Rationale for preparing a cash budget

There are numerous reasons for preferring to prepare a cash flow budget. It allows a business to make management decisions concerned with their cash reserves or cash position. In the absence of monitoring imposed by the cash budgeting process, a manager or owner may be unaware of the actual cash flow through the business. At the end of the financial year or a business cycle, a string of monthly cash flows demonstrates just how much cash has come into the business and the pattern in which it is being used. Seasonal variations will be made clear. Besides, cash budgeting also allows a firm to evaluate and plan its capital requirements. It will help one evaluate whether the firm may need any short-term borrowing at any given point of time during the operations cycle. Long term borrowing assessment can also be made. Basically, it offers good management decision making.

There are three major elements needed for the creation of a cash budget:

Time Period: Ideally, the first decision one should make while preparing a cash budget is deciding the period of time for while the budget is applicable. This means, is the firm preparing the budget for the following three month, three months, six months or twelve months or some other span?

Cash Position: The amount of cash in hand at any point of time is depended on the nature of one’s business, the estimated level of accounts receivable and the probabilities of major opportunities or catastrophes that may require the firm to have ample reserves of cash. As such, the firm may even consider its cash reserves on the basis of sales in a certain number of days. The budgeting process helps them determine if they have enough cash reserves at the end of a certain period.

Estimated sales and expenditures: One fundamental purpose of cash budget is the estimation of all future cash receipts and cash expenses that may occur during the stipulated time period. However, the most important estimation is that of sales. Once sales levels are estimated, everything else can gradually fall into place.

Example

Projection of a 10 percent increase in sales will need several other accounts to be adjusted in the budget plan, like the raw materials, stock in progress, inventory and the cost of goods sold need to be suitable adjusted in sync with the increased sales. In addition, the individual also needs to consider any other addition needed in general expenses or selling or administrative expenses or whether the increased sales be adjusted to the current capacity. Furthermore, how will the payroll and overtime expenditure be affected by this increase in sales? Rather than simply increasing every input’s expense by 10 percent, serious consideration is need in some factors that may give result in economies of scale. In simpler words, perhaps the supplier may offer a discount or allowances on the increased quantity of items purchased or the increase in sales may be easily performed efficiently by the existing sales force. All these factors and more must be taken into consideration before preparation of the cash budget. Every type of expense, as displayed on the income statement, needs to be evaluated for its capability to increase or decrease. The estimates need to be based on one’s experience running the business and his goals for the business over time, on the basis of which the budget is being prepared.