Most businesses incorporate cash budgets in their overall budgeting process. Cash budgets review anticipated cash receipts and cash disbursement for the budget period. Managers use this information to determine if the company needs additional financing for the budget period. Like all processes, cash budgets come with several disadvantages.
The budgeting process relies on estimates of future events. Managers try to anticipate the future activities of the company. The cash budget relies on estimates of future sales and future collections received on those sales. The cash budget also relies on estimates of future expenses that the company expects to incur. Managers base estimates on their instinct rather than facts. Estimates limit the effectiveness of the cash budget because factual knowledge is not available.
The budget process involves creating numbers to enter in the budget, publishing the budget numbers and distributing those reports to management. Once published, these numbers don’t change. Cash budgets include information regarding the company’s expected financing needs. Once management reviews the cash budget, they make decisions based on the expected financing needs. If the actual financing needs are less than the budget, management has already committed to the financing for the budget period. If the actual financing needs are more than the budget, management has not committed to enough financing and will incur a cash deficit. Management will need to borrow money at higher than planned interest rates to meet their cash needs.
Managers with ulterior motives manipulate budget numbers to reflect well on themselves. A manager making decisions that impact the cash budget may underestimate her expenses for the budget period. This reports budgeted cash disbursements that are too low. The manager receives praise for her work on the budget. However, when the actual expenses occur and do not meet the budget numbers, the cash disbursements will incur a variance. By that time the manager may be in a different position and not feel the repercussions of her actions.
When using a cash budget to analyze financing needs and financing options, nonfinancial factors are omitted. A business owner may choose to borrow funds from one of two banks. One bank may offer a lower interest rate, which can be quantified and reported on the cash budget. The other bank may offer better customer service and offer nonfinancial perks for borrowing from them. The nonfinancial factors are not reflected in the cash budget.