SIMULATION APPROACH

Still today we have discussed on cash management and credit analysis. Today we are going to discuss on Simulation Approach. Simulation analysis permits the financial manager to incorporate in his forecasting both likely value of ending cash balances (surplus/deficits) for each of the forecast periods (say, for each month over the next quarter) and the margin of error associated with this estimate. It involves the following steps: First, probability distributions for each of the major uncertain variables are developed. The variables would generally include sales, selling price, proportion of cash and credit sales, collection rates, production costs, and capital expenditures. Some of these variables have the greatest influence upon cash balances.

 

Clearly, more time and effort should be spent in obtaining probability distribution of these variables. Second, values are drawn at random for the variables from their respective probability distributions and using these values each balances are estimated. Third, the process is repeated several times (say, 1000times). Needless to say, such tedious and cumbersome computations are done on computer.

 

In practice, the array of possible hedging strategies is quite a bit more complicated. One is required to consider various alternatives and the associated costs and risks in hedging strategies.

Collection Rate Uncertainty

The firm is also faced with collection rate uncertainty. The firm may historically have collected an average of a certain per cent 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 extrapolation of past historic data into future periods a futile exercise.  

 

There is still another source of uncertainty – production cost uncertainty. The price of materials may change; production problems may arise that lead to increased labor costs; and errors in the sales estimates themselves would necessarily lead to forecasting errors in purchases – hence the volume of payables.  

 

Capital outflow uncertainty is one of the biggest sources of surprises in cash flow forecasting. This is the uncertainty regarding the timing of cash disbursement related to the firm’s major capital expenditure and constructions programmes. For instance, construction firms are notorious for filing late progress reports and then expecting immediate payment. While only a small per cent of the firm’s total bills are from capital construction programmes, the amounts involved are usually very large. One unexpected item of this sort can impair a carefully drawn cash flow forecast.  

 

An efficient way to deal with above uncertainties is to apply simulation analysis of the cash forecast. We will now briefly outline this method.

Source of Uncertainty in Cash Forecasting

Accurate cash flow forecasting hinges on the forecaster’s ability to reduce the amount if observed error between forecast values and actual values that have occurred. Given the short-run nature of the cash forecast, with most things occurring in the near future, one would tent to think that most financial transaction could be forecast very accurately. This is far from true.

 

In practice few firms, if any are able to forecast their inflows and outflows accurately. Sales forecasts are notoriously unreliable, for actual sales depend in part upon factors that lie outside the control of the firm. Changes in the marketing of competitive products, as well as changes in general economic conditions, can lead to large forecasting errors.

 

We may further 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).

 

Issues and Approaches to Forecasting -3

We are talking Issues and Approaches to Forecasting. An useful forecasting method is to analyze the historical payment patterns to determine the proportion of credit sales that are collected at various times after the date of sale, and then to use this information (along with the estimates of future sales) to project future receipts. We may, however, adopt a better and a more sophisticated approach.

 

In this, all collection rates are estimated simultaneously by regressing past sales figures against past collections. The estimated coefficients of the sales figures in the regression can be interpreted as the collection proportions, and the standard errors of the estimated regression coefficient as the uncertainty inherent in the estimation of these collection proportions.

 

In a situation where the firm is in multiple business lines, the use of overall payment patterns to forecast receipts will be accurate only when the proportions of total sales made in each business lines are constant. This is an unlikely situation, particularly since the different lines usually have different seasonal variations. In such a multiple situation, the most accurate forecasting result is achieved by forecasting receipts for the different units of the firm individually based on their own receipt patterns, then summing these receipts forecasts to obtain total cash receipts for the firm.

 

Issues and Approaches to Forecasting -1

We are talking issues and approaches to forecasts. The most common approach to short-term cash forecasts is the receipts and disbursement approach. This method minutely traces the movement of cash and is preferred by firms that exercise very close cash control. 

