Symposium on Money Management
Responsible Profits Steaven K. Jones, Jr., B.B.A., M.B.A.*
To the old question "Why are you in business?", the eternal answer "To make a profit!!!" is often given by the person in business. Yet the term "profit" is used so loosely that it has lost much of its meaning to the prudent financial planner. Probably the crudest definition of profit that is heard now is ''I'm taking in more than I'm paying out." Yet this statement is really dealing with cash and cash flows, and not profits in the accounting sense of the word. Accounting profits are reflected on the bottom line of an operating statement for a business and transferred to the surplus account on the balance sheet. These are really "paper profits" and have nothing to do with the availability of assets to run a business. Profits may or may not make a contribution to a particular business situation. Actually, the accountant's Statement of Funds is more relevant in pointing up results of successful business administration. Of course, accounting reports do have their important uses for the businessman, including tax purposes. But accounting profits do include noncash charges such as depreciation and amortization. For planning purposes, it seems that cash and cash flows are the most important criteria. You will note that the word planning has already been used several times. Most successful businesses do not just happen. Responsible executives are ones who are thinking ahead. They show anticipation and concern for future business operations. Business policies, administrative procedures, and budgets are established by them as part of their planning functions; then continuous follow-up is carried out to assure that their goals are met. Thus our definition for the subject "responsible profits" is: to generate the maximal possible short-term and long-term net cash flows through intelligent planning and the efficient use of time and the capital resources of yourself and your employees. *President, Steaven jones Development Co., Inc., Los Angeles, California Veterinary Clinics of North America- Vol. 6, No. I, February 1976
67
68
STEAVEN
K.
JONES, JR.
CASH FLOWS: TYPES AND TIMING Types Basically there are two types of cash flows used in financial planning: cash inflows and cash outflows. Cash inflows are those funds flowing into a business. The most popular and desirable are sales of goods and services (patient income, from the veterinarian's point of view.) Others are: (I) contributions by the owner(s), partner(s), or purchase of common or preferred stock if the business is a corporation, (2) a bank loan or debt financing, and (3) disposal or sale of fixed asset. Cash outflows are those funds flowing out of a business. In the veterinary business, probably labor or employee salaries are the biggest and most important outflow. Others are: (I) operating expenses such as rent, utilities, etc., (2) repayment of debt, (3) purchase of short-term liquidity instruments, such as certificates of deposit, treasury bills, etc., (4) purchase of fixed assets, (5) payment of taxes, (6) working capital to finance accounts receivable or inventories, and (7) cash distributions or dividends to owners or stockholders.
Timing From a planning point of view, it is as important to understand or identify when cash flows are happening, as it is to establish their magnitude. The term "net cash flow" is used to confirm that the businessman is keeping more cash flowing in than flowing out. "Cash deficit" is used when outflows exceed inflows. In order to match up the timing of cash flows, a ''cash budget" is used by the financial planner. These budgets may be established on a weekly, monthly, quarterly, or annual basis. The period usually selected will depend on the needs of that particular business and the rate at which the cash needs of the business change. Most businesses use a weekly or monthly budget. Some use annual budgets.
LONG-TERM AND SHORT-TERM FINANCIAL BUDGETS Cash Budgets The cash budget usually deals with the short-term cash needs of the business. Those cash items that occur frequently , such as sales, or patient income and every day operating expenses, make up the important segments of most cash budgets.
Capital Budgeting The long-term planning needs of the business are the object of capital budgeting. Usually this budget is related to specific items or important functions of the business, rather than to recurring time
RESPONSIBLE PROFITS
69
periods. These items are sizeable purchases or investments requiring substantial cash funds, such as fixed assets of equipment, real property, etc. In capital budgeting, the term long-term does not imply projecting cash needs far into the future. The cash budget is still the planning tool used to determine recurring cash flows, and recurring time periods can be established as far into the future as desired. The planner should be cautioned, however, that his budget is only as good as the assumptions he is willing to make about the future. Long-term in capital budgeting means weighing the cash benefits over a long period of time from acquisition or investment of cash resources. Since the planner is dealing with fixed assets in this case, these assets must be productive over a substantial period of time to justify their purchase. Capital budgeting evaluates just how productive the assets are likely to be and weighs this against their cost.
PREPARATION OF THE CASH BUDGET Since the goal is to have cash inflows exceed cash outflows, the planner must know how best to compare and evaluate each of these streams of funds. Effective comparison usually results in efficient control of the business operation. There are two ways to start: 1. Establish the cash inflows by setting up some sales projections, or patient and service income. After you know about how much cash will be available, the planner can budget his expenses accordingly. 2. If there are some unusually large or initial operating expenses facing the business, the planner can start by projecting what these will be. After knowing what obligations the business will face, sales budgets can be established to compare what cash will be available to pay for these expenses. Both of these approaches have their relative merits, depending upon the particular business situation. Usually a new business will start by listing the costs to be faced when opening the doors, whereas a seasoned business will do sales forecasting first and then set up expense budgets.
