business finance 101, learn business finance basics, fundamentals, and best practices

0:05 you have a great idea you have a product or service for which the world has been waiting you've scraped together enough cash to get your ID off the ground you have a location you've done your advertising you just know this is going to work and six months later you're out of business statistics from the small business administration indicate that about a half of new businesses fail in the first five years many new businesses fail and the reasons are many and varied in this course we're going to address some of the primary financial reasons that new businesses don't make it there are of course many non-financial reasons that new businesses struggle poor marketing poor location poor product quality we're going to limit this course to the

0:50 financial reasons for business failure if you get everything right but the financial side of things your business is going to struggle of course if you get the financial side of things right and drop the ball with the non-financial aspects of the new business you'll struggle as well with this course we'll stick with the financial aspects of struggling new businesses because that's what we know a little something about we have identified five common reasons that new businesses that struggle seem to face of course this is not an exhaustive list but these five reasons seem to consistently pop up when it comes to new businesses that struggle those five reasons are insufficient capital poor cash management poor record keeping and controls

1:36 improper product pricing and uncontrolled growth before we get started let me first say that several of these reasons for struggling are interrelated uncontrolled growth can relate to poor cash management poor cash management can relate to poor record keeping and so on while these topics can be interrelated we will address each one separately and then comment on the inner relationships when they are apparent so let's get started let's begin with the money needed to start a business too many new businesses start their business without enough Capital they just don't have enough money in the bank to support them while their cash flows get up to speed it turns out that the rent has to be paid the

2:26 utilities have to be paid equipment may need to be purchased or rented the employees have to be paid inventory has to be purchased all of your expenses have to be paid but you're waiting for potential customers first to find you and then second to pay you there's often a lag between when you get paid for providing a good or service and when you have to pay your vendors and generally that lag is not in your favor also when starting a business it takes time for your customers to find you and for you to get your sales and marketing efforts up to full speed during that time your expenses will continue to need to be paid it would be nice if all customers would pay immediately it would also be nice if vendors would wait to be paid until you are paid

3:13 yeah that would be nice many businesses are forced to close before they are able to find out if their business model has a chance to demonstrate that it's sound they just run out of money when starting a business realize that it will take time for cash inflows to start flowing but the cash outflows start flowing immediately make sure that you have access to sufficient Capital to allow your new business venture enough time to succeed so how much cash is enough cash the answer to that question can only come through a careful budgeting of cash inflows and cash outflows it is critical that as part of your business plan you sit down and carefully and realistically map out your expected cash inflows and outflows for at least the first six months of your new business

4:03 this exercise will allow you to determine any forecasted cash shortage and will allow you enough time to arrange for needed financing either from Partners or from creditors knowing well ahead of time that you will need cash allows you to make necessary arrangements for financing finding out today that you need cash tomorrow puts you in an unnecessary bind we will talk a little later in the course about the specifics of cash management but it is critical up front that you have an understanding that not having enough money to get started can result in a good idea meeting in early demise make sure you have sufficient capital or access to sufficient Capital before you open the doors to your new business again many new businesses with great business ideas don't make

4:52 it through the critical first few months a great idea is not sufficient you need to ensure that you have access to enough Capital to get you through those first few months by the way if you plan on going to a bank to ask for financing for your new business one of the first things they will ask about is your cash forecast they will want to know what capital you currently have available to you if you plan on asking friends and family to invest if they are smart they will ask about your cash forecast to obtain capital from others you need a cash forecast you might as well prepare one for yourself the cash forecast will allow you to determine how much Capital you will need to get you through those critical first few months

5:41 we know you'll need sufficient Capital to get your new business through the critical first few months let's assume you've made it through those first few months you will still need to track your cash inflows and outflows to ensure that you have sufficient cash to pay the bills that are surely coming whether you are at the start of your business or well into the life cycle of your business managing cash is critical for the well-being of your business and cash management does not happen by chance it is up to you to ensure that your cash is managed we will do this by preparing a cash forecast or budget let's start our discussion of cash management by distinguishing between two types of costs fixed costs and variable costs fixed costs are exactly that they're fixed budgeting for fixed costs is relatively straightforward the amount is

6:30 fixed at least over the short term variable costs are costs that vary relative to some activity or cost driver for a restaurant for example costs might vary based on the number of customers for a shop at the mall costs may vary based on the number of hours that the shop has opened labor costs utility costs and so forth now there can be a number of cost drivers or in other words costs can vary for a number of reasons it just depends on how complicated you want to get adding more drivers makes the arithmetic a little more complex but the concept is still the same now step one in cash management is to identify all of your fixed and all of your variable costs all of those costs it's easy to forget an expense here or an expense there and before you know it your cash forecasts

7:16 are useless the cash forecast is only as good as the inputs next we'll talk about variable costs answering the question how many customers can we expect is the hard part please don't gloss over this question your business will fail or succeed based on the answer to this question how many customers can you realistically expect many costs will vary based on anticipated customer demand answering this big question is beyond the scope of this video but it would involve such things as scoping out your competitor's volume of business assessing expected population growth in your area surveying potential customers a whole host of things your forecast of sales will be critical in

