Financial Planning and Budgeting Financial Planning ost common cited reasons for g financial Atthe end of the chapter, students are expected to be able to: One of the firms encounter is the lack of effe ge and long-range financial planning. Financial planning focuses on + discuss the basic concepts of the what the firm intends to do in the near future. It is a financial planning process; system that guides the top management to direct the + differentiate the budget used in detions of the different units of the organization in financial planning, accomplishing its objectives (Kolb & Demong, 1988). «explain the step-by-step procedure of Financial planning covers the processes of setting budgeting 1¢ primary objective, identifying the alrernativ . ‘ Oe ee gee ae + compute budget for sales, inventories, courses of action, and choosing the best alternative ee caneed expensesrand toachieve the objective. Icalso involves systematically thinking about the possible barriers a firm has to + prepare the pro-forma cash budget. confront. Although there is no exact answer to what balanos sheet. and tnopne statement the firm is looking for, preparing for the best logical and fundamentally stable plan will help it cope with the risk ie will face in the future. Financial planning is not the sole responsibility of the top management or the finance manager. Developing the plan involves the whole organization. The overall objective of the firm is set by the top management and is carried down to the lowest level of the organization, With the information properly handed down, the different units can develop their own plans that would lead to achieving the overall goals of the organization. The main function of the finance department in this process is to integrate the different plans and develop a forecast. The forecast that leads o the preparation of the budget also becomes the motivating and controlling factor of the managers of che different departments of the organization. It serves as a guide in determining if the departments are on a par with what they have set out to do before the budget is implemented. Dimensions of Financial Planning Forplanning purposes, itis always beter to think that the fucure has to be categorized as short-range and long-range. These dimensions of plans differ not only in the period covered but also in putpose, orientation, financial strength, and degreé of detail.Short-ray Inge Plan hs, I focuses on the goals needed t0 be achieygy A short-range pl ee aul i lal lly the next twelve mont a, 0 in the coming ae Ceeipanies Tend to look atthe volatility of the market, the stability oftheir operation, and the rate of change in technology in the coming year that woud affect their product lines and producti, Processes. A short range plan provides a great deal of details and dieece guidelines from cime to time to he different heads of the organization ties of the firm affecting its balance sheet, income ion, raw materials purchase, desired balance of s, and other operating expense, ing period, a short-range play ntrol or measuring device, |, at future performance A short-range plan requires forecasting all act statement, and cash flow. The sales, raw materials req inventories for che beginning and ending of the period, salaries and wage are some of the details that should be in the plan. At the start of the account serves as a guide on what to achieve. Ac the end of the year, it serves as a CO helps the firm analyze any difference in the action plan and actual performance so thi is improved. Long-range Plan ‘This is a plan chat has a time frame of two ¢ of detail. The contents of the financial statements hav« management, although the financial starements are to ‘The long-range plan, as compared with the shore-range plan, is more difficult and more prone to ertos because of the time frame involved. Covering more than a year, environmental changes, people's needs, top management composition, and even political stability affect che long-range planning, However, itis still imperative forthe firm, despite the errors ic could have, o have a long-range plan to serve as a guide for the long-term goals. Ic helps to see how far a firm has gone in terms of what has been planned in the pas. Nevertheless, a long-range plan is also subject to changes and is usually revised every year to incorporate perceptions about the future. « five, or more, years and does not require a great amoune fe to be identified as part of long-term financial be presented in terms of years and not months. Financial Plan With the short-range and long-range plans in place, financial plan is then prepared. A financial plan is also known as a budget. Budgeting is the process of transforming the planned courses of action into quantitative terms, i. in the