Thursday, September 20, 2012
Thursday, September 13, 2012
Saturday, May 5, 2012
They act as authorized to spend, that is , they give authority to budget managers to incur expenditure in their part of the organization,They act as comparators for current performance, by providing a yardstick against which current activities can be monitored.
These two roles are combined in a system of budgetary planning and control.
planning and control
Planning the activities of an organization ensures that the organization sets out in the right direction. Individuals within the organization will have definite targets which they will aim to achieve. Without a formalized plan the organization will direction and managers will not be aware of their own targets and responsibilities. Neither will they appreciate how their activities relate to those of other managers within the organization.
A formalized plan will help to ensure a coordinated approach and the planning process itself will force managers to continually think ahead, planning and reviewing their activities in advance.
However, the budgetary process should not stop with the plan. The organization has started out in the right direction but to ensure that it continues on course it is the management’s responsibility to exercise control.
Control is best achieved by comparison of the actual results with the original plan.
Appropriate action can then be taken to occurect any deviations from the plan.
The comparison of actual result with a budgetary plan, and the taking of action to correct deviations, is known as feedback control.
The two activities of planning and control must go hand in hand. Carrying out the budgetary planning exercise without using the plan for control purposes is performing only part of the task
What is a budget?
For a budget to be useful it must be quantified. For example, it would not be particularly useful for the purposes of planning and control if a budget was set as follows:
‘We plan to spend as little as possible in running the printing department this year’; or
‘We plan to produce as many units as we can possibly sell this quarter’.
These are merely vague indicators of intended direction; they are not quantified plans.
They will not provide much assistance in management’s task of planning and controlling the organization.
These ‘budgets’ could perhaps be modified as follows:
Budgeted revenue expenditure for the printing department this year is £ 60,000’; and ‘budgeted production for the quarter is 4,700 units’
The quantification of the budgets has provided:
A definite target for planning purposes; and
A yardstick for control purposes.
You may have noticed that in each of these ‘budgets’ the time period was different. The first budget was prepared for a year and the second budget was for a quarter. The time period for which a budget is prepared and used is called the budget period. It can be any length so suit management purposes but it is usually 1 year.
The length of time chosen for the type budget period will depend on many factors, including the nature of the organization and the type of expenditure being considered. Each budget period can be subdivided into control period, also of varying lengths, depending on the level of control which management whishes to exercise. The usual length of a control period is 1 month.
planning, budgetary planning and operational planning
It will be useful at this stage to distinguish in broad terms three different types of planning:
Strategic planning, Budgetary planning, Operational planning;
These three forms of planning are interrelated. The main distinction between them relates to their time span which may be short term, medium term or long term.
The short term for one organization may be the medium or long term for another, depending on the type of activity in which it is involved.
Strategic planning is concerned with preparing long-term action plans to attain the organization’s objectives.
Strategic planning is also known as corporate planning or long-range planning.
Budgetary planning is concerned with preparing the short-to medium-term plans of the organization. It will be carried out within framework of the strategic plan. An organization’s annual budget could be seen as an interim step towards achieving the long- term or strategic plan.
Operational planning refers to the short-time or day –to –day planning process. It is concerned with planning the utilization of resources and will be carried out within the framework set by the budgetary plan. Each state in the planning process can be seen as an interim step towards achieving the budget for the period.
Operational planning is also known as tactical planning.
Remember that the full benefit of any planning exercise is not realized unless the plan is also used for control purposes. Each of these types of planning should be accompanied by the appropriate control expertise covering the same time span.
preparation of budgets
The process of preparing and using budgets will differ from organization to organization. However there are a number of key requirements in the design of a budgetary planning and control process.
The budget committee
The need for coordination in the planning process is paramount. The interrelationship between the functional budgets (e.g. sales, production, purchasing) means that one budget cannot be completed without reference to several others.
For example, the purchasing budget cannot be prepared without reference to the production budget, and it my be necessary to prepared the sales budget before the production budget can be prepared. The best way to achieve this coordination is to set up a budget committee. The budget committee should comprise representatives from all functions in the organization. There should be a representative from sales, a representative from marketing, a reprehensive from personnel, and so on.
The budget committee should meet regularly to review the process of the budgetary planning process and to resolve problems that have arisen. These meeting will effectively bring together whole organization in one room, to ensure a coordinated approach to budget preparation.
CIMA participative budgeting as ‘a budgeting system in which all budget holders are given the opportunity to participate in setting their on budgets’. This may also be referred to as ‘bottom-up budgeting’. It contrasts with imposed or top- down budgets where the ultimate budget holder does not have the opportunity to participate in the budgeting process. The advantages of participative budgeting are as follows:
Improved quality of forecasts to use as the basis for the budget. Managers who are doing a job on a day-to-day basis are likely to have a better of what is achievable, what is likely to happen in the forthcoming period, local reading conditions, ect.
