Chapter 3

 

Budgeted Financial Statements

 

Based on the detail budgets we have prepared (Exhibits 1 thru 8), we can finalize our budgets in the form of a Budgeted Income Statement. A few new line items are added to account for non-operating items, such as income received on investments and financing costs. The Finance and Tax Departments will assist in estimating items like financing expenses and income tax expenses. The Budgeted Income Statement will pull together all revenue and expense estimates from our previously prepared detail budgets.

 

EXHIBIT 9 - BUDGETED INCOME STATEMENT

 

Revenues (Exhibit 1)                     $720,000

Less Cost of Goods Sold (Exh 6)     (144,125)

Gross Profit                                   575,875

Less Marketing (Exhibit 7)               (135,500)

Less G & A (Exhibit 8)                             (297,500)

Operating Income                           142,875

Less Interest on Debt                               (   8,000)

Income Before Taxes                      134,875

Taxes @ 37.5%                                     (  50,578)

Net Income                                 $   84,297     

 

 

EXAMPLE 2 - BUDGETED INCOME STATEMENT

 

Halton Company has compiled the following information:

Planned sales are 50,000 units at a price of $ 110.00 per unit.

Beginning Inventory consists of 5,000 units at a cost of $ 60.00 per unit.

Planned production is 55,000 units with the following production cost:

    Direct Materials are $ 18.50 per unit

    Direct Labor required is 4 hours per unit @ $ 12.00 per hour

    Overhead is estimated at 20% of Direct Labor Cost

Desired Ending Inventory is 6,000 units under the LIFO Method.

Marketing Expenses are budgeted at $ 350,000

General & Administrative Expenses are budgeted at $ 400,000

 

< - - - - - - - - - - - - - - - Budgeted Income Statement - - - - - - - - - - - - - - >

 

Sales (50,000 x $ 110)                                                        $ 5,500,000

Less Cost of Goods Sold:

   Beginning Inventory (5,000 x $ 60.00)              $    300,000

   Direct Materials (55,000 x $ 18.50)                     1,017,500

   Direct Labor (55,000 x 4 hours x $ 12.00)            2,640,000

   Overhead ($ 2,640,000 x .20)                               528,000

   Cost of Available Sales                           4,485,500

   Less Ending Inventory (1)                      (   380,500)

   Cost of Goods Sold                                                 (4,105,000)

Gross Profits                                                            1,395,000

Less Operating Expenses:

   Marketing Expenses                                                         (   350,000)

   General & Administrative                                          (   400,000)

Net Income                                                              $  645,000

           

(1) Under LIFO, last costs in are: $ 1,017,500 + $ 2,640,000 +  $ 528,000 = $ 4,185,500 / 55,000 = $ 76.10 x 5,000 = $ 380,500.

 

Now that we have a Budgeted Income Statement, we can prepare a Budgeted Balance Sheet. The Budgeted Balance Sheet will provide us with an estimate of how much external financing is required to support our estimated sales.

The main link between the Income Statement and the Balance Sheet is Retained Earnings. Therefore, preparation of the Budgeted Balance Sheet starts with an estimate of the ending balance for Retained Earnings. In order to estimate ending Retained Earnings, we need to project future dividends based on current dividend policies and what management expects to pay in the next planning period.

 

EXHIBIT 10 - ESTIMATED RETAINED EARNINGS

 

Beginning Balance                         $        270,000

Budgeted Net Income (Exhibit 9)                84,297

Less Estimated Dividends                (55,000)

Ending Retained Earnings               $ 299,297     

Next, we need to account for the acquisition of fixed assets. As a business depletes its asset base, it must re-invest to sustain assets which are the basis for generating revenues. For example, do we need to purchase new machinery or computer equipment? Do we plan to expand our production facilities? Operating personnel and upper-level management will decide on future capital spending. Future capital expenditures are summarized on the Capital Expenditures Budget.

 

EXHIBIT 11 - CAPITAL EXPENDITURES BUDGET

 

Purchase New Office Equipment         $     16,000

Replace Leather Cutting Machine       8,500

Total Capital Expenditures               $ 24,500     

 

Based on the beginning balance in assets and the budget for capital assets (Exhibit 11), we can estimate an ending asset balance for the Budgeted Balance Sheet.

 

EXHIBIT 12 - CHANGE IN FIXED ASSETS

 

Beginning Balance                        $ 886,000

New Acquisitions (Exhibit 11)                   24,500

Less Depreciation for the Year                 (33,500)

Ending Fixed Assets                               $ 877,000      

 

We will assume that liabilities and interest expense will remain the same. However, after we have determined our level of external financing, we will need to revise these amounts. Additionally, we need to analyze trends and ratios in order to ascertain accounts that do not fluctuate with sales. For example, prepaid expense is a current asset that has little to do with sales.

 

Since the Balance Sheet is a year-end estimate, it assumes that all other estimates have been met. In a world of rapid change, annual forecasts are rarely close. Therefore, we will simplify our preparation of the Budgeted Balance Sheet by relying on relationships. Stable relationships over the last five years are particularly helpful. The Budgeted Balance Sheet will show either a surplus (excess financing over assets) or a deficit (additional financing needed to cover assets). This difference is derived from the Accounting Equation: Assets = Liabilities + Equity.