Initial Projection of Sales or Patient Income It should be reasonably easy for an existing business to do sales forecasting. The preceding years usually offer a pretty good indication of what the person in business can expect to achieve in future cash inflows. However, it is often easy to become complacent about business. A good job of sales forecasting will keep the businessman on his toes as far as analyzing just who his patients or customers are, how much they are spending per visit, the number of visits per budget period, and the type of patient and service performed.
70
STEAVEN K. JoNEs, JR.
These kinds of analyses should be made from business records over the previous three or four years. The object is to try to discern what trends are occurring in your sales income. As the trends are established, these rates of changes should be projected into the future . For a first try at sales forecasting , do not attempt projections longer than one year. Depending on the cyclical nature of the business, sales should be broken down by the week or month. Remember these projections are only as valid as the assumptions you are willing to make about the future. Outside influences such as new competition or adverse economic conditions could alter even the most careful projections. Be sure to list what assumptions you are making, as part of your cash inflow forecasting. You must be willing to go back from time to time and alter your assumptions as conditions change. Adjusting Timing of Cash Receipts or Cash Inflows
Every person in business hopes that each patient or customer will pay cash. Unfortunately, in many instances this is not the case. The use of credit cards, or just the old-fashioned accounts receivable system, creates a delay as to when the cash is actually received. If this is true in your business, then the cash budget should reflect when the cash is actually received, not when the sale is made. If receivables is a large part of your business operation, the CiJ.Sh budget will quickly point up your need for additional working capital to finance these receivables. Establishing Expense Budget in Line with Sales Forecasts
After completing the sales forecasts, the planner must establish some means to control his costs to be consistent with the projected sales. Expense budgets are the way to do this. Since there are several types of expenses to be considered, we suggest starting with those fixed expenses that are most difficult to control. "Fixed expenses" are such items as rent, utilities, equipment or capital payments, etc. Then list the semivariable or variable costs. These are items that change directly or indirectly with sales volume, such as labor, supplies or other inventory, and administrative costs. The degree to which these costs fluctuate with sales depends on the nature of the particular business. Remember it is important to list every conceivable cost the business will face during the budget period and assign the most realistic dollar amount as the budget figure . Comparing the Cash Income with the Expense Budget
The sales having been forecasted and the expenses having been budgeted, the planner must now compare these two streams of capital by relating them to time. An example of how this may be done is shown in Table 1. You will note that we have started with a beginning cash balance and added to this sum the monthly cash sales. From this total
Table I.
Cash Budget of XYZ Animal Hospital (a California Corporation) January 1975 to December 1975 FEB.
MAR.
APR.
MAY
JUNE
JULY
10,500
2,200
8,100
3,900
8,200
6,200
22,500 3,000 7,000 2,500 45,500
19,000 3,500 7,000 3,500 35,200
16,500 5,000 8,000 5,000 41 ,600
26,000 7,000 8,000 5,000 49,900
29,000 8,000 8,000 5,000 58,200
2,000 2,500 2,000 1,000 9,000 8,000 400 700 200 400 300 100
3,000 2,500 1,500
3,500 2,500 1,500
9,000 8,000 400 700 200
9,000 8,000 400 700 200 1,600 100 100 600
4,500 3,000 2,000 1,000 9,000 8,000 400 700 200
JAN. Beginning Cash Balance
Cash Inflows Professio nal fees Grooming Boarding Drugs SUBTOTAL Cash Outflows Drugs and supplies Foods a nd prescription diets Lab and x-ray Therapy and outside medical Salaries (officers) Salaries (others) Payroll taxes (officers) Payroll taxes (others) Insurance (others) Accounting Advertising Misc. expenses Legal Meetings, dues, entertainment Office expenses Personal property taxes Printing and postage Rent Repairs and maintenance Taxes and licenses Telephone Wages (payroll) Bookkeeping Insurance Utilities TOTAL OUTFLOWS Ending cash balance Bank loan (repayment) ADJUSTED CASH BALANCE
400 100 4,500 300 1,000 500 5,000 100 4,500 300 43,300 2,200
100 100 300 400
AUG.
SEPT.
OCT.
NOV.
DEC.
