Three Important Components of Cash Budget - Coursework Example

Management Accounting and Financial Management April 11, PART A Alpha ltd Schedule ofexpected Cash collections from customers for five months October November December January February Total Cash received from previous month £400, 000 £ 400, 000 October sales £400, 000 £400, 000 £ £400, 000 November sales £400, 000 £400, 000 £400, 000 December sales £540, 000 £540, 000 £540, 000 January sales £540, 000 February sales £540, 000 Total Collections £400, 000 £400, 000 £400, 000 £ £540, 000 £1740, 000 Alpha ltd schedule of expected cash payments for raw materials the five month period October November December January February Total Cash paid to previous month purchase £80, 000 £80, 000 October Purchases (£80,000) £80, 000 £ 80,000 November purchases £80, 000 £80, 000 £80, 000 December purchases £120, 000 £120, 000 £120, 000 January purchases £120, 000 £120, 000 £120, 000 February purchases £120, 000 Total £80, 000 £80, 000 £80, 000 £120, 000 £120, 000 £480, 000 Alpha ltd schedule of expected cash payments the other variable overheads October November December January February Totals Cash paid for previous months payments 0 0 October payments £160, 000 160, 000 November payments £160, 000 160, 000 December payments 270, 000 270, 000 January payments 270, 000 270, 000 February payments 270, 000 270, 000 totals 160, 000 160, 000 270, 000 270, 000 270, 000 1, 130, 000 Alpha ltd CASH BUDGET for five months October November December January February Total Cash balance brought forward £80, 000 £80, 000 Cash collected from customers £400, 000 £400, 000 £400, 000 £540, 000 £1,740, 000 Total cash available £480, 000 £400, 000 £400, 000 0 £540, 000 £1,820, 000 Cash payments for raw materials £80, 000 £80,000 £80, 000 £120, 000 £120, 000 £480, 000 Cash payments on other variable costs £160, 000 £160,000 £270, 000 £270, 000 £270, 000 £1, 130, 000 Cash payments on fixed costs £140, 000 £140, 000 £ 140, 000 £140, 000 £140, 000 700, 000 Total cash payments £380, 000 £380, 000 £490, 000 £530, 000 530, 000 £2310, 000 Gross Cash balance £ 100, 000 £20, 000 £(90, 000) (£530, 000) £10, 000 £490, 000 C ash balance carried forward £120, 000 £30, 000 Short term loan for financing cash payments £500, 000 Available cash balances carried forward £10, 000 Purposes of Cash Budgeting Cash budget, is a financial budget that is developed to predict anticipated incoming cash and outgoing cash in a time period and at the end of the period. Besley & Brigham (2007: 598), terms the cash budget as ‘the most important tool for managing cash’. Idle cash or shortfalls in cash is easily exposed by the budget and corrective measures adopted to rectify the situation during actual operations. A cash budget is an important planning instrument as it predicts the movement of cash in and out of the business. Additionally, for the business it would be important for them to determine the amount of cash budgeted for and the actual amounts (Albrecht, 2008). The budget encompasses three important components; time period, desired cash position and estimated payments. It defines the policy in which the company stays liquid throughout its period in operation. Additionally, a cash budget may be used for planning for short time credit. For instance, in January, the cash budget predicts that there will not be any cash collected in the business and hence a credit to cover the deficit would be necessary in the month. Currently, most businesses are expected to prepare the cash budgets to precede preparation of statements on capital expenditures for new asset acquisitions or even in expansion. The predicted expansion policy towards sales and production as shown in the case study provides the best example. A healthy cash budget predicts if a business would be able to pay off the debts and other expenditures, however, depreciation is not paid for in cash, and it is the reason why it was left out in the workings above. As a matter of fact, lenders are more inclined to extend to the business loan facilities at improved terms with the cash budget in place. Without a cash budget, estimation of future sales and production can be difficult to determine. Payment policy on creditors and cash receipts from customers can be adjusted after cash budget preparation, so that the business is not at risks of being bankrupt. In addition, budgeting is a sure way of planning for the repayment of credit facilities and repayment dates. Cash budget aids in the avoidance of wastages and excessive expenditure at inopportune time periods, and the prevention of a casual day t day running of the going concern. Analysis of Example Cash Budget The cash budget for the Alpha ltd shows that at the £ 80, 000 is the amount of cash balances held at the bank before the month October. Before the planned expansion and this will take place at the beginning of December, the current sales level has been predicted to remain at the current level of £400, 000. Further, and as a rule cash to be collected from sales of the month would be received in the following month. Therefore, the sales made in the months preceding October, the one for October, November and have been entered into the cash budget for the predicted current value of £400, 000. Sales made for the months of December, January and February would increase by 50% albeit with a selling price reduction of 10% making the sales volume to rise to £540, 000. Sales made in December would be received in cash in the month of February the same would follow for January and February which would be received two months succeeding them. There would be no cash received