Financial Planning: The Cash Budget PDF

# Financial Planning: The Cash Budget ## Learning Outcomes After studying this chapter, you should: - know the conditions for compiling successful budgets - know the goals of a budget system - be able to discuss the functions of budgets - be able to list the limiting factors when compiling budget...

# Financial Planning: The Cash Budget ## Learning Outcomes After studying this chapter, you should: - know the conditions for compiling successful budgets - know the goals of a budget system - be able to discuss the functions of budgets - be able to list the limiting factors when compiling budgets - be able to discuss the financial planning process - understand the cash budget, and do a cash flow forecast for an organisation - know the steps when compiling the main budget - be able to discuss progress reporting and control of deviations in the budget system - be able to describe how budgets can be used as a tool for financial management. ## Introduction The goal of an organisation is to maximise the wealth of its owners. In order to achieve this objective, the seven functions of the organisation (financial, communication, marketing, production, purchasing, human resources and information) must be coordinated throughout its various divisions. The management functions (planning, control, organising, commanding and coordination) are used in coordinating of the activities of the organisation in the achievement of its goal. Without careful planning, the chance of failure is very high. The right kind of planning and control can be achieved by means of an integrated budget system. Such a budget system is a useful management tool mainly for the planning and control functions, but also for commanding and coordination. ## Financial Planning and Control in the Organisation A budget is a plan of action expressed in monetary terms to achieve the goals of the organisation. It is an indication of the actions that must be taken to move from the current point in time to a future objective. It is therefore clear that with a budget: - specific goals must be set - it must be stated how management plans to achieve these goals - a comparison between the actual and budgeted results must be done, which will serve as basis for evaluating various departments within the organisation, and for the organisation in total. While budgets indicate the actions needed to achieve the set goals, budget control is the mechanism for ensuring that the correct path is followed towards them. A further important function of budget control is to determine the causes if there is a diversion between budgeted and actual results, as well as the corrective measures to be taken in this regard. ## Conditions for Compiling Successful Budgets The following serve as general conditions for the successful implementation of a budget and budget control system: - There must be sufficient background information. - There must be clearly defined lines of responsibility, with a clear distinction between line and staff functions. - A successful budget system must have the support of all levels of management. - There must be a good organisational structure - There must be a reliable financial and management information system. ## The Goals of a Budget System The goals of a budget system are as follows: - To increase profitability by coordinating activities in the organisation and reducing unnecessary actions. - To ensure that cash resources are utilised optimally and financed in the best way by virtue of the knowledge obtained in forecasting the organisation's cash needs. ## Functions of a Budget The functions of a budget are the following: - It is an assignment and an authority to act. - It serves as a communication tool with subordinates. - It gives an indication of external factors that are beyond management's control. - It serves to coordinate the various divisions of the organisation in order to achieve synergism. - It is indispensable as a method of control. - It helps to indicate the responsibilities of managers, not only towards their own divisions, but also towards others in the organisation. ## Limiting Factors When Compiling Budgets In any organisation there are external and internal factors which place limitations on the activities that take place. These could be, for example, the availability of production inputs as well as other factors such as location or transport. The production process will be hampered if there are insufficient materials or labour. Another limiting factor could be the availability of capital, which will have an influence on the production activities if not enough working capital is available. These are examples of limiting factors and must be taken into consideration when compiling budgets. ## Concluding Remarks Organisations spend a lot of time preparing budgets, and their value lies in effective implementation. Nicely printed and bound budgets that are simply filed away after the process are a complete waste of time. Budgets should be used daily to compare actual events with the plan to ensure that deviations are identified and that corrective measures are taken in time. These comparisons can simply be done through an actual event column against a budget column on the monthly financial statements (or in more detail for different departments) or through a sophisticated system such as standard costing. The popularity of zero-based budgeting necessitates a few remarks on the subject. Zero-based budgeting basically ignores historical figures and does financial planning from scratch, querying the necessity of each expense. It should be noted, however, that some parts of a budget will always be zero based, for example the acquisition of non-current assets. On the other hand, it would be foolish to ignore the valuable information contained in some of the historical figures, for example items on the overheads budget. At