How to Use the Distribution Method

In order to analyze cash flows using the distribution method, a company must accumulate data on patterns of receipts for at least three or four months. Exhibit 4.1 illustrates a schedule that results from this history, allowing us to predict the receipt of payments for retail sales.

Based on forecast sales for the coming month of June of an assumed $500,000, the amount for any particular date can be calculated. Assume that Monday, June 17, is the 15th business day (as there is no activity on Sundays). We can forecast the activity of that day using the day-of-the-week factor as adjusted, times the day-of-the-month factor times the monthly sales forecast.

The adjustment changes the day-of-the-week factor by dividing it by the average day amount; a six-day week is adjusted using 16⅔ percent, while a five-day week is adjusted using 20 percent (100 percent ÷ 5 days). For June 17, the calculation is as follows:

(15 percent ÷ 16⅔ percent) × 7 percent × $500,000 = $31,500

This calculation is useful in planning for our daily business activities, but our real working capital need is for cash.

Information Required for the Cash Budget

A cash budget is based on accrual accounting² data such as sales, expenses, and other income statement accounts. We convert sales into expected cash collections by assigning the historical experience of customer payment histories as applied to actual sales. In a similar manner, we transform expenses into cash disbursements. We then add nonrecurring cash events, including dividends, taxes, capital investments, and similar activities.

Assume that sales and expense forecasts for a company are as follows:

Of course, these are forecasts based on statistical estimates and actual results will vary from our projections.

Assume that all sales are credit, with 20 percent collected in the month of the sale, 60 percent collected in the following month, and the remainder collected in the second following month. All expenses are paid during the month they are incurred; in addition, a tax payment of $4 million is due in July and again in September. The beginning cash balance in June is $6 million.

How to Prepare the Cash Budget

We'll prepare a cash flow statement for June through August; see Exhibit 4.2. Assuming the company's minimum allowable cash balance is $5 million, we'll prepare a surplus/deficit cash projection for those three months. We begin with the cash collections for June, which involve some monies collected that month (20 percent of sales, or $10 million), 60 percent of sales in the previous month (60 percent of May's sales, or $24 million), and 20 percent of sales in the second previous month (20 percent of April's sales, or $6 million). The total of “cash in” for June, then, is $10 million + $24 million + $6 million = $40 million. We can calculate July through September in a similar manner.

The payments are all made in the month incurred, but we must remember to include taxes of $4 million in July and in September. The total of “cash out” is entered, and the net of “cash in” and “cash out” is calculated, a negative $3 million for June. We began June with $6 million, and we expect to end June and begin July with $3 million. However, our minimum cash is $5 million, so we are “short” $2 million in June.

To obtain this amount, we could arrange for bank borrowings, sell short-term investments, or use other financial strategies. As we work these calculations through the remaining months, we determine total borrowings and the amount available to invest after the borrowings are repaid. The decision that results is to arrange to finance $2 million in June and $8 million in July, and to use the surpluses of $5 million in August and $11 million in September. We'll explore our options in the next sections.

Arranging for Bank Credit

When arranging for a line of credit or any type of bank loan, the borrower should come fully prepared to meet with a banker. Essential documents are the cash budget and pro forma financial statements (an income statement and a balance sheet). The term pro forma refers to projected or in the form of, and reflects expected results for coming periods. In addition, bank loan officers require audited financial statements from recent reporting periods.

Other data that should be provided include specific sources of sales, including customer names and their likely purchases; marketing plans, including advertising and promotional activities; likely employee hiring and terminations; and justification for major expenses, such as new equipment, the rental of additional production capacity, outsourcing arrangements, and other initiatives. Expect to discuss contingency arrangements in the event of a failure to meet business goals.

The banker will indicate the frequency and form of the future exchange of data to keep him or her updated on current developments. Any expectations regarding the use of other bank services, such as the products discussed in Chapter 3, will be strongly suggested. (Because of the illegality of tying arrangements, bankers cannot require that a borrower buy noncredit services in order to obtain credit.) In the interim, maintain contact with the banker—he or she does not want to be unpleasantly surprised!

