Cash Budgets

Cash is the physical form of currency, including banknotes, that can be readily spent. It is the most liquid form of money in circulation because it can be accessed and used immediately. Examples of cash currencies include the dollar, euro, and peso. Cash is also the most liquid investment because it is already in its purest form. The next most liquid asset is a cash equivalent, which is an asset that can be quickly converted into cash. Cash equivalents reach maturity much more quickly than other forms of investment. This allows companies to use cash equivalents for any short-term needs that may arise. If the company needs to convert its cash equivalent into cash, it can do so easily and quickly. This can be significant, as some business deals have short windows of opportunity.

There are five different types of cash equivalents that are readily convertible to cash: Treasury bills, commercial paper, marketable securities, money market funds, and short-term government bonds. First, Treasury bills, also known as T-bills, are a discounted, low-risk security offered by the U.S. Department of the Treasury to the general public to finance government projects. An advantage of this type of investment is that it is very safe because it is backed by "the full faith and credit" of the U.S. government; a disadvantage is that it does not yield a very high return. Another type of cash equivalent is commercial paper, an unsecured, short-term debt instrument issued by a corporation, typically for financing accounts receivable and inventories, in order to meet short-term liabilities. Commercial paper is riskier than T-bills simply because it is not backed by the U.S. government. Nonetheless, commercial paper offers a small increase in returns to investors willing to take on a small increase in risk. The third type of cash equivalent is marketable securities. Marketable securities are financial instruments comprised of either equity or debt. The risk involved with marketable securities largely depends on whether the security is backing debt or equity. If the security is backing debt, it is less risky than if it were backing equity. However, as is the case with other investments, the higher the risk, the higher the return, and the lower the risk, the lower the return. The fourth type of cash equivalent is money market funds, which are mutual funds that invest in short-term debt securities, such as T-bills and commercial paper. The risk and return of a money market fund depends on what type of securities it invests in and the individual risk of each of those securities. The last type of cash equivalent asset is the short-term government bond, which is sold to fund federal government projects. These short-term bonds are subject to inflation risk, interest rate risk, and political risk, which is a risk that could result from government disruptions. However, since short-term government bonds, such as T-bills, are backed by the government, their risk generally remains relatively low.

A cash budget is the expected amount of cash inflows and outflows for a business during a specified period. Cash inflows are the sources of income for a business, and cash outflows are the uses of income by the business. A budget usually determines whether the business has enough cash to operate and to grow. For example, at the end of their fourth quarter, Big Systems Inc. wants to buy new computer systems for $100,000. The company will not have the budget to buy the systems because it only has $66,160 available in cash. Therefore, Big Systems Inc. will need to budget to make the purchase. Budgeting for expenditures takes into consideration any of the business's future obligations. The company must forecast its sales and make assumptions about its necessary future expenses to create a budget.

For a cash budget, a company needs to project its inflows and outflows and verify that it will have enough cash and cash equivalents on hand to pay for the expenses it will face in the next period. If the business does not have enough liquid assets on hand, then it will have to modify its spending or find another way to make up the costs. If Big Systems Inc. needs new computer systems at the end of the fourth quarter, it may have to fund the purchase by taking out a short-term loan, a debt that is typically repaid in one year or less. The conversion cycle is a metric used to measure the time between when a company pays its suppliers and when it collects payment from its customers. Essentially, the conversion cycle measures how long it takes a company to turn its cash into more cash. Another period that must be considered is the operating cycle. The operating cycle is the average duration it takes to produce goods to sell, sell the goods, and receive cash from customers in exchange for the goods in order to produce more or pay bills.

