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One of the major concerns of any business organization is the management of working capital. The includes obtaining sufficient sources of short term finance and the management of individual elements of working capital such as stock, trade debtors, cash and trade creditors. These issues can be observed in this case of Enron Ltd. The company would like to prepare its cash budget for the forthcoming period to determine if it has enough cash to finance operations or if it will have to resort to external sources of funds.
Stages in the Budgeting Process
A budget has two main purposes, which are to compel planning and to establish a system of control by comparing budgeted and actual results (Atkinson et al, 2007). The budget setting process is crucial to ensure success. There are many variations of the exact stages, but essentially, setting a budget requires eight stages.
The first stage is communicating details of the budget policy and budget guidelines (Atkinson et al, 2007). The long-term plan is the starting point for the preparation of the annual budget. Managers responsible for preparing the budget must be aware of the way it is affected by the long-term plan so that it becomes part of the process of meeting the organization's objectives. For example, if the long-term plan calls for a more aggressive pricing policy, the budget must take this into account. Managers should also be provided with important guidelines for wage rate increases, changes in productivity and so on, as well as information about industry demand and output.
The second stage is determining the factors that restrict output. In most organizations the principal budget factor is sales demand. A company is usually restricted from making and selling more of its products because there would be no sales demand for the increased output at a price which would be profitable to the company (Horngren et al, 2006). Once this factor is defined then the rest of the budget can be prepared.
The third stage is preparing the sales budget. For many organizations, the principal budget factor is sales volume. The sales budget is therefore often the primary budget from which the majority of the other budgets are derived. Before the sales budget can be prepared a sales forecast has to be made. Sales forecasting is complex and involves the consideration of a number of factors like past sales, competition and legislation. There are a number of forecasting methods that a company can use like estimates by sales personnel, market research and various mathematical techniques (Drury, 2006).
Once this is done, the next stage is the initial preparation of budgets. This includes the finished goods stock budget, the production budget, the overhead cost budget, raw materials stock budget and raw materials purchase budget. Each cost centre will prepare its own budgets (Drury, 2006).
The fifth stage in the budgeting process is negotiation of budgets with superiors (Atkinson et al, 2007). Once a manager has prepared his draft budget he should submit it to his superior for approval. The superior should then incorporate this budget with others for which he or she is responsible and then submit this budget for approval to his or her superior. This process continues until the final budget is presented to the budget committee for approval.
The next stage is coordination of the budgets. The budgets must be reviewed in relation to one another. Such a review may indicate that some budgets are out of balance with others and need modifying. The budget officer must identify such inconsistencies and bring them to the attention of the manager concerned. The revision of one budget may lead to the revision of all budgets. During this process, the budgeted profit and loss account and budgeted balance sheet and cash budget should be prepared to ensure that all of the individual parts of the budget combine into an acceptable master budget (Drury, 2006).
Subsequently, there is final acceptance of the budget (Eiteman et al, 2007). When all the budgets are in harmony with one another, they are summarized into a master budget consisting of a budgeted profit and loss account, budgeted balance sheet and cash budget.
The final stage in the budgeting process is budget review. The budgeting process does not stop once the budgets have been agreed. Actual results should be compared on a regular basis with the budgeted results. The frequency with which such comparisons are made depends very much on the organization's circumstances. In short, the budgeting process does not end for the current year once the budget period has begun. Budgeting should be seen as a continuous and dynamic process.
A cash budget is a detailed budget of cash inflows and outflows and outflows incorporating both revenue and capital items. The cash budget of Enron Ltd for the six months ended 30 June 2011 is as follows:
Receipts from customers
Receipt from share issue
Payment to suppliers
Investing Surplus Cash
In the long term, a company with an ever increasing cash balance can do either one of two things. The firs thing it can do is to invest it in new business opportunities for profit while the second option is to return it to owners or shareholders by way of increased drawings or dividends (Buckley, 2000). In the short term, though, surplus funds need to be invested so that they can earn a return when they are not being used for any other purpose (Ross et al, 2005). A return can be earned perhaps by an earlier payment of business debts. The return is the 'interest' saved. Otherwise, there is a variety of deposit accounts and financial instruments which can be used to earn a return on the cash surpluses until they are needed.
Any business will normally have a number of guidelines as to how the funds are invested. A firm will try and maximize the return for an acceptable level of risk (Ross et al, 2005). What is acceptable depends on the preferences of the firm in question. There is generally held to be a relationship between risk and return. Generally speaking, a higher return involves a higher risk. A risk of an investment is its propensity to fluctuate in value.
To maintain liquidity, it is often company policy that the surplus funds should be invested in financial instruments which are easily converted into cash. In effect, enough surplus funds should be invested to maintain liquidity. Some investments are much more liquid than others - one that is highly liquid will generally attract a lower return (Buckely, 2000). Another consideration is the maturity of the investment. A longer maturity will generally provide a higher return.
