Cash Budgeting (2) – Preparing Cash Budgets

1 Introduction and pro forma

Having discussed why it is so important that a business manages its cash properly, we will now look at how we actually go about preparing a cash budget in order to forecast what our cash balances will be in the future.

Cash budgets are probably the most important tool in practice for the management of any company’s cash position. They are vital to identifying in advance a likely deficit or surplus in order that appropriate action can be taken to avoid any problem or profit from any opportunity.

The format for a comprehensive cash budget is as follows:

Notes

1. Delayed from when the sale takes place. If debtors take two months credit then receipts from January sales will be received in March.
   

2. For example, interest, capital injections and proceeds from the sale of non-current assets.
   

3. Delayed from when the purchase takes place. If suppliers are paid after one month then purchases made in January will be paid for in February.
   

4. Non-regular and easy to forget. However, if cash is tight capital expenditure can often be deferred or cut back.
   

5. Easy to overlook - no flexibility.
   

6. Non-regular and easy to forget. However, if cash is tight dividends can be cut either partially or completely.
   

7. The key figure. Is the company staying within its borrowing limits? If not it must either boost receipts (eg more capital paid in), cut back on expenditure (eg salaries, capital expenditure or dividends), or make an appointment with the bank manager to negotiate a larger loan or overdraft
   

2 Control and corrective action

Having prepared a cash budget as illustrated in the previous example, we can plan ahead on ways of dealing with forecast shortages of cash and on ways of investing any surplus cash. For example, a predicted cash shortage might be avoided by deferring some capital expenditure or by arranging an overdraft in advance.

However it is also important that we use the forecast as a means of controlling cash by comparing, month by month, our actual cash receipts and payments and comparing them to the forecast receipts and payments.

When the actual figures differ from what we had forecast, we will expect the relevant managers to explain the reason. We will then be in a position to attempt to take corrective action. For example, if our suppliers have increased the price of materials, we might look for alternative suppliers or alternative materials. Alternatively we might decide to increase our selling prices. By comparing the actual receipts and payments with the forecast amounts month-by-month we will be able to update the cash budgets for the subsequent months.

2.1 Comparing budgets, actual results and revised forecasts

Actual cash generation is 6 below budget. Identify the cause (for example late customers and higher input prices). Keep the original budget for comparison; prepare a revised forecast using actual opening cash and updated receipt/payment assumptions. Arrange finance or change spending before a shortfall occurs.

2.2 Sensitivity of a cash forecast

Opening cash is $5,000, forecast receipts $40,000 and payments $52,000. Closing balance = 5,000 + 40,000 − 52,000 = −$7,000. The overdraft limit is $10,000.

If receipts fall by 10%, with payments unchanged, receipts become $36,000 and closing balance becomes −$11,000: the limit is exceeded by $1,000. The available $3,000 headroom allows receipts to fall by at most 3,000/40,000 = 7.5%. Test one assumption at a time, then consider a combined adverse scenario.

3 The impact of inflation

By their very nature, cash budgets are based on forecasts which depend on assumptions. When preparing the budgets we do need to take into account our estimates of the inflation that is likely to impact on each of the flows. There is no ‘magic way’ of knowing what the rates of inflation are going to be and our budgets depend on the assumptions that we make. One benefit of using a spreadsheet when preparing the budget is that we can design it so that we can change the inflation rate used for each type of receipt or payment and see what the impact will be.

Inflation will usually affect costs before revenues because businesses will usually put up their prices after the costs have risen. Unless the business manages to increase selling prices by more than the increase in costs this will have a negative effect on profitability and on net cash flows.

4 Cleared funds forecast

Although cash budgets are generally prepared monthly, some businesses will also forecast on a daily basis because surplus cash at the end of each day can be put on overnight deposit in order to earn interest.

The approach is exactly the same as the approach taken when preparing a cash budget (but on a daily basis rather than on a monthly basis) except that in addition we need to take account of the fact that there is generally a short delay in transactions appearing on the bank statements.

For example, if we receive a cheque from a customer on Monday, the bank might not credit it to our account until Wednesday and it is therefore only on Wednesday that the money becomes available for us to put on deposit. ‘Cleared funds’ is the name given to cash actually available in the bank account.

4.1 Preparing a cleared funds forecast

Book cash reflects recorded receipts and payments. Cleared funds reflect the dates the bank makes receipts available or debits payments. In this illustration only, a receipt cheque clears two days later; a payment cheque is debited two days later. Actual clearing arrangements vary.

• Cleared balance = book balance − uncleared receipts + uncleared payments. Forecast each item once at its clearing date when forecasting available bank funds; do not spend or invest an uncleared receipt.

5 Chapter 5 question

At the start of the year James had inventories of $24,000; payables of $22,000; and receivables of $15,000. His cash balance was $10,000

During the year James made purchases of $358,000 and had sales of $400,000.

At the end of the year inventories were $42,000; payables were $28,000, and receivables were $48,000.

Expenses per month were $4,000, paid in the month incurred.

How much profit did James make during the year?

What is James’s net cash flow for the year?