8:04 helping to prepare your forecast of cash inflows and outflows we will do some sensitivity analysis with these numbers to determine what might happen to our profits if more or fewer customers show up now that we have a reliable forecast of our cost driver at least as reliable as possible we can now compute our variable costs please note that as our business grows and matures we we will be able to determine a much more reliable estimate on the number of customers we can expect let's now turn our attention to the next area where new business owners tend to drop the ball that is the area of poor record-keeping most new business owners hate to worry about the record keeping they would rather worry about customers and sales and Innovation and growth and everything

8:52 other than record keeping proper record-keeping and internal controls are the blocking and tackling of new businesses not very glamorous and not very interesting but it needs to be done and it's safe to say that it needs to be done well you can liken proper record-keeping and adequate internal controls to the keeping of Statistics in a football game the person tracking the statistics is not on the field playing the game but those statistics are very helpful to those who are on the field playing the game as we discussed in the previous video on cash management you need to track your inflows and outflows of cash so that you can forecast future cash flows all we're talking about here is developing a system of tracking your inflows and outflows your obligations to others and others obligations to you it can be as simple as that

9:42 depending on the size of your business you can purchase accounting software off the shelf there are a number of great products that will do the job with minimal training but it is critical that someone take responsibility for keeping the books why is it critical well three reasons off the top of my head first more accurate information about your business will assist you in running your business better you will need information about cash influence and outflows and about who you owe and who owes you second if you ever need external financing Bankers or investors will insist on accurate financial information they will need that information to assess business risk you need that same information for that same reason and third taxes payroll taxes property taxes income taxes the list

10:31 goes on and on you need a system that tracks your tax obligations to ensure that you pay the right amounts at the right times if the government has to come in and do your taxes for you via an audit remember they don't work for you they work for the taxing authorities they will not be looking out for your best interest that will not be their job so get yourself a system for tracking your inflows and outflows get a system that will keep track of who you owe and who owes you get yourself a system that will provide you with the information that you will need to better run your business now about controls what are they controls are procedures that should be in place to ensure that

11:17 one the information that is being collected in your accounting system is accurate and reliable thereby helping you to run your business better and two to safeguard your assets and your records now what sort of control should I have on information that I will collect you will need to answer questions like how will you document that your cash outflows are legitimate business expenses you better have proper documentation if I'm in a business that has inventory for resale How will I know how much I have on hand how do I know how many hours my employees have worked you better have a system for tracking this information and of course you will need a system that collects information about your cash inflows and your cash outflows and you also need to know who you owe and who owes you we've talked about that what else well you'll have information that's confidential

12:05 about employees pay rates Social Security numbers Etc that all has to be safeguarded what about customer lists what about pricing information as you can imagine there's a lot of top secret information relating to the inner workings of your business that you don't want getting out you need to ensure that you have systems that protect your information and ensures that the system producing your information is accurate and reliable one last thing to mention that is often taken for granted you will need to safeguard your cash you will need procedures in place to make sure that cash and checks are quickly and correctly deposited in the bank and that only authorized expenditures are made this is no fun to talk about but we tend to assume that those with whom we work are looking out for the best interest of the company now that is

12:53 often the case but is also often not the case many individuals are looking out for them you need to make sure that those individuals are never given the opportunity to be exposed to a situation where they might compromise their integrity that is done by developing a set of controls within your business to ensure that information is collected quickly and correctly and that procedures are in place to ensure that assets especially cash are handled properly now remember we sat at the outset that this topic is the no fun part of business no one likes to talk about paperwork if you don't talk about an establish a system that collects accurate information in a timely fashion and safeguards your assets you will have plenty time to talk about that topic later when your

13:41 business folds up a good system of record-keeping and controls is what the scientists would call a necessary but not sufficient condition a good information system will not ensure the success of your business but a bad information system will certainly contribute to your lack of success so what can be so hard about pricing a product don't you just figure out what your costs are and then add some sort of markup for profit oh that it were that easy if your price is too high regardless of your cost someone in the market will underprice you assuming that the quality of product or service is similar in many cases you will be a price taker and you will have to manage your costs so that you can

14:26 earn a profit given a certain price is determined by the market now let me say that again in most instances you don't price your product to cover your cost instead you determine if given a certain market price your cost structure is such that you can earn a profit the biggest mistake new business owners make in product pricing is not considering and covering all of their costs when entering a market now it is true that when you are initially trying to penetrate a market you may be willing to lose a little money to gain market share but that strategy is not sustainable over time over the long term you must cover all of your costs all of your costs now to our last topic uncontrolled growth growth is awesome increased market share is good sales

15:16 trending upward is the dream and unmanaged growth has killed a lot of companies growth must be carefully done or it could be fatal to your business the reason being is that growth often requires cash and cash is often the one thing that new businesses do not have a lot of in fact a lot of new business owners when faced with the cash flow issues associated with starting a new business they mistakenly think that the solution to their cash flow problems is to grow faster not realizing that the fast growth is causing the cash flow problem in the first place in other words they hit the gas when they should hit the brake so how does growth cause cash flow problems well think about it in a typical business that is selling a product to a customer on credit that is the customer will pay in say 30 days you as the business owner need to pay

