Financial Budgeting

Budgeting for a business is a process. It is the

process of preparing a detailed statement of
financial results that are expected for a given time
period in the future.
There are two keywords in that statement. The
first keyword is "expected." Expected means
something that is likely to happen. The second
keyword is "future" which is a period in the time
to come.
So, budgeting is the process of preparing a
detailed statement of financial results that are
likely to happen in a period in a time to come.
 Types of Budget
There are three primary types of budgets that businesses use.
Within these three primary types, there are many different
subtypes.
1. An operating budget outlines the total operating
expenses and income for the organization, typically for
the period of a fiscal year.
2. Capital budget evaluates the investments and assets of
the business, and
3. Cash budget shows the predicted cash flow in and out
of the business over a period of time.

In addition to these main types, budgets may be created

specifically for special events, for the recruitment and
retention of new staff, and to manage the advertising
expenses and return on investment for the business. Budgets
can be created for any specific purpose within an
organization, so the possible types of budgets are limitless.
Benefits
Budgeting is a valuable tool for a business.
Companies use budgets to gauge their financial
performance throughout the year and adjust
spending to ensure a certain amount of profit can
be maintained.
Warning
Budgets are only useful tools as long as they are
followed and used to make necessary adjustments.
If a budget is created and then placed aside, it can't
help a business manage finances. For a budget to
be a valuable resource, it must be followed as
closely as possible.
 Exercise
In your personal life, assuming you’re the
breadwinner of a family of five. How will you
budget a net monthly take home pay of
PhP50,000 if you have two retired parents and
two studying siblings - one in high school and
another in college. Do you think Php30,000 is
enough to cover the basic necessities: food,
clothing & shelter with education to think of as
well? What would be an acceptable income level?
Make a personal cash budget with some
assumptions.
 Exercise
Net Monthly Take Home Pay P50,000
Less:
Food P30,000
Rent 15,000
Tuition 10,000
Utilities : Water 200
Electricity 4,000
Cable/WIFI/CP 2,500 61,700
Net deficit (P11,700)
 What can you do?
• Increase your income
– Racket : sell items, double job
• Reduce spending
– From private to public school
– Secure scholarship
– Reduce utility consumption
 Five Major Categories of Ratios and the
Questions They Answer
• Liquidity: Can we make required payments?
• Asset management: Right amount of assets
vs. sales?
• Debt management: Right mix of debt and
equity?
• Profitability: Do sales prices exceed unit
costs, and are sales high enough as reflected
in PM, ROE, and ROA?
• Market value: Do investors like what they see
as reflected in P/E and M/B ratios?

4-7
 Why are ratios useful?
• Ratios standardize numbers and facilitate
comparisons.
• Ratios are used to highlight weaknesses
and strengths.
• Ratio comparisons should be made
through time and with competitors.
– Trend analysis
– Industry analysis
– Benchmark (peer) analysis

4-8
 Liquidity Ratios
determine the firms ability to pay its short-term
liabilities. (the higher, the better = more liquid)
Current Ratio = Current Assets/Current Liabilities

Quick Ratio = Current Assets less Inventories

Current Liabilities
 Activity Ratios
measure effective use of assets
Inventory Turnover = Cost of Sales
Beg Inventory + End Inventory
A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies
either strong sales or ineffective buying.

Average Collection Period = Days x AR

Sales
A lower average collection period is seen as optimal, because this means
that it does not take a company very long to turn its receivables into cash.

Asset Turnover = Sales/Total Assets

Measures a firm's efficiency at using its assets in generating sales or revenue - the
higher the number the better.
 SCREEN BREAK
Please come back at 1:40 p.m.
 Leverage Ratios
measure the funds supplied by owners vs creditors

Debt Ratio = Total Liabilities/Total Assets

A debt ratio of greater than 1 indicates that a company has more debt than assets,
meanwhile, a debt ratio of less than 1 indicates that a company has more assets
than debt.

