Oxford Ltd is facing problems with its cash flow, particularly its management of working capital. This report prepares a cash budget for the forthcoming period and provides some recommendations on how the firm can better manage its working capital so that it will not face cash flow problems in future.
2. BUDGETING PROCESS
A budget is a quantitative statement showing a plan of action. The annual process of budgeting should be seen as stages in the progressive fulfillment of the long term plan for the organization. The budgetary process steers the organization towards the long term strategic objectives of the entity. The budgetary process is time consuming but vital, and involves a number of major steps.
Step one is the planning stage. The budget committee is given responsibility for the task of developing and coordinating budgets. The membership varies between organizations but usually comprises people from various functions of the company. The committee would be serviced by the budget officer, usually the accountant. The budget officer' responsibility is to administer the budget when agreed and to provide technical assistance and data during the budget preparation. The budget planning process takes place prior to the budget period and where budgets are prepared on a rolling basis, budget planning is a regular, continuous activity.
Step two is the forecasting stage. An essential preliminary to making plans and budgets is to prepare forecasts. A forecast is a prediction of future events which are expected to happen, whereas a budget is a planned series of actions to achieve a given result. Invariably the primary forecast, from which most of the subsequent planning derives, is the sales forecast. Forecasting is a large and complex field frequently involving advanced mathematical and statistical techniques.
Step three is the coordination of budgets. Coordination and communication between functions is essential to ensure interlocking, feasible budgets which accord to company policies and objectives. Many of these steps need to be repeated during the budget development as inconsistencies become apparent. The testing of one budget against another for feasibility and practicability is a key element in coordinating the budget process.
Step four is the preparation of the budgets. The budget, comprising the individual departmental and functional budgets and the master budget is submitted to the chief executive or board of directors for examination and approval after any revisions thought necessary. When approved, the budget becomes an executive order and shows for each budget centre an approved level of expenditure. A budget centre is a section of the organization so designed for budgetary purposes.
Step five is the communication of the budget. The agreed budgets are published and distributed to all the budget holders and budget centres. In this way, budgets serve as a means of communicating plans and objectives downwards. In addition, that part of the budgetary process concerned with monitoring results, known as budgetary control provides upward feedback on the progress made towards meeting plans.
Step six is budgetary control. This takes place after the actual events, usually on a monthly basis. Speedy production of budgetary control statements and immediate investigation of revealed variances provide the best basis for bringing operations into line with the plan, or where there have been substantial changes in circumstances, making agreed alterations to the plan.
The final step is the investigation into variances and their causes. This provides the link between budgetary control and budgetary planning. The expenditure of operations, levels of performance and difficulties are fed to the budget committee so that the planning process is continually refined.
3. SURPLUS
Cash is needed to pay for labor and raw materials, to buy fixed assets, to pay taxes, to service debt and to pay dividends. However, cash itself earns no interest. Thus, the goal of cash management is to maximize the amount of cash the firm must hold for use in conducting its normal business activities, yet at the same time have sufficient cash to take trade discounts, to maintain its credit ratings and to meet unexpected cash needs. The rest of surplus cash should be reinvested.
A firm with surplus funds can invest them in interest bearing securities. Treasury bills are only one of the main securities that might be appropriate for such short term investments. More generally, firms may invest in a variety of securities in the money market, the market for short term financial assets.
Only fixed income securities with maturities less than one year are considered to be part of the money market. In fact, however, most instruments in the money market have considerably shorter maturity. Limiting maturity has two advantages for the cash manager. First, short term securities entail little interest rate risk. Very short term securities therefore have almost no interest rate risk. Second, it is far easier to gauge financial stability over very short horizons. One need not worry as much about deterioration in financial strength over a 90 day horizon as over the 30 year life of a bond. These considerations imply that high quality money market securities are a safe parking spot to keep idle balances until they are converted back to cash.
Most money market securities are also highly marketable or liquid, meaning that it is easy and cheap to sell the asset for cash. This property too is an attractive feature of securities used as temporary investments until cash is needed. Treasury bills are the most liquid asset. They are issued by the United States government with original maturities ranging from 90 days to one year.
Another popular money market instrument is commercial paper. This is the short term usually unsecured debt of large and well know companies. Since there is no active trading in commercial paper, it has low marketability. Therefore, it would not be an appropriate investment for a firm that could not hold it until maturity.
Alternatively, the firm could invest in certificates of deposit (CD). These are time deposits at banks, usually in denominations greater than $100, 000. Unlike demand deposits, time deposits cannot be withdrawn from the bank 0on demand. The bank pays interest and principal only at the maturity of the deposit. However, short term CDs with maturities of less than three months are actively traded, so a firm can easily sell the security if it needs cash.
Finally, Oxford Ltd can invest in repurchase agreements. Also know as repos, repurchase agreements are in effect collateralized loans. A government bond dealer sells Treasury bills to an investor, with an agreement to repurchase them at a later date at a higher price. The increase in price serves as implicit interest, so the investor in effect is lending money to the dealer and later getting it back with interest. The bills serve as collateral for the loan. If the dealer fails and cannot buy back the bill, the investor can keep it. Repurchase agreements are usually very short term, with terms of only a few days.