16:06 your rent pay your insurance pay your employees pay for the inventory then sell that inventory and wait for 30 days to collect the cash to grow faster means you need to buy and pay for more inventory and then sell that inventory and wait for 30 days to collect the cash the more inventory you have to buy the more inventory you have to pay for and then still wait 30 days to collect the cash well let's just have our suppliers wait longer to collect from us until we collect from our customers remember this your suppliers are having the same cash flow issues that you are facing they would like to receive their cash sooner rather than later whether we're talking about an individual a family or a large organization the overall

16:54 purpose of a budget is to clearly establish a plan so that performance in relation to a goal or the plan can be carefully monitored budgeting has a two-fold purpose the first purpose is to allow individuals or companies to develop a plan to meet a specified goal the second purpose is to allow ongoing comparison between actual results and the plan now the penalty for not budgeting is severe the list of companies that have failed in recent years as a result of poor planning and execution is getting longer every day now the basic difference between companies that budget and those that don't is that those that budget will spend money how where and when they want to and those that do not budget often feel like they

17:42 never have enough money to purchase those things that they need now budgeting is critical to the management planning process there are two basic types of planning the long run planning which includes strategic planning and capital budgeting and short-run planning which includes production and process prioritizing and operations budgeting also known as profit planning long-run planning involves making strategic decisions where the effects will extend several years into the future long-run strategic planning involves identifying the organization's Mission the goals flowing from that mission and the strategies and actions that will be taken to accomplish those goals with strategic planning in place the company can then plan for the purchase and use of

18:29 major assets like buildings or equipment to help the company meet its long-range goals this type of planning is called Capital budgeting once the organization's strategic decisions are in place managers are able to focus on operating plans for the immediate month quarter and year this short-run operational planning can be divided into two categories first production prioritization with the capital structure in place things like land buildings and Equipment managers need to determine how to best use those committed resources to maximize profits second is operations budgeting once the organization has established its production priorities managers are ready to go to this second category of short-run planning operations budgeting sometimes known as profit

19:19 plans operations budgets are used by managers to establish and communicate daily weekly and monthly goals for the organization budgeting is such an important activity that the top Executives of most companies coordinate and participate in the process large firms usually establish a budget committee which may include the vice presidents for sales production purchasing and finance and the controller or Chief Financial Officer these Executives work to implement the organization's strategy by coordinating the preparation of a detailed budget in their area of responsibility and then together oversee the integration of a comprehensive Master budget for the firm two important issues faced by Executives in the budgeting process are first behavioral

20:09 considerations how will the budget affect people and second involvement in preparing the budget who gets to help we will discuss these two issues in the video that follows research and experience has shown that several behavioral factors determine how successful the budgeting process is going to be first the process must have the support of top management without a clear indication from Top management that the budgeting process is important to the organization managers will not be motivated to devote the time necessary to formulate an effective and efficient budget second managers and other employees are more motivated to achieve

20:57 budget goals that they understand and help design for this process to work managers must feel that their opinions are respected and given full consideration in addition when internal or external circumstances change all parties involved should discuss the necessary budget adjustments generally the most effective companies are those that involve employees in the decision-making process however involving a lot of employees add significant time and cost to the budgeting process third deviations or variances from the budget must be addressed by managers in a positive and constructive manner identifying deviations from the plan is simply a way to

21:43 focus Management's attention on areas needing Improvement unfortunately some managers treat these deviations as an opportunity to find fault and assign blame to lower level managers the result is usually a loss of motivation accompanied by such dysfunctional Behavior as interdepartmental bickering defensive attitudes and overall unethical Behavior one output of upper level managers using budgets strictly as a punishing tool is budgetary slack in the budget system that is a lower level manager intentionally creating an easy budget Target that he or she is certain can be met obviously all these behaviors waste an organizations resource and do not contribute to meeting its strategic and operational goals a more useful reaction to

22:33 deviations is to focus on actions that need to be taken as one CEO stated quote I never made a dime for the company by assessing blame or firing a manager if I can provide help to a manager to solve a problem though we can see the benefit in administering the budget process it is extremely important that top management not use the budget as a club or a whipping stick and again we see budgeting is as much about the people as it is about the numbers the numbers help us achieve a goal but always remember that the numbers themselves they're not the goal the top-down approach sometimes referred to as authoritative budgeting is when top management

23:24 prepares a firm-wide operations budget and distributes it to the major segments of the firm and then hopefully it trickles down to each lower level segment manager its proponents argue that only top management knows the Strategic direction of the firm and is aware of all the external factors influencing its operations further since top management involves only a few people who have risen to positions where they no longer have special interest to protect they are in the best position to efficiently coordinate the competing needs of the segments well that makes some sense the alternative is the bottom-up approach also known as participative budgeting each division manager and a bottom-up approach prepares a budget request for his or her segment these

24:12 requests are combined and reviewed as they move up the organizational hierarchy with adjustments being made to coordinate the needs and goals of individual units within the overall organization proponents of this approach contend that segment managers have the best information on the products or Services they provide the customers they serve and the technology that is emerging they are therefore in the best position to identify segment needs and to weigh alternative courses of action and that makes some sense as well more importantly managers who have a role in setting segment goals are more motivated to achieve these goals it's also good training for managers to develop their planning skills in preparation for promotions to positions of Greater Authority

