ContentsAnalysing and Interpreting Financial Statements..................................................................................1

Balance Sheet....................................................................................................................................1

Income Statement.............................................................................................................................1

Statement of Cash Flows...................................................................................................................2

Statement of Shareholders' Equity....................................................................................................2

Management Report.....................................................................................................................2

Audit Report..................................................................................................................................3

Explanatory Notes.........................................................................................................................3

Supplementary Information..........................................................................................................3

Social Responsibility Reports.........................................................................................................3

Proxy Statements...........................................................................................................................3

RATIO ANALYSIS.................................................................................................................................3

Measuring Overall Profitability......................................................................................................4

Assessing Operating Management: Decomposing Net Profit Margins..........................................4

Evaluating Investment Management: Decomposing Asset Turnover............................................5

Evaluating Financial Management: Financial Leverage..................................................................6

CASH FLOW ANALYSIS.......................................................................................................................7

Analysing Cash Flow Information...................................................................................................7

Preparing a Report.............................................................................................................................8

Format...........................................................................................................................................8

Limitations of analysis of financial statements..................................................................................8

Limitations of financial reporting information...............................................................................8

Difficulties in drawing comparisons between different entities....................................................8

Limitations Of ratio analysis...........................................................................................................8

Case Study.........................................................................................................................................9

Analysing and Interpreting Financial StatementsThe goal of financial analysis is to assess the performance of a firm in the context of its stated goals and strategy. There are two principal tools of financial analysis: ratio analysis and cash flow analysis. Ratio analysis involves assessing how various line items in a firm’s financial statements relate to one another. Cash flow analysis allows the analyst to examine the firm’s liquidity, and how the firm is managing its operating, investment, and financing cash flows. Financial analysis is used in a variety of contexts. Ratio analysis of a company’s present and past performance provides the foundation for making forecasts of future performance.

Financial Statements

The four primary financial statements are the balance sheet, the income statement, the statement of shareholders’ (owner’s) equity, and the statement of cash flows.

Balance Sheet. The accounting equation is the basis of the balance sheet:

Assets = Liabilities + Equity.

The left-hand side of this equation relates to the economic resources controlled by the firm, called assets. These resources are valuable in the sense that they represent potential sources of future revenues. The company uses these resources to carry out its operating activities. In order to engage in its operating activities, the company must obtain funds to fund its investing activities. The right-hand side of the accounting equation details the sources of these funds. Liabilities represent funds obtained from creditors. These amounts represent obligations or, alternatively, the claims of creditors on assets. Equity, also referred to as shareholders' equity, encompasses two different financing sources: (1) funds invested or contributed by owners, called "contributed capital", and (2) accumulated earnings since inception and in excess of distributions to owners (dividends), called "retained earnings". From the owners' viewpoint, these amounts represent their claim on assets. It often is helpful for students to rewrite the accounting equation in terms of the underlying business activities:

Investing Activities = Financing Activities.

Recognizing the two basic sources of financing, this can be rewritten as:

Investments = Creditor Financing + Owner Financing.

Income Statement. The income statement is designed to measure a company's financial performance between balance sheet dates—hence, it refers to a period of time. An income statement lists revenues, expenses, gains, and losses of a company over a period. The "bottom line" of an income statement, net income, measures the increase (or decrease) in the net assets of a company (i.e., assets less liabilities), before consideration of any distributions to owners. Most contemporary accounting systems, the U.S. included, determine net income using the accrual basis of accounting. Under this method, revenues are recognized when earned, independent of the receipt of cash. Expenses, in turn, are recognized when incurred (or matched with its related revenue), independent of the payment of cash.

Statement of Cash Flows. Under the accrual basis of accounting, net income equals net cash flow only over the life of the firm. For periodic reporting purposes, accrual performance numbers nearly always differ from cash flow numbers. This creates a demand for periodic reporting on both income and cash flows. The statement of cash flows details the cash inflows and outflows related to a company's operating, investing, and financing activities over a period of time.

Statement of Shareholders' Equity. The statement of shareholders' equity reports changes in the component accounts comprising equity. The statement is useful in identifying the reasons for changes in owners' claims on the assets of the company. In addition, accepted practice excludes certain gains and losses from net income which, instead, are directly reported in the statement of shareholders' equity.

Financial statements are one of the most reliable of all publicly available data for financial analysis. Also, financial statements are objective in portraying economic transactions and events, they are concrete, and they quantify important business activities. Moreover, since financial statements express transactions and events in a common monetary unit, they enable users to readily work with the data, to relate them to other data, and to deal with them in different arithmetic ways. These attributes contribute to the usefulness of financial statements, both historical and projected, in business decision-making.

