least $15,000.

◆ Data obtained from other budgets and from 2. Sales : 60% are collected in the quarter sold and 40% are
management. collected in the following quarter. Accounts receivable of
$60,000 at December 31, 2016, are expected to be collected in
◆ Often prepared for the year on a monthly basis.
full in the first quarter of 2017.
◆ Contributes to more effective cash management.
3. Short-term investments are expected to be sold for $2,000 cash
◆ Shows managers the need for additional financing before in the first quarter.
actual need arises.
◆ Indicates when excess cash will be available.
Cash Budget Cash Budget

Case study: Hayes Company Assumptions Case study: Hayes Company Assumptions
4. Direct materials : 50% are paid in the quarter purchased and 7. Management plans to purchase a truck in the second quarter
50% are paid in the following quarter. Accounts payable of for $10,000 cash.
$10,600 at December 31, 2016, are expected to be paid in full in
8. Hayes makes equal quarterly payments of its estimated annual
the first quarter of 2017.
income taxes.
5. Direct labor: 100% is paid in the quarter incurred.
9. Loans are repaid in the earliest quarter in which there is
6. Manufacturing overhead and selling and administrative sufficient cash (that is, when the cash on hand exceeds the
expenses: All items except depreciation are paid in the quarter $15,000 minimum required balance).
incurred.

Prepare a schedule of collections from customers.

Cash Budget Cash Budget

Case study: Prepare a schedule of collections from customers. Case study: Prepare a schedule of cash payments for direct materials.

Budgeted Balance Sheet

◆ Developed from the budgeted balance sheet for the

preceding year and the budgets for the current year.

Case study: Pertinent data from the budgeted balance

sheet at December 31, 2016, are as follows.

Buildings and equipment $182,000

Common stock 225,000
Accumulated depreciation 28,800
Retained earnings 46,480
 Budgeted Balance Sheet

Case study: Pertinent data from the budgeted balance sheet at

December 31, 2016, are as follows.

Buildings and equipment $182,000

Common stock 225,000
Accumulated depreciation 28,800
Retained earnings 46,480

1. Cash: Ending cash balance $37,900, shown in the cash budget

2. Accounts receivable: 40% of fourth-quarter sales $270,000,

shown in the schedule of expected collections from customers

Budgeted Balance Sheet Budgeted Balance Sheet

3. Finished goods inventory: Desired ending inventory 1,000 6. Accumulated depreciation: December 31, 2016, balance
units, shown in the production budget times the total unit cost $28,800, plus $15,200 depreciation shown in manufacturing
$44. overhead budget and $4,000 depreciation shown in selling and
administrative expense budget.
4. Raw materials inventory: Desired ending inventory 1,020
pounds, times the cost per pound $4, shown in the direct 7. Accounts payable: 50% of fourth-quarter purchases $37,200,
materials budget. shown in schedule of expected payments for direct materials.

5. Buildings and equipment: December 31, 2016, balance 8. Common stock: Unchanged from the beginning of the year.
$182,000, plus purchase of truck for $10,000. 9. Retained earnings: December 31, 2016, balance $46,480, plus
net income $47,900, shown in budgeted income statement.

Budgeted Balance Sheet Example 4 Cash Budget

Question Martian Company management wants to maintain a minimum

monthly cash balance of $15,000. At the beginning of March, the
Expected direct materials purchases in Read Company are
cash balance is $16,500, expected cash receipts for March are
$70,000 in the first quarter and $90,000 in the second quarter.
$210,000, and cash disbursements are expected to be $220,000.
Forty percent of the purchases are paid in cash as incurred,
How much cash, if any, must be borrowed to maintain the desired
and the balance is paid in the following quarter. The budgeted
minimum monthly balance?
cash payments for purchases in the second quarter are:

a. $96,000 c. $78,000

b. $90,000 d. $72,000
STEP 5
Apply budgeting principles to nonmanufacturing Merchandisers
companies.

Example: Lima estimates that budgeted sales will be $300,000 in

Merchandisers July and $320,000 in August. Cost of goods sold is expected to be
◆ Sales Budget: starting point and key factor in developing the 70% of sales. The company’s desired ending inventory is 30% of
master budget. the followings month’s cost of goods sold. Required merchandise
purchases for July are computed as follows.
◆ Use a purchases budget instead of a production budget.

◆ Does not use the manufacturing budgets (direct materials,

direct labor, manufacturing overhead).

◆ To determine budgeted merchandise purchases:

Service Companies Not-for-Profit Organizations

◆ Critical factor in budgeting is coordinating professional ◆ Just as important as for profit-oriented company.
staff needs with anticipated services.
◆ Budget process differs from profit-oriented company.
◆ Problems if overstaffed:
◆ Budget on the basis of cash flows (expenditures and
► Disproportionately high labor costs. receipts), not on a revenue and expense basis.
► Lower profits due to additional salaries.
◆ Starting point is usually expenditures, not receipts.
► Increased staff turnover due to lack of challenging work.
◆ Management’s task is to find receipts needed to support
◆ Problems if understaffed:
planned expenditures.
► Lost revenues because existing and future client needs
◆ Budget must be followed, overspending often illegal.
for services cannot be met.
► Loss of professional staff due to excessive work loads.

Merchandisers Example 5 Merchandise Purchases Budget

Question Becker Company estimates that 2017 sales will be $15,000 in quarter 1,
$20,000 in quarter 2, and $25,000 in quarter 3. Cost of goods sold is 80%
The budget for a merchandiser differs from a budget for a of sales. Management desires to have ending finished goods inventory
manufacturer because: equal to 15% of the next quarter’s expected cost of goods sold. Prepare a
merchandise purchases budget by quarter for the first six months of 2017.
a. A merchandise purchases budget replaces the
production budget.

b. The manufacturing budgets are not applicable.

c. None of the above.

d. Both (a) and (b) above

 ORGANIZATION PLANNING PROCESS CASE STUDY
123 company

123 company: Financial report and other information

(attached file)

Question:
Prepare cash flow statements using direct method
Determine the Company's budget
Handle the budget (surplus or deficit)

217 218

CHAPTER 4
CONCLUSION OF CHAPTER 3 CASH FLOWS FORECASTING MODEL

Cash flow planning, whether referred to as forecasting,

planning, budgeting, or projecting, is an indispensable part of CHAPTER 4
managing the company’s cash flow.
CASH FLOWS FORECASTING MODEL
Planning process includes 4 steps:
Prepare the cash flow planning
Cash flow forecasting
Cash flow planning
Budgeting management/Cash management

Cash flow forecasts have many methods of setting, depending

on the operating conditions and characteristics of the business

220
219

CHAPTER 4
OBJECTIVE
CASH FLOWS FORECASTING MODEL

Factors affecting cash flow forecasting Synthesize internal and external factors that affect the business's

Cash flow forecasting methods cash flow forecast.

Determine the target of the cash flow forecast

Case study
Identify and select the basis of cash flow forecast

Understand the cash flow forecast method and apply these

methods in cash flow forecasting of the business.

