Financial Planning – Budgeting

Outline
Opening Case
Introduction
Financial Planning
- Profit Planning
- Budgets
- Advantages of Preparing a Budget
- Kinds of Budgets
- Master Budget
- Flexible Budget

Common budgets prepared in a business:

- Sales Budget
- Purchases Budget
- Cash Budget
- Cash Receipts Budget
- Cash Disbursement Budget
- Budgeted Income Statement

Discussion Questions

1. What is financial planning?

2. What are the objectives of financial planning?
3. What are the two major types of financial plans?
4. What is profit planning? Briefly discuss its objectives.
5. What is a budget? Explain in your own words.
6. What are the advantages offered by a budget?
7. What is a master budget?
8. What is a flexible budget?
9. What is the difference between a master budget and a flexible budget?
10. What is a sales budget? How is it prepared?
11. What is a cash budget? What are the components of a cash budget?
12. What is a projected income statement? What are its components?
13. What is the most common way to prepare a projected statement of financial position? Discuss the
method.
14. If you are given the choice to prepare a budget, would you choose to prepare one? Why or why
would you not prepare a budget?

Opening Case

Marlo is the proprietor of ABC Merchandising, an entity engaged in the reselling of toys for toddlers.
In 2013, ABC Merchandising had a favorable result of operations. For the year 2014, Marlo wanted to
forecast ABC's probable results of operations. Aside from that, he wanted to carefully plan for the
coming year through proper resource allocation. He specifically wanted to know a forecast demand
for the toys in order to project its probable sales level. He also wanted to establish a schedule that
would inform him of the appropriate quantities of toys that he must purchase each period. Lastly,
Marlo wants to see a project the firm's performance and condition for the coming year. What tools
must Marlo use in order to achieve this goal?
Introduction

Every business organization has its own sets of goals and objectives which it plans to achieve given a
specific time horizon. For instance, it would want to expand current operations or increase its current
market share, it would also want to achieve a certain level of earnings over a specific period.
However; the ultimate question is - how would a business organization make it possible to achieve its
and objectives? Would there be tools that would aid managers and business owners in assessing
whether these goals are more likely or not, achieved? The answers to all these questions can be
obtained through proper financial planning.

Financial planning plays a vital role in the success of any business organization. It sets out road maps
intended to guide, coordinate, and control actions undertaken by the firm in order to achieve its
objectives. Through financial planning, managers are able to set a clear direction of where they would
want the business to be within a given span of time. Furthermore, financial planning provides
quantitative measures that would aid businesses towards assessing the viability of their goals and
objectives.

Financial Planning Process

The financial planning process begins with long-term or strategic financial plans, which in turn, are
used to develop short-term or operating financial plans and budgets. Long-term or strategic financial
plans lay out the direction of the firm through intended actions whose anticipated results are expected
to produce an impact within the form for a period of five to ten years. Part of a firm's long term
financial plan would be considerations on research and development for existing and future products,
expenditures for major capital assets and possibly long-term sources of financing. This long-term plan
mostly includes anticipated major decisions of the firm that would require commitment of resources
over a longer time period, results of which are very difficult to reverse.

A long-term financial plan is generally supported by a series of short-term financial plans. Short-term
financial plans on the other hand specify financial actions whose results or impact are expected to
occur for a shorter period of time. Typically, short-term financial plans cover one to two years. Inputs
on short-term financial plans would highlight the firm's operations in the short-run such as sales and
production forecasts for a specific period. Outputs of short-term financial planning commonly include
operating budgets, cash budgets, as well as projected financial statements. Short-term financial plans
provide managers a picture of the entity's anticipated results of operations and resource allocation in
the short-run.

Profit Planning

Profit planning projects the firm's results of operations and overall financial position for a given period
of time, on the basis of both historical information and assumptions about the near future.
Assumptions include estimating future sales growth, cost of inventories among others. In profit
planning, the firm makes a variety of assumptions in making its projections, using internal and
external, quantitative and qualitative information that might affect the firm's overall financial condition.