On the other hand, one must recognize that accounting is a social science subject to human decision making. Moreover, it is a continually evolving discipline subject to revisions and improvements, based on experience and emerging business transactions. These limitations sometimes frustrate certain users of financial statements such that they look for substitute data. However, there is no equivalent substitute. Double-entry accounting is the only reliable system for the systematic recording, classification, and summarization of most business transactions and events. Improvement lies in the refinement of this time-tested system rather than in substitution. Accordingly, any serious analyst of a company’s financial position and results of operations, learns the accounting framework and its terminology, conventions, as well as its imperfections in financial analysis.

Financial statements are not the sole output of the financial reporting system. Additional financial information is communicated by companies through the following sources:

Management's Discussion and Analysis (MD&A). Companies with publicly traded debt and equity securities are required by the SEC to provide a report of their financial condition and results of operations in a MD&A section of its financial reports.

Management Report. The management report sets out the responsibilities of management in preparing the company's financial statements.

Audit Report. The external auditor is an independent certified public accountant hired by management to assess whether the company's financial statements are prepared in conformity with

generally accepted accounting principles. Auditors provide an important check on financial statements prior to their release to the public.

Explanatory Notes. Notes are an integral part of financial statements and are intended to communicate additional information regarding items included in, and excluded from, the statements.

Supplementary Information. Certain supplemental schedules are required by accounting regulatory agencies. These schedules can appear in notes to financial statements or, in the case of companies with publicly held securities, in exhibits to regulatory filings such as the Form 10-K that is filed with the Securities and Exchange Commission.

Social Responsibility Reports. Companies increasingly recognize their need for social responsibility. While reports of socially responsible activities are increasing, there is no standard format or accepted standard.

Proxy Statements. A proxy statement is a document containing information necessary to assist shareholders in voting on matters for which the proxy is solicited.

RATIO ANALYSIS The value of a firm is determined by its profitability and growth. In ratio analysis, the analyst can

1. compare ratios for a firm over several years (a time-series comparison)

2. compare ratios for the firm and other firms in the industry (cross-sectional comparison)

3. compare ratios to some absolute benchmark. In a time-series comparison,

The analyst can hold firm-specific factors constant and examine the effectiveness of a firm’s strategy

over time. Cross-sectional comparison facilitates examining the relative performance of a firm within

its industry, holding industry- level factors constant. For most ratios, there are no absolute

benchmarks. The exceptions are measures of rates of return, which can be compared to the cost of

the capital associated with the investment.

The Ratios:

Performance Activity

Book Value Per Common Share Asset Turnover

Cash Return On Assets Average Collection Period

Vertical Analysis Inventory Turnover

Dividend Payout Ratio Financing

Earnings Per Share Debt Ratio

Gross Profit Margin Debt / Equity Ratio

Price/Earnings Ratio Liquidity Warnings

Profit Margin Acid-Test Ratio

Return on Assets Interest Coverage

Return on Equity Working Capital

Measuring Overall Profitability The starting point for a systematic analysis of a firm’s performance is its return on equity ( ROE ), defined as:

ROE= Net incomeShareholder ’ sequity

ROE is a comprehensive indicator of a firm’s performance because it provides an indication of how well managers are employing the funds invested by the firm’s shareholders to generate returns.

Assessing Operating Management: Decomposing Net Profit Margins A firm’s net profit margin or return on sales (ROS) shows the profitability of the company’s operating activities. Further decomposition of a firm’s ROS allows an analyst to assess the efficiency of the firm’s operating management. A popular tool used in this analysis is the common-sized income statement in which all the line items are expressed as a ratio of sales revenues. Common-sized income statements make it possible to compare trends in income statement relationships over time for the firm, and trends across different firms in the industry. Income statement analysis allows the analyst to ask the following types of questions: (1) Are the company’s margins consistent with its stated competitive strategy? For example, a differentiation strategy should usually lead to higher gross margins than a low cost strategy. (2) Are the company’s margins changing? Why? What are the under- lying business causes—changes in competition, changes in input costs, or poor overhead cost management? (3) Is the company managing its overhead and administrative costs well? What are the business activities driving these costs? Are these activities necessary?

Gross Profit Margins. The difference between a firm’s sales and cost of sales is gross profit. Gross profit margin is an indication of the extent to which revenues exceed direct costs associated with sales, and it is computed as:

Gross profit margin=Sales –Cost of salesSales

Gross margin is influenced by two factors: (1) the price premium that a firm’s products or services command in the marketplace and (2) the efficiency of the firm’s procurement and production process. The price premium a firm’s products or services can command is influenced by the degree of competition and the extent to which its products are unique. The firm’s cost of sales can be low when it can purchase its inputs at a lower cost than competitors and/or run its production processes more efficiently. This is generally the case when a firm has a low-cost strategy

Tax Expense. Taxes are an important element of firms’ total expenses. Through a wide variety of tax planning techniques, firms can attempt to reduce their tax expenses. There are two measures one can use to evaluate a firm’s tax expense. One is the ratio of tax expense to sales, and the other is the ratio of tax expense to earnings before taxes (also known as average tax rate).

