How is a cash budget prepared, why is it different from profit, and what is a flexible budget used for?
Preparation of a cash budget showing opening and closing balances, the purpose of budgeting and the difference between cash and profit, and the preparation and use of a flexible budget that is adjusted to the actual level of activity.
A focused answer to the SQA Higher Accounting budgeting content, covering the purpose of budgeting, preparing a cash budget with receipts, payments and running balances, why cash differs from profit, and preparing and using a flexible budget adjusted to actual activity.
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What this dot point is asking
The SQA wants you to prepare a cash budget that forecasts the money flowing in and out month by month, explain why cash differs from profit, and prepare a flexible budget that is adjusted to the level of activity actually achieved. You must understand the purpose of budgeting and be able to comment on what a budget reveals.
The purpose of budgeting
A budget turns plans into figures so a business can prepare for the future rather than react to it. Budgets help to plan and coordinate activities, set targets, control spending by comparing actual results against plan, and give early warning of problems such as a looming cash shortage. They also motivate managers when targets are agreed and realistic.
Preparing a cash budget
A cash budget lists, for each month, the cash receipts, the cash payments, and the balance carried forward.
Only actual cash movements are entered, and they are entered in the month the cash moves, not when the sale or expense is recorded. Depreciation, a non-cash expense, never appears in a cash budget. Credit sales appear when customers are expected to pay; credit purchases appear when the business expects to pay suppliers.
Cash is not profit
A profitable business can still run out of cash. Profit is measured on the accruals basis: a credit sale increases profit at once, but the cash may arrive weeks later. Meanwhile, large cash outflows such as buying a non-current asset, repaying a loan or the owner's drawings reduce cash but are not expenses, so they never reduce profit. A cash budget reveals these timing and capital effects that the income statement hides, which is why both are needed.
Flexible budgets
A fixed budget is set for one planned level of activity. If actual output differs, comparing actual results against the original budget is unfair, because some costs should have changed with the different volume. A flexible budget solves this by recalculating the budget at the activity actually achieved: variable costs are flexed in proportion to output, while fixed costs stay the same. Comparing actual results against the flexed budget isolates true performance from the effect of producing more or fewer units than planned.
Try this
Q1. Opening cash £3,000, receipts £18,000, payments £16,000. Calculate the closing balance. [1 mark]
- Cue. £3,000 + £18,000 - £16,000 = £5,000.
Q2. Give one reason a profitable business might still be short of cash. [1 mark]
- Cue. Credit customers have not yet paid, or cash has gone on assets, loan repayments or drawings that are not expenses.
Q3. Variable cost is £6 per unit and the budget assumed 1,000 units, but 1,200 were made. State the flexed variable cost. [2 marks]
- Cue. £6 x 1,200 = £7,200.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA Higher style6 marksA business starts April with a cash balance of £5,000. Expected receipts are £30,000 in April and £36,000 in May. Expected payments are £28,000 in April and £40,000 in May. Prepare the closing cash balance for April and May, and comment on the May position.Show worked answer →
April: opening £5,000 + receipts £30,000 - payments £28,000 = closing £7,000 (2 marks).
May: opening £7,000 + receipts £36,000 - payments £40,000 = closing £3,000 (2 marks).
Comment: the business stays in a positive cash position, but the balance falls in May because payments exceed receipts that month, so management should watch for any further pressure and may wish to arrange a buffer (2 marks). Markers reward both closing balances and a sensible comment on the trend.
SQA Higher style4 marksExplain why a profitable business can still run out of cash, giving two reasons that a cash budget would reveal but the income statement would not.Show worked answer →
Reason one: credit sales are recorded as income when made, boosting profit, but the cash may not arrive for weeks, so a profitable business can be short of cash while it waits to be paid (2 marks).
Reason two: large cash outflows such as buying a non-current asset, repaying a loan or the owner's drawings reduce cash but are not expenses in the income statement, so profit looks healthy while cash falls (2 marks). Markers reward two valid reasons that distinguish profit from cash flow.
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Sources & how we know this
- SQA Higher Accounting Course Specification — SQA (2023)