Budgeting and Cash Flow - TCE Accounting (Tasmania)
“Prepare a cash budget and explain the difference between profit and cash flow.”
A cash budget forecasts cash receipts and payments to predict the closing bank balance, and it shows that a profitable business can still run out of cash because profit and cash flow are not the same thing.
What this dot point is asking
Budgeting is planning expressed in financial terms. A cash budget (cash flow forecast) is one of the most useful planning tools because it warns a business when it may run short of cash, giving time to arrange finance, delay payments or chase debtors.
Profit is not cash
The income statement is prepared on the accrual basis: revenue is recorded when earned and expenses when incurred. The cash budget is prepared on the cash basis: only actual money in and out is counted, in the period it moves. The two differ for several reasons:
- Credit sales increase profit now but cash arrives later when debtors pay.
- Credit purchases and accrued expenses reduce profit now but cash leaves later.
- Buying a non-current asset is a large cash outflow but only a small depreciation expense each year.
- Loans, capital contributions and drawings move cash but are not revenue or expenses.
- Depreciation is an expense that reduces profit but involves no cash payment.
A business can report a healthy profit yet still be unable to pay wages or suppliers if too much is tied up in inventory and unpaid debtors. Managing cash flow is about timing, and the cash budget is the tool that exposes timing problems early.
Structure of a cash budget
A cash budget is usually set out month by month with three sections:
Receipts include cash sales, collections from debtors, capital contributions and loans received. Payments include cash purchases, payments to creditors, wages, rent, asset purchases, loan repayments and drawings. The closing balance of one month becomes the opening balance of the next.
A forward-looking statement that estimates the cash a business expects to receive and pay over future periods, so it can predict its bank balance and plan for surpluses or shortfalls.
This example builds a two-month cash budget for Brae Trading, showing how receipts and payments are identified and timed, how closing cash rolls forward, and what the result reveals about the business's cash position.
Step 1: List the receipts and identify timing
Begin by reading the data carefully and deciding which cash flows belong in each month. Cash sales and debtor collections are receipts; creditor payments, wages and asset purchases are payments. Only cash that actually moves in the month is included.
Brae Trading expects: opening cash $5,000 in July. Cash sales $12,000 in July and $14,000 in August. Debtors will pay $8,000 in July and $9,000 in August. Payments are: creditors $10,000 each month, wages $6,000 each month, and a new machine for $7,000 paid in August.
Step 2: Build the July budget
Total July receipts, total July payments, then apply the formula: closing cash equals opening cash plus receipts minus payments.
Receipts = .
Payments = .
Closing cash = .
Step 3: Build the August budget
July's closing cash becomes August's opening cash. The machine purchase adds a one-off payment in August only.
Opening cash = .
Receipts = .
Payments = .
Closing cash = .
Step 4: Interpret the result
A cash budget is only useful if it prompts action. Here the numbers are in balance, but the margin is thin.
Cash holds steady at $9,000. The machine purchase in August used the entire month's surplus, so the business has no buffer. Brae Trading might delay the purchase, arrange a short-term overdraft, or speed up debtor collections to build a safety margin.
Timing of receipts and payments
The skill that separates a correct cash budget from a wrong one is timing. Credit sales are usually collected one or more months after the sale, so a question that gives a collection pattern (for example, collected the month after sale) must be applied carefully: this month's receipts come from last month's credit sales. The same applies to payments to creditors, which often lag the purchase. Cash sales hit the budget in the month they occur. Mapping each item to the month its cash actually moves, not the month the sale or purchase was made, is where most marks are won or lost.
The closing cash balance of one period becomes the opening balance of the next. A multi-month budget is a chain: get one month wrong and every later month is wrong too. Always carry the closing figure down before starting the next month.
Reading a cash budget
A cash budget is a planning tool, so interpretation matters as much as the arithmetic. A forecast surplus might be invested or used to fund growth; a forecast deficit warns management to act before it happens - arranging an overdraft, delaying an asset purchase, chasing debtors, or reducing drawings. The value of the budget is precisely this early warning: it converts a future timing problem into a decision that can be made now while options still exist.
Using budgets
Budgets also let a business compare actual results to plan (variance analysis), set targets and coordinate departments. A favourable variance means actual cash was better than budgeted; an unfavourable variance prompts investigation and corrective action. Comparing the cash budget to the later cash flow statement is one practical form of this analysis, closing the loop between planning and reporting.
Depreciation is a non-cash expense, so it never appears in a cash budget. Including it understates the cash balance. Likewise, remember to include cash-only items such as loan principal and drawings, which do not appear on the income statement.
Exam-style questions
Questions in the style of TASC exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
Practice8 marksPrepare a cash budget for Hill Traders for July and August. Opening cash 1 July 18\,000 in July and 15\,000 and July credit sales are expected to be 7\,000, rent 11\,000. In August the business will also pay $9\,000 cash for a new vehicle. Show the closing cash balance for each month and comment on the result.Show worked answer →
Collect credit sales one month in arrears, then run each month.
July receipts cash sales collection of June credit sales .
July payments .
July closing cash .
August receipts cash sales collection of July credit sales .
August payments .
August closing cash .
Comment: cash builds steadily and easily absorbs the vehicle purchase in August, leaving a healthy closing balance, so the business has adequate liquidity. Markers reward collecting credit sales in the following month, the vehicle as an August cash payment, and the closing balance of one month carried to the next.
Practice5 marksExplain why a profitable business can run out of cash, and describe two actions a cash budget could prompt management to take to avoid a shortfall.Show worked answer →
A full 5 mark answer explains the profit-versus-cash gap and gives practical actions.
A business can be profitable yet short of cash because profit is measured on the accrual basis while cash depends on timing. Credit sales raise profit before the cash is collected; cash is tied up in inventory and unpaid debtors; large cash outflows such as buying a non-current asset or repaying loan principal reduce cash but are not expenses; and drawings remove cash without affecting profit. So a firm can report profit while its bank balance falls.
A cash budget that forecasts a shortfall lets management act early, for example: arrange an overdraft or short-term loan before the shortfall hits; speed up debtor collection or tighten credit terms; delay or stage a planned asset purchase; reduce drawings temporarily; or negotiate longer terms with suppliers. Any two valid actions earn the marks. Markers reward the accrual-versus-cash explanation and two realistic, budget-driven actions.