Saturday, May 5, 2012

The purposes of budgeting

Budgets have two main roles

They act as authorized to spend, that is , they give authority to budget managers to incur expenditure in their part of the organization,
They act as comparators for current performance, by providing a yardstick against which current activities can be monitored.
These two roles are combined in a system of budgetary planning and control.

planning and control

Planning the activities of an organization ensures that the organization sets out in the right direction. Individuals within the organization will have definite targets which they will aim to achieve. Without a formalized plan the organization will direction and managers will not be aware of their own targets and responsibilities. Neither will they appreciate how their activities relate to those of other managers within the organization.

A formalized plan will help to ensure a coordinated approach and the planning process itself will force managers to continually think ahead, planning and reviewing their activities in advance.

However, the budgetary process should not stop with the plan. The organization has started out in the right direction but to ensure that it continues on course it is the management’s responsibility to exercise control.

Control is best achieved by comparison of the actual results with the original plan.

Appropriate action can then be taken to occurect any deviations from the plan.

The comparison of actual result with a budgetary plan, and the taking of action to correct deviations, is known as feedback control.

The two activities of planning and control must go hand in hand. Carrying out the budgetary planning exercise without using the plan for control purposes is performing only part of the task

What is a budget?

A budget could be defined as ‘a quantified plan of action relating to a given period of time’.

For a budget to be useful it must be quantified. For example, it would not be particularly useful for the purposes of planning and control if a budget was set as follows:

‘We plan to spend as little as possible in running the printing department this year’; or

‘We plan to produce as many units as we can possibly sell this quarter’.

These are merely vague indicators of intended direction; they are not quantified plans.

They will not provide much assistance in management’s task of planning and controlling the organization.

These ‘budgets’ could perhaps be modified as follows:

Budgeted revenue expenditure for the printing department this year is £ 60,000’; and ‘budgeted production for the quarter is 4,700 units’

The quantification of the budgets has provided:

A definite target for planning purposes; and

A yardstick for control purposes.

budget period

You may have noticed that in each of these ‘budgets’ the time period was different. The first budget was prepared for a year and the second budget was for a quarter. The time period for which a budget is prepared and used is called the budget period. It can be any length so suit management purposes but it is usually 1 year.

The length of time chosen for the type budget period will depend on many factors, including the nature of the organization and the type of expenditure being considered. Each budget period can be subdivided into control period, also of varying lengths, depending on the level of control which management whishes to exercise. The usual length of a control period is 1 month.

planning, budgetary planning and operational planning

It will be useful at this stage to distinguish in broad terms three different types of planning:

Strategic planning, Budgetary planning, Operational planning;

These three forms of planning are interrelated. The main distinction between them relates to their time span which may be short term, medium term or long term.

The short term for one organization may be the medium or long term for another, depending on the type of activity in which it is involved.

Strategic planning

Strategic planning is concerned with preparing long-term action plans to attain the organization’s objectives.

Strategic planning is also known as corporate planning or long-range planning.

Budgetary planning

Budgetary planning is concerned with preparing the short-to medium-term plans of the organization. It will be carried out within framework of the strategic plan. An organization’s annual budget could be seen as an interim step towards achieving the long- term or strategic plan.

Operational planning

Operational planning refers to the short-time or day –to –day planning process. It is concerned with planning the utilization of resources and will be carried out within the framework set by the budgetary plan. Each state in the planning process can be seen as an interim step towards achieving the budget for the period.

Operational planning is also known as tactical planning.

Remember that the full benefit of any planning exercise is not realized unless the plan is also used for control purposes. Each of these types of planning should be accompanied by the appropriate control expertise covering the same time span.

preparation of budgets

The process of preparing and using budgets will differ from organization to organization. However there are a number of key requirements in the design of a budgetary planning and control process.

The budget committee

The need for coordination in the planning process is paramount. The interrelationship between the functional budgets (e.g. sales, production, purchasing) means that one budget cannot be completed without reference to several others.

For example, the purchasing budget cannot be prepared without reference to the production budget, and it my be necessary to prepared the sales budget before the production budget can be prepared. The best way to achieve this coordination is to set up a budget committee. The budget committee should comprise representatives from all functions in the organization. There should be a representative from sales, a representative from marketing, a reprehensive from personnel, and so on.

The budget committee should meet regularly to review the process of the budgetary planning process and to resolve problems that have arisen. These meeting will effectively bring together whole organization in one room, to ensure a coordinated approach to budget preparation.