9,300
20,000
27,000
25,500
22,000
19,900
31 ,000 7,000 10,000 6,000 60,200
28,500 7,500 10,000 6,000 63,300
27,000 4,500 10,000 5,000 66,500
22,000 4,000 8,000 4,000 65,000
19,000 4,500 8,000 4,500 61 ,500
21 ,500 4,000 6,000 3,500 57,000
18,500 4,000 6,000 3,000 51 ,400
4,500 3,000 2,000
5,500 3,000 1,500
4,500 2,500 1,500
3,500 2,500 1,000
2,500 2,500 1,500
9,000 8,000 400 700 200
9,000 8,000 400 700 200
100 100
200 100
200 100
100 100
400
300 400
400
500 400
400
400
500 400
9,000 8,000 400 700 200 400 100 100 200
9,000 8,000 400 700 200
200 100
9,000 8,000 400 700 200 400 100 100 400
4,000 2,000 1,000 1,000 9,000 8,000 400 700 200
3,000 2,500 1,000
9,000 8,000 400 700 200 400 100 100
5,500 4,000 1,000 1,000 9,000 8,000 400 700 200
400
2,200 4,500 400
100 4,500 300
200 4,500 500
2,700 4,500 300
500 5,000 100
500 5,000 100
300 4,500 400 1,000 500 5,000 100
500 5,000 100
200 4,500 300
400 8,000 100 4,500 500
500 5,000 100
500 5,000 100
200 4,500 500 1,000 500 5,000 100
300 37, 100
400 47,700
400 41 ,700
400 42,200
500 40,900
500 43,300
(1 ,900) 10,000 8,100
(6,100) 10,000 3,900
8,200
16,200 (10,000) 6,200
19,300 (10,000) 9,300
20,000
~
t'l
(J)
"C
0
z
(J)
;
t"' t'l
'"d
"' 0
"1
::j
(J)
200 100
100 4,500 500
500 5,000 100
200 4,500 400 1,000 500 5,000 100
400 8,000 300 4,500 400
500 5,000 100
500 5,000 100
500 39,500
400 39,500
400 39,500
400 37,100
300 44,600
27,000
25,500
22,000
19,900
6,800
"....
72
STEAVEN
K.
jONES, JR.
we have subtracted the expenses, leaving an ending cash balance for that period. In some months there was a cash deficit because expenses exceeded sales. The beginning cash balance was reduced correspondingly. A short-term bank loan covered this cash deficit. In other months, sales exceeded expenses and the beginning cash balance for the subsequent period was increased. In either case the "Cash Budget" has been effective because the planner will be aware of what may happen before it actually does. Initial Projection of Costs or Operating Expenses
Generally this method of planning is related to what is commonly known as cost accounting procedures. The person in business is trying to learn just how much it costs to perform a particular function or service. Again, we are concentrating on those variable or semivariable costs rather than fixed costs. Basically, labor is the most critical cost to be analyzed. This cost may be separated for analysis purposes into two segments: (1) "Bare bones" labor. What is necessary to open the doors or to initiate operations on the most minimal level? (2) What amount of additional sales or services requires adding additional employee(s)? Labor is really a semivariable cost and how it may vary with sales depends on the productivity of the employees. From an income point of view, labor provides services that produce cash inflows. Cost accounting procedures will reflect (I) productive vs. nonproductive time and (2) efficient use of productive time. The first step in analyzing income is to list those procedures or functions of the business that produce income. Separate income sources into labor-concentrated sources and physical equipment-concentrated sources. Place a dollar amount on the income from physical equipment sources. The balance should be the amount of dollars needed to be covered by labor producing sources. It should be fairly easy to compute what the labor will cost to realize this dollar level. Another approach is the Break-Even Point Analysis. Since the net costs have been established, the cost accounting procedures should now offer a rate per hour of labor to cover these net costs. The total of both these functions producing income is the level at which the business operations "break even." Any amount of labor activity above this level will produce additional cash inflows over and above the variable costs. This is net cash flow since the fixed costs have already been covered. Some businessmen refer to this as "leverage," i.e., generating larger cash inflows with small labor expenditures . .Time and motion studies are popular means of evaluating labor productivity. Usually the person in business will list all the duties and functions of each employee and establish a time period in which each function is performed. The time is then converted to a dollar cost
a
73
RESPONSIBLE PROFITS
based on the labor rate. Again, since this labor is producing income, it is easy to determine whether or not: (1) you are making money from that service, (2) you should charge more for that service, (3) the employee should be doing it in less time, (4) you should obtain a new employee. The real intent of time and motion logs, however, is to make employer and employees more aware of productivity of their time. Placing a dollar value on time to perform a function provides a tool for developing income projections to cover expenses at that level of business operations.
CASH BUDGET SUMMARY The cash budget is a valuable planning tool used by most persons in business, both large and small, professional and nonprofessional. The budget is only as good as the assumptions you make about the future. The cash budget periods depend on the nature and complexity of the particular business. The real key is the rate of change of the cash flows being analyzed. How far into the future should you project? How good are your assumptions? Should you start by projecting sales or expenses initially? Again, it depends on the nature of the business and its complexity. Do it both ways and compare both budgets; analyze the differences. What differences are likely to be present? Logically, whatever approach you take, start with those items of cash flow with the greatest degree of certainty- both income and expenses. Then concentrate on those items in the budget that are most difficult to control. Remember that business conditions change, sometimes almost daily. Do not be afraid to go back and re-evaluate your budget. Be flexible and keep a broad business perspective.
CAPITAL BUDGET PREPARATION Cash budgets usually deal with dynamic cash flows. Capital budgets deal more with consistent cash flows over longer periods of time. The capital budget considers substantial funds to be expended for real or personal property. Planning is involved in answering two basic questions (in the order of business priority: whether or not to buy and when to buy). Most businesses will establish a minimal acceptable return on investment, or the "hurdle rate" referred to by some persons in finance.