Evaluating Investment Management: Decomposing Asset TurnoverAsset turnover is the second driver of a company’s return on equity. Since firms invest considerable resources in their assets, using them productively is critical to overall profitability. A detailed analysis of asset turnover allows the analyst to evaluate the effective- ness of a firm’s investment management. There are two primary areas of asset management: (1) working capital management and (2) management of long-term assets. Working capital is defined as the difference be- tween a firm’s current assets and current liabilities.

Working Capital Management. The components of operating working capital that analysts primarily focus on are accounts receivable, inventory, and accounts pay- able. A certain amount of investment in working capital is necessary for the firm to run its normal operations. For example, a firm’s credit policies and distribution policies determine its optimal level of accounts receivable. The nature of the production process and the need for buffer stocks determine the optimal level of inventory. Finally, accounts payable is a routine source of financing for the firm’s working capital, and payment practices in an industry determine the normal level of accounts payable.

The following ratios are useful in analysing a firm’s working capital management: operating working capital as a percent of sales, operating working capital turnover, accounts receivable turnover, inventory turnover, and accounts payable turnover. The turn- over ratios can also be expressed in number of days of activity that the operating working capital (and its components) can support. The definitions of these ratios are given below.

Operatingworkingcapital−¿−sales ratio=Operatingworking capitalSales

Operatingworkingcapital turnover= SalesOperatingworkingcapital

Accountsreceivable turnover= SalesAccountsreceivable

Inventory turnover=Cost of goods soldInventory

Accounts payableturnover= PurchasesAccounts payable

∨Cost of goods soldAccounts payable

Days ’receivables= AccountsreceivableAverage sales per day

Days ’ inventory= InventoryAveragecost of goods sold per day

Days ’ payables= Accounts payableAverage purchases (¿cost of goods sold) per day

Operating working capital turnover indicates how many dollars of sales a firm is able to generate for each dollar invested in its operating working capital. Accounts receivable turnover, inventory turnover, and accounts payable turnover allow the analyst to examine how productively the three principal components of working capital are being used. Days’ receivables, days’ inventory, and days’ payables are another way to evaluate the efficiency of a firm’s working capital management

Evaluating Financial Management: Financial LeverageFinancial leverage enables a firm to have an asset base larger than its equity. The firm can augment its equity through borrowing and the creation of other liabilities like accounts payable, accrued liabilities, and deferred taxes. Financial leverage increases a firm’s ROE as long as the cost of the liabilities is less than the return from investing these funds. In this respect, it is important to distinguish between interest-bearing liabilities such as notes payable, other forms of short-term debt and long-term debt, which carry an explicit interest charge, and other forms of liabilities. Some of these other forms of liability, such as accounts payable or deferred taxes, do not carry any interest charge at all. Other liabilities, such as capital lease obligations or pension obligations, carry an im- plicit interest charge. Finally, some firms carry large cash balances or investments in marketable securities. These balances reduce a firm’s net debt because conceptually the firm can pay down its debt using its cash and short-term investments.

While a firm’s shareholders can potentially benefit from financial leverage, it can also increase their risk. Unlike equity, liabilities have predefined payment terms, and the firm faces risk of financial distress if it fails to meet these commitments. There are a number of ratios to evaluate the degree of risk arising from a firm’s financial leverage.

Current Liabilities And Short-Term Liquidity. The following ratios are useful in evaluating the risk related to a firm’s current liabilities:

Current ratio= Current assetsCurrent liabilities

Quick ratio=Cash+Short−terminvestments+Accounts receivableCurrent liabilities

Cash ratio=Cash+Marketable securitiesCurrent liabilities

Operating cash flow ratio=Cash flow ¿operations ¿Current liabilities

All the above ratios attempt to measure the firm’s ability to repay its current liabilities. The first three compare a firm’s current liabilities with its short-term assets that can be used to repay the current liabilities. The fourth ratio focuses on the ability of the firm’s operations to generate the resources needed to repay its current liabilities.

CASH FLOW ANALYSISRatio analysis discussed above focused on analysing a firm’s income statement (net profit margin analysis) or its balance sheet (asset turnover and financial leverage). The analyst can get further insights into the firm’s operating, investing, and financing policies by examining its cash flows. Cash flow analysis also provides an indication of the quality of the information in the firm’s income statement and balance sheet.