form of money. Thus, che financial plan becomes a formal statement prepared by the company with regard to the expected sales, expenses, production, and other related financial transactions for a certain period. The financial plan is used in directing the firm’s operations and serves s a control device that helps measure periodic or annual performance. “The record of the actual operations of the firm is kept with the purpose of gathering information on the different units of the organization. The actual records on hand, side by side with other relevant information, are summarized and reported to the top management. Any variance between the financial plan and the ‘actual performance of the firm is analyzed and, if needed, a corrective action is adopred. Approaches to Financial Planning Basically, chere are two approaches to financial planning, They are: 1, Zero-based approach. From the name itself, “zero” means the budget’s baseline is zero. The yrevious ea's budget si i a r year’s budget is irrelevant in allocating financial resources for che current year, Managers prepati"sa zero-based budget are required to budget. One common disadvantage Present and justify all the required expenses included in the from the schedules required in the n of this approach is that it requires alot of documentation. Aside he sch Eat ormal structure of the budger, it should identify all activities and operations in decision packages ran ked in accordance with relative im (Garrison, Noreen, ‘ portance (Garrison, & Brewer, 2006). Other disadvantages of zero-based budgeting are its execution that normally takes a long period of time and its cost that is too expensive to justify on a yearly basis. Example: The previous year’s budget on the firm's advertisin, P ich is 10% of the 1B expense was P 15,000 which is h budgeted sales of P150,000. Using the zero-based approach, a percentage of the budgeted sales will not be applied. That is, if the current year’s budgeted sales is P250,000, the advertising expense will not follow the supposedly P2: ; 5,000 budgeted expense but rather, the firm has to come up with a figure based on certain conditions and assumptions, 2, Incremental-based approach. This is the traditional approach in budgeting, The budget starts with the previous year’s budget and then an amount is added or subtracted according to the anticipated needs. In this type of approach, an increment is always subject to justification. Example: Using the example from zero-based approach, the advertising expense for the current year in incremental-based approach will be P25,000. The increase by ?10,000 in the budgeted advertising, expense has to be justified in order to be approved, Objectives of Financial Planning Financial planning serves certain purposes. They are as follows: 1. Planning. Financial planning helps the firm determine its objectives and courses of action. With the clear set of objectives, the firm looks forward to placing itselfas one of the major players in the industry. 2. Coordination. Financial planning creates a harmonious relationship among the different units of the organization. Though departments are created with different Functions with a clear set of objectives, departments learn to coordinate, communicate, and work with each other. 3. Control. A financial plan becomes an important tool in enhancing and measuring the performance of the company. With che diligent preparation of summarized reports containing comparisons with the planned objectives, differences are analyzed for improvements. Itis also used as a basis to evaluate individual performance. Master Budget This budget is the combined budgets of the different units of the organization (Mejorada, 2000). Ie isa control measure that helps the firm determine ifthe set objectives are attained. The master budget is lassfied into two categories: the operating budget and the financial budget.Operating Budget This budget shows the plan of operat Out. The operating budget takes the form of of the firm in the coming year. It is compo fons where the details of sales, production, and expenses are lig f che budgeted income statement showing the operating reslg sed of the following: Sales budget. This refers to the planned volume of production that the company is expected yg sell based on forecasted sales. Production budget. This identifies the number of been established and the ending inventory has been set. Ending inventory budget. This is a budget that specifies the nu desires to have in their balance sheet at the end of the period. Direct materials budget. This shows the quantity of materials required to meet the production units and the number of units that must be purchased. It determines first how many units of material are needed per unit of production. Direct