221 222
 CASH FLOWS FORECAST CASH FLOWS FORECAST

Objective
To manage short-term money fluctuations and determine the
optimal cash balance to meet payments incurred. Factors affecting cash flow forecast
The basis for the method and model of cash flow forecasting External fators
Availability of data
Internal fators
Reliability of data
Forecast time
Sensitivity

223 224

CASH FLOW FORECAST PROCESS CASH FLOWS FORECAST METHOD

1. Determine the structure of cash flows forecasted; Simple money fluctuation method (arithmetic addition)
2. Select input data; Exponential prediction method
3. Input data collection; Methods of planning cash flows (balancing revenues and
4. Determine the relationship between input variables and forecast expenditures)
cash flows; Cash flow allocation method
5. Make predictions by applying relationships between the The percetage of revenue method
dependent variables;
Regression analysis method
6. Evaluate the accuracy of the forecast.

225 226

ADDITION FUND NEEDED

CASH FLOWS FORECAST METHOD
(Nhu cầu tiền tăng thêm)

CASE STUDY
Capital needs Increase Increase
Addition
= for increased - liabilities - retained
fund needed
assets corresponding earnings

AFN = (A/So)x∆S - (L*/So)*∆S - PM(S1)RR

227
 CHAPTER 4
AFN
CASH FLOWS FORECASTING MODEL

Trong đó:

A*_Assets increasing CHAPTER 4

CASH FLOWS FORECASTING MODEL
So_ Previous year Sales

L*_Liabilities increasing (exluding loans)

L*/So_Liabilities increasing/ Sales

S1_ Sales forecast next year

PM_Profit margin (ROS)

RR_rate of retained earnings = 1- dividend payout rate

229 230

CHAPTER 4
OBJECTIVE
CASH FLOWS FORECASTING MODEL

Factors affecting cash flow forecasting Synthesize internal and external factors that affect the business's

Cash flow forecasting methods cash flow forecast.

Determine the target of the cash flow forecast

Case study
Identify and select the basis of cash flow forecast

Understand the cash flow forecast method and apply these

methods in cash flow forecasting of the business.

231 232

CASH FLOWS FORECAST CASH FLOWS FORECAST

Objective
To manage short-term money fluctuations and determine the
optimal cash balance to meet payments incurred. Factors affecting cash flow forecast
The basis for the method and model of cash flow forecasting External fators
Availability of data
Internal fators
Reliability of data
Forecast time
Sensitivity

233 234
 CASH FLOW FORECAST PROCESS CASH FLOWS FORECAST METHOD

1. Determine the structure of cash flows forecasted; Simple money fluctuation method (arithmetic addition)
2. Select input data; Exponential prediction method
3. Input data collection; Methods of planning cash flows (balancing revenues and
4. Determine the relationship between input variables and forecast expenditures)
cash flows; Cash flow allocation method
5. Make predictions by applying relationships between the The percetage of revenue method
dependent variables;
Regression analysis method
6. Evaluate the accuracy of the forecast.

235 236

ADDITION FUND NEEDED

CASH FLOWS FORECAST METHOD
(Nhu cầu tiền tăng thêm)

CASE STUDY
Capital needs Increase Increase
Addition
= for increased - liabilities - retained
fund needed
assets corresponding earnings

AFN = (A/So)x∆S - (L*/So)*∆S - PM(S1)RR

237

AFN
Chapter Outline
Trong đó:

A*_Assets increasing • What is Financial Planning?

So_ Previous year Sales • Financial Planning Models
L*_Liabilities increasing (exluding loans)
• The Percentage of Sales Approach
L*/So_Liabilities increasing/ Sales
• External Financing and Growth
S1_ Sales forecast next year
• Some Caveats Regarding
PM_Profit margin (ROS)
Financial Planning Models
RR_rate of retained earnings = 1- dividend payout rate
239 4-240
 What is financial planning?
Chapter Outline
Financial planning formulates the way in which
financial goals are to be achieved. A financial
• What is Financial Planning? plan is thus a statement of what is to be done in
the future. Many decisions have long lead
• Financial Planning Models times, which means they take a long time to
• The Percentage of Sales Approach implement. In an uncertain world, this requires
that decisions be made far in advance of their
• External Financing and Growth
implementation.
• Some Caveats Regarding
Financial Planning Models

4-241 4-242

What is financial planning?

Elements of Financial Planning Financial Planning Process
• Investment in new assets – determined by • Planning Horizon - divide
capital budgeting decisions decisions into short-run
decisions (usually next 12
• Degree of financial leverage – determined months) and long-run
by capital structure decisions decisions (usually 2 – 5
• Cash paid to shareholders – determined by years)
dividend policy decisions
• Aggregation - combine
• Liquidity requirements – determined by capital budgeting decisions
net working capital decisions into one large project

4-243 4-244

Financial Planning Process Role of Financial Planning

Assumptions and Scenarios
• Make realistic • Examine interactions – help
assumptions about management see the
important variables interactions between
decisions
• Run several scenarios
where you vary the • Explore options – give
assumptions by management a systematic
reasonable amounts framework for exploring its
opportunities
• Determine, at a minimum,
worst case, normal case,
and best case scenarios
4-245 4-246
 Role of Financial Planning Chapter Outline

• Avoid surprises – help management identify • What is Financial Planning?

possible outcomes and plan accordingly
• Financial Planning Models
• Ensure feasibility and internal consistency – help
management determine if goals can be • The Percentage of Sales Approach
accomplished and if the various stated (and
• External Financing and Growth
unstated) goals of the firm are consistent with one
another • Some Caveats Regarding
Financial Planning Models

4-247 4-248

Financial Planning Model Financial Planning Model

Ingredients Ingredients
• Sales Forecast – many cash
flows depend directly on • Asset Requirements
the level of sales (often the additional assets that will be required to
estimated using sales meet sales projections
growth rate)
• Financial Requirements the amount of
• Pro Forma Statements – financing needed to pay for the required
setting up the plan using assets
projected financial
statements allows for
consistency and ease of
interpretation
4-249 4-250

Financial Planning Model Example I:

Ingredients Constructing a Pro Forma
• Plug Variable determined The Current Balance Sheet
by management deciding Gourmet Coffee Inc.
what type of financing
will be used to make the Balance Sheet
balance sheet balance December 31, 2011

Assets 1000 Debt 400

• Economic Assumptions
explicit assumptions about
the coming economic Equity 600
environment
Total 1000 Total 1000

4-251 4-252
 Example I: Example I:
Constructing a Pro Forma Constructing a Pro Forma
The Current Income Statement
Initial Assumptions:
Gourmet Coffee Inc.
• Revenues will grow at 15%
Income Statement (2,000*1.15)
For Year Ended
December 31, 2011 • All items are tied directly to sales, and the
current relationships are optimal
Revenues 2000
• Consequently, all other items will also
Less: costs (1600) grow at 15%
Net Income 400