74
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K.
JONES, JR.
This hurdle rate may vary from time to time, usually depending on the cost of capital.
Capital Benefit In order to determine what return a particular investment will generate, a comparison must be made between the cost of the item and the dollar benefits to be enjoyed by the business. This return usually is expressed in an annual percentage figure. For example, if a piece of equipment costs $100,000 and the business benefits are $10,000 annually, the rate of return would be 10 per cent. There are more sophisticated means to express percentage benefits, such as discounted cash flows, and it may be helpful for you to explore these further if you are interested. Another evaluation of these benefits is important and that is "risk." What are the probabilities that these benefits will be achieved? Technology or competitive factors could change circumstances drastically. Risk can be even related to the total dollars involved in the transaction and whether or not the business can afford to invest an amount of that size, even if the benefits are relatively certain.
Capital Costs All capital has a "cost," i.e., that charge for its use over a specific period of time. If the businessman does not think in these terms, he is not aware of one of the basic precepts in financial planning. Debt capital, money borrowed (usually from a financial institution), is the most common capital people know they are paying for. But debt capit~l not only has an annual interest rate, but also points (initial capital charges) are sometimes charges as well as additional fees to acquire the use of this capital. Equity capital, the businessman's own funds, also has a cost. Everyone should have a return they wish to obtain from an investment. This, in effect, is the "cost" of your capital.
Preparing the Budget The budget is a simple comparison of the benefits to be achieved from a particular purchase to the cost of capital to make the purchase. The planner starts by listing the projects on the lefthand side of the page in the order of the greatest amount of benefits (expressed in annual percentages) to the lowest. On the righthand side of the page, list the capital sources and the cost of each (also expressed in annual percentages). At the top of the list will be the least expensive capital, with the sources becoming more expensive down the list. There is a simple and logical cut-off point where the cost of the capital exceeds the benefits derived from the purchase. An example of capital budget is included in Table 2.
75
RESPONSIBLE PROFITS
Table 2.
The 1975 XYZ Animal Hospital (a California Corporation)* CAPITAL
RETURN ON DOLLAR AMOUNT
PURCHASE ITEM
INVESTMENT
$22,000.00 $ 6,000.00 $ 9,000.00 $ 8,000.00
Telephone system X-ray process X-ray machine New cages
15% 12% 10% 7%
$49,000.00
Total items to be purchased
SOURCE OF FUNDS
COST
$15,000.00 $15,000.00 $25,000.00 $10,000.00
Commercial Bank Commercial Bank Finance Co. Partner's capital
8'/•% 10% 12% 15%
$65,000.00
Total capital available
DOLLAR AMOUNT
*Analysis of Table 2: Purchase the telephone system: I. The return of 15% on investment exceeds the average capital cost of 9'/s%. 2. Average capital cost is calculated by using all of the 81/2% funds, plus $7,000 of the 10% funds from the commercial bank. Purchase the x-ray process: I. The 12% return on investment still exceeds the 10% capital cost from the commercial bank. 2. The commercial bank funds of $8,000 remaining ($15,000 less $7,000) are more than adequate to cover purchase price. Do not purchase any other capital items. I. The next best purchase, the x-ray machine, returns 10% on investment, but there are only $2,000 ($8,000 less $6,000) available at 10% from the bank funds. The other $6,000 purchase funds would have to come from the finance company, and the cost of these funds is 12%, which is in excess of the return on investment. 2. All other items return much less than the assigned capital costs.
CAPITAL BUDGET SUMMARY If the businessman is going to be faced with a number of sizeable investments over a relatively short period of time, the capital budget is a good planning tool to use. If nothing else, it will make you aware that capital does have a cost, regardless of whether it is yours or the bank's. Also, try to determine just what results or benefits (in dollar terms) a particular investment will achieve. Remember these results should be projected over a relatively long period of 'time to help justify the purchase.
SUMMARY Some persons in business have good intuitive business judgment. Most of us, however, need some planning tools to help anticipate the results we may achieve from our business or professional efforts. Cash Budgets and Capital Budgets are just two of many such tools you may use to achieve "responsible profits."
76
STEAVEN
K.
JONES, JR.