 

After the firm has determined what types of receipts and disbursement are important in its overall cash flow, an important question is how to forecast the future level of these types of inflows and outflows. There are four common techniques of forecasting financial variables (i.e. items/disbursement): 

 

 Direct Method – In using this technique, it is assumed that the variable to be forecast is independent of all other variable, or alternatively, is predetermined. The variable (e.g. lease rental) is forecast by using its excepted or predetermined level.
 

Proportion of Another Account - This technique is used to project financial variables that are expected to vary directly with the level of another variable. For example, if sales volume 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 per cent of sales.
 

ompounded Growth - This method is used when a particular financial variable is expected to grow at a steady growth rate over time.

 

Multiple Dependencies – Under this technique the variable is considered to be influenced by more than one factor. The statistical technique of liner regression is often employed with historical data to determine which explanatory variables are significant in explaining the dependent variable. We will see the application of regression technique after a while. 

 

Since cash forecast deal mostly with the near future, many of the items on the cash forecast are usually estimated by some variation of the post method. The bases of these spot estimated are usually the firm’s other financial plans. Remaining estimates are mostly on a ‘proportion of another account’ basis, the another account often being particular period’s sales. The other two methods are employed less frequently. 

Collection Experience

We talkd about Credit Analysis. we talked the business magazines generally carry the detailed analysis of financial statements and inter-firm comparison of companies in the same industry. This information would be useful in assessing the market conditions of a particular industry. The company can then explore about the credit worthiness of customer through the references provided by him. Additional information may also be obtained by interviewing the customer or visiting his place of work.

In additional to setting the credit standards, credit period, and cash discount policy, it is also important for the company to design the collection policy and procedures so as to speed up the collections as and when become due. What would the company do if the customers do not pay within the set credit period? In this regard the company has to assess the chances of collecting the accounts receivable by putting some effort. If by putting small effort the chance are that the customer will pay his bill are high then the company should go ahead with that much of effort. In situations when the chances of collecting the money are considerably less than the company should explore other ways of collecting the money. Credit Cards or business credit cards collections are easier and require less effort.

The company can use number of methods to speed up the collections. Letters and telephone calls are the easiest one and least expensive. The company may design a policy of sending a letter few days before the payment becomes due. Depending upon the situation the company can call the customers on telephone just before the due date. A visit to customer may prove to be effective when the bills are overdue. Legal action should be treated as the last resort. Before that the company should try to understand the problems of the customer and if the company finds that the integrity of the customer is at doubt, they should resort to legal action. Pre-paid debit cards are better alternative for low interest credit card. On that basis the company can find out whether the particular debt should be treated as doubtful and should be writer off or not.

Credit Analysis -3

We are talking Credit Analysis. The cost in terms of time and money resources involved in such experience would outweigh the benefits. But at the same time the company has to come o conclusion and satisfy itself that the customer to whom it is extending credit is worthy of it and the risks involved commensurate with the return. Bad Credit Repair analysis helps company to plan their credit policy.

   

In order to undertake credit analysis, the company may analyze the financial statements of the customer. For the companies which are listed on stock exchanges, obtaining their financial statements is not difficult as the same are available with the exchanges. Some of the major stock exchanges regularly publish summarized financial statements in their directories. In case the customer to whom the company is thinking to extend the credit is not listed and the financial information is not available, the company can ask the customer to submit the latest financial statements. In such situations the company may adopt a policy not to extend the credit to customers who do not submit the financial statements. Credit Repair and Credit Repair Services helps to have good credit reports for individuals.

   

Once the company gets the financial statements the following analysis would provide information about the credit worthiness of customers;

  

Ratio analysis

Fund Flow Analysis

 

Inter-firm comparison 

 

 Discriminate analysis and mark or analysis can also be usefully employed for credit analysis.

 

 

 

The business magazines generally carry the detailed analysis of financial statements and inter-firm comparison of companies in the same industry. This information would be useful in assessing the market conditions of a particular industry. Free debt settlement report helps company for credit analysis. The company can also ask the customer to provide the list of references or the names of companies with whom the customers has transacted in the past. The company can then explore about the credit worthiness of customer through the references provided by him. Repair Credit is one of the service helps company for credit analysis.  Additional information may also be obtained by interviewing the customer or visiting his place of work.