Cash Flow Basics

What is cash flow? It's basically the movement of funds in and out of your business.
You should be tracking this either weekly, monthly or quarterly. There are
essentially two kinds of cash flows:

• Positive cash flow: This occurs when the cash funneling into your business from
sales, accounts receivable, etc. is more than the amount of the cash leaving your
businesses through accounts payable, monthly expenses, salaries, etc.

• Negative cash flow: This occurs when your outflow of cash is greater than your
incoming cash. This generally spells trouble for a business, but there are steps you can
take to remedy the situation and generate or collect more cash while maintaining or
cutting expenses.
Achieving a positive cash flow does not come by chance. You have to work at it. You
need to analyze and manage your cash flow to more effectively control the inflow and
outflow of cash.
Cash flow can be further broken into three major categories:

 Operating cash flow: This refers to the net cash generated from a company’s
normal business operations. In actively growing and expanding companies,
positive cash flow is required to maintain business growth.
 Investing cash flow: This refers to the net cash generated from a company’s
investment-related activities, such as investments in securities, the purchase
of physical assets like equipment or property, or the sale of assets. In healthy
companies that are actively investing in their businesses, this number will
often be in the negative.
 Financing cash flow: This refers specifically to how cash moves between a
company and its investors, owners, or creditors. It’s the net cash generated to
finance the company and may include debt, equity, and dividend payments.

How to Improve Cash Flow

Most business owners see growth as the solution to a cash-flow problem. That's why
they often achieve their goal of growing the business only to find they have increased
their cash-flow problems in the process. Plan for growth and the related cash outlays in
advance, so they do not come as a surprise. In the meantime, the SBA recommends
that you take the following practical steps to better manage cash flow, especially for the
growing business:

• Collecting receivables - To speed up the receipt and processing of receivables, the

SBA suggests several steps. Spring for a lockbox service, post office boxes serviced by
banks so that customers in far flung locations can mail payments there and the checks
will be processed by the banks more quickly. Ask customers to preauthorize checks so
that banks can draw against their accounts at timed intervals. Centralize your banking at
one bank. Ask customers to pay with depository transfer checks, a relatively cheap fund
transfer. You can also try offering discounts to customers if they pay bills quickly.

• Tightening credit requirements - Businesses often have to extend credit to

customers, particularly when starting out or growing. But you have to do your research
beforehand to determine the risk of extending credit to each customer. Can they pay
their bills on time? Is their business growing or faltering? Are they having cash-flow
problems? The SBA recommends getting a Dun & Bradstreet report on potential
customers and asking them to fill out a credit application. You should also check
references. Another option to extending store credit is to accept credit cards. This will
cost you a percentage, generally from 2 to 5 percent of the sale, but it may be a safer
bet for getting paid on time.

• Increasing sales - If you need more cash, it seems like a no brainer to go out and try
to attract new customers or sell additional goods or services to your existing customers.
But this may be easier said than done. New customer acquisition is essential to a
growing business, but it can take time and money to convert prospects into sales.
Selling more to existing customers is cheaper and you may be able to do this by
analyzing what they're buying and why - information that may even lead you to increase
your profit margin and, hopefully, generate more cash. But the SBA warns businesses
to be careful when increasing sales because you may just increase your accounts
receivables and not actual cash if these sales are on credit.

• Pricing discounts - One option to increasing cash flow is to offer your customers
discounts if they pay early. While this practice may impact your profit margin, it may
help your management of cash flow by incentivizing customers to make payments
earlier than billing cycles typically require. Your company may also take advantage of
this with suppliers and others that you owe, but be careful that your early payments of
debt don't leave you with a cash flow shortfall.

• Securing loans - Short-term cash flow problems may sometimes necessitate a

business taking out a loan from a financial institution. Some possible types are revolving
credit lines or equity loans, according to the SBA. Most of the time this type of borrowing
accomplishes its goals, although during the financial crisis many banks were canceling
credit lines and calling in loans. Another option is a long-term amortized loan which
includes interest and principal until the loan is paid off.

Getting Control of Your Cash Flow

Campbell suggests asking yourself the following two questions to get a sense about
whether you have your business' cash flow situation under control:

1. What is my cash balance right now?

2. What do I expect my cash balance to be six months from now?

"If you can't answer these two questions, then strap yourself in for a wild ride," he says.
"You are on a roller coaster ride that's about to become really frightening. You don't
have your cash flow under control."