labor budget. This refers to the budget that provides the total cost of labor to mect the units to be produced after the sales budget hay umber of units that the company production requirements. if Factory overhead budget. This is a schedule ofall manufacturing costs other than direct materials and direct labor. Selling and administrative budget. This details the sales and administrative expenses in selling the products of the company. Pro-forma income statement. This is one of the major schedules in financial planning showing the projected income of the company. Financial Budget The financial budget shows the budgeted financial resources of the firm. Prepared right after the operating budger, it consists of the following: Cash budget. Icis prepared to determine the financial needs of the company. It shows the detailed lists of all cash receipts and expenses for a particular period. Pro-forma balance sheet. This budget presents the forecasted components of the balance sheet at a future date. The actual balance sheet of the previous period is the starting point of the pro-form: balance sheet. Basic Steps in Preparing the Budget Budget preparation is done in a sequential manner. Leaving out one of the processes could result in 2 material error in preparing a budget. The budget normally identifies the following items: i sep Firm's sales Production volume Materials’ cost Materials purchasedDirect labor cost 7, Inventory level g, Cost of goods sold 9, Selling and administrative expenses 10, Cash budget 11, Proforma income statement 12, Pro-forma balance sheet Sales Forecast This is the process of estimating the volume of sales. It serves as the mother of all the budgets that every subsequent operating and financial budget will rely on. It is prudent to make the sales forecast to be as reasonable and accurate as possible to be useful, Having an inaccurate sales forecast puts the company in limbo and in a difficult situation. Actions undertaken by the company in carrying out its operations always rey on the usefulness of is sales forecast, Having an accurate forecast makes the cash budget, production budget, and disbursement budget meaningful. In forecasting the firm's sales, the different methods discussed in the chapter on forecasting could be used, Sales Budget This refers to the planned volume that the company is expected to sell based on forecasted sales. It also begins the operating budget and financial budget. Sales estimates may be made based on the analysis of the general business condition, market conditions, political conditions, product growth curves, etc. In making the sales forecast, a qualitative forecast may also be used. There are certain things in forecasting which cannot be supported by mathematical applications. Thus, applying qualitative forecasting like group opinions, Delphi method, sales force polling, and consumer market surveys could be very useful. After determining the estimated sales volume, the sales budget is computed as follows: Expected sales in units xxx Multiply by the unit selling price Prxx Total sales Pax Example: Assume that the firrm is expecting to have the following quarterly sales: First quarter 1,200 units Second quarter 1,050 unies Third quarter 1,350 units Fourth quarter 1,450 units Assuming further that 65% of the expected sales were collected in the first quarter of the sale, 30% ‘were collected in the quarter after the sale, and 5% were uncollectible, the selling price per unit is P120. AD e.nsnnt Diannine and BudgetingLucky Merchandising Sales Budget Por the Year Ended Dec. 31, 2010 Quarter 1 2 3 4 Total Expected sales in units 1,200 1,050 1,350 1,450 5,050 x 120 1200 «120 ~ 120 x 120 Unit sales price (P) 17144,000 126,000 162,000 174,000 606,000 Total sales Schedule of Expected Cash Collections 1 2 3 4 Total Accounts receivable, 14,250 o1/o1/io 714,250 Sales First quarter 793,600 43,200 136,800 Second quarter 81,900 P37,800 119,700 Third quarter 105,300 48,600 153,900 113,100 _113,100 143,100 P1G1,700 537,750 Fourth quarter “Total cash collections 107,850 The cash collections are computed as follows: For the first quarter sales, 144,000 x 0.65 = P93,600 presented in the first quarter 144,000 x 0.30 = 743,200 presented. in the second quarter 7144,000 x 0.05 = P7,200 uncollectible account id to fourth quarters. However, the second collection ‘The same procedure shall be applied for the secon« cchedule of cash collections since it will be collect for the fourth quarter sale will nor be reflected in the s in the first quarter of the succeeding year. Production Budget The next step after creating the sales b assurance that the units required to produce the sales requirement for each period will budget serves as the basis of forming the budget for the direct materials, direct