How to Prepare a Cash Budget

In the previous chapter, "Functional Budgets and the Master Budget," we saw how every department's plan—sales, production, materials—rolls up into one overarching master plan. But there is one specific functional budget that acts as the absolute lifeblood of the entire operation: the Cash Budget.

There is an old saying in business: "Profit is vanity, cash is sanity."

You can have a highly profitable company on paper, but if you run out of cash to pay your employees on the first of the month, or to pay your suppliers for raw materials, your business will grind to a halt. Understanding how to forecast cash is one of the most critical skills in cost management, and mastering it is essential for your exam.

Why Liquidity Matters Just as Much as Profitability

Before we calculate anything, we need to understand the difference between profitability (accrual accounting) and liquidity (cash accounting).

Imagine you run a wholesale business. In January, you sell ₹10,00,000 worth of goods to a major retailer. The goods cost you ₹6,00,000 to make. Under standard accounting rules, you just made a handsome profit of ₹4,00,000 in January.

But here is the catch: the retailer bought the goods on credit and has 60 days to pay you. Meanwhile, your workers demand their wages today, your landlord wants the factory rent today, and the electricity board wants their bill paid today.

Even though you are highly profitable on paper, your bank account is empty. You have a liquidity crisis.

This is exactly why we prepare a Cash Budget. A Cash Budget ignores when a sale was made or when an expense was incurred. It only cares about one thing: When does the cash actually enter or leave the bank account?

The Receipts and Payments Method

There are a few ways to prepare a cash budget, but the Receipts and Payments Method is the most universally used in practice and is overwhelmingly the most common format tested in exams.

Think of this method as predicting your future bank statement. You start with the cash you have, add the cash you expect to collect, and subtract the cash you expect to pay out.

1. Cash Receipts (Inflows)

These are all the sources from which cash flows into the business during the budgeted period. Common examples include:

• Cash Sales: Goods sold where the customer pays immediately.
• Collection from Debtors: Cash received from customers who previously bought goods on credit.
• Sale of Fixed Assets: Cash received from selling old machinery, vehicles, or land.
• Other Inflows: Dividends received, interest received on investments, or capital introduced by the owner.

2. Cash Payments (Outflows)

These are all the ways cash flows out of the business. Common examples include:

• Cash Purchases: Raw materials bought and paid for immediately.
• Payment to Creditors: Cash paid to suppliers for goods previously bought on credit.
• Wages and Salaries: Payments made to employees.
• Overheads: Payments for rent, electricity, insurance, and administrative expenses.
• Other Outflows: Taxes paid, dividends paid to shareholders, or the purchase of new machinery.

The Golden Rule: Exclude Non-Cash Items

If you want to avoid the most common trap in cash budget problems, you must memorize this rule: If a transaction does not cause cash to physically change hands, it does not belong in the cash budget.

When examiners set a question, they will almost always hide non-cash items in the data to see if you blindly copy them over. You must actively filter them out.

Decoding "Time Lags" (Timing Differences)

The hardest part of preparing a cash budget isn't the addition or subtraction; it is figuring out when the money moves. This is expressed as a "time lag." Let's break down the common variations you will encounter.

1. The Standard Lag (e.g., "1 month lag")

If the problem says, "Credit sales are collected with a time lag of 1 month," it means the cash for January's sales is received in February. The cash for February's sales is received in March.

• Rule: Shift the data forward by the number of months stated.

2. The Split Collection (e.g., "50% in the following month, 50% in the second month")

Sometimes customers pay in installments. If January sales are ₹1,00,000, and the rule is "50% collected in the first month following the sale, and 50% in the second month":

• In February, you collect ₹50,000 (from January).
• In March, you collect the remaining ₹50,000 (from January).

3. The Fractional Lag (e.g., "1/2 month lag" or "Half month lag")

This is where students often panic, but the logic is simple once you see it. A "half month lag" means that you pay for the first half of the month during that same month, but you delay paying for the second half of the month until the next month.

Therefore, the cash you pay in any given month is made up of two halves:

• Half of the previous month's bill (which was delayed).
• Half of the current month's bill (which is paid on time).

Let's look at a concrete example. Suppose wages are paid with a 1/2 month lag.

• January Wages: ₹40,000
• February Wages: ₹60,000

How much cash is actually paid out for wages in February?

• We pay the delayed second half of January: 1/2 of ₹40,000 = ₹20,000
• We pay the first half of February: 1/2 of ₹60,000 = ₹30,000
• Total Cash Paid in February = ₹50,000

Step-by-Step Walkthrough: A Complete Cash Budget Problem

To truly master this, we must walk through a full, exam-style problem from start to finish. Read the data carefully, and then we will solve it step by step.

The Problem Data

You are required to prepare a Cash Budget for April, May, and June. The opening cash balance on 1st April is ₹25,000.

Here is the forecasted data for the relevant months:

• February: Sales ₹1,00,000 | Purchases ₹60,000 | Wages ₹10,000 | Overheads ₹20,000
• March: Sales ₹1,20,000 | Purchases ₹70,000 | Wages ₹12,000 | Overheads ₹22,000
• April: Sales ₹1,40,000 | Purchases ₹80,000 | Wages ₹14,000 | Overheads ₹24,000
• May: Sales ₹1,60,000 | Purchases ₹90,000 | Wages ₹16,000 | Overheads ₹26,000
• June: Sales ₹1,80,000 | Purchases ₹1,00,000 | Wages ₹18,000 | Overheads ₹28,000

Additional Information (The Rules of the Game):

1. 1Sales: 20% of all sales are for cash. The remaining 80% are credit sales, collected in the month following the sale (1-month lag).
2. 2Purchases: All purchases are on credit. Suppliers are paid after 2 months (2-month lag).
3. 3Wages: Wages are paid in the same month they are incurred (No lag).
4. 4Overheads: Overheads are paid with a 1-month lag. Furthermore, the overhead figures listed above include a fixed monthly depreciation charge of ₹4,000.
5. 5Special Item: An advance tax payment of ₹10,000 is scheduled to be paid in June.