from sales made and following the predicted new policy and as a result all the cash payments for that month would be paid for using short time credit. Monthly cash payments would include; for raw materials purchases, other variable costs and for the fixed costs. It should be noted that a cash budget is not the cash flow statement as it merely predicts the cash movement and does not actually report the movement of cash in the business. Cash budgeting as can be shown by the tables above is a continuous process that demands consistent and accurate checks, and comparison with anticipated financial statements, and the normal ratios. Therefore, the budgeting aids in estimation of payments that accrues to the suppliers and other creditors and other obligations. Given cash balances in the business, the payments can be scheduled to relevant dates and that not a single obligation to pay is overlooked. Anticipated cash collections into the business from customers can be estimated and planned with the relevant dates. A careful budget and the subsequent plan based on the budget, the business can maintain sufficient amounts of cash for the business needs and avoid the possibility of holding cash yet they are not being used for productive purposes. The cash budget exposes time lag in business, the period when sales is made and cash received or raw materials procured and when payment is made. A careful analysis of the difference can greatly help the business demystify their operations so that when the suppliers are paid and customers pay is addressed. For instance, the December payments are in excess of the cash collections in the same month, this implies that positive balances in October and November would be pay the negative cash balances in December, and part of January purchases and other obligations. When demand for cash is high in the business than the inflow from customers, it would be imperative upon for the business to arrange for a short time facility to address the glaring gap in cash needs (Mowen, Hansen & Mowen 2007). The loans can be addressed later when the cash balances have been received from customers, in the Alpha ltd, the loan taken to finance cash needs in January would be paid for in later months. Alpha limited needs to foster and maintain a safe level of cash availability and to enhance the business carry on its activities. The owner must be willing to use the safe level determined by the cash flow to carry on the business without undue compromise on business activities (Kimmel Weygandt & Kieso 2010). Reference list Albrecht, W. S. (2008). Accounting: concepts and applications. Australia, Thomson South-Western. Besley, S., & Brigham, E. F. (2007). Essentials of managerial finance. Fort Worth, Dryden Press. Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2010). Accounting: tools for business decision makers. Vol. 2 Vol. 2. Hoboken, N.J., Wiley. Mowen, M. M., Hansen, D. R., & Mowen, M. M. (2007). Cornerstones of managerial accounting. Mason, OH, Thomson Business & Economics. Appendix 1. Current monthly Contribution produced by sales = 0.4*400000 =160, 000 2. Raw material value 0.2*400000 = 80, 000 3. The volume of raw materials will increase as production increase by 50 % in the same proportion in the months of December to February, such that 1.5*80, 000 =120, 000 4. Sales for December to February would increase to 1 .5*400000= 600,000*0.9=540,000 5. Variable manufacturing overheads = (sales-contribution) - variable raw materials 0.6-0.2 = 0.4*400, 000 = 160, 000 6. Contribution falls to 30% therefore the variable 7. From December to February 0.7-0.2 = 0.5*540, 000= 270, 000 PART B Payback method Cash flows Years Option A £000 Option B £ 00 0 -1320 -1650 1 990 578 2 660 660 3 495 825 4 330 1073 5 330 1155 The ARR Year Net profit for option A £000 Depreciation option A£000 Total profit after depreciation 165 Net profit for option B£000 Depreciation option B£000 Net profit after depreciation 991 1 726 264 248 330 2 396 264 330 330 3 231 264 495 330 4 66 264 743 330 5 66 264 825 330 Total 1485 1320 2641 1650 The NPV Year Option A £000 Option B £000 Discounting factor 15% NPVA £000 NPV B £000 0 -1320 -1650 1 -1320 -1650 1 990 578 0.8696 860.876956 502.60869 2 660 660 0.7561 499.054820 499.054820 3 495 825 0.6575 325.470535 542.450891 4 330 1073 0.5717 188.678571 613.491232 5 330 1155 0.4971 164.068322 574.239129 NPV 718.149204 1081.844762 The IRR method Year Option A £000 Option B £000 IRR Discounting factor for option A 43% NPVA £000 IRR Discounting factor for option A 36.59% NPVB £000 0 -1320 -1650 1 -1320 1 -1650 1 990 578 0.6993 692.3561088 0.7320 423.1332357 2 660 660 0.4890 322.7993141 0.5359 353.7060895 3 495 825 0.3420 169.3121796 0.3923 323.6695548 4 330 1073 0.2392 78.93893725 0.2872 308.1746593 5 330 1155 0.16729065 55.20591458 0.2103 242.8446205 NPV 0 0 The payback method Evaluating the R&D’s the two options based on the payback method. The payback method is also referred to as the pay off method uses the cash flows rather than the net profit. Under this method of project viability evaluation project A would be considered in place of project B as it takes only one year and six month to recover the outlay of 1320 whereas project B’s recovery period for the initial outlay would last two years and six months. This method of project evaluation is simple to compute and as such god for situations in which there are risks of a time nature, such as uncertain political environments or general insecurity that might hinder proper project lifespan. In addition, the method can be used in situations in which the company, Beta plc is facing stiff competitions