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7.4. Exercise 7.3: Cash Flow and Accounting Profit

A persistent critique throughout this study and our companion bookboon texts concerns the traditional accounting definitions and presentation of working capital in published financial statements and their conventional interpretation by external users of accounts. Explained simply, they reveal little about a company's "true" financial position, future cash flow, or managerial policy.

Required:

Turning to the presentation of internal managerial data, outline the differences between a periodic cash budget and its corresponding forecast Profit and Loss Account.

An Indicative Outline Solution

Areas where the two cash flow and accounting statements differ can be identified and classified as follows:

1. The cash budget only records actual receipts from customers, including sales from previous periods. The Profit and Loss Account (P&L) records forecast sales for the period, even though payment may "carry over".

2. The cash budget records budgeted cash payments to suppliers. The P&L records forecast cost of sales, which incorporate opening stock, plus purchases, less closing stock.

3. The cash budget reveals the budgeted payments for expenses. The P&L records expenditure expected to be incurred in the period, but not necessarily paid for.

4. The cash budget records the cost of purchasing a fixed asset at the expected date of purchase and the proceeds when it is eventually sold. The P&L records a periodic depreciation charge which involves no cash flow (a non-cash expense) for the consumption of the asset and either a profit or loss on its disposal.

5. The cash budget records tax payments when they fall due, which may relate to previous period's profits. The P&L offsets the expected tax liability against profits earned in that period.

To summarize: the cash budget relates to the timing of cash payments and receipts, whilst the P&L relates to income earned and expenses incurred over the period on a traditional accrual-prepayment basis.

For example, focusing on the "terms of trade" a sales forecast for the accounting year end (December say) would appear in the annual P&L for that year. But if sales were on ninety days credit they would not appear in the cash budget until the following year (February). Likewise, if the suppliers' credit period was sixty days it would not appear in the cash budget until the following January.

7.5. Exercise 7.4: The Preparation of a Cash Budget

Before concluding our study with a review of the terms of sale and their contribution to the overall wealth of a creditor firm, we cannot leave the general subject of working capital without illustrating how a company's "credit related funds system" determined by its debtor policy is underpinned by the managerial cash budgeting process.

The following information relates to an Executive Board meeting at Kasabian Ltd. recently set up as an academic e-book publisher.

Individual texts are available online from their website in pdf format at a uniform selling price of €15. Customers are invoiced on the last day of the month.

The Marketing Director has forecast the following sales volumes:

The Marketing Director has forecast the following sales volumes:

Customers are expected to remit payment as follows:

One month after the download 40%

Two months after the download 60%

The Finance Director has also contributed the following information

The variable costs of production per book (€) are:

Materials 5

Labour 4

Overhead 2

All books are produced two months before they are sold and Kasabian's creditors are paid two months after production.

Variable overheads are paid in the month following production and are expected to increase by 25 per cent in April.

75 per cent of salaries are paid in the month of production and 25 per cent in the following month. A salary increase of 12.5 per cent will take place on March 1st.

The company is going through a modernization process and will sell one of its office suites in May for €25,000. It is also planning to buy new print hardware in May for €10,000. Depreciation is currently €1,000 per month, and will rise to €1,500 after purchasing the equipment.

The company's corporate tax liability of €10,000 is due for payment in March.

The company's cash balance on December 31st is €1,500.

Required:

1. Produce a cash budget for the six months from January to June.

2. Examine the budget and comment on how the Kasabian Company can improve its forecast working capital position.

Briefly summarize your findings.

An Indicative Outline Solution

1: The Cash Budget (for the six month period ended 30 June)

Calculations

Sales Receipts

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Forecast Sales (S)

1,000

1,000

1,000

1,250

1,500

2,000

1,900

2,200

Sales (S x 15)

15,000

15,000

15,000

18,750

22,500

30,000

28,500

33,000

Debtor Period:

1 month 40%

6,000

6,000

6,000

7,500

9,000

12,000

11,400

2 months 60%

9,000

9,000

9,000

11,250

13,500

18,000

15,000

15,000

16,500

20,250

25,500

29,400

Payment for Materials - e-books produced two months before sale

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Quantity (Q)

1,000

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Materials (Q x 5)