Analysing Cash Flow Information Cash flow analysis can be used to address a variety of questions regarding a firm’s cash flow dynamics:

• How strong is the firm’s internal cash flow generation? Is the cash flow from operations positive or negative? If it is negative, why? Is it because the company is growing? Is it because its operations are unprofitable? Or is it having difficulty managing its working capital properly?

• Does the company have the ability to meet its short-term financial obligations, such as interest payments, from its operating cash flow? Can it continue to meet these obligations without reducing its operating flexibility?

• How much cash did the company invest in growth? Are these investments consistent with its business strategy? Did the company use internal cash flow to finance growth, or did it rely on external financing?

• Did the company pay dividends from internal free cash flow, or did it have to rely on external financing? If the company had to fund its dividends from external sources, is the company’s dividend policy sustainable?

• What type of external financing does the company rely on? Equity, short-term debt, or long-term debt? Is the financing consistent with the company’s overall business risk?

• Does the company have excess cash flow after making capital investments? Is it a long-term trend? What plans does management have to deploy the free cash flow?

Preparing a ReportFormatUse report style that is headings for To, From, Date and Subject. When addressing your report think about who the report is for and what are their needs.

Introduction

Add a brief introduction to identify the purpose of the report using the requirement given.

Body of the report

Use points to make it clear and remember to state why something has changed in the entity.

Put headings for example performance, liquidity, capital structure or financial position Explain why ratios have changed and their implications/recommendations/timescales

involved

ConclusionMake sure to add a brief conclusion, particularly if there is a question identified in the requirement for example should we invest?

Appendix

Calculate the ratios on a separate page. These ratios can be referred to in the report.

Limitations of analysis of financial statementsLimitations of financial reporting information

Only provide historical data Only provide financial information Filed at least 3 months after reporting date reducing relevance Limited information to be able to identify trends over time Lack of detailed information Historic cost accounting does not take into account inflation

Difficulties in drawing comparisons between different entities Comparisons affected by changes in the entity’s business, for example selling an operation Different accounting policies between entities Different accounting practices between different entities ,eg leasing vs buying Different entities within the same industry may have different activities

Comparisons between different countries will be influenced by different legal and regulatory systems. The relative strength and weakness of the national economy and exchange rate fluctuations.

Limitations Of ratio analysis Where ratios have been provided, there may be discrepancies between how they have been

calculated for each entity/period Distortions when using year-end figures, particularly in seasonal industries and when entities

have different accounting dates Distortions due not being able to use most appropriate figures for example total sales rather

than credit sales when calculating receivables days It is difficult to identify reasons behind ratio movements without significant additional

information

Case StudyMTC Key Performance Indicators (Group)

2005 2006 2007 2008 2009 2010 2011Revenue N$ million 769 937 1113 1232 1390 1407 1453Shareholders’ Equity N$ million 646 903 999 1136 1153 1166 1121Taxation N$ million 147 171 177 181 199 187 160Netprofit after N$ million 293 337 340 358 388 397 319Capital Expenditure N$ million 160 188 340 286 260 410 237Total in N$ million 915 1169 1329 1608 1632 1791 1696Dividend N$ million 110 80 245 221 370 383,6 364

Dividend as % of after tax profit 96,7%

114,2%

Return on equity45,4%

37,3%

34,0%

31,5%

33,6%

34,0% 28,4%

Profit Margin38,1%

36,0%

30,5%

29,0%

27,9%

28,2% 21,9%

EBITDA margin 61%60,2%

52,2%

50,9%

53,8%

55,8% 53,2%

Active sim cards in 1000 403,7 555,5 743,5 1009 1284 1535 1854,7Full-time 276 272 296 397 416 395 407Monthly ARPU in N$ 159 141 125 102 90 54

BUDGETING AND BUDGETARY CONTROL

1. BUDGETING IN PERSPECTIVE The purposes of budgeting

Budgets have two main roles

a. They act as authorities to spend, i.e they give authority to budget managers to incur expenditure in their part of the organisation;

b. They act as comparators for current performance, by providing a yardstick against which current activities can be monitored.

Budgetary planning and control

Planning the activities of an organisation ensures that the organisation sets out in the right direction. Individuals within the organisation will have definite targets which they will aim to achieve. Without a formalised plan the organisation will lack direction and managers will not be aware of their own targets and responsibilities. Neither will they appreciate how their activities relate to those of other managers within the organisation.

A formalised plan will help to ensure a co-ordinated approach and the planning process itself will force managers to continually think ahead, planning and reviewing their activities in advance.

However the budgetary process should not stop with the plan. The organisation has started out in the right direction but to ensure that it continues on course it is management’s responsibility to exercise control.

Control is best achieved by comparison of the actual results with the original plan. Appropriate action can then be taken to correct any deviations from the plan.

