You have just been asked by your Managing Director to attend a meeting next week to set in motion the preparation of the annual budget for your department and the organisation as a whole. Also, in the course of your conversation the Managing Director has mentioned that the company is seeking to raise finance for a substantial capital investment opportunity that has arisen recently.
You are required to outline your understanding of the budget process and also make some suggestions as to how the company would attempt to raise finance for the proposed investment. (60 Marks)
Evaluate the need for companies to maintain an adequate cash-flow and discuss how you would attempt to measure one company’s performance against another with the use of ratios. (20 Marks)
Discuss briefly, in your opinion, what the main causes of the current economic problems in
Ireland are, and what steps should be taken to improve the economy.
(20 Marks)
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 3
Budgeting
Budgeting is one of the most important tasks undertaken in any organisation, whether it is a public or private company, a not-for-profit organisation, or any other group which must control amounts of cash or funds.
Budgeting is an integral part of the overall direction in which a business is going.
Any company, be it a start-up operation, or a long-established business; will implement a business plan to guide the course of their actions.
Business plans generally involve:
Identifying Objectives
Searching for Possible Courses of Action
Selecting a Course of Action
Implementation of Long-Term Plans.
A companies objectives might be: to make a clear profit; to establish themselves in a market-place at the expense of profits, with profit as a long-term goal; expand into new market-places; to acquire a competing business and increase market-share, etc.
Once the company has decided on its’ objectives, they must search for a possible course of action.
Does the company try to sell their product to a new market? Do they develop new products for their existing customer base? Do they bring the new product to an emerging market? Any or all of these choices represent available courses of action.
After examining possible courses of action, the company must undertake various due-diligence studies to see if there will be return on any investment made. After detailed consideration, the company must select a course of action. By doing this, they are forming the basis of a business plan which will be a ‘rolling’ document, detailing their objectives and how they plan to achieve them.
Of course, having a business plan is one thing, but how does the company put the plan into action?
How do they decide how much of their limited funding to invest in each department or action? This process is budgeting. It is concerned with the implementation of a company’s long-term plans.
Budgets are generally annual documents (due to financial accounting principles). The budget will take the form of a document or agreed programme which will detail, based on studies, pastperformance, industry-standards, and other criteria; how much funding is available to a department or section, in order for them to meet the goals set out in the company business plan. The budget will be closely reviewed throughout each year, at least each month, and gives a good indication of whether a department is performing to expected levels, or it can give advance warning of potential funding issues, etc. By reviewing on a monthly basis, a company can make necessary adjustments to stay within budget. The budget is also a ‘rolling’ document – although it is prepared for a year, by
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 4 keeping tight controls on funds vs the budget, the accounting department and senior management are able to make predictions on how the following years’ performance might look.
Aside from controlling the funds available to a company, budgets also perform additional functions.
The budget can help refine and adjust plans, by comparing monthly performance against expected results. The budget can help coordinate activities of each department by forcing them to think of how their decisions could impact on the budget of another department.
The budget can serve as a medium through which the objectives of the organisation are communicated to each department.
The budget, through targets, can provide motivation to departments.
In a similar vein, budgets can also be used as a performance evaluation tool – a department can be assessed on their performance versus the budgeted results.
The budget can also be used as a control method – reviewed monthly – there is no reason for a department to run over budget.
Preparation:
The budget is not the sole domain of the finance team. In reality, the preparation of a budget will involve all departments within an organisation. The finance team will review each departments budget and combine within an overall company budget.
Budgets are prepared in accordance with the objectives of the company and the budget policies – before a department prepares a budget, they must be made aware of any policies or objectives which must be taken into consideration when preparing their section of the budget.
Those preparing the budget must take into account any limiting factors, such as market demand, production capacity, raw material availability, etc, before preparing a budget. These factors define the starting point of the budget process.
The first department to prepare their budget is generally the sales department, as this budget will drive the planning for the rest of the organisation. Granted – the sales budget is difficult to accurately predict, due to a lot of variable factors. The sales budget will generally be based on estimates, market-research, historical growth and other factors. Once the sales budget is in place, the rest of the departments, keeping this in mind, will produce their own plans for the coming financial year with regards to staff and head-count required, materials needed, space allocations, or any other resources that might be needed, etc.
Often-times – the preparation of a departmental-budget can be a negotiation where a settlement must ultimately be reached.
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 5
Once all the preliminary budgets have been produced, they are reviewed and combined, generally by the finance department into a working document, which will be presented to the management of the company before being reviewed and accepted.
The budget will be reviewed each month (or every 4 weeks, depending on the accounting system in operation) against actual results, and any adjustments can be made.
Raising Finance
If a company were to seek to raise finance for a new investment opportunity, there are various approaches that they may take.