the other extreme, it seems highly unlikely that the personnel budget would work on a zero basis! By following the process as described briefly in the next section, businesses will ensure that the correct mix between zero-based and historically based budgeting is maintained. ## The Financial Planning Process Financial planning is used to guide organisations' actions towards the achievement of their objectives. These objectives could be long term, such as: - the maximisation of the wealth of the owners - sustainable profits. They could also be short term, such as: - efficient day-to-day operations - complete liquidity to pay suppliers, personnel and overheads. This means that the organisation must plan for the following: - Return on assets - long term - Liquidity - short term Long-term financial plans usually take the form of a so-called five-year plan, and the short-term plan could be a three-month cash budget. The periods involved will differ from company to company. Good financial planning, especially over the longer term, will include the preparation of proforma Statements of Comprehensive Income and Statements of Financial Position. These are built up from various sub- or secondary budgets, as will be explained in the following section. The financial planning process is depicted graphically in Figure 8.1. [Insert Image Description Here: A diagram of the budgeting process, showing how the sales budget informs the production plan, personnel budget, inventory, factory overheads, operating expense budget, cash budget, and proforma financial statements.] The whole financial planning process is driven by the sales budget (see Figure 8.1). Once expected sales figures are known, organisations can develop production plans, taking into account aspects such as lead times for delivery and production, and required inventory levels. From the production plan it is possible to deduce the required production facilities, direct labour and factory overheads. The sales plan also indicates the sales force requirements. Once the operating budget is available, the cash budget can be prepared and, finally, the proforma Statement of Comprehensive Income and Statement of Financial Position. The key outputs of the financial planning process are the following: - The cash budget - The proforma financial statements Preparing proforma financial statements falls outside the scope of this book, but will be briefly discussed later in this chapter. ## The Cash Budget When an organisation generates sales and profit, this does not necessarily mean that there is sufficient cash to honour commitments. A profitable transaction could give rise to debt, but may not provide immediate cash to make payments. The cash budget is one of the most important management tools which can be used to plan for future cash flow. It is a forecast of the expected cash receipts and cash payments for a specific future period. The cash budget allows the organisation to forecast its short-term cash requirements. A company expecting a cash surplus can plan for short-term investments, and a company expecting a cash shortfall can arrange for short-term financing, for example a bank overdraft. The cash budget is normally designed to cover a one-year period, at one-month intervals. In practice, a one-year cash budget could be prepared every month, updating the closing balances and utilising the information from the activities of the recent past. Companies handling large amounts of cash may even prepare cash budgets at daily intervals. The cash budget indicates to the financial manager: - the extent, timing and sources of the cash inflows - the extent, timing and sources of the cash outflows - the cash surpluses and cash shortages, their timing as well as the period of time during which they will occur. When compiling the cash budget, the following must be taken into consideration: - A clear distinction between cash and credit sales. - The credit policy that will be followed with the collection of credit sales as well as discounts allowed to encourage timeous payments and to curb bad debts. - The policy regarding the payment of trade payables. - The cash outflows as required by the operating and long-term budgets. - Specific provisions for the payment of interest, tax and dividends by the organisation. As mentioned before, the key input to the cash budget (and the whole budgetary process) is the sales budget. The task of forecasting income normally lies with the marketing department. Several techniques are used for income and sales forecasting, but these fall outside the scope of this book. Table 8.1 gives an example of a format for a cash budget. [Insert Image Description Here: A table showing a cash flow projection for a business called "Hotshots (Pty) Ltd", covering December, January and February. The table shows receipts, disbursements, net cash flow, opening balance, and closing balance.] A slightly different format, which gives the same results, is shown in Table 8.2. Remember that the cash flow projection or budget reflects only transactions that result in actual cash inflows or outflows. - Depreciation is not a cash flow transaction and should not be included. - Credit sales (trade receivables) are not a cash flow transaction and should not be included. The eventual cash collection from debtors, however, must be included as and when they occur. - Credit purchases (trade payables) are not a cash flow transaction and should not be included. The eventual cash payment of trade payables, however, must be included as and when they occur. - The cash flow projection is not an income statement, and therefore purchases of fixed assets must be included. If bought for cash, the full cash payment must be included when payment is expected to take place. If purchased on credit, the instalments must be included as and when they take place. - Provisions are not cash flow transactions. Provision