Question: The nature of a company’s business affects its need to budget for cash

Question

Question: The nature of a company’s business affects its need to budget for cash flows. H&R Block is a service company whose main business is preparing tax returns. Most tax returns are prepared after January 31 and before April 15. For a fee and interest, the company will advance cash to clients who are due refunds. The clients are expected to repay the cash advances when they receive their refunds. Although H&R Block has some revenues throughout the year, it devotes most of the nontax season to training potential employees in tax preparation procedures and to laying the ground work for the next tax season. Toy’s “R” Us is a toy retailer whose sales are concentrated in October, November, and December of one year and January of the next year. Sales continue at a steady but low level during the rest of the year. The company purchases most of its inventory between July and September. Johnson & Johnson sells the many health care products that it’s manufacturers to retailers, and the retailers sell them to the final customer. Johnson & Johnson offers retailers credit terms. Discuss the nature of cash receipts and case disbursements over a calendar year in the three companies we have just described. What are some key estimates that the management of these companies must make when preparing a cash budget?

Explanation / Answer

A cash budget is a tool for planning and controlling near-term spending, normally including both incoming cash flows and cash outflows (usually for spending on expenses)

Properly preparing your cash budget will show how cash flows in and out of your business. Also, it may then be used in planning your short-term credit needs. In today's financial world, you are required by most financial institutions to prepare cash budgets before making capital expenditures for new assets as well as for expenditures associated with any planned expansion. The cash budget determines your future ability to pay debts as well as expenses. For example, preliminary budget estimates may reveal that your disbursements are lumped together and that, with more careful planning, you can spread your payments to creditors more evenly throughout the entire year. As a result, less bank credit will be needed and interest costs will be lower. Banks and other credit-granting institutions are more inclined to grant you loans under favorable terms if your loan request is supported by a methodical cash plan. Similarly, businesses that operate on a casual day-to-day basis are more likely to borrow funds at inopportune times and in excessive amounts. Without planning, there is no certainty that you will be able to repay your loans on schedule. However, once you've carefully mapped out a cash budget, you will be able to compare it to the actual cash inflows and outflows of your business. You will find that this comparison will go a long way in assisting you during future cash budget preparation. Also, a monthly cash budget helps pinpoint estimated cash balances at the end of each month which may foresee short-term cash shortfalls.

Cash budgets are typically planned with a series of months in view, although they can also show cash revenues and spending on a weekly, quarterly, or annual basis. The distinguishing feature of the cash budget is that it represents actual cash inflows and outflows in the period they occur.

Key estimates that the management of these comapnies must make when preparing a cash budget are:

There are three main components necessary for creating a cash budget. They are:

Time Period

Cash Position

The amount of cash you wish to keep on hand will depend on the nature of your business, the predictability of accounts receivable and the probability of fast-happening opportunities (or unfortunate occurrences) that may require you to have a significant reserve of cash.

In our example, H & R Block will need more cash in between Jan-31 and before April15. Toy’s “R” Us will need more cash between July and September to purchase the inventory and more cash inflows in the m/o Jan, Oct, Nov and Dec.

Estimated Sales and Expenses

The fundamental concept of a cash budget is estimating all future cash receipts and cash expenditures that will take place during the time period. The most important estimate you will make, however, is an estimate of sales. Once this is decided, the rest of the cash budget can fall into place. Like, Toy’s “R” Us have sales mostly in the m/o Jan, Oct, Nov and Dec.

If an increase in sales of, for example, 10 percent, is desired and expected, various other accounts must be adjusted in your budget. Raw materials, inventory and the costs of goods sold must be revised to reflect the increase in sales. In addition, you must ask yourself if any additions need to be made to selling or general and administrative expenses, or can the increased sales be handled by current excess capacity? Also, how will the increase in sales affect payroll and overtime expenditures?

At a minimum, the following categories of expected cash receipts and expected cash payments should be considered:

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