Cash BudgetCash Budget

Budgets Budgets

• A budget is a A budget is a short term financial planshort term financial plan

• CIMA defines a budget as a “plan CIMA defines a budget as a “plan expressed in money”expressed in money”

• Budget are prepared in advanceBudget are prepared in advance

• They concern what is forecast and They concern what is forecast and planned for the period of the budgetplanned for the period of the budget

• A cash flow forecast is budget dealing A cash flow forecast is budget dealing with planned inflow and outflow of cashwith planned inflow and outflow of cash

Cash flow forecastCash flow forecast

• Cash flow refers to the movement of Cash flow refers to the movement of cash into and out of a businesscash into and out of a business

• Cash budgetsCash budgets– Seek to predict the flow of cash into and Seek to predict the flow of cash into and

out of the businessout of the business– Are forecasts enabling businesses to Are forecasts enabling businesses to

manage cash flowmanage cash flow– Are an essential part of the planning Are an essential part of the planning

processprocess

Internal and external useInternal and external use

• Banks and other lenders will insist on a cash Banks and other lenders will insist on a cash budget before granting a loanbudget before granting a loan

• The potential creditor will seek assurance that The potential creditor will seek assurance that net cash inflows will be sufficient to repay the net cash inflows will be sufficient to repay the loan with interestloan with interest

• But even if the business is not seeking a loan it But even if the business is not seeking a loan it is still important to construct a cash budgetis still important to construct a cash budget

• This is to ensure that the business will be able to This is to ensure that the business will be able to meet its obligations as they arise and, equally meet its obligations as they arise and, equally important, to take advantage of any surplus cashimportant, to take advantage of any surplus cash

The purpose of a cash The purpose of a cash budgetbudget• To know in advance what the likely cash To know in advance what the likely cash

balance at the end of each monthbalance at the end of each month• To increase management awareness of To increase management awareness of

potential shortages and surpluses of cashpotential shortages and surpluses of cash• To avoid problems associated with lack of cash To avoid problems associated with lack of cash

to pay debtsto pay debts• To fine tune operations to ensure adequate To fine tune operations to ensure adequate

cash is availablecash is available• To arrange financing to cover a period of cash To arrange financing to cover a period of cash

shortageshortage• To provide information to make decisions on To provide information to make decisions on

the use of cash surplus the use of cash surplus

Compare with other accounting Compare with other accounting statementsstatementsProfit and loss Profit and loss accountaccount

Deals with sales revenue, associated costs Deals with sales revenue, associated costs and profit rather than cash flowand profit rather than cash flow

Balance sheetBalance sheet Deals with assets, liabilities and capitalDeals with assets, liabilities and capital

Cash flow Cash flow statementstatement

Concerns inflow and outflow of cashConcerns inflow and outflow of cash

Cash budget or Cash budget or cash flow cash flow forecastforecast

Concerns forecast inflow and outflow of Concerns forecast inflow and outflow of cashcash

Unlike the other three, this is drawn up in Unlike the other three, this is drawn up in advance rather than after the eventadvance rather than after the event

Also, it is an internal document only shown Also, it is an internal document only shown to external stakeholders (potential to external stakeholders (potential creditors) when seeking a loancreditors) when seeking a loan

Comparisons of Cash & P&L Comparisons of Cash & P&L BudgetsBudgetsBudget profit and loss Budget profit and loss

accountaccount• Forecasts sales revenue, Forecasts sales revenue,

associated costs and profitassociated costs and profit• Includes all forecast sales Includes all forecast sales

and associated spending and associated spending for the year- whether or for the year- whether or not cash flowsnot cash flows

• Depreciation is a negative Depreciation is a negative itemitem

• Does not include planned Does not include planned capital expenditure or capital expenditure or raising finance raising finance

Cash budgetCash budget• Forecasts inflow and Forecasts inflow and

outflow of cashoutflow of cash• Only includes Only includes

transactions where transactions where cash flowscash flows

• Depreciation is Depreciation is ignored as a non-cash ignored as a non-cash itemitem

• Includes everything Includes everything where cash moves in where cash moves in or out of the businessor out of the business

If it moves count it!If it moves count it!

• Accounting is characterised by rules about how Accounting is characterised by rules about how items are treated - the rules behind accounting items are treated - the rules behind accounting have their own logic even though outsiders can have their own logic even though outsiders can find them baffling.find them baffling.

