41 Prepare Financial Budgets

Now that you have developed an understanding of operating budgets, let’s turn to the other primary component of the master budget: financial budgets. Preparing financial budgets involves examining the expectations for financing the operations of the business and planning for the cash needs of the organization. The budget helps estimate the source, amount, and timing of cash collection and cash payments as well as determine if and when additional financing is needed or debt can be paid.

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Individual Financial Budgets

Preparing a financial budget first requires preparing the capital asset budget, the cash budgets, and the budgeted balance sheet. The capital asset budget represents a significant investment in cash, and the amount is carried to the cash budget. Therefore, it needs to be prepared before the cash budget. If the cash will not be available, the capital asset budget can be adjusted and, again, carried to the cash budget.

When the budgets are complete, the beginning and ending balance from the cash budget, changes in financing, and changes in equity are shown on the budgeted balance sheet.


Capital Asset Budget

The capital asset budget, also called the capital expenditure budget, shows the company’s plans to invest in long-term assets. Some assets, such as computers, must be replaced every few years, while other assets, such as manufacturing equipment, are purchased very infrequently. Some assets can be purchased with cash, whereas others may require a loan. Budgeting for these types of expenditures requires long-range planning because the purchases affect cash flows in current and future periods and affect the income statement due to depreciation and interest expenses.


Cash Budget

The cash budget is the combined budget of all inflows and outflows of cash. It should be divided into the shortest time period possible, so management can be quickly made aware of potential problems resulting from fluctuations in cash flow. One goal of this budget is to anticipate the timing of cash inflows and outflows, which allows a company to try to avoid a decrease in the cash balance due to paying out more cash than it receives. In order to provide timely feedback and alert management to short-term cash needs, the cash flow budget is commonly geared toward monthly or quarterly figures. (Figure) shows how the other budgets tie into the cash budget.


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When the cash collections schedule is made for sales, management must account for other potential cash collections such as cash received from the sale of equipment or the issuance of stock. These are listed individually in the cash inflows portion of the cash budget.

The cash payments schedule, on the other hand, shows when cash will be used to pay for Accounts Payable. One such example are direct material purchases, which originates from the direct materials budget. When the production budget is determined from the sales, management prepares the direct materials budget to determine when and how much material needs to be ordered. Orders for materials take place throughout the quarter, and payments for the purchases are made at different intervals from the orders. A schedule of cash payments is similar to the cash collections schedule, except that it accounts for the company’s purchases instead of the company’s sales. The information from the cash payments schedule feeds into the cash budget.

Big Bad Bikes typically pays half of its purchases in the quarter of purchase. The remaining half is paid in the following quarter, so payments in the first quarter include payments for purchases made during the first quarter as well as half of the purchases for the preceding quarter. (Figure) shows when each quarter’s purchases will be paid. Additionally, the balance of purchases in Accounts Payable can be reconciled by using information from the cash payment schedule as follows:

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The first quarter of the year plans cash payments from the prior quarter as well as the current quarter. Again, since the trainers are a new product, in this example, there are no purchases in the preceding quarter, and the payments are $0. (Figure).


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While the cash payments schedule is made for purchases of material on account, there are other outflows of cash for the company, and management must estimate all other cash payments for the year. Typically, this includes the manufacturing overhead budget, the sales and administrative budget, the capital asset budget, and any other potential payments of cash. Since depreciation is an expense not requiring cash, the cash budget includes the amount from the budgets less depreciation. Cash payments are listed on the cash budget following cash receipts. (Figure) shows the major components of the cash budget.


The cash budget totals the cash receipts and adds it to the beginning cash balance to determine the available cash. From the available cash, the cash payments are subtracted to compute the net cash excess or deficiency of cash for the quarter. This amount is the potential ending cash balance. Organizations typically require a minimum cash balance. If the potential ending cash balance does not meet the minimum amount, management must plan to acquire financing to reach that amount. If the potential ending cash balance exceeds the minimum cash balance, the excess amount may be used to pay any financing loans and interest.

