Chapter 6

MANAGING CASH FLOW

FOCUS

In this chapter, we focus on short-term financial planning involving projecting monthly financial
statements for one year or less. The availability of cash is what drives the entrepreneurial
venture. Inadequate cash often constrains the venture’s ability to grow, is a primary cause of
financial distress, and can result in bankruptcy even though the venture may be profitable in an
accounting sense. The process of preparing short-term projected financial statements also helps
the entrepreneur anticipate and estimate additional external financial capital needed to support
the business plan during the next year. We also cover a venture’s operating cycle and its cash
conversion cycle and their importance in managing cash flow.

LEARNING OBJECTIVES

1. Construct a cash budget and determine the timing and amount of any monthly cash needs.
2. Describe how short-term projected statements of cash flows relate to cash budgets.
3. Explain why short-term projected statements of cash flow are important to the entrepreneur.
4. Identify and describe the use and value of conversion period ratios to the entrepreneur.

CHAPTER OUTLINE

6.1 FINANCIAL PLANNING THROUGHOUT THE VENTURE’S LIFE CYCLE

6.2 SURVIVING IN THE SHORT RUN
6.3 SHORT-TERM CASH-PLANNING TOOLS
6.4 PROJECTED MONTHLY FINANCIAL STATEMENTS
6.5 CASH PLANNING FROM A PROJECTED MONTHLY BALANCE SHEET
6.6 CONVERSION PERIOD RATIOS
A. Measuring Conversion Times
B. Interpreting Changes in Conversion Times
SUMMARY

DISCUSSION QUESTIONS AND ANSWERS

1. What does short-term financial planning involve?

  Short­term financial planning usually involves projecting monthly financial statements and 
concentrating on a venture's cash needs. Most initial business plans contain monthly 
projected (pro forma) financial statements for at least one year, and sometimes for two or 
more years. These short­horizon forecasts directly address whether a venture is expected to 
generate—or otherwise obtain—the required cash to meet its coming obligations.
2. Provide a description of the financing cost implications associated with a venture’s need for
additional funds.

The cost of obtaining additional funds may be explicit, such as additional interest expense
associated with debt. Interest expense shows up directly on the projected income statement
and, in turn, impacts the AFN shown on the balance sheet. In contrast, added “costs”
associated with obtaining equity capital from venture capitalist and other investors are based
on the expected rates of return the investors receive when they exit their investments. These
implicit costs do not show up on the projected financial statements.

3. What is meant by a cash budget? Describe how a cash budget is prepared.

A cash budget is a financial tool showing the inflows and outflows of the firm’s cash balance
over a period of time. It is calculated by determining all of the cash-basis expenses and
revenues the firm has over a period of time to find out how cash is being built and burned.

4. Besides the cash budget, what additional financial statements are projected monthly in
conjunction with short-term financial planning?

Additional statements that can be prepared on a monthly basis to provide a clear financial
picture of the firm include the income statement, balance sheet and a statement of cash flows.

5. What is meant by a venture’s operating cycle?

A venture’s operating cycle is the time it takes to purchase raw materials, assemble a product, book a
sale, and collect on it.

6. Describe the cash conversion cycle (C3).

The cash conversion cycle is the operating cycle less the days of short-term credit extended by
suppliers, employees and government (the purchase-to-payment cycle).

7. What are the three components of the cash conversion cycle (C 3)? How is each component
calculated?

The three components of the cash conversion cycle are inventory-to-sale conversion period, sales-to-
cash conversion period, and purchase-to-payment conversion period. The inventory-to-sale
conversion period is calculated by dividing average inventories by the venture’s average daily cost of
goods sold. The sale-to-cash conversion period is calculated by dividing the average receivables by
the net sales per day. The purchase-to-payment conversion period is calculated by dividing the sum of
average payables and accrued liabilities by the venture’s cost of goods sold per day.

8. Briefly explain how changes in the conversion times of the components of the C 3 can be interpreted.

A lengthening of the inventory-to-sale conversion period indicates less efficient inventory

management. A lengthening of the sale-to-cash conversion period indicates less efficient collections
or management of receivables. A decrease in the purchase-to-payment period indicates a less efficient
use of the credit provided by suppliers, employees and the government.
9. From the Headlines – Sustainable Northwest: Describe Sustainable Northwest’s short-term
inflows and outflows of cash. What would you expect to be the main ingredients of each part
of the cash conversion cycle?

