This preview shows page 1. Sign up to view the full content.
Unformatted text preview: 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 $76,000 for the 3-month
period, the financial manager should be certain that some arrangement is made to
ensure the availability of these funds. CHAPTER 3 117 Cash Flow and Financial Planning Coping with Uncertainty in the Cash Budget
Aside from careful estimation of cash budget inputs, there are two ways of coping with the uncertainty of the cash budget.8 One is to 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 differing assumptions, also should give the financial manager a sense of
the riskiness of various alternatives. This sensitivity analysis, or “what if”
approach, is often used to analyze cash flows under a variety of circumstances.
Computers and electronic spreadsheets simplify the process of performing sensitivity analysis.
EXAMPLE TABLE 3.11 Table 3.11 presents the summary of Coulson Industries’ cash budget prepared for
each month of concern using pessimistic, most likely, and optimistic estimates of
total cash receipts and disbursements. The most likely estimate is based on the
expected outcomes presented earlier.
During October, Coulson will, at worst, need a maximum of $15,000 of
financing and, at best, will have a $62,000 excess cash balance. During November, its financing requirement will be between $0 and $185,000, or it could
experience an excess cash balance of $5,000. The December projections show
maximum borrowing of $190,000 with a possible excess cash balance of A Sensitivity Analysis of Coulson Industries’ Cash Budget ($000)
October November December Pessimistic
Less: Total cash
Net cash flow
likely Optimistic Pessimistic Most
likely Optimistic Pessimistic Most
likely Optimistic $160 $210 $285 $210 $320 $ 410 $275 $340 $422 200
($ 40) 213
($ 3) 248 380 418 467 $ 37 ($170) ($ 98) ($ 57) 10 5) 305 320 $ 35 $102 50 50 50 $ 10 $ 47 $ 87 25 25 25 25 25 25 25 25 25 $ 15 — — $185 $ 76 — $190 $ 41 — — $ 22 $ 62 — — 5 — — $107 ($160) 47 280
($ ($ 51) 87 ( 160) ( 51) 30 $ 30 ($165) ($ 16) $132 $ 8. The term uncertainty is used here to refer to the variability of the cash flow outcomes that may actually occur. 118 PART 1 Introduction to Managerial Finance $107,000. By considering the extreme values in the pessimistic and optimistic
outcomes, Coulson Industries should be better able to plan its cash requirements.
For the 3-month period, the peak borrowing requirement under the worst circumstances would be $190,000, which happens to be considerably greater than
the most likely estimate of $76,000 for this period.
A second and much more sophisticated way of coping with uncertainty in the
cash budget is simulation (discussed in Chapter 10). By simulating the occurrence
of sales and other uncertain events, the firm can develop a probability distribution of its ending cash flows for each month. The financial decision maker can
then use the probability distribution to determine the amount of financing needed
to protect the firm adequately against a cash shortage. Cash Flow Within the Month WW
W Because the cash budget shows cash flows only on 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 is available for paying bills as
they come due. For an example related to this topic, see the book’s Web site at
The synchronization of cash flows in the cash budget at month-end does not
ensure that the firm will be able to meet daily cash requirements. Because a firm’s
cash flows are generally quite variable when viewed on a daily basis, effective
cash planning requires a look beyond the cash budget. The financial manager
must therefore 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
attention required. Review Questions
3–12 LG5 What is the purpose of the cash budget? What role does the sales forecast
play in its preparation?
Briefly describe the basic format of the cash budget.
How can the two “bottom lines” of the cash budget be used to determine
the firm’s short-term borrowing and investment requirements?
What is the cause of uncertainty in the cash budget, and what two techniques can be used to cope with this uncertainty? 3.4 Profit Planning: Pro Forma Statements pro forma statements
Projected, or forecast, income
statements and balance sheets....
View Full Document