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7.3. Exercise 7.2: Cash Flow and the Budgeting Process

Open any "Management Accounting" text and you will find that the subject of working capital invariably begins with the preparation of a cash budget that forecasts a company's short-term expected cash flows for the period under review. This may vary from a single day up to a year or even longer, depending on the production process, so borrowing to finance a deficit (or reinvesting surplus funds) can be planned as smoothly and efficiently as possible.

Turn to "Financial Management" and cash still holds a central position. However, short-term finance and investment decisions are evaluated within the context of long-term wealth maximization, based on present value (PV) analysis.

The role of the financial manager is to reconcile these two functions. Holding cash entails a cost, namely the opportunity cost of profits that could be earned if cash was used within the firm, or invested elsewhere. Therefore, management needs to balance the advantages of profitability against liquidity.

Cash should only be held until the marginal value of its liquidity equals the value of alternative investments foregone

Since idle cash is unprofitable cash, a fundamental objective of working capital management is to optimize the amount of cash available to the company and maximize the reinvestment of any surplus not required immediately.


Drawing upon your knowledge of Management Accounting and Financial Management, provide an overview of the preparation of a cash budget from an overall corporate perspective.

An Indicative Outline Solution

Cash budgeting amalgamates information from a variety of sources. It reveals the expected cash flows relating to the operating budget, (sales minus purchases and expenses) and the capital budget (net borrowing, which incorporates adjustments for interest, tax and dividends). The corporate motivation for holding cash is threefold.

- The transaction motive to ensure sufficient cash meets known liabilities as they fall due.

- The precautionary motive, based on the likelihood of uncertain events occurring.

- The speculative motive, which identifies temporary opportunities to utilize excess cash.

Actual deviations from forecast figures are therefore inevitable. So, astute management will prepare more than one cash budget to anticipate possible future scenarios. For example:

- A target budget that assumes forecast sales are achieved.

- An optimistic budget that assumes above-forecast sales.

- A pessimistic budget that assumes below-forecast sales.

Ultimately, the accuracy of each budget therefore depends on a forecast of future sales determined by its "terms of trade" over the planning period. Four distinct phases are involved in its preparation.

Forecast Cash Inflow divided between cash and credit sales (adjusted for any seasonal variations and bad debt loss) plus other cash receipts from investment income and the sale of fixed assets.

Forecast Cash Outflow represented by the payment of trade creditors, employee remuneration, administrative costs, capital expenditure, interest, taxation and dividends.

Forecast Net Cash Flow that compares these periodic anticipated receipts and payments.

Cumulative Net Cash Flow for each period, calculated by adding the opening cash balance to the net cash flow for the period.

Given sales and cost considerations, the minimum cash balances to support production are therefore identified. Within the overall context of working capital management, these depend upon the efficient control of stocks, debtors and creditors, plus opportunities for reinvestment and borrowing requirements.

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