AGEC 09

FINANCIAL MANAGEMENT FOR AGRI-BASED ENTERPRISE

III. MANAGEMENT OF FINANCIAL RESOURCES

III. A: MANAGEMENT OF CASH

Cash Management - refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the firm’s
liquid resources. Money is the lifeline of the business, and therefore it is essential to
maintain a sound cash flow position in the organization.

Objectives of Cash Management

Fulfill Working Capital Requirement
The organization needs to maintain ample liquid cash to meet its routine
expenses which possible only through effective cash management.

Planning Capital Expenditure

It helps in planning the capital expenditure and determining the ratio of debt
and equity to acquire finance for this purpose.

Handling Variable Costs

There are times when the company encounters unexpected circumstances
like the breakdown of machinery. These are unforeseen expenses to cope
up with; cash surplus is a lifesaver in such conditions.

Initiates Investment
The other aim of cash management is to invest the idle funds in the right
opportunity and the correct proportion.

Better Utilization of Funds

It ensures the optimum utilization of the available funds by creating a
proper balance between the cash in hand and investment.

Avoiding Insolvency
If the business does not plan for efficient cash management, the situation of
insolvency may arise. It is either due to lack of liquid cash or not making a
profit out of the money available.
Roles and Functions of Cash Management
Optimizing Cash Level: The organization should continuously function to maintain
the required level of liquidity and cash for business operations.

Controlling Cash Flows: Restricting the cash outflow and accelerating the cash
inflow is an essential function of the business.

Planning of Cash: Cash management is all about planning and decision making in
terms of maintaining sufficient cash in hand and making wise investments.

Managing Cash Flows: Maintaining the proper flow of cash in the organization
through cost-cutting and profit generation from investments is necessary to
attain a positive cash flow.

Investing Idle Cash: The company needs to look for various short term investment
alternatives to utilize surplus funds.

Cash Management Strategies

Business Line of Credit - The organization should opt for a business line of credit at
an initial stage to meet the urgent cash requirements and unexpected
expenses.

Money Market Fund - While carrying on a business, the surplus fund should be
invested in the money market funds. These are readily convertible into cash
whenever required and yield a considerable profit over the period.

Cash Deposits (CDs) - If the company has a sound financial position and can predict
the expenses well along with availing of a lengthy period, it can invest the
surplus cash in the cash deposits. These CDs yield good interest, but early
withdrawals are liable to penalties.

Inventory Management - Cash management helps an organization in managing its

inventories. Higher inventory in hand indicates trapped sales, and this
further leads to less liquidity. Therefore, a company must always focus on fast
pacing its stock out for allowing the movement of cash.
 Receivables Management - A company focuses on raising its invoices so that sales
can be boosted. The credit period with respect to receiving cash might range
between a minimum of 30 and a maximum of 90 days. This means that the
organization has recorded all its sales, but the cash with respect to these
transactions has not yet been received.

Payables Management - This is also an important function of cash management

where the companies can avail benefits like cash discounts and credit period.

Cash Flow Management Techniques

Accelerating Collection of Accounts Receivable

One of the best ways to improve cash inflow and increase liquid cash by
collecting the debts and dues from the debtors readily.

Stretching of Accounts Payable

On the other hand, the company should try to extend the payment of
dues by acquiring an extended credit period from the creditors.

Cost Cutting
The company must look for the ways of reducing its operating cost to
main a good cash flow in the business and improve profitability.

Regular Cash Flow Monitoring

Keeping an eye on the cash inflow and outflow, prioritizing the expenses
and reducing the debts to be recovered, makes the organization’s
financial position sound.

Wisely Using Banking Services

The services such as a business line of credit, cash deposits, lockbox
account and sweep account should be used efficiently and intelligently.

Upgrading with Technology

Digitalization makes it convenient for the organizations to maintain the
financial database and spreadsheets to be accessed & assessed from
anywhere & anytime.
Limitations of Cash Management

Cash management is a very time consuming and skillful activity which is required to
be performed regularly.

