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Working with an Uneven Cash Flow Stream

written by: madel57•edited by: Linda Richter•updated: 10/3/2010

What if your company awaits approval of a loan? Maybe your accountant will say, “Sir, I know that our application will be approved. Even though we have monthly uneven cash flows our cash flow statement always shows there are sufficient funds to allow for monthly amortization." What happens next?

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    Importance of Cash Flows in Business

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    Mr. Rodriguez, the manager of Manroe Shoe Manufacturing, Inc., instructed his accountant to produce hard copies of the current month’s financial statements, including the Balance Sheet, Income Statement, and Cash Flows. There are also appropriate schedules to support main figures in the statements like the list of the Property, Plant & Equipment and the detailed schedule of cash and cash equivalents. The company applied for a loan with a big commercial bank to finance the expansion of its plant production from a 1,000- to a 2,000-product capacity in order to grab the additional monthly order of 500 shoes for the next three years offered by a company based in Korea. Usually, banks examine cash flows of entities applying for loans.

    "Sir, I am positive that our loan application from Western Bank will be approved. We might have uneven cash flows but we have some reserves supported by restricted cash deposits with our bank that can pay off our loan amortization in case our cash is not enough," says Miss Resomadero, the company's accountant.

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    What is a Cash Flow: Three Major Sources of Cash

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    Before you can understand what is an uneven cash flow stream, first you must look at cash flow--the movement of cash into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time.

    There are three sources of cash flows. These three sources are integrated in a cash flow statement that accompanies all other financial statements of the company. Examples of appropriate accounts are listed for each type of cash flow source.

    1. Operational Cash Flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital.

      Examples of operational cash flow source:

      Receipts:

      Sale of goods or services

      Interest revenue

      Dividend revenue

      Disbursements:

      Inventory purchases

      Payroll

      Taxes

      Interest expense

      Other (utilities, rent, etc.)

      Note: Cash inflows from interest or dividends could be considered investing or financing activities.

      2. Investment Cash Flows: Cash received from investing activities include transactions and events involving the purchase and sale of securities (excluding cash equivalents), land, buildings, equipment, and other assets not generally held for resale. It also covers the making and collecting of loans. Investing activities are not classified as operating activities because they have an indirect relationship to the central, ongoing operation of your business (usually the sale of goods or services).

      Receipts:

      Sale of plant assets

      Sale of a business segment

      Sale of investments in equity securities of other entities or debt securities (other than cash equivalents)

      Collection of principal on loans made to other entities

      Disbursements:

      Purchase of plant assets

      Purchase of equity securities of other entities or debt securities (other than cash equivalents)

      Loans to other entities

      3. Financing Cash Flows: Cash received from all financing activities dealing with the flow of cash to or from the business owners (equity financing) and creditors (debt financing). For example, cash proceeds from issuing capital stock or bonds would be classified under financing activities. Likewise, payments to repurchase stock (treasury stock) or to retire bonds and the payment of dividends are financing activities as well.

      Receipts:

      Issuance of own stock

      Borrowing (bonds, notes, mortgages, etc.)

      Disbursements:

      Dividends to stockholders

      Repaying principal amounts borrowed

      Repurchasing business's own stock (treasury stock)

        The following is the general format for a statement of cash flows that integrates the three sources of cash flows:

        The Name of the Company

        Statement of Cash Flow

        For the Period ________

        Cash Provided (or used) by:

        Operating Activities

        Investing Activities

        Financing Activities

        Continue on Page 2 for more on What is an Uneven Cash Flow Stream?

      1. slide 3 of 6
        If you're asking just what is an uneven cash flow stream, you must realize the impact it can have on your ability to achieve loans or simply to work with unexpected corporate events. Events that impact budgets are not always predictable. Learn about uneven cash flow problems in this article.
      2. slide 4 of 6

        What is an Uneven Cash Flow Stream?

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        The question might be asked: Is it possible to have a uniform cash flow?

        • Cash flows from operations normally are not uniform. We cannot predict how much sales and how much collection we will have during a certain period. Sales and collections will depend on marketing and human resources, changing economic conditions, capacity, resources, inflation, management philosophy, and other factors that affect sales and collection.
        • Some investment and financing proposals might have uniform cash flows but if we are going to consider the time value of money, they will result in different present and future values. The data below illustrate that even though the project will give the company a uniform cash inflow of $30,000 per year for five years, values are uneven because it is practical to consider the time value of money in this situation.

        A corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate cash outflow of $100,000 (which might include machinery and employee training costs). Other cash outflows for years 1–6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 each for years 1–6. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each year:

        Year Cash Flow Present Value

        T=0 ($100,000)

        T=1 $22,727

        T=2 $20,661

        T=3 $18,783

        T=4 $17,075

        T=5 $15,523

        T=6 $14,112

        The sum of all these present values is the net present value (NPV), which equals $8,881.52. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no mutually exclusive alternative with a higher NPV.

      3. slide 5 of 6

        Ways Companies Can Augment Cash Flow

        There are no problems even if a company obtains an uneven cash flow as long as the cash flow statement obtains a net positive cash balance. The company will only have to be sensitive about budgets. Problems occur if the company applies for a loan and, after including the projected loan amortization, the forecasted cash flow obtains a negative balance. The company may also encounter situations like additional opportunities needing financial capital and other unforeseen cash expenditures.

        To eliminate the probabilities above, the company can look for ways to augment cash flows:

        1. Sales - Sell the receivables for instant cash. You might not obtain a 100% value of the receivables but it can help.

        2. Inventory - Postpone the payment of accounts payable. Without sacrificing the credit status of the company, the company can delay payments of accounts to maximize use of resources.

        3. Wages - Remunerate with stock options.

        4. Maintenance - Contract with the predecessor company that you prepay for five years in order for it to continue doing the work.

        5. Consulting Fees - Pay in shares from treasury since this is usually to related parties.

        6. Interest - Issue convertible debt where the conversion rate changes with the unpaid interest.

      4. slide 6 of 6

        Summary

        To understand what is a cash flow stream, inculcate that cash flows are essential to a company's liquidity. To keep going, a company should be cautious of its cash budget. Uneven cash flows are not a problem if management will also be careful in dealing with outflows.

        It is also a reality that budgets are only forecasts. There might be some unforeseen events that might affect budgets adversely. In facing adversity, the company should use strategic planning, and one of these plans is to augment cash inflows. The company should be sensitive in finding opportunities that may bring in more inflows to the company in order to gain competitive advantage over its competitors.

        Book and Image Credits:

        Management Advisory Services Rodelio S. Roque 1990

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        book04100016 http://www.freeimages.co.uk/

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