Budgeting

A firm's managers need to be aware of the inflow and outflow of cash to plan future finances. The firm has various costs and different sources of income [Income: Money from sales, or revenue coming into the firm. ]. To keep the business profitable and avoid running into financial difficulties, accountants ensure the firm has enough working capital [Working capital: The difference between current assets less current liabilities - the difference between a firm's cash and its short-term debts - the money it has to play with. ] to pay any short-term debts when they fall due. They plan a budget that:

1. sets performance targets over a certain time period
2. limits expenditure [Expenditure: Costs the firm has to make ie its spending. ] to what the business can afford

The firm's accountants monitor and record the actual financial performance of the firm against the budget, so that its likely financial performance can be forecast. When the two are compared there will usually be a difference. Adjustments will be made for the next budget or forecast.

Now look at both in detail and try to remember three ways of raising finance from each source.

Internal sources of finance

1. The board of a public limited company may retain profits for a year rather than share it amongst the owners. The cash can be invested to earn interest.
2. Assets that are no longer required, like an outdated computer or an obsolete piece of machinery, can be sold.
3. Stock levels can be reduced and funds made available for other uses.

External sources of finance

1. A sole trader or a small business may be able to borrow money from family or friends without paying interest.
2. Loans from a bank or a building society can be expensive. An agreed amount is borrowed and repaid over a fixed period of time with interest.
3. Grants from central or local government will cost the firm nothing.
4. Firms often lease equipment or machinery to avoid a large outlay of cash. This is useful if a firm needs to upgrade within the medium term as technology advances.

Cash flow

A firm needs to know how much cash is coming in and going out.

Factors affecting cash flow

Drawing up a cash flow forecast [Cash flow forecast: Predicting the cash income and cash payments to be coming into and going out of a business at a given point in the future. ] shows whether there is enough cash available to pay salaries and settle debts on time. It calculates the firm's reserves [Reserves: Unused cash that a firm has available. ], which could be invested in expansion projects or new equipment. Accountants identify when shortfalls are likely to happen, and surplus funds are likely to become available. This helps them plan for when the firm might need an overdraft, or be able to reinvest its reserves into the business.

A case study

Go Faster Sports is a high-street retail outlet that has only been open six months, but has already managed to establish itself locally. As a result, it is considering whether to invest in developing its operational resources. Apart from the manager, there are two full-time members of staff.

This is its cash flow budget for the past three months:

Go Faster Sports - Cash Flow Budget

How to calculate the cash balance

You can see that the total flow of cash into the business (income) for January was £15,500, and that the total outflow from the business (expenditure) was £15,000. You can find the cash balance by subtracting the expenditure from the income, shown as a net surplus (profit) or a net deficit (loss).

Income - Expenditure = Balance

£15,500 - £15,000 = £500 (a surplus)

Compare this with February's results:

Income - Expenditure = Balance

£16,100 - £17,200 = -£1,100 (a deficit)

How to assess the cash available to the business

The cash balances you have just calculated are only monthly results. To assess the cash available to the business, you have to add existing profits or deficits to the cash balance of the following month. This amount is the cash balance to carry forward, and in the next month's results is referred to as the cash balance brought forward. You will see that they are the same amount.

For example, in January, the cash balance to carry forward was £2,150, the same figure as the cash balance brought forward for February. Similarly, you can tell that the cash balance to carry forward for the previous December was £1,650.

This type of record helps managers to spot trends, and to plan the following months.

A typical exam question

Using the cash flow budget for Go Faster Sports, answer the following questions.

Now try a Test Bite