The comparison of actual results with a budgetary plan, and taking of action to correct deviations is known as feedback control.

The two activities of planning and control must go hand in hand. Carrying out the budgetary planning exercise without using the plan for control purposes is performing only part of the task.

What is a budget?

A budget could be defined as ‘a quantified plan of action relating to a given period of time’.

For a budget to be useful it must be quantified. For example it would not be particularly useful for the purposes of planning and control if a budget was set as follows:

‘We plan to spend as little as possible in running the printing department this year’; or ‘We plan to produce as many units as we can possibly sell this quarter’.

These are merely vague indicators of intended direction; they are not quantified plans. They will not provide much assistance in management’s task of planning and controlling the organisation.

These ‘budgets ‘could perhaps be modified as follows:

‘Budgeted revenue expenditure for the printing department this year is $60,000’, and ‘Budgeted production for the quarter is 4,700 units’

The quantification of the budgets has provided:

a) A definite target for planning purposes; andb) A yardstick for control purposes.

The budget period

You may have noticed that in each of these ‘budgets’ the time period was different. The first budget was prepared for a year and the second was for a quarter. The period for which a budget is prepared and used is called the budget period. It can be any length to suit management purposes but it is usually one year. The length of time chosen for the budget period will depend on many factors, including the nature of the organisation and the expenditure being considered. Each budget period can be subdivided into control periods, also of varying lengths, depending on the level of control which management wishes to exercise. The usual lengths of a control period is one month.

Strategic planning, budgetary planning and operational planning

It will be useful at this stage to distinguish in broad terms between three different types of planning;

Strategic planning; Budgetary planning; Operational planning.

These three forms of planning are interrelated. The main distinction between them relates to their timespan which may be short term, medium term or long term.

The short term of one organisation may be the medium or long term for another, depending on the type of activity which it is involved.

Strategic Planning

Strategic planning is concerned with preparing long-term action plans to attain the organisation’s objectives.

Strategic planning is also known as corporate planning or long-range planning.

Budgetary Planning

Budgetary planning is concerned with preparing the short- to long-term plans of an organisation. It will be carried out within the framework of the strategic plan. An organisation’s annual budget could be seen as an interim step towards achieving the long- term or strategic plan.

Operational planning

Operational planning refers to the short-term or day-to-day planning process. It is concerned with planning the utilisation of resources and will be carried out within the framework set by the budgetary plan. Each stage in the operational planning process can be seen as an interim step towards achieving the budget for the period.

Operational planning is also known as tactical planning.

Remember that the full benefit of any planning exercise is not realised unless the plan is also used for control purposes. Each of these types of planning should be accompanied by the appropriate control exercise covering the same time span.

Preparation of Budgets

The process of preparing and using budgets will differ from organisation to organisation. However there are a number of key requirements I the design of a budgetary planning and control process.

Co-ordination: The budget committee

The need for co-ordination in the planning process is paramount. The interrelationship between the functional budgets (for example sales, production, purchasing) means that one budget cannot be completed without reference to several others.

For example the purchasing budget cannot be prepared without reference to the production budget, and it may be necessary to prepare the sales budget before the production budget can be prepared. The best way to achieve this co-ordination is to set up a budget committee. The budget committee should comprise representatives from all functions in the organisation. There should be a representative from sales, a representative from marketing, a representative from personnel, and so on.

The budgetary committee should meet regularly to review the progress of the budgetary planning process and resolve problems that have arisen. These meetings will effectively bring together the whole organisation in one room, to ensure a co-ordinated approach to budget preparation.

Participative budgeting

Participative budgeting is defined as ’a budgeting system in which all budget holders are given the opportunity to participate in the setting of their own budges’. This may also be referred to as ‘bottom-up budgeting’. It contrasts with imposed or top-down budgets where the ultimate budget holder does not have the opportunity to participate in the budgeting process. The advantages of participative budgeting are as follows:

Improved quality of forecast to use on the basis for the budget. Mangers who are doing the job on a day to day basis are likely to have a better idea of what is achievable, what is likely to happen in the forthcoming period, local trading conditions, etc.

Improved motivation. Budget holders are more likely to want to work and achieve a budget that they have been involved in setting up themselves, rather than one that has been imposed on them from above. They will own the budget and accept responsibility for the achievement of the targets contained therein.

The main disadvantage of participative budgeting is that it tends to result in more extended and complex budgetary process. However, the advantages are generally accepted to outweigh this.

Information: the budget manual

Effective budgetary planning relies on the provision of adequate information to the individuals involved I the planning process.

Many of these information needs are contained in the budget manual.

A budget manual is a collection of documents which contains key information for those involved in the planning process. Typical contents could include the following:

a) An introductory explanation of the budgetary planning and control process including a statement of the budgetary objective and desired results.