One way to keep that situation under control is by tracking your cash flow results every
month to determine if your management is creating the type of cash flow your business
needs. This also helps you get better and better at creating cash flow projections you
can rely on as you make business decisions about expanding your business and taking
care of your existing bills.
BUDGETARY CONTROL METHODS
There are four common types of budgets that companies use: (1) incremental, (2)
activity-based, (3) value proposition, and (4) zero-based. These four budgeting methods
each have their own advantages and disadvantages, which will be discussed in more
detail in this guide.

1. Incremental budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a
percentage to obtain the current year’s budget.  It is the most common method of
budgeting because it is simple and easy to understand.  Incremental budgeting is
appropriate to use if the primary cost drivers do not change from year to year. 
However, there are some problems with using the method:

 It is likely to perpetuate inefficiencies. For example, if a manager knows that

there is an opportunity to grow his budget by 10% every year, he will simply take
that opportunity to attain a bigger budget, while not putting effort into seeking
ways to cut costs or economize.
 It is likely to result in budgetary slack. For example, a manager might overstate
the size of the budget that the team actually needs so it appears that the team is
always under budget.
 It is also likely to ignore external drivers of activity and performance. For
example, there is very high inflation in certain input costs.  Incremental budgeting
ignores any external factors and simply assumes the cost will grow by, for
example, 10% this year.

2. Activity-based budgeting

Activity-based budgeting is a top-down budgeting approach that determines the amount

of inputs required to support the targets or outputs set by the company.  For example, a
company sets an output target of $100 million in revenues.  The company will need to
first determine the activities that need to be undertaken to meet the sales target, and
then find out the costs of carrying out these activities.

3. Value proposition budgeting

In value proposition budgeting, the budgeter considers the following questions:

 Why is this amount included in the budget?

 Does the item create value for customers, staff, or other stakeholders?
 Does the value of the item outweigh its cost? If not, then is there another reason
why the cost is justified?

Value proposition budgeting is really a mindset about making sure that everything that is
included in the budget delivers value for the business. Value proposition budgeting aims
to avoid unnecessary expenditures – although it is not as precisely aimed at that goal as
our final budgeting option, zero-based budgeting.

4. Zero-based budgeting

As one of the most commonly used budgeting methods, zero-based budgeting starts

with the assumption that all department budgets are zero and must be rebuilt from
scratch.  Managers must be able to justify every single expense. No expenditures are
automatically “okayed”. Zero-based budgeting is very tight, aiming to avoid any and all
expenditures that are not considered absolutely essential to the company’s successful
(profitable) operation. This kind of bottom-up budgeting can be a highly effective way to
“shake things up”.

The zero-based approach is good to use when there is an urgent need for cost
containment, for example, in a situation where a company is going through a financial
restructuring or a major economic or market downturn that requires it to reduce the
budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather than
essential operating costs. However, it can be an extremely time-consuming approach,
so many companies only use this approach occasionally.

The budgeting process

The budgeting process lets an organization plan and prepare its budgets for a set
period. It involves reviewing past budgets, identifying and forecasting revenue for the
coming period, and assigning amounts to spend on a company’s various costs. 

When done well, the process involves input from senior management, your finance
team, and budget managers across the organization. 

Think of your budget as putting your business plan into action. You’ve set priorities and
goals for the company in the coming year, and the budget allocates financial resources
to achieving these.

8 key budgeting process steps

There is probably no one “right way” to create a business budget. But to guide you
through the process, here are eight important steps to follow:

1. Review the previous period

2. Calculate existing revenue
3. Set out fixed costs
 4. List variable costs
5. Forecast extra spending
6. Scrutinize cash flow
7. Make business decisions
8. Communicate it clearly

Let’s take a closer look at each in turn.

1. Review the previous period

The starting point should always be to look over the existing information you have to
hand. And in this case, the best evidence for how your new budget should play out is
the previous one.

A few questions to consider:

 Did you spend more or less than anticipated?

