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BALANCE SHEET AND CASH
You may wonder how a balance sheet is important to a small company since the primary role of such a company is to make a profit, which implies that the profit and loss statement should get more attention. The reason is that the balance sheet is a logical supplement to an operating budget and its benefits are more profound and lasting. The main objective is to plan a mix of assets, liabilities, and equity that will:
• Permit an unrestrained operation of the business with the least investment
• Maintain enough reserve strength to cushion economic recessions
• Provide an adequate return on investment
• Provide optimal financing methods
• Use debt or equity to raise additional funds
CUSTOMER NEEDS
The customer in this case is usually a finance manager in the corporate office. This is the individual who will be creating the detail and/or entering the data into a budget form. The needs of this individual are based on the detail and accuracy required for these two statements. If the customer wants highly accurate and detailed data, then it is best to have a computer system calculate these statements based on set assump- tions. However, if these statements are not given much consideration, then a simple input form can be created without much detail.
DIMENSIONS AND CHART OF ACCOUNT CONSIDERATIONS
There are very few, if any, considerations for the cash flow and balance sheet. Typ- ically, there will probably be few line-item details and you will budget at rollup ac- counts. An example of an account that you might want to budget with line-item details are loans on which you make periodic payments.
TOP-DOWN OR BOTTOM-UP APPROACH
There is no need to have a balance sheet or a cash flow statement budgeted by all departments and units, because these two statements are rarely looked at on a de- partmental level. However, you may want to calculate each account by this level;
therefore, these two statements should be prepared using the top-down approach, and all assumptions should be determined by the corporate office. Only companies that review their managers by their ability to generate free cash flow or a certain re- turn on investment should budget cash flow and balance sheet by department.
DRIVERS
The cash flow statement is broken into three activities:
1. Cash from operating activities. This relates net income to the way cash is gen- erated in the operation of the company. It portrays the actual cash receipts and
payments made by the company in its normal business operations and specifies how successfully this cash is utilized.
2. Cash from investing activities. This allows the company to analyze the direction of the organization’s plan on the plant and equipment categories and its net work- ing capital.
3. Cash from financing activities. This pinpoints the firm’s capacity to raise cash in financial markets and shows the ease with which it can pay debts and interest.
ASSUMPTIONS
We are going to assume that the cash flow is calculated from the balance sheet and the income statement budget; therefore, all assumptions will be solely for the balance sheet budget. Use this list of assumptions to help you complete your balance sheet and cash flow budget:
• Accounts receivable. Assume the average days outstanding to calculate accounts receivable per month. Typically, only retail companies do not have any accounts receivable, and most companies do not receive all of the cash from sales within 30 days. Therefore, companies will need to determine when they will receive the cash from their sales in terms of the number of days. Average days outstand- ing is calculated by taking the accounts receivable times 365 days divided by the sales for the year. It is imperative that this assumption be made based on historical data. Another option is to estimate what percentage of a month’s sales will be collected in each subsequent month. For example, your company may re- ceive 5 percent of sales in the current month, 55 percent in the subsequent month, 30 percent two months later, and 10 percent three months later.
• Prepaid expenses. Examples are rent, interest, and insurance. These are usually budgeted at a constant amount or are increased as a percentage of sales.
• Fixed assets. These are calculated as part of capital expenditures.
• Other assets/liabilities. These will vary for each company. Some examples in- clude goodwill and deferred charges. It is difficult to cover each possibility, so usually this will be based on the previous year’s data. For example, goodwill can be determined by taking the previous year’s amount and increase/decrease it based on the amortization for the coming year.
• Notes payable. These are dependent on the credit of the company because they may include short-term notes and revolving lines of credits. Whether a bank loans your company money or offers a line of credit is based on past earnings, current market position, demand for your products and services, competition, the economy, and your company’s capability to control costs. Notes payable is also dependent on leverage, which is based on the amount of debt that your com- pany has. The more leverage, the more debt; and more leverage implies more risk. Therefore, you will need to consider if your company will be borrowing more or less in the future.
• Accounts payable. It is necessary to estimate a normal payment cycle since each vendor may have a different payment contract with your company. You can cal- culate an average payment period by taking the accounts payable multiplied by 365 days and divided by the annual expenses. Another option is to separate each expense into its own category and assign it an average payment period.
• Accruals and other liabilities. Accrued liabilities arise when costs are incurred in one period but are not paid until a later period. Employees are a good exam- ple of an accrued liability because at the end of a month the company will still owe employees part of their wages. You can budget these in three different ways:
unchanged throughout the year; as a percentage of sales or total operation ex- penses; or as a percentage of total payroll expenses.
• Equity. The objective of every company is to expand profits and grow, and all companies need more equity to do this. Some companies are able to finance the growth through retained earnings, but many sell additional stock to private in- vestors or on the public market. Your organization has a few options for increas- ing equity.
