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The Essential Financial Tools for Running a Firm 1
P.J. van Blokland2Abstract
The paper is intended to provide the owner of an agricultural firm with the essential financial tools for running the business. Each tool is outlined and illustrated with an example. The paper starts with the historical tools, which include the firm's objectives, balance sheet and income statement and follows with the tools necessary to analyse these statements. These analytical tools examine the liquidity, solvency, profitability, efficiency and repayment capacity of the firm. The results of this analysis are used to re-examine the firm's objectives. The paper then employs the historical performance and the objectives to map out the future of the firm. The maps include enterprise and firm budgets and the cash flow budget. The results are compared with the firm's objectives which may be altered again as the budgeting results appear.Key Words
Objectives, financial statements, liquidity, solvency, profitability, efficiency, repayment capacity, enterprise, firm and cash flow budgeting.Objective
The objective of this paper is to present a description and a succinct discussion of the financial tools needed by an owner of an agricultural firm to assist in making sensible financial decisions. The owner and the manager are assumed to be the same person. Each tool is outlined sufficiently to follow the major points in using the tool.Introduction
Management in any job is basically using information to make decisions to help the firm meet its objectives. Objectives must be written down and quantified in terms of numbers and time. "Make a profit" is not an objective. "Make $100,000 net income by the end of December three years hence" is. The manager needs to know where the firm stands today and how it got there. Therefore a lot of good management consists of linking the past with the future by making sound decisions today. This paper will present some of the main financial tools that do this linking. These tools are outlined in Figure 1 .
The tools provide the information necessary to make most of the production, marketing and financing decisions in the firm. The figure starts with the information that the manager thinks he needs. This information is digested and used to write the firm's objectives. The figure then separates into two parts. The left hand side, or the recording section, shows what has happened to the firm over time. These events were recorded and analysed to write the objectives of the firm. The right hand side, or the management section, shows what might happen to the firm if it meets its current and future objectives. The left and right hand sides are linked by monitoring. In other words, by comparing what actually happened with what the manager thought would happen. He must make decisions on any differences between the two. There will, of course, always be a difference for no one is clairvoyant. The real job is to take appropriate action on this difference.
For instance, suppose that the manager thought, based on historical performance, that his second quarter cash sales margin over cash costs would be $400,000, and the margin actually was $300,000. He is $100,000 short and had probably committed that $100,000 to future uses. He may have lined up resources for that purpose and now has bills to pay. He has to find out why there was a cash margin difference of 25% and what he should do about it (doing nothing is still a decision). This is not easy but it is real management. These tools will help in this decision-making process and, if necessary, help modify future objectives.
The Balance Sheet
The balance sheet presents a picture of the firm at one point in time. This is important to digest. Because the balance sheet is a snapshot of the firm on a single day, the firm's owners, sensibly and legally, make this statement look as good as they can to impress their readers. People dress well when they are interviewed or inspected. Firm owners do the same thing when they produce their balance sheet.The balance sheet shows three things: assets, liabilities and equity or net worth. Assets are what the firm has. These possessions are usually divided into three categories in agriculture: current, intermediate and long term. Current assets are assets that can be or soon will be turned into cash. They include items like inventory for sale, supply inventory, cash, cash equivalents (e.g., savings accounts, stocks, bonds, mutual funds) and receivables. Intermediate assets usually consist of vehicles, equipment, machinery, breeding stock, plants and trees between one and seven years old, and nonpermanent buildings and structures. Long term assets typically are plants and trees over seven years old, permanent buildings and land.
Liabilities are what the firm owes. These also have three categories. Short term liabilities are what the firm owes in the period between the most recent and the next balance sheet. This period is every three months for firms with quarterly statements and every twelve months for firms with annual statements. Current liabilities list bills which must be paid in the next three months for quarterly reports or bills that must be paid over the next year for firms with annual reports. Current liabilities include the principal and interest on operating loans, payables and the current principal and interest portion of intermediate and long term debt. (i.e., what the firm owes in the next period on its notes and mortgages). Intermediate liabilities are what the firm owes on notes after deducting the current portion of the debt. Likewise long term liabilities are the remaining mortgages owed after meeting the current portion. Equity is what the firm owns. It is calculated by subtracting all the liabilities from the firm's assets. Consequently it is a residual and is found by subtraction. For example, if assets are $2.5 million and liabilities are $1.5 million, the firm's equity is $1 million. Equity is a key number for managerial scrutiny. Owners want to see steady equity growth, period after period. Equity is used in various ratios to see how the firm handles debt. For example, leverage ratio is defined as total debt divided by equity. In the above instance, the ratio is $1.5 million divided by $1 million, or 1.5. This means the firm owns $1 for every $1.5 of debt. If the ratio increases, there is more debt owed per dollar owned and its risk has increased. If the ratio falls, the firm has reduced its risk.
The balance sheet can be used to compare how the categories or any or all of the assets and liabilities have changed from one period to the next, and the effect of these changes on the firm's equity. The balance sheet is illustrated in Table 1 .
