Budget

What is a Budget? What is a forecast and how is it different to a Budget?

A budget is a detailed plan for the acquisition and use of financial resources over a specified time period. It is different to a Forecast, which is a prediction of what is likely to happen in the future, given a certain set of circumstances.

What are the 6 advantages of budgeting?

• Allows the user to define their goals and objectives

• Helps to communicate plans

• Co-ordinates activities

• Helps to think about and plan for the future

• Acts as a way of allocating resources

• Uncovers potential bottlenecks

What is a Master Plan?

A comprehensive financial plan for an organisation, summarising all its individual budget into one document.

What does a Master Plan typically include?

• A Cash Budget

• A Budgeted Statement of Profit or Loss

• Budgeted Statement of Financial Position

What are the Three Types of Budgeting?

• Incremental Budgeting

• Zero-Based Budgeting

• Rolling Budgets

What is Incremental Budgeting?

Incremental budgeting is the traditional approach. It involves using the current year’s budget as a baseline, and modifications are made to create the next year’s budget for anticipated changes, such as inflation or new projects.

What is Zero-Based Budgeting?

Each budget is prepared from the very beginning of each period (and so, doesn’t build on the previous year.) Effectively, it analyses an organisation’s needs and costs by starting from a “zero base” at the beginning of every period.

What is Rolling Budgets?

As one period ends, a new period is added to the end of the budget, effectively ‘rolling’ the budget forward to reflect current performance and future projections. As a result, these budgets are prepared more regularly (eg; monthly) and each of these budgets would plan for, for example, the next 12 months.

Are Rolling Budgets fixed or continuous?

Continuous

What is the Sales Budget? In what terms is it usually expressed in?

A detailed schedule showing the expected sales for the coming period. It can be expressed in £ and/ or units of the product.

What is the Sales Budget usually accompanied by?

A schedule of expected cash collections - the schedule of expected cash collections should take into account the possible delays that may occur when collecting credit sales.

What is the formula for Production Required?

Production Required = Budgeted Sales + Ending Inventory - Opening Inventory

In a retail firm, what replaces the Production Budget?

Purchase Budget

What is the Direct Materials Budget?

After finding out how much you need to produce, you can work out how much raw material is required to produce said quantity. Sufficient amounts of raw material must be acquired to meet both production needs and to provide for desired ending inventories.

What is the formula for Direct Materials Budget?

Direct Materials Budget: Needed for Production + Ending Inventory - Opening Inventory

What is the formula for the Cash Budget/ Cash Balance?

Opening Cash + Cash Receipts - Cash Payments = Cash Balance

What does the Cash Budget include?

• The Receipts (Cash Collections)

• The Disbursements (Cash Payments)

What is Working Capital?

An amount which can be used to measure both a company’s operational efficiency and its short-term financial health. It’s formula is:

Current Assets - Current Liabilities

Give some examples of Current Assets

• Cash at bank

• Investments

• Trade Receivables

• Inventories

Give some examples of Current Liabilities

• Trade Payables

• Bank Overdrafts

• Short-term borrowings

What does insolvency mean?

A term for when an individual or organisation can no longer meet its financial obligations with its lenders as debts become due.

What does liquidity?

The measure of ease at which an individual or company can meet their financial with the liquid assets available to them.

What are the two key measures for liquidity?

Current Ratio and Quick Asset Ratio

What is the formula for Current Ratio? What does it assume about inventory?

Current Assets / Current Liabilities.

It assumes inventory is easily saleable.

What is Quick Ratio?

(Current Ratio - Inventory) / Current Liabilites

Unlike Current Ratio, Quick Ratio excludes inventory.

What is the purpose of Liquidity Ratios?

To measure the ability to meet short term Liabilites from assets that can be quickly realised (sold for cash.)

What does a high value liquidity ratio mean for a business?

It means that the business is more liquid and can meet its current Liabilites from its available current assets more easily. However, if it is too high, then it could imply that the money held as cash or stock could be more productively invested. Generally, investors prefer a ratio >1.

What is the purpose of efficiency ratios?

Using ratios to determine how efficiently a firm uses its assets:

• Inventory turnover period

• Rate of Inventory turnover

• Receivable Collection Period

• Payables Payment Period

Why may a firm hold inventory?

• To meet demand

• Ensure the continuity of production

• To take advantage of discounts for bulk-buying

• In anticipation of price rises

• Fewer larger purchases

• Seasonal demand or supply

How to calculate Inventory Turnover Period?

Average Inventory / Cost of Sales X 365

You want to hold inventory for as short a time as possible

How to calculate Rate of Inventory Turnover?

Cost of Sales / Average Inventory.

You want the turnover to be as high as possible (it means that inventory is moving quickly from factory to a shop or from factory directly to customer.)

What are the benefits of Short-Term Finance?

• Generally more cheaper than longer term finance

• More flexible

• Includes trade payables (low cost as interest is typically not charged.)

• Long term finance (equity) is expensive since shareholders see investment as risky and so, want a reward.

What are the risks of short-term finance?

• Renewal risk is greater with shorter term loans because it relies on continuous refinancing.

• Interest rate risk is greater - fluctuations can impact renewal. (Short term interest rates that can fluctuate rapidly affects the cost of borrowing.)

What are the limitations of Working Capital Measures?

• Any point where you are analysing a firm, it may not be typical. This is particularly in the case for seasonal businesses.

• Measures are based on information from the past.

What does the Receivables Collection Period Measure? What is the formula?

Measures how long it takes on average to collect debt.

(Average Receivables / Annual Sales Revenue) X 365

What does a low receivables collection period mean?

The lower the time taken to collect debts, the lower the cost of capital of money invested in receivables balances and less chance of bad debt. However, the collection period still has to be competitive because a firm may lose customers if the terms are not generous enough.

What is a Payable Payment Period? What is the formula?

How long on average a company takes before paying suppliers.

(Average Payables / Annual Purchases) X 365

Do you want the Payables Payment Period to be low as possible or high as possible.

You would rather have it as high as possible, without straining relationships with the suppliers, so you have more time to pay.

If ‘purchases’ is not available to calculate Annual Purchases (in Payables Payment Formula), what can be used instead?

Cost of Sales

What is the Cash Operating Cycle?

The length of time between using cash to pay for materials etc, and the time when cash is received for sale of goods and services.

What are the elements of the Cash Operating Cycle?

• Raw Materials Holding Period

• Average Payables Period

• Average Production Period

• Average Inventory Period

• Average Receivables Collection Period

Raw Materials Holding Period

(Average Inventory of Raw Materials / Annual Usage) X 365

Average Production Period

(Average Inventory of Work in Progress / Annual Cost of Sales ) X 365

Annual Inventory Holding Period

(Average Inventory of Finished Goods / Annual Cost of Sales) X 365