Lines of Credit

A company may arrange with a bank for access to a line of credit, a specified amount of money accessible for a specified time period, usually one year.³ The line may be drawn as needed during seasonal shortages of cash resulting from normal operations. In the cash budget example, the company needs $2 million in June and $8 million in July, and we could use the credit line to meet those temporary needs.

The bank guarantees the line if it is committed so long as the borrowers meet all of the conditions of the agreement. An uncommitted line is not guaranteed but is almost always granted (assuming the terms of the lending arrangement are met). Depending on the credit risk and condition of the company, banks will typically charge a fee of about ½ of 1 percent for a committed facility; there is no fee for an uncommitted line. Typical pricing of the used portion of the line is about 2 to 4 percent above Fed funds, LIBOR, or the prime rate, depending on the perceived credit risk of the borrower.⁴ Because of the complexities of bank lending, a discussion in some detail is provided in Chapter 5.

Bank Returns on Lines of Credit

Banks in the United States can make a reasonable return on credit above their costs of capital when a nominal commitment fee is earned, about 5½ percent.⁵ The return on uncommitted lines is about 3 percent less, making the provision of this version of the product marginal. These results are before default losses on nonperforming losses are included. The decision of banks to provide lines of credit without commitment fees has been due to three factors:

1. Banks profitability models have been available only since about 1985, and the assumptions in these models are questionable given the strong negotiating position of large corporate borrowers, at least until the present credit crisis. In other words, a strong corporation may negotiate away commitment fees and other loan covenant conditions, and banks have been unwilling to hold the line on cost-recovery strategies.
2. In the past, noncredit products have subsidized credit such as those discussed in Chapter 2. Banks may knowingly (or unknowingly) provide no- or low-return credit products such as credit lines in order to have the opportunity to sell higher-return noncredit products.
3. Credit is profitable for banks for certain groups of companies. These include some middle markets and most small businesses, and situations where reasonable returns can be earned in specific industries due to the absence of lending competition.

There is no assurance that banks will be willing to provide free uncommitted lines or committed lines for a nominal fee of perhaps ½ of 1 percent given the recent problems of the banking industry. Furthermore, financial managers do not act prudently when they fail to lock in committed lines. The natural impulse is to bargain aggressively for a reduction in this fee, to shop for better pricing from a competitor, or to accept an uncommitted, “free” line of credit. Bargaining and shopping are certainly acceptable, but settling for an uncommitted line could be a mistake for the following reasons:

1. In normal economic times, a middle-market business may have a balance sheet composed of total assets of $150 million, with about 10 percent in cash and short-term investments. In addition, lines of credit provide access to financing that represents an additional 5–5½ percent. Assuming current commitment fee pricing of ½ of 1 percent, the cost of an assured line would be about $40,000 a year. While companies may be reluctant to spend this amount to guarantee access to credit, it should be considered to be as essential for business survival as insurance or risk management.
2. As has been noted, banks cannot make an adequate return on uncommitted credit lines, and are beginning to carefully review and expunge those activities and others that do not earn target returns. This is not a new phenomenon; banks have been ending unprofitable relationships for at least a decade. The likelihood is that further terminations will occur.
3. Credit-rating agencies are enhancing their forecasting models to include off–balance sheet financing such as lines of credit. Acceptable credit ratings are essential to maintaining good supplier relationships, particularly as more vendors look to asset-based financing for working capital, which is subject to lender approval. The borrower's creditworthiness and the agreement of companies to sell to it depend on having a committed line of credit.

Lines of credit are essential sources of liquidity for any business. A treasurer does not want to receive a telephone call from his or her banker that an uncommitted line of credit is no longer available.

Asset-Based Financing

Asset-based financing uses a company's accounts receivable and/or inventory as collateral in situations where the lender is uncertain of the borrower's creditworthiness. Typical costs are 4 to 5 percent higher than arranging a line of credit.

• Factoring of receivables involves the direct collection from the borrower's customers, who are instructed on the invoice to remit to a specified address controlled by the lender.
• Inventory financing is used in industries with expensive equipment and medium-length sales cycles. The lender uses the equipment as collateral, and the loan is paid as sales are made to customers of the borrower.