25:02 naturally the organization also benefits when its managers are proficient in planning however the bottom-up approach is very costly and time intensive when compared to the top data approach also in order to achieve personal goals participants may also engage in political maneuvering that creates budgetary slack or other problems because both the top down and the bottom-up approach are legitimate approaches most organizations use some combination of the two the budget committee members know the Strategic direction of the firm and the important external factors that affect it so they prepare a set of planning guidelines that are then communicated to lower level managers these guidelines include such things as a forecast of key

25:49 economic variables and their potential impact on the firm plans for introducing and advertising new products and some broad sales targets and resource allocations with these guidelines in mind lower level managers then prepare their individual budgets these budgets are always reviewed to be sure they are consistent with the objectives of other segments and of the company as a whole as the budget committee understands that changes to a manager's budget should be made with great care any reasons for changes should be substantial and should be discussed with the managers involved the blending of these two approaches will vary among organizations a smaller organization with a few management levels will rely more on the top-down approach

26:36 than will a larger organization top Management in smaller organizations tends to be more knowledgeable about and more involved in the operating details the master budget is the most detailed and most heavily used budget in an organization this budget is an integrated group of detailed budgets that together constitute the overall operating investing and financing plans for a specific time period the flow of the preparation of the individual budgets within this master budget network works like this first the budgeting process should be based on the long-term strategic goals and plans of the company in fact if there is no connection between the company's long-term strategic plans and the company's detail budgets

27:26 then the long-term strategic plans are irrelevant another maybe more positive way to say that same thing is that the detailed budgets within the master budget give relevance to the company's long-term strategic goals now in a manufacturing firm the master budget begins with a forecast of sales the sales forecast in connection with the long-term strategic plan leads to the capital budget or the plan for the purchase of long-term assets the label Capital expenditures is given to purchases of long-term operating assets such as land buildings and Equipment these assets are required to be used over the course of several years there are several Financial models used to make Capital budgeting decisions a simple one is called payback period and involves Computing

28:11 how many years it will take to recover the initial investment cost net present value or npv analysis involves comparing the cost of the asset with the value of the expected cash inflows after adjusting for the time value of money the value of a long-term operating asset can disappear instantly if events lower expectations about the future cash inflows that the asset can generate these computations are very interesting but unfortunately are beyond the scope of this course now the sales forecast also leads to the short-term operational plans established by top management once the sales forecast or sales budget is created the budgeting team in a Manufacturing Company splits into two sub teams one of the sub teams will use the sales forecast

28:56 to determine the detailed plan for production the production budget this team will consider the amount and timing of purchases of raw materials the hiring needs for the production laborers and the budget for the infrastructure or overhead costs this collection of production budgets provide a numerical plan for what will happen inside the factory or the production facility at the same time using that same sales budget the other sub team uses that sales budget to then construct a budget for the activities that occur outside the production facility so this selling and administrative expense budget involves the numerical plan for the advertising payments to the sales team costs of company headquarters and so forth the capital budget production budgets and selling and administrative expense budget then come together

29:43 in the construction of additional budgets the cash budget and the budgeted or pro forma financial statements preparation of the cash budget is discussed later in this course the construction of the pro form of financial statements is unfortunately outside the scope of this course formalized budgeting activity forces management to make many important decisions that guide a company towards its goals decisions involving scheduling pricing borrowing investing and cost control so we'll begin our Master budget with perhaps its most important budget component the sales budget the sales budget always Begins the budgeting process and drives many of the related budgets for example how much inventory we make is a function of how much we're going to sell how much inventory we determine to make then drives how much material we need to purchase how many workers we need to

30:32 hire and so on remember the term Master budget is not just one budget it is a series of budgets that taken together comprise what is termed the master budget the master budget starts with the long-term strategic plan made operational this year with the sales budget for this year the first step in developing a master budget is to prepare a sales budget all the other budgets are developed from this sales budget a projecting accurate sales is very difficult however because sales are a function of both uncontrollable external variables such as customer tastes and economic conditions and controllable internal variables such as price sales effort and advertising expenditures those uncontrollable external factors driving sales include the

31:21 following first there's the business environment which includes current government policies and law the status of the economy demographics which are characteristics of the population such as age wealth family status and so forth and the state of Technology another external Factor customer needs and taste with respect to the product or service being analyzed and other substitute products another Factor intensity of the competition and possible barriers to Market entry barriers that can include technology copyrights government contracts reputation or large sales volumes that provide economies scale another external Factor seasonal Cycles created abrupt changes in sales demand due to holidays or weather patterns and finally external factors such as unexpected events droughts hurricanes earthquakes now analysis of these external variables is accomplished through

32:10 research and sales forecasting techniques these techniques may be as simple as having a sales staff ask major customers about their buying plans for the next year or as sophisticated as statistical market research techniques some firms use quantitative forecasting models these range from simple growth rate trends derived from the past year sales to complex forecasting models that attempt to measure the influence of many economic and Industry variables data used to drive these analyzes are obtained from a variety of sources now for most organizations they divide their yearly sales budget in the monthly weekly or even daily budgets in order to plan production schedules and cash flows more precisely now regardless of whether the budget is on a quarterly or a yearly basis the concepts are the same remember the