Debt to Equity = Total Liabilities/SE

A high debt/equity ratio generally means that a company has been aggressive in
financing its growth with debt.
 Profitability Ratios
measure how resources generate earnings
Net Profit Margin = Net income/Sales
An indicator of a company's pricing strategies and how well it controls costs.

Return on assets = Net income/total assets

ROA gives investors an idea of how effectively the company is converting the money
it has to invest into net income. The higher the ROA number, the better, because the
company is earning more money on less investment.

Return on equity = Net income/SH Equity

ROE shows how well a company uses investment funds to generate earnings growth.
ROEs between 15% and 20% are generally considered good.
 Profitability Ratios Continuation…
Times interest earned = EBIT/Interest Expense
Indicates the extent of which earnings are available to meet interest payments.

EPS = Net Income/# o/s

The portion of a company's profit allocated to each outstanding share of common
stock. Earnings per share serves as an indicator of a company's profitability.

P/E ratio = Market Price/EPS

P/E ratio is the market's stock valuation of a company and its shares relative to the
income the company is actually generating. Stocks with higher (or more certain)
forecast earnings growth will usually have a higher P–E, and those expected to
have lower (or riskier) earnings growth will usually have a lower P–E.
 D’Leon’s Balance Sheet: Assets
2013E 2012
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Deprec. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592

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 D’Leon’s Balance Sheet:
Liabilities and Equity
2013E 2012
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592

4-16
 D’Leon’s Income Statement
2013E 2012
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Deprec. & amort. 116,960 116,960
EBIT
Interest exp. 492,648 (130,948)
EBT 70,008 136,012
Taxes 422,640 (266,960)
Net income 169,056 (106,784)
253,584 (160,176)

4-17
 Other Data
2013E 2012
No. of shares 250,000 100,000
EPS $1.014 -$1.602
DPS $0.220 $0.110
Stock price $12.17 $2.25
Lease pmts $40,000 $40,000

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 D’Leon’s Forecasted Current Ratio and Quick
Ratio for 2013
Current assets
Current ratio 
Current liabilities
$2,680

$1,145
 2.34 

(Current assets  Inventories)

Quick ratio 
Current liabilities
($2,680  $1,716)

$1,145
 0.84 

4-19
 Comments on Liquidity Ratios
2013E 2012 2011 Ind.
Current ratio 2.34x 1.20x 2.30x 2.70x
Quick ratio 0.84x 0.39x 0.85x 1.00x

• Expected to improve but still below the industry

average.
• Liquidity position is weak.

4-20
 D’Leon’s Inventory Turnover vs. the Industry
Average
Inv. turnover = Sales/Inventories
= $7,036/$1,716
= 4.10x

2013E 2012 2011 Ind.

Inventory turnover 4.1x 4.70x 4.8x 6.1x

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 Comments on Inventory Turnover
• Inventory turnover is below industry
average.
• D’Leon might have old inventory, or its
control might be poor.
• No improvement is currently forecasted.

4-22
 DSO: Average Number of Days after Making a
Sale before Receiving Cash

DSO = Receivables/Avg. sales per day

= Receivables/(Annual sales/365)
= $878/($7,036/365)
= 45.6 days

4-23
 Appraisal of DSO
2013E 2012 2011 Ind.

DSO 45.6 38.2 37.4 32.0

• D’Leon collects on sales too slowly, and is getting

worse.
• D’Leon has a poor credit policy.

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Fixed Assets and Total Assets Turnover Ratios vs.
the Industry Average
FA turnover = Sales/Net fixed assets
= $7,036/$817 = 8.61x

TA turnover = Sales/Total assets

= $7,036/$3,497 = 2.01x

4-25
 Evaluating the FA Turnover (S/Net FA) and TA
Turnover (S/TA) Ratios
2013E 2012 2011 Ind.
FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

• FA turnover projected to exceed the industry

average.
• TA turnover below the industry average. Caused by
excessive currents assets (A/R and Inv).

