Chapter 1 overview of budgeting and financial management

LEARNING OUTCOMES ▪ Explain the general principles of budgeting, its functioning and the link between long-and short term planning, ▪ Illustrate the sequence of successive planning on th

CHAPTER 1 OVERVIEW OF BUDGETING AND

FINANCIAL MANAGEMENT

DEPT OF FINANCIAL MANAGEMENT

LEARNING OUTCOMES

▪ Explain the general principles of budgeting, its functioning and the link between long-and short term planning,

▪ Illustrate the sequence of successive planning on the basis of partial plans,

▪ Do cost planning for direct costs, variable indirect costs and fixed costs using a case study on their own,

▪ Draw up a performance budget according to the cost sales style and the expenditure style of presentation,

▪ Draw up a financing plan according to the direct and indirect method as well as a budgeted balance sheet in the form of a changing balance sheet on their own,

▪ Calculate forecasts and deviation analyses

▪ Analyze, interpret and evaluate the results of a performance budget and a budgeted balance sheet

CONTENT

1.1 Introduction

1.2 The role of budgets

1.3 Budgeting and forecasting

1.4 Types of budgets

1.5 Budget process

THE ROLE OF BUDGETS

• Meeting the organization’s objectives

• Providing a basis for authorizing expenditure and delegating responsibility

• Identifying scarce resources

• Allocating resources

• Demonstrating and delivering good corporate governance

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Meeting objectives

What the organization’s objectives are?

- The primary objective: seek to maximize returns to their owners (maximize profit) in the long run.

- The secondary objective: achieving certain levels of market share, developing new products and developing staff capabilities or new technologies.

===> Budgets should be linked to objectives and strategy

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• Producing a costed plan may be easier for some elements of the budget than others.

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Monitoring and controlling

• To control costs, income and cash, we need to start with a good plan, against which

we can monitor its performance

• In most organizations, variances from budget are produced every month with major variations from budget requiring an explanation It would be better to focus on a few key figures that made up most of the budget

• The managers can monitor other figures that lead expenditure or income

• Major underspends always be monitored and explained just like overspends

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• The act of putting together budgets helps us to coordinate the activities of different parts of the organizations

• The budgets and plans need to fit and work together

• Different departments’ and units’ plans need to make the best use of the organization’s limited resources (known as the limiting factors)

• All departments need to be consistent in order to drive the organization in the same direction

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Evaluating performance

• Performance should also be measured in terms other than just the performance against the budget Perhaps budgets should be judged in conjunction with other KPIs

• Managers should be measured on what they control (as the profit in his/her store)

• Often cost and profitability are affected by teams of people working across different departments and functions

• Measuring a manager’s performance based upon his/her budget may encourage managers to negotiate their budgets to make it easier for them to achieve rather than aiming to maximize the performance of their unit

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Improving performance

• Budgets are sometimes seen as targets to beat to deliver improved performance

• If the budget is a target, it should be set carefully Too challenging, may be motivated; too easy, no strive to do their best

de-• The remedy is to put in some additional measures beyond the budget that include continuous improvement targets (such as reducing unit costs) or relative performance

• Performance benchmarking: the kind of indicators to look out for are: market share, total shareholder returns (TSRs) compared to peer companies, and level of customer satisfaction compared to peer group companies

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Motivating managers

• Managers may be motivated to perform since they are being judged against a budget

• A manager’s approach to delegating budgets will be influenced by how he views staff and perceives how they are motivated

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• A key to effective budgeting must be good communication

• Budgets inform managers and employees of the plans and strategy of the organization expressed in financial terms

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Providing a basis for authorizing expenditure and delegating

responsibility

• Budgets fail when authority and responsibility are not matched

• Budgets may be delegated through responsibility centres, these are usually called cost centres or profit centres, a rather term is investment centres

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Identifying scarce resources

• The process of building a budget may help us to identify scarce resources and resources that need to be managed carefully or increased

• Building a budget for an organization may take much negotiation and result in many iterations or rounds

• Budgeting at a strategic level must also consider longer-term capacity planning Building too little capacity constrains the organization; building too much leads to needless extra cost and suboptimal operations

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Allocating resources

• Budgets may be used to allocate resources, sometimes based on a formula

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Demonstrating and delivering good corporate governance

• The budgetary control system is effectively part of the internal control system

within an organization

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BUDGETING AND FORECASTING

• Budgets describe what the future is most likely to look like (based upon our plans)

• Forecasts describe what the budget is most likely to look like

• Forecasts as updates to the annual budget:

▪ When the budget is produced it may require some forecasting to derive some of the figures

▪ “The forecast” is an updated estimate of the outturn or result for the year

▪ A reforecast is normally produced every quarter or every month.