REFERENCES I. Eiteman , D. K.: Capital budgeting. In Essays on Business Finance. Ann Arbor, Mpsterco Press, 1952, pp. 286-308. 2. Eiteman, W. ]., and Holtz, J. N .: Working capital management. In Essays on Business Finance. Ann Arbor, Masterco Press, 1952, pp. 208-238. 3. Lippincott, C. L. : Cost accounting insures practice, efficiency and profits. VET. CuN. NORTH AM., 2 :463-481, 1972. 4. Steinmetz, L. L., Kline, J. B., and Stegall, D. P.: Managing the Small Business. Homewood, Ill., Richard D. Irwin, Inc., 1968, pp. 178-207,266-295. 5. Waterman, M. H. : Profits and funds administration. In Essays on Business Finance. Ann Arbor, Masterco Press, 1952, pp. 269-286. 516 Chapala Drive Pacific Palisades, California 90272
Responsible Profits Steaven K. Jones, Jr., B.B.A., M.B.A.*
To the old question "Why are you in business?", the eternal answer "To make a profit!!!" is often given by the person in business. Yet the term "profit" is used so loosely that it has lost much of its meaning to the prudent financial planner. Probably the crudest definition of profit that is heard now is ''I'm taking in more than I'm paying out." Yet this statement is really dealing with cash and cash flows, and not profits in the accounting sense of the word. Accounting profits are reflected on the bottom line of an operating statement for a business and transferred to the surplus account on the balance sheet. These are really "paper profits" and have nothing to do with the availability of assets to run a business. Profits may or may not make a contribution to a particular business situation. Actually, the accountant's Statement of Funds is more relevant in pointing up results of successful business administration. Of course, accounting reports do have their important uses for the businessman, including tax purposes. But accounting profits do include noncash charges such as depreciation and amortization. For planning purposes, it seems that cash and cash flows are the most important criteria. You will note that the word planning has already been used several times. Most successful businesses do not just happen. Responsible executives are ones who are thinking ahead. They show anticipation and concern for future business operations. Business policies, administrative procedures, and budgets are established by them as part of their planning functions; then continuous follow-up is carried out to assure that their goals are met. Thus our definition for the subject "responsible profits" is: to generate the maximal possible short-term and long-term net cash flows through intelligent planning and the efficient use of time and the capital resources of yourself and your employees. *President, Steaven jones Development Co., Inc., Los Angeles, California Veterinary Clinics of North America- Vol. 6, No. I, February 1976
67
68
STEAVEN
K.
JONES, JR.
CASH FLOWS: TYPES AND TIMING Types Basically there are two types of cash flows used in financial planning: cash inflows and cash outflows. Cash inflows are those funds flowing into a business. The most popular and desirable are sales of goods and services (patient income, from the veterinarian's point of view.) Others are: (I) contributions by the owner(s), partner(s), or purchase of common or preferred stock if the business is a corporation, (2) a bank loan or debt financing, and (3) disposal or sale of fixed asset. Cash outflows are those funds flowing out of a business. In the veterinary business, probably labor or employee salaries are the biggest and most important outflow. Others are: (I) operating expenses such as rent, utilities, etc., (2) repayment of debt, (3) purchase of short-term liquidity instruments, such as certificates of deposit, treasury bills, etc., (4) purchase of fixed assets, (5) payment of taxes, (6) working capital to finance accounts receivable or inventories, and (7) cash distributions or dividends to owners or stockholders.
Timing From a planning point of view, it is as important to understand or identify when cash flows are happening, as it is to establish their magnitude. The term "net cash flow" is used to confirm that the businessman is keeping more cash flowing in than flowing out. "Cash deficit" is used when outflows exceed inflows. In order to match up the timing of cash flows, a ''cash budget" is used by the financial planner. These budgets may be established on a weekly, monthly, quarterly, or annual basis. The period usually selected will depend on the needs of that particular business and the rate at which the cash needs of the business change. Most businesses use a weekly or monthly budget. Some use annual budgets.
LONG-TERM AND SHORT-TERM FINANCIAL BUDGETS Cash Budgets The cash budget usually deals with the short-term cash needs of the business. Those cash items that occur frequently , such as sales, or patient income and every day operating expenses, make up the important segments of most cash budgets.
Capital Budgeting The long-term planning needs of the business are the object of capital budgeting. Usually this budget is related to specific items or important functions of the business, rather than to recurring time
RESPONSIBLE PROFITS
69
periods. These items are sizeable purchases or investments requiring substantial cash funds, such as fixed assets of equipment, real property, etc. In capital budgeting, the term long-term does not imply projecting cash needs far into the future. The cash budget is still the planning tool used to determine recurring cash flows, and recurring time periods can be established as far into the future as desired. The planner should be cautioned, however, that his budget is only as good as the assumptions he is willing to make about the future. Long-term in capital budgeting means weighing the cash benefits over a long period of time from acquisition or investment of cash resources. Since the planner is dealing with fixed assets in this case, these assets must be productive over a substantial period of time to justify their purchase. Capital budgeting evaluates just how productive the assets are likely to be and weighs this against their cost.
PREPARATION OF THE CASH BUDGET Since the goal is to have cash inflows exceed cash outflows, the planner must know how best to compare and evaluate each of these streams of funds. Effective comparison usually results in efficient control of the business operation. There are two ways to start: 1. Establish the cash inflows by setting up some sales projections, or patient and service income. After you know about how much cash will be available, the planner can budget his expenses accordingly. 2. If there are some unusually large or initial operating expenses facing the business, the planner can start by projecting what these will be. After knowing what obligations the business will face, sales budgets can be established to compare what cash will be available to pay for these expenses. Both of these approaches have their relative merits, depending upon the particular business situation. Usually a new business will start by listing the costs to be faced when opening the doors, whereas a seasoned business will do sales forecasting first and then set up expense budgets.
