Cash flow forecast and budgeting (04) Flashcards
(15 cards)
SUMMARY
In summary, the following are covered in this topic:
1. Cash flow relates to the timing of payment commitments and receipts from
customers. Forecasting cash flow refers to estimating future cash inflows and
cash outflows, usually on a month-by-month basis.
2. Cash flow forecast helps businesses, especially start-ups, to monitor cash flow
and apply for funding.
3. Cash flow forecast is limited by the lack of accuracy, unexpected events,
personal bias, competitors’ actions and interest rates movement.
4. Budgeting is a financial planning process that enables the management to make
an informed estimate about its financial needs for its future planned activities
(usually one year).
5. A budget is a detailed, financial plan for a future time period.
6. Budgeting enables businesses to allocate scarce resources, provides direction
for the business, promotes coordination between departments, and allows
management to track its progress and corrective actions.
7. The limitation of budgeting includes being time consuming, inflexible, leads to
unnecessary spending, focuses on the short-term, and results in quality issues.
8. Variance is the difference between the budgeted and actual figures. It is either
favourable or adverse.
9. Variance analysis is an important budgetary control technique as it prompts
management to find the root cause of the variance, to take corrective action
and to plan for more accurate future budgets.
What is Forecasting Cashflow?
Forecasting cash flow means estimating future cash inflows and cash outflows, usually on a monthly basis.
What is contained in a Cashflow forecast?
1) Cash inflows
2) Cash outflows
3) Net monthly cash flow, opening and closing balance
What is in the Cash inflows section?
This section records cash received by the business, including cash sales, payments from credit sales and capital inflows.
What is in the Cash outflows section?
This section records the cash payments made by the business, including salary, materials, rent and other costs.
What is in the Net monthly cashflow, opening and closing balance section?
This shows the net cash flow for the period, and the cash balances at the start and end of the period.
If the closing balance is negative (shown by a figure in brackets), it means a bank overdraft is forecasted.
What are the uses of a Cashflow forecast?
Cash flow forecast has the following uses:
1) Identify timing of cash shortages and surpluses.
If the cash flow forecast identifies specific timing of high negative cash flows, the management can make plans to
reduce the negative balance. This can be done by reducing purchase of materials, machinery, tightening its credit sales policy or apply for credit facilities in advance to meet future cash needs.
On the other hand, if cash flow forecast shows high positive cash flow in specific period, the management could begin making investment plans. It could plan to buy equipment, purchase materials in bulk to take advantage of discounts or repay bank loans early. This is because having excess funds sitting in the bank carries an opportunity costs and poor use of money.
2) Application for funding.
When a business approaches banks or financial institutions
for funding, they will be keen to look at cash flow forecast at regular intervals,
because the cash flow forecast will reveal the ability of the business to repay loans.
3) Monitor cash flow.
The cash flow forecast ensures that the business can afford to pay suppliers and employees, as the consequence could be dire if they are not paid.
It would also allow businesses to spot problems with customer payments, as they can look at how quickly customers are paying their debt.
What are the limitations of a Cashflow forecast?
1) Accuracy of data.
The management depends on market intelligence to prepare the
cash flow forecast. However, information from some of the sources, both secondary
and primary, may be inaccurate. For example, sales executives may forecast higher
receipts from customers to please their manager. As such, the management may be
misled to think that it will have positive cash balance in future months.
The production department may forecast unrealistic higher level of purchases in future
months that will be translated to higher cash outflow causing negative cash balance.
Thus, the management will be misled to apply for credit facility or bank loans to tide
over the potential negative cash balance and incur unnecessary interest expenses.
2) Unexpected events.
An experienced finance manager or employee may be able to
draw up an accurate cash flow forecasts after meticulous research. However, an
unexpected chain of events such as sudden closure of a major customer, surge in oil
prices, political or civil unrest can totally nullify a meticulously prepared cash flow
forecasts.
3) Personal bias.
Cash flow forecasts are drawn up based on assumptions of a stable
economy and good relationships with customers and suppliers. However, these
assumptions may be incorrect due to personal bias, which would render the
cash flow forecast inaccurate.
4) Behaviour of competitors.
The actions of competitors have a direct impact on the
performance of the business. In today’s highly competitive market where
competitors entice customers with social media promotions and e-commerce apps,
a business will find it difficult to forecast its cash flow, especially its cash receipts.
The ease of entry into the market also makes it difficult for a business to track its
competitors and its strategies. Hence, businesses would have to think of creative
and innovative ways of promoting products to compete.
5) Interest rates.
Banks may change its interest rate periodically and this has an impact
on the cash flow forecast. This is because businesses may rely on bank loans to run
operations and changes in interest rates will affect its cash outflow. The impact will
be greater if the business has a large bank loan. Thus, interest rate movements will
cause difficulty in forecasting cash flow.
What is Budgeting?
Budgeting is a financial planning process that enables the management to make an
informed estimate about its financial needs for its future planned activities (usually
one year).
A budget is a document that translates these plans into monetary terms to reflect the funds needed to be expended for the planned activities and the funds that will need to be generated to cover the costs of the planned activities. In short, a budget is a detailed, financial plan for a future time period.
How does Budgeting play an important role in a business?
1) Allocation of resources.
Most, if not all businesses, have limited resources in terms
of funds. Yet these limited funds need to be allocated to various departments to
ensure smooth operations to meet the needs of the business. During the budgeting
process, the various department heads will request for funds to meet their needs
and more often than not, the aggregated needs will be more than the available
funds. As such, management needs to ensure that limited resources are allocated
according to priority among departments in order to achieve business objectives.