Improved motivation. Budget holders are more likely to want to work top achieve a budget that they have been involved in setting themselves, rather than one that has been imposed on them from above. They will on the budget and accept responsibility for the achievement of the targets contained therein.
The main disadvantage of participative budgeting is that it tends to result in a more extended and complex budgetary process. However, the advantages are generally accepted to outweigh this.
Many of these information needs are contained in the budget manual.
A budget manual is a collection of documents which contains key information for those involved in the planning process. Typical contents could include the following:
An introductory explanation of the budgetary planning and control process including statements of the budgetary objective and desired results.
Participants should be made aware of the advantages to them and to the organization of an efficient planning and control process. This introduction should give participants an understanding of the working of the planning process, and of the sort of information that they can expect to receive as part of the control process.
A form of organization charts to show who is responsible for the preparation of each functional budget and the way in which the budgets are interrelated.
A timetable for the preparation of each budget. This will prevent the formations of a ‘bottleneck’, with the late preparation of one budget holding up the preparation of all others.
Copies of all forms to be completed by those responsible for preparing budgets, with explanations concerning their completion.
A list of the organization’s account codes, with full explanations of how to use them.
Information concerning key assumption to be made by managers in their budgets, for example, the rate of inflation, key exchange tares, ect.
The name and location of the person to be contracted concerning any problems encountered in preparing budgetary plans. This will usually be the coordinator of the budget committee (the budget officer) and will probably be a senior accountant.
Sunday, January 9, 2011
The most commonly used measures of financial leverage are:
- Debt ratio.
L1 = D / (D+E) = D/V
Where D is value of debt, E is value of shareholders’ equity and V is value of total capital. D and E may be measured in terms of book value. The book value of equity is called net worth. Shareholder’s equity may be measured in terms of market value.
- Debt-equity ratio
L2 = D/E
- Interest coverage
L3 = EBIT/Interest
The first two measures of financial leverage can be expressed either in terms of book values or market values. The market value to financial leverage is theoretically more appropriate because market value reflects the current attitude of investors. But it is difficult to get reliable information on market values in practice. The market values of securities fluctuate quite frequently.
There is no difference between the first two measures of financial leverage in operational terms. They are related to each other in the following manner.
L1 = L2 / (1+L2) = (D/E) / (1+D)/E = D/V
L2 = L1 / (1-L1) = (D/V) / (1-D)/V = D/E
These relationships indicate that both these measures of financial leverage will rank companies in the same order. However, the first measure is more specific as its value will range between zeros to one. The value of the second measure may very from zero to any large number. The debt-equity ratio, as a measure of financial leverage, is more popular in practice. There is usually an accepted industry standard to which the company’s debt-equity ratio is compared. The company will be considered risky if its debt-equity ratio exceeds the industry standard. Financial institutions and banks also focus on debt-equity ratio in their lending decisions.
The first two measures of financial leverage are also measures of capital gearing. They are static in nature as they show the borrowing position of the company at a point of time. These measures, thus, fail to reflect the level of financial risk, which is inherent in the possible failure of the company to pay interest and repay debt.
The third measure of financial leverage, commonly known as coverage ratio, indicates the capacity of the company to meet fixed financial charges. The reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of the firm’s income gearing. Again by comparing the company’s coverage ratio with an accepted industry standard, investors can get an idea of financial risk. However, this measure suffers from certain limitations. First, to determine the company’s ability to meet fixed financial obligations, it is the cash flow information, which is relevant, not the reported earnings. During recessionary economic decisions, there can be wide disparity between the earnings and the net cash flows generated from operations. Second, this ratio, when calculated on past earnings, does not provide any guide regarding the future risk ness of the company. Third, it is only a measure of short-term liquidity rather than of leverage.
Friday, January 7, 2011
As stated earlier, a company can finance its investments by debt and equity. The company may also use preference capital. The rate of interest on debt is fixed irrespective of the company's rate of return on assets. The company has a legal binding to pay interest on debt. The rate of preference dividend is also fixed; but preference dividends are paid when the company earns profits. The ordinary shareholders are entitled to the residual income. That is, earnings after interest and taxes (less preference dividends) belong to them. The rate of the equity dividend is not fixed and depends on the dividend policy of a company.
The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners' equity in the capital structure, is described as financial leverage or gearing or trading on equity. The use of the term trading on equity is derived from the fact that it is the owner's equity that it is used as a basis to raise debt ; that is, the equity that is traded upon. The supplier of the debt has limited participation in the company's profit and, therefore, he will insist on protection in earnings and protection in values represented by ownership equity.