The Income Statement
The income statement shows how the firm performed in the period between the two balance sheets (i.e., during the quarter or during the year). The income statement shows three things. These are outputs, costs and incomes, each with its own section. The income statement is perhaps the most important statement to analyse in a firm. It shows how the manager used resources and what he got from their use. This analysis can often separate good managers from "other" managers, by showing the returns they received from their resource investments.The first section of the income statement shows gross output. Gross output is what the firm produced. It includes sales, the change in the supply and for-sale inventory from one balance sheet to the next, other firm income and change in receivables. Gross output should increase over time and the proportion of sales making up gross output should be consistently high. This is because gross output can increase in one period with inventory sales, but this inventory must be replaced later on.
The second section of the income statement shows costs. Costs are divided into three main groups. The most important group is cash costs, which often make up 75% of any agricultural firm's total costs. Cash costs are defined as items paid with cash. These include supplies, labour, interest, fuel, repairs, insurance, rents and marketing expenses. Cash costs are usually divided into four or five major categories for analysis. For example, some firms may find the following categories useful: 1) chemicals and fertilizers; 2) labour, social security and associated taxes and expenses; 3) marketing expenses; 4) interest ( Table 2 ). The categories will probably vary with the firm. There is no standard. The concept is to try to account for at least 80% of the firm's cash costs in these categories in order to track each category over time.
Gross output minus cash costs equals gross margin. Gross margin shows whether the firm can cover its cash costs and, if it can, how much is left to cover the rest of its commitments. Gross margin can be used for tracking individual enterprises and the whole firm. It is useful to follow the trends in gross margin of the different enterprises and use this information to make changes in enterprise operation.
The second cost group is depreciation. This cost is essentially the annual rate allowed by the IRS to write off depreciable capital assets. Depreciation is a real cost though it is not paid by the firm until it replaces its capital assets. The capital assets that can be depreciated include machinery, vehicles and buildings as well as breeding stock and orchards after they start producing. Consequently, until these assets are replaced, the depreciation allowances by the IRS add cash to the firm. This "additional" cash is most easily seen in the cash flow.
The third cost group is overhead. This group is usually disregarded by firms or used as a catch all for miscellaneous items. All overhead items can be put in either cash or depreciation costs. But because overhead is relatively unproductive compared with the other two cost groups, overhead should be recorded separately. Overhead items include all office expenses, business education and publications, lawyer and accountant fees, business travel and client entertainment. There is a tendency for firms to expand their overhead in good years when that money might be better spent on cash cost items. Therefore it is advisable to track the percentage shares of the three cost groups over time to see where the firm's expenditures go. For example, a "typical" full time Florida farm firm today might have 75% of its costs as cash, 18% as depreciation and the remaining 7% as overhead. Any marked deviation from the firm's historical trends needs investigation and explanation.
Cash plus depreciation plus overhead costs equals total costs. Gross output minus total costs equals net firm income. A positive net firm income shows the firm has covered all its costs. But net firm income is not profit. The firm still has other commitments. Net firm income is essentially equivalent to taxable income for a noncorporation because property taxes, road taxes and other firm taxes are included in cash costs. A high net firm income means higher income taxes, which might encourage the manager to purchase some needed depreciable capital asset. Depreciation reduces the net firm income and consequently the tax bill.
Net firm income minus the owners' income and social security taxes provides net income. This is the bottom line of any firm. To see how a firm is doing, follow its net income over time. A firm's net income can only be used for three things. These are the owners' salaries, re-investing in the firm and principal payments. Owners' salaries means what the owners withdraw for their living expenses including vacations, purchases for private items, education, etc. Owners' salaries are the corporate equivalent of dividends. Any firm capital purchases must also come from net income. These purchases are the same as re-investing in the firm. Finally, principal payments are settled with the firm's net income. The corporate equivalent of principal plus investments is called retained earnings.
The income statement is illustrated in Table 2 .
The income statement shows the money coming into the firm and where the money goes in the firm in the period between the two balance sheets. The cost framework in the statement can be adapted by any firm to suit its specific needs. The items listed under each cost are examples only. The net income shows how the remaining money was spent after paying total costs and owners' income taxes. Put another way, net income minus investing in the firm and principal payments equals what the owners withdrew as salary.
Typically, analysing this statement will include trends in gross output, cost groups and categories of cash costs, incomes and the changes in the components of each that caused these trends. Decisions will be made on these changes and objectives re-written as cause and effect are determined.
The Statement of Owner Equity
The statement of owner equity links the period between the beginning and ending balance sheets with the income statement to show how owner equity has changed over time. Table 3 shows the linkages for a quarterly set of statements. Owner equity is a key number to monitor. It shows how much of the firm belongs to the owners. Equity growth probably ranks second to net income as the most important firm indicator of success.This statement has three useful pieces of information. It shows firstly how equity is increased by paying off principal and investing in the firm (adding retained earnings in accounting language). Secondly, it shows how equity is depleted by taking salary from the firm. And thirdly, it shows how inflation and deflation affect equity as asset values change. The following example illustrates these functions.