labor, other expenses which are directly associated with the production. sudgee is planning the production budget. This budger gives be met. The production factory overhead, and The expected volume of production is determined as follows: Planned sales Powe ‘Add: Desired ending inventory _xxx Total needs Pxxx Less: Beginning inventory xxx Units to be produced Pxxx‘The Lucky Merchandising Production Budget For the Year Ended Dec. 31, 2010 1 2 3 4 nal Budgeted sales volume 1,200 1,050 1,350 1,450 5,050 |Add: Desired ending inventory —158 —203 218 —200 ran Units available for sale 1,358 1,253 1,568 1,650 5,250 Less: Beginning inventory _180 _158 203 218 a Required production in unies ize 1.095 1365 1433 aed | ‘The beginning inventory for the first quarter is obtained by multiplying 1,200 by 15%. ‘The beginning inventory of 180 for the first quarter is also the ending inventory of the fourth quarter of the previous year. Direct Materials Budget When the production requirements have been computed, a direct materials budget can then be prepared ‘o show the number of materials requited and the quantity that must be purchased to meet the production requirements. Firms may have different policies on the direct materials budget because of the nature of its use for their products or the seasonality of the product. Nevertheless, the quantities of the direct materials tobe purchased must conform to the desired ending inventory mentioned under the production budget. In doing the direct materials budger, the firm must identify first how many units have to be produced before converting this to the required direct materials budget. The formula in computing the purchase is as follows: Required production volume xx Multiply materials allowed per unit of production xxx Materials needed in production xxx Add: Desired ending inventory of materials xxx. Total needs xr Less: Beginning inventory of materials xxx Direct materials budget usied by aschedule of expected cash disbursements foy ae er the fepaicn of the cash budget. Payments on Purchase fod and payments coming from the previous period, ‘The direct materials budget is usu: Purchased materials. This schedule is needed for t materials consist of payments for the current peri Example: ing i ’s production needs; the end he ending inventory is 15% of the next quarter's production ; the endin sani etry for the fourth quarter is 600 units; and 75% of each quarter's purchases are pat in that quarter, with the remainder to be paid in the following quarter. Also, 3 pounds of materials ate needed per unit of product at a cost of P3 per pound. Lucky Merchandising . Direct Materials Budget 5 For the Year Ended Dec. 31, 2010 Quarter 1 2 3 4 Total Required production volume 1,178 1,095 1,365 1,433 5,070 Makiply materials alowed per unit of production x __3, 3 x 3 x 3 « 3 Materials needed in production 3533 3,285 4,095 4,298 15,219 ‘Add: Desired ending inventory of materials 493 __ 614 45 600 Total needs 4025 3,899 4,740 4,898 Less: Beginning inventory of materials 530 493 614 AS 530 Direct materials to be purchased 3495-3407 4125 4,253 15,280 Unit price of the materials oF ee Total purchase cost 10.486 710,220 P2376 P2759 45.840 Schedule of Expected Cash Payments Quarter 1 2 3 4 Total Accounts payable, 12/31/09 P 3,300 P 3,300 Purchases First quarter 7,865 P 2,622 10,486 Second quarter 7.665 P2555 10,220 “Third quarter 9.282 P 3,094 12,376 Fourth quarter 9,569 9.569 Toral cash payments PULIGS P0286 P1837 12.663 ~—P45.951. The cash payments are computed‘ follows: For the first quarter purchases, P 10,486 « 0.75 = P7,865 presented in the first quarter 10,486 x 0.25 = P2,622 presented in the second quarter The same procedures are to be applied for the second to fourth quarter purchases, However, the second payment for the fourth quarter purchase is not reflected in the schedule of cash payments since it will be paid in the first quarter of next year.pirect Labor Budget ike the direct materials budget, the production budget i also a preliminary point forthe preparat Jeirect Inbor cost budget, The firm necds to know the required labor time to meet the production ‘ that if any problem arises with regard to the labor force, the firm can immediately make reljgament. Neglecting to Took at the firm’ lor force may result in alot of trouble forthe firm. Seton requirements which cannot be met by the firm's labor will result in lost sales. Listed below is Pru fo the ret labor cost, : the suirements SO Units to be produced ae Multiply by the direct labor houts per unit a Number of hours required = Multiply by the direct labor cost per hour = ‘Total direct labor cost Example Lucky Merchandising’s per unit of production requires 6 hours of labor. The laborers are paid wich an hourly rate of P8. Lucky Merchandising