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Lester Bahr CPA, LLC
(484) 707-5934
Allentown, Pennsylvania
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What is a cash flow budget?  

Simply stated it is a projection of cash receipts and cash payments over the course of future periods.

By calculating the forecasted “net change” in the monthly cash balance, it identifies future periods in which a cash shortfall might result. This allows short-term borrowing or investment needs to be better planned in advance to prevent running out of operating funds.

A projected income statement is not a substitute for a cash flow budget.

A projected income statement usually does not correlate to cash flows. This is because actual cash receipts and disbursements often take place in different time periods as compared to when the transactions are recognized in the income statement. The income statement also includes non-cash expenses such as depreciation and amortization which do represent an actual cash expenditure in that period.

In contrast, a cash flow budget needs to reflect the cash outflow transactions associated with purchasing capital assets such as machinery, vehicles and real estate. From a cash receipts perspective, it must show any cash received from sales of equipment, not just the gain or loss on the sale as would be represented in the income statement.

Another limitation of the income statement is that it does not report the cash in/outflows related to the principal component of borrowings. Only the interest expense portion of the loan payment is reflected in the income statement.

Preparing a cash flow budget

In its simplest form, a monthly cash flow schedule can be prepared as follows:

Cash balance, beginning of month
Plus Cash collections from sales
Minus Cash payments for purchases (resale)
Minus  Cash payments for operating expenses
Equals Cash flow resulting from operations
Plus Proceeds from sales of equipment, investments
Minus  Purchases of equipments, investments
Plus Proceeds from borrowings
Minus  Principle payments on borrowings
Equals Cash balance, end of month 

It then follows that the cash balance at the end of one month will become the cash balance at the beginning of the following month and so on. 

Preparing the schedule can best be done using an Excel spreadsheet whereby the calculations can be linked together. This allows changes in assumptions to easily update throughout all months whenever a change is made.

The reliability of a cash flow budget depends on the accuracy of forecasted versus actual cash receipts and disbursements. To the extent poor estimates are used, the inaccuracies will compound throughout all months involved. Consequently, future financing decisions would be based on a flawed analysis. For this reason, skill and experience are necessary to recognize the interrelated links and correlations associated with cash flows in order to develop appropriate formulas. Since all businesses are different and operate within various industries, there is no one “standard” cash flow budget. Each must be custom developed.

In developing estimates, anticipated growth rates in sales and expenses usually starts with the historical information derived from prior period financial statements. For this reason a business without good accounting systems in place to facilitate the reporting of accurate historical financial information will not have a solid foundation upon which to begin the process. 

Forecasting cash collections

In order to estimate the cash coming into the business on a monthly basis we must first know two things: The first is the anticipated monthly sales in cash and on account. Second, for the sales on account we must estimate the payment patterns of customers in the weeks and months following that month’s sales.

To forecast cash inflows, a couple methods can be used. The first is to simply average the percentages of collections and bad debts observed over the past year. These percentages can then be applied to future monthly credit sales as reflected in the sales forecast. A more accurate method is to use statistical linear regression analysis whereby the collection-to-sale relationships are converted to percentages to facilitate the forecasting process. In either case, these procedures can only be accomplished if reliable, historical information exists from which to observe these payment patterns as they have typically occurred. Admittedly, this can be a rather time consuming part of the process in preparing a cash budget. The only way to know what the historical payment patterns have been is to go back and analyze past billing and payment reports. However, once this information has been compiled a “typical” payment pattern can be established as in the following example:

Assume that January sales on an accrual basis are $300,000. But, based on the observed historical collection pattern only $30,000 is expected to be collected by the end of January, $225,000 is expected in February, $30,000 in March, and $13,000 in the following months. Ultimately, $2,000 will not be collected. Knowing this collection pattern allows a monthly table of cash collections to be prepared.

Determining cash collections tends to be more difficult than developing the cash disbursements schedule since the business has somewhat more control over the timing of its cash payments. 

Additionally, there may be other sources of cash receipts to consider. Some of the most common sources would include proceeds from debt or investor financing as well as sale proceeds from equipment or other fixed asset sales. 

Forecasting cash disbursements

The outflows of a cash flow budget most typically consist of purchases for resale, operating expenses (exclusive of depreciation and amortization), purchases of property and equipment to be capitalized, payments on debt principal and dividends or other distributions to owners.

For a business where maintaining inventory is a material aspect of operations, the buildup or drawdown of inventory could be a significant factor that impacts cash. For example, if inventory levels are steadily increasing, then the actual cash required for purchases will be greater than the amount of purchases recorded as an expense on the income statement. Conversely, if the business is selling off excess inventory, then cash outflows for purchases will be less than the amount reported as an expense in the period.

Determining the expected monthly outflows for operating expenses usually tends to be somewhat easier in preparing a cash flow budget. As a starting point, the outflows can be determined based upon historical financial statement expenses. Then, to project the expenses forward requires that each be adjusted up or down based on the correlation to expected sales growth for the variable component of the expense.

If there is an expectation of purchasing capital equipment during the cash flow period, then this cost will also need to be shown as a cash outflow in the appropriate month of the budget.

The scheduled payments against debt principal can easily be determined from an amortization schedule of the loan(s). Then, it is simply a matter of preparing a monthly schedule to summarize these payments so that the total cash required can be listed as a cash outflow on the budget.

In summary

Preparing a cash flow budget is a process of estimating and experience. No, it is not an exact science. But, estimated guidance of cash flow needs is still much better then operating in the dark without the vision to foresee a future cash flow problem.

Using Cash Flow Budgets to Manage Liquidity