Initial Projection of Sales or Patient Income It should be reasonably easy for an existing business to do sales forecasting. The preceding years usually offer a pretty good indication of what the person in business can expect to achieve in future cash inflows. However, it is often easy to become complacent about business. A good job of sales forecasting will keep the businessman on his toes as far as analyzing just who his patients or customers are, how much they are spending per visit, the number of visits per budget period, and the type of patient and service performed.
70
STEAVEN K. JoNEs, JR.
These kinds of analyses should be made from business records over the previous three or four years. The object is to try to discern what trends are occurring in your sales income. As the trends are established, these rates of changes should be projected into the future . For a first try at sales forecasting , do not attempt projections longer than one year. Depending on the cyclical nature of the business, sales should be broken down by the week or month. Remember these projections are only as valid as the assumptions you are willing to make about the future. Outside influences such as new competition or adverse economic conditions could alter even the most careful projections. Be sure to list what assumptions you are making, as part of your cash inflow forecasting. You must be willing to go back from time to time and alter your assumptions as conditions change. Adjusting Timing of Cash Receipts or Cash Inflows
Every person in business hopes that each patient or customer will pay cash. Unfortunately, in many instances this is not the case. The use of credit cards, or just the old-fashioned accounts receivable system, creates a delay as to when the cash is actually received. If this is true in your business, then the cash budget should reflect when the cash is actually received, not when the sale is made. If receivables is a large part of your business operation, the CiJ.Sh budget will quickly point up your need for additional working capital to finance these receivables. Establishing Expense Budget in Line with Sales Forecasts
After completing the sales forecasts, the planner must establish some means to control his costs to be consistent with the projected sales. Expense budgets are the way to do this. Since there are several types of expenses to be considered, we suggest starting with those fixed expenses that are most difficult to control. "Fixed expenses" are such items as rent, utilities, equipment or capital payments, etc. Then list the semivariable or variable costs. These are items that change directly or indirectly with sales volume, such as labor, supplies or other inventory, and administrative costs. The degree to which these costs fluctuate with sales depends on the nature of the particular business. Remember it is important to list every conceivable cost the business will face during the budget period and assign the most realistic dollar amount as the budget figure . Comparing the Cash Income with the Expense Budget
The sales having been forecasted and the expenses having been budgeted, the planner must now compare these two streams of capital by relating them to time. An example of how this may be done is shown in Table 1. You will note that we have started with a beginning cash balance and added to this sum the monthly cash sales. From this total
Table I.
Cash Budget of XYZ Animal Hospital (a California Corporation) January 1975 to December 1975 FEB.
MAR.
APR.
MAY
JUNE
JULY
10,500
2,200
8,100
3,900
8,200
6,200
22,500 3,000 7,000 2,500 45,500
19,000 3,500 7,000 3,500 35,200
16,500 5,000 8,000 5,000 41 ,600
26,000 7,000 8,000 5,000 49,900
29,000 8,000 8,000 5,000 58,200
2,000 2,500 2,000 1,000 9,000 8,000 400 700 200 400 300 100
3,000 2,500 1,500
3,500 2,500 1,500
9,000 8,000 400 700 200
9,000 8,000 400 700 200 1,600 100 100 600
4,500 3,000 2,000 1,000 9,000 8,000 400 700 200
JAN. Beginning Cash Balance
Cash Inflows Professio nal fees Grooming Boarding Drugs SUBTOTAL Cash Outflows Drugs and supplies Foods a nd prescription diets Lab and x-ray Therapy and outside medical Salaries (officers) Salaries (others) Payroll taxes (officers) Payroll taxes (others) Insurance (others) Accounting Advertising Misc. expenses Legal Meetings, dues, entertainment Office expenses Personal property taxes Printing and postage Rent Repairs and maintenance Taxes and licenses Telephone Wages (payroll) Bookkeeping Insurance Utilities TOTAL OUTFLOWS Ending cash balance Bank loan (repayment) ADJUSTED CASH BALANCE
400 100 4,500 300 1,000 500 5,000 100 4,500 300 43,300 2,200
100 100 300 400
AUG.
SEPT.
OCT.
NOV.
DEC.