III. B: MANAGEMENT OF WORKING CAPITAL

1. What is working capital management?

A working capital measures the company’s liquidity. It’s your current assets minus
your current liabilities; expressed as a ratio, it’s your current assets divided by your
current liabilities. Your current assets are your cash, accounts receivable and inventory.
While, current liabilities are your payables to suppliers and your short-term debt
obligations.

If your current ratio is less than 1-to-1, you’ll have difficulty meeting your day-to-
day expenses and paying suppliers on time. A ratio 1.5-to-1 is considered adequate, but
2-to-1 is more comfortable.

Working capital management commonly involves monitoring cash flow, current

assets, and current liabilities through ratio analysis of the key elements of operating
expenses, including the working capital ratio, collection ratio, and inventory turnover
ratio.

Working capital management involves the tracking of the current assets, collection, and
inventory ratios to ensure that a company operates efficiently thereby helping to
maximize a company's profitability. Management of working capital includes inventory
management as well as management of accounts receivables and accounts payables

2. What is the importance of working capital management?

Working capital management can improve a company's earnings and profitability

through efficient use of its resources.

Working capital management can help avoid cash flow problems that could pose a
major financial risk to the business, it’s also crucial to help the business grow. When
executed well, it can help achieve a higher rate of return on capital, increasing
profitability, value appreciation, and liquidity all at once.
 Working capital management helps maintain the smooth operation of the net
operating cycle, also known as the cash conversion cycle (CCC)—the minimum amount of
time required to convert net current assets and liabilities into cash.

3. Objectives of working capital management.

To enable the company to maintain sufficient cash flow to meet its short-term
operating costs and short-term debt obligations. A company's working capital is made up
of its current assets minus its current liabilities.

To ensure that the company has enough cash to cover its expenses and debt, in
minimizing the cost of money spent on working capital, and maximizing the return on
asset investments.

4. What are the three (3) important ratios in managing working capital?

Current Ratio (Working Capital Ratio)

The working capital ratio or current ratio is calculated as current assets
divided by current liabilities. It is a key indicator of a company's financial health as it
demonstrates its ability to meet its short-term financial obligations.

The current ratio (working capital ratio) is a company's current assets divided
by current liabilities. It is a key indicator of a company's financial health as it
demonstrates its ability to meet its short-term financial obligations. Current ratios
of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may suggest that
the company is not managing its working capital efficiently. Conversely, a current
ratio below 1.0 generally indicates that a company's debts due in the upcoming
year would not be covered by its liquid assets.

Collection Ratio
The collection ratio is a measure of how efficiently a company manages its
accounts receivables. The collection ratio is calculated as the product of the
number of days in an accounting period multiplied by the average amount of
outstanding accounts receivables divided by the total amount of net credit sales during
the accounting period.

The collection ratio calculation provides the average number of days it takes
a company to receive payment after a sales transaction on credit. If a company's
billing department is effective at collections attempts and customers pay their bills
 on time, the collection ratio will be lower. The lower a company's collection ratio,
the more efficient its cash flow.

Inventory Turnover Ratio

The final element of working capital management is inventory management.
To operate with maximum efficiency and maintain a comfortably high level of
working capital, a company must keep sufficient inventory on hand to meet
customers' needs while avoiding unnecessary inventory that ties up working
capital.

Companies typically measure how efficiently that balance is maintained by

monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as
revenues divided by inventory cost, reveals how rapidly a company's inventory is
being sold and replenished. A relatively low ratio compared to industry peers
indicates inventory levels are excessively high, while a relatively high ratio may
indicate inadequate inventory levels.

5. Briefly discuss the different policies in working capital management approach.

Three (3) commonly-used policies of working capital management approaches. These are:

A relaxed, conservative approach, where a high level of assets are maintained in

order to balance out the existing liabilities. Liquidity is high, but
unfortunately, this can impact your profitability negatively. It’s safe but may
not yield as a big of a payoff.

A restricted, aggressive approach, which maintains a lower level of current assets

than the conservative approach. Liquidity is typically very low here, which is
risky, but profitability can also be higher.