The statement starts with the equity recorded in the beginning balance sheet, say on December 31. Assume equity on this date is $500,000. The net income from the income statement for the next quarter, i.e., January 1 to March 31, is added to this equity. With a net income of $50,000, equity increases to $550,000. Subtract owners' salaries of $20,000, and the revised equity is now $550,000 - $20,000, or $530,000. So firm equity increased during the quarter by $30,000. This increase resulted from paying off principal and re-investing. (Note that the $50,000 net income went on $20,000 salary and $30,000 principal and investing.)
The second function of the statement shows that equity was depleted $20,000 by withdrawing $20,000 salary. Obviously, the more the owners withdraw the less the equity growth will be. This may seem trite but it is an important point. Owners have to have enough to live on and to enjoy themselves. Only they can decide whether the increased enjoyment is worth the reduction of equity growth. This statement shows the relative effects clearly. Some 40% of the quarter's net income went to salary, so the remaining 60% was available to increase equity.
The third function of the statement shows the changes in asset valuation due to external factors. These externals are usually combined under the rubric of inflation. It is possible for a firm's equity growth to be entirely due to inflation. If, for example, land prices double, the firm's real estate is worth twice as much as it was before and equity growth is correspondingly impressive. And as inflation decreases and equity growth correspondingly falls, the firm does not look so good. This artificial type of equity growth must be realised to avoid bad decisions. In order to calculate asset valuation changes correctly, the manager needs a balance sheet recording both book and market value valuations of assets.
Book value can be measured in three ways, depending on type of asset. One measure is what the owner has invested in the items. This measure will apply to most of the firm's inventory items. For example, valuing a 10-inch plant at $4.50 because this is the sum of the cash, depreciation and overhead costs and management that went in it. A second way to measure book value is to use the recent purchase price of the item. This measurement is often used for nondepreciable assets. For example, valuing recently bought land at the purchase price of $3,500 per acre. The third way to measure book value is to use the current depreciated value of the asset. For example, a three year old tractor that was originally purchased for $70,000 and is depreciated at $10,000 per year, now has a book value of $40,000.
The market value of an asset is what the firm could get for that asset if it were sold in the period between the two balance sheets. Market value is usually greater than book value. Current assets are valued at either what has been invested in them (book value), or what they could be sold for in the market place. Suppose the book value of these assets is $90,000 and the market value is $120,000. There is a difference between the two of $30,000. Suppose that the book value of the intermediate assets was $150,000 and their market value was $200,000, for a difference of $50,000. Likewise the book value of the long term assets is $400,000 and the market value is $600,000, with a difference of $200,000.
This last sentence needs elaboration. Land assets dominate the total assets of agriculture. Land cannot be depreciated, so the "book" value of the land is either the original purchase price or, if it was purchased generations ago, the latest assessment of the value of the land. The market value is what the land can fetch in today's market. It is usually land values that signal inflation in agricultural markets.
So the book value of all the firm's assets is $90,000 + $150,000 + $400,000 = $640,000. The market value of its assets is $120,000 + $200,000 + $600,000 = $920,000. The difference between the two is $280,000. Taxes will be due on the differences in the non- current assets if they are sold. With a tax bracket of 20%, the tax due is [($600,000 + $200,000) - ($150,000 + $400,000) x 0.20)] = $50,000.
Assume that all these asset values are shown in the beginning balance sheet. If liabilities are $140,000, then the cost or book equity is $640,000 - $140,000 = $500,000. The book equity is the equity earned by the firm up to that point in time. The market value equity is $920,000 - $140,000 = $780,000. This equity is what the owners would get if they sold all their assets and met all their pre-tax liabilities. Therefore the gain in equity from the value difference alone is $670,000 - $390,000 = $280,000. Subtract the tax of $50,000 that would be due from selling these assets, = $230,000. This $230,000 is what is called the valuation equity or the amount that equity has increased solely due to increases in the value of the firm's assets.
Assume also that the ending balance sheet records a valuation equity of $260,000. The gain in the quarter, from changes in asset valuation only, is $260,000 - $230,000 = $30,000. Table 4 summarizes the three functions of the statement of owner equity.
The firm's equity increased $30,000 during the quarter from the firm's production. But it also increased $60,000 from changes in the valuation of the firm's assets. The former shows the results of the manager's work and the latter also shows the value of this work as well as the external factors, driven largely by inflation. Owners can use either or both numbers as they like. The important thing is to know the difference between the two and what the causes of these differences were.