 Were your assumptions about the industry and your own growth accurate?
 Were there unexpected hurdles or shortfalls, and what caused these?
 Was the budget easy to enforce? Did team members follow it?

You should do this at a high level for the entire company, and you should also
encourage individual budget managers (if you have them) to do the same for their own
scopes.

Also critical in this step is to consult other team leaders. As we’ll see, the best
budgets are collaborative, and you need to know how well the previous budget worked
for everyone affected.

2. Calculate existing revenue

The most obvious starting point for any budgeting exercise is to figure out how much
you have to spend. This will involve other costs, of course, but we’ll come to these next. 

At the company level, you need to identify income streams. How much money are you
making gross? List your core products, their pricing, and the expected volumes for each
in the coming year. Naturally, this involves some estimates and won’t be perfect. 

For startups that aren’t yet profitable (or don’t have paying customers at all), you’ll be
spending investor capital or venture debt. So for this stage, you need to identify the
“burn rate” you’re comfortable with - how much of the total investment you’re able to
commit for each period of time.
3. Set out fixed costs

Fixed costs - often called “overheads” - are those over which you have little control.
Most importantly, they’re not impacted by your sales - whether the business succeeds
or not won’t have any effect on the amount you pay.

Fixed costs can include: 

 Rent or mortgage payments for office space

 Website hosting and servers
 Employee salaries
 Insurance
 Interest on loans
 Utilities (Such as electricity and internet)

Assuming you know your employee headcount for the year, and have your office space
and insurance sorted, you can comfortably plan for these costs.

4. Add variable costs

Variable costs are usually thought of as discretionary expenses. As opposed to fixed

costs, these are more fluid and can be tinkered with.

Examples of discretionary expenses include:

 Marketing and advertising

 Corporate investments and donations
 Software subscriptions, particularly where they aren’t critical to running the
business
 Travel and client meetings
 Team perks
 Office decor and renovations

“Discretionary” doesn’t mean that these costs are frivolous or unnecessary. A business
won’t grow without marketing, and team perks can be a key contributor to keeping
employees happy for longer. 

But when building a business budget, these costs have to be justified more critically.
And when you’re in danger of going over budget, variable costs are usually the first to
be cut. 
5. Forecast additional spending

Are there any one-off expenses on the horizon? These can include a serious merger or
acquisition, consultant help to prepare for audit, or even a special event or party that
doesn’t come around often. 

If possible, try to set out these irregular expenses separately in your budget. You
certainly need to account for them in your spending, but they won’t be a core piece for
years to come. 

You might also consider a “rainy day fund.” Because the only certainty is uncertainty, it
pays to have some portion of your budget set aside in case unexpected events occur
and you need a safety net.

6. Scrutinize cash flow

This is where the budget analysis starts. You should now have a clear record of
expected revenue and expenses, and hopefully you even have a record of these for the
previous period. 

Was your spending as expected? Did you have consistent revenue across the last year,
or can you spot seasonal effects?

“Cash flow” refers to the relationship between money coming in and going out. You
want to know that you’re spending money you’ve budgeted for, and that income dips
you can update your expenses to match.

Look for clear indicators that certain parts of your budget might need extra attention.
You want to know the particular aspects of your business that impact the budget most
heavily, and be prepared to adjust accordingly. 

7. Make business decisions

Naturally, you now need to use all of the analysis and preparation you’ve done. And that
means forming a clear spending plan for the future. Google Sheets has a great annual
budget template, and The Balance has this very simple one.

Of course, the hardest part of the whole process is deciding which projects or priorities
get funding, and which don’t. This can be stressful, and we’ve included some best
practices below to help. Most important is to try to remain consultative throughout -
gather input and rely on the expertise of your skilled team members to guide you. 

You’ll almost certainly make updates and changes throughout the year, so it’s important
to rely on the data you have today, and to not get too bogged down. 
8. Communicate it clearly

The final step is to share the budget with your teams and make sure they know what’s
required of them. Chances are you’ll rely on many team leads to handle their own costs,
and they need to have the tools and expectations to do this well. 

Does everyone involved know how much they’re allowed to spend, and on what? And
do they also know how to report their spending as they go?

If you can’t answer “yes” to both of those, you’ll likely struggle to adequately track and
measure the effectiveness of your budget. 