32:57 sales budget is the most difficult but the most important budget in this entire budgeting process if you give an accountant an accurate sales forecast she or he can create a very useful set of budgets for you but if the sales forecast is inaccurate even the best account in the world can't generate good production budgets labor budgets or cash budgets after the sales budget is completed the second detailed budget covers the number of units to be produced during the period three factors need to be considered in preparing this production budget first the projected sales volume for the period second the desired amount of ending inventory and third the amount of inventory already on hand in the beginning inventory ending inventory is

33:45 an important figure because management wants enough units on hand to meet customer demands but not so many that unnecessary costs will be incurred because of excessive inventory so let's consider the question why does a manufacturer want andine inventory on one side what if we run out of finished goods we'll have lost sales perhaps now and forever we'll also have lost reputation but on the other hand what if we have too many finished goods we'll have excess resources tied up in inventory the inventory could get old and obsolete eventually having to be sold at a loss the next detailed budget to be prepared is the direct materials budget this budget helps Management schedule purchases from suppliers expected changes in materials

34:32 prices should definitely be included in the budget calculations similar to the production budget shown earlier the materials purchases budget is based on the level of production and on the required level of ending inventories the materials purchases budget is then adjusted for the beginning inventory expected for each quarter like the production budget the desired level of ending inventory has a big impact on the direct materials budget if management does not maintain sufficient materials then the production process could be held up if inventories are too high inventory investment and storage costs can get out of control the fourth budget in the manufacturing section of the master budget is the direct Labor budget the twenty dollars per hour wage rate must include the cost of fringe benefits such as the cost of sick

35:20 leave vacation pay insurance and so forth also we need to include the employer's portion of any payroll taxes here we get a hint of how important this detailed budgeting process is for example what if we are considering paying our laborers a higher effective wage this budgeting process allows the company to see the implications of that wage increase before implementing the increase management must plan so that sufficient but not excessive labor is always available otherwise the company is likely to suffer the high cost of frequent hiring firing layoffs and overtime work probably even more important than the high cost of employee turnover however is the feeling of demoralization among employees that lack of job security can cause now you can also start to see how our cash budget is starting to come together this

36:09 is an important aspect of budgeting both in a business and in your personal finances if you are casual about cash budgeting you tend to remember all of the expected cash collections but you forget some of the necessary cash payments a disciplined budgeting process helps you to identify all of the budgeted cash payments so we better keep going the manufacturing overhead budget includes all production costs other than those for direct materials and direct labor because manufacturing overhead is a major element of total manufacturing costs in many organizations those organizations that are able to effectively plan and control these costs have a significant advantage in the marketplace in preparing a manufacturing overhead

36:55 budget the first step is to estimate the annual variable and fixed manufacturing overhead costs to keep things simple for our example we will assume the variable overhead costs are to be allocated on the basis of direct labor hours that is those overhead costs increase in proportion to our direct labor cost this makes sense more direct labor hours means the need for more electricity more wear and tear on the equipment more need for supervisor time and so forth remember that when we were talking about the master budget I said that once the sales forecast or sales budget is created the budgeting team and a Manufacturing Company splits into two sub teams one of the sub teams will use the sales forecast to determine the detailed plan for production the

37:41 production budget this team will consider the amount and timing of purchases of raw materials the hiring needs for production laborers and the budget for the infrastructure or overhead costs this collection of production budgets provides a numerical plan for what will happen inside the factory or the production facility the other sub team at the same time uses that same sales budget to then construct a budget for the activities that will occur outside the production facility so this selling and administrative expense budget involves the numerical plan for the advertising payments to sales teams cost of company headquarters and so forth the selling and administrative expense budget includes planned expenditures for all areas other than production the cost of supplies used by the office staff the salaries of the sales manager and the company president and the depreciation

38:29 of the administrator's office building not the production facility all belong in this category and because this budget covers several areas it is usually quite large and may be supported by individual budgets for specific departments within the selling and administrative functions similar to our approach with the manufacturing overhead budget depreciation expense is eliminated from the budgeted selling and administrative expenses to determine the expected quarterly cash payments for those expenses although the selling and administrative expense budget Illustrated here looks reasonably simple it is often more complex in actual practice rather than classifying these costs based on their functions salaries depreciation and so forth as seen here we often see in practice that these budgets are divided into multiple categories that may emphasize how

39:15 costs are related to important functions in the organization such as research and development or r d product or service design marketing distribution and customer service successful organizations do this in writing and they do it all the time budgeting is a critical and important part of an organization's long-term survival remember running an organization without using a budget is a very exciting exercise from one day to the next you have no idea what's coming every morning you wake up to a whole new collection of surprises that's one way to run an organization a different way is to spend some time carefully constructing a numerical plan a budget yeah they'll still be some surprises but you will have a framework a plan a budget within which to adapt to those surprises

40:07 there are several similarities in the budgeting process for manufacturing businesses merchandising companies and service companies basically the budgeting process involves budgeting or forecasting revenues and the cash that will be generated by those revenues as well as budgeting expenses and cash that will be paid for those expenses managers are always interested in how much revenue and expense they will have during each budgeted period and how much cash and other assets and liabilities they will have at the end of each budgeted period because merchandising companies buy products rather than make them their budgeting process is less complicated than the budgeting done by manufacturing companies however the format of the merchandise company's purchases budget would be very similar to the format of the manufacturing company's production budget by combining expected sales with desired ending inventory and subtracting the beginning inventory