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 Calculate the Debt Ratio and
Times-Interest-Earned Ratio
Debt ratio = Total debt/Total assets
= ($1,145 + $400)/$3,497
= 44.2%

TIE = EBIT/Interest charges

= $492.6/$70 = 7.0x

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 D’Leon’s Debt Management Ratios vs. the
Industry Averages
2013E 2012 2011 Ind.
D/A 44.2% 82.8% 54.8% 50.0%
TIE 7.0x -1.0x 4.3x 6.2x

• D/A and TIE are better than the industry average.

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Profitability Ratios: Operating Margin,
Profit Margin, and Basic Earning Power
Operating margin = EBIT/Sales
= $492.6/$7,036 = 7.0%

Profit margin = Net income/Sales

= $253.6/$7,036 = 3.6%

Basic earning power = EBIT/Total assets

= $492.6/$3,497 = 14.1%

4-29
 Appraising Profitability with Operating
Margin, Profit Margin, and Basic
Earning Power
2013E 2012 2011 Ind.
Operating margin 7.0% -2.2% 5.6% 7.3%
Profit margin 3.6% -2.7% 2.6% 3.5%
Basic earning power 14.1% -4.6% 13.0% 19.1%

4-30
 Appraising Profitability with Operating
Margin, Profit Margin, and Basic
Earning Power
• Operating margin was very bad in 2012. It is
projected to improve in 2013, but it is still
projected to remain below the industry average.
• Profit margin was very bad in 2012 but is projected
to exceed the industry average in 2013. Looking
good.
• BEP removes the effects of taxes and financial
leverage, and is useful for comparison.
• BEP projected to improve, yet still below the
industry average. There is definitely room for
improvement.
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Profitability Ratios: Return on Assets and Return
on Equity
ROA = Net income/Total assets
= $253.6/$3,497 = 7.3%

ROE = Net income/Total common equity

= $253.6/$1,952 = 13.0%

4-32
 Appraising Profitability with ROA
and ROE
2013E 2012 2011 Ind.
ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%

• Both ratios rebounded from the previous year, but

are still below the industry average. More
improvement is needed.
• Wide variations in ROE illustrate the effect that
leverage can have on profitability.

4-33
 Effects of Debt on ROA and ROE
• Holding assets constant, if debt increases:
– Equity declines.
– Interest expense increases – which leads to a
reduction in net income.
• ROA declines (due to the reduction in net
income).
• ROE may increase or decrease (since both
net income and equity decline).

4-34
 Problems with ROE
• ROE and shareholder wealth are correlated,
but problems can arise when ROE is the sole
measure of performance.
– ROE does not consider risk.
– ROE does not consider the amount of capital
invested.
• Given these problems, reliance on ROE may
encourage managers to make investments
that do not benefit shareholders. As a result,
analysts have looked to develop other
performance measures, such as EVA.

4-35
 Calculate the Price/Earnings and Market/Book
Ratios
P/E = Price/Earnings per share
= $12.17/$1.014 = 12.0x

M/B = Market price/Book value per share

= $12.17/($1,952/250) = 1.56x
2013E 2012 2011 Ind.
P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x

4-36
 Analyzing the Market Value Ratios
• P/E: How much investors are willing to pay
for $1 of earnings.
• M/B: How much investors are willing to
pay for $1 of book value equity.
• For each ratio, the higher the number, the
better.
• P/E and M/B are high if ROE is high and
risk is low.

