Page 135 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Self Assessment

Fill in the blanks:
4. ............................ is an estimation of the flows in and out of the firm’s cash account over a
particular period of time.
5. Cash forecasting enables a firm to anticipate periods of ............................ cash and
............................ where financing will be necessary.
6. ............................ uncertainty is the uncertainty regarding the firm’s actual future collection
patterns of receivables.

8.3 Cash Balance Uncertainties

Given the short-run nature of the cash forecast, with most things occurring in the near future and
the forecast period typically being a year, one would tend to think that most financial transaction,
over this period could be forecast very accurately. Unfortunately, this is far from true. Even with
this short period there are numerous sources of risk. Among the sources are sales uncertainty;
collection rate uncertainty, production cost uncertainty, and capital outflow uncertainty. Let us
look at each one of these in turn.
Sales uncertainty refers to the risk regarding the firm’s future levels of sales. Most firms try to
forecast accurately enough to hold errors in short-run sales forecasts to less than 10 percent, but
are often unsuccessful in these efforts. Sales-projections are a product of two other projections,
units to be sold and price per unit. Both are often quite uncertain and depend on economic and
competitive conditions. Note that any errors in sales forecasts have multiple impacts on the
firm’s cash flows; they impact on receivable levels (and therefore collections) and also on
production expenses (and therefore disbursements).
Collection rate uncertainty is the uncertainty regarding the firm’s actual future collection patterns
of receivables. The firm may historically have collected an average of a certain percent of its
outstanding receivables from a particular period in another particular period, but this average
contains considerable variability. Further, changing market and economic conditions may make
for chancy extrapolation of post historic data into future period. Because of this and the
uncertainties in forecasting sales, forecasts of the collection of future receivables contain at least
three sources of uncertainty; uncertainly regarding the number of units that will be sold,
uncertainty regarding the price at which these units will be sold, and uncertainty regarding the
patterns with which the receivables generated by these sales will be collected.

Production cost uncertainty has to do with the risk of the actual labour and material costs that
go into the making of a product of service. Labour productivity may be more or less than
expected, making labour costs uncertain. The cost of materials used may vary due to unexpected
changes in price or in the amount of materials necessary to produce products and services.
Capital outflow uncertainty is one of the biggest sources of surprises in cash flow forecasting.
This is the uncertainty regarding the timing of cash disbursements related to the firm’s major
capital expenditure and construction programmes. The uncertainty arises from the nature of
payments made for new construction. When the firm undertakes to build a new plant or other
project of this sort. The total price (subject to specified revisions) is generally agreed upon in
advance. The construction firm then starts the project. After a certain percent of the project is
done, the construction firm submits a “progress report” to the firm and is paid for what has been
completed, less a retainage.

Example: Assume that the firm has contracted to have built a ` 10 crore building with a
10 percent retainage. Once the construction firm completes the first 20 percent of the project, a
payment of `1.8 crore will be due (` 10 crore times 20 percent times 90 percent).

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