5.4 Cash Budgets & Cash Flow Forecasting

Cash is the ultimate liquidity constraint of any commercial enterprise. While an organization can survive for extended periods while reporting accounting losses, it cannot survive for a single day if it runs out of cash and cannot meet its statutory liabilities, employee payroll, or supplier commitments as they fall due.

A cash budget is a detailed estimate of cash receipts and payments over a defined future period, showing the resulting projected cash balance. The cash budget is one of the most critical operational schedules within the Master Budget, serving as an early-warning radar for liquidity deficits and cash surpluses.

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Accounting Profit vs. Cash Solvency: The Danger of Overtrading

A fundamental tenet of financial and management accounting is that profit does not equal cash:

• Profitability (Accrual Concept): Under International Financial Reporting Standards (IFRS) and accrual accounting, revenues are recognized when performance obligations are satisfied (invoiced), and expenses are recognized when incurred, regardless of when cash physically moves.
• Solvency (Cash Flow Concept): Solvency depends strictly on liquid cash balances available to discharge immediate legal liabilities.

Why Profitable Companies Fail: The Overtrading Trap

Rapidly growing companies frequently plunge into insolvency through overtrading (also termed under-capitalization):

1. The business successfully secures massive new customer sales orders, generating large projected accounting profits.
2. To fulfill these orders, the business must immediately disburse cash to buy raw materials, pay shop-floor wages, and fund delivery logistics.
3. The commercial customers demand 30 to 60 days credit; trade receivables balloon on the balance sheet, but no cash has arrived.
4. Meanwhile, trade suppliers demand payment, workers demand weekly wages, and tax authorities demand corporation tax.
5. The business exhausts its liquid cash and credit lines. Despite reporting record profits on paper, the company becomes technically insolvent and is forced into administration.

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Structure and Components of the Cash Budget

A standard cash budget classifies cash flows into chronological monthly or quarterly columns across four distinct operational streams:

1. Operating Cash Receipts:
   • Cash sales collected immediately.
   • Collections from credit customers (trade receivables) reflecting specific credit payment lag patterns.
   • Sundry operating receipts (scrap material sales, licensing royalties received).
2. Operating Cash Disbursements:
   • Payments to trade payables for raw material purchases.
   • Cash disbursements for direct labour wages and supervisory salaries.
   • Cash payments for factory variable overheads, administrative rent, utilities, and sales commissions.
3. Capital Transactions:
   • Cash outflows for purchasing property, plant, machinery, or IT infrastructure (Capital Expenditure).
   • Cash inflows from the sale or disposal of obsolete non-current assets (gross cash proceeds received).
4. Taxation and Financing:
   • Corporation tax payments (typically paid in lump-sum quarterly installments according to statutory tax calendars).
   • Dividend payments distributed to equity shareholders.
   • Cash inflows from new bank loans or equity share issues.
   • Cash outflows for loan interest payments and loan principal repayments.

The Balancing Mechanism

$$\text{Net Cash Flow for Period} = \text{Total Cash Receipts} - \text{Total Cash Disbursements}$$ $$\text{Closing Cash Balance} = \text{Opening Cash Balance} + \text{Net Cash Flow for Period}$$

The closing cash balance of the current month automatically becomes the opening cash balance of the subsequent month.

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Absolute Exclusion of Non-Cash Accounting Items

A common exam point is the identification of non-cash accounting adjustments. Because the cash budget measures only the physical movement of currency into and out of enterprise bank accounts, all non-cash accounting entries must be strictly excluded:

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Modelling Cash Flow Timing: Debtor Lags and Settlement Discounts

In commercial practice, credit customers do not pay on the day of delivery. Management accountants model customer collection patterns using historical payment profiles:

Debtor Payment Lag Structure

Assume an enterprise generates credit sales where historical data indicates:

• 25% of customers pay in the month of sale, capturing a 2% prompt settlement cash discount.
• 50% pay in the month following the sale (Month $M+1$).
• 23% pay in the second month following the sale (Month $M+2$).
• 2% of credit sales represent irrecoverable bad debts that are never collected.