Sustainable Northwest is a nonprofit organization with a for-profit wholesale lumberyard

called Sustainable Northwest Wood which supports its nonprofit parent’s objectives. The
wholesale lumberyard provides raw materials gathered by selective harvesting to small
lumber mills for processing, with the processed products then being sold to home builders,
suppliers of green building products, etc.

The inventory-to-sale conversion period would involve gathering raw wood, processing the
raw wood into finished products, and carrying the finished products until sales are made.
Credit terms may need to be extended to home builders and other customers, who in turn
may need to give credit to their retail customers. Thus, Northwest Wood is likely to incur a
sale-to-cash conversion period. Furthermore, given that Northwest Wood is a wholesale
lumber yard, any purchase-to-payment conversion period to offset the length of the venture’s
operating cycle would have to come from the owners of the forests from which the trees are
harvested.

INTERNET ACTIVITIES

1. Access the U.S. census bureau web site at http://www.census.gov. Find relevant information
for trends in U.S. population growth for a specific business idea. Comment on the
manufacturing statistics and regional or national statistics relevant for that business.

Web-researched results vary due to constant updating of the related web sites.

2. For a specific business idea, find labor wage data for the types of employees that will be
involved. Examples of relevant web sites include the Bureau of Labor Statistics web site at
http://www.states.bls.gov and career information sites like http://www.wetfeet.com.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS

3. [Short-Term Financial Planning] The PDC Company was described during the early part of
this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table
6.2. PDC’s sales are projected to be $80,000 in September 2017.

[Note: An Excel spreadsheet for the PDC Company is available on the authors’ Web
site for use by instructors.]
 A. Prepare PDC’s sales schedule, purchases schedule, and the wages schedule for August
2017.

See the spreadsheet solution for Problem 11. Here we are focusing just on projecting the
month of August.

Sales Schedule:
Schedule 1: Sales Forecast
Total sales = $92,000; Credit sales (40%) = $36,800; Cash sales (60%) = $55,200
Schedule 2: Cash Collections
Cash sales = $55,200; Collection of July’s credit sales = $46,000; Total collections =
$101,200

Purchases Schedule:
Ending inventory at end of August is estimated as: Forecasted September sales = $80,000
times .8 of sales coverage times .7 to reflect cost of goods sold. Thus, ($80,000 x .8 x .7)
= $44,800. PDC adds a $46,000 inventory cushion to get to the target ending inventory
for August of: $90,800. Cost of goods sold for August is $64,400 (i.e., $92,000 x .7).
Total inventory needed is $90,800 + $64,400 = $155,200
Schedule 3: Purchases
$155,200 total inventory needed minus $97,520 beginning inventory (i.e., ending
inventory from July) = $57,680 purchases
Schedule 4: Disbursements for Purchases
Calculated as 50% of July’s purchases plus 50% of August’s purchases: ($67,620 x .5) +
($57,680 x .5) = $33,810 + $28,840 = $62,650

Wages and Commissions Schedule:

Schedule 5: Wages and Commissions
Fixed portion = $5,750. Commissions = 15% of August sales ($92,000 x .15) = $13,800.
Total wages and commissions = $5,750 + $13,800 = $19,550
Schedule 6: Disbursements (Wages and Commissions)
Calculated as 50% of July’s total wages/commissions plus 50% of August’s total
wages/commissions: ($23,000 x .5) + ($19,550 x .5) = $11,500 + $9,775 = $21,275

B. Prepare a cash budget for August 2017 for the PDC Company and describe how the
forecast affects the end-of-month cash balance.

See the spreadsheet solution for August provided in the comprehensive spreadsheet
output for Problem 11. The beginning cash balance for August was $29,487. Total cash
receipts less total cash disbursements for August were $8,075 ($101,200 - $93,125)
resulting in an ending cash balance of $37,562.

4.[Short-Term Financial Planning] The PDC Company was described during the early part of this
chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2.
PDC’s sales are projected to be $80,000 in September 2017.

A. Prepare the PDC Company’s projected income statement for August.

 See the spreadsheet solution for August provided in the comprehensive spreadsheet
output provided in Problem 11.

B. Prepare the PDC Company’s projected balance sheet for August.

See the spreadsheet solution for August provided in the comprehensive spreadsheet
output provided in Problem 11.

