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Budgeting for the Future: Why Firms Need to Forecast and Budget Their Cash Flows.

Most of us are familiar with at least one firm that has encountered serious financial difficulties, or even faced bankruptcy, while earning a Continuously larger income over time. One factor many of these firms have in common is their failure to adequately budget future operating expenses and to forecast future cash needs.

The cyclical nature of many businesses causes cash inflows and cash outflows to be inconveniently timed. For example, before increased sales can be supported, increased production must take place. Of course, this increased production requires increased cash outflows. Unfortunately, the cash inflow from the resultant sales occurs after the cash is needed to increase production. Because of this timing problem, businesses that are expanding may find that they are constantly cash starved. Such firms may find that they have a nearly constant need for short-term financing.

Properly forecasting the financial needs of a company is of paramount importance to effective management. To lessen the chance of financial problems, it is imperative that the manager arranges for the required financing before it is needed. Such planning will smooth the growth of the company by eliminating delays that might otherwise ensue from cash shortages. The importance of properly prepared cash flow projections cannot be overemphasized. These projections will not only provide the blueprint for the orderly growth of the company, but will also increase the likelihood of successfully acquiring the funds needed for growth. Simply put, a manager who approaches a lender armed with forecasted financial statements and concrete estimates of the timing and amount of cash needs, is much more likely to be successful in obtaining the needed funds.

The Budgeting Process

The budgeting process begins with forecasting future income statements. These statements may be prepared on a monthly or weekly basis and commonly extend for twelve months into the future. The starting point in preparing these forecasted income statements is forecasted sales. Once sales are forecast, the expenses necessary to support these sales can be estimated.

After the forecasted income statements for the budget period are assembled, the manager must examine the budgeted expenses to assess their effect on the firm's need for cash. It is important to note that not all expenses require cash outlays. This review of the budgeted expenses should specifically focus on the cash requirements associated with these expenses. Additionally, cash needs for capital expenditures and debt service must be accounted for at this time. It is imperative that the timing of these anticipated cash outlays be closely monitored. This information about projected cash outflows is included in the Cash Budget. The Cash Budget is a schedule that tells the manager how much financing will be needed, and perhaps more importantly, when it will be needed. After the Cash Budget is prepared, forecasted Balance Sheets for the budget period may be prepared. This article focuses on the budget process through the preparation of the Cash Budget.

Historical Data

To illustrate the budgeting process, let's assume that we are the owners of a hypothetical computer company named Data Flow. Our company's operations for the previous four quarters resulted in the simplified income statements shown in Table 1.

Three important details are immediately evident. First, sales are cyclical, with the majority of sales occurring in the period from late spring to early fall. Second, gross margin is a steady 40 percent of sales. And third, although total expenses increase as sales increase, it is clear this change is not a one-to-one relationship. The analysis of this latter relationship between expenses and sales is the key to effective budgeting. The value of any budgeting process is directly affected by how well the manager understands, and therefore, can predict the behavior of a firm's costs. The better that a manager understands the behavior of his or her firm's costs, the better he or she can predict total expenses given various levels of sales.

Cost Behavior

The firm's past history provides data that will allow management to analyze the relationship between sales and costs. The first step in this analysis is to identify costs as being either variable or fixed. Variable costs vary in total with activity, while fixed costs do not. Additionally, certain costs--referred to as mixed costs--are a combination of fixed and variable costs. Fortunately, many costs can be classified using simple common sense. For example, an 8 percent sales commission will increase as sales increase. Accordingly, this sales commission is easily identified as a variable cost. The units of production method of depreciating machinery would be a variable cost, but straight-line depreciation on fixtures, being the same amount every month regardless of sales, is a fixed cost.

Many costs will be a combination of variable and fixed. These costs are referred to as mixed costs. To illustrate mixed costs, let's assume that members of your sales department are paid a salary, plus a commission based on sales. This mixture of fixed salaries plus variable commissions (which vary with the amount of sales) is mixed cost. Utilities are often mixed costs, especially for manufacturing concerns. Frequently, however, it may be difficult to break these mixed costs into their variable and fixed components. In these more complicated situations, the determination of a firm's cost behavior will commonly require the use of regression analysis.