2) Provide directions.
The budgeting process usually involves inputs from all
employees in the business as the divisions and departments need to decide on the
respective targets to achieve for the year and determine the funds needed to
achieve them. Thus, budgeting is a purposeful exercise that provides a direction
from strategic objectives cascading down to department and individual objectives.
This provides employees with the motivation to work towards their goals
culminating in achieving business objectives.
3) Monitor progress.
Budgets allows the management to track its progress, such as
whether they meeting budgeted sales target or budgeted cost of production, so that
corrective action can be quickly taken should adverse variances occurs.
What are the benefits of Budgeting?
1) Planning.
During the budgeting process, department managers must consider future
plans carefully so that realistic targets can be set. For example, the sales manager
needs to consider various factors such economic and market conditions before
deciding on the budgeted sales targeted. This can have an impact on the planning
of budgets on other departments.
2) Effective allocation of resources.
Budgets will ensure that the business does not
spend more resources than is available. The management team needs to come
together to agree on the priorities so that business objectives are met. For example,
the operations director and the R&D director have to agree on whether to budget
for technological upgrade of production plant or increase in R&D expenditure. The
basis of agreement may be based on the strategic objective of the business. Thus,
budgeting will achieve the purpose of effective allocation of resources.
3) Realistic target setting.
Budgeting provides the opportunity for managers and employees to set realistic targets to aim for. Through that, managers and staff have some degree of accountability for setting and reaching budget levels. This will in
turn motivate them to achieve these targets.
4) Communication and coordination.
The budgeting process sets the platform for the
different heads of department to discuss how resources should be allocated across
the different departments. This promotes coordination between departments and
provides the opportunity for the entire company to work effectively together to
achieve targets.
5) Monitor, control and modify.
After the budgets are set, managers will monitor
regularly to ensure the business is on track to achieve the financial objective.
Managers cannot assume that internal and external conditions will remain constant.
If there is evidence that the budgeted level is unrealistic and objectives cannot be
achieved, then the plan or process must be modified.
6) Measuring and assessing performance.
When the budgeted period has ended,
variance analysis will be carried out to compare actual performance with the original
budgets. Managers will be required to explain the differences and this will provide
a basis to assess managers’ performance.
What are the drawbacks of Budgeting?
1) Time-consuming.
Budgeting is a time consuming and costly process. It involves
nearly all employees. On top of the usual work, employees need to side aside time
to develop the budget in their own area of work as well as meeting as a department
to develop the department budget. During the budget development process, there
will be many repetitive steps before the budget is finally approved.
2) Lack of flexibility.
Traditional budgets are set with no flexibility built into them. They
did not take into account changes in the external environment. Managers may be
unreasonably penalised as these changes are outside their control. For example, the
sales manager is given a poor rating for not meeting budgeted sales without taking
into account the sudden drop in disposable income due to economic recession. This
will adversely affect the motivation of the sales manager and his team.
3) Unnecessary spending.
Budgets may result in wastages. This is because when the
end of the budgeting period approaches, managers may realise that they have
under-spent their budgets. This may cause the managers to make unnecessary
spending decisions so that managers need not explain to top management reasons
for not fully utilising the assigned budget. The department that under-spent may
also be allocated a smaller budget the following year.
4) Focused on the short term.
Most businesses tend to prepare budgets for a 12-
month period. This practice will cause managers to take a short-term decision to
stay within budget that may not be in the best long-term interests of the business.
For example, in order to keep within budget for labour costs, managers may delay
their decisions to increase workforce size and this will prevent the business from
increasing output to meet increase in demand.
5) Quality issues.
A rigid and poorly allocated budgets can harm quality. For example,
in order to meet the budgeted cost of production, the operations manager may
compromise on the quality of raw materials by choosing suppliers that offer cheaper
but poor quality parts. This short term approach will harm the reputation of the
business due to the sub-quality products marketed by the business. Employees’
competency may also be compromised when department managers choose not to
upgrade the skills of the employees to save on training costs to meet training budget.
This will also result in poor quality goods or services provided.
6) Limited staff cooperation.
Not all the employees are involved in setting budgets.
Department heads are usually responsible for drawing up budgets for their
respective departments, with inputs from different lower ranked employees to
provide data concerning their own area of work. As such, there is a low degree of
cooperation between staff to meet to plan the department budget.
7) No direct involvement by managers.
Budgets are usually set by managers of the
department, who may not be directly involved in the operations of the business.
They are often in meetings with top management to discuss implementation of
strategies to achieve long-term goals for the company. As a result, during the
budgeting process, the managers may set budget based on their own estimation,
without a good understanding of the operations or markets of the business.
Why is Variance analysis important?
1) Acts as a controlling or corrective tool.
When there is a deviation of actual from the budgeted figure, managers will be prompted to find out the cause of the deviation, especially for adverse variances.
For example, if actual profit is below budgeted profit, managers need to determine whether the deviation was due to lower sales revenue or higher costs. If it is due to lower sales, managers will further find out the
reasons for the lower sales which could be quality issues. By rectifying the quality
issues, the business will be able to regain its competitiveness in the market.
2) Frames future budgets more accurately.
Through variance analysis, the management will be able to understand the reasons for the deviation from the
budgeted figures.
For example, if sales revenue is lower than planned due to
consumer resistance to higher prices, the management can factor this into account
when planning future budgets.
What is the formula for Variance?
Variance = actual figures – budgeted figures
