Cash Budgeting (1) – The Nature and Sources of Cash

1 Introduction

We have already looked at the importance of cash in terms of the cash operating cycle. It is vital to the survival of a company that it manages its cash efficiently. In this chapter we will discuss what we mean by cash and why it is so important that it is managed well.

1.1 Cash, cash flow and funds

Cash is money held and available in hand or in bank accounts. Cash flow is its movement: receipts less payments over a period. Funds means financial resources; specify whether a question uses it to mean cash or the broader resources tied up in working capital.

Cash accounting records receipts and payments when cash moves. Accrual accounting records income earned and expenses incurred, even if payment occurs earlier or later. Depreciation reduces accounting profit but is not a cash payment.

2 The importance of cash flow management

Although a business will wish to be profitable, it is essential that they manage their cash flows properly in order to avoid liquidity problems. Too many businesses fail because they run out of cash, even though they may be making profits.

Cash flow forecasts (or cash flow budgets) are essential when trying to forecast cash balances during the year. These will be covered in the next chapter.

The type of business will have a large impact on the pattern of cash flows - retail businesses receive cash immediately upon sale, whereas for manufacturing businesses there will be a delay in receiving cash.

Some businesses, for example those renting out properties, have relatively predictable and stable cash inflows whereas others, for example engineering firms working on large contracts, are likely to have more erratic cash flows.

3 Different types of cash receipts and payments

Companies receive and pay cash for several different reasons:

• Regular revenue receipts and payments: cash received from sale and cash paid for expenses
  

• Capital payments and receipts: cash payments for the purchase of non-current assets and cash received from the sale of non-current assets
  

• Drawings and dividends: cash paid to the owner(s) of the business
  

• The issue and redemption of shares
  

• The taking and repaying of loans, and the interest on any loans
  

• Irregular receipts and payments: e.g. the payment to the state of tax on profits
  

4 Cash accounting and accruals accounting

When we calculate the profit made by a business during a period, we bring in all income and all expenditure during the period, regardless of whether the cash has been received/paid or not. Income and expenditure are matched on a time basis. This is known as accruals accounting, and it means that a business's results are not dependent on accidents of timing of cash payments and receipts.

However, it is vital that a business keeps track of its cash position: businesses go into liquidation primarily because they run out of cash, not because they make losses. It is very easy for a profitable business to run out of cash if it buys too many non-current assets, pays dividends that are too high or has to pay an unexpected amount of tax. So, it is vital to calculate the net cash flow over a period and to make forecasts of cash balances looking at when cash is actually received or paid.

There are many reasons why the profits and the net cash flows will be different:

• Receivables and payables: all sales and expenses during the period are recorded when calculating the profit, but if there are receivables and payables at the end of the period then the cash received and paid will differ.
  

• Purchase of non-current assets: if a non-current asset is purchased then there is a cash outflow of the entire cost. However when calculating the profit, this cost is spread over the life of the asset and only part is charged (as depreciation) each year.
  

• Sale of non-current assets: if a non-current asset is sold then there is a cash inflow of the entire proceeds. However when calculating the profit we only bring in the profit on the sale.
  

• Inventories: if we purchase goods but do not use them all in the period (and therefore have inventory remaining at the end) then the cash outflow is the cost of all the purchases, whereas when calculating the profit we only take account of the cost of the goods actually used.
  

• Other cash receipts and payments that do not affect the profit: e.g. an issue of shares to raise cash; the taking and repaying of loans.

4.1 Reconciling profit to cash

Example ($000): profit is 30, including depreciation of 8. Inventory increases by 6, receivables increase by 10 and payables increase by 4. Ignore tax and interest for this example.

• Working-capital increases use cash unless financed by increased payables. Capital spending and loan principal change cash but do not form part of operating profit.

5 Chapter 4 questions