To the layman without a financial back-ground – the obvious method which we immediately think of is a loan. In finance terms, this is known as debt finance and would generally involve the company offering something of value as security for the loan. In return for such credit, the company will pay interest to the financial institution. Examples of debt finance include short-term loan, overdraft, company mortgage, letter of credit, etc.
A company may also choose to seek an equity financier. In such a case, a ‘venture capital’ company or individual (business angel) would offer to invest money in a developing or promising company in return for equity or part-ownership of the company. Their investment is ‘unsecured’ and carries a higher risk; consequently, this form of finance will inevitably cost the company more than a loan, but there may be advantages associated with this avenue. Advantages might include – the investor may bring specific knowledge and experience which can help the company to grow; the amounts invested may be significantly higher than which might be available via debt-finance.
The company may also choose to ‘go public’ i.e. offer their shares for sale to the public on the stock exchange. This avenue is generally not available to developing companies as the acceptance criteria and obligations may not be achievable by a young start-up company.
A company experiencing cash-flow problems and with a need to raise capital, may choose to go down the route of factoring or invoice discounting. Both of these options are available to companies that provide credit, and are experiencing a lot of their cash-flow being tied up in debtor balances.
Through factoring, a company may receive up to 80% of the value of its’ sales invoices upfront. The factoring company will take control of the accounts receivable and collect the monies owed. The remaining 20% of the debt will be paid to the company when the monies have been collected. The factoring company will charge a fee for this service – either a percentage of the annual turnover, or a finance charge on the amount of funds advanced. Strict controls and checks are required before a finance company will offer factoring.
Invoice discounting is similar to factoring, but differs in that the original company will retain control of the accounts receivable process.
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 6
Although the above mentioned avenues are available to a company – they all involve the company paying for finance – either through interest charges or administration costs.
Ideally – a company should look internally to see what finance may be available within the company.
Often this is overlooked, but can be a valuable source of funds:
The company may choose to use either of 3 separate methods or a combination of them:
Retaining Profits – dividend policy
More efficient use of existing assets – release equity in owned property
Identify areas where cuts can be made within the organisation.
Through retaining profits, a company may communicate to its’ shareholders their intention to invest, and through consensus, agree to re-invest any profits into the business.
A company may also look to existing properties within the business and release equity by taking out mortgages based on the security and value of the property. A company may also choose to use the
‘Sale and leaseback’ arrangement where they give up the ownership of a property, but under agreement, lease the property back from the buyer.
Finally – a company might examine their operations internally to see if any cuts can be made, perhaps by outsourcing a particular function, or other methods and so raise additional working capital. In seeking to raise finance – a company will look at all options available and select the appropriate course of action – such decisions should be carefully considered and chosen with the company’s best interests at the forefront of the decision.
Cash-flow & Company Performance
Having an adequate cash-flow must be the single most important short-term goal in any company, particularly in today’s challenging environment. Cash-flow is the life-blood of an organisation – cash enables a company to pay its’ employees, it enables a company to pay its’ creditors, to purchase new material – basically to keep the organisation running. Some people may be of the opinion that profit is more important than cash, but a good analogy of the two items is the comparison between the need for food and water. If you compare cash to water – without cash (or water) a company or individual will only last a very short amount of time, whereas without profit (or food), a company or person might be able to last for some considerable amount of time, drawing on reserves which have been previously built up.
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 7
In comparing two companies, one must approach with an unbiased view, and base their comparison on information. The best source of this information is the company balance-sheet. The balance sheet provides an ‘at a glance’ appraisal of the company’s performance and current liquidity. Whilst the balance sheet might tell you some limited information (net & gross profit figures, stock amounts, etc), in order to get a clear picture and understanding of the health of a company, one must use some accounting ratios which will give a pro-rata comparison of the company’s status, regardless of size. The ratios that are commonly used to assess and compare performance generally look to examine three different characteristics of a business:
1. Profitability
2. Efficiency
3. Liquidity
Though the balance sheet might show the gross or net profit figures; without comparing these figures to some other essential data, they do not give an accurate picture of the current health of the company.
The ratios which examine profitability are all quoted in percentages and give a good indication of the profitability of a company regardless of size. The ratios compare (a) Return on Investment (or
Return on Capital Employed), (b) Gross Margin, and (c) Net Margin. The formulae used to arrive at these figures are shown below. Note – all of the information required to reach a conclusion should be easily found in the company balance sheet.