Budgets

A budget is a plan expressed in quantitative terms, which emphasizes the resource use and resource
allocation of an entity over a specified period of time. Budget preparation is a planning and control
tool often utilized by most decision-makers. It facilitates the quantification of plans and proposals
along with the potential financial effects of such actions.
Advantages of Preparing a Budget

One of the advantages offered by budgeting is efficient and effective resource utilization. Because
resources that firms control are scarce, firms, through budgets, should be able to forecast its resource
needs and effectively allocate each resource along with current demands or requirements. Budgets
also serve as frameworks for performance evaluation. Any difference between the results and the
budget could be a signal for management as to how effective they are in performing their specific
functions and could serve as a basis for incentive or disincentive. Lastly, budgeting facilitates
coordination, communication cooperation within the organization, but such would require inputs from
different departments across the firm. Each budget would require inputs coming from different
departments across the firm. An input provided by one department is critical in the budget preparation
of another, thus cooperation is highly needed in order to create accurate budgets.

Kinds of Budgets

1. Master budget – represents the overall plan of an organization for a given period. It is an
aggregation of all lower level budgets in the organization.

2. Flexible budget - a budget that allows for varying provisions based on a given level of activity.
Usually prepared at the end of the period for purposes of comparing actual with budgeted results.

Common budgets prepared in a business:

a. Sales Budget

Since budgets play a crucial role in organizational control and coordination, it is important that an
organization prepares its budgets for a given period. However, the most relevant question to be
posed is: where do we begin? Where will budget preparation start? All other budgets are anchored on
the sales budget and it is essential that an entity starts with the preparation of a sales budget.

The most important assumption to be considered in the process of preparing a sales budget would be
the firm's sales forecast. A sales forecast is a prediction of the firm's sales over a specific period,
based on external and internal information. Typical inputs to a firm's sales forecast would be the
anticipated demand for the product, industry trend and analysis and possibly, opinion from the top
management regarding future sales projections. The key input in a sales budget would be the
expected number of units to be sold by the entity. If the firm is a multiproduct firm, the product would
need to have a forecast.

For example, ABC Merchandising, which is engaged in the reselling of toys, is in the process of
preparing its budgets for the calendar year 2015. Last year, ABC was able to sell 150,000 toys with a
selling price of P40 per toy. For the current year, on the basis of both external and internal
information, ABC expects to sell 40,000 toys for the first quarter alone. The firm also expects that unit
sales per quarter would increase by 10%. Selling price is also expected to increase by 10% for 2015.
 ABC Merchandising
Sales Budget
For the year 2015
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total
Forecasted 40,000 toys 44,000 toys 48,400 toys 53,240 toys 185,640
sales (in units)
(Given) (40k x 1.1) (44k x 1.1) (48.4k x 1.1)
Selling price P44 P44 P44 P44 P44
per unit
Total Sales P1,760,000 P1,936,000 P2,129,600 P2,342,560 P8,168,160

b. Purchases Budget

After preparing the sales budget, a merchandising business can now start preparing a purchases
budget. Basically, this contains the estimated number of units the firm needs to purchase for a
specific time period. In preparing the purchases budget, key inputs would be as follows: beginning
inventory, desired ending inventory and estimated sales in units. Some firms would want to maintain
a given inventory level at all times, thus, desired ending inventory is considered in estimating
purchases volume. If there were any unsold inventory from prior periods, these implies that units to
be purchased can be reduced since these unsold inventories from prior periods can be sold in the
current period.

ABC Merchandising
Purchases Budget
For the year 2015
(in units) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total
Forecasted 40,000 toys 44,000 toys 48,400 toys 53,240 toys 185,640
sales

Add: Desired 8,800 9,680 10,648 10,500* 39,628

Ending (44,000 x 0.2)
(48,400 x 0.2) (53,240 x 0.2)
Inventory
Total 48,800 53,680 59,048 63,740 225,268
Inventory
Requirement
Less: 8,000 8,800 9,680 10,648 37,128
Beginning
Inventory
Estimated 40,800 44,880 49,368 53,092 188,140
Purchases
*arbitrary
At the close of 2014, ABC still had 8,000 units of inventory on hand. Observe that each quarter's
desired ending inventory is based on 20% of the unit sales of the succeeding quarter. Furthermore,
the beginning inventory for each quarter is the ending inventory of the preceding quarter.