And then there’s the messaging. For many governments, “budget day” is the biggest
day of the year. There’s a reason why political leaders take the messaging so seriously.
And while you don’t need to go overboard, it makes sense to get your communication
right too. 

THE ROLE OF BUDGET PERSONNEL

A personnel budget is a decision-support and control tool that focuses on employment

costs. Forecasts and decisions can be made with reference to all the business data
available.
 Checks employment costs by reference to the contractual and payroll information
held on various databases and to cumulative actual data (monthly, bi-monthly, quarterly
etc.)
 Simulates employment costs, preparing long-term budgets without time
constraints, via what-if analysis.
 Forecasts recruitment scenarios based on the skill profiles already employed
(part time, full time, fixed term or permanent, etc.)
 Calculates overtime costs in various ways (statistical, specific, with percentage
uplifts etc.)
 Processes budget revisions during the year
 Compares alternative budget scenarios.
Inaz Personnel Budget is essentially for businesses, professional firms, public entities
that want to monitor, forecast and simulate the cost of their human resources.
Personnel budgeting is a cross-functional process in every organization, the results of
which are used by key functions:
 the HR Manager prepares the personnel budget
 Management Control includes the budgeted employment costs in the forecast
income statement
 Administration analyses actual costs with respect to budget.
Inaz Personnel Budget quickly provides each of these functions with information that is
certain and precise.

SOME PROBLEMS IN BUDGET DEVELOPMENT

There are a number of serious problems associated with budgeting, which include
gamesmanship, excessive time required to create budgets and budgeting
inaccuracy. In more detail, the problems with budgeting include the items noted
below.
Unrealistic Results

A budget is based on a set of assumptions that are generally not too far distant from
the operating conditions under which it was formulated. If the business environment
changes to any significant degree, the company’s revenues or cost structure may
change so radically that actual results will rapidly depart from the expectations
delineated in the budget. This condition is a particular problem when there is a
sudden economic downturn, since the budget authorizes a certain level of spending
that is no longer supportable under a suddenly reduced revenue level. Unless
management acts quickly to override the budget, managers will continue to spend
under their original budgetary authorizations, thereby rupturing any possibility of
earning a profit. Other conditions that can also cause results to vary suddenly from
budgeted expectations include changes in interest rates , currency exchange rates ,
and commodity prices.

Rigid Decision-Making

The budgeting process only focuses the attention of the management team on
strategy during the budget formulation period near the end of the fiscal year. For the
rest of the year, there is no procedural commitment to revisit strategy. Thus, if there
is a fundamental shift in the market just after a budget has been completed, there is
no system in place to formally review the situation and make changes, thereby
placing a company at a disadvantage to its nimbler competitors.

Time Required to Complete the Budget

It can be very time-consuming to create a budget, especially in a poorly-organized

environment where many iterations of the budget may be required. The time
involved is lower if there is a well-designed budgeting procedure in place,
employees are accustomed to the process, and the company uses budgeting
software. The work required can be more extensive if business conditions are
constantly changing, which calls for repeated iterations of the budget model.

Gaming the System

An experienced manager may attempt to introduce budgetary slack , which involves

deliberately reducing revenue estimates and increasing expense estimates, so that
he can easily achieve favorable variances against the budget. This can be a serious
problem, and requires considerable oversight to spot and eliminate. Further, anyone
who uses gaming is essentially being encouraged to engage in unethical behavior,
which can lead to further difficulties related to fraud.

Blame for Outcomes

If a department does not achieve its budgeted results, the department manager may
blame any other departments that provide services to it for not having adequately
supported his department.
Expense Allocations

The budget may prescribe that certain amounts of overhead costs be allocated to
various departments, and the managers of those departments may take issue with
the allocation methods used. This is a particular problem when departments are not
allowed to substitute services provided from within the company for lower-cost
services that are available elsewhere.

Use It or Lose It

If a department is allowed a certain amount of expenditures and it does not appear

that the department will spend all of the funds during the budget period, the
department manager may authorize excessive expenditures at the last minute, on
the grounds that his budget will be reduced in the next period unless he spends all
of the authorized amounts. Thus, a budget tends to make managers believe that
they are entitled to a certain amount of funding each year, irrespective of their
actual need for the funds.

