Budget preparation - Cash budgets and working capital

Learning Outcomes

After reading this article, you will be able to prepare cash budgets for business planning and control, distinguish between cash budgets and profit forecasts, identify key elements of working capital, and analyse how cash budgets can highlight potential liquidity issues. You will also understand how to forecast receipts and payments and recognise the significance of effective working capital management in maintaining organisational solvency.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand the preparation and purpose of cash budgets and the working capital cycle. This article focuses on:

• Explaining the difference between profit and cash budgets
• Preparing and interpreting cash budgets for planning and control
• Forecasting the timing of receipts from customers and payments to suppliers
• Identifying the main components of working capital
• Understanding the importance of cash flow management in business
• Recognising the impact of poor cash flow on organisational stability

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 information does a cash budget provide that a profit forecast does not?
2. List three key components of working capital.
3. If a business pays its suppliers in the month after purchase but receives payments from customers two months after the sale, what effect might this have on its cash flow?
4. Explain briefly why a profitable business could still face liquidity problems.

Introduction

Cash budgets are essential tools for managing an organisation’s short-term financial health. Unlike a profit and loss forecast, which shows the expected profit or loss for a period, a cash budget estimates the actual inflows and outflows of cash. By planning for when money is received and paid, managers can anticipate periods of cash shortage or surplus, and make informed decisions to avoid liquidity problems.

Key Term: cash budget
A plan showing projected cash inflows and outflows over a set period, used to forecast cash balances and manage liquidity.

Key Term: working capital
The difference between current assets and current liabilities, representing the amount of cash and other liquid assets available for day-to-day operations.

CASH BUDGETS: PURPOSE AND USES

A cash budget is not the same as a forecast of profit. Although a business may forecast profits, this does not automatically guarantee there is enough cash to pay bills as they fall due. This is because the timing of receipts and payments often differs from when revenue is earned and expenses are incurred.

Key roles of a cash budget

• Planning for periods when additional finance may be required
• Avoiding cash shortfalls and potential insolvency
• Identifying times when surplus funds can be invested
• Supporting management decisions about payment terms, borrowing and investment

Exam Warning Do not confuse “profit” with “cash position”. Both are necessary for business survival, but solvency relies on available cash, not just profits on paper.

Cash budgets in the planning and control cycle

Cash budgets sit within the overall budgetary cycle as a forward-looking tool. They help management set payment policies and prepare for events such as loan repayments, asset purchases, or seasonal sales fluctuations.

SCHEDULING RECEIPTS AND PAYMENTS

Forecasting receipts

Forecasting cash receipts requires understanding not only the value of future sales but also when those sales will be converted into cash. For credit sales, the timing of payment is often delayed.

Steps for forecasting receipts

1. Identify expected sales for each period.
2. Determine the percentage of sales made on credit and the usual time to receive payment.
3. Calculate cash inflows by matching receipts to the periods in which cash is actually received.

Forecasting payments

A similar process applies to expenditures. Not all purchases or expenses are paid immediately. Some may be paid in advance (e.g., rent), while others, like supplier invoices, can be paid on credit terms.

Steps for forecasting payments

1. Identify planned payments (e.g., purchases, wages, overheads).
2. Establish when each payment is due.
3. Calculate outflows for each period.

Example payment schedule

A common scenario is credit purchases, paid a month (or more) after the purchase. Timing of payroll, taxes, lease payments, and capital expenditures should also be scheduled in the cash budget.

CONSTRUCTING A CASH BUDGET

A typical cash budget includes:

Cash budgets are usually prepared monthly, but may be weekly in cash-tight situations.

Worked Example 1.1

A business expects sales of £10,000 in Month 1, £15,000 in Month 2, and £12,000 in Month 3. It gives customers one month’s credit; all sales are on credit. Purchases are £6,000, £8,000, and £7,000 in the same periods and are paid for in the month following purchase. The opening cash balance is £2,000. Prepare the cash receipts, payments, and closing balances for Months 1-3.

Answer:
Month 1 cash receipts: None (since Month 1 sales not paid until Month 2).
Month 1 payments: Payment for previous month’s purchases (none in this example).
Month 1 closing balance: £2,000 (no receipts or payments).
Month 2 cash receipts: £10,000 (from Month 1 sales).
Month 2 payments: £6,000 (payment for Month 1 purchases).
Closing balance: £2,000 + £10,000 - £6,000 = £6,000.
Month 3 cash receipts: £15,000 (from Month 2 sales).
Month 3 payments: £8,000 (payment for Month 2 purchases).
Closing balance: £6,000 + £15,000 - £8,000 = £13,000.

