What is a cash budget. How it is useful in managerial decision making?

Answer 1

THE CASH BUDGET

In contrast to cash flow statements, cash budgets provide much more timely information regarding cash inflows and outflows. For example, whereas cash flow statements are often prepared on a monthly, quarterly, or annual basis, cash budgets are often prepared on a daily, weekly, or monthly basis. Thus, cash budgets may be said to be prepared on a continuous rolling basis (e.g., are updated every month for the next twelve months). Additionally, cash budgets provide much more detailed information than cash flow statements. For example, cash budgets will typically distinguish between cash collections from credit customers and cash collections from cash customers.

A thorough understanding of company operations is necessary to reasonably assure that the nature and timing of cash inflows and outflows is properly reflected in the cash budget. Such an understanding becomes increasingly important as the precision of the cash budget increases. For example, a 360-day rolling budget requires a greater knowledge of a company than a two-month rolling budget.

While cash budgets are primarily concerned with operational issues, there may be strategic issues that need to be considered before preparing the cash budget. For example, predetermined cash amounts may be earmarked for the acquisition of certain investments or capital assets, or for the liquidation of certain indebtedness. Further, there may be policy issues that need to be considered prior to preparing a cash budget. For example, should excess cash, if any, be invested in certificates of deposit or in some form of short-term marketable securities (e.g., commercial paper or U.S. Treasury bills)?

Generally speaking, the cash budget is grounded in the overall projected cash requirements of a company for a given period. In turn, the overall projected cash requirements are grounded in the overall projected free cash flow. Free cash flow is defined as net cash flow from operations less the following three items:

1. Cash used by essential investing activities (e.g., replacements of critical capital assets).
2. Scheduled repayments of debt.
3. Normal dividend payments.

If the calculated amount of free cash flow is positive, this amount represents the cash available to invest in new lines of business, retire additional debt, and/or increase dividends. If the calculated amount of free cash flow is negative, this amount represents the amount of cash that must be borrowed (and/or obtained through sales of nonessential assets, etc.) in order to support the strategic goals of the company. To a large degree, the free cash flow paradigm parallels the cash flow statement.

Using the overall projected cash flow requirements of a company (in conjunction with the free cash flow paradigm), detailed budgets are developed for the selected time interval within the overall time horizon of the budget (i.e., the annual budget could be developed on a daily, weekly, or monthly basis). Typically, the complexity of the company's operations will dictate the level of detail required for the cash budget. Similarly, the complexity of the corporate operations will drive the number of assumptions and estimation algorithms required to properly prepare a budget (e.g., credit customers are assumed to remit cash as follows: 50 percent in the month of sale; 30 percent in the month after sale; and so on). Several basic concepts germane to all cash budgets are:

1. Current period beginning cash balances plus current period cash inflows less current period cash outflows equals current period ending cash balances.
2. The current period ending cash balance equals the new (or next) period's beginning cash balance.
3. The current period ending cash balance signals either a cash flow opportunity (e.g., possible investment of idle cash) or a cash flow problem (e.g., the need to borrow cash or adjust one or more of the cash budget items giving rise to the borrow signal).