What you'll learn
A budget is a financial plan for a future period, and a cash flow forecast is the particular budget that predicts when money will actually enter and leave the bank. The distinction that governs this whole topic is that profit and cash are not the same thing: a business can be profitable on paper and still fail because it cannot pay wages this month. This guide covers the purposes of budgeting, the main types of budget, how a cash flow forecast is constructed and read, variance analysis with worked figures, the causes and remedies of cash flow problems, and the behavioural effects budgets have on the people held to them. It sits in Unit 1 Module 3.
Key terms and definitions
Budget — a financial plan for a future period, expressed in money.
Cash flow forecast — a prediction of cash receipts and payments period by period.
Receipts — cash actually coming into the business.
Payments — cash actually going out.
Net cash flow — receipts less payments for a period.
Opening balance — the cash held at the start of a period.
Closing balance — opening balance plus net cash flow; the opening balance of the next period.
Working capital — current assets less current liabilities.
Variance — the difference between a budgeted figure and the actual outcome.
Favourable variance — a difference improving profit: revenue above budget or costs below it.
Adverse variance — a difference reducing profit: revenue below budget or costs above it.
Zero-based budgeting — building each budget from nothing, justifying every item afresh.
Incremental budgeting — basing the budget on last period's figures adjusted for expected change.
Budgetary control — comparing actual results against budget and acting on the differences.
Credit period — the time customers take to pay, or the business takes to pay suppliers.
Core concepts
Why businesses budget
Budgets serve several purposes at once, and questions often ask you to distinguish them.
Planning forces managers to think ahead and quantify their intentions. Coordination ensures departments' plans are consistent, so production matches what sales expects to sell. Communication tells managers what is expected of them. Motivation can arise from a target that is challenging but believed achievable. Control compares actual outcomes against plan and prompts action on the difference. Authorisation gives a manager permission to spend up to a stated limit.
Types of budget
A sales budget forecasts revenue and is usually prepared first, because most other budgets depend on it. A production budget follows from it. Cost budgets cover materials, labour and overheads. A capital expenditure budget covers non-current asset purchases. The cash budget — the cash flow forecast — pulls the cash consequences of all the others together. The master budget consolidates everything into a forecast income statement and statement of financial position.
Incremental budgeting takes last period's figures and adjusts them. It is quick and simple, and it carries forward inefficiencies that were never questioned. Zero-based budgeting requires every item to be justified from nothing each period. It exposes waste and forces priorities to be examined, at a considerable cost in management time — which is why many businesses use it selectively rather than annually.
Constructing a cash flow forecast
The forecast lists receipts, then payments, then derives the net flow and the running balance.
Net cash flow = Receipts − Payments Closing balance = Opening balance + Net cash flow
Worked example. A business opens January with $10,000 in the bank.
| January | February | March | |
|---|---|---|---|
| Receipts | $50,000 | $40,000 | $45,000 |
| Payments | $45,000 | $52,000 | $55,000 |
| Net cash flow | $5,000 | −$12,000 | −$10,000 |
| Opening balance | $10,000 | $15,000 | $3,000 |
| Closing balance | $15,000 | $3,000 | −$7,000 |
Reading it. The business is fine in January, tight in February and overdrawn by $7,000 in March. The value of the forecast is entirely in seeing that now rather than in March: an overdraft can be arranged in advance at a reasonable rate, whereas a business discovering the shortfall on the day borrows in an emergency, on worse terms, or fails to pay.
The essential point, repeatedly examined: the closing balance of one period is the opening balance of the next, so a deficit carries forward and compounds.
Why profit and cash differ
A profitable business can run out of cash, and the reasons are structural rather than exceptional.
Credit sales are recorded as revenue when the sale is made but produce cash only when the customer pays. Purchases of non-current assets consume cash immediately while the cost is spread across years in the income statement. Depreciation is an expense reducing profit but involves no cash payment at all. Loan repayments reduce cash but only the interest portion is an expense. Inventory build-up consumes cash before any sale occurs. And drawings or dividends remove cash without appearing as an expense.