Presenting receipts and payments of other items

Care must be taken to handle non-trading receipts and payments, such as loans received or repaid, interest, tax payments, capital expenditure, and dividends. These do not appear in the profit and loss statement but affect the cash budget.

Revision Tip Always map receipts and payments to the correct period. Prepare a simple table to track the flow and avoid missing delayed payments or receipts.

PROFIT VS CASH FLOW

One of the most important points highlighted in a cash budget is the difference between cash movement and profit.

Key reasons for the difference:

• Revenue and expenses are recorded in profit figures when earned/incurred, not when cash is received or paid.
• Some income and expenses, such as depreciation, affect profit but have no direct cash impact.
• Timing of tax payments and purchases of non-current assets may also create differences.

Worked Example 1.2

A business has sales of £50,000, cost of goods sold of £30,000, and depreciation of £2,000. Customers pay two months after sale; suppliers are paid one month after purchase. If the opening cash balance is £1,500 and there is no other cash flow, what is the cash balance at the end of Month 3?

Answer:
In Month 3, the only cash inflow relates to sales two months earlier (£0, assuming first sales just started). Cash outflows: payment to suppliers for previous month’s purchases (£0, given same assumption). Only depreciation affects profit, not cash, so it is ignored for cash flow. Without previous months’ sales, the closing balance remains £1,500. If figures are given for prior months, receipts/payments would be matched accordingly.

COMPONENTS OF WORKING CAPITAL

Working capital keeps the daily operations of a business running. It represents the funds tied up in current assets (such as inventory, receivables, cash) minus current liabilities (such as payables, short-term debts).

Key Term: working capital cycle
The time between outlay of cash for materials and collection of cash from customers, representing how quickly a business converts investments into cash.

Working capital includes:

• Inventory (raw materials, work in progress, finished goods)
• Receivables (money owed by customers)
• Cash and cash equivalents
• Payables (amounts owed to suppliers and creditors)

A business must maintain enough working capital to meet everyday expenses but not so much that resources are tied up unnecessarily.

The working capital cycle

The cycle can be described as follows:

1. Buy or produce inventory
2. Sell inventory (may be on credit)
3. Wait to collect receivables
4. Use cash collected to pay suppliers and wages
5. Begin new cycle

A longer cycle increases the risk of cash shortages, while a shorter cycle is usually better for liquidity.

EFFECTIVE WORKING CAPITAL MANAGEMENT

Managing working capital means controlling the timing and amount of:

• Inventory held
• When customers pay invoices
• When suppliers are paid
• Cash balances

Techniques for improving cash flow

• Invoice promptly and follow up receivables
• Negotiate supplier credit periods
• Consider early payment discounts with care
• Avoid holding excessive inventory
• Plan for non-routine payments such as tax or capital expenditure

Worked Example 1.3

A company allows customers 60 days to pay but must pay suppliers in 30 days. Inventory is held for 45 days. How long is the working capital cycle?

Answer:
Inventory holding: 45 days
Receivables: 60 days
Minus payables: 30 days
Working capital cycle = 45 + 60 – 30 = 75 days

LIMITATIONS AND RISKS OF CASH BUDGETING

While cash budgets are a powerful planning tool, they are dependent on the accuracy of forecasts for sales, collections, and payments. Unexpected events—such as delayed receivables, unplanned expenses, or changes in credit terms—may lead to unfavourable cash positions.

Exam Warning Overly optimistic assumptions about customer payments and sales can lead to serious cash shortfalls. Use realistic estimates and consider “what if” analysis for key assumptions.

Common cash management risks include:

• Overestimating cash inflows
• Underestimating payment obligations or omitting periodic outflows
• Ignoring possible delayed customer payments (bad debts)
• Not planning for seasonal cash needs

Revision Tip Regularly compare actual cash flows to the cash budget to identify trends or emerging issues early. Update the cash budget frequently, especially in periods of financial uncertainty.

Summary

Cash budgets provide a practical, essential forecast of when cash will move in and out of the business, enabling effective planning and early warning of liquidity shortfalls. Effective working capital management keeps operations smooth, minimises financing costs, and reduces the risk of insolvency. The cash budget should be updated regularly and used alongside other management tools for robust financial control.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between cash budgets and profit forecasts
• Identify the main components and cycle of working capital
• Prepare and interpret a simple cash budget table
• Schedule receipts from customers and payments to suppliers accurately
• Explain why a profitable business can still face liquidity issues
• Recognise risks and limitations of cash budgets and working capital management

Key Terms and Concepts

• cash budget
• working capital
• working capital cycle