Cash Budgets and the Master Budget

A business can be profitable and still run out of money. Profit is earned when a sale is made. Cash arrives when the customer pays, perhaps two months later, while wages, suppliers and tax must be paid on fixed dates. The cash budget is the plan that shows, month by month, whether the cash will be there when it is needed.

This topic covers the cash budget and cash flow forecast, how to work out cash received from credit sales and cash paid to suppliers, and how to put the plan together in a full cash budget. It then explains the master budget: the budgeted statement of profit or loss, the budgeted statement of financial position, and the cash budget, with the receivables, inventory and payables figures that link them.

The syllabus asks for a simple cash budget without cash discounts and a simple master budget, which is the standard here.

The cash budget

A cash budget is a detailed plan of cash receipts and cash payments in a planning period, divided into shorter periods. It is usually prepared monthly or quarterly as part of the annual master budget, but many businesses also prepare weekly or even daily cash plans for short-term control.

Uses of a cash budget

• Ensures liquidity: cash is available for day-to-day expenses and obligations when due.
• Forecasts surpluses and shortages: so that surplus cash can be invested and shortages financed in good time.
• Supports decisions: about borrowing, lending or delaying spending.
• Plans financing needs: when external funds, such as a loan or overdraft, will be needed and how much.
• Improves control: actual cash flows are compared with the plan and variances investigated.
• Coordinates activities: spending plans are matched with expected income and priorities.
• Facilitates short-term planning: it complements the master budget by showing timing and availability of cash.
• Enhances financial discipline: clear cash targets and limits promote accountability.

Cash flow forecasts

A cash flow forecast also estimates future cash needs or surpluses. The difference is that a cash budget is part of the formal, structured annual budget, while a forecast is often prepared on a rolling basis throughout the year to give up-to-date insight into short-term liquidity. Its objectives:

• ensure liquidity so that suppliers, wages, taxes and other expenses are paid on time;
• identify surpluses and shortages in good time;
• support financial planning, such as when to expand, delay purchases or seek funding;
• communicate with external parties, such as banks and investors, to show the business can meet its obligations;
• monitor and control cash by comparing forecast with actual, improving accuracy over time; and
• aid budgetary control by giving continuous feedback on the cash position.

Format of a cash budget

A cash budget is a table. Each column is a time period (a month, for example). Rows list the cash receipts, then the cash payments. The net cash flow for the period is added to the opening balance to give the closing balance, which becomes the next period’s opening balance.

Rules for what to include

• Include all cash items: cash from issuing shares, interest or dividends received, interest paid (only in the month paid), tax paid (only in the month paid) and dividends paid.
• Record each item in the month it is expected to occur, not when it is earned or incurred.
• Non-cash items, such as depreciation, are excluded. They reduce profit but do not use cash.
• Buying a non-current asset is a cash payment in the month it is paid, but it does not appear in the profit statement.

Receipts from credit sales

One of the harder parts of a cash budget is working out when customers pay. A question gives a collection pattern, and this has to be applied to each month’s sales to find which month the cash arrives. Bad debts reduce the cash collected. You may need sales figures for earlier months, or have to estimate sales for several periods, before you can find a month’s receipts.

Example. Monthly sales (₦000) are: October 80, November 90, December 100, January 120, February 130, March 140. Customers pay as follows: 20% in the month of sale, 50% in the next month, 28% in the second month after the sale, and 2% become bad debts (never collected).

Each cell is a percentage of the sales for the month in brackets. For January, the 2% bad debt on October sales (₦1,600) was never collected and does not appear. Note that the January receipts (₦99,200) are less than the January sales (₦120,000), because of the credit period.

Payments to suppliers

Payments to suppliers are worked out in a similar way, but they are based on purchases, not sales, and finding purchases may require a few steps.

1. Find the cost of sales for each month, from sales and the gross margin.
2. Find the closing stock policy for each month.
3. Purchases = cost of sales + closing stock − opening stock.
4. Apply the payment pattern to purchases.

Bad debts are irrelevant here: goods bought must be paid for whether or not customers pay.

