1. Chapter 23 Developing the Cash Budget

2. Learning Objectives Explain the importance of a cash budget Explain why an organization needs to carry cash balances List and describe where cash is generated by an organization and where an organization uses its cash Understand how to prepare a cash budget

3. Why a Cash Budget? The key source of information to determine the firm’s short-term needs for cash Allows management to manage liquidity position through: –Increasing level of cash and investment reserves –Restructuring maturity of existing debt –Arranging a line of credit with a bank

4. Motivation for Holding Cash Primary needs to maintain cash and investments: 1.Short term working capital needs 2.Capital investment needs 3.Contingencies 4.Supplement operating earnings

5. Short Term Working Capital Needs 2008: average NFP U.S. hospital held 20-30 days in short-term cash and investments to meet short- term working capital needs Most health care firms should carry about 20 days of expected cash transactions at any point in time (e.g. to cover payroll and supplies needs) Capital replacement and contingencies funds require higher cash needs

6. Capital Investment Needs NFP health care firms must routinely set aside cash for replacement and renovation of existing assets, because they have no access to equity capital markets Amount to be reserved for capital assets in NFP firms depends on: –Percentage of debt financing to be used –Projected future levels of capital expenditures IO firms access capital from equity investors (e.g. issue stocks) who decide whether or not to supply more capital based on the expected return

7. Debt Financing If debt financing is limited, larger sums should be set aside for replacement and expansion Absence of debt reduces future financial risk Board establishes levels of debt financing based on trade-offs between the risk and firm’s needs for capital Access to debt usually related to historical and projected financial performance and credit ratings –NFPs with high levels of cash have greater access to debt financing at lower interest rates through higher credit ratings

8. Projection of Capital Expenditures Two main factors: –Routine replacement needs –Strategic planning of the firm Common method – based on allowances for depreciation:  If all firm’s existing assets were to be replaced, if there were no inflation in replacement cost, and if no new capital assets other than replacement items were purchased, the present allowance-for-depreciation balance would be an accurate estimate of future capital expenditures

9. Allowance for Depreciation Example Digital mammography unit acquired - $500,000 Estimated life – 5 years Depreciation rate - $100,000 per year At the end of first year, allowance for depreciation would be $100,000 and would increase each year by $100,000

10. Funding Depreciation Program adopted by NFP hospitals without access to equity capital Example: hospital would place $100,000 in a fund each year At the end of 5-year useful life would have $500,000 available for replacement, assuming no pricing increase

11. Allowance for Depreciation, cont. Most replacement capital assets do increase in price Projected capital expenditures exceed present allowance-for- depreciation balances To adjust forecast of capital expenditures, an inflation factor is usually applied, where present allowance-for-depreciation balance is increased at some projected inflation rate compounded at the average age of the firm’s present capital assets:

12. Contingencies Unexpected demands for cash flow Amount reserved reflects tolerance for risk and estimates of unexpected cash demands upon the firm Examples: under-funded pension or professional liability claims –Payment is required at future date –This investment is over and above short-term working capital needs

13. Supplement Operating Earnings Provide dependable flow of investment earnings that can be used to supplement expected weaknesses in operating earnings Also called “operating endowments” Adopted by some NFP U.S. health care firms May be adopted when significant deterioration in operating earnings is expected

14. Defining Cash Balance Example Consider Saint Aleydis Health System’s (SAHS) sources of cash, as of December 31, 20X9:

15. Cash Balance Example, cont. Required Capital Fund (000s):

16. Cash Balance Example, cont. SAHS should carry $114,860,000 to maintain a 20-day cash-on-hand position: (operating expenses – depreciation)/365*20 ($2,186,536,000 - $90,339,000)/365*20 = $114, 860,000 To estimate projected future capital asset expenditures, inflation was assumed at 4-8%

17. Contingency Reserve Example Desired balance reflects firm’s propensity to tolerate risk SAHS needs to set funds aside for: –Defined benefit retirement plan (had negative status of $111,552,000) –Accrued liability for medical malpractice ($90,194,000)

19. Sources and and Uses of Cash Sources of cash: –Collection of accounts receivable –Cash sales –Investment income –Sale of assets –Financings –Capital contributions Uses of cash: –Payments to employees –Payments to suppliers –Payments to lenders for interest and principal –Purchase of fixed assets –Investments

20. Cash Flows Not equal to income Amount reported for revenues in a given period of time will not equal actual amount of cash realized In most health care settings, there is a lag between recording of revenue and collection of accounts receivable Similarly, expenses for wages, salaries, and supplies may not equal the amount of cash expended within a period of time

21. Cash Budgets Volatility of cash flows determines length of cash budgets (e.g. monthly vs. quarterly) Cash budgets are routinely revised due to inaccuracy of original budget assumptions The greater the degree of possible variation between actual and forecasted cash flow, the higher the liquidity need of the firm

22. Cash Budget Preparation Revenue forecast – most important component Revenue forecast is determined by: –Volumes by product line –Expected prices by payer category Volume estimation: –Subjective forecasts –Statistical forecasts

23. Subjective Forecasts Not very favorable, referred to as “seat of the pants” methods Wisdom and understanding of the forecaster are crucial May be most reliable when future volumes are likely to deviate from historical patterns

24. Statistical Forecasts Future prices can be predicted based on some mathematical model extrapolated from the past Challenging for health care firms, as they rely on other entities to determine prices (e.g. Medicare and Medicaid) Due to large volumes of Medicare/Medicaid business, even small changes in prices may cause forecasting errors and have major impact on firms’ cash flows

25. Figure 23–1 Integration of the Budgetary Process

26. Projecting Cash Flows One common way – through the use of “decay curves” Decay curves relate future collections to past billing Consider collection pattern example: –The first 15% of any month’s revenue is collected in the 1st month ($300,000) –The next 30% is collected in the 2nd month ($600,000) –The next 25% is collected in the 3rd month ($500,000) –The next 20% is collected in the 4th month ($400,000) –The next 5% is collected in the 5th month ($100,000) –The remaining 5% of any month’s revenue is written off and not collected ($100,000)

27. Figure 23–2 Decay Curve Analysis: Percentage Uncollected by Month after Billing

28. Decay Curve Example

29. Cash Disbursements After forecasting cash receipts, a schedule of cash disbursements is necessary to complete cash budget Labor – often about 60% of total expenses –Payroll expenses are monthly, but most disbursements are biweekly –Must be adjusted for withholding and other deductions (e.g. payroll taxes, workers’ compensation, unemployment) Supplies –Similarly to labor, not equal to actual supplies disbursement

30. Schedule of Expected Cash Disbursements

31. Cash Budget To complete the budget, desired level of cash balances must be defined Example – short-term balance of $1,350,000 is required Finally, cash receipts and disbursements are combined to produce cash budget Example – no month has balance less than required $1,350,000 and no need for short- term financing

32. Cash Budget Summary