
Financial
Forecasting



are part of an integrated strategy that, along
with production and marketing plans, guides
the firm toward strategic goals
Those long-term activities, marketing and
product development actions, capital structure,
and major sources of financing
Also included would be termination of existing
projects, product lines, or lines of business;
repayment or retirement of outstanding debts;
any planned acquisitions
Such plans tend to be supported by a series of
annual budgets
SHORT-TERM (OPERATING) FINANCIAL
PLANS


FINANCIAL PLANNING

is an important aspect of the firm’s operations
because it provides road maps for guiding,
coordinating, and controlling the firm’s actions
to achieve its objectives
TWO KEYS ASPECTS
1.
o
2.
involves preparation of the firm’s cash
budget
PROFIT PLANNING
o
involves preparation
statements
Key inputs:

of
pro


forma
Both are useful for internal financial planning
They also are routinely required by existing and
prospective lenders.


FINANCIAL PLANNING PROCESS


begins with long-term or strategic financial
plans
guide the formation of short-term or operating
plans and budget – implements the firm’s longterm strategic objectives
include the sales forecast and various forms of
operating and financial data
Key outputs:

CASH PLANNING
specify short-term financial actions and the
anticipated impact of those actions
These plans most often cover a 1- to 2-year
period

include a number of operating budgets, the
cash budget, and pro forma financial statement
Here we focus solely on cash and profit
planning from the financial manager’s
perspective
begins with the sales forecast --- from it,
companies develop production plans that take
into account lead (preparation) times and
include estimates of the required raw materials
Using the production plans, the firm can
estimate direct labor requirements, factory
overhead outlays, and operating expenses
Once these estimates have been made, the firm
can prepare a pro forma income statement and
cash budget.
With these basic inputs, the firm can finally
develop a pro forma balance sheet
LONG-TERM (STRATEGIC) FINANCIAL
PLANS



lay out a company’s planned financial actions
and the anticipated impact of those actions
over periods ranging from 2 to 10 years
Five–year strategic plans, which are revised as
significant new information becomes available,
are common
firms that are subject to high degrees of
operational uncertainty, relatively short
production cycles, or both, tend to use shorter
planning horizons
CASH
PLANNING:
BUDGETS
CASH
CASH BUDGET OR CASH FORECAST

is a statement of the firm’s planned inflows and
outflows of cash





It is used by the firm to estimate its short-term
cash requirements, with particular attention
being paid to planning for surplus cash and for
cash shortages
is designed to cover a 1-year period, divided
into smaller time intervals
The number and type of intervals depend on
the nature of the business
The more seasonal and uncertain a firm’s cash
flow, the greater the number of intervals
Because many firms are confronted with a
seasonal cash flow pattern, the cash budget is
quite often presented on a monthly basis. Firm
with stable patterns of cash flow may use
quarterly or annual time intervals

Finally, adjustments may be made for additional
internal factor, such as production capabilities
Firms generally uses a combination of external
and internal forecast data to make the final
sales forecast
The internal data provide insight into sales
expectation and the external data provide a
means of adjusting these expectations to take
into account generally economic factors
the nature of the firm’s product also often
affects the nix and types of forecasting methods
used
SALES FORECAST






The key inputs to the short-term financial
planning process
This prediction of the firm’s sales over a given
period is ordinarily prepared by marketing
department
On this basis, the financial manager estimates
the monthly cash flows that will result from
projected sales and from outlays related to
production, inventory, and sales
The manager also determines the level of fixed
assets required and the amount of financing, if
any, needed to support the forecast level of
sales and production
In practice, obtaining good data is the most
difficult aspect of forecasting
The sales forecast may be based on an analysis
of external data, internal data, or a combination
of the two
PREPARING THE CASH BUDGET
CASH RECEIPTS

include all of a firm’s inflows of cash during a
given financial period
Common Components:
a)
b)
c)
cash sales
collections of accounts receivable
other cash receipts
LAGGED 1 MONTH

These figures represent sales made in the
preceding month that generated accounts
receivable collected in the current month.
LAGGED 2 MONTHS
EXTERNAL FORECAST


is based on the relationships observed between
the firm’s sales and certain key external
economic indicators such as the gross domestic
product (GDP), new housing starts, consumer
confidence, and disposal personal income --forecasts containing these indicators are readily
available
(GDP) is the total monetary or market value of
all the finished goods and services produced
within a country's borders in a specific time
period
INTERNAL FORECAST



are based on a consensus of sales forecast
through the firm’s own sales channels
Typically, the firm’s salespeople in the field are
ask to estimate how many units of each type of
product they expect to sell in the coming year
are collected and totaled by the sales manager,
who may adjust the figures using knowledge of
specific markets or of the forecasting
salesperson’s ability

These figures represent sales made 2 months
earlier that generated accounts receivable
collected in the current month.
Forecast Sales – this initial entry is merely
informational; it provides as an aid in calculating
other sales – related items.
Cash sales – the cash sales shown for each month
represents 20% of the total sales forecast for that
month.
Collection of A/R – these entries represent the
collection of accounts receivable (A/R) resulting
from sales in earlier month.
Other cash receipts – these are cash receipts from
other sources other than sales.
Payment of A/P – represents the payment of
accounts payable resulting from purchases in
earlier months.
CASH DISBURSEMENTS

include all outlays of cash by the firm during a
given financial period.
Most Common Cash Disbursements:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
Cash purchases
Payment of accounts payable
Rent payments
Wages and salaries
Tax payments
Fixed-assets outlays
Interest payments
Cash dividend payments
Principal payments (loans)
Repurchases or retirement of stocks
NET CASH FLOW, ENDING CASH,
FINANCING, AND EXCESS CASH



LAGGED 1 MONTH

These figures represent purchases made in the
preceding month that are paid in the current
month.

