Cash flow forecasts provide an early warning of liquidity problems and funding needs. Banks often expect business customers to provide a cash forecast as a condition of lending.
Cash budgets and forecasts can be used for control reporting.
3 Cash budgets in receipts and payments format
Introduction
A cash budget is a detailed forecast of cash receipts, payments and balances over a planning period. It is formally adopted as part of the business plan or master budget for the period.
3.1 Assumptions
For each item of cash inflow or outflow, assumptions must be made about the quantity and timing of the flow. The total amount of receipts and payments will be derived from other budgets, such as the
company's operating budgets and capital expenditure budget. Assumptions will already have been made for these to prepare the profit or loss budget. Assumptions about the time to pay must be introduced for cash forecasting.
The forecasting method can be either one or a combination of the following.
• Identifying a particular cash flow, and scheduling when it will be received or paid • Projecting future trends and seasonal cycles in business activity and cash flows • Analysing historical payment patterns of regular repeat payments
3.2 Preparing the cash budget
Cash budgets are prepared by taking operational budgets and converting them into forecasts as to when receipts and payments occur. The forecast should indicate the highest and lowest cash balance in a period as well as the balance at the end.
The steps in preparing the cash budget are as follows: Preparation
1 Set up a proforma cash budget
Month 1 Month 2 Month 3
$ $ $
Cash receipts
Receipts from customers X X X
Loan etc X X X X X X Cash payments Payments to suppliers X X X Wages etc X X X X X X Opening balance X X X
Net cash flow (receipts – payments) X X X
Closing balance X X X
Sort out cash receipts
2 Establish budgeted sales month by month
3 Establish the length of credit period taken by customers
Receivables collection period (no. of days credit) =
period in sales credit total period during s receivable end) - year (or average
× no. of days in period
4 Determine when budgeted sales revenue will be received as cash (by considering cash receipts from total receivables)
5 Establish when opening receivables will pay
6 Establish when any other cash income will be received Sort out cash payments
7 Establish production quantities and material usage quantities each month
8 Establish material inventory changes and hence the quantity and cost of materials purchases each month
9 Establish the length of credit period taken from suppliers and calculate when cash payments to suppliers will be made
Payables payment period (no. of days credit) =
period in credit on purchases total period during payables end) - year (or average
× no. of days in period
10 Establish when amount due to opening payables will be paid
11 Establish when any other cash payments (excluding non-cash items such as depreciation) will be made
12 Show clearly on the bottom of the budget opening position, net cash flow and closing position If an overdraft is shown, suggest delaying payments to suppliers, speeding up payments from customers, reducing production volumes or arranging further overdraft facilities
3.3 Cash payments
Assumptions about payments are easier to make than assumptions about income. Assumptions about payments to suppliers can take account of:
(a) The credit terms given by suppliers (or groups of suppliers), company policy on purchase orders and the administration of cheque payments
(b) Any specific supply arrangements, (such as a delivery once every two months, with payment for each delivery at the end of the following month)
(c) Past practice (eg the proportion of invoices (by value) paid in the month of supply and invoice, the proportion paid in the month following, and so on)
(d) Predictable dates for certain payments, such as payments for rent, business rates, telephones, electricity and company tax
As a guideline, assumptions about payments should lean towards caution, ie if in doubt, budget for earlier payments.
3.4 Fixed cost expenditures
Some items of expenditure will be regarded as fixed costs in the operating budget. Salaries, office expenses and marketing expenditure are three such items. With some fixed costs, it could be assumed that there will be an equal monthly expenditure on each item, with cash payment in the month of expenditure perhaps, or in the month following. Other costs may not be monthly. If annual building rental is payable quarterly in advance, the budget should plan for payments on the specific dates.
3.5 Receipts
Assumptions about receipts might be more difficult to formulate than assumptions about payments. (a) For a company that depends almost entirely on consumer sales by cash, credit card and debit
card, the major uncertainty in the cash flow forecast will be the volume of sales. The timing of receipts from a large proportion of those sales will be predictable (payment with sale).
(b) Companies that have a mixture of cash and credit sales must attempt to estimate the proportion of each in the total sales figure, and then formulate assumptions for the timing pattern of receipts from credit sales.
(c) There are several ways of estimating when receipts will occur.
(i) If the company has specific credit terms, such as a requirement to pay within 15 days of the invoice date, it could assume that:
(1) Invoices will be sent out at the time of sale
(2) A proportion, say 25%, will be paid within 15 days (1/2 month)
(3) A proportion, say 65%, will be paid between 16 days and 30 days (one month after invoice)
(4) A proportion (say 9%) will pay in the month following
(5) There will be some bad debts (say 1%, a proportion that should be consistent with the company's budgeted expectations)
(ii) If there is a policy of cash discounts for early payment, the discounts allowed should be provided for in the forecasts of receipts.
(iii) The time customers take to pay can be estimated from past experience. Care should be taken to allow for seasonal variations and the possibility that payments can be slower at some times of the year than at others (for example, delays during holiday periods).
(iv) Payment patterns can also vary from one country to another. Companies in France and Italy for example will often take several months after the invoice date to pay amounts due.
3.6 Calendar variations
Assumptions could be required to take account of calendar variations.
(a) Days-in-the-month effect. It could be assumed that receipts will be the same on every day of the 20th/21st/22nd/23rd etc working day each month. Alternatively, it could be assumed that receipts will be twice as high in the first five days of each month. Assumptions should generally be based on past experience.
(b) Days-in-the-week effect. Where appropriate, assumptions should be made about the cash inflows on each particular day of the week, with some days regularly producing higher cash inflows than other days. Such forecasts should be based on historical analysis.
Receipts for some companies, particularly retailers, follow a regular weekly pattern (with some variations for holidays and seasons of the year). Companies should be able to estimate total weekly takings in cash (notes and coins), cheques and credit card vouchers, the number of cheques and credit card vouchers handled and the deposit spread (for each day, the percentage of the total takings for the week, eg 10% on Monday, 15% on Tuesday).
3.7 Time periods and overdraft size
Dividing the forecast period into time periods should coincide as closely as possible with significant cash flow events, to provide management with information about the high or low points for cash balances. In other words, as well as predicting the month end surplus or overdraft, the maximum overdraft during the month should be predicted.
Oak Tree Villa operates a retail business. Purchases are sold at cost plus 331/
3%. Or put another way,
purchases are 75% of sales. (a)
Budgeted sales Labour cost Expenses incurred
$ $ $
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 160,000 5,000 7,000
April 120,000 4,000 7,000
(b) It is management policy to have sufficient inventory in hand at the end of each month to meet sales demand in the next half month.
(c) Payables for materials and expenses are paid in the month after the purchases are made or the expenses incurred. Labour is paid in full by the end of each month.
(d) Expenses include a monthly depreciation charge of $2,000. (e) (i) 75% of sales are for cash.
(ii) 25% of sales are on one month's interest-free credit.
(f) The company will buy equipment for cash costing $18,000 in February and will pay a dividend of $20,000 in March. The opening cash balance at 1 February is $1,000.
Required
(a) Prepare an income statement for February and March. (b) Prepare a cash budget for February and March.