 

EXHIBIT 13 - BUDGETED BALANCE SHEET

 

Cash                                         $  36,000    5% of Sales

Accounts Receivable                     86,400           12% of Sales

Inventory                                   50,400     7% of Sales

Prepaid Expenses                         11,000    5 year trend analysis

Fixed Assets                                  877,000    Exhibit 12

                   Total Assets                   $1,060,800

                  

Accounts Payable                        79,200     11% of Sales

Current Portion of LT Debt                6,000      Principal Paid

Long Term Debt                           60,000      Subject to Revision

                   Total Liabilities                               145,200

Common Stock                                      450,000     unchanged

Retained Earnings                         299,297     Exhibit 10

                   Total Equity                      749,297

                   Total Liab & Equity                894,497

         

External Financing Required          $ 166,303       

 

We also can calculate External Financing Required (EFR) based on the relationships between assets, liabilities, and sales. The following formula can be used:

 

EFR = (A / S x ?Sales) - (L / S x  ?Sales) - (PM x FS x (1 - d))

A / S: Assets that change given a change in sales, expressed as a percentage of sales.

?Sales: Change in sales between the last reporting period and the forecasted sales.

L / S: Liabilities that change given a change in sales, expressed as a percentage of sales.

PM: Profit Margin on Sales; i.e. net income / sales.

FS: Forecasted Sales

(1 - d): Percent of earnings retained after paying out dividends; d is the dividend payout ratio.

 

EXAMPLE 3 - CALCULATE EXTERNAL FINANCING NEEDED

 

Falcon Company has compiled the following information:

 

Assets of $ 900 (mostly current assets) from the last period change with sales. Liabilities of $ 300 from the last period change with sales. Sales were $ 3,000 for the last period. Forecasted sales are $ 3,900. Profit margins on sales are 6% and 40% of earnings are paid-out as dividends.

 

A / S = $ 900 / $ 3,000 = .30

L / S = $ 300 / $ 3,000 = .10

Change in Sales = $ 3,900 - $ 3,000 = $ 900        

EFR = .30($ 900) - .10($ 900) - .06($3,900)(1-.40)  =   $ 270 - $ 90 - $ 140.4 = $ 39.6

 

EXAMPLE 4 - PREPARE BUDGETED BALANCE SHEET

 

Gilmer Company has compiled the following information:

 

* Sales for the last reporting period were $ 600,000

* Projected sales are $ 800,000

* Profit Ratio is 5% of sales

* Dividend Payout Ratio is 40%

* Current Balance in Retained Earnings is $ 200,000

* Cash as a % of sales is 4%

* Accounts Receivable as a % of sales 10%

* Inventory as a % of sales is 30%

* Net Fixed Assets are budgeted at $ 300,000

* Accounts Payable as a % of sales is 7%

* Accrued Liabilities as a % of sales is 15%

* Common Stock will remain at $ 220,000

 

                                        Budgeted Balance Sheet

 

Cash ($ 800,000 x .04)                                     $     32,000

Accounts Receivable ($ 800,000 x .10)                       80,000

Inventory ($ 800,000 x .30)                          240,000

Net Fixed Assets                                        300,000

        Total Assets                                 $   652,000

 

Accounts Payable ($ 800,000 x .07)                   $     56,000

Accrued Liabilities ($ 800,000 x .15)                        120,000

Common Stock                                                     220,000

Retained Earnings (1)

       Total Liabilities & Equity                                  620,000

                Total Additional Financing Required            32,000

                 Total Liabilities & Equity after financing        $   652,000   

 

(1): Beginning Balance                            $ 200,000

      Increase for New Income:

      $ 800,000 x .05 (profit margin)                40,000

      Less Dividends:

      .40 x $ 40,000 Net Income                    (16,000)

      Ending Balance                      $ 224,000

 

After we have prepared budgeted financial statements, it is very important to carefully review these statements with management. For example, can we truly expect to raise $ 166,303 in capital as indicated in Exhibit 13? Will the budgeted financial statements meet the expectations of shareholders? Several critical questions must be asked before we finalize our budgeted financial statements.

 

Additionally, our budgets were prepared on an annual basis. Many unplanned events can take place during the year, making our annual budgets extremely inaccurate. Therefore, financial planning is often improved by simply forecasting on a monthly or quarterly basis as opposed to an annual basis.

The Cash Budget

 

A good example of short-term financial planning is the Cash Budget. The Cash Budget is an estimate of future cash inflows and outflows. Cash Budgets are often included with the Budgeted Balance Sheet. However, it should be noted that Cash Budgets are not widely used as a general forecasting tool since they are specific to one account, namely cash. Instead, Cash Budgets are often used by Cash Managers and Treasury personnel for managing cash.

We can use our previous forecasts to help us prepare a Cash Budget. For example, we can get an idea of payable disbursements for manufacturing by looking at the Materials Budget (Exhibit 3), Labor Budget (Exhibit 4), and the Overhead Budget (Exhibit 5). We can start preparing a Cash Budget by simply looking at our stable cash flow patterns, such as accounts receivable, accounts payable, payroll, etc. We also have several predictable transactions, such as insurance payments, loan payments, etc.

 

EXHIBIT 14 - CASH BUDGET FOR JANUARY

 

Beginning Cash Balance                                              $       28,000

Cash Collections on Sales (60 day lag)               $          47,000

Sold old machine in January                       3,000

Investment Revenues                                         2,000

                   Total Cash Inflows                       52,000

 

Disbursements for Manufacturing (30 day lag)  12,400

Marketing Expenses                                10,000

General & Administrative Expenses            26,000

Capital Expenditures                                  - 0 -

Repayments on Debt                                   750

Debt Interest Payments                                         450

Dividend Payments                                     - 0 -

Taxes Paid                                               - 0 -

                   Total Cash Outflows                     49,600

                   Net Cash Inflow (Outflow)               2,400                     2,400

Ending Cash Balance                                                  30,400

Minimum Desired Cash Balance                                     10,000

Cash Surplus or (Deficit)                                             $ 20,400