To demonstrate the preceding concepts, let's assume that a regression analysis was performed on the historical financial data for our firm Data Flow. The results of this analysis can be found in Table 2.

Forecasting the Income Statement

The regression analysis for Data Flow indicates that there are monthly fixed costs of $25,000 and that the variable costs total 25 percent of the company's sales. The information about the behavior of our expenses found in Table 2 provides the information needed for the creation of forecasted income statements. Forecasted income statements for the first quarter of 2001 are found in Table 3.

This forecasted income statement clearly indicates that Data Flow is expected to be profitable with anticipated before-tax income of $67,500 for the first three months of 2001. However, a firm's profitability does not ensure that it has enough cash on hand to meet its anticipated cash needs.

The Cash Budget

Table 3 reveals the danger inherent in failing to consider a company's cash flows, since Data Flow has anticipated revenues that exceed their anticipated expenses. If Data Flow failed to consider their anticipated cash flows, they may mistakenly interpret their anticipated profitability as a sign of a trouble-free financial future. However, as was previously noted, the timing and amount of cash flows can be dramatically different from the revenues and expenses reported in a firm's income statements. Because of these differences, proper cash management requires that anticipated expenses be further analyzed to determine the amount and timing of the associated cash outlays. An analysis of the cash outlays for Data Flow can be found in Table 4.

The figures in Table 4 illustrate the difference between projected expenses and projected cash outflows for Data Flow.

Because of these differences, proper planning for a firm's cash outlays requires the creation of cash budgets. Cash budgets allow managers to easily compare anticipated cash inflows with anticipated cash outflows, and enable them to properly plan for sufficient balances of cash throughout the budgeted time frame. To demonstrate the value of cash budgets, Table 5 provides a cash budget for the first quarter for Data Flow. Using a spreadsheet, such as that presented in Table 5, facilitates the preparation of cash budgets. All cash flows presented in the budgets are calculated using the data in Table 4.

A cash budget consists of two parts. The first part is the "scorekeeping" section. In this section, cash flows are itemized and receipts are compared to disbursements. The Change in Gash Position is simply total cash receipts minus total cash disbursements. Notice that cash flow from operations is expected to be negative throughout the first quarter, even though income is projected to be positive.

The second part is the financing section. This section highlights the timing and amount of loans and their repayments. Data Flow plans to maintain a minimum cash balance of $5,000. Because it began in January with this $5,000 balance, the net cash outflow of $8,000 would, in the absence of any financing, overdraw its account by $3,000. However, they must borrow the entire $8,000 in order to maintain their minimum balance. This financing results in the ending cash balance of $5,000, as demonstrated in Table 5.

The most important observation about this cash budget is that it indicates that Data Flow can anticipate spending more cash than it collects during the budgeted period. At first this may seem strange, since the forecasted income statements clearly indicate that the company is expected to be profitable. But the difference between the anticipated profitability reported in Table 4 and the potential cash flow problem reported in Table 5, underscores the need for the creation of cash budgets. Without the warning given by the cash budget, Data Flow could find that it is unable to meet its financial obligations. Additionally, these forecasts of income and cash needs should significantly enhance the company's ability to secure additional funds from lenders.


Budgeting for cash is a critical part of safeguarding a firm's financial future. It is far from uncommon for a profitable company to get into financial problems because of its failure to properly forecast and plan future cash flows. Fortunately, many liquidity problems, such as those which bankrupted Penn Central and W. T. Grant, can be avoided through effective planning. Cash budgets enable management to foresee when cash problems are likely to arise, and allow them to arrange for funds to meet the cash requirements of these periods.

Brian Carpenter, Ph.D., CMA is a Professor of Accounting at the University of Scranton.

Laura Ellis, Ph.D., CPA is an Assistant Professor of Accounting at the University of Scranton.
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Author:Carpenter, Brian; Ellis, Laura
Publication:The National Public Accountant
Geographic Code:1USA
Date:Aug 1, 2000
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