ContentsAnalysing and Interpreting Financial Statements1Balance Sheet1Income Statement1Statement of Cash Flows2Statement of Shareholders' Equity2Management Report2Audit Report.3Explanatory Notes3Supplementary Information3Social Responsibility Reports3Proxy Statements3RATIO ANALYSIS3Measuring Overall Profitability4Assessing Operating Management: Decomposing Net Profit Margins4Evaluating Investment Management: Decomposing Asset Turnover5Evaluating Financial Management: Financial Leverage6CASH FLOW ANALYSIS7Analysing Cash Flow Information7Preparing a Report8Format8Limitations of analysis of financial statements8Limitations of financial reporting information8Difficulties in drawing comparisons between different entities8Limitations Of ratio analysis8Case Study9

Analysing and Interpreting Financial StatementsThe goal of nancial analysis is to assess the performance of a rm in the context of its stated goals and strategy. There are two principal tools of nancial analysis: ratio analysis and cash ow analysis. Ratio analysis involves assessing how various line items in a rms nancial statements relate to one another. Cash ow analysis allows the analyst to examine the rms liquidity, and how the rm is managing its operating, investment, and nancing cash ows. Financial analysis is used in a variety of contexts. Ratio analysis of a companys 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 (owners) 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 dateshence, 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 companys 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 rm is determined by its protability and growth. In ratio analysis, the analyst can 1. compare ratios for a rm over several years (a time-series comparison)2. compare ratios for the rm and other rms in the industry (cross-sectional comparison) 3. compare ratios to some absolute benchmark. In a time-series comparison, The analyst can hold rm-specic factors constant and examine the effectiveness of a rms strategy over time. Cross-sectional comparison facilitates examining the relative performance of a rm 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:PerformanceActivity

Book Value Per Common ShareAsset Turnover

Cash Return On AssetsAverage Collection Period

Vertical AnalysisInventory Turnover

Dividend Payout RatioFinancing

Earnings Per ShareDebt Ratio

Gross Profit MarginDebt / Equity Ratio

Price/Earnings RatioLiquidity Warnings

Profit MarginAcid-Test Ratio

Return on AssetsInterest Coverage

Return on EquityWorking Capital

Measuring Overall Profitability The starting point for a systematic analysis of a rms performance is its return on equity ( ROE ), dened as:

ROE is a comprehensive indicator of a rms performance because it provides an indication of how well managers are employing the funds invested by the rms shareholders to generate returns.Assessing Operating Management: Decomposing Net Profit Margins A rms net prot margin or return on sales (ROS) shows the protability of the companys operating activities. Further decomposition of a rms ROS allows an analyst to assess the efciency of the rms 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 rm, and trends across different rms in the industry. Income statement analysis allows the analyst to ask the following types of questions: (1) Are the companys 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 companys margins changing? Why? What are the under- lying business causeschanges 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 rms sales and cost of sales is gross prot. Gross prot margin is an indication of the extent to which revenues exceed direct costs associated with sales, and it is computed as:

Gross margin is inuenced by two factors: (1) the price premium that a rms products or services command in the marketplace and (2) the efciency of the rms procurement and production process. The price premium a rms products or services can command is inuenced by the degree of competition and the extent to which its products are unique. The rms 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 efciently. This is generally the case when a rm has a low-cost strategyTax Expense. Taxes are an important element of rms total expenses. Through a wide variety of tax planning techniques, rms can attempt to reduce their tax expenses. There are two measures one can use to evaluate a rms 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 companys return on equity. Since rms 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 rms investment management. There are two primary areas of asset management: (1) working capital management and (2) management of long-term assets. Working capital is dened as the difference be- tween a rms 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 rm to run its normal operations. For example, a rms 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 nancing for the rms working capital, and payment practices in an industry determine the normal level of accounts payable. The following ratios are useful in analysing a rms 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 denitions of these ratios are given below.

Operating working capital turnover indicates how many dollars of sales a rm 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 efciency of a rms working capital managementEvaluating Financial Management: Financial LeverageFinancial leverage enables a rm to have an asset base larger than its equity. The rm can augment its equity through borrowing and the creation of other liabilities like accounts payable, accrued liabilities, and deferred taxes. Financial leverage increases a rms 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 rms carry large cash balances or investments in marketable securities. These balances reduce a rms net debt because conceptually the rm can pay down its debt using its cash and short-term investments.While a rms shareholders can potentially benet from nancial leverage, it can also increase their risk. Unlike equity, liabilities have predened payment terms, and the rm faces risk of nancial distress if it fails to meet these commitments. There are a number of ratios to evaluate the degree of risk arising from a rms nancial leverage.Current Liabilities And Short-Term Liquidity. The following ratios are useful in evaluating the risk related to a rms current liabilities:

All the above ratios attempt to measure the rms ability to repay its current liabilities. The rst three compare a rms 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 rms operations to generate the resources needed to repay its current liabilities.CASH FLOW ANALYSISRatio analysis discussed above focused on analysing a rms income statement (net prot margin analysis) or its balance sheet (asset turnover and nancial leverage). The analyst can get further insights into the rms operating, investing, and nancing policies by examining its cash ows. Cash ow analysis also provides an indication of the quality of the information in the rms income statement and balance sheet.Analysing Cash Flow Information Cash ow analysis can be used to address a variety of questions regarding a rms cash ow dynamics: How strong is the firms 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 companys 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 companys 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.