A right-down-the-middle, moderate approach, which seeks to find a balance right

between the two. This is sometimes easier to do once your business is up
and running for at least a short period of time so you have more flexibility.
III. C: MANAGEMENT OF RECEIVABLES

Receivable Management: Objectives, Importance, Nature, Scope

Meaning of Receivable Management

Receivable management is a process of managing the account receivables within a
business organization. Account receivables simply mean credit extended by the company
to its customers and are treated as liquid assets. It involves taking decisions regarding the
investment to be made in trade debtors by organization. Deciding the proper amount be
lent by the company to its customers in the form of credit sales is quite important. It
affects the overall cash availability for undertaking various operations.

Receivable management business ensures that a sufficient amount of cash is

always maintained within the business so that operations can continue uninterrupted. It
helps in deciding the optimum proportion of credit sales. The overall process of
receivable management involves properly recording all credit sales invoices, sending
notices on due date to collection department, recording all collections, calculation of
outstanding interest on late payments etc.

Receivable management aims at raising the sales volumes and profit of the
business by managing and providing credit facilities to customers. A proper receivable
management process aims at monitoring and avoidance of occurrence of any overdue
payment and non-payment. It is an effective way of improving the financial and liquidity
position of the company. Credit facilities are important for attracting and retaining
customers and this makes management of credit facilities by business crucial.

Objectives of Receivable Management

Monitor and Improve Cash Flow

Receivable management monitors and control all cash movements of an
organization. It maintains a systematic record of all sales transactions.
Receivable management helps business in deciding appropriate investment
in trade debtors. It aims that a sufficient amount of cash needed for day-to-
day activities is maintained at business. Credit facilities are extended by
doing proper analysis and planning to ensure optimum cash flow in a business
organization.

Minimizes Bad Debt Losses

Bad debts are harmful to organizations and may lead to heavy losses.
Receivable management takes all necessary steps to avoid bad debts in
 business transactions. It designs and implement schedules for collection of
outstanding amount timely and informs the collection department on due
dates. Customers are notified for amount standing against them and charges
interest on delay in payments.

Avoids Invoice Disputes

Receivable management has an efficient role in avoiding any disputes arising
in business. Disputes adversely affect the relationship between customers
and business organizations. Complete and fair record of all transactions with
customers are maintained on a daily basis. There is no chance of confusion
and dispute arising as all sales transactions are accurately maintained.
Automated receivable management systems present full evidence in a short
time in case of dispute arising for resolving them.

Boost Up Sales Volume

Receivable management increase the sales and the profitability of the
organization. By extending the credit facilities to their customers business
are able to boost up their sales volume. More and more customers are able to
do transactions with the business by purchasing products on a credit basis.
Receivable management helps business in managing and deciding their
investment in credit sales. This leads to increase in the number of sales and
profit level.

Improve Customer Satisfaction

Customer satisfaction and retention are key goals of every business. By
lending credit, it supports financially weaken customers who can’t purchase
business products fully on a cash basis. This strengthens the relationship
between customer and organization. Customers are happy with the services
of their business partners. Receivable management help in organizing better
credit facilities for their customers.

Helps in Facing Competition

Receivable management helps in facing stiff competition in the market.
Several competitors existing in market offers different credit options to
attract more and more customers. Receivable management process analysis
all information about market and helps the business in farming its credit
lending policies. Customers are provided better services by extending credit at
convenient rates. Appropriate amount and rates of credit transactions
can be easily decided through receivable management process. All credit and
payment terms are decided for every customer as per their needs.
Nature of Receivable Management

Regulate Cash Flow

Receivable management regulates all cash flows in an organization. It
controls all inflow and outflow of funds and ensure that an efficient amount of
cash is always available. Proper management of receivables enables
organizations in efficient functioning at all the times.

Credit Analysis
It performs a proper analysis of customer credentials for determining their
credit ratings. Monitoring and scanning of customers before provide them
any credit facility helps in minimizing the credit risk.

