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Week 3 budgeting & cash management
- 1. FINANCIAL MANAGEMENT Prepared by Tishta Bachoo 1
- 2. Lecture 3 - overview Prepared by Tishta Bachoo 2 • Management Decision Making: Budgeting and Cash Management 1.explain what a budget is and describe the key steps in the budgeting process 2.explain the different types of budgets 3.prepare a schedule of receipts from accounts receivable and a cash budget 4.explain the use of budgeting in planning and control 5.debt management – method of finance 6.loan repayment schedule
- 3. Strategic planning concerns longer term planning (typically, 3-5 years) It is usually carried out by senior management Budgeting is a process that focuses on the short term, commonly one year, and results in the production of budgets that set the financial framework for that period Budgets operationalise strategic plans and allow operational areas to understand how their area contributes to the entity’s strategic objectives 3 Prepared by Tishta Bachoo
- 4. Budgets continuedA budget is the quantitative expression of an entity’s plans Budgeting can assist in decision making by: putting into operation longer term plans Assessing the feasibility of strategic plans setting targets for managers identifying resource constraints in budget period identifying periods of expected cash shortages and excess cash holdings assisting with short-term planning decisions, such as capacity utilisation providing profit forecasts and other financial data to the capital markets forecasting data such as sales or fees, which commonly set the level of activity for the budget period helping determine required inventory levels and purchasing requirements for raw materials planning labour and other inputs determining the ability of the entity to meet financing commitments 4 Prepared by Tishta Bachoo
- 5. 1. Consideration of past performance 2. Assessment of expected trading and operating conditions 3. Preparation of initial budget estimates 4. Adjustment to estimates based on communication with, and feedback from, managers 5. Preparation of budgeted reports and sub-budgets 6. Monitoring of actual performance against the budget over the budget period 7. Making any necessary adjustments to the budget during the budget period 5 Prepared by Tishta Bachoo
- 6. Sales (or fees) budget Operating (expenses) budget Production and inventory budgets Purchases budget Manufacturing overhead budget Budgeted income statement Cash budget Budgeted balance sheet Capital budgets Program budget 6 Prepared by Tishta Bachoo
- 7. The cash budget is a statement of expected future cash receipts and payments It assists decision making by: documenting timing of all cash receipts and payments helping to identify periods of expected cash shortages and surpluses identifying suitable times for purchase of non-current assets assisting with planning and use of borrowed funds providing a framework for ‘what if’ analysis For an entity that provides goods or services on credit, one of the main tasks in the preparation of a cash budget is calculating the cash receipts from the credit sales or fees generated This is commonly shown in a schedule of receipts from debtors/accounts receivable 7 Prepared by Tishta Bachoo
- 8. 8 To illustrate the calculations in the schedule, if we take the December sales of $303 000: •50% will be received in the month following the sale (January); •40% in the second month (February); and •the final 10% in the third month (March). Prepared by Tishta Bachoo
- 9. The preparation of the cash budget is an important part of the planning process It can then be used for monitoring cash performance, also known as the control process 9 Prepared by Tishta Bachoo
- 10. A cash budget prepared on a month- by-month basis is much more useful for planning and control than one prepared on a quarterly or yearly basis As each month passes, actual cash numbers can be compared to the budget numbers, with the difference between the two known as a variance 10 Prepared by Tishta Bachoo
- 11. A favourable variance (‘F’) will occur when actual revenues are larger than budgeted, or actual costs are lower than budgeted. An unfavourable variance (‘U’) will arise when the actual revenue is less than budgeted, or actual costs are greater than budgeted 11 Prepared by Tishta Bachoo
- 12. Improving cash flow Cash inflow may be increased by: improving the collections of cash from debtors seeking ways to improve sales or fees reducing unnecessary stock levels arranging external finance providing an extra capital contribution from the owners, or considering a change in ownership structure selling excess non-current assets 12 Prepared by Tishta Bachoo
- 13. Cash outflow may be reduced by: cutting expenses by identifying areas of waste, duplication or inefficiency making use of creditors’ terms keeping inventory levels to only what is required, as excess inventory ties up cash and often adds to storage and handling costs deferring capital expenditures Reducing carbon footprint 13 Prepared by Tishta Bachoo
- 14. 1. Equity Financing Additional investment from owners. Sole Trader: Owner contributes more money. Partnership: Partners contribute more money and/or admit a new partner(s). Company: Issue more shares. 2. Debt Financing Borrowing money. Increases the level of financial risk. 14 Prepared by Tishta Bachoo
- 15. The risk of defaulting on an interest payment. The more funds that are borrowed, the greater the financial risk. Loans Risk of Default Risk of Failure Interest Payments 15 Prepared by Tishta Bachoo
- 16. Each loan repayment will be the same therefore the following equation can be used: PV = NCFi]n Where: NCF: Loan Repayment i: Interest calculated each compounding period. n: Number of repayments throughout life of loan/investment. 16 Prepared by Tishta Bachoo