Only Considers Financial Outcomes

The nature of the budget is numeric, so it tends to focus management attention on

the quantitative aspects of a business; this usually means an intent focus on
improving or maintaining profitability . In reality, customers do not care about the
profits of a business – they will only buy from the company as long as they are
receiving good service and well-constructed products at a fair price. Unfortunately, it
is quite difficult to build these concepts into a budget, since they are qualitative in
nature. Thus, the budgeting concept does not necessarily support the needs of
customers.

The problems noted here are widely prevalent and difficult to overcome. 

TYPES OF BUDGETS
Your final budget is usually a combination of inputs from several other budgets that are
prepared at a departmental level. Let’s look at the different types of budget and how
they contribute to drafting a business plan.

1. Master budget
A master budget is an aggregation of lower-level budgets created by the different
functional areas in an organization. It uses inputs from financial statements, the cash
forecast, and the financial plan. Management teams use master budgets to plan the
activities they need to achieve their business goals. In larger organizations, the senior
management is responsible for creating several iterations of the master budget before it
is finalized. Once it has been reviewed for the final time, funds can be allocated for
specific business activities.

Smaller businesses often use spreadsheets to create their master budgets, but
replacing the spreadsheets with efficient budgeting software typically reduces errors.

2. Operating budget
An operating budget shows a business’s projected revenue and the expenses
associated with it for a period of time. It’s very similar to a profit and loss report. It
includes fixed cost, variable cost, capital costs, and non-operating expenses. Although
this budget is a high-level summary report, each line item is backed up with relevant
details. This information is useful for checking whether the business is spending
according to its plans.

In most organizations, the management prepares this budget at the beginning of each
year. The document is updated throughout the year, either monthly or quarterly, and
can be used as a forecast for consecutive years.

3. Cash budget
A cash flow budget gives you an estimate of the money that comes in or goes out of a
business for a specific period in time. Organizations create cash budgets using
inferences from sales forecasts and production, and by estimating the payables and
receivables.
The information in this budget can help you evaluate whether you have enough liquid
cash for operating, whether your money is being used productively, and whether there
is and whether you are on track to earn a profit .

4. Financial budget
Businesses draft this budget to understand how much capital they’ll need and at what
times for fulfilling short-term and long-term needs. It factors in assets, liabilities, and
stakeholder’s equity—the important components of a balance sheet, which give you an
overall idea of your business health.

5. Labor budget
For any business that is planning on hiring employees to achieve its goals, a labor
budget will be important. It helps you determine the workforce you will require to
achieve your goals so you can plan the payroll for all of those employees. In addition to
planning regular staffing, it also helps you allocate expenses for seasonal workers.

6. Static budget
As the name suggests, this budget is an estimate of revenue and expenses that will
remain fixed throughout the year. The line items in this budget can be used as goals to
meet regardless of any increases or decreases in sales. Static budgets are usually
prepared by nonprofits, educational institutions, or government bodies that have been
allocated a fixed amount to use for their activities in each area.

OPERATING BUDGETS

The more detailed an operating budget is, the more relevant and valuable it becomes.
An operating budget may include a high-level summary along with several supporting
sub-budgets that provide greater detail. Here are the most common components of an
operating budget:

Revenue

This includes all the different ways a company makes money by selling goods or
services. Projected revenue can be based on a simple year-over-year forecast, but
breaking revenue down into its underlying components, such as unit volume and
average price, can yield greater insights.

Variable Costs

These are costs that rise or fall in lockstep with sales volume. Examples include
expenses for raw materials, labor, freight, and sales commissions. 

Fixed Costs

Fixed costs are expenses that remain fairly constant; they have to be paid whether
sales are up or down. Examples include rent, utilities, equipment leases, and insurance.

Non-Cash Expenses

The most common non-cash expenses include depreciation, amortization, unrealized

gains or losses, stock-based compensation, and deferred income taxes.

Non-Operating Expenses

These are costs that are not directly related to a business’s main activity. The most
common non-operating expenses include interest payments, losses on the disposition
of assets, and costs from currency exchanges.

Some industries or organizations may include other items in their operating budgets.
However, capital expenses are not ordinarily part of an operating budget because they
are long-term costs and an operating budget is a short-term budget.