Once the purchases budget (in volume) is prepared, the purchases budget in terms of costs can be
prepared next. However, for a manufacturing firm, a production volume and production budget will
also be prepared. The firm should estimate total manufacturing cost per unit of the product to be
produced. Costs such as direct materials, direct labor, and manufacturing overhead should be
identified in order to assign costs in the budgeted production volume.

Referring back to ABC Merchandising, ABC estimates that each toy would cost P30 for 2015.
ABC Merchandising
Purchases Budget
For the year 2015
(in units) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total
Estimated 40,800 44,880 49,368 53,092 188,140
Purchases
Multiplied by P30 P30 P30 P30 P30
Cost
Estimated P1,224,000 P1,346,400 P1,481,040 P1,592,760 P5,644,200
Total Cost
Purchases

c. Cash budget

A cash budget shows the planned inflows and outflows of cash in the entity for a given period of time.
This schedule will aid the firm towards estimating its short-term cash requirements. The schedule
emphasizes possibility that the firm may experience cash shortages, in which case, it would need to
borrow additional cash to meet financing requirements or cash surplus that might present short-term
investment opportunities for the firm. Generally, a cash budget could further be divided into cash
receipts and cash disbursements schedules.

Cash Receipts Budget

A firm's cash receipts budget focuses on all cash inflows expected by the firm for a given time period.
The most common sources of cash would be cash sale of goods and services, accounts receivable
collections, and other cash receipts.

ABC Merchandising is in the process of estimating its cash receipts for the fourth quarter of the year.
It is estimated that sales for each month will be as follows: October - P700,000, November -
P800,000, December - P842,560. Twenty percent of each month's sales are cash sales, and the
balance is expected to be collected as follows: 30% one month after the sale and remaining 50% is
collected two months after the sale. ABC expects to receive a P140,000 dividend from one of its
investments for both October and December.
 Cash Receipts Schedule
October November December Total
Sales Forecast P700,000 800,000 842,560 2,342,560

Cash Sales P140,000 160,000 168,512 P468,512

(700,000 x 0.2)
(800,000 x 0.2) (842,560 x 0.2)
Collection of Accounts Receivables:
1 Month Lagged P210,000 240,000 450,000
(700,000 x 0.3) (800,000 x 0.3)
2 Months Lagged P350,000 350,000
(700,000 x 0.5)
Other Cash Receipts P140,000 P140,000 280,000
Budgeted Cash P280,000 P370,000 P898,512 P1,548,512
Receipts

Cash Disbursements

A firm's cash disbursements, on the other hand, shows possible outflow of cash for a given time
period. Typical disbursements of cash include, cash purchases for inventory or raw materials,
payment of accounts payable, rental payments, payment of wages and salaries, tax payments, and
possibly, interest payments.

ABC has the following inventory purchases for fourth quarter, October: P160,000, November:
P200,000, December: P220,000. ABC pays 30% of the purchases on the month of purchase, 40% of
the purchase is paid a month after and the remaining 30% two months after the purchase. ABC pays
a monthly rent of P5,000 and pays a total of P20,000 monthly wages to its four workers.

Cash Disbursement Schedule

October November December Total
Purchases 160,000 200,000 220,000 580,000

Payment of Purchase on Account:

Month of Purchase 48,000 60,000 66,000 174,000
 (160,000 x 0.3) (200,000 x 0.3) (220,000 x 0.3)
1 Month Lagged 64,000 80,000 144,000
(160,000 x 0.4) (200,000 x 0.4)
2 Months Lagged 48,000 48,000
(160,000 x 0.3)
Rental Payments P5,000 P5,000 P5,000 15,000
Wages P20,000 P20,000 P20,000 60,000
Budgeted Cash P73,000 P149,000 P219,000 P441,000
Disbursements

Since both cash receipts and disbursement schedules were already prepared we are now ready to
prepare the firm's cash budget for the three-months provided. ABC requires that a minimum cash
balance of 50,000 is maintained at all times. The ending cash balance for the month of September
was 10,000.

