MY INTERNAL ‘FARMER'S ALMANAC’ warns me that there could be cash flow problems soon,” said Sarah Clare, the manager of Dinner Bell Hotel (DBH), a Michigan resort. (The Farmer's Almanac is a periodical famous for its long-range weather predictions and astronomical data, as well as humor, trivia, and personal advice.) Sarah continued: “We need to know now what the likely situation will be. I think I'd better redo the forecast.”

CASH FLOW ISSUES

Two months ago (in early January 2011), Sarah and her financial staff had prepared a cash flow forecast for the period July 2011 to March 2012. July through early November are the busiest times for the hotel. Summer and fall guests enjoy the atmosphere of an old-fashioned resort with large meals, farm animals, a petting zoo, nature walks, bicycling and hiking trails, fishing, tennis courts, a lake for swimming and boating, and a nine-hole golf course.

The phrase “dinner bell” dates back about two centuries, when people who lived and worked on vast tracts of land as ranchers or farmers needed a way to be called to dinner. The hotel continues that tradition by ringing a bell to announce mealtime. The weather gets too cold by early November for most outdoor activities, so the hotel built an indoor pool and developed long theme weekends like classic movies, card tournaments, and supervised child and teen amusements.

It is not unusual for the hotel to run cash deficits during most, if not all, of the months between November and April, and about break-even in May and June. However, the cash surplus generated during the peak period, from July through November, is typically sufficient to meet the shortfall. This is what Sarah had predicted would occur when she had made the cash budget projection for July onward. But now, in early March, she is having second thoughts about the forecast due to several concerns:

• The hotel requires major renovations to continue to be attractive to five-day to weeklong guests, which is the typical reservation. The work planned for January needs to be more extensive than originally thought. Sarah, her engineers, and the contractors had estimated the cost to be $250,000, but it appears $300,000 of work is necessary.
• The resort's longtime group sales and convention manager left unexpectedly in February, and her replacement is not as effective in obtaining business from regional businesses and organizations.
• The Great Recession has affected much of the area, and sales at the hotel are definitely sensitive to the regional economy. Fewer offsite meetings have been scheduled, as companies prefer to stay in a location where attendees can commute from their homes to avoid the costs of rooms, some food, most recreational charges, and transportation.

These concerns make recent forecasts—thought to be the “most likely” case—too optimistic. “I can see indications of this now,” she tells the monthly meeting of the hotel's senior managers and board of directors. “Revenue was off 15 percent for January and February, and our advance bookings through the fall months are also down. I'm sure we won't hit the levels we predicted.” Sarah has always been an advocate of cash budget forecasts and constantly revises an estimate in light of new information. There is no doubt a new projection is necessary.

ALTERNATIVE ACTIONS

Some thoughts from the monthly meeting follow, along with Sarah's responses. As she explained, there are problems with most of these alternatives.

• “Can any of the renovations be postponed?” (a comment from the construction engineer)

  If the renovations are not made in January, sales will likely suffer in future months. The resort is showing signs of wear, and it is important to improve the hotel's appearance periodically. And, of course, the renovations are best made during an off-peak month like January.

• “Should we increase the advertising budget?” (a comment from the new sales and convention manager)

  Advertising is expensive, and there is no evidence that print or broadcast marketing has very much effect on our potential guests. They repeatedly state that their visits are due to the wide variety of facilities and the meals, and to referrals from other guests. Very few guests mention that an advertisement affected their vacation plans.

• “Should we reduce the planned spending on food, such as offering fewer entrée choices?” (a comment from the catering manager)

  Worst idea of all—our guests come for the food! You might as well change our name to the “Fast-Food Hotel”!

• “Should we delay disbursements for accounts payable?” (a comment from the accounting manager)

  We could be completely open with the suppliers about the hotel's financial situation and ask for a deferment of some payments until August. In return, we will promise to pay COD (cash on delivery) when business picks up. “They just might agree to this. We've been a good customer, and it is in their interest to help us out. After all, it's not like we're in danger of bankruptcy.”

• “Should we arrange for a bank loan?” (a comment from a board member)

  The prospect of a loan is not particularly appealing. The bank, even assuming it would grant a loan, is likely to impose severe restrictions on the operation of the resort through covenants in the loan agreement. That would be an unwelcome interference.

• “So . . . what will you do in the event of a cash shortfall?” (a comment from a board member)

  The good news is that reservations for next summer are extremely strong, and we should be rolling in cash by September. We've got to do another cash flow forecast to know how bad the situation is. Why don't we meet again tomorrow morning? By then, the senior managers and I can prepare a new cash budget.

Sarah asks the managers to return with relevant reports and records so that a new plan can be considered.

THE “RAW” DATA

Sales in December were $228,500 and in January were $157,500. Typically, 65 percent of the resort's sales are paid in cash; that is, by cash, debit, or credit card. The other 35 percent is paid as a hotel charge and collected in the month following the sale, and is permitted for group meetings and conferences. Assume that there are no uncollectible receivables.

The hotel incurs the following monthly expenses: mortgage, $30,000; utilities and maintenance, $25,000; and rental and miscellaneous expenses, $22,500. Property taxes of $75,000 are due in February, income taxes of $10,000 are due in November and in May, and the renovations will be paid for in February. Estimated payroll and supplier expenses are attached. Supplier expenses in November were $85,000 and in December were $45,000. One-third of the supplier expenses are paid one month after they are incurred and two-thirds in two months. The required minimum cash balance at its bank is $50,000, and the expected balance at the beginning of February is $400,000.

QUESTIONS

1. Prepare a cash budget for the period February through August. See Exhibit C1.1 for necessary data.
2. Is there any advantage to extending the forecast through September, October, and November? Explain.
3. Let's assume the hotel's cash flow would not be sufficient to cover any shortfall occurring during the cash budget period. What proportion of payables must be deferred to get the resort through this period?
4. Sarah, in essence, may be asking the firm's vendors for a loan if she requests a deferral on payables. From the hotel's point of view, the size of the loan is your answer to question 3. From the suppliers' point of view, however, the size of their investment in the loan is actually less than that amount. Explain why.
5. Do the suppliers have an incentive to cooperate? Explain.
6. The suppliers may be unable to cooperate. Why?
7. As a follow-up to question 6, if the suppliers are unable (or unwilling) to cooperate, how do you think Sarah should proceed?
8. Do you think that a cash budget is a more important financial tool for a small operation such as Dinner Bell Hotel or a large firm such as Exxon? Explain.