4-253 4-254

Example I: Constructing a Pro Example I: Constructing a Pro

Forma Income Statement Forma Balance Sheet
Gourmet Coffee Incorporated
Gourmet Coffee Incorporated Pro Forma Balance Sheet
December 31, 2012
Pro Forma Income Statement 2011 Forecasted Pro forma
growth 2012
For the Year Ended 2012
Total Assets 1,000 1.15 1,150
2011 Forecasted Pro forma Total Debt 400 1.15 460
growth rate 2012 Equity 600 1.15 690
Revenues 2,000 1.15 2,300 Total Liab + OE 1,150

Less: costs 1600 1.15 (1,840) In this example, the dividends are the “plug variable” so first we estimate the future total
Net Income 400 1.15 460 assets and total debt by increasing them 1.15%. Next we compute the dividend change
(from the estimated profits from the pro forma income statement) : 460 – increase in
equity needed to balance the equation so we have 460 NI – RE reinvested 90 = 690 new
4-255 equity and 370 paid out as dividends. 4-256

Example I: Constructing a Pro Forma

Balance Sheet Chapter Outline
Gourmet Coffee Incorporated
Pro Forma Balance Sheet
December 31, 2012
• What is Financial Planning?
2011 Forecasted Pro forma
growth 2012 • Financial Planning Models
Total Assets 1,000 1.15 1,150
Total Debt 400 1.15 90
• The Percentage of Sales Approach
Equity 600 1.15 1,060
Total Liab. + OE 1,150
• External Financing and Growth
In this second example of a pro forma balance sheet, the debt is the “plug variable” so first • Some Caveats Regarding
we estimate the future total assets by increasing them 1.15. There are no dividends paid
out so all of the net income is available as an addition to retained earnings. Thus Equity of Financial Planning Models
600 + 460 NI = 1060 for the new equity figure. The current debt is 400 but we will use
funds to pay down the debt to get the balance sheet to balance. 400 current debt – 310 = 90
as the new pro forma debt figure. Thus we can repay 310 debt dollars. 4-257 4-258
 Percentage of Sales Approach Percentage of Sales Approach
Income Statement Income Statement
• Costs may vary directly with sales - if this • Dividends are a management decision
is the case, then the profit margin is and generally do not vary directly with
constant sales – this influences additions to
retained earnings
• Depreciation and interest expense may
not vary directly with sales – if this is the
case, then the profit margin is not
constant

4-259 4-260

Example II: % of Sales Pro Percentage of Sales Approach

Forma
Income Statement Balance Sheet
Tasha’s Toy Emporium Tasha’s Toy Emporium
Income Statement, 2011 Pro Forma Income Statement,
2012 • Initially assume all assets, including
% of
Sales
Sales 5,500 fixed, vary directly with sales
Sales 5,000 Less: costs (3,300)
Less: costs
EBT
(3,000)
2,000
60%
40%
EBT 2,200
• Accounts payable will also normally
Less: taxes (800) 16%
Less: taxes (880)
vary directly with sales
(40% of Net Income 1,320
EBT)
Net Income 1,200 24% Dividends 660
Dividends 600 Add. To RE 660
Add. To RE 600 4-261 4-262

Percentage of Sales Approach Example II: % of Sales Pro

Forma Balance Sheet
Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
• Notes payable, long-term debt and Current % of
Sales
Pro
Forma
Current % of
Sales
Pro
Forma
equity generally do not vary directly ASSETS Liabilities & Owners’ Equity

with sales because they depend on Current Assets

Cash $500 10% $550 A/P
Current Liabilities
$900 18% $990
management decisions about capital A/R 2,000 40 2,200 N/P 2,500 n/a 2,500

structure Inventory
Total
3,000
5,500
60
110
3,300 Total
6,050 LT Debt
3,400
2,000
n/a
n/a
3,490
2,000
Owners’ Equity
• The change in the retained earnings
Fixed Assets
Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000
portion of equity will come from the Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760

dividend decision Total

Total L & OE
4,100
9,500
n/a 4,760
10,250
4-263 4-264
 Chapter Outline Example II: External Financing
Needed (EFN)
• What is Financial Planning? Tasha’s Toy Emporium needs to come up
• Financial Planning Models with an additional $200 in debt or
equity to make the balance sheet
• The Percentage of Sales Approach
balance:
• External Financing and Growth
• Some Caveats Regarding TA – T liab. & OE
Financial Planning Models
10,450 – 10,250 = 200
4-265 4-266

Example II: External Financing

Fixed Assets at Full Capacity?
Needed (EFN)
• Where will the $200 EFN come from? If we are operating our fixed assets
There are four choices: (machinery, for example) at full capacity,
then we need new fixed assets if we are to
1. Borrow more short-term (Notes Payable) funds
expand the business
2. Borrow more long-term (LT Debt)
3. Sell more common stock (CS & APIC)
4. Decrease the dividend payout, which increases
the Additions To Retained Earnings

4-267 4-268

Fixed Assets at Full Capacity? Operating at Less than Full

Capacity
But what happens if we are NOT running at Suppose we are operating our fixed
full capacity? Do we require additional
assets at 80% of capacity.
fixed assets?
We want to grow 10% next year.
Q: Do we need more fixed assets?
A: No, 80% + 10% growth 100%
(we still have idle capacity!)
4-269 4-270
Growth and External Financing Growth and External Financing

• At low growth levels, internal financing Examining the

(retained earnings) may exceed the relationship between
required investment in assets with no EFN growth and external
required. financing required
(EFN) is a useful tool in
• As the growth rate increases, the internal long-range planning
financing will not be enough, and the
firm will have to go to the capital markets
for money.

4-271 4-272

The Internal Growth Rate

The Internal Growth Rate
Example from Tasha’s Toys
The internal growth rate tells us how
The formula for the growth rate is:
much the firm can grow assets using ROA x b
retained earnings as the only source 1 – ROA x b

of financing. ROA = 1200 / 9500 = .1263

B = 0.50
The formula for the internal growth rate is: .1263 x .50
1 - .1263 x .50
ROA x b = .0674 = 6.74%

1 – ROA x b This firm could grow assets at 6.74% without raising additional external capital.

Relying solely on internally generated funds will increase equity (retained earnings are
part of equity) and assets without an increase in debt. Consequently, the firm’s leverage
Where ROA is the Return on Assets and b is will decrease over time. If there is an optimal amount of leverage, as we will discuss in
the dividend payout rate later chapters, then the firm may want to borrow to maintain that optimal level of
4-273 leverage. This idea leads us to the sustainable growth rate. 4-274

The Sustainable Growth Rate

The Sustainable Growth Rate
Example from Tasha’s Toys
The sustainable growth rate tells us how The formula for the sustainable growth rate is:
much the firm can grow assets using ROE x b
internally generated funds and issuing debt 1 – ROE x b

to maintain a constant debt ratio. ROE = 1200 / 4100 = .2927

The formula for the sustainable growth rate is: B = 0.50
.2927 x .50
1 - .2927 x .50
ROE x b = .1714 = 17.14%
1 – ROE x b Note that no new equity is issued.