Decide Credit Policy

Receivable management decides the credit policy and standards as per
which credit facility should be extended to customers. A company may have
a lenient credit policy where customer credit-worthiness is not at all considered
or a stringent policy where credit-worthiness is considered for providing
credit.

Credit Collection
Receivable management focuses on efficient and timely collection of
business payments from its customers. It works towards reducing the time gap
in between the moments when bills are raised and payment is collected.

Maintain Up-To-Date Records

Receivable management maintains a systematic record of all business
transactions on a regular basis. All transactions are maintained fairly in the
form of proper billing and invoices which helps in avoiding any confusion or
settling of disputes arising later.

Importance and Function of Receivable Management

Evaluates Customer Credit Ratings

Receivable management evaluates its customers borrowing capacity and
repaying ability for determining their credit ratings. It approves any credit
facility to its customers after analyzing their information both qualitatively
and quantitatively. Proper investigation of client details helps in reducing the
credit risk.
 Minimizes Investment in Receivables
It reduces investment in receivable by ensuring optimum funds are available
within organization at all the times. Receivable management decides proper
credit limit and credit period for avoiding any bankruptcy situations.
Attempts are made to collect account receivable as soon as they become due
for payment which reduces the overall investment in receivables.

Optimize Sales
Efficient receivable management assist business in raising their sales volume.
Businesses are able to attract more and more customers by providing them
credit facilities. They are able to properly decide and monitor credit facilities
with the help of a receivable management.

Reduce Risk of Bad Debts

It takes all steps to avoid any instances of bad debts. Receivable
management notify all customers for the payment as soon as the amount gets
due. It charges interest on delay payments and aims at optimum
collection of all payment timely. Implementation of proper schedule and
monitoring of collection process results in minimizing the risk of bad
debts.

Maintain Efficient Cash

Maintenance of efficient cash is crucial for the survival of every organization.
Receivables management properly records all cash inflows and outflows of a
business. All credit facilities are extended after analyzing the capability of
organization and due payments are collected timely. This results in steady
cash flow within the organization.

Lower Cost of Credit

Receivable management helps business in lowering its cost of credit by
limiting the credit amount and credit period for its customers. It performs all
processes such as acquiring credit information of clients and collecting all
due payments in an efficient way which lower the overall cost associated with
credit facilities.

Scope of Receivable Management

Formulation of Credit Policy

 Receivable management is the one which formulates and implements an
effective credit policy in an organization. Credit policies are decided as per
the capabilities of an organization. A company may either follow a liberal policy
or stringent credit policy for providing credit facilities to its customers.

Credit Evaluation
Credit evaluation involves examining the credit worthiness of customer
before approving any credit amount. Proper investigation of customer’s
information lowers the risk of bad debts. Receivable management acquire all
credentials of client for determining their borrowing capacity and repaying ability.

Credit Control
Receivable management implement a proper structure for monitoring all
credit functions of business. It records credit sales with proper documents on
a daily basis. Invoices are raised immediately after goods get dispatch and
amount are collected soon as they become due for payment.

Maximize Profit
It plays an efficient role in maximizing the profit of organizations. Receivable
management helps in boosting the sales volume by providing credit facilities
to customers. More and more people are able to purchase goods on credit
which maximizes the overall profit level.

Better Competition
Efficient account receivable management helps business in facing the strong
competition in market. It enables in providing credit facilities to customers as
per their needs and capabilities. Receivable management analyses the credit
strategies adopted by competitors and according frame policy for an
organization. It attracts more and more customers by offering them credit
facilities at convenient rates.

III. D: MANAGEMENT OF INVENTORIES

Inventory Management

Definition: Inventory management is an approach for keeping track of the flow of

inventory. It starts right from the procurement of goods and its warehousing and
continues to the outflow of the raw material or stock to reach the manufacturing units or
to the market, respectively. The process can be carried out manually or by using an
automated system.
When the goods arrive at the premises, inventory management ensures receiving,
counting, sorting, arrangement, storage and maintenance of these items, i.e. stock, raw
material, components, tools, etc., efficiently.
Inventory Management Objectives

Inventory management is performed to simplify the operational activities. Some of

the primary objectives for which it is carried out are as follows:

Preventing Dead Stock or Perishability: With an optimal inventory level, the

chances of wastage in the form of goods spoilage or dead stock.