Direct Labor Budget For the Year Ended Dec. 31, 2010 Quarter 1 2 3 4 Total Units to be produced 1,178 1,095 1,365 1,433 5,070 Direct labor hours per unit 6 8 6 & 6.66 x 6 Total hours 7,065 6,570 8,190 8,595 30,420 Direct labor cost per hour x8 x« 8° x 8 x 8 x 8 ‘Ta direct labor cost 56,520 52,560 65,520 PO8.760 243.360 Factory Overhead Budget The next step in preparing budgets is making the factory overhead budget. The factory overhead budget provides schedules for indirect materials, indirect labor, and all other manufacturing costs that cannot be conveniently charged to specific units, jobs, or products. Indirect materials refer to those needed for the completion of the product but whose consumption with regard to the product.is either so small or so complex that it would be futile to treat it as a direct material item. Glue, paint, varnish, thread, nails, tacks, rivets, and other items usually belong to this category. Indirect labor is an expense which does not affect the construction or the composition of the finished product. Examples are labor of foremen, shop clerks, general helpers, and cleaners. In doing the factory overhead budget, the variable cost and fixed cost must be separated, Normally, firms Sstablish a predetermined overhead rate on the variable portion of the factory overhead. All cash expenses ‘stimated in the factory overhead budget will become part of the cash payment portion of the cash budget, re are expenses which do not require cash payment but are included in the income statement. These Senses must be excluded in the cash budget. An example of non-cash expense is the depreciation expense. sal Ptanming and Budgetingproduced. The total variable cost increases. the production increases, Examples ae supplies, fuel, power, small tools, spoilage, salvage, and reclamarog xPenses; receiving, hauling within plant, royalty, travel, and communication costs; overtime premium, and payroll taxes, Eixed cost on the other hand, isa cost that does not vary in direct proportion to the ung produced, ‘The tal fixed cost does not change but the unit cost becomes smaller as production increase! Examples are salaries of production executives, depreciation, taxes on real estate, taxes on plant equipmeny, Patent amortization, wages of watchmen and janitors, maintenance and repairs of building and ground, insurance, and rent. Example: Lucky Merchandising determined thar the quarterly variable factory overhead rate is at P3.50 of the quarterly direct labor hours. The fixed factory overhead is budgeted at P15,000 per quarter. The depreciation expense per quarter is P12,500. Factory overhead costs ate paid in the quarter when they The variable cost varies in direct proportion to the unit are incurred. Lucky Merchandising Factory Overhead Budget For the Year Ended Dec. 31, 2010 Quarters 1 2 3 4 Total Direct labor hours per quarter 7,065 6,570 8,190 8,595 30,420 ‘Variable overhead rare 350 __3.50 3.50 3.50 350 Budgeted variable overhead 24,728 22,995 P28,665 P30,083P106.470 Budgeted fixed overhead 15,000 15,000 15,000 15,000 __60,000 Budgeted factory overhead 39,728 37,995 43,665 45,083 P166,470 Less: Non-cash expense Depreciation 12,500 12,500 __50,000 Cash payments for the overhead P3165 32,583 P116,470 Ending Inventory Budget To determine the unit cost of the unsold units, the formula is as follows: Direct materials Unit cost of direct materials Prxx Multiply by raw materials per unit of production xxx Total unit cost of direct materials Pxxx Direct labor C Labor rate per hour Pxxx Multiply by direct )Abor hours per unit of production xxx ‘Total unit cost’of direct labor XXXVariable factory overhead Predetermined variable overhead rate Multiply by direct labor hours per unit of production Total unit cost of variable factory ovethead Pxxx xxx xxx oral variable manufacturing cost Once all the needed data had been computed for the unit production cost, the ending inventory budget can then be prepared. This budget is necessary in computing for the cost of goods sold in the pro-forma jacome statement and the ending balance of the merchandise inventory for the unsold units to be presented inthe pro-forma balance sheet. Example: The following information provides the firm’s total variable manufacturing, cost per unit of production. Direct materials Unit cost of direct materials 3.00 Raw materials per unit of production «5 Total unit cost of direct materials P9.00 Direct labor Labor rate per hour 8.00 Required hours per unit of production x 6 Total unit cost of direct labor 48.00 Variable factory overhead Predetermined variable overhead rate P3.50 Direct labor hours per unit of production x 6 Total unit cost of variable factory overhead Total variable manufacturing cost Lucky Merchandising Ending Inventory Budget