Building a Cash Budget

Receipts

Why Forecast Receipts?

The broader field of cash flow forecasting is integral to ensuring organizational liquidity. Maintaining cash receipts over a given time frame enables organizations to have cash at hand in a predictable fashion, thus allowing them to reinvest in business operations to avoid the opportunity cost of having unused cash and cash receivables. Forecasting cash inflows and outflows in advance is a primary role of corporate financiers and accountants. It enables efficient use of existing assets to capture maximum competitive value in the marketplace.

Cash Receipts and Disbursements (R&D)

The direct method of projecting incoming cash flow is to understand the cash receipts and disbursements for the projected time period. 

Receipts

Receipts generally refer to the collection of accounts receivable, which are the payments of paying customers over time. They also refer to the returns on short-term investments and the sale of various assets. Other potential incoming cash flows also fall under receipts, which are worth noting on a case-by-case basis.

Disbursements

On the inverse side of receipts, disbursements are outgoing cash flows during a short-term business operation. These can quite accurately project accounts payable, payroll costs, dividend payments, interest payments, and other short-term alterations to existing cash flow. By comparing receipts with disbursements, the overall available cash flow can be derived.

How to Forecast Receipts

As with all forecasting, shorter-term forecasts are more certain than longer-term forecasts (in general). Short-term forecasts can be quite accurate, as the various accounts receivable, accounts payable, short-term investments, and short-term costs are often relatively established (contractually and operationally). In shorter-term situations, most forecasting is done through implementing what is known with the probability that these obligations will be met.

With longer-term forecasting, it can be useful to consider past averages over time. Larger organizations can look at their average cash receipts over the past few years and couple that with growth trajectories to project what level of cash inflow is likely over a given time frame. It's important to remember that forecasts are only estimations, and organizations should know the error margins involved.

Normal Distributions When creating a forecast utilizing past data, it is important to recognize the degree of certainty that can be reasonably applied to this forecast. By creating a normalized distribution and identifying the percentage likelihood of a certain outcome, organizations can better prepare for all likely outcomes.

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Payments

Why is cash flow forecasting important? If a business runs out of cash and cannot obtain new financing, it will become insolvent. It is no excuse for management to claim that they didn't see a cash flow crisis coming. So, in business, "cash is king."

Cash Payments

Cash payments describe cash flowing out of a business. They can result from operating activities, investment activities, or financing activities.

Generally speaking, normal operating activities refer to the cash effects of transactions involving revenues and expenses that impact net income. Cash payments must be made for relevant expenses. Typical payments include those to:

• Suppliers for inventory or other supplies
  
  
• Employees for wages
  
  
• Government for taxes
  
  
• Lenders for interest on borrowed money

Typical cash outflows from investing activities include:

• Purchase of capital assets
  
  
• Purchase of bonds/notes or shares of other entities
  
  
• Loans to other entities

Typical cash outflows from financing activities include:

• Payments of dividends to the company's shareholders
  
  
• Redemption (repurchase) of the company's shares
  
  
• Repayment of principal and interest on the company's bonds or notes
  
  

Sample Paystub This is an example of a paystub to an employee, one of the most significant cash disbursements necessary for a company.

Disbursement Cycle

It is important to consider the cash disbursement cycle when analyzing cash payments. This is the total time between when an obligation occurs and when the payment clears the bank. A company's objective regarding the cash disbursement cycle should be to increase the cycle time or delay making payments until they are due. A firm may delay payments by:

1. Mailing checks from locations not close to customers. This will increase the mail time, or mail float, within the disbursement cycle.
   
   
2. Disbursing checks from a remote bank. This will increase the time required for the payment to clear the bank.
   
   
3. Purchasing with credit cards requires a much longer processing time. You will receive a bill at the end of the month, payable in 30 days, which creates more processing time or processing float.

Therefore, when a company manages cash flow cycles, it tries to control three types of float times:

1. Mail float, or the time spent for a payment in the mail.
   
   
2. Clearance float, or the time spent for a payment to clear the bank.
   
   
3. Processing float, or the time required to process cash flow transactions.

The Forecast Budget

Understanding cash and liquidity needs is critical for organizations to capture opportunities and ensure all profitable processes are funded.

The Purpose of Forecasting

Financial planning is a critical financial tool for funding profitable operations and dividing existing organizational assets optimally to pursue revenue maximization. The forecast budget will project what cash flows will be needed for each organizational process and how those cash flows will be utilized over a fixed period of time. Suppose there is a problem with liquidity during an operational period. In that case, it can result in huge opportunity costs (i.e., an organization cannot capture an existing opportunity in the market).

How to Forecast

There are several ways to approach financial forecasting for a cash budget. A cash budget is all about liquidity, and forecasting what available liquidity will be required over a given period is the primary input for forecasting budgets. There are several different approaches, though most of them rely on understanding the inputs required for various business operations.

The inputs include the following cash obligations during regular operations:

• Payroll
  
  
• Payment of accounts payable
  
  
• Dividends 
  
  
• Interest on debt
  
  
• Sourcing raw materials

It is also worth noting that various cash inflows will occur during a given time period. For example, accounts receivable, short-term financing options, and various other sources of income may directly convert into usable capital. However, budgeting should either build these into the current budget forecast or utilize them during the next calculation of budgetary requirements.

The Direct Method

At their simplest, cash flow forecasting and budgeting can be computed directly based on fixed information over a short time frame. This works particularly well for consistent businesses that run routine operations with limited risk-taking and diversification.

The Adjusted Net Income Method (ANI)

The adjusted net income method starts by calculating operating income (EBIT or EBITDA) and adding/subtracting short-term changes in the balance sheet, such as those that occur to inventories, payables, receivables, and other short-term. This gives the organization some idea of what short-term cash flows are typically required during an operational period.

Pro-forma Balance Sheet

Pro formas are financial statements created in advance as a projection or estimation of what that document will look like after the financial period is finished. By using a pro-forma balance sheet for the upcoming period being budgeted for, the short-term assets and liabilities (if accurately projected) will underline the amount of cash that should be set aside for budgeting purposes.

Accrual Reversal Method

A third option for projecting cash budgets is accrual reversal. This process relies on statistical distributions, reversing large accruals, and projecting cash effects via algorithms. This method requires a lot of data and statistical skill and is best utilized for mid-term forecasting (unlike the direct method, which is much better for a shorter time frame). The advantage of this method is that it is often accurate to the day or week, enabling high accuracy.

Budget Forecast Example This chart demonstrates a budget forecast based on the reality of what actually occurred. Budgeting is an estimation, often adjusted over time.