• Limit sales growth. When demand increases to a point above your company’s capability, it can raise prices or lay off salespeople until the growth level is right. This is rarely an option for most companies, however.
• Keep dividends low. Investors will be happy with this as long as the stock price is rising, but it will cause problems if the competitors are giving dividends.
• Sell more stock. Most successful companies use this tactic at some point.
• Increase financial leverage. To borrow more will increase the risk of the com- pany, so this choice must be investigated and reviewed.
SPECIAL CONSIDERATIONS
You first need to decide whether cash flow will be determined from the balance sheet and income statement or will be prepared separately. If you are going to calcu- late the cash flow, then the cash line on the balance sheet will be the plug item. In essence, it is the amount that enables the balance sheet to balance. So using this pro- cedure you will calculate and work out all other accounts before determining the cash account. If a cash budget is prepared beforehand, then this amount is trans- ferred to the balance sheet.
USERS
Most likely, the users will be executives. Thus, the input form should be fairly straightforward, with lines for each of the major accounts, such as cash, accounts re- ceivable, and accounts payable. The balance sheet should be the only area on which the executives will enter numbers; the cash flow will be calculated from the income statement and the balance sheet. Or the executives can enter the assumptions and have a computer program automatically calculate the balance sheet and cash flow.
BEST PRACTICES
Ideally, the cash flow will be determined from both the balance sheet and the income statement. The fill account, to make the balance sheet balance, should comprise the cash and cash equivalents. Therefore, best practices will focus on the other line items on the balance sheet. It is best to do top-down for your subsidiaries/departments and at a rollup level for the accounts. For example, there is no need to budget for each different type of prepaid expense, whereas it is helpful to budget a total prepaid expense.
The first account to determine is accounts receivable. Two ways were discussed earlier for determining accounts receivable, but one is simpler: Determine the days outstanding. After determining the number of days, you will be able to calculate the amount that the company’s accounts receivable will change each month.
For inventory, you can take a percentage of the subsequent month’s cost of sales.
Prepaid expenses should be a set amount or a percentage of sales. The fixed assets will be determined during the capital budgeting stage, described previously. Other assets are difficult to generalize, but they may be unchanged or calculated as a percentage of sales.
The first liability is generally accounts/notes payable. Typically, the accounts payable is determined from the inventory purchased. You can calculate this as you would accounts receivable. Calculate the days payable outstanding to determine the amount of payables paid out each month. Payables are typically calculated from the inventory. Notes payable may be consistent if you are only making interest pay- ments and your company is not borrowing any more money, but that is unlikely. You will need to make an assumption about the amount to be borrowed or paid off in the coming year based on the company’s growth and leverage. Accruals and other lia- bilities should be calculated as a percentage of total operating expenses or payroll, or it should stay unchanged throughout the year. Existing loans can be calculated from the actual amortization schedule.
The equity accounts will be based on the company’s growth potential. Your company will need to determine if it is going to sell more stock, increase or decrease dividends, or increase leverage. Many assumptions have to be made for the balance sheet; however, because you have made many assumptions during the entire budget process, and if your assumptions are reasonable and based on research, then your balance sheet/cash flow will be useful.
In the future, there will be a new approach to cash flow and balance sheet bud- geting when the technology that is an offshoot of the current best practices becomes available. For example, you will have categories called sales, purchases, rent, and taxes, which are used solely for your income statement accounts. Within sales, you will set up average receivable terms for 0, 30, 60, and 90 days. You will estimate what percentage will be paid each month, just like previously. The system will then au- tomatically calculate the cash flow and balance sheet associated with the sales—
cash and accounts receivable.
Exhibit 14.1 shows that sales for January are $100,000 and that payment terms are 5 percent for the first month. Therefore, cash flow increases by $5,000 and
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Currency: USD Opening BalanceChange in Cash FlowBalance Sheet JanFebMarAprJanFebMar Cash50,0005,00066,250102,500138,75055,000121,250223,750 Account Receivable100,00095,00058,75047,50036,250195,000253,750301,250 Income Statement Payment TermsJanFebMarApr 0 Days5%Sales100,000125,000150,000175,000 30 Days60% 60 Days20% 90 Days15% EXHIBIT 14.1Integrated Profit and Loss, Balance Sheet, and Cash Flow Model
accounts receivable increases by $95,000. In February, the sales are $125,000, which implies that cash will increase by $66,250 (5 percent ×$125,000 + 60 percent ×
$100,000). The remainder will then go into accounts receivable for February. This will continue for all sales. This format will also be set up for payment terms. Rent will, however, be different because the cash may be paid out six months early or prior to each month. Taxes will be calculated based on net income, but usually will be paid out every quarter.
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