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Give those budgets a thorough work out! Part 2

Continuing from last month's discussion of budgets, we turn this month to the cash budget, and the question: Why is cash flow important?

As many local CEOs of SMEs (small- or medium-sized enterprises) have told me time and time again, it's ok to lose money once in a while, but the real problems come when cash levels thin out. Many CEOs recount battle stories about overdue payments to vendors who are holding their supplies "hostage" until they can get some sense of an imminent payment. The customers, however, are already over 90 days in arrears and there is little the CEO can do except scramble around for short-term working capital to really close the transaction.

Given this painful history, the budget is the best place to set up lines of defence to avoid future cash-crunch episodes. If there is going to be a cash crunch, you should get some sense of it in the cash budget, well before it happens. Unlike your profits and loss forecast, which begins with expected sales, the cash budget begins with your expected cash balance which is drawn from the cash item on your balance sheet. From there, lay out your expected cash receipts and disbursements for the coming quarters or months.

On the receipts side, remember to factor in both the amounts that you expect to receive from your customers as well the timing in which these payments will arrive to your firm. Specifically, this means you will need to make estimates of these cash inflows based on your credit terms. Companies rarely have only one credit term that can be applied to all their customers, so take the time to analyze your terms over the last year and see which can be applied in next year's budget. You might need to default to some average for these forecasted receipts.

Disbursements that affect the cash budget will be a function of factors such as direct materials, direct labour, sales and administrative costs, and, of course, tax payments. You will also need to consider outward payments for new fixed assets such as computers and office furniture. Speaking of fixed assets, note that depreciation expense, which normally goes into the income statement to arrive at net income, is a non-cash expense that we don't need to include here.

The bottom line for the cash budget, that is, the difference between the cash receipts and disbursements, is also the amount of financing you will need for that particular period you are forecasting. For example, if expenses exceed receipts in the second quarter of next year, you'll need to prepare a source of financing, either in debt or new equity, to cover that shortfall. You'll also obviously want to do it by the end of the first quarter. Remember that if this particular round of financing is in debt, your subsequent quarters will also need to include the repayment of that debt in the cash flow forecasts.

Sounds straight forward, doesn't it? But it's not. Speaking to CEOs in Beijing, I continue to be surprised at how many local SME's rarely do this exercise. Sure it's a lot of number crunching, but it's a small price to pay if you consider the alternative of running critically short of cash thereby risking heightened financial risk and even bankruptcy. With China continuing to boom, the CEO would have no one to blame but himself.

Writing on finance and economics for the last 18 years, David Seto, CFA splits his time between Hong Kong and Beijing where he reads Chinese Classics and tries to revive his defunct band, Scarbelly. Any comments on his columns can be sent to dseto@btmbeijing.com.