For the Year Ended Dec. 31, 2010 Ending Inventory Units Unit Costs Toul Direct materials 600 Pea P 1,800 Finished goods 200 unis P78 15,600 Selling and Administrative Expense Budget The selling and administrative expense budget lists the overall budgeted operating expenses in areas other than those included in manufacturing. Like the factory overhead, the selling and administrative ‘expense is segregated into variable and fixed expenses. The variable selling and administrative expense is in direct proportion to sales while the fixed selling and administrative expense remains unchanged unless the firm goes beyond its normal capacity. To arrive atthe estimated cash payment for selling and administrative “pense, all non-cash expenses should be excluded.sample: of Lucky Merchandising amounts (0 6 per ya it ice supplies. The fixed selling and administay in the same quarter when they °° a administrative expense freight, and offi “The expenses are pai ‘The varlable selling and of sales, including sales commission, expense amounts to P12,000 per quarter, incurred, Lucky Merchandising Selling and Administrative Expenses Budget For the Year Ended Dec. 31, 2010 Quarter 1 2 3 4 Tou! Budgeted sales volume 1,200 1,050 1,350 1,450 5,955 Vatiable selling and administrative expense rate perunit P_6,00 P_6,00 P 6.00 P 6.00 P 60 Budgeted variable selling and administrative expense. 7,200 P 6,300 P 8,100 P 8,700 P30,395 Fixed selling and administrative expense 12,000 12,000 12,000 12,000 48,009 Budgeted selling and administrative expense £19,200 218,300 20,100 20.700 P78,309 Cash Budget One of the final stages in the preparation of a budget is making the cash budget. Organizing the budget is a continuous process. It can be checked for consistency and accuracy by comparing budgeted amounts with amounts that can be expected from using typical ratios or financial statement relationships. For example, the treasurer will estimate the payments made to suppliers of merchandise or materials, the payments to employees for wages and salaries, and other payments that the firm is obligated to make. These payments can be scheduled by dates so that discounts are taken and no obligation is overlooked when it becomes due. Cash collections from customers can also be estimated and scheduled by dates along with other expected cash receipts. With careful cash planning, the firm should able to maintain a sufficient cash balance for its needs and not put itself in the position of holding excessive balances of non-productive cash. In the normal course of operations in a merchandising business, for example, merchandise is purchased and sold to customers who eventually pay for the products sold to them, Usually, there is a time lag in busines operations. It may be necessary to pay the suppliers for the merchandise before it is sold to the customers Before and during a busy selling season, the demand for cash may be higher than the inflow of cash from operations. In this case, it is necessary to arrange short-term loans. When the selling season is over, cash collections from customers are relatively large and the loans can be paid off. The cash budget is composed of four major sections: 1. The cash receipts section lists all the cash inflows, except for financing, during the covered period of the budget. Cash receipts start with the beginning balance where the cash collections from sls. are added. 2. The cash payments section consists of all cash outflows in the budget period. Included in the ash payments are direct material purchases, direct labor, factory overhead, and other éash payments 3, The cash surplus or deficit section simply shows the difference between the cash receipts sectio"™ and the cash payments section, ‘This section indicates if the firm needs to borrow funds to supp" the operations of the company or use the excess money for paying their obligations ot investing other profitable activities,4, The financing section shows the borrowings and payments made by the company. Example: To prepare the cash budget of Lucky Merchandising, further assume the following information: 1, The cash balance at the beginning of the irst quarter is P10,000. 2, The management desires to maintain a P10,000 minimum cash balance at the end of each quarter. 3, Lucky Merchandising has a credit line with RCBC that enables it to borrow at an interest rate of 12% per year. All borrowings and repayments must be in multiples of P 1,000 and take place at the beginning and at the end of each quarter, respectively. 4, Additional equipment amounting to P25,000 is to be acquired in the third quarter. The board of directors approved a cash dividend of P1,500 per quarter. 