for taxes or dividends must not be included. Only actual dividends or tax paid must be included in the expected period of payment. Note that the collection of cash from trade receivables does not necessarily take place in the month after the sale has been made, but could be several months later, if at all (bad debts). This lagging of collections needs to be taken into account when preparing a cash budget. A similar lagging can also be found in the payment of trade payables. ## Example Cashstrapped Ltd's expected sales, all on credit, for June, July and August are R210000, R250 000 and R240 000 respectively. Actual sales for March, April and May were R140 000, R180 000 and R190 000. Experience has shown that 75% of a month's sales are collected in the following month, and 15% a month later, while the rest are never collected at all (bad debts). [Insert Image Description Here: A table showing a cash flow projection per month, from March to August.] Note that cash flow projections using monthly intervals give no indication of cash flow within a month. If Cashstrapped had to disburse the cash outflows for December within the first week but only received receipts in the last week, there would be a cash shortfall of almost R60 000 for a two-week period for which financing would be needed. Preparing a daily cash flow projection for at least the next 30 days in addition to the monthly projection could solve the problem. It should be noted that all budgeting in the modern workplace is done on computers using spreadsheet applications such as Excel or, for larger companies, specially written software. These programs facilitate the updating of budgets, and enable management to do extensive scenario analysis and strategy testing, which would simply not have been possible in a world without computers. ## Steps When Compiling the Main Budget The main budget consists of the various operating and financial budgets of the organisation's activities for the budgeted future period. In practice, there is no consensus on the types and number of "sub-budgets" or supporting budgets that must form part of the main budget. The number of units that will be sold (sales budget) is the basis of all the supporting budgets. Thereafter one can determine the number of units that must be produced, as well as whether the existing production capacity is sufficient to manufacture them. After the long-term goals of the organisation have been determined, the following steps can be followed in compiling the main budget: - Make a forecast of the external economic conditions that have an influence on the organisation. - Evaluate competitors, the industry and other specific factors that might play a role. - Make a forecast of the internal conditions of the organisation, such as level of education, labour and technology. - Determine the short-term goals of the organisation. - Determine the short-term limiting factors that might place constraints on the organisation, such as demand, production capacity, labour and financing. - Taking the internal and external conditions into consideration, forecast the number of units which the organisation plans to sell. This forms the basis of the sales budget, and must be expressed in units as well as in rand value. - Based on the sales budget, the production budget in units must be compiled. This will indicate what, how much and when units must be produced. - The production budget forms the basis of the raw materials, direct labour and manufacturing overhead budgets. - In order to determine the cost of sales budget, the opening inventory and finished goods are added to the production budget. - The operating expense budgets are then compiled. Examples are the following: - The marketing budget, taking into account all promotions, advertising and sales staff salaries - Administrative and personnel budgets - The research and development budget - The training budget - Finally, the capital investment and cash budgets are compiled, which will form the basis of the budgeted income statement and balance sheet. The main budget is obtained by coordinating all these budgets. ## The Budgeted (Proforma) Statement of Comprehensive Income and Statement of Financial Position The ultimate goal of the integrated budget system is to produce the budgeted or forecast Statement of Comprehensive Income and Statement of Financial Position. The budgeted Statement of Comprehensive Income is derived from the various operating budgets, and indicates the projected income for the period. Thereafter the proforma Statement of Financial Position is compiled, which includes all the closing balances of the assets, liabilities and owners' equity, as indicated by the various supporting budgets. Apart from the internal use of these proforma financial statements, they are sometimes required by the suppliers of capital (financial institutions) in order to evaluate the creditworthiness of the organisation. ## Progress Reporting and Control of Deviations In order to achieve the goals of the integrated budget system, management must receive reports on a regular basis, which must indicate the actual results compared with the budgeted results. It is of the utmost importance that management receives these reports on a regular basis in order to exercise effective control over the activities of the organisation. The following can serve as guidelines for progress reports: - The reports must be synchronised with the organisational structure in order to include all levels of responsibility. - The reports must be repetitive, and the timing between them must make sense. - The reports must be adapted to the needs of the most important user thereof. - The reports must be as simple as possible. - The information on the reports must be correct and reliable in order to identify a deviation immediately. - One must be able to complete the reports easily, fast and timeously in order to ensure