## **Learning Outcomes**

After reading this article, you will be able to explain why businesses prepare cash budgets and how these assist cash management. You will be able to define and calculate the cash operating cycle, interpret working capital ratios, and identify key factors affecting cash and payables management. You will also understand the relationship between cash flow, liquidity, and profitability, and be able to apply these concepts in an exam context.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand the role of cash and payables management in overall working capital efficiency. In particular, your revision should focus on:

- The reasons for holding cash and the use of cash budgets and cash flow forecasts
- The calculation and interpretation of the cash operating cycle
- Analysis of working capital ratios relating to inventory, payables, and receivables
- The impact of payables policy on liquidity and profitability
- Short-term funding and investment strategies for working capital
- Preparation of cash budgets and understanding their use in identifying cash surpluses or shortfalls

## **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 main purpose of preparing a cash budget in business management?
   a) To calculate profit
   b) To ensure all invoices are paid on time
   c) To forecast future cash inflows and outflows
   d) To determine the level of long-term funding required

2. The cash operating cycle measures:
   a) The number of days inventory is held before sale
   b) The number of days between paying suppliers and receiving cash from customers
   c) The difference between current assets and current liabilities
   d) The total length of a business’s financial year

3. True or false? A longer payables period will always increase a company's profitability.

4. Briefly explain the difference between the current ratio and the quick (acid test) ratio.

5. What effect does paying suppliers more quickly have on the company’s cash operating cycle and liquidity?

## **Introduction**

Effective cash and payables management ensures a company can meet its financial obligations while avoiding unnecessary costs or risks. Cash budgets allow managers to track expected receipts and payments, preventing unexpected shortfalls or idle cash balances. Understanding the cash operating cycle provides visibility into how long money is tied up in operations, helping to identify efficiency improvements. Management of payables is central to balancing liquidity and profitability, with significant implications for working capital needs.

> **Key Term: cash budget**
> A forecast summarising expected cash receipts and payments over a future period, used to plan and control cash flows.

## CASH BUDGETS AND CASH MANAGEMENT

A cash budget projects future cash inflows and outflows, often on a monthly basis. Its main role is to help managers anticipate periods of cash surplus or deficit, so they can take action in advance. For example, knowing in advance about a future cash shortage allows a company to arrange short-term finance or defer non-essential payments.

Key points to consider:

- Cash inflows include cash sales, payments from receivables, loans received, and asset sales.
- Cash outflows cover supplier payments, wages, overheads, loan repayments, dividends, tax, and capital expenditures.
- The net cash flow for each period is calculated as total inflows minus outflows.

By tracking the opening and closing cash balances across the forecast period, a business can ensure it remains solvent and avoid late payment penalties or missed investment opportunities.

> **Key Term: working capital**
> The capital invested in current assets (such as inventory and receivables) less current liabilities (such as payables and overdrafts). It represents the liquidity available for day-to-day operations.

## THE CASH OPERATING CYCLE

The cash operating cycle measures the time between paying for materials and collecting cash from customers. A shorter cycle means cash is tied up for less time, reducing funding needs and associated costs.

For a manufacturing business, the cash operating cycle (in days) is typically calculated as:

- Raw materials holding period
- Plus work-in-progress period
- Plus finished goods holding period
- Plus receivables collection period
- Minus payables payment period

For retailers or wholesalers, the cycle is:

- Inventory holding period
- Plus receivables collection period
- Minus payables payment period

> **Key Term: cash operating cycle**
> The number of days between paying suppliers for inventory and collecting cash from customers for the sale of goods or services.

### **Worked Example 1.1**

A manufacturing company has the following data:

- Raw materials held: 18 days
- WIP: 12 days
- Finished goods: 25 days
- Receivables collection: 45 days
- Payables payment period: 30 days

Calculate the cash operating cycle.

> **Answer:**
> Cash operating cycle = 18 + 12 + 25 + 45 – 30 = 70 days.
> This means cash is tied up in the operating cycle for 70 days before being recovered.

## WORKING CAPITAL RATIOS

To manage cash and payables effectively, several ratios are used:

- **Inventory holding period:**  
  $$ \text{Inventory} / \text{Cost of sales} \times 365 $$
- **Receivables collection period:**  
  $$ \text{Receivables} / \text{Credit sales} \times 365 $$
- **Payables payment period:**  
  $$ \text{Payables} / \text{Credit purchases} \times 365 $$

Monitoring these ratios helps to identify inefficiencies, such as slow collections or excessive inventory.

> **Key Term: current ratio**
> The ratio of current assets to current liabilities, used to assess a company’s short-term liquidity.
>
> **Key Term: quick ratio (acid test)**
> The ratio of current assets minus inventory to current liabilities, indicating immediate liquidity and ability to meet obligations without selling inventory.

### **Worked Example 1.2**

Company X reports the following year-end balances:

- Current assets: \$800,000
- Inventory: \$300,000
- Current liabilities: \$400,000

Calculate the current ratio and the quick ratio.

> **Answer:**
>
> - Current ratio = \$800,000 / \$400,000 = 2.0
> - Quick ratio = (\$800,000 – \$300,000) / \$400,000 = \$500,000 / \$400,000 = 1.25
>   The current ratio shows assets cover liabilities twice over; the quick ratio confirms liquid assets safely cover debts.

## PAYABLES MANAGEMENT

Managing payables means balancing liquidity with supplier relationships. Delaying payments can improve cash flow but may harm supplier goodwill or forfeit settlement discounts.

- **Advantages of longer payables period:**
  - Improved liquidity and reduced need for external financing
  - Potential for negotiating better terms

- **Disadvantages of extended payables:**
  - Possible loss of discounts
  - Damaged supplier relationships
  - Risk of supply disruption

> **Key Term: trade payables**
> Amounts owed to suppliers for goods or services purchased on credit, forming a key component of working capital.

## THE INTERPLAY OF LIQUIDITY AND PROFITABILITY

Holding high cash and paying suppliers slowly can improve liquidity but impair profitability if supplier discounts are lost. Conversely, paying early may secure discounts, improving profit but reducing cash available.

Striking the right balance is essential. Overly aggressive payables policies can lead to financial distress, while excessive liquidity may signal inefficient use of resources.

### **Worked Example 1.3**

A company can pay a supplier in 30 days or take a 2% discount by paying within 10 days. Its overdraft interest rate is 10% per annum. Should it take the discount?

> **Answer:**
> The annualised cost of giving up a 2% discount for an extra 20 days’ credit is significantly higher than 10%. It is usually cheaper to pay early and take the discount.

### **Exam Warning**

> Do not confuse cash budgets with profit forecasts. Cash budgets monitor actual cash movements (regardless of accounting period), while profit forecasts include non-cash items and accruals.

### **Revision Tip**

> Use cash budgets to identify periods of expected cash shortages well in advance. This helps you plan funding solutions and avoid costly last-minute borrowing.

## **Summary**

Cash and payables management revolves around predicting, monitoring, and controlling cash flows using budgets and understanding the cash operating cycle. Sound payables policies and working capital ratio analysis support good liquidity while minimising costs.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- The purpose and structure of cash budgets
- How to prepare, interpret, and use a cash budget for decision-making
- The calculation and significance of the cash operating cycle
- Key working capital ratios: inventory, receivables, and payables periods
- The effect of payables policy on liquidity and profitability
- The difference between current and quick ratios
- Practical steps for managing cash shortages and supplier payments

## **Key Terms and Concepts**

- cash budget
- working capital
- cash operating cycle
- current ratio
- quick ratio (acid test)
- trade payables

Cash and payables management - Cash budgets and cash operating cycle