6. The income tax payable amounting to P6,000 was paid in March of 2010. Cash balance, beginning, ‘Add: Cash receipts ‘Accounts receivable collections Total cash available Less: Cash payments Direct materials Direct labor Factory overhead Selling and administrative expense Purchase of equipment Cash dividend Income tax payment Cash surplus (deficit) Financing Borrowing Repayment Interest Total financing Cash balance, ending. Quart 3 P 12,357 143,100 4 P 10,335 Lucky Merchandising Cash Budget For the Year Ended Dec. 31, 2010 1 2 P 10,000 P 10,238 107,850 125,100 117,850 135,338 P 11,165 P 10,286 56,520 52,560 27,228 25,495 19,200 18,300 1,500 1,500 6,000 PI21612 P 108,141 P (3,762) P 27,197 14,000 P155,457 P 11,837 65,520 31,165 20,100 25,000 1,500 P155,122 P 335 10,000 10,335 P172,035 P 12,663 68,760 32,583 20,700 1,500 P136,206 P 35,829 (10,000) (600) P(10,600) 225,229 Total P 10,000 537,750 P547.750 P 45,951 243,360 116,470 78,300 25,000 6,000 6,000 P 26,669 24,000 (24,000) (1.440) P.(.440) 25,229Budgeted income Statement From the various budgets prepared, the Pro ‘Components of planned revenue and expenses fo Statement serves as a control device in measuring U outcome with its budgeted figures forma income statement can then summarize the Various + ahe budgeting period. In a sense, the pro-forma income he firm’s performance by means of comparing the aca) “The concerned department witha signin rence beeen the budgeted and che etal gy Chou ae herenson for auch, Likewise, the pro-forma income statement becomes the basis fy vestigate the s , ! Imontering tk peormance ofthe diferent units ofthe erganiavon, whether hey met their assigney budgets or not. “The projected income statement for Lucky Merchandising follows. Assume a ax ate of 32% Lucky Merchandising Pro-Forma Income Statement For the Year Ended December 31, 2010 Sales (5,050 units x P120) 606,000 Less: Variable expenses Variable cost of sales (5,050 units x P78) 393,900 Variable selling and administrative expenses 30.300 424,200 Contribution margin P181,800 Less: Fived expenses Fixed factory ovethead P 60,000 Fixed selling and administrative expenses 48,000 108,000 Net income before interest and income tax P 73,800 Less: Interest expense 1,440 Net income before income tax P 72,360 Less: Income tax (32%) 23,155 Net income P_ 49,205 Ics noticeable that the prepared pro-forma income statement consists only of variable expenses and fixed expenses. The firm has the option to choose which type of income statement—the traditional income statement of the contribution margin approach—to prepare. Ic is important that the income statement is useful and applicable to whatever purpose it may serve the company. Budgeted Balance Sheet The budgeted balance sheet is developed using the previous year's actual balance sheet. All che accousts entered in the balance sheer are real and are used to carry over the remaining balances to the succeediag year. The same balances from the previous year’s balance sheet are added or subtracted from the budge accounts appearing from the different budgets to arrive at the budgeted balance sheet, Having a budgeted balance sheet helps the company check the accuracy of the other budgets male ‘Ac the final stage of the budget preparation, it helps compute financial ratios to highlight any unfavorat financial conditions that might occur, With these forward-looking capabilities, the firm can easily chané any unfavorable conditions or situations in the furure.Boample: ‘Assume that the previous year's balance sheet of Lucky Merchandising has the following balances: Lucky Merchandising Balance Sheet For the Year Ended December 31, 2009 Liabilities and a Stockholders’ Equity Curent assets Current liabilities Goh P 10,000 Accounts payable ‘Accounts receivable 14,250 Income tax payable Raw materials inventory 1,590 Finished goods inventory 14,040 739,880 . ion civ ics Stockholders’ equity fad P 80,000 Common stock, no pat P114,999 Building and equipment 150,000 Retained earnings 55,581 ‘Accumulated depreciation. (90,000) 140,000 170,580 “Total liabilities and — 279.880 “wockholders equity —_ 179,880 The illustrated balances from the previous year’s balance sheet serve as the starting point of the pro-forma balance sheet. The changes on the accounts together with the source budget or schedules are as follows: 1. Cash The balance amounting to P25,229 appears in the cash budget. Cash, beginning balance P 10,000 Add: Expected cash receipts 537,750 Total cash available 547,750 Less: Expected cash payments 521,081 Cash surplus P 26,669 Less: Interest expense on financing 1,440 Budgeted cash, ending balance 225,229 2. Accounts receivable Accounts receivable, Dec. 31, 2009 P 14,250 Add: Planned sales (from sales budget) 606,000 Total 620,250 Less: Expected cash collections (Schedule of expected cash collections) 537,750 Budgeted accounts receivable, Dec. 31, 2010 P._82.500 Raw materials inventory (See ending inventory budget) P_1,800 Finished goods inventory (See ending inventory budget) P_15,600 Land — No acquisition made in 2010 P_80,0006. Building and equipment 150,000 ing and equipment, Dec: 31 2000 ats 28.000 Add: Equipment o be acquired in the 3° 0 ro Budgeted building and equipment, . % Accouns payable P 3300 Accounts payable, Dec. 31, 2 . 