LAGGED 2 MONTHS

These figures represent purchases made 2
months earlier that are paid in the current
month.
𝑁𝐸𝑇 𝐶𝐴𝑆𝐻 𝐹𝐿𝑂𝑊 =
𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑝𝑡𝑠 − 𝑐𝑎𝑠ℎ 𝑑𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡𝑠
𝐸𝑁𝐷𝐼𝑁𝐺 𝐶𝐴𝑆𝐻 =
𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑐𝑎𝑠ℎ + 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝐸𝑋𝐶𝐸𝑆𝑆 𝐶𝐴𝑆𝐻 =
𝑒𝑛𝑑𝑖𝑛𝑔 𝑐𝑎𝑠ℎ − 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑐𝑎𝑠ℎ 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
IF ending cash < minimum cash balance:
o financing is required
o Such financing is typically viewed as
short-term and is represented by
notes payable
IF ending balance > minimum cash balance
o excess cash exists
o Any excess cash is assume to be
invested in a liquid, short-term,
interest-paying vehicle – that is, in
marketable securities.
EVALUATING THE CASH BUDGET

Purchases - purchases represent 70% of
forecast sales for each month. Of this amount,
10% is paid in cash ,70% is paid in the month
immediately following the month of purchase
and the remaining 20% is paid 2 months
following the month of purchase.
Rent payments – rent of P 5,000 will be paid
each month.
Wages and salaries – fixed salaries for the year
are P 96,000, or P 8,000 per month. In addition,
wages are estimated 10% of monthly sales.
Taxes payments – taxes of P 25,000 must be
paid in December.
Fixed-asset outlays – New machinery costing
P130,000 will be purchased and paid for in
November.
Interest payments – an interest of P 10,000 is
due in December.
Cash dividend payments – cash dividends of
P20,000 will be paid in October.
Principal payments (loans) – a P20,000 principal
payment is due in December.
Cash purchases – for each month represent 10%
of the monthly purchases.
The cash budget indicates whether a cash
shortage or surplus is expected in each of the
months covered by the forecast.

Each month’s figure is based on the internally
imposed requirement of a minimum cash
balance and represents the total balance at the
end of the month.

Example, at the of each of the 3 months, the
company expects the following balances in
cash, marketable securities, and notes payable:
End-of-month balances (000)
Account
Oct. Nov. Dec.
Cash
25 25 25
Marketable securities
22 0 0
Notes payable
0 76 41
Note that the firm is assume first to liquidate its
marketable securities to meet deficits and then
to borrow with notes payable if additional
financing is needed.
As a result, it will not have marketable securities
and notes payable on its books at the same
time.
Because it may be necessary to borrow up to
P76,000 for the 3- month period.
The finance manager should be certain that
some arrangement is made to ensure the
availability of these funds.
COPING WITH UNCERTAINTY IN
THE CASH BUDGET
PREPARING THE PRO FORMA
INCOME STATEMENT
TWO
WAYS
OF
COPING
WITH
UNCERTAINTY IN THE CASH BUDGET
PERCENT- OF-SALES METHOD
1.
prepare several cash budgets – based on
pessimistic, most likely, and optimistic forecasts

From this range of cash flows, the financial
manager can determine the amount of
financing necessary to cover the most
adverse situation.

The use of several cash budgets, based on
different scenarios, also should give the
financial manager a sense of the riskiness
of the various alternatives.

This scenario analysis, or “what if“
approach, is often used to analyze cash
flows under a variety of circumstances.

Clearly, the use of electronic spreadsheets
simplifies the process of performing
scenario analysis.
CASH FLOW
MONTH




WITHIN


Because the cash budget shows cash flows only
a total monthly basis, the information provided
by the cash budget is not necessarily adequate
for ensuring solvency.
A firm must look more closely at its pattern of
daily cash receipts and cash disbursements to
ensure that adequate cash available for paying
bills as they come due.
The financial manager must plan and monitor
cash flow more frequently than on a monthly
basis.
The greater the variability of cash flows from
day to day, the greater the amount of attention
required.
relies on accrual concepts to project the firm’s
profit and overall financial position
Shareholders, creditors, and the firm’s
management pay close attention to the pro
forma statements which are projected income
statements and balance sheets.
The approaches for estimating the pro forma
statements are all based on the belief that the
financial relationship reflected in the firm’s past
financial statements will not change in the
coming period.
TWO INPUTS REQUIRED FOR PREPARING
PRO FORMA STATEMENTS:
1.
2.