Optimizing Storage Cost: It reduces the chances of maintaining excessive stock,

even the requirements are pre-determined, which ultimately cuts done the unnecessary
warehousing costs.

Maintaining Sufficient Stock: Now, the production department need not worry
about the shortage of raw material or goods because of its constant supply.

Enhancing Cash Flow: Inventory has a significant impact on the cash flow of the
company. With effective inventory management, the organization can ensure
sufficient liquid cash to enhance its operational efficiency.

Reducing the Inventories’ Cost Value: When there is a constant purchase of goods
or stock, the organization can ask for discounts and other benefits to decrease the
purchase price.

Types of Inventory Management

While installing an inventory management system, the organization has to consider
the various aspects like cost, budget, utility and accessibility. However, it can be classified
into the following types:

Continuous Inventory Management:

It links the barcode and radio frequency identification with the accounting
inventory system, inventory received, and point of sales systems along with the
production system, to trace the path of inventory movement. It is mostly beneficial
for accounting purpose. This is also termed as perpetual inventory management.

Periodic Inventory Management:

 It is a manual process, which is used for determining the closing inventory
value, for putting it up in the ledger at the end of a financial year. Depending on
the organizational need, it can also be analyzed quarterly. However, it is a time-
consuming way, since the inventory has to be physically counted.

Inventory Management Process

Since it is a process of identifying and resolving inventory-related obstacles. Given below
is the step-by-step method of improving the organization’s inventory management
system:

Step 1: Determining the Loopholes

The foremost step is to evaluate the inventory requirement and the actual stock of the
goods. Also, the reasons for this gap between the demand and inventory should be
ascertained.

Step 2: Analyzing Consumer Demand and Spending Patterns

The market demand forecasting holds equal importance. This is because it helps the
organization to estimate the production quantity, which ultimately leads to the
maintenance of adequate inventory.

Step 3: Evaluating the Cost Involved

Its implementation involves different types of expenses such as warehousing,
maintenance, transport, bulk discounts and supply chain costs. Each of these should be
well analyzed.

Step 4: Identifying the Extent of Process Automation

It is not possible for every organization to completely automate the inventory
management process. However, the management can recognize those particular areas
where there are possibilities of automation.

Step 5: Inspecting Supplier’s Practices and Performance

The next step is to find out the suppliers’ inventory management practices since this
strategy cannot be implemented solely. If the supplier is resistant to change and tends to
proceed with the traditional means, the organization needs to look for alternative
vendors.

Step 6: Classifying Inventories into Different Categories

The goods have to be segregated into various categories depending upon the product
type, customer class, maintenance cost or profit margin.

Step 7: Setting Objectives for Each Inventory Category

To efficiently manage and track the performance of the applied technique for each
category, it is essential to set individual goals. It not only provides a base for
benchmarking but also identifies the problems and issues faced in each of these
categories.

Step 8: Prioritizing the Areas of Improvement

Now, that we are aware of the problems, the next step is about finding out the density of
each issue and its impact. The concerns which can be resolved immediately needs to be
addressed first. And then, the ones which are complex and requires restoration should be
considered.

Step 9: Taking Advice or Opinion from Experts

Designing an appropriate inventory management system is the task of the personnel who
specialize in the field. Thus, at this stage, the organization needs to hire consultants or
experts for advice and opinion on current technology and problem fixation within the
desired budget.

Step 10: Framing Suitable Inventory Management Policy

The last step is to implement a satisfactory inventory management strategy for the
desired change. This improvement should be incorporated as an inventory management
policy to deal with the changes in demand and add value to customer experience.