The sustainable growth rate is substantially higher than the internal growth rate. This
Where ROE is the Return on Equity and b is is because we are allowing the company to issue debt as well as use internal funds.
the dividend payout rate
4-275 4-276
 Determinants of Growth Work the Web
1. Profit margin – operating efficiency

2. Total asset turnover – asset use efficiency

• Looking for estimates of company
growth rates?
3. Financial leverage – choice of optimal debt ratio
• What do the analysts have to say?
4. Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm • Check out Yahoo Finance – click the web
The first three components come from the ROE and the Du Pont identity presented in surfer, enter a company ticker and
the previous chapter.
follow the “Analyst Estimates” link
It is important to note at this point that growth is not the goal of a firm in and of itself.
Growth is only important so long as it continues to maximize shareholder value. For
example, we could grow sales by cutting prices, but this would squeeze margins and
possibly reduce overall earnings. 4-277 4-278

Chapter Outline Important Questions

It is important to remember that we are
• What is Financial Planning? working with accounting numbers;

• Financial Planning Models

• The Percentage of Sales Approach
• External Financing and Growth
therefore, we must ask ourselves some
• Some Caveats Regarding important questions as we go through the
Financial Planning Models planning process.

4-279 4-280

Important Questions Ethics Issues

• How does our plan affect the • Should managers overstate budget
timing and risk of our cash flows? requests (or growth projections) if they
know that central headquarters is going
• Does the plan point out to cut funds across the board?
inconsistencies in our goals? • If manager’s compensation is
connected to forecasts, should
• If we follow this plan, will we estimates be understated to ensure
maximize owners’ wealth? making the “target”?
4-281 4-282
 Quick Quiz Comprehensive Problem
• What is the purpose of long-range planning?
Part I
• What are the major decision areas involved in XYZ has the following financial information for 2011:
developing a plan? Sales = $2M, Net Inc. = $0.4M,
Div. = $0.1M, C.A. = $0.4M,
• What is the percentage of sales approach? F.A. = $3.6M, C.L. = $0.2M, LTD = $1M, C.S. = $2M, R.E. =
$0.8M
• How do you adjust the model when operating at
less than full capacity? What is the sustainable growth rate?

• What is the internal growth rate? ROE = net income / shareholders’ equity = $.4M / ($2M + $.8M) = .1429
Payout ratio = dividends/net income = .1M/.4M = .25
• What is the sustainable growth rate? Plowback ratio (b) 1 – payout ratio = 1 - .25 = .75
Sustainable growth rate = ROE X b / 1 – ROE X b = .1429 X .75 / (1 – (.1429 X
• What are the major determinants of growth? .75)) = .12
4-283 4-284

Comprehensive Problem Comprehensive Problem

Part II Part II
Profit margin = net income/sales = .4M/2M = .2
Projected net income = profit margin X projected sales = .2 X $2.4M = $.48M
XYZ is operating at full capacity and the Projected addition to retained earnings = projected net income X (1 – payout ratio) =
profit margin and payout ratio remain $.48M X (1-.25) = $.48M X .75 = $.36M

constant. % change in sales = ($2.4M - $2M)/$2M = .2

2009 total assets = $.4M + $3.6M = $4M
Projected total assets = $4M X 1.2 = $4.8M
Sales for 2012 are projected to be $2.4M. Projected C.L. = $.2M X 1.2 = $.24M

What is the amount of EFN needed? Projected R.E. = 2006 R.E. + projected addition to R.E. = $.8M + $.36M = $1.16M

Projected liabilities and owners’ equity = projected C.L. + LTD + C.S. + projected R.E. =
$.24M + $1M + $2M + $1.16M = $4.4M

External Financing Needed = projected assets – projected liabs. and OE = $4.8M - $4.4M
4-285 = $.4M 4-286

Terminology Formulas
The formula for the internal growth rate is:
• Pro forma income statement ROA x b
• Pro forma balance sheet 1 – ROA x b
• Percent of Sales forecasting
Where ROA is the Return on Assets and b is
• External Financing Needed (EFN) the dividend payout rate

forecasting The formula for the sustainable growth rate

• Fixed Asset Capacity is:

• Internal Growth Rate ROE x b

• Sustainable Growth Rate 1 – ROE x b
Where ROE is the Return on Equity and b is
the dividend payout rate
4-287 4-288
 Key Concepts and Skills Key Concepts and Skills

• Describe the financial planning • Compute a firm’s sustainable

process growth rate.
• Construct a financial plan using • Compute a firm’s internal growth
the percent of sales technique rate.
• Construct a financial plan using • Explain and apply the four major
the external financing needed decision areas involved in long-
(EFN) technique term financial planning
4-289 4-290

What are the most important What are the most

topics of this chapter? important topics of this
chapter?

1. Financial planning focuses on a 4. Percent of Sales and EFN forecasting

firm’s financing needs for the future. identify future funding requirements.
2. A pro forma income statement and
balance sheet provide the financial 5. Growth rate estimates can be
picture for the future of the firm. computed for internal and sustainable
growth of the firm.
3. Fixed assets are needed for growth
above capacity.

4-291 4-292

CHAPTER 5
CASH MANAGEMENT MODEL

CHAPTER 5
CASH MANAGEMENT MODEL

4-293 294
 CHAPTER 5
CHAPTER OUTLINE
CASH MANAGEMENT MODEL

Cash flows planning Tracing Cash and Net Working Capital

Cash management model The Operating Cycle and the Cash Cycle

Budget handling Some Aspects of Short-Term Financial Policy

The Cash Budget

Case study
A Short-Term Financial Plan

295 296

CHAPTER OUTLINE
Overarching Principles
Much of this chapter is
Make a cash plan based on addition fund needed
about timing:
Reasons for Holding Cash
Keep the money you have
Understanding Float
as long as you can;
Cash Collection and Concentration

Managing Cash Disbursements

Get the money owed you
as soon as you can.
Investing Idle Cash

297

The Operating Cycle The Operating Cycle

• Operating cycle – time between purchasing • Accounts receivable period – time required
the inventory and collecting the cash from to collect on credit sales
sale of the inventory
• Operating cycle = inventory period +
• Inventory period – time required to accounts receivable period
purchase and sell the inventory
 Cash Cycle Cash Cycle
• Cash cycle • Accounts payable period – time
– Amount of time we finance our between purchase of inventory and
inventory payment for the inventory

– Difference between when we receive • Cash cycle = Operating cycle –

cash from the sale and when we have to accounts payable period
pay for the inventory

Example Information
Operating and Cash Cycles
• Inventory:
– Beginning = 200,000
– Ending = 300,000
• Accounts Receivable:
– Beginning = 160,000
– Ending = 200,000
• Accounts Payable:
– Beginning = 75,000
– Ending = 100,000
• Net sales = 1,150,000
• Cost of Goods sold = 820,000

Example Solution – Operating Cycle Example Solution – Cash Cycle

• Inventory period
– Average inventory = (200,000+300,000)/2 = 250,000
– Inventory turnover = 820,000 / 250,000 = 3.28 times • Payables Period
– Inventory period = 365 / 3.28 = 111 days – Average payables = (75,000+100,000)/2 =
87,500
• Receivables period
– Payables turnover = 820,000 / 87,500 = 9.37
– Average receivables = (160,000+200,000)/2 = times
180,000
– Payables period = 365 / 9.37 = 39 days
– Receivables turnover = 1,150,000 / 180,000 = 6.39
times
– Receivables period = 365 / 6.39 = 57 days
• Cash Cycle = 168 – 39 = 129 days
• Operating cycle = 111 + 57 = 168 days
 Example Solution – Interpretation
Chapter Outline
• We have to finance our inventory for 129
days •Tracing Cash and Net Working Capital
•The Operating Cycle and the Cash Cycle
• If we want to reduce our financing needs, •Some Aspects of Short-Term Financial Policy
we need to look carefully at our •The Cash Budget
receivables and inventory periods – they •A Short-Term Financial Plan
both seem extensive.