Cash Budget
October November December
Cash Receipts P280,000 P370,000 P898,512
Less: Cash P73,000 P149,000 P219,000
Disbursements
Net Cash Flow P207,000 221,000 679,512
Add: Beginning P10,000 P217,000 P438,000
Cash Balance
Ending Cash P217,000 P438,000 P1,117,512
Balance
Less: Minimum P50,000 P50,000 P50,000
Cash Balance
Required
Financing
Excess Cash P167,000 P 388,000 P1,067,512

d. Budgeted Income Statement

In the process of short-term financial planning, the entity would be interested towards projecting its
probable results of operations given the budgeted sales and purchases levels forecast previously.
The budgeted income statement shows the entity's budgeted sales, budgeted cost of sales, along
with budgeted operating expenses in order to arrive at the projected net profit for that given
accounting period. Budgeted sales will come from the firm's sales budget while budgeted cost of
goods sold would need both sales and production forecasts in conducting the estimate. In most
cases, projected operating expenses are expressed as a certain percentage of total sales for that
specific period.

One of the most crucial schedules to prepare in doing a budgeted income statement would be the
estimated cost of goods sold for that period. The following is a pro-forma computation for estimating
cost of goods sold for a given period:

ABC Merchandising
Budgeted Cost of Goods Sold
For the year 2015
(in pesos) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total
Estimated 8,000 8,800 9,680 10,648 37,128
Beginning
Inventory
Add: 40,800 44,880 49,368 53,092 188,140
Budgeted
Purchases
Estimated 48,800 53,680 59,048 63,740 225,268
Goods
Available for
Sale
Less: Ending 8,800 9,680 10,648 10,500* 39,628
Inventory

Budgeted 1,200,000 1,320,000 1,452,000 1,597,000 5,569,200

Cost of
Goods Sold

Once the budgeted cost of goods sold has been prepared, it will now be easy for the firm to complete
its budgeted income statement with assumptions on its operating expenses being taken into
consideration. Continuing the illustration using ABC Merchandising, it is estimated that total operating
expenses incurred by the company is 10% of the quarter's gross sales. With that assumption,
presented below is ABC's budgeted income statement for 2015:

ABC Merchandising
Budgeted Income Statement
For the year 2015
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Total
Sales P1,760,000 P1,936,000 P2,129,600 P2,342,560 P8,168,160
Less: Cost of 1,200,000 1,320,000 1,452,000 1,597,000 5,569,200
Goods Sold
 Gross Profit 560,000 616,000 677,600 745,360 P2,598,960
Less: 176,000 193,600 212,960 234,256 P816,816
Operating
Expenses
Net Income P384,000 P422,400 P464,640 P511,104 1,782,144

e. Budgeted Statement of Financial Position

A budgeted statement of financial position shows a projection of the resources, claims, and residual
interests in the firm for a specific date. This will facilitate the evaluation of the firm's projected financial
position. Similar to most budgeting exercises, the preparation of a budgeted statement of financial
position requires the use of various assumptions. The most common method used in projecting the
statement of financial position is the judgmental approach. Under this approach, the firm estimates
the values of some statement of financial position accounts and uses its external financing as a "plug”
figure in order to balance the statement of financial position.

Exercises

True or False I
On the space provided, write TRUE if the idea being expressed is correct and FALSE if otherwise.

___T_1. A financial plan serves as a roadmap for a business organization.

___F_ 2. A short-term financial plan serves as a strategic financial plan of the entity.

____T_ 3. A long-term financial plan is composed of a series of short-term financial plans.

____T_ 4. Profit planning allows a business to project its results of operations.

____F_ 5. A short-term financial plan would range for 5-10 years at a maximum.

____F_ 6. A long-term financial plan would affect the firm in the immediate future, such as 1-2 years.

____T_ 7. A budget is a tool that facilitates profit planning.

____T_ 8. Financial planning is an essential tool to help manage business operations.

____T_ 9. Acquisition of major capital assets is an example of an activity included in a firm's strategic
financial plan.

____T_ 10. Projection of the firm's operation results, along with short-term resource needs form part
of a short-term financial plan.

True or False Il
On the space provided, write TRUE if the idea being expressed is correct and FALSE if otherwise.

____F_ 1. A budget is a qualitative plan for a business organization.

____T_ 2. A sales forecast is the most important assumption in preparing a budget.

____F_ 3. Assumptions made in preparing a budget should not be revised in light of more relevant
information becoming available.