• Cash budgeting on the other hand is based on a Cash budgeting on the other hand is based on a few very simple rules:few very simple rules:

• If it leads to a cash flow (into or out of the If it leads to a cash flow (into or out of the business) count itbusiness) count it

• If there is no cash flow then ignore itIf there is no cash flow then ignore it• If cash flows in, it is a positive itemIf cash flows in, it is a positive item• If cash flows out, it is a negative itemIf cash flows out, it is a negative item

Constructing a cash Constructing a cash budgetbudget

Importance of SpreadsheetsImportance of Spreadsheets

• Cash budgets are best produced using a Cash budgets are best produced using a spreadsheetspreadsheet

• Each column represents a month of the year Each column represents a month of the year whereas each row across represents various whereas each row across represents various categories of inflow and outflowcategories of inflow and outflow

• The use of a spreadsheet not only improves The use of a spreadsheet not only improves presentation and but also makes it easier to presentation and but also makes it easier to make amendments where necessarymake amendments where necessary

• The planned inflows and outflows are The planned inflows and outflows are recorded in the cells of the spreadsheet - so recorded in the cells of the spreadsheet - so we have a record of not just how much but we have a record of not just how much but also when the cash is expected to flowalso when the cash is expected to flow

Components of a cash Components of a cash budgetbudgetCash inflowCash inflow Inflow from cash sales, credit sales Inflow from cash sales, credit sales

and from the introduction of capitaland from the introduction of capital

Cash Cash outflowoutflow

Outflow resulting from revenue and Outflow resulting from revenue and capital expenditurecapital expenditure

Net cash Net cash flowflow

Cash inflow minus cash outflowCash inflow minus cash outflow

Opening Opening balancebalance

Cash and money held in bank Cash and money held in bank account at the start of the monthaccount at the start of the month

Closing Closing balancebalance

Opening balance plus net cash flow Opening balance plus net cash flow for the periodfor the period

Cash inflowCash inflow

• FromFrom salessales– CashCash fromfrom sales.sales.– CashCash fromfrom creditcredit salessales (comes(comes inin afterafter aa timetime lag)lag)

• FromFrom ownersowners – CashCash fromfrom aa shareshare issue-capitalissue-capital investedinvested inin thethe

businessbusiness

• FromFrom lenderslenders– BankBank loanloan

• CashCash fromfrom thethe disposaldisposal ofof unwantedunwanted assetsassets– E.g.E.g. disposaldisposal ofof fixedfixed assetsassets

Forecasting cash inflow Forecasting cash inflow

• This is the greatest problem in constructing the budgetThis is the greatest problem in constructing the budget• For an established business forecast sales will be based on For an established business forecast sales will be based on

time series analysis (e.g. moving averages). This involves time series analysis (e.g. moving averages). This involves isolating the trend and extrapolating it into the futureisolating the trend and extrapolating it into the future

• Forecasting is more difficult for start up businesses with no Forecasting is more difficult for start up businesses with no past track recordpast track record

• As well as customer demand, the forecast should take the As well as customer demand, the forecast should take the firm’s capacity into accountfirm’s capacity into account

• As well as forecasting total sales it is also necessary to As well as forecasting total sales it is also necessary to forecast timing and the likely balance between cash and forecast timing and the likely balance between cash and credit salescredit sales

• Remember credit sales in January might not result in a Remember credit sales in January might not result in a cash inflow until February or Marchcash inflow until February or March

Types of cash outflows Types of cash outflows

• PurchasesPurchases ofof stockstock paidpaid forfor inin cashcash

• PaymentPayment toto creditorscreditors

• PaymentPayment ofof wageswages

• PaymentPayment ofof rentrent

• PaymentPayment ofof insuranceinsurance premiumpremium

• ExpenditureExpenditure onon marketingmarketing

• PurchasePurchase ofof fixedfixed assetsassets

• PaymentPayment ofof interestinterest onon debtdebt

• PaymentPayment ofof taxtax

• AnyAny purchasepurchase onon creditcredit willwill showshow upup inin columncolumn ofof thethe monthmonth inin whichwhich cashcash flowedflowed outout

Purchases of stockPurchases of stock

• This will be a major ongoing item in the cash This will be a major ongoing item in the cash budgetbudget

• Stocks bought on credit will usually be paid for Stocks bought on credit will usually be paid for in a subsequent month. As with cash inflow from in a subsequent month. As with cash inflow from sales, purchase of stocks in a cash budget will sales, purchase of stocks in a cash budget will show up in the month in which the cash flowed show up in the month in which the cash flowed outout

