Cash Budgeting The Elusive Cash Balance ‘‘What do you mean we’ve used up all our cash and lines of credit? I don’t get it! I thought we had a healthy financial position as per last year’s financial statements

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Cash Budgeting

The Elusive Cash Balance

‘‘What do you mean we’ve used up all our cash and lines of credit? I don’t get it! I thought we had a healthy financial position as per last year’s financial statements. How could this have happened, Patrick?” said Donald Hunt to his chief accountant. “If our suppliers find out, we could be in a compromising position. I can’t let that happen. Prepare a detailed report including a cash budget for the next year and give it to me by 10 AM to-morrow. Build in a minimum cash balance that is at least 25% higher than our last year’s ending cash balance, but make sure that it’s not more than

50% higher than our last year’s ending cash balance in any period.”

Donald Hunt, the owner of Hunt Distributing, Inc., had inherited the family business five years ago, when his father, Nelson, suddenly passed away. Under Nelson’s leadership, the firm had grown slowly but steadily.

Nelson had always maintained strong ties with local businesses, suppliers, and customers. As Patrick began examining the financial statements

(Tables 1 and 2), he couldn’t help recalling how Nelson had managed to always keep the firm’s liquidity position strong by being conservative and planning for the future. He did not take undue risk and only accepted prod-ucts of the highest quality for distribution. Bills were always paid on time, and credit terms were only extended to those customers and retailers who were well known to Nelson (as most were).

Donald, on the other hand, had always criticized his father’s conserv-ative business policies. As soon as he took over, he unleashed a host of

liberal terms and policies. He significantly expanded the list of products

offered for distribution to retailers, extended much longer credit periods to

clients, and took on additional bank loans to finance his expansions. The

list of product offerings grew from 300 to 650, and the number of suppli-

ers more than tripled. Although revenues increased during the five-year

period, the volatility increased as well. More importantly, the cash balance

had been very unstable and had significantly decreased over time, indicat-

ing a problem in cash management.

 

As Patrick crunched the numbers, he realized that in order to prepare

a detailed cash budget and financial report he needed to figure out the

average receivables period, the average payables period, and a periodic

sales forecast. He made the assumption that sales would increase at the

last year’s rate of 25%. After consulting the sales manager, Patrick devel-

oped a breakdown of monthly sales for the last quarter of 2015 and for

the forthcoming year (Table 3). Table 4 presents the collection schedule

that Patrick assumed the firm would follow in the coming year. All other

expenses and charges would be assumed to vary proportionately with sales

or held constant. Patrick was aware that the firm would be acquiring a new

delivery truck for $40,000 in May of the coming year and figured that he

better include it in the cash budget. All operating expenses were uniformly

distributed over the year. Debt payments were made monthly, while taxes

were paid in March, June, September, and December of each year. The

firm had a policy of ordering goods one month in advance of forecasted

sales and would pay for them within about 90 days.

 

As he glanced at his watch, Patrick realized that he better get some

assistance or he’d face an irate boss in the morning. He picked up the

telephone and called for Kelly, his recently hired assistant, to come to his

rescue in solving this problem of the “elusive cash balance.”

Questions:

 

1. What seems to be the major problem with Hunt Distributing

Inc.? Why has this problem occurred?

 

2. Based on the prior years’ financial statements, what conclu-

sion do you think Patrick would be justified in reaching? What

calculations should he make to analyze the cash position of

the company? Substantiate your answer by making the neces-

sary calculations.

 

3. Should Patrick prepare a quarterly or a monthly cash budget

for Hunt Distributing Inc.? Explain why.

 

4. Prepare a suitable cash budget for Hunt Distributing Inc.

Build in minimum and maximum cash balances as requested

by Donald. Assume that the cash position at the start of the

budgeting period is zero.

 

5. Based on your calculations, which months seem to be the most

vulnerable to cash deficits and which ones have the greatest

surplus funds?

 

6. Assuming borrowed funds cost 10% per year and excess funds

can be invested at 6% per year, prepare an annual financial

plan for Hunt Distributing, Inc.

 

7. How might the firm avoid cash shortages in the future?

Explain.

 

8. Based on the data provided calculate and comment on the ab-

solute liquidity of Hunt Distributing, Inc.