financial statements for the preceding year
the sales forecast for the coming year
It forecasts sales and then expresses the various
income statement items as percentages of the
project sales.
The percentages used are likely to be the
percentages of sales for those items in the
previous year.
Example:
𝐶𝑂𝐺𝑆
80,000
=
= 80%
𝑆𝑎𝑙𝑒𝑠
100,000
𝑂𝑃𝐸𝑋
10,000
=
= 10%
𝑆𝑎𝑙𝑒𝑠
100,000
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
1,000
=
= 1%
𝑆𝑎𝑙𝑒𝑠
100,000
CONSIDERING TYPES OF COST
AND EXPENSES

THE
PROFIT PLANNING: PRO FORMA
STATEMENTS





The technique that is used to prepare the
proformas income statement assumes that all
the firm’s costs and expenses are variable.
That is, for a given percentage increase in sales,
the same percentage increase in cost of goods
sold, operating expenses, and interest expense
would result.
For example, sales increase by 35%, we
assumed that its cost of goods sold also
increased by 35%.
On the basis of this assumption, the firm’s net
profit before tax also increased by 35%.
PREPARING THE PRO FORMA
BALANCE SHEET




A number of simplified approaches are
available for preparing the pro forma balance
sheet amounts as a strict percentage of sales.
A better and more popular is the judgmental
approach, under which the firm estimates the
values of certain balance sheet accounts and
uses its external financing as a balancing or
“plug” figure.
The judgmental approach represents an
improved version of the percent-of-sales
approach to pro form balance sheet
preparation.
Because the judgmental approach requires only
slightly more Information and should yield
better estimates than the somewhat naïve
percent-of-sales approach.
Positive Value for “External Financing
Required”


based on its plan, the firm will not generate
enough internal financing to support its
forecast growth in the assets
To support the forecast level of operation, the
firm must raise funds externally by using debt
and/or equity financing or by reducing
dividends
Once the form of financing is determined, the
pro forma balance sheet is modified to replace
“external financing required” with the planned
increases in the debt and/or equity account
Negative Value for “ External Financing
Required”


indicates that, based on its plans, the firm will
generate more financing internally than it
needs to support its forecast growth in assets
In this case, funds are available for use in
repaying debt, repurchasing stock, or increasing
dividends
Once the specific actions are determined,
“external financing required” is replaced in the
pro forma balance sheet with the planned
reductions in the debt and/or equity accounts.
Obviously, besides being used to prepare the
pro forma balance sheet, the judgmental
approach is frequently used specifically to
estimate the firm’s financing requirements.
that it can take 73 days on average to satisfy its
accounts payable. Thus, accounts payable
should equal one-fifth (73 days / 365 days) of
the firm’s purchases, or P 8,100 (1/5 x 40,500).
7. Taxes payable will equal one – fourth of the
current year’s tax liability, which equals P 455
(one-fourth of the tax liability of P 1,823.
8. Notes payable will remain unchanged from
their current level of P 8,300.
9. No change in other current liabilities is
expected. They remain at the level of the
previous year: P 3,400.
10. The firm’s long-term debt and its common stock
will remain unchanged at P 18,000 and P
30,000, respectively; no issues, retirements, or
purchases of bonds or stock are planned.
11. Retained earnings will increase from the
beginning level of P 23,000 to P 29,327. The
increase of P6,327 represents the amount of
retained earnings.
ADDITIONAL FUNDS NEEDED (
AFN )

Funds that a firm must raise externally from
non-spontaneous sources, i.e., through
borrowing or by selling new stock, to support
operations… a sharp increase in its forecasted
sales.
ADDITIONAL FUNDS NEEDED ARE BEST
DEFINED AS:
a.
b.
Assumptions:
1. A minimum cash balance of P 6,000 is required.
2. Marketable securities will remain unchanged
from their current level of P 4,000.
3. Accounts receivable on average represent
about 45 days of sales (about 1/8 of a year).
Annual sales are projected to be P 135,000,
accounts receivable should average P 16,875
(1/8 x 135,000).
4. The ending inventory should remain at a level of
about 16,000, of which 25% (approximately P
4,000) should be raw materials and the
remaining 75% (approximately P 12,000) should
consist of finished goods.
5. A new machine costing P20,000 will be
purchased. Total depreciation for the year is P
8,000. Adding the P 20,000 acquisition to the
existing net fixed assets of P 51,000 and
subtracting the depreciation of P 8,000 yields
net fixed assets of P 63,000.
6. Purchases represent approximately 30% of
annual sales, which in the case is approximately
P 40,500 (0.30 x 135,000). The firm estimates
c.
d.
e.
Funds that are obtained automatically from
routine business transactions.
Funds that a firm must raise externally through
borrowing or by selling new common or
preferred stock.
The amount of assets required per peso of
sales.
The amount of cash generated in a given year
minus the amount of cash needed to finance
the additional capital expenditures and working
capital needed to support the firm’s growth.
A forecasting approach in which the forecasted
percentage of sales for each item is held
constant.
RAISING
NEEDED



THE
ADDITIONAL
FUNDS
Based on the forecasted balance sheet,
MicroDrive will need 2,200 million of operating
assets to support its forecasted 3,300 million of
sales.
We define required assets as the sum of its
operating assets plus the previous amount of
short-term investments.
Since the company had no short-term
investments in 2004, its required assets are
simply 2,200 million.