C. Prepare the PDC Company’s projected statement of cash flow for August.

See the spreadsheet solution for August provided in the comprehensive spreadsheet
output provided in Problem 11.

D. Compare your balance sheet at the end of August with the balance sheet in Table 6.1 in
the chapter and apply the balance sheet method to determine cash flows over the March-
August time period.

See the spreadsheet solution for August provided in the comprehensive spreadsheet
output provided in Problem 11.

7. [Short-Term Financial Planning] Artero Corporation is a traditional toy products retailer

that recently also started an Internet-based subsidiary that sells toys online. A markup is
added on goods the company purchases from manufacturers for resale. Swen Artero, the
company president, is preparing for a meeting with Jennifer Brown, a loan officer with First
Banco Corporation, to review year end financing requirements. After discussions with the
company’s marketing manager, Rolf Eriksson, and finance manager, Lisa Erdinger, sales
over the last three months of 2017 are forecasted to be:
____________________________________________________________________
Month Sales Forecast
__________________________________________________($000)_____________

October 2017 $1,000

November 1,500
December 3,000
____________________________________________________________________

Artero’s balance sheet as of the end of September, 2017 was as follows.

____________________________________________________________________
Artero Corporation
Balance Sheet as of September 30, 2017 (in $ Thousands)
____________________________________________________________________
Cash $ 50 Accounts payable $ 0
Accounts receivable 700 Notes payable 800
Inventories 500 Long-term debt 400
Net fixed assets 750 Total liabilities 1,200
Equity 800
Total assets $2,000 Total $2,000
____________________________________________________________________

All sales are made on credit terms of net 30 days and are collected the following month and
no bad debts are anticipated. The accounts receivable on the balance sheet at the end of
September thus will be collected in October. The October sales will be collected in
November, and so on. Inventory on hand represents a minimum operating level (or “safety”
stock), which the company intends to maintain. Cost of goods sold average 80 percent of
sales. Inventory is purchased in the month of sale and paid for in cash. Other cash expenses
average 7 percent of sales. Depreciation is $10,000 per month. Assume taxes are paid
monthly and the effective income tax rate is 40 percent for planning purposes.
The annual interest rate on outstanding long-term debt and bank loans (notes payable) is
12%. There are no capital expenditures planned during the period, and no dividends will be
paid. The company’s desired end-of-month cash balance is $80,000. The president hopes to
meet any cash shortages during the period by increasing the firm’s notes payable to the bank.
The interest rate on new loans will be 12 percent.

A. Prepare monthly pro forma income statements for October, November, and December,
and for the quarter ending December 31, 2017.
B. Prepare monthly pro forma balance sheets at the end of October, November, and
December, 2017.

C. Prepare both a monthly cash budget and pro forma statements of cash flows for October,
November, and December 2017.
 D. Describe your findings and indicate the maximum amount of bank borrowing that is
needed.

Based on the financial projection above, a maximum of $1,916,000 is needed.

8. Cash Conversion Cycle] Two years of financial statement data for the Munich Export
Corporation are shown below.

MUNICH EXPORTS CORPORATION

Balance Sheet 2015 2016

Cash $50,000 $50,000
Accounts Receivables 200,000 300,000
Inventories 450,000 570,000
Total Current Assets 700,000 920,000
Fixed Assets, Net 300,000 380,000
Total Assets $1,000,000 $1,300,000

Accounts Payable 130,000 $180,000

Accruals 50,000 70,000
Bank Loan 90,000 90,000
Total Current Liabilities 270,000 340,000
Long-Term Debt 400,000 550,000
Common Stock ($.05 par) 50,000 50,000
Additional Paid-in-Capital 200,000 200,000
Retained Earnings 80,000 160,000
Total Liab. & Equity $1,000,000 $1,300,000
 Income Statement 2015 2016
Net Sales $1,300,000 $1,600,000
Cost of Goods Sold 780,000 960,000
Gross Profit 520,000 640,000
Marketing 130,000 160,000
General & Administrative 150,000 150,000
Depreciation 40,000 55,000
EBIT 200,000 275,000
Interest 45,000 55,000
Earnings Before Taxes 155,000 220,000
Income Taxes (40% rate) 62,000 88,000
Net Income $93,000 $132,000

A. Calculate the inventory-to-sale, sale-to-cash, and purchase-to-payment conversion

periods for Munich Exports for 2016.