• Normally there is a mathematical relationship Normally there is a mathematical relationship between sales and purchases. For instance between sales and purchases. For instance purchases of stock might be one-third of sales purchases of stock might be one-third of sales revenuerevenue

• This relationship will be used when constructing This relationship will be used when constructing a cash budgeta cash budget

Timing of cash flows is all-Timing of cash flows is all-importantimportant

• Remember the cash budget does not Remember the cash budget does not record when the sale or purchases record when the sale or purchases are expected to be madeare expected to be made

• Instead it records when cash movedInstead it records when cash moved– When the cash from credit sales is When the cash from credit sales is

expected to flow into the businessexpected to flow into the business– When the cash for credit purchases is When the cash for credit purchases is

expected to flow out of the businessexpected to flow out of the business

Net cash flowNet cash flow

• Net cash flow is equal toNet cash flow is equal to– Cash inflow for the period (e.g. a month) Cash inflow for the period (e.g. a month)

minusminus– Cash outflow for the same periodCash outflow for the same period

• Negative cash flow: outflows exceed Negative cash flow: outflows exceed the inflowsthe inflows

• Positive cash flow: inflows exceed the Positive cash flow: inflows exceed the outflowsoutflows

Opening balanceOpening balance

• This refers to the cash position at the This refers to the cash position at the start of the monthstart of the month

• Assuming that all money is banked and Assuming that all money is banked and all payment is made from the firm’s bank all payment is made from the firm’s bank account, the opening balance is the state account, the opening balance is the state of the firm’s account at the start of the of the firm’s account at the start of the monthmonth

• This could be positive or it could be This could be positive or it could be negativenegative

Closing balanceClosing balance

• This equals the opening balance plus the This equals the opening balance plus the net cash flownet cash flow

• Remember that it is possible for opening Remember that it is possible for opening balance to be negative-similarly the net balance to be negative-similarly the net cash flow could be negativecash flow could be negative

• When you add the opening balance and When you add the opening balance and closing balance together be careful about closing balance together be careful about negative and positive valuesnegative and positive values

• The closing balance of one month becomes The closing balance of one month becomes the opening balance of the nextthe opening balance of the next

Putting it all together - Putting it all together - exampleexample(£k)(£k) Jan Jan Feb Feb March March

Cash receiptsCash receipts 250250 260260 280280

Cash paymentsCash payments 340340 280280 240240

Net cash flow Net cash flow (90)(90) (20)(20) 4040

Opening balanceOpening balance (120)(120) (210)(210) (230)(230)

Closing balance Closing balance (210)(210) (230)(230) (190)(190)

Commentary on the Commentary on the exampleexample• We start the year with a bank overdraft of £120KWe start the year with a bank overdraft of £120K• In January cash payments are expected to exceed cash In January cash payments are expected to exceed cash

inflow from sales by £90kinflow from sales by £90k• With a net cash outflow, the forecast overdraft at the end With a net cash outflow, the forecast overdraft at the end

of the month shows a riseof the month shows a rise• The closing balance at the end of January becomes the The closing balance at the end of January becomes the

opening balance for Februaryopening balance for February• Cash inflow is expected to improve in February but a net Cash inflow is expected to improve in February but a net

cash outflow is still expected for the month. As a result cash outflow is still expected for the month. As a result the overdraft is forecast to risethe overdraft is forecast to rise

• In March there is an expected net cash inflowIn March there is an expected net cash inflow• A reduction in the overdraft is projected and this is the A reduction in the overdraft is projected and this is the

sum that will be taken into April as the opening balancesum that will be taken into April as the opening balance

Uses of a cash budgetUses of a cash budget

The role of a cash budgetThe role of a cash budget

• Highlights when cash balances are expected to be positive so Highlights when cash balances are expected to be positive so that surplus cash can be invested appropriatelythat surplus cash can be invested appropriately

• Identifies when outflows might exceed inflowIdentifies when outflows might exceed inflow• Ensures that the firm has sufficient cash to carry out planned Ensures that the firm has sufficient cash to carry out planned

activitiesactivities• Ensures that cash balances are sufficient to meet expected Ensures that cash balances are sufficient to meet expected

paymentspayments• Justify to lenders that any borrowed funds can and will be Justify to lenders that any borrowed funds can and will be

repaidrepaid• Plan when and how to finance significant items of expenditurePlan when and how to finance significant items of expenditure• Plan for any bank overdraft or loan which may become Plan for any bank overdraft or loan which may become

necessarynecessary• Control cash flow by comparing actual events against plansControl cash flow by comparing actual events against plans• Optimise the holdings of cash (e.g. invest surplus cash)Optimise the holdings of cash (e.g. invest surplus cash)

