Cash budgets and forecasts - Cash flow forecasting technique...

Learning Outcomes

After reading this article, you will be able to explain the purpose of cash budgets and forecasts, select appropriate cash flow forecasting techniques, critically evaluate the impact of key assumptions, and apply scenario analysis in practical ACCA Financial Management exam tasks.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand the methods and challenges involved in producing cash budgets and forecasts. In particular, you must be comfortable with:

• The definition and purpose of cash budgets and forecasts within business planning and control
• Key techniques used to forecast cash flows, including receipts and payments analysis and adjusted profit methods
• Core assumptions required when preparing cash flow forecasts, and the risks introduced by making inaccurate or unrealistic assumptions
• The use of scenario and sensitivity analysis to assess the impact of changing assumptions on forecast cash positions
• Identifying limitations of cash forecasting and strategies to manage forecast risk

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary objective of preparing a cash budget within business management?
   1. Maximising reported profit
   2. Planning and controlling cash inflows and outflows
   3. Reducing taxation liabilities
   4. Preparing for year-end audits
2. Which ONE of the following is NOT a core assumption commonly required in cash flow forecasting?
   1. Timing of customer receipts
   2. Capitalisation of development costs
   3. Supplier payment terms
   4. Opening cash balance

3. True or false? The adjusted profit method starts with budgeted profit and adjusts for non-cash items and changes in working capital to estimate cash flow from operations.

4. Give TWO examples of risks that can arise from over-optimistic cash flow forecast assumptions.

Introduction

Effective cash management is essential to ensure the survival and growth of any business. Even profitable entities may collapse if they are unable to pay bills when due. Cash budgets and forecasts are planning tools that provide management with essential information on expected cash inflows and outflows over a future period. This knowledge allows organisations to anticipate shortfalls, negotiate funding, or manage surpluses effectively. Understanding both how to prepare cash forecasts and the importance of realistic assumptions is a key requirement of the ACCA Financial Management syllabus.

Key Term: Cash budget
A financial plan estimating expected cash receipts, payments, and resulting balances over a specified period, used for planning and control purposes.

CASH BUDGETS AND FORECASTS: PURPOSE AND STRUCTURE

A cash budget is a forward-looking document providing management with projected cash receipts and payments by period, usually on a monthly basis. It highlights potential cash shortages and surpluses, facilitates proactive decision making, and supports relationships with lenders and investors.

The structure of a cash budget includes:

• The opening cash/bank balance
• Forecasted cash inflows (e.g., customer receipts, loan proceeds)
• Forecasted cash outflows (e.g., supplier payments, wages, asset purchases)
• The closing cash/bank balance for each period

Key Term: Cash flow forecasting
The process of estimating future cash inflows and outflows to predict the business’s likely cash position over time.

CASH FLOW FORECASTING TECHNIQUES

The two primary methods for cash forecasting in the ACCA exam are the receipts and payments method and the adjusted profit method.

Receipts and Payments Method

This approach forecasts all cash inflows and outflows during each period, largely based on sales and purchase projections, expected payment terms, and other known cash movements. The method is simple and shows the timing of predicted cash surpluses or deficits in detail.

Key Term: Receipts and payments method
A cash forecasting approach that lists all expected cash receipts and payments to calculate period-end cash balances for each forecast interval.

Adjusted Profit Method

Here, the process begins with budgeted profit (or loss) and adjusts for:

• Non-cash expenses (e.g., depreciation)
• Non-operating cash movements (e.g., capital expenditure, financing)
• Anticipated movements in receivables and payables (i.e., changes in working capital)

This gives an estimate of net cash generated or absorbed by the business operations, adjusted for the impact of working capital changes.

Key Term: Adjusted profit method
A forecasting approach starting with forecast profit and adjusting for non-cash items and working capital movements to estimate operational cash flows.

Scenario and Sensitivity Analysis in Forecasting

Cash forecasts rely on assumptions which may change due to market or economic conditions. Scenario planning allows management to evaluate “optimistic,” “pessimistic,” and “most likely” cases by varying forecasts for sales, costs, or payment timings. Sensitivity analysis tests how sensitive the cash position is to changes in key assumptions, helping to identify critical risks requiring closer management attention.