• A comparison to industry averages would

help solidify this assertion.

Short-Term Financial Policy Short-Term Financial Policy

Size of investments in current assets Financing of current assets
– Flexible (conservative) policy – maintain a – Flexible (conservative) policy – less short-
high ratio of current assets to sales term debt and more long-term debt
– Restrictive (aggressive) policy – maintain a – Restrictive (aggressive) policy – more
low ratio of current assets to sales short-term debt and less long-term debt

Carrying vs. Shortage Costs Carrying vs. Shortage Costs

• Managing short-term assets Carrying costs – increase with increased levels of
current assets, the costs to store and finance the
involves a trade-off between assets
carrying costs and shortage costs.
Is there an optimal balance Shortage costs – decrease with increased levels of
between the two? current assets

• Trading or order costs

• Costs related to safety reserves, i.e., lost sales
and customers, and production stoppages
 Temporary vs. Permanent Temporary vs. Permanent
Assets Assets
Temporary current assets: Permanent current assets:

– Sales or required inventory build-up – Firms generally need to carry a

may be seasonal minimum level of current assets at all
– Additional current assets are needed times
during the “peak” time – These assets are considered
– The level of current assets will “permanent” because the level is
decrease as sales occur constant, not because the assets
aren’t sold

Timing of Asset Requirements Choosing the Best Policy

 Cash reserves
 High cash reserves mean that firms will be less likely to
experience financial distress and are better able to
handle emergencies or take advantage of unexpected
opportunities
 Cash and marketable securities earn a lower return
and are zero NPV investments
 Maturity hedging
 Try to match financing maturities with asset maturities
 Finance temporary current assets with short-term
debt
 Finance permanent current assets and fixed assets
with long-term debt and equity

Choosing the Best Policy Comparative Funding

• Interest Rates
– Short-term rates are normally lower than
long-term rates, so it may be cheaper to
finance with short-term debt
– Firms can get into trouble if rates increase
quickly or if it begins to have difficulty
making payments – may not be able to
refinance the short-term loans

• A firm must consider all of these factors

and determine a compromise policy that
fits the needs of the firm
 Chapter Outline Cash Budget
• Forecast of cash inflows and outflows over
the next short-term planning period
•Tracing Cash and Net Working Capital
• Primary tool in short-term financial planning
•The Operating Cycle and the Cash Cycle
•Some Aspects of Short-Term Financial Policy • Helps determine when the firm should
•The Cash Budget experience cash surpluses and when it will
need to borrow to cover working-capital
•A Short-Term Financial Plan
requirements
• Allows a company to plan ahead and begin
the search for financing before the money is
actually needed

Example: Cash Budget Example: Cash Budget

Information Information
Pet Treats, Inc. specializes in gourmet pet Pet Treats, Inc. specializes in gourmet pet
treats and receives all income from sales treats and receives all income from sales
• Sales estimates (in millions) • Other expenses
– Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 – Wages, taxes, and other expense are 30%
next year = 550 of sales
• Accounts receivable – Interest and dividend payments are $50
– Beginning receivables = $250 – A major capital expenditure of $200 is
– Average collection period = 30 days expected in the second quarter
• Accounts payable
– Purchases = 50% of next quarter’s sales • The initial cash balance is $80, and the
– Beginning payables = 125 company maintains a minimum balance of
– Accounts payable period is 45 days $50

Example: Cash Budget Example: Cash Budget

Cash Collections Cash Disbursements
• Payables period is 45 days, so half of the purchases will be
• ACP = 30 days; this implies that 2/3 of sales are collected in paid for each quarter and the remaining will be paid the
the quarter made and the remaining 1/3 are collected the following quarter
following quarter
• Beginning receivables of $250 will be collected in the first • Beginning payables = $125
quarter Pet Treats, Inc. Q1 Q2 Q3 Q4
Pet Treats, Inc. Q1 Q2 Q3 Q4 Payment of accounts 275 313 362 338
Beginning Receivables 250 167 200 217 Wages, taxes and other 150 180 195 240
Sales 500 600 650 800 expenses
Capital expenditures 200
Total Cash Collections 583 567 633 750
Interest and dividend payments 50 50 50 50
Ending Receivables 167 200 217 267
18-323 18-324
Total cash disbursements 475 743 607 628
 Example: Cash Budget – Net Short-Term Borrowing
Cash Flow and Cash Balance
Pet Treats, Inc. Q1 Q2 Q3 Q4
Unsecured Loans
– Line of credit
Total cash collections 583 567 633 750
Total cash disbursements 475 743 607 628
– Committed vs.
Net cash inflow 108 -176 26 122 non-committed
Beginning Cash Balance 80 188 12 38
Net cash inflow 108 -176 26 122 – Revolving credit
arrangement
Ending cash balance 188 12 38 160
Minimum cash balance -50 -50 -50 -50 – Letter of credit
18-325 Cumulative surplus (deficit) 138 -38 -12 110

Example: Compensating
Short-Term Borrowing
Balance
• Secured Loans We have a $500,000 line of credit with a 15% compensating
– Accounts receivable balance requirement.
financing
• Assigning The quoted interest rate is 9%.
• Factoring
– Inventory loans We need to borrow $150,000 for inventory for one year.
• Blanket inventory lien
Note that this method of finding the effective rate only works if we are borrowing the
• Trust receipt money for one year. If we are borrowing the money for less than one year, enter the
• Field warehouse amount available for use today as the PV and the repayment amount after subtracting
financing the money available from the compensating balance as the FV (remember the negative

• Commercial Paper sign), then enter N as the fraction of a year and compute I. For example, PV = 150,000;
FV = 176,471 + 15,882 – 26,471 with a negative sign = -165,882; N = 1; CPT I =
• Trade Credit 10.588%

Example: Compensating Example: Factoring

Balance
How much do we need to borrow? Last year your company had average
accounts receivable of $2 million.
150,000/(1-.15) = $176,471
Credit sales were $24 million.
What interest rate are we effectively You factor receivables by discounting them
paying? 2%.
Interest paid = 176,471(.09) = $15,882
Effective rate = 15,882/150,000
= .1059 or 10.59%
 Example: Factoring Chapter Outline
What is the effective rate of interest?
•Tracing Cash and Net Working Capital
Receivables turnover = 24/2 = •The Operating Cycle and the Cash Cycle
12 times •Some Aspects of Short-Term Financial Policy
•The Cash Budget
•A Short-Term Financial Plan
APR = 12(.02/.98) = .2449 or 24.49%

EAR = (1+.02/.98)12 – 1 = .2743 or 27.43%

Short-Term Financial Plan Ethics Issues

A large retailer such as Wal-Mart possesses

power over smaller suppliers. In theory, Wal-
Mart could force these suppliers to sell on
payment terms that were well beyond a
typical industry norm.
– How would this impact Wal-Mart’s cash cycle?
– How would this impact the supplier’s cycle?
– Are there any ethical issues involved in such a
18-333 practice?