Analytical Tools
The historic performance of the firm has been presented in balance sheets, income statements and the statement of owner equity. These statements must now be analysed. There are five basic toolboxes used in analysis. Each box contains several different tools. These toolboxes are: 1) the liquidity toolbox, 2) the solvency toolbox, 3) the profitability toolbox, 4) the efficiency toolbox, and 5) the repayment capacity toolbox.Liquidity
This toolbox provides the tools necessary to see how "liquid" the business is. In other words, how difficult is it to raise cash? The definition of liquidity is the ability to meet liabilities when they become due. The due liabilities are the current liabilities listed in the balance sheet. The cash to pay them comes from the current assets listed in the same balance sheet. There must be enough of these, as cash, to pay current liabilities. If there are, the firm is liquid. If there are not, the firm is illiquid. All firms must stay liquid. Cash is their most important asset. Managers must spend a lot of time making certain that their firms are safely liquid.Working Capital
Working capital is one of the major tools in the liquidity toolbox. It is calculated by subtracting current liabilities from current assets. For example, if the firm's current assets are $80,000 and current liabilities are $50,000, there is $30,000 working capital. In other words, after paying all the due debts, there is $30,000 left. The firm is liquid and that is good news.Quick Working Capital
Some current assets may not be quite as liquid as others. For instance, growing crops are not as easy to sell (i.e., not as liquid, as crops waiting to go to market). And nothing is as liquid as cash. This is the meaning of liquidity. Quick working capital is a tool that takes the "stickiness" of some of the current assets into account, to give a more realistic picture of what cash is actually available. Only current assets which can be sold quickly without a discount are included. Items which can be sold quickly include cash, savings, investments in stocks, and most mutual funds, receivables that can be realistically realised quickly and any inventory that is at, or close to, the point of sale. There will be times when the working capital of a firm looks substantial, but the quick working capital is negative. In other words, the firm is not as liquid as it originally looked.Current Ratio
The current ratio is calculated by dividing current assets by current liabilities. Thus if the current ratio of a firm at a specific point in time is 1.25 to 1, this means there is $1.25 to cover every $1 of debt due. Most firms will find it safe to keep their current ratio between two and three, meaning that they have $2 to $3 available to cover current liabilities. If the ratio falls below two, the manager should make sure that he can get liquid when he needs to. And if the ratio rises above three, he then has cash available for investing.Current Debt Ratio
The current debt ratio is found by dividing current liabilities by the total liabilities of the firm. It shows what proportion of all the firm's debt, both principal and interest, is due in the next period. For example, if current liabilities are $35,000 and total debt is $150,000, the current debt ratio = 35,000/150,000 = 0.23. This means that 23 cents of every dollar owed is due in the following period. Obviously it is hard to generalise about any "correct" ratio because it depends completely on the firm's debt load. But for a typical firm with a normal debt load, it is probably useful to keep the ratio below 0.1. A current debt ratio of 0.1 means that the firm must pay some 10% of its total debt in the next period. Most firms will find this a difficult objective to achieve.Solvency
Solvency is a long-run concept. It shows whether the firm can meet all its debts if it sells all its assets. If the assets are greater than the liabilities, the firm is solvent. If they are not, the firm is insolvent or bankrupt.Equity
This is the single best measurement of solvency. If the firm has equity, it is solvent. Perhaps the most useful indicator of a firm's progress is a good equity trend.Leverage Ratio
The leverage ratio is calculated by dividing total debt by equity. For example, if the firm's total debts are $200,000 and equity is $100,000, the leverage ratio is 200,000/100,000 or two. In other words, the firm has $2 in debt for every $1 that it owns. Most firms should keep this ratio below one. However it obviously depends on the situation the firm is in and the objectives and ages of the owners. Usually younger owners will have higher leverage ratios than older owners because the young tend to borrow more. A high leverage ratio is nothing to be ashamed of. It is something to reduce.Profitability
Profitability is a word that everyone recognises but few people define. Profitability is concerned with the returns obtained over time from some form of investing. For example, the annual return on assets or equity will reflect the profitability of those investments. Profit is perhaps an easier term. A common sense measure of profit might be net firm income or net income. The distinction between profitability and profit is important. Whether the profit is good or not depends on the amount of investment it took to get it.Return on Equity (ROE)
This is an important trend to follow. It shows the return on owned money in the firm. It is calculated using the formula:(Net income minus owners' salaries) x 100 / beginning equity.
Suppose the firm's net income for the quarter was $40,000. The owner withdrew $16,000 for salary and the equity at the start of the quarter was $300,000. The firm's ROE is therefore (40,000 - 16,000) x 100 / 300,000 = 8%.
The question to ask is whether this profitability indicator is the best return the owner could get for investing his money. Or are there higher achievable returns for investing in something with much the same risk and requiring the same skills? This is a question that only the owner can answer. If the owner loves what he currently does to earn 8% when he knows there are better opportunities available, then his decision should be respected.
Return on Assets (ROA)
This tool is calculated using the formula:(Net firm income + interest paid - owners' salary) x100 / beginning assets.
The interest paid on debts is added back because the firm has borrowed money to buy assets and is paying interest as a cost of borrowing. The interest represents the return from that part of an asset financed by borrowed money. Part of the asset is financed with debt and part with equity and the manager wants to know the total return on that asset. Hence the interest must be added back to calculate the total return. Hopefully it will be greater than the cost of borrowing. It is not sensible to borrow at 10% if the investment is returning 6%. This will happen if ROE is less than ROA. The firm is earning less than it is paying to borrow funds.
Suppose the firm had a net firm income of $50,000 during the quarter, paid interest of $10,000 and withdrew salary of $16,000. The assets at the beginning of the quarter were $600,000. The ROA is therefore:
(50,000 +10,000 - 16,000) x 100 / ( 600,000 ) = 7.33%.
