Financial Planning and

Budgeting
P RE S E N T E D BY:
CA RM E LA CA P I N DO
CH RI S TO PHE R A N DRE W BU I T I ZON
M A RY S A JOY BOYA N O
Introduction
One of the most common reason why companies fail is the lack of effective short and long-range
financial planning.
Financial Planning focuses on what a company wants to do in the near future. It is a system that
guides top management of a company to direct the actions of its different units to accomplish its
objectives. (Kolb and Demong, 1988)
It covers the processes of setting the primary objective, identifying the alternative courses of
action, and choosing the best alternative to achieve the objective. It also systematically entails
confronting barriers that a company faces.
It is not simply the responsibility, but rather, financial planning involves the whole company.
It goes from the top management, that sets the overall objective, and passed down to the lower
level of the organization. Then each department inside the organization can plan accordingly.
The finance department then takes those plans and develop a forecast.
The forecast leads to the preparation of the budget.
Dimensions of Financial Planning
Short-range Plan – Usually covers the next twelve months, it focuses on the needed to be
achieved in the coming year. It provides many details and direct guidelines from time to time to
the different heads of the company. It requires the forecasting of all the activities of a company
that can affect the balance sheet, income statement and cash flow. At the beginning of the
accounting cycle, it is used as a way to determine the goals of the company. It is also used as a
measuring device at the end of the cycle.
Long-range Plan – Usually covers 2 to 5 years and does not require a large amount of details. It is
more difficult and prone to error than a short—range plan as it covers more than a year. It is,
however, still essential as a guide to a companies long-term goals. It is usually revised yearly.
Financial Plan
With the Short and Long-range plan in place, a financial plan or budget is then prepared.
Budgeting is the process of transforming planned courses of action into quantitative terms.
Thus, the financial pan becomes a formal statement that a company produces regarding
expected sales, expenses, production, and other financial transactions for a certain period. It is
used in directing a company’s operations and serve as a device that helps measure periodic or
annual performance.
Approaches to Financial Planning
Zero-based approach – Means the budget baseline is zero, the previous year’s budget is
irrelevant to allocating financial resources for the current year. Managers need to present and
justify all required expenses in this approach. It usually requires a lot of documentation.
Incremental-based approach – The traditional approach to budgeting, it starts with the previous
year’s budget, and an amount is added or subtracted accordingly. Increment is always subject to
justification.
Objectives of Financial Planning
Planning – It helps companies determine their objectives and their courses of action.
Coordination – it creates a harmonious relationship between the different units of a company.
Departments have different set of functions and objectives but they may learn to coordinate,
communicate and work with each other.
Control – A financial plan becomes an important tool in enhancing and measuring the
performance of a company. It is also used as a basis to evaluate individual performances.
Master Budget
The combined budgets of the different units or departments of a company. A control measure
that helps a company determine if its sets of objectives are attained. It is classified into two
categories, the operating budget and financial budget.
Operating Budget
This budget shows the plan of operations where the details of sales, production and expenses are laid
out. It takes the form of a budgeted income statement showing the operating results of a company in
the coming year. It is composed of the following:
◦ Sales Budget – Designated revenue the company expects to generate based on forecast.
◦ Production Budget – Identifies the number of units to be produced after the sales budget has been
established and the ending inventory has been set.
◦ Ending Inventory Budget – Identifies the number of units that a company desires to have in their balance
sheet at the end of the period.
◦ Direct Materials Budget – Shows the quantity of materials needed to meet the production units and the
number of units to be purchased.
◦ Direct labor Budget – Refers to the budget that provides the total cost of labor to meet production
requirements.
◦ Factory Overhead Budget – Manufacturing costs other than direct materials and direct labor.
◦ Selling and Administrative Budget – Shows the details of selling and administrative expenses in selling the
products of a company.
◦ Pro Forma Income Statement – It shows the projected income of a company.
Financial Budget
It shows the budgeted financial resources of a company and is prepared after preparing the
operating budget. It consists of the following:
◦ Cash Budget – It is prepared to determine the financial needs of a company. It shows the detailed lists
of all cash receipts and disbursements for a particular period.
◦ Pro Forma Balance Sheet – Represents the forecasted assets, liabilities and equity of a company with
the previous balance sheet as the starting point.
Basic Steps in Preparing Budget
The budget is done in a sequential manner and identifies the following items:
◦ Company’ sales
◦ Production Volume
◦ Materials’ cost
◦ Materials Purchased
◦ Direct Labor Cost
◦ Factory Overhead
◦ Inventory level
◦ Cost of Goods Sold
◦ Selling and Administrative Expenses
◦ Cash Budget
◦ Pro Forma Income Statement
◦ Pro Forma Balance Sheet
Basic Steps in Preparing Budget
Sales Forecast – Estimating the volume of sales. It is the basis of all the budgets as every
subsequent operating and financial budget relies on it. It is done reasonably and accurately as
much as possible for it to be useful.