Inventory-to-Sale Conversion Period = Average Inventories / (Cost of Goods Sold/365) =

[($450,000 + $570,000)/2]/$960,000/365 = $510,000/$2,630.14 = 193.91 days

Sale-to-Cash Conversion Period = Average Receivables / (Net Sales/365) = [($200,000 +

$300,000)/2]/ ($1,600,000/365) = $250,000/$4,383.56 = 57.03 days

Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued

Liabilities) / (Cost of Goods Sold/365) = [(($130,000 + $180,000)/2) + (($50,000 +
$70,000)/2) / ($960,000/365) = ($155,000 + $60,000)/$2,630.14 = $215,000/$2,630.14 =
81.74 days

B. Calculate the length of Munich Exports’ cash conversion cycle for 2016.

Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash

Conversion Period – Purchase-to-Payment Conversion Period

Cash Conversion Cycle = 193.91 days + 57.03 days – 81.74 days = 163.20 days

9. [Cash Conversion Cycle] Castillo Products Company improved its operations from a net loss
in 2015 to a net profit in 2016. While the founders, Cindy and Rob Castillo, are happy about
these developments, they are concerned with trying to understand how long the firm takes to
complete its cash conversion cycle in 2016. Use the following financial statements to make
your calculations. Balance sheet items should reflect the averages of the 2015 and 2016
accounts.

CASTILLO PRODUCTS COMPANY
INCOME STATEMENT 2015 2016
Net sales $900,000 $1,500,000
Cost of goods sold 540,000 900,000
Gross profit 360,000 600,000
Marketing 90,000 150,000
General and administrative 250,000 250,000
Depreciation 40,000 40,000
EBIT –20,000 160,000
Interest 45,000 60,000
Earnings before taxes –65,000 100,000
Income taxes 0 25,000
Net income (loss) –$65,000 $ 75,000

BALANCE SHEET  2015 2016

Cash $ 50,000 $ 20,000
Accounts receivable 200,000 280,000
Inventories 400,000 500,000
Total current assets 650,000 800,000
Gross fixed assets 450,000 540,000
Accumulated depreciation  – 100,000  – 140,000
Net fixed assets 350,000 400,000
Total assets $1,000,000 $1,200,000

Accounts payable $ 130,000 $160,000

Accruals 50,000 70,000
Bank loan 90,000 100,000
Total current liabilities 270,000 330,000
Long­term debt 300,000 400,000
Common stock (0.05 par) 150,000 150,000
Additional paid­in­capital 200,000 200,000
Retained earnings 80,000 120,000
Total liabilities and equity $1,000,000 $1,200,000

A. Calculate the inventory-to-sale conversion period for 2016.

Inventory-to-Sale Conversion Period = Avg. Inventory/Avg. Daily COGS

= (($400,000 + $500,000)/2)/($900,000/365) = 182.50 days

B. Calculate the sale-to-cash conversion period for 2016.

 Sale-to-Cash Conversion Period = Avg. Receivables/Avg. Daily Sales
= (($200,000 + $280,000)/2)/($1,500,000/365) = 58.40 days

C. Calculate the purchase-to-payment conversion period for 2016.

Purchase-to-Payment Conversion Period

= (Avg. Payables + Avg. Accruals)/Avg. Daily CGS
= (($130,000 + $160,000)/2 + ($50,000 + $70,000)/2)/($900,000/365) = 83.14 days

D. Determine the length of the Castillo Product’s cash conversion cycle for 2016.

Length of the Cash Conversion Cycle = (Inventory-to-Sale Conversion Period) + (Sales-

to-cash Conversion Period) – (Purchase-to-Payment Conversion Period)
= 182.50 days + 58.40 days – 83.14 days = 157.76 days

10. [Cash Conversion Cycle] Safety-First, Inc. makes portable ladders that can be used to exit
second floor levels of homes in the event of fire. Each ladder consists of fire resistant rope
and high strength plastic steps. A lightweight fire resistant cape with a smoke filter is
included with Safety-First ladder. Each ladder and cape, when not in use, are rolled up and
stored in a pouch the size of a back pack and can easily be taken on trips and vacations.
Jan Smithson founded Safety-First as soon as she graduated from a private liberal arts
college in the northwest three years ago. After struggling for the first year, the venture
seemed to be growing and producing profits. Following are the two most recent years of
financial statements, expressed in thousands of dollars, for the Safety-First, Inc.