Efficiency
This is perhaps the most familiar toolbox to agriculturalists. Most efficiency tools refer to the relationship between inputs and outputs. Examples include yields per acre, feed per pound of liveweight gain, cash costs per bushel, sales per week, boxes picked per hour of labour, etc. These types of tools are often kept by each firm and will not be presented here, except to emphasise their importance.Operation Ratios
This tool is particularly useful in examining how costs change over time. It uses percentage ratios that always add to 100%. The components are: 1) cash costs excluding interest, 2) depreciation, 3) interest, 4) owners' taxes and social security, 5) other costs not already counted, and 6) net income. All of these components come from the income statement. Adding the six components together gives the firm's gross output. For example, see Table 5 .The interpretation is that 17% of the firm's gross output results in net income, 58% goes on cash costs excluding interest, 10% on interest and so on. Put another way, for every dollar that the firm generated in that quarter, 17 cents was net income, 58 cents went on cash costs excluding interest, etc. The most useful thing about this tool is spotting trends. If, for example, interest costs took an increasing share of each gross output dollar, the manager has some decisions to make.
Asset Turnover
Firms have to know how quickly they turn their assets over to generate output. The basic definition for asset turnover is Gross Output / Average Total Assets. The greater the ratio, the better the assets are used. For example, if the firm produces $1,000,000 gross output in a year and its average asset valuation was $5 million, the turnover ratio is 20%. One fifth of its assets turn over annually. But because of the almost unique asset fixity in agriculture (i.e., the land domination of assets) another denominator might be more useful. For those firms who have more than 30% of their total asset values in land, remove land from the denominator and work with the remaining assets. Then compare the turnovers with and without land.Repayment Capacity
There are three main repayment capacity measurements and they all focus on how the firm can pay its debts. Note that these three measures ignore both the principal and interest of operating debt. It is assumed that operating debt will be repaid as the output it financed is sold. So unless any operating debt is carried over from the previous period, it is excluded from the formulae.Coverage Ratio
The coverage ratio is calculated using the following formula:net income + depreciation + interest - owners' salaries and taxes / annual principal and interest payments.
The higher the ratio, the easier it is for the firm to meet its debt commitments. If the ratio is one, it can just meet them. It also means that the firm is living, to some extent, off depreciation to service the debt. In other words the firm cannot replace any of the capital depreciation with new purchases. Anything greater than one gives the firm room to do other things.
For example, with a net income of $40,000, depreciation of $11,000, interest of $10,000, owners' salaries and taxes of $26,000 and principal payments of $13,000, the coverage ratio of this firm is:
$40,000 + $11,000 + $10,000 - $26,000 ÷ $13,000 + $10,000 =1.52.
The coverage ratio of 1.52 means that the firm can meet all its current debt obligations and still have 52 cents available for other uses.
Capital and Debt Margin
This ratio is essentially the next step up from the coverage ratio. It shows whether the firm can both meet its debt and afford to replace the capital assets lost in producing its net income. The capital and debt margin =net income + depreciation - owners' salaries and taxes - principal payments.
For example, using the numbers from the previous example, the capital and debt ratio of this firm is:
$40,000 + $11,000 - $26,000 - $13,000 = $12,000,
which means that there is $12,000 available after paying its current debt obligations and covering depreciation.
Debt to Income Ratio
The debt to income ratio is calculated using the following formula:average total liabilities / net firm income.
The average total liabilities is calculated from adding the liabilities of the beginning and ending balance sheets together and dividing by two. The ratio shows the number of times that the firm's debt exceeds its net firm income. For example, if liabilities are $300,000 and the net firm income is $50,000, the ratio is six. This means that, at the current rate, it would take six years for the income to equal debt. If the ratio falls to five, then its income leverage is reduced and the firm has reduced its risk. If the ratio rises, then income leverage is increasing, increasing the firm's risk because it becomes increasingly difficult to service this debt from current income.
Summary of What Did Happen
Managers, by necessity, use past performance to see how the firm is doing. This synopsis, using balance sheets, income statements and statements of owner equity, provides the raw data for the five analytical tools of liquidity, solvency, profitability, efficiency and repayment capacity. The manager is expected to produce answers from this analysis that will show whether the firm is meeting its objectives and to help formulate new objectives. But, unfortunately, analysis is neither entirely scientific nor precise. Analyzing the financial health of a firm involves experience and intelligent guesswork in much the same way that a doctor assesses and makes conclusions on the physical health of a patient.Perhaps the most important part of this assessment is to estimate what the firm or the patient will look like in the future. It is this estimate that produces the objectives of the firm by bringing past performance and future predictions together. Analysis of past performance and knowledge of the present situation formulates what the firm can do in the future. These future predictions use the tools on the right hand side of Figure 1 , and will be presented now.