We define the specific sources of financing as
the sum of forecasted levels of operating
current liabilities, long-term debt, and common
equity plus notes payable carried over from the
previous year:
Accounts payable
66.0
Accruals
154.0
Notes payable (carryover) 110.0
Long-term bonds
754.0
Preferred stock
40.0
Common stock
130.0
Retained Earnings
831.3
Total
2,085.3
Based on its required assets and specified
sources of financing, MicroDrive’s AFN is 2,200
– 2,085.3 = 114.7 million.
Because the AFN is positive, MicroDrive needs
114.7 million of additional financing and its
initial financing policy thru N/P.
Spontaneous liability 2004
Sales 2004
A/P & Accruals
Total assets 2004
Profit margin
Net profit/2004 sales
AFN
=
(A */So)ΔS - (L*/So)ΔS - MS₁(RR)
Projected
Projected sales 2005
Change in sales ( 2005 - 2004 )
Retention ratio
Actual
Retained earnings 2004/net profit 2004
AFN = (2,000M/3,000M)300M – (60M+140M/3,000M)300M – 114M/3,000M x 3,300M(56M/114)
= 0.667(300M) – 0.067(300M) – 0.038 (3,300M) (0.491)
= 200.1M – 20.1M – 62M (rounded )
= 118M
SPONTANEOUS LIABILITIES






are called "spontaneous" because they arise
from changes in sales activity
are not directly controlled by the firm, but
instead are controlled by sales or production
volumes.
Accounts payable are short-term debt
obligations owed to creditors and suppliers.
For example, if a company owes its supplier for
raw materials used in production, the company
would typically have time to pay the invoice.
The terms for payables might be 30, 60, or 90
days in the future. Wages payable for those
workers tied to production if there's overtime
or added shifts as sales increase.
Also, taxes payable might fall under
spontaneous liabilities since the company's
profit would rise with sales leading to larger tax
liability to the Bureau of Internal Revenues.
SPONTANEOUSLY GENERATED FUNDS
ARE BEST DEFINED AS:

Funds that are obtained automatically from
normal operations, and they include increases
in accounts payable and accruals.
NET WORKING CAPITAL


Managing Working
Capital
IMPORTANCE

The importance of efficient working capital
management is indisputable given that a firm’s
viability relies on the financial manager’s ability
to effectively manage receivable, inventory and
payables.

PROFITABILITY


DEFINITION




is the money you put into your business
operating cycle
(abbreviated WC) is a financial metric which
represents operating liquidity available to a
business, organization, or other entity,
including governmental entities
equivalent to the amount of cash it can deploy
very rapidly, otherwise known as its operating
liquidity
required for any business to pay its trade
creditors for its day-to-day trading operations
The goal of working capital (or short-term
financial) management is to manage each of the
firm’s current assets (inventory, accounts
receivable, marketable securities and cash) and
current liabilities (notes payable, accruals and
accounts payable) to achieve a balance
between profitability and risk that contributes
positively to the firm’ s value.



commonly called working capital
represent the portion of investment that
circulates from one form to another in the
ordinary conduct of business
this idea embraces the recurring transition from
cash to inventories to accounts receivable and
back to cash
As cash substitute, marketable securities are
considered part of working capital.





represent the firm’s short-term financing,
because they include all debts of the firm that
come due in 1 year or less
these debts usually include amounts owed to
suppliers, employees and governments and
banks, among others
How changing the level of the firm’s current
assets affects its profitability-risk trade-off by
using the ratio of current assets total assets.
This ratio indicates the percentage of total
assets that is current.
For purposes of illustration, we will assume that
the level of total assets remains unchanged.
When the ratio increases – that is, when current
assets increase – profitability decreases. Why?
Because current assets are less profitable than
fixed assets
FIXED ASSETS




CURRENT LIABILITIES

is the probability that a firm will be unable to
pay its bills as they come due
CHANGE IN CURRENT ASSETS
CURRENT ASSETS


is the relationship between revenues and costs
generated by using the firm's assets –both
current and fixed – in productive activities.
A firm can increase its profit by:
(1) increasing revenues or
(2) decreasing costs
RISK
GOAL

difference between the firm’s current assets
and its current liabilities
When current assets exceed current liabilities,
the firm has a positive net working capital
When current assets are less than current
liabilities, the firm has negative net working
capital

are more profitable because they add more
value to the product than that provided by
current assets
Without it, the firm could not produce the
product
The risk effect, however, decrease as the ratio
of current assets to total assets increases.
The increase in current assets increases net
working capital, thereby reducing the risk of
insolvency.
In additional, as you go down the asset side of
the balance sheet, the risk associated with the
assets increases:
o Investment in cash and marketable
securities is less risky than investment in
accounts receivable, inventories and fixed
assets.
CURRENT ASSETS TO TOTAL
ASSETS RATIO (CATA)


It indicates the extent of total funds invested for
the purpose of working capital and throws light
on the importance of current assets of a firm
It should be worthwhile to observe that how
much of that portion of total assets is occupied
by the current assets, as current assets are
essentially involved in forming working capital
and also take an active part in increasing
liquidity
CHANGES
LIABILITIES