____T_ 4. A cash budget shows a projection of the cash inflows and outflows of the entity for a given
period of time.

____F_ 5. Depreciation expense is included in the firm's cash disbursement projections.

____T_ 6. Under the judgmental approach, a plug figure in the form of an external financing needed
is used to maintain the equality in a statement of financial position.

____T_ 7. A master budget is a compilation of all other operational budgets a business organization
has.

____F_ 8. A flexible budget does not account for variations in activity levels of a firm.

____T_ 9. If a firm's cash balance falls below a minimum requirement, there is a need to obtain
external financing.
____T_ 10. A budgeted income statement shows the projected resources and obligations of a firm
over a specific time period given. 8

Identification
Identify the term/s being described by each statement.

________Budget__ 1. A plan expressed in quantitative terms, which emphasizes the resource use
and resource allocation of an entity over a specified period of time.
_______Financial planning___ 2. It sets out road maps intended to guide, coordinate, and control
actions undertaken by the firm in order to achieve its objectives.
____Long term financial plan______ 3. Lays out the direction of the firm through intended actions
whose anticipated results are expected to produce an impact within the firm for a period of five to ten
years.
_____Short term financial plan_____ 4. It specifies financial actions whose results or impact are
expected to occur for a shorter period of time, typically one to two years.
_____Profit Planning_____ 5. Projects the firm's results of operations and overall financial position for
a given period of time, on the basis of both historical information and assumptions about the near
future.
_____Master Budget_____ 6. Represents the overall plan of an organization for a given period. It is
an aggregation of all lower level budgets in the organization.
_____Flexible Budget_____ 7. A budget that allows for varying provisions based on a given level of
activity. Usually prepared at the end of the period for purposes of comparing actual with budgeted
results.
_____Sales Budget_____ 8. A prediction of the firm's sales over a specific period, based on external
and internal information.
_____Cash Budget_____ 9. Shows the planned inflows and outflows of cash in the entity for a given
period of time.
_____Budgeted Statement of Financial Position_____ 10. The most common method used in
projecting the statement of financial position.
8

Multiple Choice
Circle the choice that corresponds to the best answer.

1. Mark, a merchandiser of shirts is planning to forecast the most likely results of its operations for
the next year. Which should be determined first in order to have a sound projection of operation
results?
a. sales budget c. purchases budget
b. sales forecast d. cash budget
2. A finance manager was tasked to carefully monitor the entity's cash balance for the end of each
quarter. A _____ is the most appropriate tool for this goal.
a. sales budget c. cash budget
b. budgeted income statement d. budgeted statement of financial position

3. A long-term financial plan would most likely include all of the following except:
a Acquisition of capital assets
b. Research and development for new projects
c. Sources of long-term financing
d. Cash budget for one year

4. All of the following are advantages of preparing a budget except:

a. It forces managers to quantity plans and proposals.
b. It provides a measure of performance evaluation.
c. It forces cooperation and coordination among units in the organization.
d. All are advantages of preparing a budget.

5. Which of the following is not a source of cash for an entity?

a. cash sales c. payment of expenses
b. collection of receivables d. investment from the owner

6. Which of the following is not an example of a cash outflow for the firm?
a. Payment of purchases on account c. Receipt of cash dividends
b. Payment of this month's utilities d. Disbursement for loan payments

7. Which of the following is not a valid assumption to be used in preparing a projected balance
sheet?
a. Cash balance is maintained at its current level.
b. Accounts payable is expected to decrease by 50%.
c. Net fixed assets is expected to total +85,000.
d. Equity of the firm is maintained at its current level, ignoring any results of operations.

8. A projected income statement will reflect all of the following except:

a. Cash balance c. Cost of sales
b. Sales d. Operating expenses
9. Which is an appropriate sequence in preparing a series of operational budgets?
a. sales budget, purchases budget, cost of sales budget, budgeted income statement
b. purchases budget, cost of sales budget, sales budget, budgeted income statement
c. budgeted income statement, sales budget, purchases budget, cost of sales budget
d. cost of sales budget, purchases budget, budgeted income statement, sales budget

10. Which is not an operational budget?

a. Sales budget c. Capital budget
b. Purchases budget d. All are operational budgets.