This chapter introduces budgeting for planning and control, defining a budget as a plan showing a company’s objectives and how management intends to acquire and use resources to reach them. It covers the master and responsibility budgets, the human factors that make budgeting effective, and building an operating budget from a sales forecast.
What a budget is for
A budget formalizes management’s plans in quantitative terms, forcing all levels of management to think ahead, anticipate results, and take corrective action before problems occur. Several kinds of budgets serve different purposes, including the master budget, responsibility budgets tied to individual managers, the capital budget for longer-term asset spending, and the planned operating and financial budgets that together project a company’s income statement and balance sheet.
Making budgeting work
A budget succeeds only when top management visibly supports it and when the employees who must live within it participate in setting its goals, since people are more likely to strive toward targets they helped set. Results must be communicated promptly and clearly so employees can adjust their performance, the budget itself must stay flexible enough to be restated if the assumptions behind it change, and managers must follow up continuously rather than treating the budget as fixed once approved.
Building the operating budget
Managers typically begin a planned operating budget in units rather than dollars, forecasting sales units for the year and then, based on that sales forecast and the company’s inventory policy, the units that must be produced. Dollar figures are introduced afterward: expected selling prices and costs are analyzed, a schedule forecasts cost of goods sold, and a separate budget covers selling and administrative expenses, supported by further schedules as needed.
This chapter explains the purposes and uses of the statement of cash flows and where items appear on it, and describes how to calculate operating cash flows under the direct and indirect methods. It covers preparing the statement across operating, investing, and financing activities, and analyzing results with cash flow per share and margin.
Purpose and content of the statement of cash flows
The statement of cash flows reports the cash a company generated and used during a period, classified into operating, investing, and financing activities, and reconciles the change in cash from the beginning to the end of that period. It supplements the income statement and balance sheet by showing where cash actually came from and where it went, which matters because a profitable company can still face a cash shortage if its earnings are not backed by cash.
The direct and indirect methods
Cash flows from operating activities can be calculated under the direct method, which lists actual cash receipts and payments such as cash collected from customers and cash paid to suppliers, or under the indirect method, which starts from net income and adjusts it for noncash items and changes in working capital accounts to arrive at the same operating cash flow figure. Both methods produce identical totals for investing and financing activities; they differ only in how the operating section is presented.
Analyzing cash flow results
Once prepared, a statement of cash flows can be analyzed using ratios such as cash flow per share of common stock, cash flow margin, which relates operating cash flow to sales, and cash flow liquidity ratios, which compare cash resources to current obligations. Applied to a real company’s statement, these measures help assess whether reported earnings are supported by actual cash generation rather than by accounting estimates alone.
This chapter describes the objectives and sources of information for financial statement analysis, and explains how to measure change using horizontal analysis, vertical analysis, and trend analysis. It covers ratio analysis through liquidity ratios, long-term solvency ratios, profitability tests, and market tests, and the considerations that shape how analysts interpret the results.
Objectives and sources of financial statement analysis
Management analyzes financial statements to plan, evaluate, and control operations within the company, drawing on internally requested special-purpose reports. Investors, creditors, and regulatory agencies outside the firm instead rely on general-purpose statements, including the balance sheet, income statement, statement of stockholders’ equity, statement of cash flows, and the explanatory notes that accompany them. Although these users pursue different immediate goals, their shared objective is to use the information to predict a company’s future performance.
Horizontal, vertical, and trend analysis
Horizontal analysis compares financial statement items across two or more periods to measure the dollar and percentage change over time, while vertical analysis expresses each item as a percentage of a base figure, such as total assets or net sales, within a single period. Trend analysis extends horizontal analysis over a longer run of periods to reveal the direction a company’s results are moving, giving analysts a clearer picture of underlying performance than any single year’s figures alone.
Ratio analysis and its considerations
Ratio analysis relates one financial statement figure to another to assess a company from several angles: liquidity ratios test its ability to meet short-term obligations, long-term solvency ratios test its ability to meet long-term debt, profitability tests measure its capacity to generate income, and market tests relate its earnings and dividends to its share price. Because ratios are only as reliable as the statements behind them, analysts also weigh considerations such as comparability across periods and companies and the effects of estimates and accounting choices.
This chapter lists the characteristics of plant assets and the costs of acquiring them, the major factors affecting depreciation expense, and the methods used to calculate it. It distinguishes capital from revenue expenditures and describes the subsidiary records used to control plant assets, plus the rate of return on operating assets.
Acquiring property, plant, and equipment
Plant assets are long-lived resources used in operations rather than held for resale, and their recorded cost includes all reasonable and necessary expenditures needed to get the asset into working condition and location, not just its purchase price. The chapter identifies which costs are capitalized into the asset’s recorded cost and which are instead expensed immediately as incurred.
Depreciation methods
Depreciation expense depends on an asset’s cost, its estimated salvage value, its estimated useful life, and the pattern in which the asset is expected to be used over that life. The chapter works through the various methods available for calculating depreciation and shows how the choice of method affects both reported expense and the asset’s carrying value over time.
Capital versus revenue expenditures, and control records
A capital expenditure extends an asset’s useful life or increases its capacity and is added to the asset’s recorded cost, while a revenue expenditure merely maintains normal operating condition and is expensed immediately instead. The chapter also describes the subsidiary ledgers used to track individual plant assets, and the rate of return on operating assets used to evaluate how effectively property, plant, and equipment is being used.
This chapter covers accounting for uncollectible accounts receivable under the allowance method, recording credit card sales, and defining current and long-term liabilities. It explains clearly determinable, estimated, and contingent liabilities, and accounting for notes receivable and payable, including interest calculations and receivables turnover analysis for the business.
Uncollectible accounts and credit card sales
Under the allowance method, a business estimates in advance the portion of its accounts receivable it expects will never be collected, recording that expense in the same period as the related sales rather than waiting until a specific account is finally known to be uncollectible. The chapter also covers recording sales made through credit cards and the processing fees that come with them.
Types of liabilities among receivables and payables
Liabilities are classified as current or long-term based on when they fall due, and further as clearly determinable, estimated, or contingent depending on how certain their amount and existence actually are. A contingent liability, for example, depends on the outcome of some future event and is disclosed rather than formally recorded unless it becomes both probable and reasonably estimable.
Notes receivable and payable
Notes receivable and payable involve a formal written promise to pay a specific amount, often with interest, by a specific future date. The chapter shows how to calculate that interest and account for both interest-bearing and non-interest-bearing notes, and closes with turnover ratios used to analyze how efficiently a company is collecting on its receivables.