40:57 expected to be on hand the merchandise company will arrive at the number of boats to be purchased rather than produced for the period now these labels manufacturing company and Merchandising company may seem a bit strange but let me convince you that you already understand the distinction between the two a good example of a manufacturing company is General Motors General Motors assembles raw materials employs skilled Auto Workers maintains a large infrastructure of production facilities machinery and supervisory staff and actually makes cars and trucks GM then sells those manufactured cars and trucks to automobile dealerships General Motors makes cars and trucks it's a Manufacturing Company in contrast a merchandising company doesn't make anything a good example is Walmart the goods sold by Walmart are all made by other companies Procter Gamble PepsiCo

41:48 Kraft Foods and Campbell Soup Walmart buys those completed Goods puts them on the shelves and sells them Walmart doesn't make anything Walmart is a merchandising company the master budgeting process for a merchandising firm is much less complicated than that done for a manufacturing firm merchandising companies replace four budgets the production budget the direct materials budget the direct Labor budget and the manufacturing overhead budget used by manufacturing firms with a single budget the purchases budget the sales budget and the selling and administrative expense budget are similar to those prepared for manufacturing firms so we won't discuss those budgets again each year service companies are becoming a larger and larger percentage of the businesses in the

42:35 United States and worldwide service companies differ from manufacturing and Merchandising companies in that they provide services to customers instead of a product some common service businesses are as follows their law accounting and engineering firms they're doctors and dentists hotels and motels hunting and fishing guide Services Automotive home and appliance repair services internet providers so here's a thought question for you is McDonald's a service business a merchandising business or a manufacturing business think for a second and the answer is the McDonald's has elements of all three types of business McDonald's manufactures the food that you buy so there's an element of manufacturing McDonald's provides a service because they prepare the food for you and deliver it in a rapid ready to eat

43:22 fashion there's an element of service McDonald's often sells toys and other items as part of its promotions so McDonald's doesn't make these toys they're for McDonald's is a merchandising company budgeting for service firms is similar to budgeting for manufacturing firms in fact you can think of a service company as being the same as a Manufacturing Company except that the cost of materials is very low and the focus is on the labor and on the infrastructure support or overhead costs as was the case with both manufacturing and Merchandising companies the budgeting process for service firms begins with a sales budget the service firm does not require a production budget service firms sell intangible products such as physician appointments car repairs room rentals or monthly internet service that can't be inventoried therefore the sales

44:09 volume determined in the sales budget is the same as the production budget for that operating period the cash budget which shows expected cash receipts and disbursements during a period is impacted by all of the preceding budgets in the master budget a detailed cash budget will point out when a company has excess cash to invest and when it has to borrow funds this allows a firm to earn maximum interest on excess funds and to avoid the cost of unnecessary borrowing the cash receipts section of a cash budget summarizes all cash expected to flow into the business during the budget period because many companies generally extend credit to their customers a lot of their sales are originally

44:59 recorded as accounts receivable the collection of accounts receivable is a major source of cash and its timing is an important consideration in preparing a cash budget now in our example we assume that all customers always pay wouldn't that be nice in truth some customers never pay and these uncollectible accounts must be considered when analyzing estimated cash collections from our accounts receivable economic factors often play a significant role in the timing of the collection of our accounts receivable during recessionary periods customers often drag out their payments much longer than they would in prosperous times and we'd need to factor that in

45:48 so far the budgets discussed in this topic are static budgets that is they are geared to only one level of sales activity however as hard as companies try to predict sales volume these numbers rarely turn out to be exactly as predicted in fact as there are unexpected changes in the economy technology or competitors actual sales can turn out to be very different from plant sales this is a critical issue since sales budgets are the key input in building the rest of the operational budgets therefore the budgets need to be recomputed based on the actual sales activity this is the process of creating a flexible budget a flexible budget is much more useful

46:35 for control and performance evaluation because it is not confined to one level of activity flexible budgets are Dynamic that is they can be tailored to any level of activity within a relevant range using a flexible budget a manager can look at the actual level of activity attained and then determine what the cost should have been for that level of activity for a company that sells a product the company's operating cycle is the amount of time that elapses from when the company buys the inventory until when the company collects the cash from selling that inventory the length of the operating cycle is the sum of the length of two very different processes first how long from when a company buys the inventory until it sells or uses that

47:25 inventory second how long from when a company makes a sale until the company collects the cash from that sale let's talk about that first length of time which is often called the number of days sales and inventory let me illustrate with an example Nike makes athletic shoes and other sportswear Nike manufactures these items and then sells them to retail outlets typically on credit in terms of the length of Nike's operating cycle we must first consider how many days elapsed from the time that Nike buys raw materials until the time that Nike sells the finished shoes and sportswear to retail outlets using data from Nike's Financial reports it can be computed that this is about 80 days this is called the number of days sales and inventory we must then determine how long until Nike collects the cash from these sales to retail

