The Budgeting Process

The budgeting process is the systematic approach to planning and allocating a company’s financial resources, integrating decisions on investments, financing, and working capital to achieve strategic objectives.

The budgeting process involves putting together the financing and investment strategy in terms that allow those responsible for the financing of the company to determine what investments can be made and how these investments should be financed. In other words, budgeting pulls together decisions regarding capital budgeting, capital structure, and working capital.

Consider a company whose line of business is operating retail stores. Its store renovation plan is part of its overall strategy of regaining its share of the retail market by offering customers better quality and service. Fixing up its stores is seen as an investment strategy.

The company evaluates its renovation plan using capital budgeting techniques (e.g., net present value). But the renovation program requires financing-this is where the capital structure decision comes in. If it needs more funds, where do they come from? Debt? Equity? Both? And let’s not forget the working capital decisions. As the company renovates its stores, will this change its need for cash on hand? Will the renovation affect inventory needs? If the company expects to increase sales through this program, how will this affect its investment in accounts receivable? And what about short-term financing? Will it need more or less short-term financing when it renovates?

While the company is undergoing a renovation program, it needs to estimate what funds it needs, in both the short and the long run. This is where cash budget and pro forma financial statements are useful.

The starting point is generally a sales forecast, which is related closely to the purchasing, production, and other forecasts of the company. What are the company’s expected sales in the short term? In the long term? Also, the amount that the company expects to sell affects its purchases, sales personnel, and advertising forecasts. Putting together forecasts requires cooperation among Sears’s marketing, purchasing, and finance staff.

Once the company has its sales and related forecasts, the next step is a cash budget, detailing the cash inflows and outflows each period. Once the cash budget is established, pro forma balance sheet and income statements can be constructed. Following this, the company must verify that its budget is consistent with its objective and its strategies.

Budgeting generally begins four to six months prior to the end of the current fiscal period. Most companies have a set of procedures that must be followed in compiling the budget. The budget process is usually managed by either the CFO, a vice president of planning, the director of the budget, the vice president of finance, or the controller. Each division or department provides its own budgets that are then merged into a company’s centralized budget by the manager of the budget.

A budget looks forward and backward. It identifies resources that the company will generate or need in the near and long term, and it serves as a measure of the current and past performance of departments, divisions, or individual managers. But management has to be careful when measuring deviations between budgeted and actual results to separately identify deviations that were controllable from deviations that were uncontrollable. For example, suppose management develops a budget expecting $10 million sales from a new product. If actual sales turn out to be $6 million, do we interpret this result as poor performance on the part of management? Maybe, maybe not: If the lower-than-expected sales are due to an unexpected downturn in the economy, probably not; but yes, if they are due to what turns out to be obviously poor management forecasts of consumer demand.

Cash Budget

A cash budget is a detailed statement of the cash inflows and outflows expected in future periods. This budget helps management identify financing and investment needs.

A cash budget can also be used to compare actual cash flows against planned cash flows so that management can evaluate both management’s performance and management’s forecasting ability.

Cash flows come into the company from:

• Operations, such as receipts from sales and collections on accounts receivable.
• The results of financing decisions, such as borrowings, sales of shares of common stock, and sales of preferred stock.
• The results of investment decisions, such as sales of assets and income from marketable securities.

Cash flows leave the company from:

• Operations, such as payments on accounts payable, purchases of goods, and the payment of taxes.
• Financing obligations, such as the payment of dividends and interest, and the repurchase of shares of stock or the redemption of bonds.
• Investments, such as the purchase of plant and equipment

As we noted before, the cash budget is driven by the sales forecast. The cash budget, by providing estimates of cash inflows and outflows, provides an estimate of the company’s need for funds, requiring short- or long-term capital, or excess funds, requiring the company to invest the funds, pay down debt, or return capital to owners.