Budgeting
Budgeting is trying to plan future expenditures and match these in some way with future sales and other dollar inflows. It is one of the most important functions in running a firm. No one knows the future, so budgeting results will usually be wrong. But it is essential to try. A budget is a map for the future of the firm and no one should go on a journey into the unknown without a map. And as with a journey, budgeting estimates change as circumstances change. The procedure is to start with budgeting the firm's individual enterprises. These enterprises are then added together to make the firm budget. The firm budget is then used to produce the cash flow for the firm.Enterprise Budget
A generalized enterprise budget is shown in Table 6 . Realize that the blanks under each category are where the individual items making up that category are entered. For example, the items of fertilizer, chemicals, labour, etc., would go under cash costs. Realize also that the sums of the different categories are shown by a capital letter.There are a lot of things to discuss in this table. Firstly, sales have proxied for gross output. If it is possible to budget the gross output of the enterprise, inventory changes and all, it should be done. But as sales are usually easier to estimate, and as they typically make up at least 90% of the enterprise gross output, they are a good proxy for gross output.
Secondly, the table shows that each enterprise has to play its part in meeting all the firm's outlays. Some items like the cash costs are directly applicable to an individual enterprise. For example, the fertilizer applied to a specific crop is charged entirely to that crop. Others, like depreciation, are not as directly applicable, in that resources like machinery are usually shared among all the enterprises. So some form of cost sharing needs to be done to allocate this type of cost to the enterprise. In other words, items like depreciation must be prorated. The alternative is to diligently record the number of hours etc. that an individual machine (for example) spends on each enterprise. This practice is rarely realistic, though it would usually provide better information.
The practical alternative is to have a simple method of cost sharing and later modify it as experience is gained. One of the simplest methods is to share the item in the same proportion as sales are shared. For instance, suppose a firm gets 70% of its sales from one enterprise and 30% from a similar enterprise. The depreciation could then be prorated between the two enterprises 70% and 30%. And if later experience shows that the smaller enterprise uses slightly more of the firm's depreciable capital assets per unit of output than the larger enterprise, the prorated shares might change to 65% and 35%. The sales percentage model is just one method. Sharing acording to cash costs is another possibility. So is sharing based on experience. The important point is that each enterprise must cover these prorated items in order to contribute to the firm's profit.
Thirdly, the table shows that each enterprise must contribute to owners' taxes, salary and principal payments. This contribution is obviously essential, but is unfortunately not often seen in a specific firm's enterprise budget. The prorating method should be simple, and modified as experience dictates. Again, the essential point is that each enterprise must be able to cover these items. If it cannot, then the budget should be reassessed. This means examining the costs and the prorated numbers including the projected salaries. If the reassessment does not produce a positive number to re-invest in the firm, the manager needs to consider how much longer he wants to produce this enterprise because it is currently not paying its way.
Assume that the enterprise does generate a positive "L," and that the firm owner is considering its production. A positive L is a necessary but not yet sufficient reason to produce it. Fourthly and finally, there are at least four questions to answer now before the enterprise is produced. These are: 1) are there enough resources available to produce it? In other words, is there sufficient land, labour, debt and equity capital and managerial ability available? 2) is there a market for this enterprise and what must the firm do to get the enterprise to that market? 3) what must be done to the enterprise before it is marketable? For example, how must it be prepared, graded, packaged, transported etc? 4) what are the production, financing and marketing risks involved (yield; cost and price volatility; capital availability as well as the effects of weather, pests, diseases, breakdowns,strikes, etc.)?
If the answers to these four questions look good, then: 1) repeat the process with other possible enterprises, 2) select the ones that look the most profitable, and 3) combine these enterprises into a firm budget.
Combining Selected Enterprises to Make a Firm Budget
The procedure is to firstly, list the enterprises in a table; secondly, complete the row names in the table; thirdly, calculate the net enterprise incomes from each enterprise and, finally, add across the table to produce the firm budget. The net enterprise summation provides the net firm income and the salary, principal and re-investing totals show how the firm's net income is budgeted. A reasonable layout for this exercise is shown in Table 7 , which also includes the projected numbers for the five enterprises and a total.The table shows the contribution of each enterprise to the firm and how each contribution is shared among the outlays. Thus the owner expects the firm to have around $800,000 in sales, to pay some $470,000 in cash costs, use up about $115,000 of capital assets as depreciation and to prorate the $45,000 overhead between the enterprises as shown in the table. Consequently the owner will have to pay around $34,000 in income and social security taxes, leaving a net income of $136,000, which is allocated as shown between salaries, principal and re-investing in the firm.
The Firm Cash Flow
The cash flow is a planning tool stemming from the firm budget. It is also the final planning tool, before resources are allocated to produce the firm's enterprises. The cash flow plans the future inflows and outflows of cash in the firm over a specific time period. It also shows cash in the business at the start of the period and cash left in the business at the end of the period. Examples of cash coming into the business include sales, new borrowing, other firm income and new equity. Examples of cash leaving the business include cash costs, principal payments, owners'salaries, asset purchases and owners' income taxes and social security.The cash flow does three things. It predicts, monitors and presents decision-making data. It predicts the future cash inflows and outflows within specific time periods, usually monthly. It monitors these monthly predictions by comparing the monthly estimates with what actually happened during the month. Finally it helps the manager to make decisions on the difference between the predicted results and the actual results. For example, suppose August sales were predicted to be $60,000, but were actually $40,000, or 33% less than the estimate. What decision should the manager make? The answer, of course, depends on why the sales were down. If it was because the market price fell, or yields or quality was down, then some future adjustments will be necessary. But if the output was not quite ready for sale, then perhaps only September's numbers should be adjusted.