CONVERSION



CURRENT
We also can demonstrate how changing the
level of the firm’s current liabilities affects its
profitability-risk trade-off by using the ratio of
current liabilities to total assets.
This ratio indicates the percentage of total
assets that has been financed with current
liabilities.
Again, assuming the total assets remain
unchanged, the effects both on profitability and
risk of an increase or decrease in the ratio.
When the ratio increases, profitability
increases.
Because the firm uses more of the lessexpensive current liabilities financing and less
long-term financing.
Current liabilities are less expensive because
only notes payable, which represent about 20%
of the typical manufacture’s current liabilities,
have cost.
The other current liabilities are basically debts
on which the firm pays no charge or interest.
However, when the ratio of current liabilities to
total assets increases, the risk of insolvency also
increases because the increase in current
liabilities in turn decreases net working capital.
The opposite effects on profit and risk result
from a decrease in the ratio of current liabilities
to total assets.
We use net working capital to consider the basic
relationship between current assets and
current liabilities and then use the cash
conversion cycle to consider key aspects of
current asset management
CASH
(CCC)

IN
CALCULATING THE CASH CONVERSION
CYCLE
Operating cycle (OC)
is the time from the beginning of the production
process to collection of cash from the sale of the
finished product
encompasses two major short-term asset
categories
o inventory
o accounts receivable
It is measured in elapsed time by summing the
average age of inventory (AAI) and the average
collection period (ACP):
OC = AAI + ACP
Average payment period (APP)




However, the process of producing and selling a
product also includes the purchase of
production inputs (raw materials) on account,
which results in accounts payable.
Accounts payable reduce the number of days a
firm’s resources are tied up in the operating
cycle.
The time it takes to pay the accounts payable,
measured in days
The operating cycle less the average payment
period yields the cash conversion cycle.
The formula is: CCC = OC – APP
Substituting the relationship of the two
equations, we can see that the cash conversion
cycle has three main components:
(1) average age of the inventory,
(2) average collection period, and
(3) average payment period:
CCC = AAI + ACP – APP
Clearly, if a firm change any of these time
periods, it changes the amount of resources tied
up in the day-to-day operation of the firm.
Example: IBM had annual revenues of 98,786
million, cost of revenue of 57,057 million, and
accounts payable of 8,054 million. IBM had an
average age of inventory (AAI) of 17.5 days, an
average collection period of 44.8 days, and an
average payment period (APP) of 51.2 days
(IBM’s purchases were 57,416 million). Thus the
cash conversion cycle for IBM was 11.1 days
(17.5 + 44.8 – 51.2). The resources IBM had
invested in this cash conversion cycle (assuming
a 365-day year) were:
CYCLE
measures the length of time required for a
company to convert cash invested in its
operations to cash received as a result of its
operation
Average age of inventory (AAI)


represents the average number of days that
pass before a company sells its inventory
balance
it is an important working capital efficiency
metric that is also referred to as days’ inventory
on hand (DOH)



If the firm’s sales are constant, then its
investment in operating should also be
constant, and the firm will have a permanent
funding requirement.
A constant investment in operating assets
resulting from constant sales overtime.
If the firm’s sales are cyclic, then its investment
in operating assets will vary over time with its
sales cycles, and the firm will have seasonal
funding requirement.



CASH CONVERSION CYCLE FUNDING REQUIREMENT AND
STRATEGIES
Because under this strategy the amount of
financing exactly equals the estimated funding
need, no surplus balance exist.
Alternatively, Semper can choose a
conservative strategy, under which surplus cash
balance are fully invested.
This surplus will be the difference between the
peak need of $1,125,000 and the total need,
which between $135,000 and 1,125,000 during
the year.
PERMANENT FUNDING REQUIREMENT

is a constant investment in operating assets
resulting from constant sales over time

SEASONAL FUNDING REQUIREMENT

is an investment in operating assets that varies
over time as a result of cyclic sales
If a firm does not face seasonal cycle, then it will
only face a permanent funding requirement.
With seasonal needs, the firm must also decide
on how it wishes to meet the short-term nature
of its seasonal cash demands.
The firm may choose either an aggressive or a
conservative policy toward this cyclical need.
An investment in operating assets that varies
over time as a result of cyclic sales. T
The definition of cyclical is something that goes
in cycles, or something that occurs in a
repeating pattern.
The change of seasons each year is an example
of something that would be described as
cyclical. Recurring at regular intervals. Tending
to rise and fall in line with the fluctuations of the
business cycle.
AGGRESSIVE FUNDING STRATEGY






is a funding strategy under which the firm funds
its seasonal requirements with short-term debt
and its permanent requirements with long-term
debt
CONSERVATIVE FUNDING STRATEGY



is a funding strategy under which the firm funds
both its seasonal and its permanent
requirements with long – term debt.
Example: Semper Pump Company has a
permanent funding requirement of $135,000 in
operating assets and seasonal funding
requirements that vary between $0 and
$990,000 and average $101,250.
If Semper can borrow short-term funds at 6.25%
and long-term funds at 8%, and if can earn 5%
on the investment of any surplus balances, then
the annual cost of an aggressive strategy for
seasonal funding will be:

The average surplus balance would be
calculated by subtracting the sum of the
permanent need (135,000) and the average
seasonal need ($101,250) from the seasonal
peak need ($1,125,000) to get $888,750
($1,125,000-$135,000-101,250).
This represents the surplus amount of financing
that on average could be invested in short-term
assets that earn a 5% annual return.
It is clear from these calculations that for
Semper, the aggressive strategy is far less
expensive than the conservative strategy.
However, it is equally clear that Semper has
substantial peak-season operating-asset needs
and that it must have adequate funding
available to meet the peak needs and ensure
ongoing operations.
Clearly, the aggressive strategy’s heavy reliance
on short-term financing makes it risker than the
conservative strategy because of interest rates
swing and possible difficulties in obtaining
needed short-term financing quickly when
seasonal peak occurs.
The conservative strategy avoids these risks
through the locked-in interest rate and longterm financing, but it is more costly because of
the negative spread between the earnings rate
on surplus funds (5%) and the cost of the longterm funds that create the surplus (8%).
Where the firm operates, between the
extremes of the aggressive and conservative
seasonal funding strategies, depends on
management’s disposition toward risk and the
strength of its banking relationship.
STRATEGIES FOR MANAGING
THE CASH CONVERSION CYCLE


Some firms establish a target cash conversion
cycle and then monitor and manage the actual
cash conversion cycle toward the targeted
value.
A positive cash conversion cycle, means the firm
must use negotiated liabilities (such as bank


loan) to support its operating assets. Negotiated
liabilities carry an explicit cost, so the firm
benefits by minimizing their use in supporting
operating assets.
Simply stated, the goal is to minimize the length
of the cash conversion cycle, which minimizes
negotiated liabilities.
This goal can be realized through use of the
following strategies:
1. Turn over inventory as quickly as possible
without stockouts that result in lost sales.
2. Collect accounts receivable as quickly as
possible without losing sales from highpressure collection techniques.
3. Manage mail, processing and clearing
time to reduce them when collecting from
customers and to increase them when
paying suppliers.
4. Pay accounts payable as slowly as
possible without damaging the firm’s
credit rating.
o
o
2.
o
o
3.
o
o
o
COMPONENTS
OF
CASH
CONVERSION CYCLE (CCC)
1.
INVENTORY MANAGEMENT

The first component of cash conversion cycle is
the average age of inventory.
The objective for managing inventory is to turn
over inventory as quickly as possible without
losing sales from stockouts.
The differing viewpoints about appropriate
inventory level commonly exist among a firm’s
finance, marketing, manufacturing and
purchasing managers.
Each views inventory levels in the light of his or
her own objectives.
The finance manager’s general disposition
toward inventory level is to keep them low, to
ensure that the firm’s money is not being
unwisely invested in excess resources.
The marketing manager, on the other hand,
would like to have a large inventories of the
firm’s finished products. This would ensure that
all orders could be filled quickly, eliminating the
need for backorders due to stockouts.
The
manufacturing
manager’s
major
responsibility is to implement production plan
so that it result in the desired amount of
finished goods of acceptable quality available
on time at a low cost.






Common
Inventory

1.
o
o
techniques
for
items with the largest peso investments. This
group consists 20% of the firm's inventory items
but 80% of its investment in inventory.
The group B consists of items that account for
the next largest investment in inventory.
The C group consists of a large number of items
that require a relative small investment.
Two-bin method
The item is stored in two bins. As an item is
needed, inventory is removed from the first bin.
When that bin is empty, an order is placed to
refill the first bin while inventory is drawn from
the second bin.
Economic Order Quantity ( EOQ ) Model
One of the most common techniques for
determining the optimal order size for
inventory items is the EOQ model.
The EOQ model considers various costs of
inventory and then determines what order size
minimizes total inventory cost.
EOQ assumes that the relevant costs of
inventory can be divided into order costs and
carrying costs.

Order costs include fixed clerical costs of
placing and receiving orders: the cost of
writing a purchase order, of processing the
resulting paperwork, and of receiving an
order and checking it against the invoice.

Carrying costs are the variable costs per
unit of holding an item of inventory for a
specific period of time.

Carrying costs include storage costs,
insurance costs, the costs of deterioration
and obsolescence, and the opportunity or
financial cost of having funds invested in
inventory.

Formula:
where:
S = usage in units per period
O = order cost per order
C = carrying cost per unit per period
Managing
The most commonly used techniques are:
ABC system
The inventory management techniques that
divides inventory into groups – A, B and C, in
descending order of importance.
The A group includes those items with the larges
peso investment. Typically, this group includes

where:
D = annual demand
C = cost per order
H = Holding or carrying cost per unit
Example: Max Company, a producer of
dinnerware, has an A group inventory item that
is vital to the production process. This item
costs P1,500, and Max uses 1,100 units of the
item per year. Order cost per order P150 and
the carrying costs per unit per year is P200.
Calculate the EOQ?
CREDIT STANDARDS

The firm’s minimum requirements
extending credit to a customer.
for
FIVE C’S OF CREDIT
4.





5.
6.

7.

8.

2.