(a) Return on Investment: (PBIT*/Capital Employed) x 100
*PBIT = Profit before Interest and Tax
(b) Gross Margin: (Gross Profit/Turnover*) x 100
*Turnover = Sales
(c) Net Margin: (Net Profit/Turnover) x 100
The ratios comparing efficiency are expressed in average days. Again – these give a good indication of how one company might be performing compared to another, by comparing (on average) how long it takes them to turn over stock (Stock Turnover), how long they take to pay their creditors
(Creditor Days) and how long they take to collect monies owed, or how long they extend credit to their customers (Debtor days). The formulae for comparing each of these items are detailed below.
(a) Stock Turnover: (Average Stock/Cost of Sales) x 365
(b) Debtor Days: (Trade Debtors/Turnover) x 365
(c) Creditor Days: (Trade Creditors/Purchases or Cost of Sales*) x 365
*Use purchases figure if available.
Finally – based on a balance sheet – one can compare the likelihood of the company continuing to trade in the event of a catastrophic event. These ratios compare the company’s assets vs their debts and consequently gives an indication of the company’s ability to pay their debts
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 8
These values are expressed as a ratio of x : 1, where ‘x’ is the company’s holding against every ‘1’ of debt (in local currency).
The ‘Current Ratio’ is a straight division of the company’s current assets over current liabilities and is expressed as per below:
Current Ratio: (Current Assets/Current Liabilities) : 1
(a ‘good’ ratio is deemed to be at least 2:1)
The liquidity ratio or acid test is similar to the ratio above, but excludes the company’s stock on the basis that stock is least likely to be liquidated or converted to cash.
The formula is:
{(Current Assets – Stock)/Current Liabilities} : 1
(A ratio of at least 1:1 is deemed to be acceptable)
Ireland’s Economy:
Without claiming to understand the broader picture of economics, my simplistic view on the root cause of the problems in the Irish economy is greed was at the centre of this whole mess. Simplistic
– maybe, but we had a simplistic government in place.
The origins of this problem stem back to when we jumped on the back of Europe. For a long time – we were Europe’s pet project – money was thrown at us to improve our infrastructure. Those who were in power leading up to the crash were junior ministers at the time. Naturally – they had rising construction companies lobbying for the contracts which the European money would generate. In typical fashion – some of the companies went to any lengths to secure such contracts, paying gratuities and other payments to junior ministers who soon realised that this was a great way to
‘earn’ a little extra money, and “sure what harm would they be doing?” This may have been the beginning of it, and perhaps they started with good intentions, but circumstance breeds greed and these people were in the right (or wrong) place at the right time.
Years later, these junior ministers had risen within the ranks of government, and those companies who got those early contracts had continued to build on their success to become extremely wealthy and influential.
It is of no surprise that as the country began to prosper, the status quo remained. There was a housing crisis in Ireland. Something needed to be done – the people had money to buy houses, due to the foreign investment in the country; and if there was money to be spent, then the government had no problem encouraging the public to spend it. Their ‘supporters’ benefitted with new contracts, the public benefitted with housing, the government benefitted with increased revenue – what could go wrong????
Diploma in Logistics and Supply Chain Management
Module 1: Financial Management
Gary Doyle, Student Member, CILT 9
Despite the warnings that our booming economy was built on a falsehood; a bubble, the government were content to let it continue, rather than make the difficult choices. They allowed a woefully inefficient civil service to continue to get guaranteed increases in pay for absolutely zero return. The union lobby in the country negotiated some extremely lucrative deals for its members, again, for zero return. The government didn’t worry, because we had a large cash surplus, and this fantasy world surely couldn’t end, could it?? (Despite the warnings, and crashes in other similar economies such as Japan)
Eventually - in line with a global decline – the bubble burst, and in a catastrophic way. There were literally billions wiped out of the Irish property market – money that never existed in the first place.
Over the last 3-4 years, we have all felt the pain of this black-hole in our economy.
I believe we are on the road to recovery. We need to become competitive again and lose our delusions of grandeur. Ireland was once known as a humble and welcoming country, but in the recent past – we had lost these values. Through austerity and lowering costs of goods, services and labour – we are again becoming competitive. This needs to continue.
We have a long way to go yet. We need to tackle three major areas before we get ourselves out of this difficult period:
We need to bring the pay and conditions in our civil service in line with the actual performance, and overhaul all sectors of the service.
We also need to address the waste and inefficiency in our Social Welfare costs. Granted – it is a difficult political decision to take more from the people who have so little anyway but the criteria for qualifying and retaining benefits needs to be re-examined. I do not have all the answers on how this could be achieved, but nevertheless, it is the ‘elephant in the room’ that everyone knows is there but no-one will talk about.
Finally – we need to have a fair taxation system where those people who benefitted during our boom pay on an equivalent basis what the average person in the country pays. Again – another tough political decision, considering these people are the key supporters of the political parties in power, but they are the decisions which need to be made.