Financial budgets
Learning outcome statements
The learning outcome statements relevant for this section are:
- define the purposes of a cash budget and describe the relationship between the cash budget and all other budgets
- demonstrate an understanding of the relationship between credit policies and purchasing (payables) policies and the cash budget
- prepare a cash budget
Budgeted financial statements
After the operating budget (ending with the budgeted income statement) is complete, the financial budget is prepared: the cash budget, the budgeted balance sheet, and the budgeted statement of cash flows. This section covers the latter two:
- the budgeted balance sheet and
- the budgeted statement of cash flows.
These statements complete the financial picture of the organization’s expected position by the end of the budget period.
Budgeted balance sheet
The budgeted balance sheet projects the company’s financial position by estimating assets, liabilities, and equity balances at the end of the period. This statement is based on data from previous budgets, such as inventory levels from the production budget and accounts receivable/payable projections from the sales and purchases budgets.
In practice, this statement is essential for evaluating the company’s financial stability and liquidity at the end of the budgeting period.
Budgeted statement of cash flows
This statement projects cash inflows and outflows throughout the budget period. It’s often critical for cash management, helping organizations anticipate funding needs or surpluses, and it differs from the cash budget, as described below.
The cash budget
The cash budget is a key component of financial budgets and serves several essential purposes:
- Ensuring liquidity: The cash budget forecasts cash inflows and outflows over short-term periods, often monthly, ensuring that the company has adequate cash to meet operational and financial obligations as they arise.
- Supporting cash flow planning: It helps to anticipate cash surpluses and deficits, allowing management to plan financing actions, such as borrowing or investing excess funds.
- Informing decision-making: By monitoring cash requirements, the cash budget informs strategic decisions on capital investments, expense management, and working capital adjustments.
Cash budget vs. budgeted statement of cash flows
While both the cash budget and the budgeted statement of cash flows focus on projecting cash flow, they serve different purposes, are structured differently, and are based on distinct components.
Cash budget
Prepared first, the cash budget projects short-term cash inflows and cash outflows to manage immediate liquidity and ensure that funds are available to meet operational, capital, and financial needs on a monthly or quarterly basis. The components of the cash budget are the following:
- Cash receipts: Includes all expected cash inflows, primarily from sales, but also from other sources such as interest income or the sale of assets. Sales-related cash receipts are influenced by credit policies and collection patterns.
- Cash disbursements: All planned cash outflows, including payments for direct materials, labor, overhead costs, selling and administrative expenses, capital expenditures, and other operating costs. Payments align with purchasing policies, which determine timing and amounts for cash outflows.
- Financing section: Loan proceeds and loan repayments (including interest) are recorded here, not in cash receipts. If there is a projected cash deficit, this section outlines planned borrowings, repayments, or financing activities to cover the shortfall. Conversely, if there is a cash surplus, it may include planned investments of excess cash or debt repayments.
The example below builds a complete February cash budget, from collections and disbursements through the financing decision needed to maintain the minimum cash balance.
Example: Preparing a cash budget
Buchanan Co. is preparing its cash budget for February. Its beginning cash balance on February 1 is $15,000, and management wants to maintain a minimum cash balance of $20,000 at all times.
Cash collections: Buchanan expects credit sales of $80,000 in January and $100,000 in February. Based on its collection history, 60% of a month’s credit sales are collected in the month of sale, and the remaining 40% are collected in the following month.
- February sales collected in February: 60% × $100,000 = $60,000
- January sales collected in February: 40% × $80,000 = $32,000
- Total February cash collections: $60,000 + $32,000 = $92,000
Cash disbursements: Buchanan purchases $50,000 of direct materials in January and $70,000 in February, paying 50% of a month’s purchases in the month of purchase and the remaining 50% in the following month. February also requires $40,000 of cash payments for direct labor, overhead, and selling and administrative expenses (depreciation is excluded because it isn’t a cash outflow).
- February purchases paid in February: 50% × $70,000 = $35,000
- January purchases paid in February: 50% × $50,000 = $25,000
- Total payments for purchases: $35,000 + $25,000 = $60,000
- Total February disbursements: $60,000 + $40,000 = $100,000
Combining the pieces: compute the cash available before financing, compare it to the minimum balance, and borrow to cover any shortfall.
- Beginning cash balance: $15,000
- Plus cash collections: $92,000
- Cash available before financing: $15,000 + $92,000 = $107,000
- Less total disbursements: $100,000
- Cash balance before financing: $107,000 - $100,000 = $7,000
- Minimum cash balance required: $20,000
- Deficiency (minimum balance less cash available): $20,000 - $7,000 = $13,000
Answer: Buchanan must borrow $13,000 in February to meet its $20,000 minimum cash balance, ending the month with cash of $7,000 + $13,000 = $20,000.
Budgeted statement of cash flows
Provides a comprehensive annual view of projected cash movements, structured according to US GAAP financial reporting format. It is more focused on long-term planning and financial statement alignment than on managing immediate cash needs. The components of the budgeted statement of cash flows are as follows:
- Operating activities: This section includes cash flows from core business operations, such as cash receipts from customers and cash payments for operating expenses. It reflects the net cash generated from day-to-day activities.
- Investing activities: This section details cash flows related to investment in or sale of long-term assets, such as property, equipment, or securities. For example, cash outflows for purchasing new machinery or inflows from selling an asset are recorded here.
- Financing activities: This section includes cash flows related to borrowing and repaying debt, issuing equity, and distributing dividends. It reflects how the company’s financing strategy impacts cash flow, whether through new financing, debt repayment, or shareholder payouts.
Relationship of the cash budget with other budgets
The cash budget consolidates inputs from multiple operational and financial budgets to project cash requirements accurately. Key relationships include:
- Sales and collections: The sales budget informs projected cash inflows, considering the timing of collections from credit sales. Delayed collections impact cash flow planning and can require adjustments in financing or cash reserves.
- Direct materials, direct labor, overhead, and selling and administrative budgets: These budgets outline anticipated expenses for purchasing materials, paying labor, covering overhead, and covering selling and administrative costs. Since these are often cash outflows, they feed into the cash budget, highlighting timing and amounts of expected payments.
- Capital expenditures: Planned asset purchases, such as equipment or property, represent significant cash outflows. Including these in the cash budget helps management plan for financing needs or adjust spending.
- Feeding the budgeted balance sheet and statement of cash flows: The cash budget’s ending cash balance, together with the projected accounts receivable and accounts payable balances from the sales and purchases budgets, carries forward into the budgeted balance sheet. Any planned borrowings or repayments also flow into the financing section of the budgeted statement of cash flows and signal when outside financing will be needed.
Understanding the impact of credit policies and purchasing policies
Credit policies (related to sales) and purchasing policies (related to payables) directly affect cash flow and are integral to preparing a realistic cash budget:
Credit policies
Credit terms determine how quickly customers are expected to pay. For example, if a company offers net 30 terms, payment is due within 30 days of the sale, so collection typically lags the sale by up to a month (longer when customers pay late), and the cash budget must reflect that lag. Adjustments to credit terms, such as offering discounts for early payments, can accelerate cash collections but might reduce revenue slightly.
Purchasing policies
Payment terms with suppliers affect cash outflows. Favorable payment terms, such as net 60 days, delay cash outflows, preserving cash for other needs. However, paying early might allow the company to take advantage of supplier discounts, impacting cash management strategies.
Effective alignment of credit and purchasing policies with cash budget planning helps companies optimize cash flow and liquidity, minimizing reliance on external financing.