We will discuss asset-based lending in more detail in Chapters 6 and 7.

“No Effort Investments” and Equivalents

There are two investment vehicles that do not require any action by the financial manager: ECRs and sweeps. Although we could just leave any unneeded money in the bank, the earnings we would receive on such “no effort investments” are minimal.

“Some Effort” Investments and Equivalents

Many companies use telephone or Internet instructions to their banks or securities firms to make safe investments with reasonable returns. While financial managers may receive advice, they must actively choose among the instruments and maturities. Furthermore, these investments may charge a transaction fee, and there is a cost for the movement of funds to pay for the investment. See Exhibit 4.4 for short-term investment rates just before the 2008–2009 credit crisis, a period generally considered as “normal,” and in early 2014, during an unusual period in our economic history due to the policies of the Federal Reserve.

• Banker's acceptance. A banker's acceptance (BA) is an instrument created when a bank guarantees an international transaction using a letter of credit. The bank sells the BA to investors at a discount and accepts the responsibility for repaying the loan, protecting the investor from default risk. BAs are generally issued for up to six months.
• Repos. A repo (repurchase agreement) is an investment contract between a brokerage firm or bank and an investor (usually a financial institution or large corporation). The repo is sold with an agreement for repurchase at a future date at a set price, with most settling overnight. There is minimal risk with repos, although companies interested in this investment should ascertain that there is adequate collateral supporting the repo.
• Commercial paper (CP). Commercial paper involves unsecured notes issued by companies with high credit ratings. Maturities are from a few days to 270 days. Most issuers use CP as a continuing financing source and reissue the CP at the time of redemption. Sales are either direct to investors or through dealers (securities firms). Much of the outstanding CP is backed by bank credit lines, minimizing any risk to investors. CP typically carries ratings by leading credit rating agencies and is graded as A-1, P-1, or A-2, P-2.
• Money market mutual funds (MMFs). Money market mutual funds are pools of various types of short-term investments that offer shares to corporate investors. A significant benefit of MMFs is that relatively small units of funds can be placed, allowing the earning of some yield even to the small corporate investor. The diversification in these funds mitigates any risk from the decline in value of a particular holding.
• U.S. Treasury securities. Securities of the U.S. government include Treasury bills and notes (those with maturities from 1 to 10 years); and Treasury bonds, with maturities from 10 to 30 years. These instruments are highly liquid and risk-free, although the longer the maturity, the greater the risk that inflation could impact the real return.
• U.S. agencies. Although not generally well known, there are various federal agencies that issue securities to fund their operations. Two of these agencies are backed by the full faith and credit of the government: Ginnie Mae (the Government National Mortgage Association) and Vinnie Mac (the Department of Veterans Affairs). Other agencies include Fannie Mae (the Federal National Mortgage Association), Freddie Mac (the Federal Home Loan Mortgage Corporation) and the CoBank ACB, a component of the U.S. farm credit system that funds agribusinesses.¹⁰
• Municipal securities. State and local government municipal securities (munis) have the attraction of having their interest payment exempt from taxes, although yields are less than those of other instruments. The investor has various options in selecting among municipals, including revenue securities, which are backed by revenue streams from specific projects; and general obligation securities, which are backed by the income sources of the issuer.

Policies on Short-Term Investing

Many companies have written policies that clearly define acceptable risks, instruments, and maturities for investments. Such policies should reflect the appropriate profile on risk and expectations on return. The purpose of these policies is to protect the company against bad investment decisions and the possible loss of principal. This is not a trivial issue due both to the large amounts at risk and to catastrophic losses experienced by apparently “safe” money managers.¹¹

A committee made up of the board of directors and financial managers will normally draft an investment policy. Exhibit 4.5 outlines the issues that an investment policy should address. The typical policy will limit short-term investments to certain classes of securities, such as highest-rated U.S. Treasury instruments and commercial paper (A-1 by Moody's and P-1 by Standard & Poor's). These are particularly important in the context of the collapse of Bear Stearns in 2008 and the possibility of the loss of invested funds.