45,340 ‘Add: Planned purchases (Direct materials budget) eau “Total accounts payable Less; Planned cash payments (Schedule of expected cash payments) 45,951 Budgeted accounts payable, December 31, 2010 P_ 3189 8. Income tax payable (Sce pro-forma income statement) P_23,155 9. Common stock (See Dec. 31, 2009 balance sheet) PLI4.999 10, Retained earnings Retained earnings, Dec. 31, 2009 P 55,581 ‘Add: Net income (Pro-forma income statement) 49,205 Total P104,786 Less: Planned dividend payments (Cash budget) 6,000 Budgeted retained earnings, Dec. 31, 2010 P98,786 Then pro-forma balance sheet will be: Lucky Merchandising Pro-forma Balance Sheet For the Year Ended December 31, 2010 Assets Liabilities & Stockholders’ Equity Current assets Current liabilities Cash P 25,229 Accounts payable Pp 3189 ‘Accounts receivable 82,500 Income tax payable B55 Raw materials inventory 1,800 ‘Total current liabilities P2634 Finished goods inventory 15,600 Total curtent assets 125,129 Non-current assets Stockholder’ equity Land P 80,000 Common stock 114,99 Building and equipment 175,000 Retained earnings 9878 Accumulated depreciation 140,000) ‘Total stockholder’ equity 7213785 Total non-current assets 115,000 “oral liabilities and Total assets £240,129 stockholders’ equity 740.123Other Budgets Aside from the aforementioned budgets, there are other possible budgets that the firm can do. They are the pro-forma cash flow statement and the budgeted financial ratios. Pro-forma Cash Flow Statement ‘Once the pro-forma balance sheet is prepared and the actual balance sheet is available, the pro-forma cash flow statement can be done. Like the regular cash flow statement, the pro-forma cash flow statement is dassified into three activities: operating, investing, and financing, ‘The pro-forma cash flow statement is prepared so that firms can have a preview of the likely movernents of cash in the next accounting period. Although the cash budget can also provide the information needed. companies sometimes need assistance in making sound judgments about che firm’ ability to handle more fixed commitments. The top management would also like to see the general perspective of cash flows by classifying them into three activities that are not provided by the cash budget which generally shows only the cash receipts and cash disbursements, Example: Using the balance sheet of December 31, 2009 and the pro-forma balance sheet and income statement for December 31, 2010 of Lucky Merchandising, the pro-forma cash flow statement could be written as follows: Lucky Merchandising Pro-forma Cash Flow Statement For the Year Ended December 31, 2010 Cash flows from operating activities Net income ‘P 49,205 ‘Add: Depreciation expense 50,000 Increase in accounts receivable (68,250) Increase in raw materials inventory (210) Increase in finished goods inventory (1,560) Decrease in accounts payable (110) Increase in income tax payable 17,155, 746,230 Cash flow from investing activity Purchase of an equipment : (25,000) Cash flow from financing activities Cash dividend payment £6,000) Net increase in cash 15,230 Cash at che beginning of the year 10,000 Budgeted cash at the end of the year 25,230‘Much of the cash flows of the Lucky Merchandising come from its operating activities totaling 46,25) Despite planned acquisition ofan equipment worth P25,000 and cash dividend payment of 6,000, Ly, Merchandising is able to increase its cash by P'15,230. Budgeted Financial Ratios With a pro-forma income statement and a balance sheet, the company may develop several finan ratios for a more detailed analysis. Having an initial preview of the financial ratios, the company can aly, ‘compare their past performance with the possible outcome in the incoming accounting period. From the, the firm may decide to scrap or change the budget for improved or better results. Example: 12/31/09 Budget for 2010 Current ratio = 4.29 475% Current liabilities Debeto-cquity ratio = __ Total liabilities 5.45% 12.32% Stockholders’ equity Rate of rerurn on sales = Net income 8.12% Net sales Rate of return on ‘total assets = Netincome 20.49% Toral assets Toral asset turnover = _Netsales 252 Total assets From the illustrated financial ratios, the firm will be able to decide if it will change its budget or not One has to bear in mind that in developing the financial ratios, a comparison should always be made for better outcomes.