from rival companies. In volatile industries in which changes such as packaging styles changes rapidly, the method come in handy. The major drawback of the approach is that the system ignores the time value of money and does not consider cash flows after the payback period. Additionally, the approach does not address the question of profitability. Finally, the approach provides useful insight into the liquidity of the company and however it cannot be recommended for Beta plc as it is has adequate capital. ARR This is the Average Rate of Return on Investment, however, unlike the other method it is a measure of profitability that relates income to investment, measured in accounting terms. From Appendix 2, Option B provides an average rate of returns of 60 % compared to Option A return of 12.5 %, making it the most viable option for the R%D. The higher the ARR, the better the project hence option B must considered instead of Option A. Just like the payback method, the ARR, method is simple to compute, understand and use. The accounting data is read and used in the computation. The method, unlike the payback method uses income streams when arriving at the best rate. Just like the payback method, this approach does not take into account the time a value of money. In accounting and finance principles, profits are not usually reinvested into the business, however, the approach does not provide a window for the net profit to be reinvested back into the project. The NPV This is the net value or even benefit of project when the costs have been discounted to present value at the accounting rate of interest or the opportunity cost of capital. All future inflows are discounted by the applicable interest rate to get the present values. The criterion is one of the best methods of appraisal. Normally its decision should be upheld with respect to the other methods. The NPV method unlike the two previous methods considers time value of money and utilizes the expected future cash flows when determining the best project. Option A provides a NPV of £ 718, 149. 20 and Option B provides a NPV of £ 1,081 844. 76, therefore, Option B> Option A and Option b becomes the better project to Option A and should be considered under the NPV criterion. The NPV takes into account the risk of future cash flows, unlike the payback method and the ARR method. Further, the method assumes that investment and reinvestment is done at the opportunity cost of capital. This method can be used in choosing mutually exclusive projects unlike the other two methods whose primary role is to assist in making decision on competing projects. The unreliability and intricacies involved in cost of capital estimation might be drawback on the method. Unlike the ARR, the NPV provides a monetary criterion when choosing between two projects. The IRR method This is the rate of return that makes the “NPV of the incremental net benefit stream equal to zero” (Brigham& ‎Ehrhardt 2013: 404). It is the maximum rate of interest that a project could pay for the resources used if the project is to recover the investment and operating costs and still breakeven . This is one of the most effective methods of measuring a projects worth. When calculating the IRR, it is normal to use trial and error method to arrive at the final figure. The IRR method is important when the worth of a project and it is to be determined and hence the tool is important in economic analysis. Therefore, it is important to assume all independent projects which have the IRR which is equal to or even greater than the cost of capital. The IRR of a series of cash flow can only exist when at least one value is negative because if all the values are positive then no discount rate with make the NPV to be equal to zero. Both the two projects have r*> r. for Option A, r* which is the IRR rate is 43% and the r is 15%, therefore, the project is viable. In option B, r* is 36.59 % where as r is 15%. IRR just like the NPV considers time value of money and cash flow over the entire life cycle of a project. However it does not provide a conclusive choice in case two competing choices both have r*> r, just like in the case under the report. Just like the NPV, the IRR can also be used to choose mutually exclusive projects (Rich 2012).  This means the IRR method does not provide conclusive criterion of choosing either options and hence it is imperative to discard is applicability to the scenario. Provided with the different methods of considering the two options, considerations on Project B would be important as it gives Higher NPV than option B and incorporates all the cash flows over the entire project period and the time value of money. According to (Moles, Parrino, & KidwelL 2011: 396) the ARR method should not be considered when “evaluating a capital project”, such as the one initiated by the R&D of Beta Plc. Reference List Brigham, E. F., &  ‎ Ehrhardt, M. (2013). Financial management: theory & practice. Hinsdale, Ill, Dryden Press. Moles, P., Parrino, R., & KidwelL, D. S. (2011). Corporate finance. Hoboken (N.J.), Wiley. Rich, J. S. (2012). Cornerstones of financial & managerial accounting. Mason, OH, South-Western/Cengage Learning. Appendix 1 1320-990 = 330, 330/660= ½ 578+660 = 1650-1238 = 412, 412/825 = ½ Appendix 2 ARR = Option A 165/ 1320 = 0.125, 12.5 % Option B 991/1650 = 0.600, 60. 0% Appendix 3 NPV = Ʃn t = 1 - C0 where - the future cash flows C0 -initial investment Df-discounting factor t is the time. The work above in the paper is a tabular working of this formula. Appendix 4 Mathematically, IRR is the discount rate such that NPV = Ʃn t = 1 - C0 = 0 Read More