Participative budgeting

CIMA participative budgeting as ‘a budgeting system in which all budget holders are given the opportunity to participate in setting their on budgets’. This may also be referred to as ‘bottom-up budgeting’. It contrasts with imposed or top- down budgets where the ultimate budget holder does not have the opportunity to participate in the budgeting process. The advantages of participative budgeting are as follows:

Improved quality of forecasts to use as the basis for the budget. Managers who are doing a job on a day-to-day basis are likely to have a better of what is achievable, what is likely to happen in the forthcoming period, local reading conditions, ect.

Improved motivation. Budget holders are more likely to want to work top achieve a budget that they have been involved in setting themselves, rather than one that has been imposed on them from above. They will on the budget and accept responsibility for the achievement of the targets contained therein.

The main disadvantage of participative budgeting is that it tends to result in a more extended and complex budgetary process. However, the advantages are generally accepted to outweigh this.

budget manual

Effective budgetary planning relies on the provision of adequate information to the individuals involved in the planning process.
Many of these information needs are contained in the budget manual.

A budget manual is a collection of documents which contains key information for those involved in the planning process. Typical contents could include the following:


An introductory explanation of the budgetary planning and control process including statements of the budgetary objective and desired results.

Participants should be made aware of the advantages to them and to the organization of an efficient planning and control process. This introduction should give participants an understanding of the working of the planning process, and of the sort of information that they can expect to receive as part of the control process.


A form of organization charts to show who is responsible for the preparation of each functional budget and the way in which the budgets are interrelated.


A timetable for the preparation of each budget. This will prevent the formations of a ‘bottleneck’, with the late preparation of one budget holding up the preparation of all others.

Copies of all forms to be completed by those responsible for preparing budgets, with explanations concerning their completion.

A list of the organization’s account codes, with full explanations of how to use them.


Information concerning key assumption to be made by managers in their budgets, for example, the rate of inflation, key exchange tares, ect.


The name and location of the person to be contracted concerning any problems encountered in preparing budgetary plans. This will usually be the coordinator of the budget committee (the budget officer) and will probably be a senior accountant.

Monday, January 10, 2011

(247)---MEASURES OF FINANCIAL LEVERAGE

Measures of Financial Leverage


The most commonly used measures of financial leverage are:
  • Debt ratio.
The ration of debt to total capital

L1 = D / (D+E) = D/V

Where D is value of debt, E is value of shareholders’ equity and V is value of total capital. D and E may be measured in terms of book value. The book value of equity is called net worth. Shareholder’s equity may be measured in terms of market value.

  • Debt-equity ratio
The ratio of debt to equity,

L2 = D/E

  • Interest coverage
The ratio of net operating income to interest charges

L3 = EBIT/Interest

The first two measures of financial leverage can be expressed either in terms of book values or market values. The market value to financial leverage is theoretically more appropriate because market value reflects the current attitude of investors. But it is difficult to get reliable information on market values in practice. The market values of securities fluctuate quite frequently.

There is no difference between the first two measures of financial leverage in operational terms. They are related to each other in the following manner.

L1 = L2 / (1+L2) = (D/E) / (1+D)/E = D/V

L2 = L1 / (1-L1) = (D/V) / (1-D)/V = D/E


These relationships indicate that both these measures of financial leverage will rank companies in the same order. However, the first measure is more specific as its value will range between zeros to one. The value of the second measure may very from zero to any large number. The debt-equity ratio, as a measure of financial leverage, is more popular in practice. There is usually an accepted industry standard to which the company’s debt-equity ratio is compared. The company will be considered risky if its debt-equity ratio exceeds the industry standard. Financial institutions and banks also focus on debt-equity ratio in their lending decisions.


The first two measures of financial leverage are also measures of capital gearing. They are static in nature as they show the borrowing position of the company at a point of time. These measures, thus, fail to reflect the level of financial risk, which is inherent in the possible failure of the company to pay interest and repay debt.

The third measure of financial leverage, commonly known as coverage ratio, indicates the capacity of the company to meet fixed financial charges. The reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of the firm’s income gearing. Again by comparing the company’s coverage ratio with an accepted industry standard, investors can get an idea of financial risk. However, this measure suffers from certain limitations. First, to determine the company’s ability to meet fixed financial obligations, it is the cash flow information, which is relevant, not the reported earnings. During recessionary economic decisions, there can be wide disparity between the earnings and the net cash flows generated from operations. Second, this ratio, when calculated on past earnings, does not provide any guide regarding the future risk ness of the company. Third, it is only a measure of short-term liquidity rather than of leverage.