48:13 outlets on average this is about 50 days we call this the average collection period if you take these two numbers and add them together 80 Days From purchase of raw materials to the sale of the finished goods and sportswear and then 50 days from the sale to the cash collection you get 130 days that's the length of Nike's operating cycle again the operating cycle is the time from the purchase of the raw materials to the collection of the cash from the sale of the finished goods for Nike that's 130 days when Nike purchases its raw materials on credit from its suppliers Nike pays those bills off in about 40 days so Nike buys raw materials on credit and then pays for those raw materials after about 40 days but Nike doesn't collect the cash from selling the finished

48:59 shoes and sportswear until a total of 130 days have passed this is why companies such as Nike must carefully manage purchases sales and cash collections in order to balance out this mismatch between the timing of cash payments and the timing of cash collections if Nike wishes to manage its operating cash flow the company has three dials it can turn first one is the number of days sales and inventory in a Manufacturing Company such as Nike reducing the number of days sales and inventory involves streamlining the production process to get materials through the process as quickly as possible the longer it takes to make the shoes after buying the materials then the longer Nike has to wait until collecting the cash from the sale of the shoes second dial average collection period if Nike allows its customers the retail stores to delay paying

49:49 for their purchases that means that Nike must borrow cash in order to pay its own bills while waiting for the customer cash there is a fine balance here balancing the desire to collect the cash with a desire to please the customer by not pestering for cash payment too quickly the third dial is the number of days purchases in accounts payable managing operating cash flow sometimes means stretching out the time when you pay your suppliers again this is a balancing act if you can stretch out this time which averages 40 Days for Nike then you are preserving your cash to pay for other things however you don't want to anger your suppliers by keeping them waiting too long if we put all the numbers together it takes Nike 130 days to convert purchased raw materials

50:34 into operating cash collections 80 days to make and sell the product and 50 days to collect the cash in the meantime Nike pays for those raw materials in about 40 days so for 90 days the difference between 130 days and 40 days Nike has to use cash from other sources to keep its operation going of course in a steady state Nike and other companies can use cash collected from prior sales to pay for the materials purchased to make goods for future sales but in a growing business or cash payments to make goods for future sales are greater than cash collected from past sales this operating cycle mismatch can create large operating cash flow shortfalls now to see a different operating cash flow pattern let's talk about the cash operating cycle at McDonald's I love the cash flow pattern of McDonald's from the time that McDonald's buys

51:25 raw materials food and packaging until McDonald's sells the finished product the food wrapped in the packaging about seven days a lapse cash collection takes about two seconds because even when the customer uses a credit or debit card McDonald's gets its electronic cash almost instantly so the length of McDonald's operating cycle is seven days plus two seconds seven days from the purchase of the raw materials until the sale and then two more seconds to collect the cash now if McDonald's pays its suppliers under standard credit terms McDonald's will pay for the food and packaging in about 30 days so for 23 days 30 days minus the seven days and two seconds McDonald's has the cash before needing to pay its own suppliers this means that with this pattern of

52:14 operating cash flows McDonald's or another company with a similar pattern could grow as fast as it wanted with the operating cycle itself providing all the cash to finance the operating growth Capital expenditures are purchases of long-term operating assets such as land buildings and Equipment these assets are required to be used over the course of several years in the statement of cash flows we classify the purchase of these assets as investing activities the value of long-term operating assets stems from the fact that they help companies generate future cash flows Capital budgeting is the name given to the process whereby decisions are made about acquiring long-term operating assets there are several Financial models used to make Capital budgeting

53:02 decisions a simple one is called payback period and involves Computing how many years it will take to recover the initial investment cost net present value or npv analysis involves comparing the cost of the asset with the value of the expected cash inflows after adjusting for the time value of money the value of a long-term operating asset can disappear instantly if events lower expectations about the future cash flows the asset can generate these computations are very interesting but are beyond the scope of this course Capital budgeting decisions such as the purchase of operating assets or the purchase of another company are basically cash flow decisions the company gives up a certain amount of cash flows today the purchase price and in the future operating outlays in the hope

53:48 of receiving a greater amount of cash flows in the future as the asset generates revenues and or produces cost savings to illustrate a simple Capital budgeting decision assume that Yosef manufacturing makes joysticks and other computer game accessories Yosef is considering expanding its operations by buying an additional production facility the cost of the new Factory is a hundred million dollars this is an investing activity Yosef expects to be able to sell the joysticks and other items made in the factory for 80 million dollars per year at that level of production the annual cost of operating the factory the wages the insurance the materials the maintenance and so forth is expected to Total 65 million dollars the factory is expected to remain in operation for

54:34 about 20 years should Yosef buy this new Factory for 100 million dollars that's an investing activity decision to summarize Yosef must decide whether to pay a hundred million dollars for a factory that will generate a net cash inflow of 15 million dollars per year the 80 million inflow and the 65 million outflow for 20 years now one simple method that can be used to analyze this purchase is called the payback method or the payback period the payback period is just the time it takes for the company to recover its original investment calculated by dividing the original investment cost by the net annual cash inflows received from the investment in the case of the factory purchase being considered by Yosef manufacturing the payback period is 6.67 years computed as follows if the payback period is the initial investment divided by the annual inflow that's a hundred