Sales Budget – This refers to the planned sales revenue that a company expects to have based
on the forecasted sales.
◦ After the estimated sale volume is determined, the sales budget is computed as follows:
◦ Expected sales in units xxx
◦ Multiple by the unit selling price Php xxx
◦ Total Sales xxx
Basic Steps in Preparing Budget
Production Budget – The next step in creating the sales budget. This gives an assurance that the
units required to produce the sales requirements for each period will be met. It is determined as
follows:
Planned Sales xxx
Add: Desired Ending Inventory xxx
Total Needs xxx
Less: Beginning Inventory xxx
Units to be Produced xxx
Direct Materials Budget
It shows the number of materials required and the quantity that must be purchased to meet
production requirements. It is computed as follows:
Required Production Volume xxx
Multiply Materials allowed per unit of production xxx
Materials Needed in Production xxx
Add: Desired Ending Inventory of Materials xxx
Total Needs xxx
Less: Beginning Inventory of Materials xxx
Direct Materials to be purchased xxx
Multiply Material Cost per Unit xxx
Direct Materials Budget xxx
Direct Labor Budget
The production budget is also a preliminary data point for the preparation of direct labor cost
budget. It is computed as follows:
Units to be produced xxx
Multiply by the direct labor hours per unit xxx
Number of hours required xxx
Multiply by the Direct Labor Cost per hour Php xxx
Total Direct Labor Cost Php xxx
Factory Overhead Budget
It provides the budget for indirect materials, indirect labor and all other MANUFACTURING costs.
In preparing the FO budget, the variable and fixed cost must be separated. The variable cost
changes as the production changes. The fixed cost, from the term fixed, does not change with
the volume of production.
Direct Labor Hours xxx
Multiply Variable Overhead Rate Php xxx
Budgeted Variable Overhead Php xxx
Add: Budgeted Fixed Overhead Php xxx
Budgeted Factory Overhead Php xxx
Less: Noncash Expenses Php xxx
Factory Overhead Budget Php xxx
 Ending Inventory Budget
Unit cost of unsold units. It is computed as follows
◦ Direct Material
Unit cost of Direct material Php xxx Ending Inventory Budget:
Multiply by raw materials per unit of production xxx
Desired Ending Inventory Unit Unit Cost Total
Total Unit cost of direct materials Php xxx
Direct Material xxx Php xxx = Php xxx
◦ Direct Labor
Finished Goods xxx Php xxx = Php xxx
Labor rate per hour Php xxx
Multiply by direct labor hours per unit of production xxx
Total Unit cost of direct labor Php xxx
◦ Variable Factory Overhead
Predetermined Variable Overhead rate Php xxx
Multiply by direct labor hours per unit of production xxx
Total Unit cost of Variable Factory Overhead Php xxx
Total Variable Manufacturing Cost Php XXX
Selling and Administrative Expense
Budget
Lists the overall budgeted operating expenses other than those included in manufacturing. Like
the FO, it is separated to variable and fixed cost. The variable selling and administrative
expenses are directly proportional to the sales, while fixed selling and administrative expense
remains unchanged unless a company goes beyond its normal capacity. All noncash expenses
should be excluded.
Budgeted Sales Volume xxx
Multiply Variable Selling and Administrative Expense Rate per Unit Php xxx
Budgeted Variable Selling and Administrative Expense Php xxx
Add: Fixed Selling and Administrative Expense Php xxx
Budgeted Selling and Administrative Expense Php xxx
Cash Budget
One of the final stages of budgeting, organizing the budget is a continuous process. The cash
budget is composed of four major sections.
1. Cash Receipts – This section lists all the cash inflows, except for financing, during the period covered.
2. Cash Payments – Consists of all cash outflows.
3. Cash Surplus or Deficit – Shows the difference between the cash receipts and cash payments.
4. Financing – Shows the borrowing and payments of a company.
Cash Budget
Cash Balance, Beginning ₱ xxx
Add: Cash Receipts
Accounts Receivable Collections (Sales) ₱ xxx
Total Cash Available ₱ xxx
Less: Cash Payments
Direct Materials ₱ xxx
Direct Labor ₱ xxx
Factory Overhead ₱ xxx
Selling and Administrative Expense ₱ xxx
Purchase of Equipment ₱ xxx
Cash Dividend ₱ xxx
Income Tax Payment ₱ xxx ₱ xxx
Total Cash Payments ₱ xxx
Cash Surplus (Deficit) (Total Cash Available – Total Cash Payments) ₱ xxx or (₱ xxx)
Cash Budget
Financing
Borrowing ₱ xxx
Repayment (₱ xxx)
Interest (₱ xxx)
Total Financing ₱ xxx
Cash Balance, Ending ₱ xxx
Budgeted Income Statement
The budgets from the previous budgets are summarized in the pro forma income statement. It is used
to measure the company’s performance by comparing the budgeted income statement to the actual
income statement at the end of the accounting cycle.
