In this article, we are going to see how we can build up a cash budget using the receipts and payments account. We will start by looking at the cash budget for a new trading organisation, so that we can get a clear idea of the main principles. We will also see how the cash budget fits in with the budgeted profit and loss account and balance sheet. Later on we will see how we can build on our technique to develop cash budgets for existing businesses by incorporating data from the opening balance sheet.
The Basic process of preparing a cash budget
Linking with other budgets
The data that we use to create all our budgets must be consistent so that all our budgets are based on the same assumptions. We will find that much of the data for a cash budget can be found in a budgeted profit and loss account, if this has already been prepared. However, the key to accurate cash budgets is to remember that receipts and payments are based on when the receipts and payments occur, and therefore most of the figures in the budgeted profit and loss account will need analyzing or modifying.
When we receive or pay cash at a different time to the recording of the sale, purchase or expense, this is known as lagging. It is these lagged figures — based on the time of receipt or payment — that we will use in our cash budget.
For example, if credit sales of $10,000 were made in January, on two months’ credit, then the money would be received in March. Although the sale would be recorded in the profit and loss account in January, it must appear in the March column in the cash budget.
A cash budget will not show any non-cash items that appear in the budgeted profit and loss account — the most common example of this is depreciation. There are also items that will appear in the cash budget, but are not shown in the budgeted profit and loss account. These are capital items (purchase or disposal of fixed assets), disbursements like drawings and tax, and exceptional items like financing (funds from equity or loans).
The diagram below shows how the data in a simple cash budget links with the data used in other budgets.
We will now use a Case Study to show how a simple cash budget can be produced for a new business, using the sources of data shown in the diagram above.
First Trade: Simple Cash Budget
Jim First is planning to start a trading business. He has prepared the following budgeted profit and loss account for the initial four months trading.
Jim First: Budgeted Profit & Loss Account
Jim also provides you with following information regarding his plans:
- Sales are made on two months credit. The sales figures in the budgeted profit and loss account are based on monthly sales as follows:
- Purchases made in the first month must be paid for immediately. Subsequent purchases will be on one month’s credit. The purchases figure in the budgeted profit & loss account is made up as follow:
- Cash expenses are based on paying out $1,000 in each of the first four months of the business.
- Equipment is to be bought for $15,000 in the first month of the business. The depreciation shown in the budgeted profit and loss account is based on depreciating these fixed assets at 20% per year on a straight-line basis.
- Jim has $25,000 to invest in the business in month 1. The business has no opening cash balance.
- Jim wishes to withdraw $2,000 from the business in month 4.
Prepare a cash budget in receipts and payments format for the first four months trading of First Trade.
The cash budget is prepared in the following way:
- The capital invested is entered as a receipt in month 1.
- The receipts from sales are entered on the appropriate line, taking account of the two months’ credit by lagging the receipts by two months, i.e. sales for months 1 and 2 are received in months 3 and 4. Note that the sales made in months 3 and 4 do not appear on this cash budget as the money will not be received until months 5 and 6.
- The payments for purchases and expenses are entered into the appropriate lines, using the data on payment terms. Remember that the first month’s purchases are paid for in month 1 and subsequent purchases are given one month’s credit.
- The payments for fixed assets and drawings are entered as appropriate.
- The receipts and payments totals are completed, and each month’s cash flow is calculated (i.e. total receipts minus total payments).
- The bank balance brought forward for month 1 is inserted (here it is zero).
- The carried forward bank balance for each month is calculated in turn. This is based on the calculation for each month using the formula:
cash flow for month + bank balance brought forward = bank balance carried forward
The closing bank balance (bank balance carried forward) for one month is then entered as the opening bank balance for the following month (bank balance brought forward).
We can see from the cash budget that if everything goes according to plan, Jim’s business bank balance will be $3,000 in credit at the end of month 1, but will fall to an overdrawn balance of $2,000 by the end of month 4.
Jim would, therefore, need to arrange suitable finance if he wishes to follow this budget. He should also consider the impact of things not going according to plan. For example, sales may be lower than forecast and expenses may be higher. This ‘what-if’ planning process is called sensitivity analysis.
Linking cash budget with the budgeted Balance Sheet
Cash budget and master budget
A full set of budgets for an organization will include a budgeted balance sheet as at the end of the budget period, as well as a budgeted profit and loss account and cash budget.
The budgeted balance sheet is based on the same format as the historical balance sheet produced for Financial Accounting purposes, but is based in the future. It is a statement of the expected assets, liabilities and capital at the end of the budgeting period. Because this document will tie in with the other two main budgets, it will incorporate the profit generated in the budgeted profit and loss account, and the final cash or bank balance as predicted in the cash budget.
The budgeted profit and loss account and the budgeted balance sheet are together known as the master budget.
There are also a number of other subsidiary budgets that often have to be created in more complex businesses in order to build up sufficient information to create the master budget and the budgeted cash flow statement. Examples of these are the sales budget, the production budget, and the materials usage budget. You will have examined the use of these budgets if you have studied the unit ‘contributing to the planning and control of resources’.
cash budget and budgeted balance sheet
In order to understand fully how the cash budget works, we need to be able to create a budgeted balance sheet either in full, or in extract form. By creating a full budgeted balance sheet we can also check that the budgets that we have created link together properly and that the final result balances.
Of particular importance are the following links between the cash budget and the budgeted balance sheet at the end of the budget period.
- The debtors figure in the budgeted balance sheet will represent the credit sales made that have not yet been received in cash. These are typically the sales for the final period(s) where receipts do not appear in the cash budget.
- The cash/bank figure in the budgeted balance sheet will be taken directly from the final cash/bank balance in the cash budget. If this is a negative figure it will be recorded as an overdraft under current liabilities.
- The trade creditors figure in the budgeted balance sheet will represent the credit purchases (and possibly expenses) that were made in the budget period, but are unpaid at the period end. In a similar way to sales, these are typically the purchases or expenses for the final period(s) that do not appear in the cash budget.
We will now continue the previous Case Study to see how the budgeted balance sheet can be developed in practice.
First Trade – Preparing a Budgeted Balance Sheet
Jim First is planning to start a trading business (see above case study). He has prepared a budgeted profit and loss account for the initial four months trading that showed a budgeted profit of $3,000. A cash budget has also been prepared that shows an overdrawn bank balance of $2,000 at the end of month 4. The data shown in the above case study is also relevant.
Prepare a budgeted balance sheet as at the end of month 4.
The budgeted balance sheet is as follows, with notes showing how each figure was arrived at.
(1). The fixed assets were bought in month 1. They are valued at cost, less the depreciation as shown in the budgeted profit & loss account, since this is also the cumulative depreciation.
(2). The stock figure is the closing stock used in the budgeted profit & loss account.
(3). The debtors figure is made up of the sales for months 3 and 4 ($5,000 + $7,000). The proceeds of these sales will not have been received within the budget period, since the sales are made on 2 months’ credit.
(4). The trade creditors figure is the month 4 purchases that are not due to be paid until month 5.
(5). The bank overdraft is the final closing balance on the cash budget.
(6). The budgeted profit is as recorded on the budgeted profit & loss account.
(7). The budgeted drawings are as recorded in the cash budget.
Examine the above figures and notes carefully to ensure that you understand fully how the figures were arrived at. Note that the budgeted balance sheet should balance when the data is used consistently.