- 17. Compounded Annually 8% 12 Months Compounded Semi-Annually 4% 4% 12 6 (Months) 17 Prepared by Tishta Bachoo
- 18. Compounded Quarterly 2% 2% 2% 2% 12 3 6 9 (Months) 0.66 0.66 0.66 0.66 0.66 0.66 0.66 0.66 0.66 0.66 0.66 0.66 0.66% 1 2 3 4 5 6 7 8 9 10 11 12 Compounded Monthly Prepared by Tishta Bachoo 18
- 19. Practice Question 1 Edward wants to buy a new car. He will need to borrow $20,000. The best interest rate Edward can get from the bank is 8%pa and he wants to repay the loan in ten years. If repayments are made annually, what is the amount of each repayment? 19 Prepared by Tishta Bachoo
- 20. Solution PV = $20,000 i = 8% pa N = 10 PV = NCFi]n 20,000 = NCF (T2,8%,10) Referring to Table 2 (annuity table) (T2, 8%. 10) = 6.710 NCF = 20,000 / 6.710 Yearly repayment = $2,981 (rounded to nearest whole $) 20 Prepared by Tishta Bachoo
- 21. Practice Question 2 If Edward makes quarterly repayments, what is the amount of each repayment? 21 Prepared by Tishta Bachoo
- 22. Solution PV = $20,000 i = 2% per quarter N = 40 PV = NCFi]n 20,000 = NCF (T2,2%,40) Referring to Table 2 (annuity table) (T2, 2%, 40) = 27.355 NCF = 20,000 / 27.355 Quarterly repayment = $731 (rounded to nearest whole $) 22 Prepared by Tishta Bachoo
- 23. Prepared by Tishta Bachoo 23 END OF SESSION
- 24. Next week … Financing the Investments Prepared by Tishta Bachoo 24
Editor's Notes
- The way in which the strategic planning process is conducted depends upon a range of issues, including the industry and culture of the entity. For example, larger entities will use a rather formal process, while more creative or smaller entities may opt for a less formal process. Nevertheless, the outcomes from the process are the strategic plans of the entity, and these will guide shorter term planning such as budgeting.
- The nature of the entity will determine the type of budget that might be prepared but, as a minimum, we would expect to see the financial statements that have been covered in chapters 5, 6 and 7 prepared in budgeted form.
- Budgeting process is a process involving evaluating past performance, assessing and incorporating expectations, preparing estimates, and monitoring and adjusting budgets as required by changing circumstances. The budgeting process will commonly involve a series of steps, throughout the process, communication with managers who are affected by the budgets should occur. These managers are commonly responsible for a segment of the entity, such as a division, a department or a branch. These segments may be referred to as responsibility centres, and may form part of the entity structure.
- The nature of the entity will determine the type of budgets prepared. This slides lists budgets that are commonly prepared. Sales (or fees) budget —sets expected levels of activity. Operating (expense) budget — often departmental expense budgets. Production and inventory budgets (for manufacturing entities). There would most likely be sub-budgets relating to direct materials, direct labour (if any) and indirect costs etc. Purchases budget, sets the required purchases of inventory or direct materials based on sales budget (and possibly the production/inventory budgets). Budgeted income statement an aggregation of the other sub-budgets such as sales budget and operating expenses budget . Cash budget — a statement of expected future cash receipts and cash payments. Budgeted balance sheet (assets and liabilities at end of period) and Capital budgets — focuses on expenditure relating to long-term investments. Manufacturing overhead budget which focuses on estimating the overheads or expenses associated with production activities. Program budget — a budget form commonly used in the government and not-for-profit sector, where the focus is on costs associated with a specific program.
- A cash budget prepared on a month-by-month basis over the budget period is preferable, as it provides more timely information and enables closer monitoring of the cash position.
- This slide shows an example of a schedule of receipts from debtors/accounts receivable i.e. A schedule calculating the cash receipts from credit sales or fees generated To illustrate the calculations in the schedule, if we take the December sales of $303 000: 50% will be received in the month following the sale (January); 40% in the second month (February); and the final 10% in the third month (March).
- Determining the underlying reasons for a budget variance is not a straightforward exercise. For example: a favourable cost variance could be obtained by an efficient use of resources, or by the use of lower quality, low-cost resources. Each organisation determines the level of variance that it will tolerate. Any such variance will provide the necessary feedback to inform future actions, and may require a revision of the budget
- The cash budget identifies periods of expected cash shortages In such situations, corrective action can restore the cash position improving the collections of cash from debtors — perhaps the entity needs to review its invoicing and follow-up procedures, offer incentives for prompt payment or charge interest on overdue accounts reducing unnecessary stock levels — discounting obsolete stock will generate cash selling excess non-current assets — a sale and leaseback arrangement may be more suitable.
- • making use of creditors’ terms — where purchases are made on credit, there is some benefit in using the full extent of the credit terms • keeping inventory levels to only what is required, as excess inventory ties up cash and often adds to storage and handling costs • deferring capital expenditures — it may be necessary to delay the acquisition of any non-current assets.