Example. Using the sales above (and April sales of ₦150,000), cost of sales is 60% of sales. The company holds closing stock equal to 15% of the next month’s cost of sales. It pays 40% of purchases in the month of purchase and 60% in the next month.

A shortcut for closing stock: 15% of the next month’s cost of sales. Here the January cost of sales is 72, so the December closing stock is 15% × 72 = 10.8.

A full cash budget

Other items are added: wages paid monthly, overheads, rent paid in advance, new equipment, dividends and tax. The same company has an opening cash balance of ₦30,000 at 1 January. Wages are ₦25,000 a month. Overheads are ₦20,000 a month including ₦8,000 of depreciation. Rent of ₦18,000 for the quarter is paid in January. Equipment costing ₦40,000 is bought and paid for in February. A dividend of ₦30,000 and tax of ₦20,000 are paid in March.

Interpretation. The company is profitable on paper, but it runs out of cash in February and by March needs about ₦72,000 of finance. Reasons: customers pay slowly (only 20% in the month of sale), while wages, rent and the new equipment are paid at once; the dividend and tax fall in March.

Management should arrange an overdraft facility of at least ₦75,000, or delay the equipment or the dividend, or ask customers to pay faster. This shows what the cash budget is for.

The master budget

The master budget is the final approved budget that summarises the plan for the period. It is normally presented as three statements: a budgeted statement of profit or loss, a budgeted statement of financial position at the end of the year, and a cash budget (or cash flow forecast). It combines all the functional budgets into one plan.

Budgeted statement of profit or loss

It can be built from the functional budgets, as in the previous topic, with depreciation and other expenses added. Or it can be built from ratios that relate each item to sales. For example, if a firm budgets sales of ₦2,000,000, a gross profit margin of 40%, administration expenses of 12% of sales, distribution costs of 8%, depreciation of 5% and finance costs of 2%:

Budgeted statement of financial position

Building it needs the closing position for each asset and liability. The key figures are closing receivables, inventory and payables. They can be found from:

• the budgeted receivables collection period (credit given to customers);
• the budgeted inventory holding period (time stock is held before use or sale); and
• the budgeted payables period (average time taken to pay suppliers),

or from the workings used for the cash budget.

Payables are based on purchases, not cost of sales. If the inventory level is changing, purchases must first be found: purchases = cost of sales + closing inventory − opening inventory.

Receivables from cash budget workings. If a customer pays 30% in the month after sale and 70% in the second month. November sales are ₦120,000 and December sales (the last month of the year) ₦150,000, then receivables at 31 December are: from November, the 70% not yet collected = ₦84,000; from December, all ₦150,000. Closing receivables = ₦234,000. Sales made before the year end but collected after it are receivables.

A complete master budget

Zaria Trading Ltd has this opening position at 1 January: non-current assets ₦700,000 (carrying amount); inventory ₦200,000; receivables ₦250,000; cash ₦120,000; payables ₦240,000. Share capital is ₦800,000 and retained profit ₦230,000 (net assets ₦1,030,000). Budget for the year: sales ₦2,400,000; gross margin 35%; operating expenses excluding depreciation ₦480,000; depreciation ₦100,000; no asset purchases; no dividend. Receivables are 1.5 months of sales, inventory is 3 months of cost of sales, and payables are 2 months of purchases at year end.

1. Profit.
   Cost of sales = 65% × ₦2,400,000 = ₦1,560,000.
   Gross profit = ₦840,000.
   Less expenses ₦480,000 and depreciation ₦100,000 = ₦260,000.
2. Closing inventory.
   ₦1,560,000 × 3 ÷ 12 = ₦390,000.
3. Purchases.
   ₦1,560,000 + ₦390,000 − ₦200,000 = ₦1,750,000.
   Closing payables = ₦1,750,000 × 2 ÷ 12 = ₦291,667.
4. Closing receivables.
   ₦2,400,000 × 1.5 ÷ 12 = ₦300,000.
5. Non-current assets.
   ₦700,000 − ₦100,000 = ₦600,000.
6. Equity.
   ₦800,000 + ₦230,000 + ₦260,000 = ₦1,290,000.
7. Cash (balancing figure)
   equity ₦1,290,000 − (non-current assets ₦600,000 + inventory ₦390,000 + receivables ₦300,000) + payables ₦291,667 = ₦291,667.