Quick Quiz Comprehensive Problem

 With a quoted interest rate of 5% and a 10%

• How do you compute the operating cycle and
the cash cycle? compensating balance, what is the effective
rate of interest (use a $200,000 loan
• What are the differences between a flexible
proceeds amount)?
short-term financing policy and a restrictive
one? What are the pros and cons of each?  With average accounts receivable of $5
• What are the key components of a cash million and credit sales of $24 million, you
budget? factor receivables by discounting them 2%.
• What are the major forms of short-term What is the effective rate of interest?
borrowing?
 Comprehensive Problem Terminology

•Net Working Capital (NWC)

Borrow $200,000 / (1 - .1) = $222,222
Pay interest of .05 x $222,222 = $11,111 •Sources and Uses of Cash
Effective rate of interest = $11,111/$200,000 = .05555 = 5.56% •Operating Cycle
•Cash Cycle
Receivables turnover = $24/$5 = 4.8 times
APR = 4.8(.02/.98) = .09796 = 9.8% •Cash Budget
EAR = {[1+(.098/4.8)]^4.8}-1=10.19% •Compensating Balance
•Factoring

Formulas Key Concepts and Skills

•Define the components
Operating cycle = inventory period + of the cash cycle and
accounts receivable period evaluate the importance of
the components.
Cash cycle = Operating cycle – •Explain the pros and cons of
accounts payable period the various short-term financing
policies and options.
•Construct a cash budget.

What are the most important What are the most

topics of this chapter? important topics of this
chapter?

1. Bring cash into the organization and

4. The operating cycle and the cash cycle
dispersing it efficiently is the focus of
work together to demonstrate how
working capital management.
much time it takes to go from inventory
2. The timing of cash is the key to insure to cash received.
we have sufficient funds to pay our bills
on time. 5. Short-term borrowing fills in the “gaps”
of needed funds
3. The cash budget forecasts future cash
needs.
 MAKE OPTIMAL CASH BALANCE
Understanding Float

Reasons for Holding Cash: Float – difference between cash balance recorded in the cash
account and the cash balance recorded at the bank
Disbursement float
Speculative motive – hold cash to take advantage of unexpected
opportunities Generated when a firm writes checks
Precautionary motive – hold cash in case of emergencies Available balance at bank – book balance > 0

Transaction motive – hold cash to pay the day-to-day bills Collection float
Checks received increase book balance before the bank
Trade-off between opportunity cost of holding cash relative to
the transaction cost of converting marketable securities to cash credits the account.
for transactions Available balance at bank – book balance < 0
Net float = disbursement float + collection float
343

Example: Measuring Float

Example: Types of Float
Size of float depends on the dollar amount and the time delay.
You have $3,000 in your checking account. You just deposited
Delay = mailing time + processing delay + availability delay
$2,000 and wrote a check for $2,500.
Suppose you mail a check each month for $1,000 and it takes
3 days to reach its destination, 1 day to process, and 1 day
What is the disbursement float? -> $2,500 before the bank makes the cash available.
What is the collection float? -$2,000
What is the net float? -> $2,500 – 2,000 = $500 What is the average daily float (assuming 30-day months)?
What is your book balance? -> $3,000 + 2,000 – 2,500 = Method 1: (3+1+1)(1,000)/30 = 166.67
$2,500
Method 2: (5/30)(1,000) + (25/30)(0) = 166.67
What is your available balance? -> $3,000

Example: Cost of Float Cash Collection

Cost of float – opportunity cost of not being able to use the
money
Payment Payment Payment Cash
Suppose the average daily float is $3 million with a weighted Mailed Received Deposited Available
average delay of 5 days.
What is the total amount unavailable to earn interest?
Mailing Processing Delay Availability Delay
5 × $3 million = $15 million Time

What is the NPV of a project that could reduce the delay by Collection Delay
3 days if the cost is $8 million?
Immediate cash inflow = 3 × $3 million = $9 million One of the goals of float management is to try to reduce the
NPV = $9 – $8 = $1 million collection delay. There are several techniques that can reduce
various parts of the delay.
 Lockbox System No Lockbox System
1. A lockbox system is a service whereby checks are
mailed to a local PO Box address.
2. The checks are picked up daily (or even multiple
times per day) by the servicing firm.
2-3 Days
3. The checks are deposited into the local branch 2-3 Days by Mail
bank. by Mail

4. The balances are electronically transferred to the

firm’s branch of the bank, available for use
immediately.

No Lockbox System Lockbox System II

Transmitted
1. You have a business in Texas Electronically
2. You have one customer in California (nanoseconds)
3. You have a second customer in Virginia
4. Each customer mails their check to you via US Mail taking
2-3 days.
5. The firm deposits the checks in their local Texas bank. 1 Day by Mail
6. Total time: 3-4 days
1 Day by Mail

Lockbox System Example: Accelerating Collections – Part I

Your company does business nationally, and currently all
checks are sent to the headquarters in Tampa, FL. You are
1. You have a business in Texas considering a lock-box system that will have checks processed
2. You have one customer in California
in Phoenix, St. Louis, and Philadelphia. The Tampa office will
3. You have a second customer in Virginia
continue to process the checks it receives in house.
4. Each customer mails their check to a LOCAL Post office
branch with a Lockbox system taking one day. Collection time will be reduced by 2 days on average.
5. The checks are removed daily from the Post Office and Daily interest rate on T-bills = 0.01%.
deposited into a LOCAL branch of the bank the firm deals
Average number of daily payments to each lockbox is
with.
5,000.
6. The local bank electronically transfers the funds into the
Texas firm’s branch and the funds are now available to the Average size of payment is $500.
business. The processing fee is $0.10 per check plus $10 to wire
7. Total time: 1-2 days thus saving 1-2 days of float! funds to a centralized bank at the end of each day.
 Cash Disbursements
Example: Accelerating Collections – Part II
Slowing down payments can increase disbursement float –
Benefits but it may not be ethical or optimal to do this. (not ethical
Average daily collections = 3(5,000)(500) = 7,500,000 to systematically pay bills late; may lose cash discounts by
paying late and this can be very expensive)
Increased bank balance = 2(7,500,000) = 15,000,000
Controlling disbursements
Costs
Zero-balance account: maintain a master account; when
Daily cost = 0.10(15,000) + 3 × 10 = 1,530
checks are written on sub-accounts, cash is transferred
Present value of daily cost = 1,530 / 0.0001 = 15,300,000 from the master account to the sub-account to cover the
checks; can maintain a smaller overall cash balance by
NPV = 15,000,000 – 15,300,000 = -300,000
utilizing this technique
The company should not accept this lock-box Controlled disbursement account: cash is transferred to
proposal. bank account to cover the day’s anticipated payments