Participants should be aware of the advantages to them and to the organisation of an efficient planning and control process. This introduction should give participants an understanding of the workings of the planning process, and the sort of information that they can expect to receive as part of the control process.

b) A form of organisation chart to show who is responsible for the preparation of each functional budget and the way in which budgets are interrelated.

c) The timetable for the preparation of each budget. This will prevent the formation of a ‘bottleneck’, with the late preparation of one budget holding up the preparation of all the others.

d) Copies of all forms to be completed by those responsible for preparing budgets, with explanations concerning their completion.

e) A list of the organisation’s account codes, with full explanations of how to use them.f) Information concerning key assumptions to be made by managers in their budgets, for

example the rate of inflation, key exchange rates, etc.g) The name and location of the person to be contacted concerning any problems encountered

in preparing budgetary plans. This will usually be the co-ordinator of the budget committee (the budget officer) and will probably be a senior accountant.

Early identification of the principal budget factor

The principal budget (key budget) factor is the factor which limits the activities of the organisation. The early identification of this factor is important in the budgetary planning process because it indicates which budget needs to be prepared first.

The principal budget factor can also be called limiting factor. A limiting factor is any factor which is in scarce supply and which stops the organisation from expanding its activities further, i.e. it limits the organisation’s activities.

The limiting factor for many trading organisations is sales volume because they cannot sell as much as they would like. However, other factors may also be limited, especially in the short term. For example, machinery capacity or the supply of skilled labour may be limited for one or two periods until some action can be taken to alleviate the shortage..

For example, if sales/issues volume is the principal budget factor, then the sales/issues budget must be prepared first, based on the available sales/issues forecasts. All other budgets should be linked to this.

Alternatively machine capacity may be the limited for the forth coming period and therefore machine capacity is the principal budget factor. In this case the production budget must be prepared first and all other budgets must be linked to this.

Failure to identify the principal budget factor at an early stage could lead to delays later on when managers realise that they have been working with are not feasible. Work out the exercises below to give you practice in identifying the limiting factor from data provided.

Decisions involving a single limiting factor

If an organisation is faced with a single limiting factor, for example machine capacity then it must ensure that a production plan is established which maximises the profit from the use of the available capacity. Assuming that the fixed cost remain constant, this is the same as saying that the contribution must be maximised from the use of the available capacity. The machine capacity must be allocated to those products which earn the most contribution per machine hour.

The decision rule can be stated as ‘maximising the contribution per unit of limiting factor’.

The Interrelationships of budgets

The critical importance of the principal budget factor stems from the fact that all budgets are interrelated. For example, if sale (issues/annual demand) is the principal budget factor this is the first budget to be prepared. This will then provide the basis for the preparation of several other budgets including the selling expenses budget and production budget.

However, the production budget cannot be prepared directly from the sales budget without considering the stock holding policy. For example, management may plan to increase the finished goods stock in anticipation of a sales drive. Production quantities would then have to be higher than the budgeted sales level. Similarly if a decision is taken to reduce the level of material stocks held, it would not be necessary to purchase all of the materials required for production.

Using Computers in budget preparation

A vast majority of data is involved in the budgetary planning process and managing this volume of data in a manual system is an onerous and cumbersome task. A computerised budgetary planning system will have the following advantages over a manual system:

Computers can handle the volume of data involved;

A computerised system can process the data more rapidly than a manual system; A computerised system can process the data more accurately than a manual system; Computers can quickly and accurately access and manipulate the data in the system.

Organisations may use specially designed budgeting software. Alternatively, a well-designed spread sheet model can take into account of all the budget interrelationships described above.

The model will contain variables for all of the factors about which decision must be made in the planning process, for example sales volume, unit costs, credit periods and stock volumes.

If managers wish to assess the effect on the budget results of a change in one of the decision variables, this can be accommodated easily by amending the relevant variable in the spread sheet model. The effect of the change on all of the budgets will be calculated instantly so that managers can make better informed planning decisions.

Budgetary planning is an iterative process. Once the first set of budgets have been prepared, those budgets will be considered by senior managers. The criteria used to assess the suitability of the budgets may include adherence to the organisation’s long term objectives, profitability and liquidity. Computerised spreadsheet models then provide managers with the ability to amend the budgets rapidly,, and adjust decision variables until they feel they have achieved the optimum plan for the organisation for the forthcoming period.

The master budget

The master budget is a summary of all the functional budgets. It usually comprises the budgeted profit and loss account, budgeted balance sheet and budgeted cash flow statement. It is this master budget which is submitted to senior managers for approval because they should not be burdened with an excessive amount of detail. The master budget is designed to give the summarised information that they need to determine whether the budget is an acceptable plan for the forthcoming period.