a high level of usage. The most important function of these progress reports is to compare the budgeted with the actual results, and the subsequent corrective actions. There are a number of ways in which the deviations between the actual and the budgeted results can be indicated. To indicate the deviations as absolute amounts will more than often not illustrate the magnitude or importance thereof. It may be necessary to indicate the deviation as a percentage or ratio to make it more clear to the relevant user. ## Budgets as a Tool for Financial Management As indicated above, budgets must be designed to assist management in the planning, control and coordination of the various functions of the organisation. - **Planning**. Planning is the first action that management must undertake in order to achieve the goals of the organisation. It is the framework within which production inputs are organised, coordinated and controlled. The activities must be quantified, and the physical quantities and monetary projections of income and expenses for the forecast period compiled. Planning is done at first on a macro basis, after which it is broken down to the finest detail. - **Control**. Control in the broader sense implies the comparison between the actual results and the quantified financial standards, the evaluation of the differences, reporting to management, the responsibility of the lower to the higher levels of management, and the taking of corrective measures. In order to have effective control, reliable work norms must exist, the responsibilities in the organisational structure must be clearly defined and a reliable organisational structure must exist. - **Coordination**. Budgets are important tools in coordinating all the activities of the organisation. In compiling an integrated budget system into the main budget, one will find that inefficiencies or duplicating activities are eliminated. ## Delegation of Power Management does not have the time to attend to all the diversions in the budget. The budget system can therefore be used to practise the principle of controlling only the exceptions. While management can attend to the relatively large exceptions managing the non-exceptions can be delegated to the lower levels of management. ## Significance of This Chapter The management of any organisation must continuously engage in financial planning in order to support and enhance its economic survival. It has been said that cash represents the lifeblood of the organisation. The cash flow forecast, as an integral part of the financial planning process, is an important tool in the hands of the financial manager to forecast and manage the cash flow of an organisation. A thorough understanding and correct application of the cash budget of an organisation is critical for enhancing profitability, managing future cash flow and ensuring the short- and long-term sustainability of the organisation. ## Conclusion In this chapter we discussed financial planning in terms of budgets, highlighting their conditions and functions. Thereafter the cash budget was introduced and the importance of the lagging effect of cash collections of debtors was illustrated. The role of the proforma Statement of Comprehensive Income and Statement of Financial Position was discussed. Progress reporting and control of budget deviations was deliberated. The chapter concluded by underlining the importance of budgets as a financial management tool. ## Self-Test Questions 1. Prepare a cash flow projection for Coldstart (Pty) Ltd for the months December, January and February from the following information, using the format provided. - Coldstart (Pty) Ltd had sales of R50000 in October and R60000 in November. Expected sales for December, January and February are R70000, R80000 and R100000 respectively. - The balance in the bank at the end of November was R5000. - Of the organisation's sales, 20% are for cash, 60% are collected one month after sales have taken place, and 20% two months after that. - The company collects R2000 every month for a surplus store- room it sublets. - Expected purchases are R50000, R70000 and R80000 for December to February, respectively. This will be paid in cash. - Rent for offices is R3000 per month. - Salaries are paid in the form of commission of 10% of sales. This is paid in the month following sales. - A cash dividend of R3000 will be paid in December. - An annual instalment of R4000 on a loan is payable in February. - Equipment expected to cost R6000 will be bought for cash in January. - Taxes of R6000 are due in February. [Insert Image Description Here: A table showing the balance sheet of Coldstart (Pty) Ltd, showing cash inflows and outflows relevant to the business] 2. Assuming Nomanni Ltd has a cash balance of R42000 at the beginning of November, prepare a monthly cash budget from November to the end of April. The following figures for Nomanni Ltd are available: [Insert Image Description Here: A table showing sales and purchases for Nomanni Ltd that will be used to build the cash flow statement. The table shows data for September to April.] The following information is available: - Of all sales, 20% are cash, 40% are collected in the next month and the other 40% within two months. - Of purchases, 10% are paid for in cash, and the rest in the next month. - Interest income expected is R12000 every month. - Wages and salaries amount to 20% of the preceding month's sales. - Rent is R 20 000 per month. - Interest payments of R10000 per month are due in January and February. - A principal payment of R30000 is due in April. - The company expects to pay cash dividends of R20000 in January as well as in April. - Taxes of R80000 are due in April. - Assets of R25000 will be purchased for cash in December. [Insert Image Description Here: A table showing an example of a possible cash flow statement that could be used to solve the problem above.]