Investing Cash Seasonal Cash Demands

Money market – financial instruments with an

original maturity of one year or less
Temporary Cash Surpluses
Seasonal or cyclical activities – buy marketable
securities with seasonal surpluses, convert securities
back to cash when deficits occur
Planned or possible expenditures – accumulate
marketable securities in anticipation of upcoming
expenses

Characteristics of Short-Term Securities Quick Quiz

Maturity – firms often limit the maturity of short-term What are the major reasons for holding cash?
investments to 90 days to avoid loss of principal due to changing
interest rates What is the difference between disbursement float
and collection float?
Default risk – avoid investing in marketable securities with
significant default risk How does a lockbox system work?
Marketability – ease of converting to cash What are the major characteristics of short-term
Taxability – consider different tax characteristics when making a securities?
decision (Money market preferred stock is becoming more
popular. Like traditional preferred, corporations receive a
dividend exclusion (at least 50 percent under the new law).
Unlike traditional preferred, the dividend is variable, which
keeps the price more stable (more like a money market).
 CASH MANAGEMENT MODEL
Comprehensive Problem
Boumol model – A proposed single lockbox system will reduce
Miller – Orr model collection time 2 days on average
Stone model – Daily interest rate on T-bills = .01%
– Average number of daily payments to the lockbox is
3,000
– Average size of payment is $500
– The processing fee is $.08 per check plus $10 to wire
funds each day.
– What is the maximum investment that would make
this lockbox system acceptable?
361

Comprehensive Problem BAUMOL MODEL

Baumol model: The cash management model follows the

Benefits: discrete method, applying the same principles as the inventory
Daily collections: 3,000 * $500 = $1.5M management model (Economic ordering quantity_EOQ)
Increased bank balance = 2 * $1.5M = $3M Assumptions :
Over a certain period of time, net cash flows appear at a constant rate,
Costs: the cash balance will be periodically added by selling short-term
(3,000 * $0.08) + $10 = $250 securities at a fixed cost of transaction;
PV = $250 / .0001 = $2.5M
There is no collection in the planning period;

Anything less than $500,000 would make this a positive There are no cash reserves for safety purposes;
NPV project. Additional cash management.

364

Costs of Holding Cash The Baumol Model – I

Trading costs increase when the firm F = The fixed cost of selling securities to raise cash
Costs in dollars of must sell securities to meet cash needs. T = The total amount of new cash needed
holding cash R = The opportunity cost of holding cash, i.e., the interest rate

Total cost of holding cash If we start with $C, spend at a

constant rate each period, and
replace our cash with $C when
Opportunity we run out of cash, our average
C
Costs cash balance will be
The investment income C
–
foregone when holding cash. –C2 2
The opportunity cost of holding
is
Trading costs –2 –2 ×R
C C

Time
C* Size of cash balance 1 2 3
 The Baumol Model – II The Baumol Model – III

C T
As we transfer $C each period we
Total cost = R+ F
incur a trading cost of F. 2 C

C Opportunity C  R
If we need $T in total over the Costs 2
planning period, we will pay $F
times. T
–C2 –C
T
F
The trading cost is –CT× F Trading costs
C

1 2 3 Time C* Size of cash balance

2T
C* = F
R

The Baumol Model – IV The Baumol Model – IV

The optimal cash balance is found where the opportunity costs equals
the trading costs.
Example: Hermes Co. has cash outflows of $500 per day,
the interest rate is 10% and the fixed transfer cost is $25.
Opportunity Costs = Trading Costs
T = 365 × 500 = 182,500
C T
R = F F = 25
2 C R = .1
Multiply both sides by C.
C* = $9,552.49
C 2
2TF TF
R =TF C* = C2 = 2
2 R R

MILLER – ORR MODEL MILLER – ORR MODEL

Assumptions:
The net cash flow of the business fluctuates completely randomly;
Miller - Orr model: A model of money management that An enterprise holds two types of assets: corporate bonds and liquid assets,
follows a continuous method and applies the same principles as such as liquidity securities with a yield of k;
the inventory management model (EOQ).
Transaction costs are fixed. This transaction cost is the same for buying
and selling liquid securities;

Overcoming the limitation of discrete money management, Matured securities are automatically reinvested or not mentioned as part of
cash flow;
which does not fully reflect the fluctuation and intertwining of
cash flows. The budget will not fall below the lower limit of money reserves;
Based on the principles of inventory management, Miller - Orr
hypothesizes that the goal of the business is to minimize the cost of
holding money.

371 372
 The Miller-Orr Model The Miller-Orr Model: Math
• The firm allows its cash balance to wander randomly between
upper and lower control limits. • Given L, which is set by the firm, the Miller-Orr
model solves for C* and U
When the cash balance reaches the upper control limit U, cash is invested
3 Fσ 2
$ elsewhere to get us to the target cash balance C.
C* = 3 +L U * = 3C * − 2 L
4R
U When the cash balance
reaches the lower control where s2 is the variance of net daily cash flows.
limit, L, investments are
sold to raise cash to get us
• The average cash balance in the Miller-Orr model is:
up to the target cash
balance.
C 4C * − L
Average cash balance =
L 3
Time

Implications of the
The Miller-Orr Model: Math
Miller-Orr Model
L (U) is a lower (upper) limit on the amount of cash to be To use the Miller-Orr model, the manager must do four
held, while C* is the optimal cash balance. things:
1. Set the lower control limit for the cash balance.
Example: Suppose F = $25, R = 1% per month, and the
variance of monthly cash flows is $25,000,000 per month. 2. Estimate the standard deviation of daily cash flows.
Assume a minimum cash balance of $10,000. 3. Determine the interest rate.
C* = 10,000 + ( ¾ (25)(25,000,000)/.01)1/3 = $13,605.62
4. Estimate the trading costs of buying and selling
U* = 3(13,605.62) – 2(10,000) = $20,816.86 securities.