The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus or deficit will increase or decrease the return on the owners' equity. The rate of return on the owners' equity is leverage above or below the rate of return on total assets. For example, if a company borrows 100$ at 8% interest and invests it to earn 12% return, the balance of 4% after payment of interest will belong to the shareholders, and it constitutes the profit from financial leverage. On the other hand, if the company could earn only a return of 6% on 100$, the loss to the shareholders would be 2$ per annul. Thus, financial leverage at once provides the potentials of increasing the shareholders' earnings as well as creating the risks of loss to them. It is a double-edged sword. The following statement very well summarises the concept of financial leverage.
The role of financial leverage suggests a lesson in physics, and there might be some point in considering the rate of interest paid as the fulcrum used in applying forces through leverage. At least it suggests consideration of pertinent variables; the lower the interest rate, the greater will be the profit, and the less the chance of loss; the less amount borrowed the lower will be the profit or loss; also, the greater the borrowing, the greater the risk of unprofitable leverage and the greater the chance of gain.
Friday, December 31, 2010
The capital budgeting of a firm, it has to decide the way in which the capital projects will be financed. Every time the firm makes an investment decision, it is the same time making a financing decision also. For example, a decision to build a new plant or to buy a new machine implies specific way of financing that project. Should a firm employ equity or debt or credit? What are implies of the debt-equity mix? What is an appropriate mix of debt and equity?
Capital Structure Defined
The assets of a company can be financed either by increasing the owners' claims or the creditors claims. The owners' claims increase when the firm raises funds by issuing ordinary shares or by retaining the earnings; the creditors' claims increase by borrowing. The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firms capital expenditure, and therefore, the long-term claims are said to from the capital structure of the enterprise. The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid up share capital, share premium and reserves and surplus.
The financing or capital structure decisions is a significant managerial decision. It influences the shareholder's return and risk. Consequently, the market value of the share may be affected by the capital structure initially at the time of its promotion. Subsequently, whenever funds have to be raised to finance investments, a capital structure decision is involved. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. This decision will involve an analysis of the existing capital structure and the factors, which will govern the decision at present. The dividend decision, is, in a way, a financing decision. The company's policy to retain or distribute earnings affects the owners' claims. Shareholders' equity position is strengthened by retention of earnings. Thus, the dividend decision has a financing decision of the company may affect its debt-equity mix. The debt-equity mix has implications for the shareholders' earnings and risk, which in turn, will affect the cost of capital and the market value of the firm.
The management of a company should seek answers to the following questions while making the financing decision:
- How should the investment project be financed?
- Does the way in which the investment projects are financed matters?
- How does financing affect the shareholders' risk, return and value?
- Does there exist an optimum financing mix in terms of the maximum value of the firms shareholders?
- Can be optimum financing mix be determined in practice for a company?
- What fact ores in practice should a company consider in designing its financing policy?
Sunday, December 26, 2010
- The most important aspects of the capital budgeting process are identification, evaluation, authorisation and control
- Identification of investment ideas is the most critical aspect of the investment process, and should be guided by the overall strategic considerations of the firm. It needs appropriate managerial focus. Each potential idea should be developed into a project.
- A company should have system for estimating cash flows of projects. A multi-disciplinary team of managers should be assigned the task of developing cash flow estimates.
- Once cash flows have been estimated, projects should be evaluated to determine their profitability. Evaluation criteria chosen should correctly rank the projects.
- Once the projects have been selected they should be monitored and controlled to ensure that they are properly implemented and estimates are realised. Proper authority should exist for capital spending. The top management may supervise critical projects involving large sums of money. The capital spending authority may be delegated subject to adequate control and accountability.
- A company should have a sound capital budgeting and reporting system for this purpose. Based on the comparison of actual and expected performance, projects should be reappraised and remedial action should be taken.
- Companies in practice have a total capital budgeting system including processes for project identification, development, evaluation, authorisation and control. Most companies prepare a capital budget, and integrate it with the overall budgeting system.
- Companies are increasingly using discounted cash flow techniques, but payback remains universally popular for its simplicity and focus on recovery of funds and liquidity.
- In practice, judgement and qualitative factors also play an important role in investment analysis. A number of companies pay more attention to strategy in the overall selection of projects.
- Strategic investments are large-scale expansion or diversification projects, and they involve either by their nature or by managerial actions valuable options. Such options include right to expand, right to abandon, right to delay, right to build new businesses, or right to disinvest or harvest.
- Real options create managerial flexibility and commitment. In principle, they can be valued in the same way as financial options are valued. But in practice, it is difficult to get all input parameters for valuing real options. Since large number of real assets are not trade in the market, it is quite difficult therefore to get information on the value of the underlying assets and the volatility.
- Since real options are valuable, managers must identify them, value them, monitor them and exercise them when it is optimal to do so. Managers generally strive to create flexibility and commitment by building real options into investment projects.