Preparation of operational budgets

The best way to see how budgets are prepared is to go through an example

Example :preparing an operational budget

A company manufactures two products. Aye and Bee. Standard cost data for the products for next year are as follows

Product Aye per

unit

Product Bee per

Unit

Direct materials:

X at $2 per Kg 24 kilos 30 kilos

Y at $5 per Kg 10 kilos 8 kilos

Z at $6 per Kg 5 kilos 10kilos

Direct wages:

Unskilled at $3 per hour 10 hours 5 hours

Skilled at $5 per hour 6 hours 5 hours

Budgeted stocks are as follows

Product Aye per

unit

Product Bee per

Unit

1-Jan 400 800

31-Dec 500 1100

Material X Material Y Material Z

1-Jan 30000 25000 12000

31-Dec 35000 27000 12500

Budgeted sales for next year: product :Aye 2,400 units; product Bee 3,200 units

You are required to prepare the following budgets for next year:

a) production budget, in units;

b)material purchases budget in kilos and $;

c) direct labour, in hours and $

a) Production budget for next year

Product Aye units

Product Bee units

Sales units required

Closing stock    

   

Less opening stock    

Production units required    

b) Material purchases budget fo next year

Material X kg

Material Y kg

Material Z kg Total

Requirements for production

product Aye1

product Bee

     

Closing Stock at the end of the year      

     

Less opening stock      

Material purchases required      

Standard price per kg $2 $5 $6

Material purchases value        

Note 1: Matrerial for product Aye

c) Direct labour budget for next year

Unskilled labour hours

Skilled labour hours Total

Requirements for production:

product Aye1

product bee

Total hours required    

Standard rate per hour

Direct labour cost      

Note 1; Unskilled labour for product Aye:

Budget interrelationships

This example demonstrated how the data from one operational budget becomes an input in the preparation of another budget. The last budget in the sequence will also provide input data for other budgets. For example, the material purchases budget would probably be used in preparing the creditors budget, taking into account of the company’s intended policy on the payment of suppliers. The creditors budget would indicate the payments to be made to creditors, which would then become an input for the cash budget, and so on.

The cash budget is the subject of the next section.

Exercise 2

Each unit of product alpha requires 3 kg of raw material. Next month’s budget for product alpha is as follows:

Opening stock:

raw materials 15000 kg

finished goods 2000 units

Budgeted sales of alpha 60000 units

Planned closing stocks:

raw materials 7000 kg

finished units of Alpha 3000 units

The number of kilograms of raw material that should be purchased next month is

A 172 000

B 175 000

C 183 000

D 191 000

The Cash Budget

The cash budget is one of the vital planning documents in an organisation. It will show the effect of all of the decisions taken in the planning process.

Management decisions will have been taken concerning such factors as stockholding policy, credit policy, selling price policy and so on. All of these plans will be designed to meet the objectives of the organisation. However, if there are insufficient cash resources to finance the plans they may need to be modified or perhaps action might be taken to alleviate the cash restraint.

A cash budget can give a forewarning of potential problems that could arise so that managers can be prepared for the situation or take action to avoid it

The process of forecasts to modify actions so that potential threats are avoided or opportunities exploited is known as feed forward control.

There are four possible positions that could arise:

Cash position possible management action

Short-term deficit arrange a bank overdraft, reduce debtors and stocks, increase creditors

Long-term deficit Raise long-term finance, such as loan capital or share capital Short-term surplus Invest short term, increase debtors and stocks to boost sales, pay

creditors early to get cash discounts Long-term surplus Expand or diversify operations, replace or update fixed assets

You should notice that the type of action taken by management will depend not only on whether a deficit or a surplus is expected, but also on how long the situation is expected to last. For example management would not wish to use surplus cash to purchase fixed assets, if the surplus was only short term and the cash would soon be required again for the day to day operations.

Cash budgets therefore forewarn managers of whether there will be cash surpluses or cash deficits, and how long the surplus or deficits are expected to last.

Preparing cash budgets Before we work through a full example of the preparation of a cash budget, it will be useful to discuss a few basic principles

a) The format of a cash budget

There is no definitive format which should be used for a cash budget. However , whichever format you decide to use it should include the following:

i). A clear distinction between cash receipts and cash payments for each control period Your budget should not consist of a jumble of cash flows. It should be logically arranged with a subtotal for receipts and a subtotal for payments

ii). A figure for the net cash flow for each period. It could be argued that this is not an essential feature of a cash budget. However, you will find it easier to prepare and use a cash budget if you include the net cash flow. Also, managers find it in practice that a figure for the net cash flow helps to draw attention to cash flow implications of their actions during the period.

iii). The closing balance for each period. The closing balance for each period will be the opening balance for the following period.

b) Depreciation is not included in cash budget

Remember that depreciation is not a cash flow. It may be included in your data for overheads and must therefore be excluded before the overheads are inserted into the cash budget.

c) Allowance must be made for bad and doubtful debts

Bad debts will never be recived in cash and doubtful debts may not be received. When you are forecasting the cash receipts from debtors you must remember to adjust for these items.

