Short notes: cash budget, credit policy, operating cycle

Option (b), the reorder point for inventory, is outside the current syllabus (paper note); notes are written on (a), (c) and (d).

(a) The Cash Budget

Meaning. A cash budget is an estimate of cash receipts and disbursements during a future period of time: an analysis of the flow of cash in a business over a future short or long period, a forecast of expected cash intake and outlay. It is the most important device for the control of receipts and payments of cash.

Purpose. It shows in advance when the firm will have a shortage of cash (so that a bank overdraft or short-term loan can be arranged in time) and when it will have a surplus (so that it can be invested productively for short periods). It is the most important tool for determining the optimal cash balance.

Preparation (receipts and payments method). For each month (or other period):

Comparing the closing balance with the minimum balance required shows the finance needed or the surplus available.

Kinds. Short-term budgets (weekly or monthly, for day-to-day control) and long-term forecasts (three or more years, for working capital and capital projects).

Limitations. It rests on forecasts of sales and collections, which can go wrong; it needs regular revision.

(c) The Credit Policy

Credit policy. A firm's credit policy is the set of decisions that govern its sales on credit: to whom credit is given (credit standards), on what terms (credit terms), and how the debts are collected (collection policy). It determines both the quantity and the quality of the firm's receivables. A liberal policy raises sales and profit but also bad debts, collection costs and the funds tied up in debtors; a tight policy does the reverse and improves liquidity. The optimum policy is where the trade-off between cost, profitability and liquidity is best: credit is liberalised only as far as the extra revenue covers the extra cost.

Credit terms are the conditions on which credit is granted. They are usually stated in a form such as "3/15 net 60": a 3% discount if paid within 15 days, otherwise the full amount within 60 days. They have three parts, each with its own role:

1. Credit period. The time allowed to customers for payment. A longer period attracts new customers and raises sales, often under competitive pressure, but it increases the investment in receivables and the risk of bad debts. The length of the credit period and the discount allowed determine the size of the investment in receivables.
2. Cash discount. An incentive for early payment that speeds up collections and releases funds. It has a cost, so it is offered only if the benefits it brings (earnings on the funds released, extra sales, fewer bad debts and lower collection costs) exceed that cost.
3. Discount period. The period within which the discount may be taken. A longer discount period may induce more customers to take the discount and pay, but those who already paid early may now pay later.

Role. By setting these terms the firm controls how fast its sales turn into cash, and so balances the extra profit from credit sales against the cost of financing receivables, bad debts and collection.

(d) The Operating Cycle

Meaning. Working capital is needed because there is a time gap between production and the realisation of cash from sales: the firm passes through an operating cycle of buying raw materials, producing, selling and collecting cash. The operating cycle is the time taken to convert cash into raw materials, raw materials into work in progress and finished goods, finished goods into debtors, and debtors back into cash.

Components (each measured as the average balance divided by the matching flow per day):

1. Raw material storage period (R) = average raw material stock ÷ raw material consumed per day;
2. Work-in-progress period (W) = average WIP ÷ cost of production per day;
3. Finished goods storage period (F) = average finished goods ÷ cost of goods sold per day;
4. Debtors' collection period (D) = average debtors ÷ credit sales per day;
5. Creditors' payment period (C) = average creditors ÷ credit purchases per day.

Gross and net cycle. Gross operating cycle = R + W + F + D; net operating cycle = R + W + F + D − C, since supplier credit finances part of the cycle. Number of operating cycles in a year = 360 (or 365) ÷ operating cycle; the more cycles, the shorter each cycle and the better for the firm.

Use. The length of the net operating cycle decides how much working capital is needed: the longer the cycle, the more funds are blocked in current assets. Shortening it, by faster production, quicker collection or longer supplier credit, reduces the working capital requirement.