▪ The process of reforecasting encourages managers to rethink how the year’s result is going to

develop, this may enable them to identify problems sooner and become more proactive and less reactive when managing the budget.

• Rolling forecasts: forecasts can also be produced on a rolling basis beyond the

end of the current financial year The time period of forecasting depends upon the company and the industry

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Forecasts, projects and contracts

• Working on a project/contract, you could forecast to its end This approach might help you identify problems earlier

• Reviewing the project just on its performance to date may make you complacent

• When producing the forecast, you need to remember the matrix of impact and variability described earlier

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Forecasting tools and techniques

• Within the business there are a variety of figures which may be forecasted including:

Operating budget

• Revenues and associated expenses in day-to-day operations are budgeted in detail and are divided into major categories such as revenues, salaries, benefits, and non-salary expenses

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Capital budget

• Capital budgets are typically requests for purchases of large assets such as property, equipment, or IT systems that create major demands on an organization’s cash flow The purposes of capital budgets are to allocate funds, control risks in decision-making, and set priorities

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Cash budget

• Cash budgets tie the other two budgets together and take into account the timing of payments and the timing of receipt of cash from revenues Cash budgets help management track and manage the company’s cash flow effectively by assessing whether additional capital is required, whether the company needs to raise money,

or if there is excess capital

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Budget process

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Budget process

• The budgeting process for most large companies usually begins four to six months before the start of the financial year, while some may take an entire fiscal year to complete Most organizations set budgets and undertake variance analysis on a monthly basis

• Starting from the initial planning stage, the company goes through a series of stages to finally implement the budget Common processes include communication within executive management, establishing objectives and targets, developing a detailed budget, compilation and revision of budget model, budget committee review, and approval

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Chapter 2.

Overview of F Statement

DEPT OF FINANCIAL MANAGEMENT

Chapter objective

After studying this chapter, you should be able to:

◼ Discuss the content, form and utility of financial statements (BS,IS,CFS)

◼ Show the relationship among financial statements

◼ Identify the uses and limitations of an financial statements.

Equity Financing

Debt Financing

Investment

in Producing Assets

Goods &

Services

Net Earnings Operating

Businesses are like Fruit Trees…

Roots

Branches Trunk & Fruit

The 3 basic activities involved in conducting a business are:

• Financing activities (Roots):

- Owners contribute cash and receive equity shares in return.

- Creditors loan cash in return for the promise of interest and principal payments

• Investing activities (Trunk and branches):

Once the capital is collected it is invested in producing assets, like buildings,

equipment, machinery and vehicles.

• Operating activities (Fruit):

The assets are operated to produce goods & services which are sold to customers The Net Income of these sales can be used in three ways:

1 Reinvested in the producing assets

2 Returned to the creditors in the form of debt payments

3 Returned to the owners in the form of dividends

The Financial Statements are designed to measure different

aspects of the business (the fruit tree):

• The Balance Sheet

Is a picture of the tree (fruit, branches, trunk & roots) at a certain point in time.

It includes assets (inventory of goods and producing assets) and financing sources (equity, debt and reinvestments from net income) of the business

• The Income Statement

Accounts for all activities involved in the operation of the business (growing and

selling the fruit) over a period of time It contains a list of all operating expenses and revenues of the business

• The Statement of Cash Flows

Details all the cash inflows and outflows that occurred over a period of time

associated with the operating (fruit), investing (trunk and branch) and financing (roots) activities of the business

• The Statement of Retained Earnings

Reports how much of the net income from the operating activities are retained by the business and how much paid as dividends