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

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

AppendixCalculate 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 inflationDifficulties in drawing comparisons between different entities Comparisons affected by changes in the entitys 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 activitiesComparisons 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)

2005200620072008200920102011

Revenue N$ million76993711131232139014071453

Shareholders Equity N$ million6469039991136115311661121

Taxation N$ million147171177181199187160

Netprot after N$ million293337340358388397319

Capital Expenditure N$ million160188340286260410237

Total in N$ million915116913291608163217911696

Dividend N$ million11080245221370383,6364

Dividend as % of after tax profit96,7%114,2%

Return on equity45,4%37,3%34,0%31,5%33,6%34,0%28,4%

Prot Margin38,1%36,0%30,5%29,0%27,9%28,2%21,9%

EBITDA margin61%60,2%52,2%50,9%53,8%55,8%53,2%

Active sim cards in 1000403,7555,5743,51009128415351854,7

Full-time276272296397416395407

Monthly ARPU in N$1591411251029054

BUDGETING AND BUDGETARY CONTROL

1. BUDGETING IN PERSPECTIVE The purposes of budgeting Budgets have two main rolesa. 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 managements 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 managements 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 unitsThe quantification of the budgets has provided:a) A definite target for planning purposes; andb) A yardstick for control purposes.

The budget periodYou 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 planningIt 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 organisations objectives.Strategic planning is also known as corporate planning or long-range planning.Budgetary PlanningBudgetary 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 organisations annual budget could be seen as an interim step towards achieving the long- term or strategic plan.Operational planningOperational 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 BudgetsThe 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 committeeThe 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 budgetingParticipative 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 manualEffective 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 organisations 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 factorThe 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 organisations 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 factorIf 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 budgetsThe 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 preparationA 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 organisations 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 budgetsThe best way to see how budgets are prepared is to go through an exampleExample :preparing an operational budgetA company manufactures two products. Aye and Bee. Standard cost data for the products for next year are as followsProduct Aye per unitProduct Bee per Unit

Direct materials:

X at $2 per Kg24 kilos30 kilos

Y at $5 per Kg10 kilos8 kilos

Z at $6 per Kg5 kilos10kilos

Direct wages:

Unskilled at $3 per hour10 hours5 hours

Skilled at $5 per hour6 hours5 hours

Budgeted stocks are as follows

Product Aye per unitProduct Bee per Unit

1-Jan400800

31-Dec5001100

Material XMaterial YMaterial Z

1-Jan300002500012000

31-Dec350002700012500

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 unitsProduct Bee units

Sales units required

Closing stock

Less opening stock

Production units required

b) Material purchases budget fo next year

Material X kgMaterial Y kgMaterial Z kgTotal

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 hoursSkilled labour hoursTotal

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 interrelationshipsThis 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 companys 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 months budget for product alpha is as follows:

Opening stock:

raw materials15000 kg

finished goods2000 units

Budgeted sales of alpha60000 units

Planned closing stocks:

raw materials7000 kg

finished units of Alpha3000 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 BudgetThe 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 positionpossible management action Short-term deficit arrange a bank overdraft, reduce debtors and stocks, increase creditors Long-term deficitRaise long-term finance, such as loan capital or share capital Short-term surplusInvest short term, increase debtors and stocks to boost sales, pay creditors early to get cash discounts Long-term surplusExpand or diversify operations, replace or update fixed assetsYou 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 principlesa) The format of a cash budgetThere 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 paymentsii). 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 budgetRemember 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 debtsBad 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 budget

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

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 valueJune (estimate)$12,500

July (budget)$13,600

August$17,000

September$16,800

Direct wages$1300 per month

Direct materialsJune (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 months credit. Payments to creditors are made in the month following purchase. Wages are paid as they are incurred. Watson takes one months 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 $1,235You are required to prepare a cash budget for each of the months July to September

Solution

Watson 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 $000Material purchases $000Overhead $000Sales $000

February6201030

March 8301240

April10251660

May9351450

June12301870

July10251660

August9251450

September9301450

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 showni) 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.Solution

Cash 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 exerciseNow 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.