5,000

6,250

7,500

10,000

9,500

11,000

11,000

11,500

Paid 2 months later

5,000

6,250

7,500

10,000

9,500

11,000

Variable Overheads

Nov

Dec

Jan

Feb

Mar

Apr

May

Jun

Quantity (Q)

1,000

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Overhead (Q x 2)

2,000

2,500

3,000

4,000

3,800

Overhead (Q x 2.5)

5,500

5,500

5,750

Paid one month later

2,000

2,500

3,000

4,000

3,800

5,500

5,500

Salaries

Dec

Jan

Feb

Mar

Apr

May

Jun

Quantity (Q)

1,250

1,500

2,000

1,900

2,200

2,200

2,300

Salaries (Q x 4)

5,000

6,000

8,000

Salaries (Q x 4.5)

8,550

9,900

9,900

10,350

75% this month

3,750

4,500

6,000

6,412

7,425

7,425

7,762

25% next month

1,250

1,500

2,000

2,137

2,475

2,475

3,750

5,750

7,500

8,412

9,562

9,900

10,237

The Cash Budget

Jan

Feb

Mar

Apr

May

Jun

Receipts:

Credit sales

15,000

15,000

16,500

20,250

25,500

29,400

Property Disposal

-

-

-

-

25,000

-

15,000

15,000

16,500

20,250

50,500

29,400

Payments:

Materials

5,000

6,250

7,500

10,000

9,500

11,000

Variable Overheads

2,500

3,000

4,000

3,800

5,500

5,500

Salaries

5,750

7,500

8,412

9,562

9,900

10,237

Equipment

-

-

-

-

10,000

-

Corporation Tax

-

-

10,000

-

-

-

13,250

16,750

29,912

23,362

34,900

26,737

Net cash flow

1,750

(1,750)

(13,412)

(3,112)

15,600

2,663

Balance b/f

1,500

3,250

1,500

(11,912)

(15,024)

576

Cumulative cash flow

3,250

1,500

(11,912)

(15,024)

576

3,239

2: The Working Capital Position: A Commentary

Given the anticipated cash deficits that will occur in March and April, Kasabian Ltd. must identify suitable methods of financing to ensure continuity of future production. Companies typically finance short-term cash deficits (if only by default) with their overdraft facilities. However, we are not aware of any such arrangements with their bankers. So, Kasabian should consider the following steps.

a) Revisions to the Terms of Trade

o Reduce the debtor collection periods. For example, if the company could reverse the trend by introducing a modest discount for early payment and an interest charge for default, so that 80 per cent of customers paid one month after the sale and only 20 per cent after two months, the cash flow would improve significantly.

o Delay the creditor payment period, perhaps for a month. Although this should only be by prior agreement with suppliers and not unilateral.

From the outset of this study we have observed that for a given level of sales using time value of money criteria, accounts receivable (from debtors) should be collected as soon as possible and, accounts payable (to suppliers) should be delayed as long as possible. However, as we noted at the beginning of Chapter Four, both policies may be untenable because of their "goodwill" implications.

The former ignores the fact that a reduction in the period of credit granted to customers may cause the company's clientele to look elsewhere, thereby reducing future sales. Likewise, an increase in the creditor payment period offered to suppliers may cause them to cease trading with the company altogether, thereby interrupting the whole production process.

b) Reductions in the Level of Inventory

Kasabian Ltd is effectively holding two months' stock. If this figure was reduced, or better still "just in time" (JIT) techniques were adopted, the cash flow would improve.

c) Delays to Capital Expenditure

Perhaps the purchase of new computer hardware could be delayed. Although it would not affect the deficit in March or April, delaying the purchase until June or July would ease the cash drain in a very difficult month (particularly if the office suite sale did not go through until May).

d) Deferred Taxation

Although the non-payment of corporation tax is illegal, maybe the fiscal authorities would consider its payment by future installments.

Summary

If none of the above options are possible, then Kasabian Ltd. must approach its bank (or other financial institutions) to obtain either an overdraft facility, or short-term loan to cover the deficits. Failing this and if it is to survive, the company must consider debt factoring and the possibility of sale and leaseback as a matter of urgency.

 
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