This is why the cash flow forecast exists alongside the budgeted income statement rather than instead of it.
Causes and remedies of cash flow problems
Causes. Customers paying late or not at all; holding too much inventory; overtrading, where a business expands faster than its working capital can support; seasonal fluctuation in trade; unexpected large costs; poor forecasting; and buying non-current assets from short-term funds.
Remedies for receipts. Invoice promptly, chase overdue accounts systematically, offer discounts for early settlement, run credit checks before extending terms, and use debt factoring where the cost is justified.
Remedies for payments. Negotiate longer credit with suppliers, schedule payments to match receipts, lease rather than buy, and delay non-essential capital spending.
Remedies for the gap. Arrange an overdraft in advance, take a short-term loan, sell surplus assets, or inject further owner capital.
Each remedy has a limit, and saying so is what distinguishes a strong answer. Pressing customers too hard loses them; stretching suppliers risks supply being withheld; cutting inventory too far means running out of stock; and an overdraft costs interest and is repayable on demand.
Variance analysis
A budget is only useful if actual results are compared against it and the differences acted on.
Worked example.
| Budget | Actual | Variance | Type | |
|---|---|---|---|---|
| Sales revenue | $200,000 | $185,000 | $15,000 | Adverse |
| Costs | $150,000 | $140,000 | $10,000 | Favourable |
| Profit | $50,000 | $45,000 | $5,000 | Adverse |
Revenue fell $15,000 short, which is adverse. Costs came in $10,000 below budget, which is favourable. The net effect is profit $5,000 below plan.
Interpreting it is where the marks are. A favourable cost variance is not automatically good news: costs may be down because sales volume was lower, in which case the two variances have the same cause. They may also be down because quality was reduced, maintenance deferred or training cancelled — savings that create larger costs later. Always ask why a variance occurred before judging it.
Investigating every variance is not worth the management time. Businesses normally set a threshold — by size or percentage — and investigate only those exceeding it, which is management by exception.
Behavioural effects
Budgets are applied to people, and people respond to them.
A target believed achievable motivates; one believed impossible causes disengagement, which is expectancy theory applied to budgeting. Managers who negotiate their own budgets may build in slack — understating revenue or overstating costs — so the target is easy to beat. Budgets set without consultation are resisted, while participation improves both accuracy and commitment. And where budgets drive rewards, managers may act to hit the number rather than to serve the business, such as spending an unused allocation before year end to protect next year's allowance.
Worked examples
Example 1: Completing a forecast
Question: "Complete the cash flow forecast and advise the business." (15 marks)
Working. Take each column in turn: net cash flow is receipts less payments, and the closing balance is the opening balance plus that net flow, carried into the next period as its opening balance. In the example above, January closes at $15,000, February at $3,000, and March at −$7,000.
Advice. Identify the March deficit and state its size. Then give remedies matched to the cause and scaled to the gap: arrange an overdraft facility in advance for roughly the shortfall, accelerate receipts by chasing overdue accounts and offering settlement discounts, defer any non-essential payment falling in March, and negotiate longer terms with suppliers for that month. Note the limits — an overdraft costs interest and is repayable on demand, and pressing customers risks losing them. Conclude by making the general point: the forecast's value lies in revealing the problem in time to arrange finance cheaply rather than in an emergency.
Example 2: Variance analysis
Question: "Calculate the variances and comment on what they show." (12 marks)
Working. Sales: $200,000 budget against $185,000 actual = $15,000 adverse. Costs: $150,000 budget against $140,000 actual = $10,000 favourable. Profit: $50,000 budget against $45,000 actual = $5,000 adverse.