9,300
20,000
27,000
25,500
22,000
19,900
31 ,000 7,000 10,000 6,000 60,200
28,500 7,500 10,000 6,000 63,300
27,000 4,500 10,000 5,000 66,500
22,000 4,000 8,000 4,000 65,000
19,000 4,500 8,000 4,500 61 ,500
21 ,500 4,000 6,000 3,500 57,000
18,500 4,000 6,000 3,000 51 ,400
4,500 3,000 2,000
5,500 3,000 1,500
4,500 2,500 1,500
3,500 2,500 1,000
2,500 2,500 1,500
9,000 8,000 400 700 200
9,000 8,000 400 700 200
100 100
200 100
200 100
100 100
400
300 400
400
500 400
400
400
500 400
9,000 8,000 400 700 200 400 100 100 200
9,000 8,000 400 700 200
200 100
9,000 8,000 400 700 200 400 100 100 400
4,000 2,000 1,000 1,000 9,000 8,000 400 700 200
3,000 2,500 1,000
9,000 8,000 400 700 200 400 100 100
5,500 4,000 1,000 1,000 9,000 8,000 400 700 200
400
2,200 4,500 400
100 4,500 300
200 4,500 500
2,700 4,500 300
500 5,000 100
500 5,000 100
300 4,500 400 1,000 500 5,000 100
500 5,000 100
200 4,500 300
400 8,000 100 4,500 500
500 5,000 100
500 5,000 100
200 4,500 500 1,000 500 5,000 100
300 37, 100
400 47,700
400 41 ,700
400 42,200
500 40,900
500 43,300
(1 ,900) 10,000 8,100
(6,100) 10,000 3,900
8,200
16,200 (10,000) 6,200
19,300 (10,000) 9,300
20,000
~
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(J)
"C
0
z
(J)
;
t"' t'l
'"d
"' 0
"1
::j
(J)
200 100
100 4,500 500
500 5,000 100
200 4,500 400 1,000 500 5,000 100
400 8,000 300 4,500 400
500 5,000 100
500 5,000 100
500 39,500
400 39,500
400 39,500
400 37,100
300 44,600
27,000
25,500
22,000
19,900
6,800
"....
72
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we have subtracted the expenses, leaving an ending cash balance for that period. In some months there was a cash deficit because expenses exceeded sales. The beginning cash balance was reduced correspondingly. A short-term bank loan covered this cash deficit. In other months, sales exceeded expenses and the beginning cash balance for the subsequent period was increased. In either case the "Cash Budget" has been effective because the planner will be aware of what may happen before it actually does. Initial Projection of Costs or Operating Expenses
Generally this method of planning is related to what is commonly known as cost accounting procedures. The person in business is trying to learn just how much it costs to perform a particular function or service. Again, we are concentrating on those variable or semivariable costs rather than fixed costs. Basically, labor is the most critical cost to be analyzed. This cost may be separated for analysis purposes into two segments: (1) "Bare bones" labor. What is necessary to open the doors or to initiate operations on the most minimal level? (2) What amount of additional sales or services requires adding additional employee(s)? Labor is really a semivariable cost and how it may vary with sales depends on the productivity of the employees. From an income point of view, labor provides services that produce cash inflows. Cost accounting procedures will reflect (I) productive vs. nonproductive time and (2) efficient use of productive time. The first step in analyzing income is to list those procedures or functions of the business that produce income. Separate income sources into labor-concentrated sources and physical equipment-concentrated sources. Place a dollar amount on the income from physical equipment sources. The balance should be the amount of dollars needed to be covered by labor producing sources. It should be fairly easy to compute what the labor will cost to realize this dollar level. Another approach is the Break-Even Point Analysis. Since the net costs have been established, the cost accounting procedures should now offer a rate per hour of labor to cover these net costs. The total of both these functions producing income is the level at which the business operations "break even." Any amount of labor activity above this level will produce additional cash inflows over and above the variable costs. This is net cash flow since the fixed costs have already been covered. Some businessmen refer to this as "leverage," i.e., generating larger cash inflows with small labor expenditures . .Time and motion studies are popular means of evaluating labor productivity. Usually the person in business will list all the duties and functions of each employee and establish a time period in which each function is performed. The time is then converted to a dollar cost
a
73
RESPONSIBLE PROFITS
based on the labor rate. Again, since this labor is producing income, it is easy to determine whether or not: (1) you are making money from that service, (2) you should charge more for that service, (3) the employee should be doing it in less time, (4) you should obtain a new employee. The real intent of time and motion logs, however, is to make employer and employees more aware of productivity of their time. Placing a dollar value on time to perform a function provides a tool for developing income projections to cover expenses at that level of business operations.
CASH BUDGET SUMMARY The cash budget is a valuable planning tool used by most persons in business, both large and small, professional and nonprofessional. The budget is only as good as the assumptions you make about the future. The cash budget periods depend on the nature and complexity of the particular business. The real key is the rate of change of the cash flows being analyzed. How far into the future should you project? How good are your assumptions? Should you start by projecting sales or expenses initially? Again, it depends on the nature of the business and its complexity. Do it both ways and compare both budgets; analyze the differences. What differences are likely to be present? Logically, whatever approach you take, start with those items of cash flow with the greatest degree of certainty- both income and expenses. Then concentrate on those items in the budget that are most difficult to control. Remember that business conditions change, sometimes almost daily. Do not be afraid to go back and re-evaluate your budget. Be flexible and keep a broad business perspective.
CAPITAL BUDGET PREPARATION Cash budgets usually deal with dynamic cash flows. Capital budgets deal more with consistent cash flows over longer periods of time. The capital budget considers substantial funds to be expended for real or personal property. Planning is involved in answering two basic questions (in the order of business priority: whether or not to buy and when to buy). Most businesses will establish a minimal acceptable return on investment, or the "hurdle rate" referred to by some persons in finance.
