588 CHAPTER 16 Working Capital ManagementIn addition to holding cash for transactions, precautionary, and compensating bal-
ances, it is essential that the firm have sufficient cash to take trade discounts.Suppli-
ers frequently offer customers discounts for early payment of bills. As we will see later
in this chapter, the cost of not taking discounts is very high, so firms should have
enough cash to permit payment of bills in time to take discounts.
Finally, firms often hold short-term investments in excess of the cash needed to
support operations. We discuss short-term investments later in the chapter.Why is cash management important?
What are the two primary motives for holding cash?The Cash Budget
The cash budgetshows the firm’s projected cash inflows and outflows over some
specified period. Generally, firms use a monthly cash budget forecasted over the next
year, plus a more detailed daily or weekly cash budget for the coming month. The
monthly cash budgets are used for planning purposes, and the daily or weekly budgets
for actual cash control.
The cash budget provides more detailed information concerning a firm’s future
cash flows than do the forecasted financial statements. In Chapter 11, we developed
MicroDrive Inc.’s 2003 forecasted financial statements. MicroDrive’s projected 2003
sales were $3,300 million, resulting in a net cash flow from operations of $163 million.
When all expenditures and financing flows are considered, its cash account is pro-
jected to increase by $1 million in 2003. Does this mean that it will not have to worry
about cash shortages during 2003? To answer this question, we must construct the
cash budget for 2003.
To simplify the example, we will only consider the cash budget for the last half of- Further, we will not list every cash flow but rather focus on the operating cash
flows. Sales peak in September, and all sales are made on terms of 2/10, net 40, mean-
ing that a 2 percent discount is allowed if payment is made within 10 days, and, if the
discount is not taken, the full amount is due in 40 days. However, like most compa-
nies, MicroDrive finds that some of its customers delay payment up to 90 days. Ex-
perience has shown that payment on 20 percent of dollar sales is made during the
month in which the sale is made — these are the discount sales. On 70 percent of
sales, payment is made during the month immediately following the month of sale,
and on 10 percent of sales, payment is made in the second month following the month
of sale.
Costs average 70 percent of the sales prices of the finished products. These pur-
chases are generally made one month before the firm expects to sell the finished prod-
ucts, but MicroDrive’s terms with its suppliers allow it to delay payments for 30 days.
Accordingly, if July sales are forecasted at $300 million, then purchases during June
will amount to $210 million, and this amount will actually be paid in July.
Such other cash expenditures as wages and lease payments are also built into the
cash budget, and MicroDrive must make estimated tax payments of $30 million on
September 15 and $20 million on December 15. Also, a $100 million payment for a
new plant must be made in October. Assuming that the target cash balance is $10
million, and that it projects $15 million to be on hand on July 1, 2003, what will its
monthly cash surpluses or shortfalls be for the period from July to December?
The monthly cash flows are shown in Table 16-2. Section I of the table provides a
worksheet for calculating both collections on sales and payments on purchases. Line 1
See Ch16 Tool Kit.xlsfor all
calculations.