Question

The textbook states that the cash budget is one of the most important parts of the master budget. There are several reasons listed as to why a cash budget is considered to be this important; I would like your thoughts as to why you consider the cash budget to be this important. How does the granting of credit to customers (and to your company from suppliers) affect your answer? What happens when you face a cash shortage? Is there something that can be "built in" the budget that considers such a situation and incorporates it into the master budget? What happens to the cash budget when you face an unforeseen emergency requiring cash?

Answer 1

Here one thing to see that is importance of cash budget which is important part of Master Budget. Cash budget basically shows inflow-outflow of cash as well as balance of cash required during the period. Somehow we underestimate cash budget importance because every organization is having cash accordingly to their requirement. But one thing to understand, that every business should plan its funds in such a way so that it can earn maximum. There should not be any surplus cash in business or if any then that should be invested to earn additional income and if there is any shortage of cash then urgent requirement of cash can be fulfilled.

Before giving answer I would like to assume you running a business because that would help you understanding more this thing.

Now come to points you asked in question:

1. How does the granting of credit to customers (and to your company from suppliers) affect your answer?

So here is the answer. Suppose you run a business and you follow fixed credit term to pay your suppliers and get payment from your debtors (receivable). So now just think you are receiving amount from debtors (which includes profit and other expenses along with cost you incurred) and you are paying to your creditor from that amount (obviously every time you can’t lose your pocket-personal one). So what if you don’t receive payment or received payment late from debtors then you will not be able to payment to your creditors. So somehow business would be in trouble. So here cash budget help you to know. What are the requirements of business to pay off and get paid that should be in sync.

2. What happens when you face a cash shortage?

If business faces a cash shortage then everything will get mess up. Because you will not be able to pay suppliers and you will not more goods\inventory. Also you staff would have negative impact as business would not be able to pay their compensation. Other expenses will also be not incurred. Everything will get stopped. Also more borrowings might be taken which can affect profitability adversely.

3. Is there something that can be "built in" the budget that considers such a situation and incorporates it into the master budget?

Yes, a good cash budget should always incorporate cash requirements of cash and funds. Because no one knows when emergency situation can happen therefore it is good to incorporate that in cash budget as well. That might be in terms of some marketable securities or some other quick overdraft facility (in case of shortage).

4. What happens to the cash budget when you face unforeseen emergency requiring cash?

Cash budget should incorporate these situations as well but in cash budget we would make changes which would impact cash inflows so cash budget will get changed for emergency cash requirements and quick cash facilities (overdraft or sale of marketable securities) would be in scene. Somehow cash budget would also have changes (if not in to consideration) for emergency cash requirements.