What if questionsWhat if questions

• Cash budgets produced on a spreadsheet are Cash budgets produced on a spreadsheet are especially useful in answering “what if” questionsespecially useful in answering “what if” questions

• What will be the impact on cash flow ofWhat will be the impact on cash flow of– a rise in the cost of stock?a rise in the cost of stock?– a rise in interest payments or rent?a rise in interest payments or rent?– investment in new fixed assets?investment in new fixed assets?– a wage rise? a wage rise? – lower than expected sales?lower than expected sales?

• If we change in one cell of the spreadsheet we If we change in one cell of the spreadsheet we can rapidly analyse the new scenariocan rapidly analyse the new scenario

Cash budgets and new Cash budgets and new businesses businesses • A cash budget is an essential part of a A cash budget is an essential part of a

business plan and loan applicationbusiness plan and loan application• The typical start up business will The typical start up business will

experience negative net cash flow in the experience negative net cash flow in the early months or even yearsearly months or even years

• This is because of high start-up costs and This is because of high start-up costs and slow growth in salesslow growth in sales

• The cash budget helps owners/ managers The cash budget helps owners/ managers to plan finance in order to steer the to plan finance in order to steer the business through this difficult periodbusiness through this difficult period

Seasonality Seasonality

• Although we associate seasonality with Easter Although we associate seasonality with Easter eggs, firework, tourism and sun tan lotion the fact eggs, firework, tourism and sun tan lotion the fact is that a large proportion of all businesses is that a large proportion of all businesses experience some seasonal fluctuations in salesexperience some seasonal fluctuations in sales

• Seasonality will be reflected in the cash budget - Seasonality will be reflected in the cash budget - there will be periods of net cash outflow caused by there will be periods of net cash outflow caused by low seasonal sales and these will be followed by low seasonal sales and these will be followed by periods of net cash inflow during the peak seasonperiods of net cash inflow during the peak season

• A cash budget enables manager to plan spending A cash budget enables manager to plan spending to cope with this problemto cope with this problem

Monitoring and controlMonitoring and control

• It is usual to subdivide the column for It is usual to subdivide the column for each month into:each month into:– the budgeted cash receipts/payments the budgeted cash receipts/payments

forecast for the monthforecast for the month– the actual cash receipts/receipts in the the actual cash receipts/receipts in the

monthmonth

• There difference between the two There difference between the two figures is known as a variancefigures is known as a variance

Favourable and adverse Favourable and adverse variancesvariances• A A favourable variancefavourable variance is one where the is one where the

actual figure is better than the budget (or actual figure is better than the budget (or forecast) figure:forecast) figure:– cash receipts higher than expectedcash receipts higher than expected– cash payments lower than expectedcash payments lower than expected

• An An adverse varianceadverse variance is unfavourable. The is unfavourable. The actual figure is worse than the budget figure: actual figure is worse than the budget figure: – cash receipts lower than expectedcash receipts lower than expected– cash payments higher than expectedcash payments higher than expected

Variances - example Variances - example Item Item Budget Budget Actual Actual Variance Variance F or A?F or A?

Cash Cash inflowinflow

250250 260260 1010 FavourablFavourablee

Cash Cash outflowoutflow

340340 370370 (30)(30) Adverse Adverse

Net cash Net cash flowflow

(90)(90) (110)(110) (20)(20) Adverse Adverse

Opening Opening balancebalance

(120)(120) (120)(120) 00 As As expectedexpected

Closing Closing balancebalance

(210)(210) (230)(230) (20)(20) Adverse Adverse

Variances - questions to Variances - questions to askask• What was the size of the variance? What was the size of the variance?

• What was the variance as a percentage of What was the variance as a percentage of the budget figure?the budget figure?

• Was it favourable or adverse?Was it favourable or adverse?

• Was the variance within normal tolerance?Was the variance within normal tolerance?

• What is the explanation for the variance?What is the explanation for the variance?

• We did not foresee it but was it foreseeable?We did not foresee it but was it foreseeable?

• What can we do get back on track?What can we do get back on track?