Importance of Inventory Management

The evolving technology and changing consumer preference have significantly brought
forward the need for a robust inventory management system. Given below are some of
the most prominent reasons for which it is considered beneficial for every business
entity:

Proper Warehouse Management:

The barcode system, LIFO and FIFO techniques provide a clear picture of the
past and present inventory available with the company to optimize the
warehousing functions.

Efficient Inventory Valuation:

It provides for proper evaluation of the different types of inventory, i.e.,
stock in hand, opening and closing stocks, raw material, finished goods, etc. This
data is also used to prepare the cost sheet.

Supports Supply Chain Management:

Being a segment of supply chain management, it is responsible for
streamlining all the warehousing operations and flow of raw material or stock.
 Manages Sales Operations:
Sales, as we know, is a continuous process which depends upon the
production of goods or services. If there is inefficient inventory management in the
organization, the chances of unavailability of raw material for manufacturing may
arise.

Challenges Faced in Inventory Management

Inventory management has become an inevitable part of significant business
entities. Also, many small organizations have adopted the concept to keep track of their
stock and raw material.

But while practically implementing it, the companies have to deal with the
following limitations:

Lack of Knowledge:
The personnel at the receiving and warehousing departments may lack the
required expertise and adequate knowledge of segregating the regular and
seasonal goods out of the whole stock.

Expanding Product Portfolios:

The customers’ demand and requirements for a wide range of products have
tremendously increased the inventory size, making it difficult to manage, manually.

Supply Chain Complexity:

The organization, at times, fail to track the stock or goods during the supply
chain process. Moreover, it is not necessary that the business partners also
maintain an inventory management system, creating hurdles.

Conclusion
Inventory management is a useful method for simplifying all the warehousing
activities of the organization. With this technique, the company can now access and
determine its stock and inventory with efficiency to smoothen all the business
operations.

It has also proved to be a valuable tool for maintaining the working capital
requirement.
IV. OTHER TOOLS IN FINANCIAL MANAGEMENT

IV. A: COST AND RETURN ANALYSIS

Cost and Return Analysis

Cost and return analysis - a useful tool to any business firm that helps them in assessing
the profitability of their operation. A type of analysis that evaluates the overall result of a
production/farming, from the inputs used, production operations, post-production
activities until it reaches the consumer, whereby sales are realized. This tool mainly helps
the management in monitoring, evaluating and making sound decisions.

Function of Cost and Return Analysis

1. Monitoring Function
2. Evaluating Function
3. Decision Making Function

Importance of Cost and Return Analysis

1. Improves efficiency
2. Maximize profit
3. Basis for planning
4. Better management control

Basic Content of Cost and Return

1. Expenses
A. Labor cost
 B. Material cost
C. Other cost

2. Income
A. Gross Sales

3. Net Sales
A. Net Income/Profit
B. Return on Investment (ROI)
C. Other financial ratio (break-even qty, break-even price, etc.)
ESTIMATED
ITEMS / DESCRIPTION ACTUAL AMT REMARKS
AMT
I. EXPENSES
A. LABOR COST
PLOWING - - -
HARROWING - - -
PLANTING - - -
ORG. FERT. APPL'N - - -
IRRIGATION - - -
WEEDING - - -
SPRAYING - - -
HARVESTING - - -
OTHER LABOR
SUB-TOTAL (A)
- - -
B. MATERIAL COST
SEEDS - - -
ORGANIC FERTILIZER (2L) - - -
FPFS - - -
BIO-PESTICIDE - - -
SACKS - - -
OTHER MATERIALS
SUB-TOTAL (B)
C. OTHER COST
MISCELLANEOUS - - -
CONTINGENCIES - - -
SUB-TOTAL (C)
- - -

TOTAL EXPENSES (A+B+C)

- - -

II. INCOME
SALES
Selling Price (P) - - -
Total harvest (kg) - - -
GROSS SALES
- - -

(Gross sales
NET INCOME Less Total
Expenses) - -

ROI (Net Income / Total Expenses)

- - -

IV. B: PARTIAL BUDGETING

Partial Budgeting

Partial budgeting (also known as marginal analysis) is a management tool that can
compare the costs and returns that are affected by a potential change in a business. It is
especially useful in evaluating budgets that involve small, specific, and limited changes
within a business by helping to determine the profitability of that change. If the potential
change will impact several aspects of the business, then it will be necessary to use a
whole-farm budget. Whole-farm budgets contain both cash and non-cash income and
expenses; and they also consider fixed costs that are associated with the business. You
may want to do a complete whole-farm budget of your business to see if it has
profitability, liquidity, and solvency subsistence over the long term.