4. ANALYSIS
Oxford Limited
Cash Budget for Six Months Ending 30 June 2011
Jan ()
Feb ()
Mar ()
Apr ()
May ()
Jun ()
Receipts
Receipts from customers
30,000
30,000
30,000
30,000
40,000
40,000
Sale of vehicle C
5,000
Receipt from share issue
125,000
Total Receipts
155,000
30,000
30,000
35,000
40,000
40,000
Payments
Payment to suppliers
25,000
35,000
30,000
30,000
35,000
35,000
Salaries
12,000
12,000
12,000
12,000
12,000
12,000
Rental
6,000
6,000
6,000
6,000
6,000
6,000
Salesmen's commission
1,500
1,500
1,500
1,500
2,000
2,000
Advertising
15,000
15,000
Purchase of vehicle G
40,000
Total Payments
44,500
69,500
49,500
89,500
70,000
55,000
Cash flow
110,500
-39,500
-19,500
-54,500
-30,000
-15,000
Opening balance
-50,000
60,500
21,000
1,500
-53,000
-83,000
Closing balance
60,500
21,000
1,500
-53,000
-83,000
-98,000
5. CASH COLLECTION
The success or failure of a business depends primarily on the demand for its products and services. Generally, the higher its sales, the larger its profits and the higher the value of its stock. Sales, in turn depend on a number of factors, some external but others under the control of the firm. The major controllable determinants of demand are sales price, product quality, advertising and the firm's credit policy.
Credit policy consists of four variables. One, credit period which is the length of time buyers are given to pay for their purchases. Two, credit standards, which refer to the financial strength of acceptable credit customers and the amount of credit available to different customers. Three, collection policy which is measured by its toughness or laxity in following up on slow paying accounts. Four, discounts given for early payment, including the discount percentage and how rapidly payment must be made to qualify for discount
Having a good credit policy is vital to ensure prompt and sufficient collection of debt from credit customers. Even if a firm generates good sales, it will not translate into adequate profit or cash flow if the debtor collection period is very long or there are a high percentage of bad and doubtful debts. Therefore, Oxford Ltd should take steps to set up an effective credit control system to ensure prompt payment from customers.
First, the company should establish a sound credit policy. This will guide it in deciding to whom and how much trade credit is appropriate. Second, it should make a rigorous assessment of customer creditworthiness. Customers' financial position should be analyzed to determine whether they face solvency problems both in the short and long term. The company can use advanced software for this purpose which can calculate various ratios. Third, the company needs to establish a bad debt policy. It should decide the acceptable threshold for writing off a debt as bad, since it may not be economically viable to pursue debtors for small amounts of debts. Nevertheless, writing off debts as bad should be a last resort, after all legal avenues have been exhausted, and it must be authorized by a senior manager. Fourth, the company should examine ways to encourage customers to pay promptly. This includes offering discounts for early settlement. Fifth, the company can make arrangements with a debt factor firm. These factors collect debt on behalf of the company and it is sometimes more efficient and effective. However, it must be remembered that this comes at a financial cost which must be analyzed to ensure that it cost effective to the firm. Finally, for multinational firms, there must be a policy to manage exchange rate risk. Adverse shifts in exchange rates during the period from the credit sale to its settlement will reduce the value of a debt. To overcome this, the firm can perform a series of hedging measures.
6. DEFICIT
When a firm faces temporary cash deficits like Oxford Ltd in this forecast, it can overcome it by using an overdraft facility. This is a comparatively cheaper form of borrowing, as overdrafts are actually short term loans with changing interest rates. These fluctuations will not matter since the borrowing period is generally short.
Nevertheless, using overdrafts has disadvantages. One is that it cannot be used to raise large amounts of capital as there are strict limits to an overdraft facility. Hence, a firm in need of massive funds must resort to other alternatives like raising equity or long term debt like bonds. Also, since they are short term in nature, they must be repaid quickly. A firm with a constant cash flow problem cannot move from overdraft to overdraft as it is prohibited by banks.
7. RECOMMENDATION
To reduce its cash flow problems, it is recommend Oxford Ltd to tighten its credit control system to ensure prompt payment from customers. However, the main problem faced by the company is not so much its credit control policy, but in terms of expenses. Even if all sales were on a cash basis, the company spends more each month than it earns. This is guaranteed to put it in a constant cash outflow position. Therefore, it is recommended that the company should reduce operating expenses if it wants to achieve profitability.
8. CONCLUSION
In conclusion, Oxford Ltd has some serious cash flow problems. These are mainly due to expenses exceeding income, though a poor credit control policy makes the situation worse. The company should seriously address these shortcomings instead of relying on temporary measures like overdrafts to overcome deficits. If these problems are not solved soon, the company will face long term solvency problems.
