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Financial Planning & Budgeting

You must have a sound understanding of the principles of finance to keep your business profitable.
 It starts with maintenance of financial records and preparation of accounts and statements.
 Analyse your business performance by looking at sales figures and costs such as materials and wages.
 Financial planning for downturns and the business cycle.
 Manage cash flow and your working capital requirements.

The Link between the Business Plan and the Budget
A budget can be defined as "a financial statement", prepared for a specific accounting period (typically a year), containing the plans and policies to be pursued during that period.

The main purposes of a budget are:
 To monitor the business and managerial performance
 To forecast the period's trading
 To assist with cost control.

Generally, a functional budget is prepared for each functional area within a business (e.g. call-centre, marketing, production, research and development, finance and administration). In addition, it is also normal to produce a "capital budget" detailing the capital investment required for the period, a "cash flow budget", a "stock budget" and a "master budget", which includes the budgeted profit and loss account and balance sheet.

Preparing the Budget
A typical business plan looks up to three years forward and it is normal for the first year of the plan to be set out in considerable detail. This one-year plan, or budget, will be prepared in such a way that progress can be regularly monitored (usually monthly) by checking the variance between the actual performance and the budget, which will be phased to take account of seasonal variations.

The budget will show financial figures (cash, profit/loss working capital, etc) and also non-financial items such as personnel numbers, output, order book, etc. Budgets can be produced for units, departments and products as well as for the total organisation.

Budgets for the forthcoming period are usually produced before the end of the current period. It is common practice for revised forecasts to be produced during the year as circumstances change.

Key Purposes of Budgets
 A method of planning the use of resources.
 A vehicle for forecasting.
 Budgets allow the business to establish targets and standards which employees are motivated to achieve.
 Budgets help to evaluate performance against the budget. They provide a framework for evaluating the performance of managers in meeting individual and department targets.
 It enables a business to motivate staff and improve efficiency.
 A means of controlling the activities of various departments within the business.
 A means of motivating individuals to achieve performance levels agreed and set.
 A means of communicating the objectives and aspirations of senior management.
 Management can measure progress against the original plan, making adjustments where necessary.
 It controls income and expenditure and informs remedial action when there is deviation from the plan.

Incremental budget
Budgets are prepared using a previous period’s budget or actual performance as a basis. Incremental amounts are changed or added for the new budget period.
The allocation of resources is based upon allocations from the previous period.

The budget is stable and change is gradual. Managers can operate their departments on a consistent basis. The system is relatively simple to operate and easy to understand. Co-ordination between budgets is easier to achieve.

Zero based budget
ZBB starts each budget period afresh-not based on historical data. Budgets are zero unless managers make the case for resources and the relevant manager must justify the whole of the budget allocation.

Each plan of action has to be justified in terms of total cost involved and total benefit to accrue, with no reference to past activities. Zero based budgets are designed to prevent budgets creeping up each year.

Working capital - why a business needs it
Working capital is the cash needed to pay for the day to day operations of the business.

In other words, working capital is needed by the business to:
 Pay suppliers and other creditors
 Pay employees
 Pay for stocks
 Allow for customers who are allowed to buy now, but pay later (so-called “trade debtors”)

Different industries have different working capital profiles, reflecting their methods of doing business and what they are selling.

Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses.

Businesses that exist to sell completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress.

Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature.

Larger companies may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a track record of credit worthiness) may be required to pay their suppliers immediately.

What is crucially important, therefore, is that a business actively manages working capital. It is the timing of cash flows which can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not necessarily mean that there is cash coming into and out of the business.

Working capital needs also fluctuate during the year. The amount of funds tied up in working capital would not typically be a constant figure throughout the year. Only in the most unusual of businesses would there be a constant need for working capital funding. For most businesses there would be weekly fluctuations.
Many businesses operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others. Some businesses will receive their payment at certain times of the year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as “seasonality” of cash flow. For example, travel agents have peak sales in certain times of the year.

The more permanent needs (fixed assets and the fixed element of working capital) should be financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and repaid easily and at short notice.

The working capital cycle
Here are the main types of cash inflow and outflow in a typical business:

Inflows Outflows
Cash sales to customers Purchasing finished goods for re-sale
Receipts from customers who were allowed to buy on
credit (trade debtors)
Purchasing raw materials and other components
needed for the manufacturing of the final product
Interest on bank and other balances Paying salaries and wages and other operating expenses
Proceeds from sale of fixed assets Purchasing fixed assets
Investment by shareholders Paying the interest on, or repayment of loans
Paying taxes

Cash flow can be described as a cycle:
 The business uses cash to acquire resources (assets such as stocks)
 The resources are put to work and goods and services produced. These are then sold to customers
 Some customers pay in cash (great), but others ask for time to pay. Eventually they pay and these funds are used to settle any liabilities of the business (e.g. pay suppliers)
 And so the cycle repeats

Hopefully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But not necessarily, and if management don’t carefully monitor cash flow and take corrective action when necessary, a business may find itself sinking into trouble.

There are many advantages to a business that actively manages its cash flow:
 It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact
 It can plan ahead with more confidence. Management are in better control of the business and can make informed decisions for future development and expansion
 It can reduce its dependence on the bank and save interest charges
 It can identify surpluses which can be invested to earn interest

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