Chapter 13 Cash Flow Budgeting Farm Management Chapter 13 Cash Flow Budgeting

Figure 13-1 Illustration of cash flows farm management chapter 13

Common Types of Cash Flows Sunk costs – costs that have accrued in the past Opportunity costs – costs of lost options Side effects Positive side effects – benefits to other projects Negative side effects – costs to other projects Changes in net working capital Financing costs Taxes With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant. Sunk costs – our government provides ample examples of inappropriately including sunk costs in their capital allocation decisions. Opportunity costs – the classic example of an opportunity cost is the use of land or plant that is already owned. It is important to point out that this is not “free.” At the very least we could sell the land; consequently if we choose to use it, we cost ourselves the selling price of the asset. A good example of a positive side effect is when you will establish a new distribution system with this project that can be used for existing or future projects. The benefit provided to those projects needs to be considered. The most common negative side effect is erosion or cannibalism, where the introduction of a new product will reduce the sales of existing, similar products. A good real-world example is McDonald’s introduction of the Arch Deluxe sandwich. Instead of generating all new sales, it primarily reduced sales in the Big Mac and the Quarter Pounder. It is important to consider changes in NWC. We need to remember that operating cash flow derived from the income statement assumes all sales are cash sales and that the COGS was actually paid in cash during that period. By looking at changes in NWC specifically, we can adjust for the difference in cash flow that results from accounting conventions. Most projects will require an increase in NWC initially as we build inventory and receivables. We do not include financing costs. Students often have difficulty understanding why when it appears that we will only raise capital if we take the project. It is important to point out that because of economies of scale, companies generally do not finance individual projects. Instead, they finance the entire portfolio of projects at one time. The other reason has to do with maintaining a target capital structure over time, but not necessarily each year. Taxes will change as the firm’s taxable income changes. Consequently, we have to consider cash flows on an after-tax basis. farm management chapter 13

Actual versus Estimated Cash Flows A cash flow budget contains estimates of cash flows for a future time period. It is possible to record and organize actual cash flows for some past time period into a Statement of Cash Flows. The actual values can be compared against the budgeted values. Also, this statement can provide insight into the financial structure of the business. farm management chapter 13

Table 13-1 Simplified Cash Flow Budget farm management chapter 13

Constructing a Cash Flow Budget Develop a whole-farm plan Take inventory Estimate crop production and livestock feed requirements Estimate cash receipts from livestock Estimate cash crop sales farm management chapter 13

Constructing a Cash Flow Budget (continued) Estimate other cash income Estimate cash farm operating expenses Estimate personal and nonfarm cash expenses Estimate purchases and sales of capital assets Find and record the scheduled principal and interest payments on existing debts farm management chapter 13

Table 13-2 Form for a Cash Flow Budget farm management chapter 13

Table 13-2 (continued) Form for a Cash Flow Budget farm management chapter 13

Table 13-3 Example of a Cash Flow Budget

Table 13-3 (continued) Example of a Cash Flow Budget

Calculating Interest Due farm management chapter 13

Uses for a Cash Flow Budget Plan borrowing and debt repayment Suggest ways to minimize borrowing Combine business and personal financial affairs into one complete plan Help establish realistic line of credit Plan purchases to obtain discounts Aid tax planning Find imbalances between current and noncurrent debt farm management chapter 13

Monitoring Actual Cash Flows A cash flow budget can be used for monitoring and control. The budgeted amounts can be compared to what actually transpires. farm management chapter 13

Table 13-4 A Form for Monitoring Cash Flows farm management chapter 13

Investment Analysis Using a Cash Flow Budget Will a new investment generate enough cash income to meet its additional cash requirements? In other words, is the investment financially feasible? farm management chapter 13

Table 13-5 Cash Flow Analysis for an Irrigation Investment farm management chapter 13

Summary A cash flow budget is a summary of all cash inflows and outflows for a given future time period. No noncash entries are included. This budget can provide an estimate of borrowing needs and repayment capacity. It can also be used to analyze the feasibility of investment alternatives. farm management chapter 13

1. Why is machinery depreciation not included on a cash flow budget? Machinery depreciation is a noncash expense and only expenses requiring a cash outflow are included on a cash flow budget. For this reason, a cash flow budget contains no depreciation of any kind. farm management chapter 13

2. Identify four sources of cash inflows which would not be included on an income statement but which would be on a cash flow budget. Why are they on the cash flow budget? Cash received from: 1) new loans, 2) nonfarm income, 3) full sale price of capital assets, and 4) gifts and inheritances. They are on a cash flow budget because they are cash inflows and represent cash, which is or could be available for farm use even though they are not farm business revenues. farm management chapter 13

3. Identify four types of cash outflows which would not be included on an income statement but which would be on a cash flow budget. Why are they on the cash flow budget? Cash used for: 1) principal payments on debt, 2) full purchase price of capital assets, 3) family living expenses and other personal withdrawals, and 4) income and self employment taxes. They are on a cash flow budget because each requires the expenditure of cash but are not farm business expenses. farm management chapter 13

2) accounts receivable, 3) accounts payable, and 4) depreciation 4. Identify four noncash entries found on an income statement but not on a cash flow budget Noncash entries found on an income statement but not on a cash flow budget include: 1) inventory changes, 2) accounts receivable, 3) accounts payable, and 4) depreciation farm management chapter 13

5. Discuss the truth or falsity of the following statement: A cash flow budget is used primarily to show profit from the business. This statement is false. A cash flow budget should not be used to project profit. Questions 2, 3, and 4 above illustrate some of the major differences between finding net cash flow and net farm income. While a large number of the same items appear on both of these financial documents, there are too many differences to be able to estimate net farm income from a cash flow budget. farm management chapter 13

Discuss how you would use a cash flow budget when applying for a farm business loan A cash flow budget is extremely helpful when applying for a loan. It shows why, when, and how much money will be needed. Just as important, it shows if, when, and how much of the loan can be repaid with interest. A lender is interested in both aspects but particularly in the repayment ability shown on the cash flow budget. farm management chapter 13

8. A feasible cash flow budget should project a positive cash balance for each month of the year, as well as for the entire year. When making adjustments to the budget to achieve this, should you begin with the annual cash flow or the monthly values? Why farm management chapter 13