Implications of the
Other Factors Influencing the Target Cash Balance
Miller-Orr Model (ctd.)
• The model clarifies the issues of cash management: • Borrowing
• Borrowing is likely to be more expensive than
– The optimal cash position, C*, is positively related selling marketable securities.
to trading costs, F, and negatively related to the • The need to borrow will depend on management’s
interest rate R. desire to hold low cash balances.
– C* and the average cash balance are positively
related to the variability of cash flows.
 CASE STUDY PRESENTATION
CASH FLOW MANAGEMENT OF 123 COMPANY

123 company (Chapter 2)

Requirement:
GROUP PRESENTATION
Determine cash inflow
Determine cash outflow
Planning cash flow
Make a cash flow management model
Make a cash management and budget management model

379 380

CONCLUSION

Focus on clarifying some fundamental theories about cash Chapter

management. 20
Cash management needs to build a corporate governance model
and determine the optimal level of cash balance. Some cash
management models such as Baumol model, Miller - Orr model, Credit Management
Stone model.
Deficit and surplus budget needs to be done to reduce the cost
of the business’s cash balance. The model building and budget
handling help optimize the cash flow management of the
business.
Understand and implement cash management applications on
the software to increase the efficiency of cash flow management
of businesses.
381 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Chapter Outline

(Appendix)
•Credit and Receivables •Alternative Credit Policy Analysis
•Terms of the Sale
•Analyzing Credit Policies The One-Shot Approach
•Optimal Credit Policy The AR Approach
•Credit Analysis •Discounts and Default model
•Collection Policy
•Inventory Management
•Inventory Management Techniques
 Chapter Outline Credit Management: Key Issues
• Granting credit generally increases
•Credit and Receivables sales
•Terms of the Sale
• Costs of granting credit
•Analyzing Credit Policies
– Chance that customers
•Optimal Credit Policy
will not pay
•Credit Analysis
•Collection Policy – Financing receivables
•Inventory Management • Credit management examines the
•Inventory Management Techniques trade-off between increased sales
and the costs of granting credit

Components of Credit Policies Components of Credit Policies

• Terms of sale • Collection policy
–Credit period Effort expended on collecting receivables
–Cash discount and discount period
–Type of credit instrument
• Credit analysis
Distinguishing between “good”
customers that will pay and “bad”
customers that will default

The Cash Flows from Chapter Outline

Granting Credit
• Credit and Receivables
Credit Sale Check Mailed Check Deposited Cash Available • Terms of the Sale
• Analyzing Credit Policies
Cash Collection • Optimal Credit Policy
Accounts Receivable • Credit Analysis
• Collection Policy
• Inventory Management
• Inventory Management Techniques
 Terms of Sale Example: Cash Discounts
• Finding the implied interest rate when
Basic Form: 2/10 net 45 customers do not take the discount
– 2% discount if paid in 10 days
– Total amount due in 45 days if discount not • Credit terms of 2/10 net 45
taken – Period rate = 2 / 98 = 2.0408%
Buy $500 worth of merchandise with the – Period = (45 – 10) = 35 days
credit terms given above – 365 / 35 = 10.4286 periods per year
– Pay $500(1 - .02) = $490 if you pay in 10 days • EAR = (1.020408)10.4286 – 1 = 23.45%
– Pay $500 if you pay in 45 days • The company benefits when customers choose
to forgo discounts

Chapter Outline Credit Policy Effects

• Revenue Effects:
•Credit and Receivables
•Terms of the Sale –Delay in receiving cash
•Analyzing Credit Policies from sales
•Optimal Credit Policy –May be able to increase
•Credit Analysis price
•Collection Policy
–May increase total sales
•Inventory Management
•Inventory Management Techniques

Credit Policy Effects Example: Evaluating a

Proposed Policy – Part I
• Cost Effects:
• Your company is evaluating a switch from a
– Cost of the sale is still incurred even though the cash only policy to a net 30 policy. The price
cash from the sale has not been received per unit is $100, and the variable cost per
unit is $40. The company currently sells 1,000
– Cost of debt – must finance receivables units per month. Under the proposed policy,
– Probability of nonpayment – some percentage of the company expects to sell 1,050 units per
customers will not pay for products purchased month. The required monthly return is 1.5%.
• What is the NPV of the switch?
– Cash discount – some customers will pay early and
pay less than the full sales price • Should the company offer credit terms of net
30?
 Example: Evaluating a Total Cost of Granting Credit
Proposed Policy – Part II
• Incremental cash inflow • Carrying costs
(100 – 40)(1,050 – 1,000) = $3,000 – Required return on receivables
– Losses from bad debts
• Present value of incremental cash inflow
– Costs of managing credit and collections
3,000/.015 = $200,000
• Shortage costs
• Cost of switching
– Lost sales due to a restrictive credit policy
100(1,000) + 40(1,050 – 1,000) = $102,000
• Total cost curve
• NPV of switching
– Sum of carrying costs and shortage costs
200,000 – 102,000 = $98,000
– Optimal credit policy is where the total cost
• Yes, the company should switch! curve is minimized

Chapter Outline Carrying and Opportunity

Costs
•Credit and Receivables
•Terms of the Sale
•Analyzing Credit Policies
•Optimal Credit Policy
•Credit Analysis
•Collection Policy
•Inventory Management
•Inventory Management Techniques

Chapter Outline Credit Analysis

• The process of deciding which customers
•Credit and Receivables
receive credit
•Terms of the Sale
•Analyzing Credit Policies • Gathering information
•Optimal Credit Policy – Financial statements
•Credit Analysis – Credit reports
•Collection Policy – Banks
•Inventory Management – Payment history with the firm
•Inventory Management Techniques • Determining Creditworthiness
– 5 Cs of Credit
– Credit Scoring
 One-Time Sale Model Example: One-Time Sale
NPV = -v + (1 - )P / (1 + R) • Your company is considering granting credit
to a new customer.
where: v = variable cost per unit
• The variable cost per unit is $50; the
 = probability of default current price is $110;
P = Current Price
• The probability of default is 15%;
R = Monthly required
return • The monthly required return is 1%.

One-Time Sale Model Example: Repeat Customers

NPV = -v + (1 - )P / (1 + R) In the previous example, what is the
NPV if we are looking at repeat
• NPV = -50 + (1-.15)(110)/(1.01) business?
= $42.57
• NPV = -v + (1-)(P – v)/R
• What is the break-even probability?
• NPV = -50 + (1-.15)(110 – 50)/.01
NPV = $0 = -50 + (1 - )(110)/(1.01)
= $5,050
 = .5409 or 54.09%

Example: Repeat Customers Credit Information

Interpretation
• Repeat customers can be very valuable • Financial statements
(hence the importance of good customer • Credit reports with customer’s
service)
• It may make sense to grant credit to almost
payment history to other firms
everyone once, as long as the variable cost is • Banks
low relative to the price
• If a customer defaults once, you don’t grant • Payment history with the company
credit again
 Five Cs of Credit Chapter Outline
• Character – willingness to
meet financial obligations •Credit and Receivables
•Terms of the Sale
• Capacity – ability to meet financial obligations
•Analyzing Credit Policies
out of operating cash flows
•Optimal Credit Policy
• Capital – financial reserves •Credit Analysis
• Collateral – assets pledged as security •Collection Policy
• Conditions – general economic conditions •Inventory Management
related to customer’s business •Inventory Management Techniques

Collection Policy Collection Policy

Monitoring receivables • Collection policy
Keep an eye on average –Delinquency letter
collection period relative –Telephone call
to your credit terms –Collection agency
Use an aging schedule to –Legal action
determine percentage of
payments that are being
made late