Example 2: cash budgetWatson limited is preparing its budgets for the next quarter. The following information has been drawn from the budgets prepared in the planning exercise so far

Watson limited is preparing its budgets for the next quarter. The following information has been drawn from the budgets prepared in the planning exercise so far

sales value June (estimate) $12,500

July (budget) $13,600

August $17,000

September $16,800

Direct wages $1300 per month

Direct materials June (estimate) $3,450

July (budget) $3,780

August $2,890

September $3,150

Other information

Watson sells 10 per cent of its goods for cash. The remainder of customers receive one month’s credit.

Payments to creditors are made in the month following purchase. Wages are paid as they are incurred. Watson takes one month’s credit on all overheads. Production overheads are $3,200 per month. Selling, distribution and administration overheads amount to $1,890 per month. Included in the amounts form the overhead given above are depreciation charges of

$300 and $190 respectively. Watson expects to purchase a delivery vehicle in august for cash payment of 49,870 The cash balance at the end of June is forecast to be $1,235

You are required to prepare a cash budget for each of the months July to September

SolutionWatson Ltd cash budget for july to september

July $

August $

September $

Sales reciepts:

10% in cash

90% in one month

Total reciepts      

Payments

Material purchases (one month credit)

direct wages

Prodution overheads

Selling, distribution and administration overhead

Delivery vehicle

Total payments      

Net cash inflow/outflow

Opening cash balance      

Closing cash balance at the end of the month      

Interpretation of the cash budget

The cash budget forewarns the management of Watson limited that their plans will lead to a cash deficit of $1,115 at the end of August. They can also see that it will be a short –term deficit and can take appropriate action.

They may decide to delay the purchase of the delivery vehicle or perhaps negciate a period of credit before the payment will be due. Alternatively overdraft facilities may be arranged for the appropriate period.

If it is decided that overdraft facilities are to be arranged, it is important that due account is taken of the timing of the receipts and payment within each month.

For example all the payments in August may be made at the beginning of the month but receipts may not be expected until nearer the end of the month. The cash deficit could then be considered greater than it appears from looking at the month end balance.

If the worst possible situation arose, the overdrawn balance during August could become as large as $4,495-$19,550= $15,055. If management had used the mnth end balances as a guide to the overdraft requirement during the period then they would not have arranged a large enough overdraft facility with the bank. It is important therefore that they look in detail at the information revealed by the cash budget, and not simply at the closing cash balances.

Practise what you have learnt about cash budgets by attempting the following exercise

Exercise 3

The following information relates to XY Ltd

MonthWages

Incurred $000

Material purchases

$000Overhead

$000Sales $000

February 6 20 10 30

March 8 30 12 40

April 10 25 16 60

May 9 35 14 50

June 12 30 18 70

July 10 25 16 60

August 9 25 14 50

September 9 30 14 50

a) It is expected that the cash balance on 31 May will be $22,000b) The wages may be assumed to be paid within the month they are incurred.c) It is company policy to pay creditors for materials three months after receipt.d) Debtors are expected to pay two months after delivery.e) Included in the overhead figure is $2,000 per month which represents depreciation on

two cars and one delivery van.f) There is a one month delay in paying the overhead expenses.g) 10 per cent of the monthly sales are for cash and 90 per cent are sold on credith) A commission of 5 per cent is paid to agents on all the sales on credit but this is not paid

until the month following the sales it relates; this expense is not included in the overhead figures shown

i) It is intended to repay a loan of 425,000 on June 30.j) Delivery is expected in July of a new machine costing $45,000 of which $15,000 will be

paid on delivery and $15,000 in each of the following months.k) Assume that overdraft facilities are available if required.

You are required to prepare a cash budget for each of June, July and August.

SolutionCash budget for June , July and August

June $

July $

August $

Receipts:

Receipts from debtors (90% in two months)

Cash sales (10% sales month)

Total receipts      

Payments

Material purchases (three months credit)

Wages

Overheads

Commission

Loan repayment

Payments for new machinery

Total payments      

Net cash inflow/outflow

Opening cash balance      

Closing cash balance at the end of the month      

A complete exercise

Now that you have seen how to prepare functional budets and cash budgets, have a go at the following exercise. It requires you to work from basic data to produce anumber of functional budgets, as wellas the master budgets, i.e budgeted cash flow, profit and loss account and balance sheet.