Companies also practice capital budgeting. This is the process of analyzing and leveraging assets in order to prepare for large long-term expenditures. Capital expenditures include costs such as acquiring new building space or investing in a long-term venture. The assets, such as equipment and factories, needed for a company to conduct business are referred to as capital. The ultimate business goal of capital budgeting is maximizing shareholder value. Instead of holding on to its cash and cash equivalents, a company can invest them to maximize shareholder value, as long as it has the capacity to do so. Capacity is the maximum level of output a company can sustain without accessing its cash and cash equivalent assets. For capital budgeting purposes, Big Systems Inc. is looking to purchase new office space within its second quarter. To do this, Big Systems Inc. needs $150,000 and therefore it must first look at its cash budget to determine whether it has enough cash to pursue this capital expenditure.

Businesses use cash budgeting to determine the timing and planning of cash inflows and outflows. If there is going to be a shortfall, the company needs to create a plan to address the shortfall. One of the ways that it can make up for a shortage is by establishing a line of credit. A line of credit is an arrangement between a bank and a business that establishes the maximum amount of a loan that a business can borrow. Having a line of credit will help provide a cash infusion whenever the business experiences a shortfall of cash inflows. A line of credit provides a company with unique flexibility, as it can be used for a range of reasons—such as funding operating costs, covering inadequate cash flows, and seeking out new opportunities. For example, Big Systems Inc. requires $100,000 worth of material to complete its envelope orders. However, the total cash available to fund operations is only $75,000. Big Systems Inc. has a $60,000 line of credit available through Mason Money Co. Thus, Big Systems Inc. draws $25,000 from its available line of credit with Mason Money Co. to fund its operations. A line of credit can be revolving or non-revolving. A revolving credit line is a line of credit where available funds can be used and repaid repeatedly as long as the borrower abides by the creditor's terms. The most common example of a revolving credit line is a credit card. With credit cards, businesses are only charged interest on the actual amount borrowed. They can continually reuse the card and repay the debt as long as they do not exceed their credit limit and they meet other requirements, such as making payments on time. After Big Systems Inc. paid Mason Money Co. back $25,000 plus interest, the line of credit available is again $60,000. Here, Big Systems Inc. has a revolving line of credit with Mason Money Co. because the available line of credit was replenished after the previous transaction was paid in full. In contrast, non-revolving credit is a line of credit where available funds can only be used once, and when they are repaid, they can never be borrowed again. The most common examples of non-revolving credit lines are automobile loans and student loans.

In cash budgeting, it is also important to know when and if the company will experience a surplus of cash flow. The surplus cash flow can be utilized to cover short-term investment needs or even a long-term investment in the event of a substantial surplus of cash.

A key variable in deciding the health of a company is its working capital, sometimes also referred to as net working capital. Working capital is current assets minus current liabilities, which can help determine the business entity’s ability to pay current liabilities. This is a measurement of the company's operational efficiency and short-term financial health. With an understanding of its current financial state, if an unexpected balance were to come due, a business could react more quickly to deal with the issue. This is because after computing a company's working capital, managers are aware of how much money is available to address unexpected issues. For instance, if its working capital is substantially positive, this means that the company has enough funds from its available assets to cover its current liabilities and can determine how much can be allocated to these unexpected costs. In contrast, if the working capital is substantially negative, then the company likely does not have enough funds to pay its current liabilities and will not be able to put money toward the unexpected costs. For example, if Big Systems Inc.'s building needs to be repaired, the company should calculate its working capital to determine if it can first meet its current liabilities before using its money for this repair cost. If Big Systems Inc. has a negative working capital, it means that it has insufficient funds to pay its current liabilities and/or any unexpected costs. Additionally, it does not have enough money to repair its building, Big Systems Inc. may turn to short-term financing.

Capital budgeting is vital to long-term growth and success and requires creating a plan for replacing machinery, updating facilities, or making any changes that will improve business operations. This planning is essential for the ongoing success of a company, since all businesses strive to continue to operate and grow. Capital budgets provide a measurable basis for companies to determine the long-term profitability of potential investment projects. If a project will yield a high enough return on investment, it will likely be approved because it will be able to pay for itself over time and make a profit for the company. If there is a deficit in the capital budget, then a company may need to decide whether or not it can do a project. If the project is necessary but funding is not readily available, the company may get a loan from a bank in order to pursue the project.