Page 150 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 9: Cash Flows Forecasting and Treasury Management

Y = a (2) Notes
1 0
where a is the expected or predetermined level of Y.

Example: If we are doing cash forecast and we know that the level of particular types of
disbursement (such as rental payments) will be ` 12,000 in every month because of the firm’s
lease agreement, it would be reasonable to use the spot method to estimate rental payments as
` 12,000 per month.
9.3.2 Proportion of another Account

This technique is used to project financial variables that are expected to vary directly with the
level of another variable. The formula used is:

Y = a X (3)
1 1 1
where X is the other variable to which Y is related and a is the constant of proportionality
1 1
between the two. The “percent of sales” method is a variation of this technique, wherein X is
1
sales for a particular period and a is the percent. The “proportion of another account” method
1
is widely used, when there is a causal link from the explanatory variable to the variable to be
forecast.

Example: If sales volume (units sold) increases, it is natural that more units will have to
be produced to replenish inventory. It is then reasonable to project certain direct costs of
production, such as direct materials, as a percent of sales In this circumstance, if costs of direct
materials have historically been 50 percent of sales, and sales for a particular period have been
forecast as ` 1, 00,000, the firm would normally project direct material purchases at ` 50,000 for
that period.

9.3.3 Compounded Growth

This method is used when a particular financial variable is expected to grow at a steady growth
rate over time. The formula is the same as equation (3), but the explanatory variable X is the
1
prior period’s level of Y, and a is one plus the expected growth rate. That is:
Y = (1+g)Y (4)
t t-1
Where g is the period’s growth rate.

Example: If it is expected that a firm’s level of selling expenses will grow at 10 percent
per year, and this year’s selling expenses are ` 10,00,000, we would project next year’s selling
expenses as ` 1,00,000.
9.3.4 Multiple Dependencies

Here the variable is thought to depend on more than one factor; not just sales or some other
variable but a combination of several variables. The general linear model as expressed in
equation (1) is used, and the statistical technique of linear regression is often employed with
historic data to estimate which explanatory variables are significant in determining Y and to
estimate the coefficients of these variables. A classic example of multiple dependencies is
inventory level. Finns often keep a “base level” or “safety stock” of inventory to hedge
uncertainty and vary the remaining portion of inventory in response to demand. In such a
system, there are two appropriate variables associated with inventory level:

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