If cash is unavailable when it is expected, there is more than sales to consider. Cash outflows were originally matched to the inflows. If inflows fall, then cash commitments such as debt service, payables and salaries cannot be met. Consequently other cash sources must be tapped to meet these commitments. A properly used cash flow shows what is happening and suggests what the consequences will be when predictions have to be changed. The cash flow is constantly changing and provides the manager the cash map necessary for cash management.
Cash flow forms vary and no one basic form fits every firm. It is more important to have a good cash flow system than worry about form uniformity. A good system should run for three years and as it becomes increasingly difficult to predict that far in advance, each year will present less detail than the year before. For example, the first year of the system typically uses monthly columns, the second uses quarters and the third an annual column only. Rows can also be simplified. The monthly columns would show, for example, the different types of chemicals to be used in individual rows, while the third year annual column might show all the chemicals combined in a single row.
There is nothing wrong with designing an individual system that fits a specific firm. It seems reasonable for firms that essentially operate six months a year to have more columns, weekly or monthly, in their busy times and perhaps have the remainder of the year reflected by quarters. The important point is that a cash flow must be used constantly to be useful. Including unnecessary detail is almost as bad as excluding vital data. Always keep 12 months ahead in each of the three cash flows in the system. When one month passes, introduce the same month in the following year. And as a quarter expires, predict the following quarter in the second cash flow.
A simplified cash flow layout is shown in Table 8 . This can be modified to fit the system in any firm.
Any one of these row names can be divided into its components, to provide detail or summarised to present a succinct picture. It may also be useful to use a separate loan section in the above table to itemise each loan and keep a running total of the current debt situation. The cash flow times debt repayments. It shows when there is cash and when there is no cash. Use it to present sensible debt scheduling to lenders. It is the firm cash flow rather than the lender which shows what can be done in paying interest and principal. Make sure that all parties involved understand this.
The cash flow also incorporates new events. As events change so will the firm results. Thus the cash flow must be changed constantly to reflect these changes and to reflect increasing knowledge of what will happen to cash inflows and cash outflows. The alterations show the results of the changes.
The cash flow shows when the firm can afford to buy assets. If the cash is not there and the asset is needed, it shows the consequences of increasing the debt load. It also shows how much salary can be drawn by the owners and the consequences of paying salary rather than spending the cash on other things.
Monitoring compares predictions with what actually happened. Predictions will be wrong, and the further away the predictions, the less accurate they may be. But the firm has to buy and use resources such as fertiliser and labour before it produces sales and make a hoped for profit. These are normal business risks. The cash flow helps to think through this process.A good cash flow shows more than just predictions. It also shows the actuals, side by side with the predictions. Table 9 shows the next step.
This cash flow has three sets of columns, shown in the Table 9 as "item," "July" and "January to July." It also simply illustrates some rows rather than presenting them all. The Table 9 layout is used for the nearby cash flow only. One set of columns (Item) lists the row names as before. The second (July) lists the predicted monthly cash results, the actual monthly cash results and the difference between them. The final set (January to July) lists these same three columns for the year to date. The idea behind this final set of columns is to prevent over- reaction to temporary events when the firm is basically still on track. Thus decisions should be made from the last column in Table 9 rather than the monthly difference column.
For example, there were no sales in July when the prediction was $40,000. This could be alarming, but the last column shows that the firm is only 8% down in sales for the year to date. So if the product was not quite ready for sale in July, then there is not much to worry about. Sales predictions have been pretty good. (Another story if there were other reasons for no sales in July, such as poor quality or price falls). Costs are also well predicted. The reason for no principal payments in July was because there were no July sales. The only problem with these numbers is that salary is higher than was predicted and this needs to be watched.
It is probably more useful to use percentages than numbers to express the differences between predicted and actuals. Percentages summarise the differences better. For example, a reduction in sales of $1 million looks startling, but if it is equivalent to a 3% drop, this does not seem too bad. So the essential purpose of the cash flow is to make decisions doing the cash flow and working with it. Producing, reviewing and using a cash flow are among the hardest tasks that a manager can do. But because cash is so vital today, it is this task that brings the highest reward.
Tables
Table 1. A simple balance sheet.
