Friday, 28 May 2010

Cash Budgeting Brings a Sense of Reality to the Business

Businesses can easily get overboard with their profitability projections and expansion plans. If orders are increased by offering too liberal terms of credit, for example, the high levels of sales might hide the problem that most of it are non-cash, and not available to meet day-to-day expenses. As mentioned in the last post on Cash Conversion Cycle, if receivables and inventories are too high, a business can have little cash to pay accruing liabilities and meet daily expenses.

A cash budget estimates in advance the lkely cash inflows and outflows of the business. Instead of sales, it will be collections from credit customers (and cash sales, if any) that will be shown on the receipts side. And the payments side will include not only operating expenses but also installment payments under long-term liabilities such as term loans and dividend payouts to owners. Such a cash budget will identify any likely cash shortages the business is likely to face.

Once a business becomes aware of cash shortages that are likely to occur, it can plan in advance and organize to raise needed funds to meet these. In the absence of cash budgeting, the business can suddenly find itself short of cash and unable to pay its creditors. And unpaid creditors can seriously disrupt business operations by going to a court.

So how do you prepare a cash budget? An example cash flow statement is illustrated below (click on it to get a larger, readable, view). We look at the process of cash budgeting below.

Estimate Cash Realizations


Look at the average credit that customers actually take advantage of. Then include this time lag while estimating the cash realizations from your sales. For example, suppose that your total sales for a month are 20,000 (of which 2,000 is cash sales) and the average time taken by customers is 2.5 months. You will then include the credit sale of 18,000 in the cash budget as a receipt only in the third month after the sale. The cash sale of 2,000 can of course be included in the month of sale.

Any receipts under bank or other loans, or capital brought in by owners, are also included under the month in which it is received. In fact, after preparing the first draft of the cash budget, you might find that you need to arrange funds under these categories to meet any shortfalls in cash foreseen.

Estimate Cash Payments


Established businesses might be able to obtain liberal credit terms from their suppliers. Small and new businesses might, however, get only short credit periods. Look at the actual credit that your suppliers allow you, and include payments that you have to make for the supplies you have purcahsed accordingly. For example, if you get only one month's credit, include payments for purchases in the month after the purchase.

Next, look at the various other kinds of payments you have to make. These typically include:


  • Operating expenses that you incur, such as travel expenses, petty purchases, employee salaries, tax payments, etc
  • Interest payments on any borrowings you have made
  • Repayments of borrowings that typically occur in installments at agreed intervals on specified dates
  • Any advance payments or deposits that you have committed to make
  • Dividend payments or owners' cash drawals from the business


Prepare a Monthly Cash Budget


Each month column of the cash budget will start with the opening balance of cash for that month, to which estimated cash receipts during that month will be added and from the resulting total will be deducted the estimated cash payments during that month. The month column will end with the resulting closing balance of cash, which will be carried over as the opening balance for the next month.

The first draft of cash budget might indicate that the closing balance is negative in one or more months. In such a case, you will have to think of how to arrange external funds to meet the cash shortage. With a realistic cash budget, you will even find it easier to get a bank advance needed funds to meet any temporary shortfalls.

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