Some explanations for Some explanations for variancesvariances• Incorrect sales forecastsIncorrect sales forecasts• Change in the environment leading to Change in the environment leading to

reduced salesreduced sales• Suppliers insist on payments more Suppliers insist on payments more

rapidly than expectedrapidly than expected• Unexpected rise in costsUnexpected rise in costs• Production problems leading to reduced Production problems leading to reduced

output and salesoutput and sales• Discounts offered to boost salesDiscounts offered to boost sales

Cash managementCash management

Cash managementCash management

• AimAim –– toto havehave thethe rightright amountamount ofof cashcash availableavailable atat thethe rightright timetime

• ThereThere isis aa tradetrade offoff betweenbetween liquidityliquidity andand opportunityopportunity costscosts– liquidityliquidity isis neededneeded inin orderorder toto settlesettle debtsdebts asas

theythey fallfall duedue– butbut thethe opportunityopportunity costcost ofof holdingholding cashcash isis thethe

lossloss ofof earningsearnings fromfrom usingusing cashcash• GoodGood cashcash managementmanagement requires:requires:

– accurateaccurate cashcash flowflow forecastingforecasting andand monitoringmonitoring– obtainingobtaining short-termshort-term borrowingborrowing whenwhen neededneeded– investinginvesting anyany surplussurplus cashcash

Cash shortagesCash shortages

• ShortagesShortages ofof cashcash resultsresults inin– creditorscreditors beingbeing unpaidunpaid– legallegal actionaction forfor recoveryrecovery ofof debtdebt– inabilityinability toto purchasepurchase stocksstocks– refusalrefusal toto supplysupply moremore creditcredit– disruptiondisruption toto productionproduction– resultantresultant lossloss ofof salessales– labourlabour unrestunrest throughthrough inabilityinability toto paypay wageswages– businessbusiness failurefailure

Surplus cashSurplus cash

• CashCash richrich businessesbusinesses oftenoften failfail toto taketake advantageadvantage ofof aa cashcash surplussurplus

• SurplusSurplus cashcash cancan bebe – spentspent onon stockstock– usedused toto purchasepurchase fixedfixed assetsassets– depositeddeposited inin anan interestinterest bearingbearing accountaccount– investedinvested inin R&DR&D– usedused toto financefinance acquisitionsacquisitions– investedinvested inin newnew productsproducts– lentlent inin taxtax efficientefficient waysways

Causes of cash flow Causes of cash flow problemsproblems• Over-investment in fixed assetsOver-investment in fixed assets• Overtrading - rapid expansion with insufficient Overtrading - rapid expansion with insufficient

working capitalworking capital• Poor credit control - excessive credit, late Poor credit control - excessive credit, late

payment by debtors, bad debtpayment by debtors, bad debt• Suppliers wanting quick paymentSuppliers wanting quick payment• Stock piling - excessive investment in stockStock piling - excessive investment in stock• Seasonal variations in sales and cash flowSeasonal variations in sales and cash flow• Over borrowing at high interest ratesOver borrowing at high interest rates• Changing tastes - decline in salesChanging tastes - decline in sales• Management error-poor planningManagement error-poor planning

Solution: increase inflowSolution: increase inflow

• Sell idle fixed assetsSell idle fixed assets• Sale and leasebackSale and leaseback• Stimulate sales by price discountStimulate sales by price discount• Improve debtor control – chase debtorsImprove debtor control – chase debtors• Discounts for prompt customer paymentDiscounts for prompt customer payment• Tighter credit controlTighter credit control• Debt factoringDebt factoring• Raise more capitalRaise more capital• Arrange overdraft facilitiesArrange overdraft facilities

Solution: reduce outflowSolution: reduce outflow

• Lengthen supplier credit termsLengthen supplier credit terms• Postpone investmentPostpone investment• Reduce stock holding-adopt lean production Reduce stock holding-adopt lean production

techniques (e.g. JIT)techniques (e.g. JIT)• Purchase stock on creditPurchase stock on credit• Ask trade creditors for extended creditAsk trade creditors for extended credit• Spread the cost of purchases - lease or hire Spread the cost of purchases - lease or hire

purchasepurchase• Negotiate rescheduling of debt paymentsNegotiate rescheduling of debt payments• Diversify to avoid seasonal variations in cash flowDiversify to avoid seasonal variations in cash flow• Improve planning, monitoring and controlImprove planning, monitoring and control