Step 1: Prepare the Working Notes

Never jump straight into drawing the final budget table. Always calculate your tricky figures in working notes first.

Working Note 1: Collection from Sales (Receipts) We need to calculate the cash coming in for April, May, and June. Every month's receipt has two parts: Cash Sales (20% of current month) + Collection from Debtors (80% of previous month).

• April Receipts:
• Cash Sales (20% of April's ₹1,40,000) = ₹28,000
• Debtors (80% of March's ₹1,20,000) = ₹96,000
• Total April Receipts = ₹1,24,000

• May Receipts:
• Cash Sales (20% of May's ₹1,60,000) = ₹32,000
• Debtors (80% of April's ₹1,40,000) = ₹1,12,000
• Total May Receipts = ₹1,44,000

• June Receipts:
• Cash Sales (20% of June's ₹1,80,000) = ₹36,000
• Debtors (80% of May's ₹1,60,000) = ₹1,28,000
• Total June Receipts = ₹1,64,000

Working Note 2: Payment for Purchases (Creditors) There is a 2-month lag. This means in April, we pay for February. In May, we pay for March.

• April Payment: February Purchases = ₹60,000
• May Payment: March Purchases = ₹70,000
• June Payment: April Purchases = ₹80,000

Working Note 3: Payment for Overheads There is a 1-month lag, AND we must remove the ₹4,000 non-cash depreciation from every month's figure before we pay it.

• April Payment: We pay March's overheads. March total was ₹22,000. Subtract ₹4,000 depreciation. Cash paid = ₹18,000.
• May Payment: We pay April's overheads. April total was ₹24,000. Subtract ₹4,000 depreciation. Cash paid = ₹20,000.
• June Payment: We pay May's overheads. May total was ₹26,000. Subtract ₹4,000 depreciation. Cash paid = ₹22,000.

Step 2: Construct the Cash Budget

Now, we simply plug our working notes into the standard Receipts and Payments format. We must do this one month at a time, because April's closing balance becomes May's opening balance.

Month 1: APRIL

• Opening Balance: ₹25,000 (Given in problem)
• Add Receipts:
• Cash Sales & Debtors (from WN1): ₹1,24,000
• Total Cash Available: ₹1,49,000 (25,000 + 124,000)
• Less Payments:
• Creditors (from WN2): ₹60,000
• Wages (No lag, use April data): ₹14,000
• Overheads (from WN3): ₹18,000
• Total Payments: ₹92,000
• Closing Balance for April: ₹57,000 (1,49,000 - 92,000)

Month 2: MAY

• Opening Balance: ₹57,000 (Carried over from April's closing)
• Add Receipts:
• Cash Sales & Debtors (from WN1): ₹1,44,000
• Total Cash Available: ₹2,01,000 (57,000 + 144,000)
• Less Payments:
• Creditors (from WN2): ₹70,000
• Wages (No lag, use May data): ₹16,000
• Overheads (from WN3): ₹20,000
• Total Payments: ₹1,06,000
• Closing Balance for May: ₹95,000 (2,01,000 - 1,06,000)

Month 3: JUNE

• Opening Balance: ₹95,000 (Carried over from May's closing)
• Add Receipts:
• Cash Sales & Debtors (from WN1): ₹1,64,000
• Total Cash Available: ₹2,59,000 (95,000 + 164,000)
• Less Payments:
• Creditors (from WN2): ₹80,000
• Wages (No lag, use June data): ₹18,000
• Overheads (from WN3): ₹22,000
• Advance Tax (Special item for June): ₹10,000
• Total Payments: ₹1,30,000
• Closing Balance for June: ₹1,29,000 (2,59,000 - 1,30,000)

And there you have it. By the end of June, the business is projected to have a healthy cash balance of ₹1,29,000. If the final number had been negative, management would know three months in advance that they need to arrange a bank overdraft or a short-term loan to survive June. That is the true power of a cash budget.

Quick Revision

• Purpose: A cash budget tracks liquidity, not profitability. It ensures the business has enough physical cash to meet its day-to-day obligations.
• Method: The Receipts and Payments method is the standard format. It acts like a forecasted bank statement.
• Structure: Opening Balance + Receipts - Payments = Closing Balance.
• The Golden Rule: Never include non-cash items. Always subtract depreciation, amortization, and provisions from expenses before entering them as cash payments.
• Time Lags: Pay close attention to delays. A 2-month lag on purchases means January's purchases are paid for in March.
• Fractional Lags: A 1/2 month lag means the payment is made up of 50% of the previous month's bill and 50% of the current month's bill.
• Sequential Calculation: You must finish calculating one entire month to find its closing balance before you can start the next month, because the closing balance of Month 1 is the opening balance of Month 2.
• Capital vs Revenue: The cash budget does not care about accounting distinctions between capital and revenue. If you buy a machine for cash, the whole amount is an outflow immediately. If you take a loan, the whole amount is an inflow immediately.