Importance Of Cash Budget

Published Date: 02 Nov 2017

Cash budget is the projection of a company’s cash inflow and outflow over a period of future time which uses to plan for and control the use of cash. (Jain & Khan, 2008) Usually, a company will prepare a cash budget on an annual basis and subdivided into month. However, some companies will prepare the cash budget on weekly or even daily basis for more detail and refine. (Moyer et al, 2012)

Importance of Cash Budget

Cash budget is important to help a company in taking good decisions in regard to the company cash reserve for future. It helps to determine any excessive idle cash or cash shortage during the period in order to plan accordingly to maintain a safe level of cash so that the company’s activities can run smoothly. It is useful in determining the amount of short term funds the company may need to borrow to cover any projected cash shortage. (Moyer et al, 2012)

Beside, cash budget is very important, especially for smaller companies to allow them to determine the credit amount that it can extend to customers without having problems with liquidity. Also, the income fluctuation can be controlled as it helps the company to have a better understanding over a series of monthly cash flow in the company. At the same time, preparing a cash budget also helps the company to evaluate a strong plan for the company capital need as well as expected emergency needs during any shortcomings.

Introduction

"I Love Pets" Veterinary Clinic has a cash balance on 1st January 2012 of $50,000. An analysis of the budget shows the following.

All the sales are in cash basis and the period allowed by creditors is 3 months. The salaries and wages as well as operating expenses will be paid at the end of each month while other expenses will be paid one month after incurring the expenses i.e January expenses will be paid in February.

In additional:

1. The purchase for October, November and December 2011 were $15,000, $12,000 and $10,000.

2. Marketing expenses for December 2011 were $1,100 while administrative expenses and insurance

payment were remained unchanged.

3. The repair and maintenance service of equipments will be carried out in every 3 months and the

expenses will be paid at the end of each month.

From all in above, the overall cash budget for the clinic from January to June 2012 will be as shown in appendix. In overall, the table shows that the clinic is still manage to run their business although they are facing shortage of cash in every month except for February. This is because the sales in February are higher compare to other months while the salaries and wages on that month are lesser than the previous month. Although there are an increasing of operating expenses due to the increasing of sales, the clinic is still manage to cover the cost and therefore the clinic has sufficient cash to run the business in next month. In overall, the clinic will be able to furthering the business in the next six months if they continue make profit.

Framework 1

Suppose the radiography machine in the clinic has been used for many years and failure in February. The directors are decided to buy a new digital radiography machine which cost $ 75000 per unit to replace the old one. The maintenance fee for the new machine is $6000 per year and the maintenance is carry out in every month. The expenses will be paid at the end of each month. Since it is a big amount, the directors planned to borrow a 5 years loan from bank. However, the loan will only approve after two month due to several factors. Thus, the clinic is using cash to buy the machine and payment by installments. The clinic pays $18750 as down payment.

From above, the closing balance for each month is remained positive. Therefore, it can be said that there is no harm for the clinic to buy the machine. However, if looking in long term, it is actually harmful to the business as the clinic has to pay $3688 for loan repayment in every month for 5 years. (refer appendix) and the maintenance fees has increase as well. Unless the business is continued to making profit, otherwise the clinic will facing insufficient of cash in future.

The cost to repairing the machine is $ 2500. If the clinic chooses to repair the machine, then the cash flow will be as below.

As shown in the table, the clinic remained stable. The business can run better without the loan repayment and additional maintenance fee. The only risk would be the old machine might failure again which caused inconvenience for the business and might affect their profit earn. So, the directors have to think twice whether to buy a new machine or just repair the old machine.

Framework 2

Assume that there is someone interested to invest the business. A new capital of $50000 will be injected in the business on January. The cash budget will be as below.

Now, the clinic has idle cash on hand. The excessive funds can be used to buy a new radiography machine. The directors have two choices, whether they use the cash to buy the new machine or borrow the loan as planned before.

a) If they buy the machine using cash:

b) If they buy the machine using loan:

From above table, the clinic is encouraged to buy the new machine using loan because the cash on hand will remain lesser if they buy with cash. The clinic will face a situation where cash will be running out after June. This is harmful to the business because insufficient of cash will make the business facing difficulty in operation. On the other hand, using the loan to buy a new machine, the clinic will have excessive cash on hand. They can run their business smoothly with idle cash. However, a company is not encourages to hold an excessive cash in bank as it will not bring more profit to the business. Thus, the directors can make some small investments such as engage in short term money market, government securities or make a fixed deposit to earn extra profit.

Conclusion

Even though cash budget is useful to assist a business to control its cash flow, it is still has some drawbacks that can’t be ignored. Firstly, the budgeting is only an assumption as it is mostly prepared based on past records. In fact, the changes in the business environment are unpredictable and may bring huge difference in the actual cash flow. Secondly, preparing a cash budget can be very time consuming, especially for those small companies and businesses which are poorly-organized. Furthermore, cash budget may be inaccurate due to the dishonesty of a manager who did not provided the actual amount during the preparing process.

In short, the net profit of a business is directly related to the cash budget. The directors should balance the sales objective with the cost of production to avoid negative cash flow so that cash is always sufficient to running the business. Also, a company should try to the decrease the expenses or increase the sales in order to help to increase the cash flow in and hence increase the profit earned.