Reorder Point
Once the firm has determined its economic
order quantity, it must determine when to place
an order.
The point at which to reorder inventory,
expressed as days of lead time x daily usage.
Formula: Reorder point = Days of lead time x
daily usage
The reorder point of Max Company, assuming
that Max Co. operates 250 days per year and
uses 1,100 units of this item, its daily usage is
4.4 (1,100 / 250). If its lead time is 2 days and
Max wants to maintain safety stock of 4 units.
Calculate the reorder point.
Reorder point = [(2 x 4.4) + 4] = 12.8 or 13 units
Total cost of inventory
o The sum of order costs and carrying costs
of inventory.
Safety stock
The extra inventory that is held to prevent
stockouts of important items.
Just–in-time (JIT) System
The inventory management technique that
minimize inventory investment by having
materials arrive at exactly the time they are
needed.
Materials Requirement Planning (MRP) System
Inventory management technique that applies
EOQ concept and a computer to compare
production needs to available balances and
determine when orders should be place for
various items on a product’s bill of materials.
ACCOUNTS
MANAGEMENT
RECEIVABLE
The second component of the cash conversion
cycle is the average collection period.
This period is the average length of time a sale
on credit until the payment becomes usable
funds for the firm.
The average collection period has two parts:
1. time from sale until the customer mails the
payment - involves managing the credit
available to the firm’s customer and the
second part involves collecting and
processing payments
2. time from when the payment is mailed until
the firm has the collected funds in its bank
account

One popular credit selection technique is the
five C’s credit, which provides a framework for
in-depth credit analysis.

The five C’s are:
1. Character: The applicant’s record of
meeting past obligations.
2. Capacity: The applicant’s ability to repay
the requested credit, as judged in term of
financial statement analysis focused on
cash flows available to repay debt
obligations.
3. Capital: The applicant’s debt relative to
equity.
4. Collateral: The amount of assets the
applicant has available for use in securing
the credit.
5. Conditions: Current general and industryspecific economic conditions and any
unique condition surrounding specific
transaction.
CREDIT SCORING






Credit scoring is a method of credit selection
that firms commonly use with high
volume/small-peso credit request.
Credit scoring applies statistically derived
weights to a credit applicant’s scores on key
financial and credit characteristics to predict
whether he or she will pay the requested credit
in a timely fashion.
Simply stated, the procedure results in a score
that measures the applicant, overall credit
strength, and the score is used to make the
accept/reject decision for granting the applicant
credit.
Credit scoring is most commonly used by large
credit card operations, such as those of banks,
oil companies and department stores.
The purpose of credit scoring is to make a
relative informed credit decision and
inexpensively, recognizing that the cost of a
single bad scoring decision is small.
However, if bad debts from scoring decision
increase, then the scoring system must be
reevaluated.
CHANGING CREDIT STANDARDS

The firm sometimes will contemplate changing
its credit standards in an effort improve its
returns and create greater value for its owners.

To demonstrate, consider the following changes
and effects on profits expected to result from
the relaxation of credit standards.






If credit standards were tightened, the opposite
effect would be expected.
Example: Dodd Tool, a manufacture of lathe
tools, is currently selling a product for P10 per
unit. Sales all on credit for last year were 60,000
units. The variable cost per unit is P6. The firm’s
total fixed costs are P120,000. The firm is
currently contemplating a relaxation of credit
standards that is expected to result in the
following: a 5% increase in units sales to 63,000
units: an increase in the average collection
period from 30 days (the current level) to 45
days; an increase in bad debt expense from 1%
to 2%. The firm determines that its cost of tying
up funds in receivables is 15% before taxes.
Sales are expected to increase by 5%, or 3,000
units. The profit contribution per unit will equal
the difference between the sale price per unit
(P10) and the variable cost per unit (P6). The
profit contribution per unit will be P4. The total
additional profit contribution from sales will be
P12,000 (3,000 x 4 per unit).
COST OF THE MARGINAL INVESTMENT
IN ACCOUNTS RECEIVABLE



To determine the cost of the marginal
investment in accounts receivable, we must find
the difference between the cost of carrying
receivables under the two credit standards.
Because its concern is only with the out-ofpocket costs, the relevant cost is the variable
cost.
Formula:
We calculate the margin investment in accounts
receivable and its cost as follows:
The resulting value of P2,574 is considered a
cost because it represents the maximum
amount that could have been earned before
taxes on the P17,159 had it been placed in an
equally risk investment earning 15% before
taxes.
COST OF MARGINAL BAD DEBTS







The total variable cost of annual sales under the
present and proposed plan can be found as
follows, using the variable cost per unit of P 6.
where: Turnover of accounts receivable =
365/Average collection period
Total variable cost of annual sales:
o Under present plan: (6 x 60,000 units) =
360,000
o Under proposed plan: (6 x 63,000 units) =
378,000
The turnover of A/R is the number of times each
year that the firm's A/R actually turned into
cash.
It is found by dividing the average collection
period into 365 days.
Turnover of accounts receivable:
o Under present plan: 365/30 = 12.2
o Under proposed plan: 365/45 = 8.1
By substituting the cost and turnover data just
calculated into, we get the following average
investments in A/R:
Average investment in A/R
o Under present plan: P360,000(sales)/12.2
= P29,508
o Under
proposed
plan:
P378,000
(sales)/8/1 = P46,677