Check on the cash figure. Opening cash ₦120,000 + cash from customers (opening receivables ₦250,000 + sales ₦2,400,000 − closing receivables ₦300,000 = ₦2,350,000) − payments to suppliers (opening payables ₦240,000 + purchases ₦1,750,000 − closing payables ₦291,667 = ₦1,698,333) − expenses ₦480,000 = ₦291,667. ✓ The cash budget and the statement of financial position agree.

The ideas in more depth

Profit and cash are different

Profit is revenue less expenses on the accruals basis. Cash is the actual movement of money. The differences are depreciation (not cash), credit sales and purchases (timing), stock changes (cash spent but not yet an expense), capital expenditure (cash but not an expense), and tax and dividends (cash but not part of operating profit).

A growing business often needs more cash than profit because it builds stock and receivables ahead of sales.

What to do about a forecast deficit

What to do about a surplus

Surplus cash may be invested short term, used to pay down borrowing, used to prepay suppliers for a discount, or kept as a reserve. Surplus cash earns little if left idle.

Cash budget compared with the profit budget

A budget that shows a healthy profit but a negative cash balance in some months is a warning. Banks examining a loan request often look at the cash budget first, because it shows whether the firm can pay its debts as they fall due.

Cash budget with a rolling update

A forecast can be updated each month: replace the month that has passed with actual figures and add a new month at the end, so the forecast always looks a fixed number of months ahead. This is why forecasts are usually more current than the formal cash budget.

Worked example: a cash budget

1. Receipts.
   January: 10% × 240 = 24; 60% × 220 = 132; 28% × 200 = 56; total 212.0.
   February: 10% × 260 = 26; 60% × 240 = 144; 28% × 220 = 61.6; total 231.6.
   March: 10% × 280 = 28; 60% × 260 = 156; 28% × 240 = 67.2; total 251.2.
2. Payments to suppliers. January pays for December: 150. February pays for January: 160. March pays for February: 170.
3. Overheads (cash).
   25 − 5 depreciation = 20 a month.
4. January.
   Payments = 150 + 40 + 20 = 210.
   Net = 212.0 − 210 = +2.0.
   Closing = 50 + 2.0 = 52.0.
5. February.
   Payments = 160 + 40 + 20 + 90 = 310.
   Net = 231.6 − 310 = −78.4.
   Closing = 52.0 − 78.4 = (26.4).
6. March.
   Payments = 170 + 40 + 20 = 230.
   Net = 251.2 − 230 = +21.2.
   Closing = −26.4 + 21.2 = (5.2).
7. Comment. The business has an overdraft of ₦26,400 at the end of February, caused by the equipment purchase. It would need a facility of about ₦30,000 and should consider phasing the purchase.

Common mistakes in the exam

• Including depreciation as a cash payment.
• Putting receipts and payments in the month of sale or purchase instead of the month of cash movement.
• Applying the wrong percentage to the wrong month’s sales.
• Including bad debts as cash receipts, or deducting bad debts from payments to suppliers.
• Forgetting the opening balance, or not carrying the closing balance forward.
• Using cost of sales instead of purchases to find payments to suppliers.
• Leaving out capital expenditure, tax or dividends.
• In the master budget, finding payables from cost of sales instead of from purchases.
• Not checking that the cash balancing figure in the statement of financial position agrees with the cash budget.

Quick revision

• Cash budget: receipts and payments by period, opening and closing balance. Cash items only. Exclude depreciation.
• Cash flow forecast: similar, often rolling and shorter term. Cash budget is part of the formal annual budget.
• Receipts from credit sales: apply the collection pattern to monthly sales. Payments to suppliers: find purchases (cost of sales + closing − opening stock), then apply the payment pattern.
• Master budget: budgeted profit or loss, budgeted statement of financial position, cash budget.
• Closing receivables = sales × credit months ÷ 12.
  Inventory = cost of sales × months held ÷ 12.
  Payables = purchases × credit months ÷ 12.
  Cash is the balancing figure.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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