Financial Management Flashcards
What is the difference between the income statement budget and the capex budget?
The income statement budget, which details items of income and expenditure and how they will combine to make a profit or loss for the coming year.
The capex (capital expenditure) budget. The capex budget details the expected spend on capital assets (such as machinery and buildings for example).
What is the difference between top-down budgeting and bottom-up budgeting?
Top-down budgeting involves setting a budget to deliver what shareholders/management expect.
Bottom-up budgeting involves operational members of stuff providing the inputs for a budget based on what they think they can deliver.
In practice, it’s often a bit of both – i.e. there will be a number of budget reviews which should ensure that all parties are happy with the final outcome – the board believing that it is sufficiently challenging and management feeling that it is achievable.
What are the two major influences on the shape of the budget?
There are two major influences on the shape of the budget:
The Company’s long-term strategic plan and
The Board’s view on the macro-economic climate and the specific conditions for your market.
The strategic plan and the budget is the source of the company’s ”guidance”- Guidance is forward-looking information released by a company with a view to bringing the market closer to management’s view of the future- Typically companies guide on the coming year and set less specific targets for the medium term- Sell-side analysts use this guidance as part of the mix when forecasting company profits in order to value the business- The average of sell-side analysts forecasts is called “consensus” or “market expectations”- Guidance is an art – ideally companies would like to announce earnings that are either in-line with guidance or even a little better- Missing guidance can be very negative for the share price.
How would you begin to set a budget?
You would always begin by thinking about revenue. Unless you know your revenue target, you can’t estimate the costs needed to achieve this
Specifically, you need to know how revenue is made up in terms of volume, mix and price. And of course, the big influences on all of these will be the economic climate, sector or market conditions and the level of competition etc.
Once you have established the target revenues, you can start to estimate the costs you need to incur to deliver it
Think about how the costs break down (e.g. wages = no. of employees x wage rate) and which element is expected to change?
Also think about how the costs behave (fixed, variable etc.)?
What should you consider when building your budget?
When building your budget
Consider current/future trends
Understand the budget assumptions and the implications for your area
Consider the implications for each line
Remember that different types of cost behave differently
Think what drives the cost in your area
Try to think creatively about how things could be done better/differently rather than thinking incrementally (zero-based budgeting)
Zero based budgeting is where managers start with a clean sheet of paper each year and to determine from scratch what resources they will require
Compare your budget to last year (it is important to do a reality check).
Define fixed, variable and stepped costs?
Fixed costs: Fixed costs are those that remain unchanged in the short term, even if activity (i.e. volume) increases or decreases. Examples might be rent, rates, salaries and insurance.
Variable costs: Variable costs are those that change directly in relation to activity. Examples might be purchases of raw materials, sales commission, and in some circumstances, electricity and telephone costs.
Stepped costs: Many fixed costs are, in reality, stepped - i.e. they are fixed for a range of sales volumes, but after a point they step up. An example would be factory rent. At some point the factory will reach capacity and you will need an additional facility.
Why is it important to phase a budget?
Revenues and costs need to be phased, or spread, over the year as they are expected to arise, taking into account seasonality.
If reporting against budget is to be useful on a monthly basis, the budget needs to be phased as accurately as possible. So rather than just spreading the annual amount equally over the 12 months, you should split the amount into the month that you think that the revenue is earned or the cost is incurred.
The income statement (and therefore the income statement budget) is prepared on an accruals basis, NOT a cash basis. In other words, revenues are recognised when they are EARNED (not received) and costs are recognised when they are INCURRED (not paid)
For example, regardless of when payment is made:
The cost of attending a training course is incurred on the day of the course;
The cost of an advert is incurred when the advert is aired; and
The cost of travel is incurred on the day of travel.
What is budget variance analysis? Why would you want to do this?
Once the budgeted year begins, the finance department will prepare monthly management accounts that show the actual results for the month and the year to date, compared to budget
Typically, the report also shows variances to budget (i.e. the differences between the planned and actual numbers) and variances compared to the prior year.
You want to understand why these variances occurred and think about whether they have implications for the future.
This holds management accountable for revenue/cost control.
It also enables management to spot potential problems and capitalise on potential benefits.
What are typical causes of variances in budgeting?
1) Major shocks (e.g. COVID-19)
2) Other one-off events not predicted
3) Strategic changes
3) Timing issues (phasing)
4) Better/worse sales price, volume or mix than expected
5) Better/worse cost control/efficiencies
6) Better/worse staff turnover
7) Incorrect assumptions regarding uncontrollable costs in the budget
Inflation
Commodity prices
Exchange rates
Taxes
Regulatory environment
How is the forecast different from the budget?
The forecast is your latest estimate for the year. It doesn’t replace the budget as the control, but it provides useful additional information
The company may need to update its guidance to bring the market’s view in line with the company’s latest view of the current and future years
The forecast alerts management to changes in performance and enables action to be taken.
Performance changes may need to be communicated to parent company or shareholder/analysts.
Describe the forecasting process.
At the beginning of the year, the budget is fixed. At this point, the budget is the forecast for the year.
As the year progresses, the actual YTD results are fed into the forecast, so the forecast contains some actual results and some forecast results.
Throughout the year, things can change, including macro-economic factors and market conditions, and these changes will need to be factored into the forecast
There may also be business reasons for permanent variances against budget (e.g. unexpected rent increases, the need for more staff etc) and these will also need to be factored into the remaining months to make the forecast as accurate as possible
Most companies willre-forecast either monthly or quarterly.
What is the best way to review budgets and forecasts? (4)
1) Look at the revenue variance
Is the variance caused by price or volume?
2) Look at the direct costs variances
Remember, variable costs should change with the volume
What else might have caused the variances?
3) Look at the indirect costs variances
What might have caused the variances?
4) Remember, variances might not always be about performance! e.g.
Timing differences
One-off items
Mis-coding of invoices
What is the time value of money concept?
There is a time value to money due to
Inflation
Opportunity cost
What two key things should investment decision involve?
Investment decisions involve
1) Forecasting cash flows
2) Discounting those cash flows to take account of the opportunity cost (cost of capital)
What is NPV?
NPV (net present value) is the sum of the discounted future cash benefits minus the initial investment.