If your operation seems to need fine-tuning, then a partial budget would be a more
appropriate tool to analyze its performance. Business managers should evaluate their
individual situations and make an informed decision about how they will be impacted by
future events when considering their options regarding the proposed change. It is
especially important to keep in mind that the answers you obtain from partial budgeting
are no better than the quality of the information used in the analysis.

When Should You Use A Partial Budget?

You might want to use a partial budget to analyze the effect of:

1. Expanding an enterprise. (ex: adding 20 cows to a 100-cow herd)

2. Substituting commodities with similar requirements. (ex: substituting 50 ha of

tomatoes for 50 ha of peppers)

3. Buying new equipment or machinery. (ex: buying new equipment rather than
leasing or custom-hiring or vice versa)
4. Changing or adopting production practices. (ex: changing feed rations in a
livestock enterprise)

5. Participating in a government program.

6. Considering an alternative enterprise.

This gives you an idea of the types of changes that partial budgeting can analyze.
However, you should always keep in mind that partial budgeting can only analyze small
changes within the business, not major reorganizations.

Components of Partial Budgeting

In order to use partial budgeting to evaluate a potential change in a business, a manager
must first be able to answer four questions about that change:

1. What new or additional costs will be incurred?

2. What current costs will be reduced or eliminated?
3. What new or additional returns will be received?
4. What current returns will be reduced or lost?

The partial budget can be divided into three main sections: (I) costs, (II) benefits, and (III)
analysis. The analysis section includes net change in profits and a break-even analysis
(also known as benefit/cost ratio).
Limitations
of Partial
Budgeting
Although partial budgeting can be applied in a variety of situations it does have
limitations to its use.

The first limitation of partial budgeting is that it is restricted to evaluating only two
alternatives.

The second limitation is that the results obtained from a partial budget are only
estimates, and are only as good as the original data that is entered. If you enter
inaccurate information in the budget, you receive inaccurate results.

A third limitation is that partial budgeting does not account for the time value of money.
That is, the difference in the value of cash received and/or expended now, versus its
value at some future date. Another limitation is that partial budgeting only provides an
estimate of the profitability of an alternative relative to current operations. It does not
provide an estimate of the absolute profitability of the business.

Finally, costs and returns that are not affected by an intended change are not included in
the partial budget. In other words, you can only use the partial budget to consider the
costs and returns of a specific action. If you cannot determine all the areas that will be
affected by the intended change, it might be better to use a whole-farm budget to
evaluate the impacts of the change

IV. C: CAPITAL BUDGETING

Capital budgeting is the process of making investment decisions in long term assets. It is
the process of deciding whether or not to invest in a particular project as all the
investment possibilities may not be rewarding.

Thus, the manager has to choose a project that gives a rate of return more than the cost
financing such a project. That is why he has to value a project in terms of cost and
benefit.

Following are the categories of projects that can be examined using capital budgeting
process:

-The decision to buy new machinery

-Expansion of business in other geographical areas
-Replacement of an obsolete equipment
-New product or market development, etc.
Thus, capital budgeting is the most important responsibility undertaken by a financial
manager. This is because:

-It involves the purchase of long-term assets and such decisions may determine the
future success of the firm.
-These decisions help in maximizing shareholder’s value.
-Principles applicable to capital budgeting process also apply to other corporate
decisions like working capital management.

Process of Capital Budgeting

Following are the steps of capital budgeting process:

Idea Generation
The most important step of the capital budgeting process is generating good investment
ideas. These investment ideas can come from a number of sources like the senior
management, any department or functional area, employees, or sources outside the
company.