4-37
 Cash Cycle
A metric that expresses the length of time, in
days, that it takes for a company to convert
resource inputs into cash flows. The cash
conversion cycle attempts to measure the amount
of time each net input dollar is tied up in the
production and sales process before it is
converted into cash through sales to customers.
This metric looks at
a) the amount of time needed to sell inventory,
b) the amount of time needed to collect
receivables and
c) the length of time the company is afforded to
pay its bills without incurring penalties.
Calculated as:
Cash Conversion Cycle (CCC)
CCC = DIO + DSO – DPO
Where:
DIO represents days inventory outstanding
(Cash is Locked-Up as Inventory)
DSO represents days sales outstanding (Cash is
Locked-Up in Receivables)
DPO represents days payable outstanding (Cash
Is Free Because the Business Has Not Paid Its
Bills)
 Components of the Formula Used to Compute the
Cash-to-Cash Cycle
How to Calculate It
DIO : Days Cash is Locked-Up as Inventory

Average Dollar Value Inventory During the Reporting Period

divided by
(Cost of Goods Sold */ Number of Days in the Reporting Period)

*Obtain the Cost of Goods Sold (COGS) for the reporting period from the
business's Profit/Loss statement for that period.
If it is not available, compute the cost of goods sold (COGS) using the
following formula:
COGS = Dollar Value of Inventory at the Beginning of the Reporting Period
+ Dollar Value of Purchases During the Reporting Period
- Dollar Value of Inventory at the End of the Reporting Period.
"Purchases" refers to materials and supplies bought for producing new outputs.
DSO :Days Cash is Locked-Up in Receivables

Average Dollar Value of Accounts Receivable

During the Reporting Period
divided by
(Sales / Number of Days in the Reporting Period)
DPO:Days Cash Is Free Because the
Business Has Not Paid Its Bills

Average Dollar Value of Accounts Payable

During the Reporting Period
divided by
(Cost of Goods Sold / Number of Days in the
Reporting Period)
Calculated as:
Cash Conversion Cycle (CCC)
CCC = DIO + DSO – DPO
Where:
DIO represents days inventory outstanding
(Cash is Locked-Up as Inventory)
DSO represents days sales outstanding (Cash is
Locked-Up in Receivables)
DPO represents days payable outstanding (Cash
Is Free Because the Business Has Not Paid Its
Bills)
 Cash Flow Analysis
A cash flow statement is a listing of the flows
of cash into and out of the business or
project. Think of it as your account at the
bank. Deposits are the cash inflow and
withdrawals are the cash outflows. The
balance in your account is your net cash flow
at a specific point in time.
 Cash Flow Budget
A cash flow budget is a projection of the future
inflows and outflows to your account.
A cash flow statement is not only concerned
with the amount of the cash flows but also
the timing of the flows.
Many cash flows are constructed with multiple
time periods. For example, it may list monthly
cash inflows and outflows over a year’s
time. It not only projects the cash balance
remaining at the end of the year but also the
cash balance for each month.
 Cash Flow Budget continuation…
Cash flow budgets are constructed so that you
can monitor the accuracy of your projections.
These budgets allow you to make monthly
cash flow projections for the coming year and
also enter actual inflows and outflows as you
progress through the year. This will allow you
to compare your projections to your actual
cash flows and make adjustments to the
projections for the remainder of the year.
Reasons for Creating a Cash Flow Budget
• Think of cash as the ingredient that makes the business
operate smoothly just as grease is the ingredient that
makes a machine function smoothly. Without adequate
cash a business cannot function because many of the
transactions require cash to complete them.
• By creating a cash flow budget you can project your
sources and applications of funds for the upcoming time
periods. You will identify any cash deficit periods in
advance so you can take corrective actions now to alleviate
the deficit. This may involve shifting the timing of certain
transactions. It may also determine when money will be
borrowed. If borrowing is involved, it will also determine
the amount of cash that needs to be borrowed.
• Periods of excess cash can also be identified. This
information can be used to direct excess cash into interest
bearing assets where additional revenue can be generated
or to schedule loan payments.
 Cash Flow is not Profitability
• A cash flow statement lists cash inflows and
cash outflows while the income statement
lists income and expenses.
• A cash flow statement shows liquidity while an
income statement shows profitability.
 Exercises
• Create your own cash flow budget (weekly) for
the month of March showing:
– Beginning balance
– Estimated inflows
– Projected outflows
– Net weekly cash flows
– Cumulative cash flows