The cost of marginal bad debts by taking the
difference between the level of bad debts
before and after the proposed relaxation of
credit standards.
Cost of marginal bad debts
Note that the bad debt costs are calculated by
using the sales price per unit (P10) to deduct not
just the true loss of variable cost (P6) that
results when a customer fails to pay its account
but also the profit contribution per unit (in this
case P4) that is included in the “additional profit
contribution from sales.”
Max Company has annual sales P10 million and
an average collection period of 40 days
(turnover = 365 ÷ 40 = 9.1). In accordance with
the firm’s credit terms of net 30, this period is
divided into 32 days until the customers place
their payments in the mail (not everyone pays
within 30 days) and 8 days to received, process
and collect payments once they are mailed. Max
is considering initiating a cash discount by
changing its credit terms form net 30 to 2/10
net 30.
The firm expects this change to reduce the
amount of time until the payments are placed in
the mail, resulting in an average collection
period of 25 days (turnover = 365 ÷ 14.6).
Max has raw material with current annual usage
of 1,100 units. Each finished product produced
requires one unit of this raw material at a



variable cost of P1,500 per unit, incurs another
P800 of variable cost in the production process,
and sells for P3,000 on terms of net 30.
Variable costs therefore, total P2,300 (P1,500 +
P800). Max estimates that 80% of its customers
will take the 2% discount and that offering the
discount will increase sales of the finished
product by 50 units (from 1,100 to 1,150 units)
per year but will not alter its bad debt
percentage.
Max’s opportunity cost of funds invested in
accounts receivable is 14%.
Should Max offer the proposed cash discount?
CASH DISCOUNTS PERIOD



The financial manager can change the discount
period, the number of days after the beginning
of the credit period during which the cash
discount is available.
The net effect of changes in this period is
difficult to analyze because of the nature of
forces involved.
For example, if a firm were to increase its cash
discount period by 10 days (for example,
changing its credit terms form 2/10 net 30 to
2/20 net 30), the following changes would be
expected to occur:
(1) Sales would increase, positively affecting
profit.
(2) Bad-debt expenses would decrease,
positively affecting profit.
(3) The profit per unit would decrease as a result
of more people taking the discount, negatively
affecting profit.
AGING OF ACCOUNTS RECEIVABLE




An aging schedule breaks down accounts
receivable into groups on the basis to their time
of origin.
The breakdown is typically made on a monthby-month basis, going back 3 or 4 months.
The resulting schedule indicates the percentage
of the total accounts receivable balance that
have been outstanding for specified period of
time.
The purpose of the aging schedule is to enable
the firm to pinpoint problems.

(1) the time from purchase of goods on account
until the firm mails its payment and
(2) the receipt, processing, and collection time
required by the firm’s suppliers.
The receipt, processing and collection time for
the firm, both from customers and to its
suppliers, is the focus of receipt's and
disbursement management.
FLOAT






Float refers to funds that have been sent by the
payer but not yet usable funds to the payee.
Float is important in the cash conversion cycle
because its presence lengthens both the firm
average collection period and its average
payment period.
However, the goal of the firm should be to
shorten its average collection period and
lengthen its average payment period. Both can
be accomplished by managing float.
Float has three component parts:
1. Mail float is the time delay between when
payment is placed in the mail and when it
is received.
2. Processing float is the time between
receipt of the payment and its deposit
into the firm’s account.
3. Clearing float is the time between deposit
of the payment and when spendable
funds become available to the firm.
This component of float is attributable to the
time required for a check to clear the banking
system.
Some popular techniques for managing the
component parts of float to speed up
collections and slow down payments.
SPEEDING UP COLLECTION




Speeding up collection reduces customer
collection float time and thus reduces the firm’s
average collection period, which reduces the
investment the firm must make in its cash
conversion cycle.
A popular technique for speeding up collections
is a lockbox system.
A lockbox system is a collection procedure in
which customers mail payments to a post office
box that is emptied regularly by the firm’s bank,
which processes the payments and deposits
them in the firm’s account.
This system speed up collection time by
reducing processing time as well as mail and
clearing time.
SLOWING DOWN PAYMENTS

3.
MANAGEMENT OF RECEIPTS AND
DISBURSEMENTS

The third component of cash conversion cycle,
the average payment period, also has two parts:


Float is also a component of the firm’s average
payment period.
In this case, the float is in the favor of the firm.
The firm may benefit by increasing all three of
the components of its payment float.

One of the popular technique for increasing
payment float is controlled disbursing.
Controlled disbursing, which involves the
strategic use of mailing points and bank
accounts to lengthen mail float and clearing.
Firms must use this approach carefully, though,
because longer payment periods may strain
supplier relations.
CASH CONCENTRATION

Cash concentration is the process used by the
firm to bring lockbox and other deposits
together into one bank, often called the
concentration bank.
DEPOSITORY TRANSFER CHECK (DTC)

It is an unsigned check drawn on one of a firm’s
bank accounts and deposited in another.
(ACH)
AUTOMATED
HOUSE)TRANSFER

CLEARING
is a preauthorized electronic withdrawal from
the payer’s account and deposit into the
payee’s account via a settlement among banks
by the automated clearing house.
WIRE TRANSFER

is an electronic communication that, via
bookkeeping entries, removes funds from the
payer’s bank and deposits them in the payee’s
bank.
ZERO - BALANCE ACCOUNTS (ZBA)

is a disbursements account that always has an
end-of-day balance of zero because the firm
deposits money to cover checks drawn on the
account only as they presented for payment
each day. The purpose is to eliminate
nonearning cash balance in corporate checking
accounts.