Chapter 1 overview of budgeting and financial management

DEPT OF FINANCIAL MANAGEMENT CHAPTER OVERVIEW OF BUDGETING AND FINANCIAL MANAGEMENT LEARNING OUTCOMES ▪ Explain the general principles of budgeting, its functioning and the link between long-and short term planning, ▪ Illustrate the sequence of successive planning on the basis of partial plans, ▪ Do cost planning for direct costs, variable indirect costs and fixed costs using a case study on their own, ▪ Draw up a performance budget according to the cost sales style and the expenditure style of presentation, ▪ Draw up a financing plan according to the direct and indirect method as well as a budgeted balance sheet in the form of a changing balance sheet on their own, ▪ Calculate forecasts and deviation analyses ▪ Analyze, interpret and evaluate the results of a performance budget and a budgeted balance sheet CONTENT 1.1 Introduction 1.2 The role of budgets 1.3 Budgeting and forecasting 1.4 Types of budgets 1.5 Budget process INTRODUCTION What is a budget? • A budget is a financial plan that takes into account estimated revenue and expenses over a certain period of time • Re-evaluated periodically • Three types of budgets: Operating budget; Capital budget; Cash budget THE ROLE OF BUDGETS • Meeting the organization’s objectives • Planning • Monitoring and controlling • Co-ordinating • Evaluating performance • Improving performance • Motivating managers • Management contract • Communicating • Providing a basis for authorizing expenditure and delegating responsibility • Identifying scarce resources • Allocating resources • Demonstrating and delivering good corporate governance Meeting objectives What the organization’s objectives are? - The primary objective: seek to maximize returns to their owners (maximize profit) in the long run - The secondary objective: achieving certain levels of market share, developing new products and developing staff capabilities or new technologies ===> Budgets should be linked to objectives and strategy Planning • The budget can act as a plan to help us to achieve our objectives In fact, in many organizations, the budget is often referred to as the annual operating plan • A different view and probably a different approach: a budget should be a costed version of what we are going to over the year, in fact budget performance with no variances should perhaps be viewed with some suspicion • Producing a costed plan may be easier for some elements of the budget than others Monitoring and controlling • To control costs, income and cash, we need to start with a good plan, against which we can monitor its performance • In most organizations, variances from budget are produced every month with major variations from budget requiring an explanation It would be better to focus on a few key figures that made up most of the budget • The managers can monitor other figures that lead expenditure or income • Major underspends always be monitored and explained just like overspends Co-ordinating • The act of putting together budgets helps us to coordinate the activities of different parts of the organizations • The budgets and plans need to fit and work together • Different departments’ and units’ plans need to make the best use of the organization’s limited resources (known as the limiting factors) • All departments need to be consistent in order to drive the organization in the same direction Evaluating performance • Performance should also be measured in terms other than just the performance against the budget Perhaps budgets should be judged in conjunction with other KPIs • Managers should be measured on what they control (as the profit in his/her store) • Often cost and profitability are affected by teams of people working across different departments and functions • Measuring a manager’s performance based upon his/her budget may encourage managers to negotiate their budgets to make it easier for them to achieve rather than aiming to maximize the performance of their unit 10 Accounts Receivable as Collateral (cont'd) • Factoring of Accounts Receivable – An arrangement in which a firm sells receivables to the lender (the factor) and the lender agrees to pay the firm the amount due from its customers at the end of the firm’s payment period 27205 Accounts Receivable as Collateral (cont'd) • Factoring of Accounts Receivable – For example, if a firm sells its goods on net 30 terms, then the factor will pay the firm the face value of its receivables, less a factor’s fee, at the end of 30 days • The firm may be able to borrow as much as 80% of the face value of its receivables, thereby receiving its funds in advance – In such a case, the lender will charge interest on the loan in addition to the factor’s fee – The lender charges the factor’s fee, which may range from 0.75% to 1.50% of the face value of the accounts receivable, whether or not the firm borrows any of the available funds 27206 Accounts Receivable as Collateral (cont'd) • Factoring of Accounts Receivable – With Recourse • A loan in which the lender can claim all the borrower’s assets in the event of a default, not just explicitly pledged collateral – In other words, the lender can seek payment from the borrower should the borrower’s customers default on their bills 27207 Accounts Receivable as Collateral (cont'd) • Factoring of Accounts Receivable – Without Recourse • A loan in which the lender’s claim on the borrower’s assets in the event of default is limited to only explicitly pledged collateral – In other words, the lender bears the risk of bad-debt losses 27208 Inventory as Collateral • Floating Lien – A financial arrangement in which all of a firm’s inventory is used to secure a loan – Also known as General Lien or Blanket Lien • This is the riskiest setup from the standpoint of the lender because the value of the collateral used to secure the loan dwindles as inventory is sold 27209 Inventory as Collateral (cont'd) • Trust Receipt Loan – A type of loan in which distinguishable inventory items are held in a trust as security for the loan • As these items are sold, the firm remits the proceeds from their sale to the lender in repayment of the loan – Also known as Floor Planning 27210 Inventory as Collateral (cont'd) • Warehouse Arrangement – When the inventory that serves as collateral for a loan is stored in a warehouse – A warehouse arrangement is the least risky collateral arrangement from the standpoint of the lender; however warehouse arrangements are expensive • The business operating the warehouse charges a fee on top of the interest that the borrower must pay the lender for the loan 27211 Inventory as Collateral (cont'd) • Public Warehouse – A business that exists for the sole purpose of storing and tracking the inflow and outflow of inventory • If a lender extends a loan to a borrowing firm, based on the value of the inventory, this arrangement provides the lender with the tightest control over the inventory Inventory as Collateral (cont'd) • Field Warehouse – A warehouse arrangement that is operated by a third party, but is set up on the borrower’s premises in a separate area • Inventory held in the field warehouse can be used as secure collateral for borrowing 27213 Example 27214 Example (cont'd) 27215 Alternative Example • Problem – Shop At Lorelei’s wants to borrow $5 million for one month – Using its inventory as collateral, it can obtain a 8% (APR) loan – The lender requires that a warehouse arrangement be used and the warehouse fee is $30,000, payable at the end of the month – Calculate the effective annual rate of this loan for Shop at Lorelei’s 27216 Alternative Example • Solution  At the end of one month, Shop at Lorelei’s will owe: Interest of: 8% ữ 12 ì $5,000,000 = $33,333  Warehouse fee of: $30,000  Total Cost = $63,333 12  $5, 063, 333  EAR =  − = 16.3%   $5, 000, 000  Inventory as Collateral (cont'd) • The method that a firm adopts when using its inventory to collateralize a loan will affect the ultimate cost of the loan 27218 Chapter Quiz What is the effect of seasonalities on short-term cash flows? What is the difference between temporary and permanent working capital? What is the difference between a committed and uncommitted line of credit? What is commercial paper? What is the difference between a floating lien and a trust receipt? 27219