$$\text{Cash Collected in Month } M = (\text{Month } M \text{ Credit Sales} \times 25\% \times 0.98) + (\text{Month } M-1 \text{ Sales} \times 50\%) + (\text{Month } M-2 \text{ Sales} \times 23\%)$$

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Comprehensive Worked Multi-Month Cash Budget: Meridian Technologies Ltd

Meridian Technologies Ltd is preparing its quarterly cash budget for April, May, and June. The management accountant compiles the following operating forecasts:

1. Sales Forecasts (Actual and Projected):

• February (Actual): $100,000
• March (Actual): $120,000
• April (Forecast): $140,000
• May (Forecast): $160,000
• June (Forecast): $180,000

2. Customer Credit Terms and Payment Patterns:

• 25% of total sales are cash sales, collected immediately in the month of sale.
• The remaining 75% are credit sales, collected as follows:
  • 60% collected in the month following the sale ($M+1$).
  • 38% collected in the second month following the sale ($M+2$).
  • 2% are irrecoverable bad debts.

3. Material Purchases and Supplier Credit Terms:

• Raw material purchases: March (Actual) $50,000; April $60,000; May $70,000; June $75,000.
• Trade suppliers extend one month of credit (all purchases are paid in full in Month $M+1$).

4. Payroll and Operating Expenses:

• Direct wages: April $30,000; May $34,000; June $36,000 (paid in the month incurred).
• Variable overheads: April $15,000; May $18,000; June $20,000 (paid in the month incurred).
• Fixed overheads: $17,000 per month, which includes $5,000 monthly plant depreciation. The balance ($12,000 cash overhead) is paid in the month incurred.

5. Capital Transactions and Financing:

• In April, the company sells an obsolete delivery van for $8,000 cash (carrying book value was $6,000; the $2,000 profit on disposal is an accounting non-cash item).
• In May, the company purchases a high-precision CNC milling machine for $50,000 cash.
• In June, an interim corporation tax installment of $25,000 is due for payment.
• Opening bank cash balance at 1 April is $15,000.

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Working 1: Schedule of Customer Cash Collections

First, break down sales into cash sales (25%) and credit sales (75%):

• February: Credit Sales = $75\% \times \text{\textdollar}100,000 = \text{\textdollar}75,000$
• March: Credit Sales = $75\% \times \text{\textdollar}120,000 = \text{\textdollar}90,000$
• April: Cash Sales = $25\% \times \text{\textdollar}140,000 = \text{\textdollar}35,000$; Credit Sales = $75\% \times \text{\textdollar}140,000 = \text{\textdollar}105,000$
• May: Cash Sales = $25\% \times \text{\textdollar}160,000 = \text{\textdollar}40,000$; Credit Sales = $75\% \times \text{\textdollar}160,000 = \text{\textdollar}120,000$
• June: Cash Sales = $25\% \times \text{\textdollar}180,000 = \text{\textdollar}45,000$; Credit Sales = $75\% \times \text{\textdollar}180,000 = \text{\textdollar}135,000$

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Working 2: Schedule of Cash Disbursements

• Payments for Purchases (Month $M+1$):
  • April pays March purchases: $50,000
  • May pays April purchases: $60,000
  • June pays May purchases: $70,000
• Cash Fixed Overheads:
  • Fixed overheads = $\text{\textdollar}17,000 - \text{\textdollar}5,000 \text{ (depreciation)} = \text{\textdollar}12,000$ per month.

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The Completed Master Cash Budget Statement

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Managing Cash Deficits and Surpluses

The cash budget reveals that Meridian Technologies operates with a comfortable cash surplus of $33,500 at the end of April, but plunges into an overdraft deficit of –$3,300 in May, which deepens to –$9,400 in June due to the capital equipment purchase and tax liability.

Management must adopt proactive strategies based on whether cash shortfalls or surpluses are short-term or long-term: