Contents

Analysing 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 Statements

The 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 ow analysis. Ratio analysis involves assessing
how various line items in a firms financial statements relate to one another.
Cash ow analysis allows the analyst to examine the firms liquidity, and how the
firm is managing its operating, investment, and financing 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 ows.

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 ow only over the life of the firm. For periodic reporting
purposes, accrual performance numbers nearly always differ from cash ow
numbers. This creates a demand for periodic reporting on both income and cash
ows. The statement of cash ows details the cash inows and outows 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 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 firms 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 firms performance is its return
on equity ( ROE ), defined as:

ROE=

Net income
Shareholder s equity

ROE is a comprehensive indicator of a firms performance because it provides an

indication of how well managers are employing the funds invested by the firms
shareholders to generate returns.

Assessing Operating Management: Decomposing Net Profit Margins

A firms net profit margin or return on sales (ROS) shows the profitability of the
companys operating activities. Further decomposition of a firms ROS allows an
analyst to assess the efficiency of the firms 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 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 firms 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 sales

Sales

Gross margin is inuenced by two factors: (1) the price premium that a firms
products or services command in the marketplace and (2) the efficiency of the
firms procurement and production process. The price premium a firms products
or services can command is inuenced by the degree of competition and the
extent to which its products are unique. The firms 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 firms 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 Turnover

Asset turnover is the second driver of a companys 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 firms 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 between a firms 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 payable. A certain amount of investment in working capital is necessary for the firm
to run its normal operations. For example, a firms 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 firms
working capital, and payment practices in an industry determine the normal level
of accounts payable.
The following ratios are useful in analysing a firms 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.

Operating working capitalsales ratio=

Operating working capital turnover=

Accounts receivable turnover=

Inventory turnover=

Sales
Operating working capital

Sales
Accounts receivable

Cost of goods sold

Inventory

Accounts payableturnover=

Days receivables=

Operating working capital

Sales

Purchases
Cost of goods sold

Accounts payable Accounts payable

Accountsreceivable
Average sales per day

Days inventory=

Inventory
Average cost of goods sold per day

Days payables=

Accounts payable
Average 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 firms working capital
management

Evaluating Financial Management: Financial Leverage

Financial 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 firms 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 firms net debt
because conceptually the firm can pay down its debt using its cash and shortterm investments.
While a firms 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 firms
financial leverage.
Current Liabilities And Short-Term Liquidity. The following ratios are useful in
evaluating the risk related to a firms current liabilities:

Current ratio=

Current assets
Current liabilities

Quick ratio=

Cashratio=

Cash+ Shortterm investments+ Accounts receivable

Current liabilities

Cash+ Marketable securities

Current liabilities

Cash flow
Operating cash flow ratio= operations

Current liabilities

All the above ratios attempt to measure the firms ability to repay its current
liabilities. The first three compare a firms 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 firms operations to generate the resources needed to repay
its current liabilities.

CASH FLOW ANALYSIS

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

Analysing Cash Flow Information

Cash ow analysis can be used to address a variety of questions regarding a
firms cash ow dynamics:
How strong is the firms internal cash ow generation? Is the cash ow 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 ow? Can it continue to meet
these obligations without reducing its operating exibility?
How much cash did the company invest in growth? Are these investments
consistent with its business strategy? Did the company use internal cash ow to
finance growth, or did it rely on external financing?
Did the company pay dividends from internal free cash ow, 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 ow after making capital investments? Is
it a long-term trend? What plans does management have to deploy the free cash
ow?

Preparing a Report
Format
Use 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

Conclusion
Make 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 statements

Limitations 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 ination

Difficulties 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 activities
Comparisons between different countries will be inuenced by different
legal and regulatory systems. The relative strength and weakness of the
national economy and exchange rate uctuations.

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 Study
MTC Key Performance Indicators (Group)
200 200 200 200 200

201

2011

Revenue N$ million
Shareholders Equity N$
million
Taxation N$ million
Netprofit after N$ million
Capital Expenditure N$
million

769

937

7
111
3

646
147
293

903
171
337

160

Total in N$ million
Dividend N$ million
Dividend as % of after tax
profit
Return on equity
Profit Margin
EBITDA margin
Active sim cards in 1000
Full-time
Monthly ARPU in N$

999
177
340

8
123
2
113
6
181
358

9
139
0
115
3
199
388

0
140
7
116
6
187
397

915

188
116
9

340
132
9

286
160
8

260
163
2

110

80

245

221

370

45,4
%
38,1
%

37,3
%
36,0
%
60,2
%
555,
5
272
141

34,0
%
30,5
%
52,2
%
743,
5
296
125

31,5
%
29,0
%
50,9
%
100
9
397
102

33,6
%
27,9
%
53,8
%
128
4
416
90

410
179
1
383,
6
96,7
%
34,0
%
28,2
%
55,8
%
153
5
395
54

61%
403,
7
276
159

1453
1121
160
319
237
1696
364
114,2
%
28,4
%
21,9
%
53,2
%
1854,
7
407

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 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 units
The quantification of the budgets has provided:
a) A definite target for planning purposes; and
b) 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 organisations 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 organisations 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 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 ination, 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 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 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 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 ow 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

Unskilled at $3 per hour

10 hours

5 hours

Skilled at $5 per hour

6 hours

5 hours

Direct wages:

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

$2

$5

$6

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

Material purchases value

Note 1: Matrerial for product Aye

Total

c) Direct labour budget for next year

Unskilled
labour
hours
Requirements for production:
product Aye1
product bee
Total hours required

Standard rate per hour

Direct labour cost

Note 1; Unskilled labour for product Aye:

Skilled
labour hours

Total

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 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 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 ows. 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 ow.
Also, managers find it in practice that a figure for the net cash ow helps
to draw attention to cash ow 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 ow. 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 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 budget

sales value

June (estimate)

$12,50
0
$13,60
0

July (budget)
August

$17,000

September

$16,800

Direct wages

$1300 per month

Direct materials

June (estimate)

$3,450

July (budget)

Other information

$3,780

August

$2,890

September

$3,150

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 $1,235
You 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
$

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

August
$

September
$

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

Month

Wages
Incurred
$000

Material
purchases
$000

Overhead
$000

Sales
$000

February

20

10

30

March

30

12

40

April

10

25

16

60

May

35

14

50

June

12

30

18

70

July

10

25

16

60

August

25

14

50

September

30

14

50

a) It is expected that the cash balance on 31 May will be $22,000

b) 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 credit
h) 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.

Solution
Cash budget for June , July and August

June
$

Receipts:
Receipts from debtors (90% in two months)
Cash sales (10% sales month)
Total receipts

July
$

August
$

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 ow, profit and loss account and balance sheet.