Sales (Expected Sales X Unit Selling Price) Php xxx
Less: Variable Expenses
Variable Cost of Sales (Expected Sales X Variable Manufacturing Cost) Php xxx
Variable Selling And Administrative Expenses Php xxx Php xxx
Contribution Margin Php xxx
Less: Fixed Expenses
Fixed Factory Overhead Php xxx
Fixed Selling and Administrative Expense Php xxx Php xxx
Net Income Before Interest and Tax Php xxx
Less: Interest Expense Php xxx
Net Income Before Tax Php xxx
Less: Tax Expense Php xxx
Net Income Php xxx
Budgeted Balance Sheet
It is developed using the previous year’s balance sheet. All the accounts entered are real and are
used to carry over are real and are used to carry over the remaining balances to the succeeding
year. The same balances from the previous year’s balance sheet are added or subtracted from
the budgeted accounts appearing from the different budgets in order to arrive at the budgeted
balance sheet.
Pro Forma Cash Flow Statement
Once the budgeted and actual balance sheet is available, the pro forma cash flow can be
prepared. Just like an actual cash flow, it is separated into three parts: Operating, Investing and
Financing. It is prepared so that companies can have a preview of the probable movements of
cash in the next accounting period.
Budgeted Financial Ratios
With a Pro Forma Income Statement and Pro Forma Balance Sheet, pro forma financial ratios
can then be computed. By having a preview of the financial ratios, a company can compare its
performance with the possible outcomes in the incoming accounting period. From there, the
company can decide to scrap or change the budget for improved and better results.
Additional Funds Needed
When a company is planning to increase its sales, it must be fully supported by the assets to
achieve the planned increase, otherwise the planned sales will not be realized.
Example:
The total assets of a company amounts to ₱15,000,000.00 and its total sales are at ₱25,000,000.00. This
means that it requires an asset-to-sales ratio of 60% to generate a peso sale, provided that the total assets
was utilized at its full capacity. Assuming that the asset-to-sales ratio remains constant and should sales
increase by 20% or ₱5,000,000.00, the company will need to increase its assets by ₱3,000,000.00.
(₱30,000,000.00 - ₱25,000,000.00)(0.60) = ₱3,000,000.00
 Additional Funds Needed
When Calculating AFN, a company needs to determine if its total assets are already operating at full capacity: If
not, the company may expand sales without having to invest additional assets.
Example
Let us assume that the company is planning to increase its sales to ₱25,000,000.00 from ₱20,000,000.00. Currently,
the company has an asset-to-sale ratio of 60%, and the total assets consisting of current and non-current assets had been
utilized at 100% and 80% respectively. As the current assets had been fully utilized, the non-current assets must determine at
which level an additional fund is not required to support the increase in sales.
Full Capacity Sales = Actual Sales / Percentage of capacity at which non-current assets were operated
= ₱20,000,000.00 / .80 = ₱25,000,000.00
Assume that the non-current assets stand at ₱15,000,000.00
Target Non-Current Assets / Sales = Actual Non-Current Asset / Full Capacity Sales
= ₱15,000,000.00 / ₱25,000,000.00 = 0.60 or 60%
As the targeted sales is the same as the full capacity sales, no additional funds is needed for the non-current assets.
 Additional Funds Needed
When sales grow at a rapid pace, the requirement for additional assets also increases. Thus, an increase in assets
is dependent on how fast sales grow. When the assets grow, the liabilities and equities should also grow at a level
equivalent to the assets to make the balance sheet equal. Following that logic of growth, AFN now has the
following equation:
AFN = (A*/S0)S – (L*/S0)S – MS1(1 – DPO)
Where:
A* - Assets tied directly to sales
L* - Spontaneous Liabilities affected by sales
S0 – Last Year’s Sales
S1 – Forecasted or Targeted Sales
S – Change in Sales (S1 – S0)
M – Profit Margin
DPO – Dividend Payout Ratio
Additional Funds Needed
The (A*/S0 ) is the capital intensity ratio which represents the ratio of the assets required
to support the needed sales. When it is multiplied by S, it gives the needed increase in total
assets.