Comment. Do not stop at the labels. The favourable cost variance may simply reflect the lower sales volume, in which case the two variances share one cause and the cost saving is not an achievement. Alternatively costs fell through genuine efficiency, or through deferring maintenance and training, which stores up expense later. Recommend investigating the sales shortfall first, since it is the larger variance and the one driving the profit gap, and note that a business would normally investigate only variances exceeding a set threshold rather than every difference.
Example 3: Profit against cash
Question: "Explain how a profitable business can run out of cash." (10 marks)
Outline. Establish the principle: profit records revenue when earned and costs when incurred, while cash records money when it actually moves. Then give the mechanisms concretely. Sales made on credit are profit now and cash perhaps sixty days later, so a business growing rapidly on credit terms records rising profit while its bank balance falls. Buying a machine takes the cash immediately but charges only a portion as depreciation each year. Depreciation reduces profit without moving any cash at all. Loan repayments take cash while only the interest is an expense. Inventory build-up consumes cash before any sale. Conclude with overtrading as the clearest case — a business expanding faster than its working capital can support is profitable and insolvent at the same time — and note that this is the commonest cause of small-business failure.
Common mistakes and how to avoid them
Treating profit and cash as the same. They differ in timing and in what each records.
Forgetting to carry the closing balance forward. It becomes the next period's opening balance.
Calling all favourable variances good. Costs below budget may mean sales were below budget too.
Including depreciation in a cash flow forecast. It involves no cash movement.
Recommending remedies without limits. Every remedy has a cost or a risk.
Investigating every variance. Management by exception applies a threshold.
Ignoring behavioural effects. Budgetary slack and disengagement are examined.
Inventing figures in a forecast question. Use the figures given and show the working.
How this links to your Internal Assessment
Cash flow is one of the more accessible quantitative themes, because even small businesses that keep no formal accounts usually know when money is tight.
Expect informality. Many small Caribbean businesses do not prepare written forecasts, and establishing that — and what it costs them — is a finding rather than a dead end. Asking how the owner knows whether there will be enough cash next month often produces a more revealing answer than asking to see a forecast.
If you can obtain figures, construct the forecast yourself and show the working. Look for the seasonal pattern, since tourism, agriculture and school-term trade all produce predictable peaks and troughs that a forecast makes visible. And treat any figures the owner provides as their estimates rather than as verified data, saying so in your limitations.
Exam technique for budgeting and cash flow
Show the formula and the working for every figure you derive.
Carry the closing balance forward as the next opening balance, and check the sequence.
Label variances as favourable or adverse, and never as merely positive or negative.
Explain why a variance may have arisen before judging it.
Scale remedies to the size of the gap and state the limit of each.
Keep profit and cash distinct throughout; questions are built on the difference.
Include behavioural effects in evaluation questions.
Watch the command word: complete and calculate want the working, explain wants the mechanism, evaluate and advise want a justified recommendation.
Quick revision summary
A budget is a financial plan serving planning, coordination, communication, motivation, control and authorisation, built either incrementally from last period's figures or from zero by justifying every item afresh. The cash flow forecast predicts receipts and payments, deriving net cash flow and a running balance in which each closing balance becomes the next opening balance, so a deficit carries forward and compounds. Profit and cash differ because credit sales are revenue before they are cash, asset purchases take cash immediately while spreading the cost, depreciation reduces profit without moving cash, loan repayments take cash beyond the interest expense, inventory consumes cash before any sale, and drawings remove cash without being an expense. Cash problems arise from late payment, excess inventory, overtrading, seasonality, unexpected costs and funding assets from short-term sources; remedies operate on receipts, on payments and on arranging finance, and each has a limit worth stating. Variance analysis compares budget with actual, labelling differences favourable or adverse, and the interpretation matters more than the label, since a favourable cost variance may simply reflect lower sales or deferred maintenance. Businesses investigate by exception above a threshold rather than examining every difference. Budgets also act on people, producing motivation where targets are believed achievable, disengagement where they are not, and budgetary slack where managers negotiate their own.