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    Prepare a cash budget to help explain the lack of liquidity

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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, Carl?" said Robert McGovern to his chief accountant. "If our suppliers find out, we could be in a compromising position. I can't let that happen. Why don't you prepare a detailed report including cash budget for the next year and give it to me by 10 AM tomorrow. Build in a minimum cash balance that is at least 25% higher than our last year's ending cash balance in any period.

    Robert McGovern, the owner of McGovern Distributing Inc., had inherited the family business 5 years ago, when his father, Bradley, suddenly passed away. Under Brad's leadership, the firm had grown slowly but steadily. Brad had always maintained strong ties with local businesses, suppliers, and customers. As Carl began looking at financial statements (see Tables 1 and 2), he couldn't help recalling how Bradley 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 products 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 Bradley (most were!).

    Robert, on the other hand, had always criticized his father's conservative business policies. As soon as he took over, he unleashed a whole 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 a lot of additional bank loans to finance his expansions. The list of product offerings grew from 300 to 650 and the number of suppliers 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, indicating a problem in cash management.

    As Carl crunched out the numbers, he realized that in order to prepare a detailed cash budget and financial report he would need to figure out the average receivables period, the average payables period, and a periodic sales forecast. He figured that he would make the assumption that sales would increase at the last year's rate of 25%. After consulting the sales manager, Carl developed a breakdown of monthly sales for the last quarter of 2004 and for the forthcoming year (see Table 3). Table 4 presents the collection schedule that Carl 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. Carl 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, Carl realized that he better get some assistance or he would have to face an irate boss in the morning. He picked up the telephone and called for Lisa, his recently hired assistant, to come to his rescue in solving this problem of the "elusive cash balance."


    1. What seems to be the major problem with McGovern Distributing Inc.? Why has this problem occured?

    2. Based on the prior years'financial statements, what concluson do you think Carl would be justified in reaching? What calculations should he make to analyze the cash position of the company? Substantiate your answer by making the necessary calculations.

    3. Should Carl prepare a quarterly or a monthly cash budget for McGovern Distributing Inc.? Explain why.

    4. Prepare a suitable cash budget for McGovern Distributing Inc. Build in minimum and maximum cash balances as requested by Robert. 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. If borrowed funds cost 10% per year and excess funds can be invested at 6% per year, prepare an annual financial plan for McGovern Distributing Inc.

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

    8. Based on the data provided calculate and comment on the absolute liquidity of McGovern Distributing Inc.

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    Solution Summary

    The expert prepares a cash budget to help explain the lack of liquidity.