The (L*/S0) represents the ratio of current liabilities to its current sales. When multiplied
to S, it becomes the spontaneously generated funds brought by an increase in sales. These
spontaneously generated funds represent the increase in the accounts payable that requires
additional inventories lent by suppliers. The increase in sales also results in an increase in
accrued expenses from increasing its workforce. The tax payable also increases as a result of
higher sales. The increase in spontaneously generated funds helps reduce the AFN.
The MS1(1 – DPO) represents the increase in retained earnings of a company, provided
that not all income is declared as dividends. These retained earnings help reduce the AFN.
WHEN AFN HAS A POSITIVE BALANCE, IT MEANS ADDITIONAL FUNDING IS NEEDED,
EITHER BY BORROWING OR ISSUING ADDITIONAL EQUITY
AFN Formula if Sales Growth Rate is
Given
AFN = (A*)(S / S0) – (L*)(S / S0) – MS1(1 – DPO)
Where:
A* - Assets tied directly to sales
L* - Spontaneous Liabilities affected by sales
S0 – Last Year’s Sales
S1 – Forecasted or Targeted Sales
S – Change in Sales (S1 – S0)
M – Profit Margin
DPO – Dividend Payout Ratio

(S / S0) represents the Sales Growth Rate.

 Additional Funds Needed
Example:
As of December 31, 2020, Keisha Company has assets of ₱3,000,000.00, accounts payable of
₱100,000.00, notes payable of ₱75,000.00, accrued expenses of ₱65,000.00 and tax payable of ₱35,000.00.
The company sales were ₱10,000,000.00 with a net profit margin of 2%. If the company anticipates next
year’s sales grow by 10%, and it pays 25% of its net income in dividends, then what are the estimated
additional funds needed by Keisha Company?
AFN = (A*/S0)S – (L*/S0)S – MS1(1 – DPO)
AFN = (3,000,000/10,000,000)1,000,000 – (275,000/10,000,000)1,000,000 – 0.02(11,000,000)(1 – 0.25)
Or = (3,000,000)(.1) – (275,000)(.1) – 0.02(11,000,000)(1 – 0.25)
AFN = ₱300,000.00 - ₱27,500.00 - ₱165,000.00
AFN = ₱107,500.00
To support the additional sales of ₱1,000,000.00, Keisha Company has to raise ₱107,500 additional funds.
Sustainable Growth Rate
It is the maximum growth rate without a company having to raise external funds. At this level,
AFN is said to be zero. The guiding principle of behind a sustainable growth rate is that there is
no need to issue new debts or equity and that the capital structure remains unchanged.
Example:
FLT has current sales of ₱60,000.00. Sales are expected to grow to ₱80,000.00 next year. FLT
currently has accounts receivable of ₱10,000.00, inventories of ₱20,000.00, and fixed assets of
₱20,000.00. These assets are expected to grow at the same rate as sales over the next year. Accounts
Payable are expected to increase from their current level of ₱15,000.00 to ₱19,000.00 next year. FLT
wants to increase its cash balance at the end of the year by ₱5,000.00. Earnings after taxes are forecasted
to amount to ₱12,000.00. FLT plans to pay a ₱1,000.00 dividend. FLT’s income tax rate is 30%.
 Sustainable Growth Rate
At what growth rate can FLT succeed without the need for additional funds?
AFN = Projected Increase in Assets – Increase in Spontaneous Liabilities – Increase in Retained Earnings
= ₱50,000.00x + ₱5,000.00 - ₱4,000.00 - ₱11,000.00
= ₱50,000.00x - ₱10,000.00
-₱50,000x / -₱50,000.00 = -₱10,000.00 / -₱50,000.00
X = 0.2 or 20%
 Sustainable Growth Rate
B. Assume that the fixed assets were operating only at 85%. What are the revised additional funds needed?
AFN = (50,000 / 60,000)(80,000-60,000) + 5,000 – (19,000 – 15,000) – (12,000 – 1,000)
AFN = ₱21,667 - ₱4,000 – ₱11,000
AFN = ₱6,667
Full Capacity Sales = ₱60,000/0.85 = ₱70,588
Fixed Assets to Sales Ratio = ₱20,000 / ₱70,588 = 28.33%
Additional Fixed Assets needed = (₱80,000 - ₱70,588)(0.2833) = ₱2,666
Forecasted Fixed Assets = ₱20,000(₱80,000 / ₱60,000) = ₱26,666
Fixed Asset will increase by ₱6,666 (₱26,666 - ₱20,000) which gives us the forecasted increase in fixed assets
of ₱6,666, which is higher by ₱4,000 (₱6,666 – ₱2,666)
Therefore the revised additional funds needed is ₱2,667 (₱6,667 - ₱4,000)