Dadley Corporation, the photocopier machine manufacturer is in the process of expansion of the market. The first step, and one that has already been decided, is that of estimating the expected sales and the raw materials for the same. The sales budget has already been prepared by the director of marketing. She is now confident that the sales estimate for the next year will not only be met but also exceeded. The collection from debtors policy has also been decided on the basis of previous experience and payment policy has also been decided. The other expenditure and its payment schedule are planned accordingly as well.
The main points of the report which are to be discussed are described as below:
The budgeting process is the first step in business strategy planning. Various Budgets are prepared by various departments of the business and then a master budget is prepared accordingly. The sales budget is already in place for Dadley Corporation and now it will be important to estimate cash flows on a quarterly basis. Cash management is an integral part of the working capital policy of any company.
As an assistant chief accountant, the responsibility of preparing a cash budget has been assigned to me. This is a most critical budget of prime importance, especially when the company is engaged in a vast expansion plan. The report will be prepared on the basis of following information, provided in this case:
- An excellent record in debtor’s collection has been observed by the company in the past and it is expected that this trend will continue in future also. Uncollectable accounts are insignificant and hence will not be taken into consideration. The billing done by the company is collected at the ratio of 60 % in the first fortnight and 40 % in the second fortnight
- The largest expenditure for the company is the purchase of raw material, whose costs are approximately 50 % of the sales amount. The purchase is planned in such a way that
60 % of the raw materials are procured one month prior to sale and then a balance of
40 % is received during the month of sale.
- The payment schedule of the creditors of Dadley Corporation is such that 80 % of them are paid after one month of the receipt of material and the balance 20 % is paid two months after receipt, i.e. the company is buying on credit for one and two months respectively.
- Sales volumes decide hourly wages, which are 20 % of the current month’s sales. The wages are paid at the end of the respective month in which they are incurred.
- General and administrative expenses are fixed at £2 640 000 for the year. These expenses are assumed to be spread over the year evenly except property taxes, which are paid on a quarterly basis spread over the year.
- Based on the profits for the previous quarter, corporation tax payments are made in the first month of the quarter
- Equipment and warehouse facilities are being acquired to support the company’s rapidly growing sales and for this, the budgets for April and May are given.
We can see the Cash budget of Dadley Corporation as follows:
|CASH BUDGET FOR Dadley Corporation FOR THE SECOND QUARTER OF THE CALENDER YEAR|
|SALES/ RECEIVED FROM DEBTORS|
|60% OF MARCH/APRIL/MAY RESPECTIVELY||1080000||1320000||1500000||3900000|
|40% OF FEB./MARCH/APRIL RESPECTIVELY||800000||720000||880000||2400000|
|PAYMENT TO CREDITORS:|
|80% OF PURCHASES OF MARCH / APRIL/MAY RESPECTIVELY||816000||1304000||1072000||3192000|
|20% OF PURCHASES OF FEB/MARCH/APRIL RESPECTIVELY||188000||204000||326000||718000|
|WAGES PAID( 20% OF CURRENT MONTH SLAES)||440000||500000||560000||1500000|
|GENERAL & ADMIN EXPENDITURE PAID|
( QUATERLY INSTALMENT PAID AT THE END OF QUARTER)
|TAX PAID (40% OF PROFIT OF PREVIOUS QUARTER)||244800||244800|
|INTEREST PAID AT THE END OF QUARTER||8000||8000|
|SURPLUS ( RECIEPTS – PAYMENTS)||191200||32000|
|DEFICIT ( PAYMENTS- EXPENDITURE)||246000|
IMPORTANCE OF CASH BUDGET
The preparation of a cash budget helps in many ways; the surplus or the deficit calculated at the end of every quarter helps in the smooth flow of cash in the business. For any business to run smoothly, it is extremely important to monitor cash flow, which is the life line of any company. The entire business of the company depends on how well its cash is managed, as cash is required not only for the purchase of raw material but also for payment of wages, corporation taxes and for expansion plans envisaged by this company.
In Dadley Corporation, we can see that the cash balance in the month of April is as per the policy decided, and sufficient to maintain the cash balance, but in the month of May and June it was not sufficient to do so and hence the company has had to borrow cash on a short term basis.
This anomaly could lead to problems for the company: a shortage of cash could pose the problem of payment of wages, which as per the company policy, have been fixed and are to be paid on the dates mentioned and agreed. Moreover, supplier’s payments, even though they are to be paid one and two months after the supply of the material, account for a large chunk of expenditure. This fact cannot be ignored. Moreover, there are further expenses: there is a statutory requirement of government, which says that corporation taxes are to be paid on a regular basis at a designated time. The company has already decided to make payment on a quarterly basis, and that means a provision has been made so obviously necessary cash has to be arranged. But as per the analysis, it is observed that the company would be facing problems in the months mentioned, so this borrowing on short term basis would lead to an extra interest burden on the company, which in turn would reflect the profit margin at the end of financial year.
The above cash budget is part of Budgeting and also helps in budgetary control. In many cases, it is a statutory requirement also. The cash budget helps a company know at a glance its actual position i.e. where the cash lies. By knowing the actual position of the cash, the company can plan its operations. It is very well understood and clear that the most important operation of the company is its cash management. As has been explained earlier, the very existence and smooth functioning of the company depend on how effectively its accounts department can manage its funds. It is just not possible to manage the affairs of the company on the basis of its own funds. Few companies can survive on their own funds alone, and, similarly, this company has to depend on outside sources for essential funding. By borrowing money, the company can meet its funding requirement, but the interest chargeable by the creditors can eat into the profit margin of the company. Moreover, in a recession with credit all but dried up, banks are extremely reluctant to lend money, and this could cause problems. The less the company depends on borrowing, the better it is as it can save money, which it will end up paying to creditors on account of interest or delayed payment charges. One method of avoiding this is to borrow from a lender who is charging the lowest rate of interest, but then in any case, the interest has to be paid. The alternative is to take additional credit from suppliers, which means making delayed payments. Here, one problem is that the company is already enjoying a delayed credit advantage, which is dual in nature viz. 30 days and 50 days. The current market condition is such that no supplier can afford to wait for such a long period for payment; after all, he also has to run his business. Furthermore, by delaying the payment to its creditors, the company may lose its good reputation in the market and suppliers may not agree to supply the raw material to it; or the company may not be able to procure items of good quality any more. All these factors could lead to problems in the longer run for the company and may affect its business as well as its profit margin. It is extremely important for the company to manage its cash and funds, and to avoid short term borrowings which could lead to problems at a later date. The company can now plan to review the collection policy, the payment policy or the expenditure management for the next quarter budgeting process and thus manage the business in the most effective manner. The process of budgeting and planning is an ongoing activity and has to be continued in a systematic way to avoid such types of cash management problems. By consolidating in such a way, the present and future success of Dadley Corporation will more likely be assured, especially during the current recession.