Enron Ltd should set up guidelines for investing surplus cash. The guidelines should state, among other things, that surplus funds can only be invested in specified types of instruments (Drury, 2006). All investments must be convertible easily into cash within a set number of days. Investments should be ranked. Surplus funds to be invested in higher risk instruments when only a sufficiency has been invested in lower risk items so that there is always a cushion of safety. If Enron Ltd invests in certain financial instruments, a credit rating should be obtained. Credit rating agencies issue grades according to risk.
Steps in Establishing a Credit Control System
A credit control system is essential for any business. Credit control refers to the function that is responsible for granting credit, monitoring credit and taking necessary action against slow players (Horngren et al, 2006). There are three steps in a credit control system.
The first step is establishing overall credit terms. Should the firm provide no credit at all, or provide them to particular classes of customers? Some firms opt for credit as a percentage of sales. These are some of the issues the firm has to address when establishing credit terms.
The second step is having procedures for offering credit (Atkinson et al, 2007). Enron should obtain references for each potential debtor and review their accounting information. If possible, the company should send representatives to visit customers. Finally, the company should prepare formal agreements with debtors. The agreement should contain terms regarding the probationary period and settlement terms. Care must be taken to ensure that agreements comply with consumer credit legislation.
The third sage in a credit control system is instituting control mechanisms (Atkinson et al, 2007). One way is to have debtor aging reports while the second is to chase slow paying customers. That way, the debtor collection period can be reduced.
When establishing a credit control system, Enron Ltd should establish a policy on bad debts. At some stage, it will often become more costly to pursue reluctant payers than their debt is worth (Buckley, 2000). The firm should decide what its policy on writing off bad debts should be. Once having been established, the policy should be followed except in unusual circumstances. It is important that writing off bad debts only occurs when all the steps identified in the policy have been followed. It is also important that writing off bad debts can only be authorized by a fairly senior employee.
Enron should also consider offering discounts for prompt payment. The costs and advantages of allowing discounts should be assessed. If the company establishes a particular policy of allowing discounts, care should be taken to ensure that customers are allowed to deduct discounts only when they have in fact paid within the specified period.
In addition, Enron could consider factoring debts (Ross et al, 2005). It is possible to enter into an arrangement with a firm of debt factors. Here the factor collects the debts on behalf of the supplier firm. The precise arrangements can vary considerably but fairly typically, payment at a discount is made immediately after the sale by the factor, who then goes on to collect the debt and to manage all accounting and administrative matters concerned with it. This relieves the supplier firm of the administrative and financial burden of granting trade credit, but at a cost.
Advantages and Disadvantages of Using Overdraft Finance
When payments form a current account exceeds income to the account for a temporary period, the bank finances the deficit by means of an overdraft. It is very much a form of short term lending, available to both personal and business customers.
Many small and medium enterprises (SMEs) require their banks to provide financial assistance for normal trading over the operating cycle, if for example seasonal factors mean they face temporary cash shortages (Buckely, 2000). An overdraft will increase in size if the customer writes more cheques, but will reduce in size when money is paid into the account. There should be times when there will be no overdraft at all, and the account is in credit for a while.
If the hard core element of the overdraft appears to be becoming a long term feature of the business, the bank might wish, after discussions with the customer to convert the hard core of the overdraft into a medium term loan, thus giving formal recognition to its more permanent nature (Eiteman et al, 2007). Otherwise, annual reductions in the hard core of an overdraft would typically be a requirement of the bank. This is what may occur to Enron Ltd as the company seems to have a prolonged overdraft state. In the budget for the first six months of 2011, the company is in overdraft. Overdrafts should never be used to finance operations for such an extended period.
A mix of overdrafts and loans might be suggested in some cases (Ross et al, 2005). Consider a case where a business asks for a loan to purchase a shop with stock. The banker might wish to suggest a loan to help with the purchase of the shop, but the stock ought to be financed by an overdraft facility. The offer of part-loan part-overdraft is an option that might be well worth considering.
In practice, although an increasing amount of bank lending is on a fixed term basis, the time scale may not be all that long. Because of the risks involved, banks are often lending for a period significantly shorter than the life of the investment.
The importance of good working capital management cannot be overstated. Enron Ltd is a company that faces serious working capital problems. By examining its budget for the first six months of 2011, it appears that the company's lack of cash will continue well into the foreseeable future. To help it cope, the management has decided to extend the overdraft facility and raise funds through new shares. However, these are not enough. The company should perhaps raise even more funds through its share issue. It should also reduce its purchases which equal to or sometimes exceed monthly sales. It should also introduce other cost cutting measures to stay afloat.