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This hurdle rate may vary from time to time, usually depending on the cost of capital.
Capital Benefit In order to determine what return a particular investment will generate, a comparison must be made between the cost of the item and the dollar benefits to be enjoyed by the business. This return usually is expressed in an annual percentage figure. For example, if a piece of equipment costs $100,000 and the business benefits are $10,000 annually, the rate of return would be 10 per cent. There are more sophisticated means to express percentage benefits, such as discounted cash flows, and it may be helpful for you to explore these further if you are interested. Another evaluation of these benefits is important and that is "risk." What are the probabilities that these benefits will be achieved? Technology or competitive factors could change circumstances drastically. Risk can be even related to the total dollars involved in the transaction and whether or not the business can afford to invest an amount of that size, even if the benefits are relatively certain.
Capital Costs All capital has a "cost," i.e., that charge for its use over a specific period of time. If the businessman does not think in these terms, he is not aware of one of the basic precepts in financial planning. Debt capital, money borrowed (usually from a financial institution), is the most common capital people know they are paying for. But debt capit~l not only has an annual interest rate, but also points (initial capital charges) are sometimes charges as well as additional fees to acquire the use of this capital. Equity capital, the businessman's own funds, also has a cost. Everyone should have a return they wish to obtain from an investment. This, in effect, is the "cost" of your capital.
Preparing the Budget The budget is a simple comparison of the benefits to be achieved from a particular purchase to the cost of capital to make the purchase. The planner starts by listing the projects on the lefthand side of the page in the order of the greatest amount of benefits (expressed in annual percentages) to the lowest. On the righthand side of the page, list the capital sources and the cost of each (also expressed in annual percentages). At the top of the list will be the least expensive capital, with the sources becoming more expensive down the list. There is a simple and logical cut-off point where the cost of the capital exceeds the benefits derived from the purchase. An example of capital budget is included in Table 2.
75
RESPONSIBLE PROFITS
Table 2.
The 1975 XYZ Animal Hospital (a California Corporation)* CAPITAL
RETURN ON DOLLAR AMOUNT
PURCHASE ITEM
INVESTMENT
$22,000.00 $ 6,000.00 $ 9,000.00 $ 8,000.00
Telephone system X-ray process X-ray machine New cages
15% 12% 10% 7%
$49,000.00
Total items to be purchased
SOURCE OF FUNDS
COST
$15,000.00 $15,000.00 $25,000.00 $10,000.00
Commercial Bank Commercial Bank Finance Co. Partner's capital
8'/•% 10% 12% 15%
$65,000.00
Total capital available
DOLLAR AMOUNT
*Analysis of Table 2: Purchase the telephone system: I. The return of 15% on investment exceeds the average capital cost of 9'/s%. 2. Average capital cost is calculated by using all of the 81/2% funds, plus $7,000 of the 10% funds from the commercial bank. Purchase the x-ray process: I. The 12% return on investment still exceeds the 10% capital cost from the commercial bank. 2. The commercial bank funds of $8,000 remaining ($15,000 less $7,000) are more than adequate to cover purchase price. Do not purchase any other capital items. I. The next best purchase, the x-ray machine, returns 10% on investment, but there are only $2,000 ($8,000 less $6,000) available at 10% from the bank funds. The other $6,000 purchase funds would have to come from the finance company, and the cost of these funds is 12%, which is in excess of the return on investment. 2. All other items return much less than the assigned capital costs.
CAPITAL BUDGET SUMMARY If the businessman is going to be faced with a number of sizeable investments over a relatively short period of time, the capital budget is a good planning tool to use. If nothing else, it will make you aware that capital does have a cost, regardless of whether it is yours or the bank's. Also, try to determine just what results or benefits (in dollar terms) a particular investment will achieve. Remember these results should be projected over a relatively long period of 'time to help justify the purchase.
SUMMARY Some persons in business have good intuitive business judgment. Most of us, however, need some planning tools to help anticipate the results we may achieve from our business or professional efforts. Cash Budgets and Capital Budgets are just two of many such tools you may use to achieve "responsible profits."
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REFERENCES I. Eiteman , D. K.: Capital budgeting. In Essays on Business Finance. Ann Arbor, Mpsterco Press, 1952, pp. 286-308. 2. Eiteman, W. ]., and Holtz, J. N .: Working capital management. In Essays on Business Finance. Ann Arbor, Masterco Press, 1952, pp. 208-238. 3. Lippincott, C. L. : Cost accounting insures practice, efficiency and profits. VET. CuN. NORTH AM., 2 :463-481, 1972. 4. Steinmetz, L. L., Kline, J. B., and Stegall, D. P.: Managing the Small Business. Homewood, Ill., Richard D. Irwin, Inc., 1968, pp. 178-207,266-295. 5. Waterman, M. H. : Profits and funds administration. In Essays on Business Finance. Ann Arbor, Masterco Press, 1952, pp. 269-286. 516 Chapala Drive Pacific Palisades, California 90272