Big Bad Bikes has a minimum cash balance requirement of $10,000 and has a line of credit available for an interest rate of 19%. They also plan to issue additional capital stock for $5,000 in the first quarter, to pay taxes of $1,000 during each quarter, and to purchase a copier for $8,500 cash in the third quarter. The beginning cash balance for Big Bad Bikes is $13,000, which can be used to create the cash budget shown in (Figure).


Budgeted Balance SheetThe cash budget shows how cash changes from the beginning of the year to the end of the year, and the ending cash balance is the amount shown on the budgeted balance sheet. The budgeted balance sheet is the estimated assets, liabilities, and equities that the company would have at the end of the year if their performance were to meet its expectations. (Figure) shows a list of the most common changes to the balance sheet and where the information is derived.

Common Changes in the Budgeted Balance SheetInformation SourceBalance Sheet Change
Cash balanceending cash balance from the cash budget
Accounts Receivable balanceuncollected receivables from the cash collections schedule
Inventoryending balance in inventory as shown from calculations to create the income statement
Machinery & Equipmentending balance in the capital asset budget
Accounts Payableunpaid purchases from the cash payments schedule

Other balance sheet changes throughout the year are reflected in the income statement and statement of cash flows. For example, the beginning cash balance of Accounts Receivable plus the sales, less the cash collected results in the ending balance of Accounts Receivable. A similar formula is used to compute the ending balance in Accounts Payable. Other budgets and information such as the capital asset budget, depreciation, and financing loans are used as well.

To explain how to use a budgeted balance sheet, let’s return to Big Bad Bikes. For simplicity, assume that they did not have accounts receivable or payable at the beginning of the year. They also incurred and paid back their financing during the year, so there is no ending debt. However, the cash budget shows cash inflows and outflows not related to sales or the purchase of materials. The company’s capital assets increased by $8,500 from the copier purchase, and their common stock increased by $5,000 from the additional issue as shown in (Figure).


Though there seem to be many budgets, they all fit together like a puzzle to create an overall picture of how a company expects the upcoming business year to look. (Figure) detailed the components of the master budget, and can be used to summarize the budget process. All budgets begin with the sales budget. This budget estimates the number of units that need to be manufactured and precedes the production budget. The production budget (refer to (Figure)) provides the necessary information for the budgets needed to plan how many units will be produced. Knowing how many units need to be produced from the production budget, the direct materials budget, direct labor budget, and the manufacturing overhead budget are all prepared. The sales and administrative budget is a nonmanufacturing budget that relies on the sales estimates to pay commissions and other variable expenses. The sales and expenses estimated in all of these budgets are used to develop a budgeted income statement.

The estimated sales information is used to prepare the cash collections schedule, and the direct materials budget is used to prepare the cash payment schedule. The cash receipts and cash payments budget are combined with the direct labor budget, the manufacturing overhead budget, the sales and administrative budget, and the capital assets budget to develop the cash budget. Finally, all the information is used to flow to the budgeted balance sheet.


Molly Malone is starting her own company in which she will produce and sell Molly’s Macaroons. Molly is trying to learn about the budget process as she puts her business plan together. Help Molly by explaining the optimal order for preparing the following budgets and schedules and why this is the optimal order.

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budgeted balance sheetbudgeted income statementcapital asset budgetcash budgetcash collections schedulecash payments scheduledirect materials budgetdirect labor budgetmaster budgetmanufacturing overheadproduction budgetsales budgetselling and administrative budget

Solution

A master budget always begins with the sales budget must be prepared first as this determines the number of units that will need to be produced. The next step would be to create the production budget, which helps determine the number of units that will need to be produced each period to meet sales goals. Once Molly knows how many units she will need to produce, she will need to budget the costs associated with those units, which will require her to create the direct materials budget, the direct labor budget and the manufacturing overhead budget. But Molly will have costs other than manufacturing costs so she will need to create a selling and administrative expenses budget. Molly will need to determine what are her capital asset needs and budget for those. Now that Molly has all her revenues budgeted and her costs budgeted, she can determine her budgeted cash inflows and outflows by putting together the cash schedules that lead to the cash budget. Molly will then need to create a cash collections schedule and a cash payments schedule and that information, along with the cash inflow and outflow information from her other budgets, will allow her to create her cash budget. Once Molly has completed her cash budget she will be able to put together her budgeted income statement and budgeted balance sheet.