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Fundamental Procedures of the Cash Budgeting Cycle

written by: •edited by: Marjory Pilley•updated: 7/1/2011

Cash budgeting procedures must be performed regularly to ensure that cash balances do not fall to unexpectedly low levels. The cash budget is an important tool allowing management to plan the adequate financing of the business. Procedures must take into account all cash inflows and outflows.

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    Advantages of Cash Budgeting

    Cash budgeting is an important part of business planning. The cash budget may help a business foresee periods when cash will be short and borrowing may be necessary. It also helps to plan for periods when there will be a cash surplus. Cash budgeting is particularly important for businesses whose cash flow is uneven, for example seasonal businesses. Retailers also need to carefully consider their cash budgeting as many retailers collect more cash at certain times of the year such as holiday and sales periods. Most importantly of all, cash budgeting can reveal when there is a possibility that the business will become insolvent and help management to take early action to avert business failure.

    Cash Flow Cash budgeting must be approached systematically so that certain steps are followed and no details are missed. As the cash flow picture is always changing with fluctuations in sales and prices, the fundamental procedures of the cash budgeting cycle must be repeated at regular intervals. The procedure must cover cash inflows from sales and other sources and cash outflows from expenses, interest and capital expenditure. Other outflows, such as dividends and taxes, must be taken into account. At the end of each period the cash budget will reveal a cash surplus or deficiency and this enables management to engage in early planning to deal with the situation. For example, if a cash deficiency is forecast it may be necessary to consider short-term borrowing to keep the business functioning over that period. Part of the cash budgeting procedure, therefore, involves planning the pattern of borrowing and the interest payments that will be necessary.

    A business will need to keep a reserve of cash at all times to deal with unexpected short-term problems that require additional expenditure. The level of the cash reserve will differ according to the type of business and the strategy pursued by management. The need to keep this cash reserve will be taken into account when preparing the cash budget and deciding on the level of borrowing required.

    Another advantage of preparing a cash budget is that the actual cash flow during a period can be compared to the budget to reveal the variances that have occurred. This may be useful in highlighting a need to collect debts more quickly, negotiate more favorable payment terms with creditors or control expenditure on certain items. The cash budget is therefore an important management information tool that facilitates decision making.

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    Forecasting Cash Inflows and Outflows

    The first step in cash budgeting is to forecast the earnings from sales and cash inflows from other sources such as fixed asset sales. For retail businesses where many sales are made in cash the pattern of cash flow will match earnings closely. For other businesses that make mainly credit sales the position is more uncertain because the cash flow depends on the success of collecting the debts. Accurate cash flow prediction, therefore, depends on forecasting both sales volume and the average period required for debt collection.

    Cash Budget Other types of cash inflow include dividends and interest in addition to cash from the sale of investments. Income is also earned from the sale of fixed assets or from rent received from letting or subletting of office or factory space. Cash inflows may also arise from the issue of bonds or shares.

    Cash outflows relate to the direct costs of labor and materials and general overhead expenses. Other outflows could arise from payments of interest, tax or dividends. There may also be planned investments in fixed assets. When a new capital project is started, it is likely that there will be separate cash flow projections done for the feasibility study on the project and these can be incorporated into the main cash budget. Most of the expenses are likely to be on credit terms and the actual cash outflow will occur some time after the expense is incurred. This may allow the enterprise some latitude to adjust the outflow of cash, depending on the terms negotiated with creditors and the interest charged by the suppliers and other creditors. For some types of expenditures the cash amounts will be payable in advance and this must be taken into account when preparing the cash budget. Any loan repayments that arise also need to be considered.

    When the total cash inflows and outflows for the period have been computed, and the cash balance at the beginning of the period is taken into account, the cash budget arrives at the cash balance at the end of the period. This may be compared to the level of cash reserve required by the enterprise and any shortfall can be quantified. The cash level must be enough to deal with payments as they arise and to also cover minor emergencies that may occur in the course of business activities.

    When the forecast cash level is not sufficient, it may lead to a course of action aimed at improving the cash flow in the period in question. If the enterprise is holding investments that can be readily turned into cash, the sale of some investments must be planned in advance. The need for financing at various times needs to be assessed and the enterprise must decide on the term for which financing would be required. Interest arising and loan repayments resulting from the additional financing would then need to be included in the cash budget for future periods.

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    Cash Budgeting and Management Decisions

    Cash Balances Depending on the type of business, a cash budget should be performed at least monthly. For some larger businesses, weekly or daily cash budgets may be deemed necessary. If the intervals for which cash budgets are performed are too long, this may hide fluctuations of cash levels within the budgeting period that could present problems for the enterprise.

    The cash budget is an important tool and provides vital information to management. Many potentially profitable businesses fail because they cannot resolve cash flow problems. If a cash shortage occurs unexpectedly, a business may not be able to negotiate the financing necessary to continue operations in the short term even if in the longer term the business model is sound. The business may find itself having to default on an important payment to a large trade creditor, a bank or the government, leading to legal action against the enterprise. This can be avoided if the fundamental cash budgeting procedures are carried out regularly.

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