Analyzing Individual Proposals

A manager must gather information to forecast cash flows for each project in order to
determine its expected profitability. This is because the decision to accept or reject a
capital investment is based on such an investment’s future expected cash flows.

Planning Capital Budget

An entity must give priority to profitable projects as per the timing of the project’s cash
flows, available company resources, and a company’s overall strategies. The projects that
look promising individually may be undesirable strategically. Thus, prioritizing and
scheduling projects is important because of the financial and other resource issues.

Monitoring and Conducting a Post Audit

It is important for a manager to follow up or track all the capital budgeting decisions. He
should compare actual with projected results and give reasons as to why projections did
not match with actual performance. Therefore, a systematic post-audit is essential in
order to find out systematic errors in the forecasting process and hence enhance
company operations.

Techniques of Capital Budgeting

Capital budgeting techniques are the methods to evaluate an investment proposal in
order to help the company decide upon the desirability of such a proposal. These
techniques are categorized into two heads: traditional methods and discounted cash flow
methods.

Traditional Methods
Traditional methods determine the desirability of an investment project based on its
useful life and expected returns. Furthermore, these methods do not take into account
the concept of time value of money.

Pay Back Period Method

Payback period refers to the number of years it takes to recover the initial cost of
an investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has
liquidity issues, in such a case, shorter a project’s payback period, better it is for
the firm.

Therefore,
Payback period = Full years until recovery + (unrecovered cost at the beginning of
the last year)/

Cash flow during the last year

Here, full years until recovery is nothing but the payback that occurs when
cumulative net cash flow equals to zero. Cumulative net cash flow is the running
total of cash flows at the end of each time period.

Average Rate of Return Method (ARR)

Under ARR method, the profitability of an investment proposal can be determined
by dividing average income after taxes by average investment, which is average
book value after depreciation.

Based on this method, a company can select those projects that have ARR higher
than the minimum rate established by the company. And, it can reject the projects
having ARR less than the expected rate of return.

Discounted Cash Flow Methods

As mentioned above, traditional methods do not take into the account time value of
money. Rather, these methods take into consideration present and future flow of
incomes. However, the DCF method accounts for the concept that a money earned today
is worth more than a money earned tomorrow. This means that DCF methods take into
account both profitability and time value of money.
 Net Present Value Method (NPV)
NPV is the sum of the present values of all the expected incremental cash flows of
a project discounted at a required rate of return less than the present value of the
cost of the investment.

In other words, NPV is the difference between the present value of cash inflows of
a project and the initial cost of the project. As per this technique, the projects whose
NPV is positive or above zero shall be selected.

If a project’s NPV is less than zero or negative, the same must be rejected. Further,
if there is more than one project with positive NPV, then the project with the
highest NPV shall be selected.

Internal Rate of Return (IRR)

Internal Rate of Return refers to the discount rate that makes the present value of
expected after-tax cash inflows equal to the initial cost of the project.

In other words, IRR is the discount rate that makes present values of a project’s
estimated cash inflows equal to the present value of the project’s estimated cash
outflows.

If IRR is greater than the required rate of return for the project, then accept the
project. And if IRR is less than the required rate of return, then reject the project.

Profitability Index
Profitability Index is the present value of a project’s future cash flows divided by
initial cash outlay. Thus, it is closely related to NPV. NPV is the difference between
the present value of future cash flows and the initial cash outlay.

Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV is negative,
PI will be less than 1. Therefore, based on this, if PI is greater than 1, accept the
project otherwise reject.

Thus, the manager has to evaluate the project in terms of costs and benefits as all the
investment possibilities may not be rewarding. This evaluation is done based on the
incremental cash flows from a project, opportunity costs of undertaking the project,
timing of cash flows and financing costs.
Therefore, it is the planning of expenditure and benefit that spreads over a number of
years.

Capital budgeting process used by managers depends upon size and complexity of the
project to be evaluated, size of the organization and the position of the manager in the
organization.