Assets Liabilities + Equities
Current Current cash + cash equivalents payables sale inventory operating loans supply inventory current portion of notes other inventory current portion of mortgages receivables other loans Immediate Intermediate vehicles vehicle notes equipment equipment notes temporary buildings building notes Long term Long term permanent buildings building mortgages land land mortgages Equity TOTAL TOTAL
GROSS OUTPUT sales other income to firm change in supply inventory change in sales inventory change in receivables TOTAL CASH COSTS category 1. e.g. chemicals and fertilisers category 2. e.g. all hired labor expenses category 3. e.g. transportation, fuel, repairs category 4. e.g. all marketing expenses category 5. e.g. all other cash costs TOTAL GROSS OUTPUT - CASH COSTS = GROSS MARGIN DEPRECIATION vehicles machinery and equipment buildings all other depreciable assets TOTAL OVERHEAD office expenses salaries and fees business travel entertainment all other overhead TOTAL TOTAL COSTS cash depreciation overhead TOTAL GROSS OUTPUT - TOTAL COSTS = NET FIRM INCOME OWNERS' TAXES income taxes social security taxes other taxes TOTAL NET FIRM INCOME - OWNERS' TAXES = NET INCOME NET INCOME principal payments re-investing owners' salaries Table 3. Statement of owner equity.
BEGINNING BALANCE SHEETDECEMBER 31
ENDING BALANCE SHEETMARCH 31
INCOME STATEMENT JANUARY 1 TO MARCH 31
STATEMENT OF OWNER EQUITYJANUARY 1 TO MARCH 31
Table 4. Summary of statement of owner equity.
BOOK MARKET Owner equity in beginning balance sheet 500,000 780,000 1. Net income during the quarter plus 50,000 50,000 2. Salary taken during quarter minus (20,000) (20,000) 3. Change in valuation equity ending balance sheet +$260,000 beginning balance sheet -$230,000 total change plus 30,000 Owner equity in ending balance sheet 530,000 840,000 Change in owner equity plus 30,000 60,000 Table 5. A statement illustrating operation ratios.
COMPONENTS $ % cash costs, excl. interest 70,000 58 depreciation 10,000 9 interest 12,000 10 taxes and S.S. 4,000 3 overhead 4,000 3 net income1 20,000 17 GROSS OUTPUT 120,000 100 1This is the residual from subtracting all the costs from the gross output. Table 6. A general enterprise budget.
Anticipated sales and costs of producing one (UNIT) of enterprise (NAME) in (WHERE) in (YEAR) $ per UNIT SALES anticipated (yield______) x anticipated (price________) =A COSTS AND INDICATORS (1) Cash costs _________ _________ Total cash costs =B GROSS MARGIN (A) - (B) =C (2) Depreciation _________ _________ Total Depreciation =D (3) Overhead (prorated) =E TOTAL COSTS (B) + (D) + (E) =F NET ENTERPRISE INCOME (A)-(F) =G (4) Owners' estimated taxes and SS (prorated) =H NET INCOME (G) - (H) =I MINUS (PRORATED) 1) salary to owners =J 2) principal payments =K EQUALS amount left for buying assests i.e., (I) - (J+K) =L Table 7. Enterprise and firm budgets: a methodology.
Enterprise Budgets($'000)
Firm Budget
CATEGORIES 1 2 3 4 5 Total SALES 250 200 150 100 100 800 Cash costs 150 120 80 60 60 470 Depreciation 36 29 22 14 14 115 Overhead 14 11 8 6 6 45 TOTAL COSTS 200 160 110 80 80 630 NET ENTER INCOME 50 40 40 20 20 170 owner income tax + s.s. 10 8 8 4 4 34 NET INCOME 40 32 32 16 16 136 salary 15 13 10 6 6 50 principal 12 10 8 5 5 40 re-investing 14 12 8 6 6 46 Table 8. A basic cash flow layout.
Time Period 1 Time Period 2 opening cash balance CASH IN sales other cash income new borrowing new equity additions Total cash available (A) CASH OUT cash costs owners' salaries asset purchases principal payments owners' taxes and SS Total cash spent (B) (A) - (B) = closing cash balance Table 9. The proper cash flow ($'000).
ITEM July January to July predict actual diff predict actual diff sales 40,000 0 (40000) 300,000 276,000 8% down costs 30,000 32,000 2,000 200,000 205,000 3% up salary 3000 3000 0 21,000 24,000 14% up prin. pt 5000 0 (5000) 30,000 25,000 17% down
Footnotes
1. This document is Circular 1210, EIR 97-8, one of a series of the Food and Resource Economics Department, Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida. Published: October, 1998. Reviewed: June 2003. Please visit the EDIS Web site at http://edis.ifas.ufl.edu.2. P.J. van Blokland, Professor, Food and Resource Economics Department, Indian River REC--Ft. Pierce, FL; Florida Cooperative Extension Service, Institute of Food and Agricultural Sciences, University of Florida, Gainesville, 32611.
The Institute of Food and Agricultural Sciences (IFAS) is an Equal Opportunity Institution authorized to provide research, educational information and other services only to individuals and institutions that function with non-discrimination with respect to race, creed, color, religion, age, disability, sex, sexual orientation, marital status, national origin, political opinions or affiliations. For more information on obtaining other extension publications, contact your county Cooperative Extension service.
U.S. Department of Agriculture, Cooperative Extension Service, University of Florida, IFAS, Florida A. & M. University Cooperative Extension Program, and Boards of County Commissioners Cooperating. Larry Arrington, Dean.
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