2.1.The Balance Sheet

⚫ The balance sheet

shows assets and

the financing of

those assets at a

point in time

⚫ Assets are the things

that a firm owns

⚫ Liabilities are the

debts of the firm

⚫ Equity is the

difference between

assets and liabilities

Elvis Products International

Total Current Assets 1290.00 1124.00

Plant & Equipment 527.00 491.00 Accumulated Depreciation 166.20 146.20

Net Fixed Assets 360.80 344.80

Total Assets 1650.80 1468.80

Liabilities and Owner's Equity

Accounts Payable 175.20 145.60 Short-term Notes Payable 225.00 200.00 Other Current Liabilities 140.00 136.00

Total Current Liabilities 540.20 481.60

Long-term Debt 424.61 323.43

Total Liabilities 964.81 805.03

Common Stock 460.00 460.00 Retained Earnings 225.99 203.77

Total Shareholder's Equity 685.99 663.77

Total Liabilities and Owner's Equity 1650.80 1468.80

Major Balance Sheet Items

Current and Fixed Assets

◼ Current assets: convert to cash over the next 12 months

◼ Fixed Assets are held for periods longer than the accounting period.

◼ Tangible assets: land, building, machinery…

◼ Intangible assets: patent, copy rights, goodwill….

Liquidity

mature.

◼ Current assets: liquid assets

◼ Fixed assets: illiquid assets

LIMITATION OF B.S

◼ Under GAAP, assets are showed at historical Cost

◼ It ignores : Time (how long assets are purchased)

Present value (how much they are worth to day)

◼ Many of most valuable assets that a firm may have

(good mgt, reputation, talented employees) don’t appear on the balance sheets.

2.2.The Income Statement

Elvis Products International

Income Statement For the Year Ended Dec 31, 1997 ($ 000's)

Sales 3900.00 3500.00 Cost of Goods Sold 3250.00 2864.00

Selling and G&A Expenses 330.30 240.00 Fixed Expenses 100.00 100.00 Depreciation Expense 20.00 18.90

The Income Statement

time collection)

product will be recognized at that time.

The Income Statement

measures operating performance over a particular period of time

Operating Revenues

− Operating Expenses

= Operating Income+ Other Revenues (non- operating Revenues)

− Other Expenses (non- operating Expenses)

= Net Income before Taxes

− Income Taxes

= Net Income after Taxes / Number of Shares

= Income per Share

Net income is the most important number disclosed on the financial statements

Nature of Revenues

firm for providing them goods & services.

◼ Eg: - sale goods for $5,000 in cash

- a customer sent an advance of $5,000

+ Sales of goods/services

+ Sales of assets

+Interest, dividend, fees….

Nature of expense

revenue during a period of time

Expired and unexpired cost

•Expired costs are the

ones that helped to

•Unexpired costs recognized as assets

in balance sheet.

•Unexpired costs are also known as capital expenditure

= Gross Profit – selling, G&A expenses

Depreciation: a non-cash item

⚫ Accountants define depreciation as, “a

systematic method of allocating the cost of

an asset over its useful life.”

For tax purposes, we aren’t allowed to

deduct the full cost of an asset in the year

of purchase Instead, we must deduct the cost over the life of the asset through

depreciation

⚫ In finance, we tend to think of depreciation

as a way of reducing taxes

Straight-line Depreciation

⚫ Straight-line depreciation assumes that the value

of an asset declines equally in each year of its life:

Useful Life

Where:

Cost of the asset is the purchase price of the asset

Salvage value is the value of the asset at the end of its useful life Useful life of asset represents the number of periods/years in

which the asset is expected to be used by the company

Straight Line Example

Company A purchases a machine for $100,000 with

an estimated salvage value of $20,000 and a useful

life of 5 years.

The straight line depreciation for the machine would be calculated as follows:

⚫ Cost of the asset: $100,000

⚫ Cost of the asset – Estimated salvage value: $100,000 – $20,000 =

$80,000 total depreciable cost

⚫ Useful life of the asset: 5 years

⚫ Divide step (2) by step (3): $80,000 / 5 years = $16,000 annual

depreciation amount

⚫ Therefore, Company A would depreciate the machine at the amount

of $16,000 annually for 5 years

MACRS Depreciation method

D = m(1/n)NBV

Where:

D is Depreciation cost per year

n is Useful life of the asset NBV is Net book value of the asset

m is Depreciation coefficient If:

n = 3; 5; 7 or 10 years => m = 2 (double-declining-balance depreciation or 200%-declining-balance depreciation)

n = 15 or 20 years => m = 1.5