Key Term: Scenario analysis
A technique in which forecasts are prepared under different possible future conditions (e.g., best, worst, and most likely), helping management prepare for uncertainty.

ASSUMPTIONS IN CASH FLOW FORECASTING

Every cash budget is based on assumptions, including:

• Sales volumes and the proportion sold for cash or credit
• The credit terms extended to customers and expected collection periods
• Supplier payment terms, and whether discounts are utilised
• Timing of major expenditures (e.g., asset purchases, loan repayments)
• Expected financing receipts (loan drawdowns, capital injections)
• Timings and amounts of non-operating cash flows (tax payments, dividends)

Poor or unrealistic assumptions can lead to inaccurate forecasts. For instance, assuming customers always pay promptly may exaggerate cash inflows.

Key Term: Forecasting assumptions
The foundational inputs regarding timing, amounts, and baseline conditions used to estimate future cash flows in a budget or forecast.

LIMITATIONS AND RISKS OF CASH FORECASTING

No forecast can predict the future with certainty. Common limitations include:

• Reliance on estimates for sales, collections, and supplier timing
• Difficulty accounting for unexpected events (e.g., customer default, supply chain disruption)
• Unplanned capital expenditures or maintenance
• External factors: interest rate changes, inflation, or regulatory shifts

Scenario and sensitivity analysis help mitigate these risks but cannot remove them. Effective cash forecasting must be regularly updated as actual results unfold.

Worked Example 1.1

ABC Ltd is preparing a 3-month cash budget. Expected credit sales are $40,000 per month. Customers pay 60% in the month of sale, 35% in the following month, and 5% is uncollectible. Purchases are $25,000 a month, paid the month after purchase. Other monthly cash outflows are $10,000. The opening cash balance on 1 January is $5,000.

What is the expected closing cash balance at the end of March?

Answer:

January receipts: 60% x $40,000 = $24,000
February receipts: 60% x $40,000 = $24,000 (current month from Feb sales) + 35% x $40,000 = $14,000 (from Jan sales) = $38,000
March receipts: 60% x $40,000 = $24,000 (current) + 35% x $40,000 = $14,000 (from Feb) = $38,000

Purchases are paid with a one-month lag:

• January: $0 (December purchases if any, but not given)
• February: $25,000 (Jan purchases)
• March: $25,000 (Feb purchases)

Monthly outflows: $10,000 each month.

Calculate net cash flow for each month and track cash balance:

• January: Opening $5,000 + $24,000 - $10,000 = $19,000
• February: Opening $19,000 + $38,000 - $25,000 - $10,000 = $22,000
• March: Opening $22,000 + $38,000 - $25,000 - $10,000 = $25,000

Expected closing balance at end of March: $25,000

Worked Example 1.2

XYZ’s management expects sales of $60,000, $80,000, and $90,000 in January, February, and March. All sales are on credit. One scenario estimates customers will pay in 30 days on average. Another scenario uses 45 days.

How does changing the collection assumption affect forecasted cash receipts and cash balance?

Answer:

If customers pay in 30 days, January sales are received in February, February sales in March, and so on.

If customers pay in 45 days, receipts for January sales occur mid-March and receipts for February sales occur in April. Hence, in the first quarter, cash receipts are significantly lower under the longer collection period, increasing the risk of a cash shortage.

Regular review and adjustment of collection assumptions are essential parts of effective forecasting.

Exam Warning

Always check whether a forecast requires receipts and payments to be recorded based on invoice dates or cash flow dates. The distinction is examined frequently.

Summary

Cash budgets and forecasts are essential for predicting periods of cash surplus or shortage. Receipts and payments, adjusted profit, and scenario analysis are all techniques used to project future cash balances. The usefulness of any forecast depends on the realism of its key assumptions, which must be updated as business conditions change.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the purpose and main components of a cash budget and forecast
• Apply the receipts and payments and adjusted profit methods for cash flow forecasting
• Identify and critically evaluate major forecasting assumptions and associated risks
• Use scenario and sensitivity analysis in cash budgeting
• Recognise limitations of forecasts and the need for ongoing review and adjustment

Key Terms and Concepts

• Cash budget
• Cash flow forecasting
• Receipts and payments method
• Adjusted profit method
• Scenario analysis
• Forecasting assumptions