SAFETY-FIRST, INC.
Income Statements (in $ Thousands)
2015 2016
Net sales 3,750 4,500
Cost of goods sold 2,250 2,700
Gross profit 1,500 1,800
Operating expenses 670 860
Interest 30 40
Income before taxes 800 900
Income taxes 250 300
Net income 550 600

Balance Sheets (in $ Thousands)

2015 2016
Cash 400 150
Accounts receivable 500 800
Inventories 1,450 2,000
Total current assets 2,350 2,950
 Gross fixed assets 2,000 2,800
Less accumulated depreciation -950 -1,250
Net fixed assets 1,050 1,550
Total assets 3,400 4,500
2015 2016
Accounts payable 300 400
Bank loan 150 250
Accrued liabilities 100 150
Total current liabilities 550 800
Long-term debt 150 150
Common stock 850 1,100
Retained earnings 1,850 2,450
Total liabilities and equity 3,400 4,500

A. Using yearend data, calculate the inventory-to-sale conversion period, the sale-to-cash
conversion period, and the purchase-to-payment conversion period for 2015 and 2016.

Note: because inventories, accounts receivable, accounts payable, and accrued liabilities
are not available for 2014, averages of these accounts cannot be calculated for 2015. So
for 2015 versus 2016 comparative purposes, we use yearend data for these accounts.

Inventory-to-Sale Conversion Period = (Yearend Inventories) / (COGS / 365)

2015: 1450 / (2250 / 365) = 1450/6.1644 = 235.22
2016: 2000 / (2700 / 365) = 2000/7.3973 = 270.37

Note: the calculation for 2016 using average inventories would be:
Inventory-to-Sale Conversion Period = (Average Inventories) / (COGS / 365)
2016: ((1450 + 2000) / 2) / (2700 / 365) = 1725/7.3973 = 233.19

Sale-to-Cash Conversion Period = (Yearend Receivables) / (Net Sales / 365)

2015: 500 / (3750 / 365) = 500/10.2740 = 48.67
2016: 800 / (4500 / 365) = 800/12.3288 = 64.89

Note: the calculation for 2016 using average receivables would be:
Sale-to-Cash Conversion Period = (Average Receivables) / (Net Sales / 365)
2016: [(500 + 800) / 2] / (4500 / 365) = 650/12.3288 = 52.72

Purchase-to-Payment Conversion Period = (Yearend Payables + Yearend Accrued Liabilities) /

(COGS / 365)
2015 (300 + 100) / (2250 / 365) = 400/6.1644 = 64.89
2016: (400 + 150) / (2700 / 365) = 550/7.3973 = 74.35

Note: the calculation for 2016 using average payables and average accruals would be:
Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued
Liabilities) / (COGS / 365)
2016: ((300 + 400)/2) + ((100 + 150)/2) = 350 + 125 = 475
475 / (2700 / 365) = 475/7.3973 = 64.21
 B. Determine the cash conversion cycle for each year and discuss the changes that took
place, if any.

Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash

Conversion Period – Purchase-to-Payment Conversion Period

2015: 235.22 + 48.67 – 64.89 = 219.00

2016: 270.37 + 64.89 – 74.35 = 260.91

Note: using average (2015 and 2016) balance sheet accounts for 2016 results in the
following cash conversion cycle:
2016: 233.19 + 52.72 – 64.21 = 221.70

11. Short-term financial planning for the PDC Company was described during the early part of
this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2.
PDC’s monthly sales for the remainder of 2017 are expected to be:

September $80,000
October $100,000
November $130,000
December $160,000

A. Prepare PDC’s sales schedule, purchases schedule, and the wages schedule for each of
the last four months of 2017.

See spreadsheet solution below.

B. Prepare cash budgets for each of the last four months of 2017 for the PDC Company
and describe how the forecast affects the end of month cash balances.

See spreadsheet solution below.

C. Prepare the PDC Company’s projected monthly income statements for the August
through December period.

See spreadsheet solution below.

D. Prepare the PDC Company’s projected monthly balance sheets for the August
through December period.

See spreadsheet solution below.

E.Prepare the PDC Company’s projected monthly statements of cash flow for the August
through December period.
 See spreadsheet solution below.

F.Compare your balance sheet at the end of December with the balance sheet in Table 6.1 in
the chapter and apply the balance sheet method to determine cash flows over the March-
December period.

See spreadsheet solution below.

1