Building a Cash Budget

This section emphasizes the importance of cash and good cash management to a business. You will learn how to analyze cash inflows and outflows to better forecast a firm's cash budget. When you have completed this section, you will be able to describe the direct and indirect methods of cash flow forecasting. Cash flow is often used as a determinant providing financing to firms. A cash budget is used along with pro forma financial statements to assess the result of financial transactions.

In order to determine the optical cash balance for a company, cash flows are estimated and a forecast is prepared.


LEARNING OBJECTIVE

  • Apply the appropriate cash flow forecasting method given a company's needs


KEY POINTS

    • Cash is the most liquid of assets, and it represents the lifeblood for growth and investment.
    • If a business runs out of cash and is not able to obtain new financing, it will become insolvent.
    • In order to generate cash, a company manages activities. such as billing customers as quickly as possible, disbursing payments only when they come due, collecting cash on overdue accounts, and investing idle cash.
    • What a cash flow forecast does is estimate cash inputs and outputs over a period of time, usually at least 90 days, in order to give you assurance that your business will have the cash necessary to meet its obligations to others.

TERM

  • insolvent

    Unable to pay one's bills as they fall due.


Building a Cash Budget

There is a saying in business that "cash is king". Cash is the most liquid of assets, and it represents the lifeblood for growth and investment, particularly for start-ups and small enterprises. One of the worst things that can happen to a company is to run short of cash unexpectedly. This can make it difficult to pay suppliers and employees without scurrying around to raise needed cash quickly. When cash must be raised quickly, it is often a difficult and expensive task. If a business runs out of cash and is not able to obtain new financing, it will become insolvent. In order to generate cash, businesses must efficiently and effectively manage the activities that provide cash. These activities include billing customers as quickly as possible, disbursing payments only when they come due, collecting cash on overdue accounts, and investing idle cash. Managing cash flow involves several objectives:

  • Accelerating cash inflows wherever possible.
  • Delaying cash outflows until they come due.
  • Investing surplus cash to earn a rate of return.
  • Borrowing cash at the best possible terms.
  • Maintaining an optimal level of cash that is neither excessive nor deficient.

This last objective is of vital importance. If a business hold too much cash, it loses the opportunity to earn a return on idle cash. If it holds too little cash, it runs the risk of not making timely payments to suppliers, banks, and other parties. The optimal cash balance is determined by looking at the four reasons for holding cash:

  • Transactions: A company must hold enough cash to cover their outstanding payments or transactions.
  • Precautionary measures: A company needs to maintain cash for unexpected disbursements.
  • Speculative measures: If a company is anticipating making an investment, it will hold a speculative amount to take advantage of opportunities in the marketplace.
  • Financial measures: In order to acquire assets, retire debt, or meet some major event, a company must accumulate and hold a certain amount of cash.

The Cash Flow Forecast

One of the best ways to determine the optimal cash balance is to fully understand cash flow patterns. This requires that we plot cash flows and prepare a forecast. What a cash flow forecast does is estimate cash inputs and outputs over a period of time, usually at least 90 days, in order to give you assurance that your business will have the cash necessary to meet its obligations to others. Think of the cash flow forecast as an "early warning system. " A cash flow forecast also answers several questions, such as how long can we invest idle cash, when will it be necessary to borrow cash, and when can we purchase new capital assets? A typical cash flow forecast will include: cash on hand, expected receipts, and expected disbursements.


Forecast Example: This is an example of a cash flow forecast.


Direct and Indirect Methods

The direct method of cash flow forecasting schedules the company's cash receipts and disbursements (R&D). This direct R&D method is best suited to the short-term forecasting horizon of 30 days or so because this is the period for which actual, as opposed to projected, data is available. Three indirect methods are based on the company's projected income statements and balance sheets.

  1. The adjusted net income method starts with operating income and adds or subtracts changes in balance sheet accounts, such as receivables, payables, and inventories to project cash flow.
  2. The pro-forma balance sheet method looks straight at the projected book cash account; if all the other balance sheet accounts have been correctly forecast, cash will be correct, too.
  3. The accrual reversal method is similar to the adjusted net income method, but instead of using projected balance sheet accounts, large accruals are reversed and cash effects are calculated based upon statistical distributions and algorithms. This allows the forecasting period to be weekly or even daily.

The adjusted net income and pro-forma balance sheet methods are best suited for medium-term and long-term forecasting horizons. Both need to be adjusted for the difference between book cash and bank balances, which are often significantly different. The accrual reversal method is more complicated and best suited for medium-term forecasting. Consider the following points when preparing forecasts

  • Prepare forecasts for shorter periods of time (weekly or daily) if cash flows are tight.
  • Use available data as much as possible.
  • If necessary, prepare two forecasts: an early warning forecast for longer periods of time and a targeted forecast for shorter periods.
  • Forecasting is extremely difficult in periods of rapid growth.