55:24 million dollars divided by 15 million dollars per year that's 6.67 years that's how long it takes Yosef to get its money back one way to use this payback period number is to invest only in assets that pay back within a certain period of time perhaps within five or six years this required payback period might be set differently for different types of Assets in addition qualitative factors such as strategic positioning for future expansion and potential positive motivational effects on employees would influence the decision the important concept to remember here is that long-term operating assets have value because they are expected to help a company generate cash flows in the future if events occur to change this expectation concerning those future cash flows

56:10 then the value of the asset changes for example if consumer demand for computer joysticks dries up the value of a factory built to produce joysticks can plunge overnight even though the factory itself is still as productive as it ever was in addition to analysis of whether a certain investing activity cash investment is a good idea a manager must also assess the timing of the investment to fit current cash management needs some of the questions that need to be addressed are as follows is current cash flow from operating activities or through financing activities such as borrowing sufficient to pay for an attractive investing activity this year if not should the acquisition of the land Building or equipment be delayed until next year it is often

56:56 efficient to acquire land buildings and equipment in amounts a bit larger than you need immediately knowing that you will grow into them in future years this can be better than expanding your productive capacity a little bit each year for example so our current cash flow is sufficient to pay for a large amount of investing activities this year you see that managing investing cash flow requires you to think about your current operating and financing cash flows a company's cash is a unifying element that links all aspects of a business operating investing and financing the two sources of cash from financing activities are borrowing an owner investment the most desirable sequence of decision making with respect to cash from financing activities is as follows

57:44 forecast the level of activity such as the level of sales evaluate the amount of cash that will be generated from or consumed by operating activities after a careful Capital budgeting process determine the amount of cash that will be needed for investing activities and finally if financing cash inflows are needed compare the relative costs of obtaining cash from borrowing and cash from owner investment as a general statement the interest rate cost of borrowing money is lower than the cost of giving up ownership of part of the company in exchange for new partner investment or new shareholder investment the exact decision this year of whether it's best to obtain financing cash inflow from borrowing or from owner investment depends on market conditions this year

58:32 detailed consideration of these decisions is part of the field of Finance an important cash outflow from Financial activities is the payment of cash dividends a key question in the field of corporate finance is why do companies pay cash dividends and if I could answer this question I'd get a Nobel prize in economics but what we do observe is the following most established companies pay dividends companies are reluctant to increase dividends they want to make sure that they'll be able to permanently sustain any increased level of dividends cutting dividends is viewed as very bad news and finally dividends seem to be used to give the illusion of stability if companies can get investors and potential investors to focus on their steady dividends rather than

59:19 their volatile net income then the companies look much less risky it's the illusion of stability in terms of managing financing cash flows it is very important for a company to manage its relationships with providers of financing lenders current investors and potential future investors reminder there are two traditional Revenue recognition criteria that both must be satisfied before Revenue can be recognized the seller has to do something the work and the buyer has to do something pay or provide a valid promise to pay now in many many cases Revenue recognition is not a big issue the primary example here is so-called Cash and Carry businesses such as

1:00:05 Walmart Home Depot farmers markets a restaurant a Cash and Carry business and one in which the customer visits the business receives a service or chooses a good pays cash and then leaves from an accounting standpoint this is a very simple transaction now let's think about the biggest Cash and Carry business in the world Walmart in terms of the two traditional Revenue recognition criteria and let's examine them first the work Walmart's work is providing the retail location and the goods for the customers to choose once the customer has chosen the merchandise that they want put it in their shop shopping cart and taking it outside the store Walmart's work is done you can see that in this Cash and Carry setting verifying that the work has been done is simple and fairly

1:00:52 non-controversial now some of you have just said to yourself hey wait what if I return something to Walmart how does that fit in here no problem in fact if you look in Walmart's income statement you will see that it doesn't say sales it says net sales the net means that Walmart has made a subtraction for the amount of sales that have been returned so the net sales reported by Walmart is the amount of final sales Walmart's work is done but still Revenue cannot be recognized unless both criteria are satisfied the second one a cash payment or a valid promise of payment cash payment questions are not a problem in cash and carry businesses such as Walmart because the customer can't get out of the building without paying cash for the goods now some of you are saying

1:01:39 to yourself well what about credit card sales those aren't cash sales but from the standpoint of the retailer such as Walmart a credit card sale is the functional equivalent of a cash sale in fact in its Financial reports Walmart reports that credit card amounts are collected so quickly just a few days at most that the credit card amounts that are still in process are reported as cash so with a Cash and Carry business the revenue recognition issues are quite simple the work is completed at the time of the sale when the goods are provided to the customer to take home the cash is collected almost immediately because customers are required to pay before they leave the store here are the two traditional Revenue recognition criteria that must both be satisfied before

1:02:29 Revenue can be recognized the seller has to do something the work and the buyer has to do something pay or provide a valid promise to pay so is it okay to recognize Revenue before the cash is collected well yes if the buyer has provided a valid promise to pay this is just an ordinary credit sale the customer buys now and pays later so let's talk about credit sales for just a moment cellion credit is a marketing technique providing a service to customers to entice more customers to buy companies sell on credit to the extent that the increase in sales justifies the increased bookkeeping bad debt and carrying costs associated with credit sales

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