THE EFFECT OF BUDGETS ON FINANCIAL PERFORMANCE OF MANUFACTURING COMPANIES IN NIGERIA

Description

CHAPTER ONE

INTRODUCTION

1.1 Background to the study

Business budgeting is a basic and essential process that allows businesses to attain many goals in one course of action. There are several goals that many businesses seek to achieve (or should be trying to work toward) when they create and implement a budget. These goals include control and evaluation, planning, communication, and motivation (Lucey, 2004). (Kariuki, 2010), suggests that budgeting is a process of planning the financial operations of a business. Budgeting as a management tool helps to organize and formulize management‟s planning of activities. Budgeting as a financial tool is useful for both evaluation and control of organizations for the planning of future activities. Application of these tools can greatly impact the performance of a company (Larson, 1999).

Budgeting as a tool in financial management regularly prepares performance plans and budget requests that describe performance goals, measures of output and outcomes in various activities aimed at achieving performance goals. This helps in the sense that annual plans set forth in measurable terms  form  the levels  of performance for each  objectives  in  the budget  period (Larson, 1999).

The budgeting process in manufacturing companies incorporates a policy in financial welfare. For instance, it indicates how money is distributed by the management to the different departments and key areas to focus on. This helps the management in planning and forecasting in order to reduce costs and unnecessary spending and also to increase profits so that the company may fulfill its corporate vision and mission and also to enable the company to fulfill its debts if any and to ensure the company’s long term technical and financial viability. (Horngren, 1990).

1.1.1 The Budget

The budget acts as financial management tool in the manufacturing firm to measure the actual and forecast against the budget throughout the planning process, it also  assist in monitoring and controlling  of current performance by providing early warning of deviations from the  plans and analyses the anticipated versus actual results. Various types of budgets exist.

1.1.1.1 Project Budget: The project budget is a prediction of the costs associated with a particular project. These costs include labor, materials and other related expenses. The project budget is often broken into specific tasks, with task budgets assigned to each. Capital Budget: This shows the amounts and timing of approved major capital expenditure over the budget year.

1.1.1.2 Production Budgets: Product oriented companies make a production budget that estimates the number of the units that must be manufactured to meet the sales goals. The production budget also estimates the various costs incurred in manufacturing the units including labor and materials (David, 1988).

1.1.1.3 Marketing Budget: The marketing budget is an estimate of the funds needed for the promotion, advertising and public relations in order to market the product or service.

1.1.1.4 Sales Budget: The sales budget is an estimate of future sales often expressed on both units and monetary terms .It is used to create company sales goals (Kariuki, 2010).

1.1.1.5 Revenue Budget: The revenue budget consists of revenue receipts of government and the expenditure met from these revenues .Tax revenues are made up of taxes and other duties that the government levies.

1.1.1.5 Cash Flow/Cash Budgets: The cash flow budget is a prediction of future cash receipts and expenditure for a particular period .The cash flow budget helps the business determine when income will be sufficient to cover expenses and when the company will need to seek external financing (Kariuki, 2010).

Conditions for successful budgeting are:  the involvement and support of top management, clear cut definition long term, corporate objectives within which the budgeting system will operate, a realistic organization structure with clearly defined responsibilities, genuine and full involvement of the line managers in all aspects of the budgeting process (this is likely to include a staff development and education programme in the meaning and use of budgets).

An  appropriate  accounting  and  information  system  which  will  include:  the  records  of expenditure and performance related to responsibility, a prompt and accurate reporting system showing actual performance against budget, the ability to provide more detailed information or advice on requests, in short accounting system should be seen as supportive and not threatening. Regular revisions of budgets and targets, (where necessary) should be made (Engler, 1995).

Budgets  should  be administered  in  a flexible manner. Changes  in  conditions  may call  for changes in plans and the resulting budgets. Rigid adherence budgets which are clearly inappropriate for current conditions will cause whole budgeting system to lose credibility and effectiveness. Indeed budgets are not subject to revision they are effectively decisions and not plan (Engler, 1995).

1.1.2 Financial performance and its measurements

Finance always being disregarded in financial decision making since it involves investment and financing in short-term period. Further, also act as a restrain in financial performance, since it does not contribute to return on equity (Rafuse, 1996). A well designed and implemented financial management is expected to contribute positively to the creation of a firm‟s value (Padachi, 2006). Dilemma in financial management is to achieve desired trade- off between liquidity, solvency and profitability (Lazaridis, 2006).The subject of financial performance has received significant attention from scholars in the various areas of business and strategic management. It has also been the primary concern of business practitioners in all types of organizations  since  financial  performance  has  implications  to  organization‟s  health  and ultimately its survival. High performance reflects management effectiveness and efficiency in making use of company‟s resources and this in turn contributes to the country‟s  economy at large. (Naser and Mokhtar, 2004).

There have been various measures of financial performance. For example return on sales reveals how much a company earns in relation to its sales, return on assets determines an organization‟s ability to make use of its assets and return on equity reveals what return investors take for their investments. The advantages of financial measures are the easiness of calculation and that definitions are agreed worldwide. Traditionally, the success of a manufacturing system or company has been evaluated by the use of financial measures (Tangen, 2003).

Liquidity measures the ability of the business to meet financial obligations as they come due, without disrupting the normal, ongoing operations of the business. Liquidity can be analyzed both structurally and operationally. Structural liquidity refers to balance sheet measures of the relationships between assets and liabilities and operational liquidity refers to cash flow measures. Solvency measures the amount of borrowed capital used by the business relative the amount of owner‟s equity capital invested in the business. In other words, solvency measures provide an indication  of  the  business‟ ability to  repay all  indebtedness  if  all  of  the  assets  were  sold. Solvency measures also provide an indication of the business‟ ability to withstand risks by providing information about the operation‟s ability to continue operating after a major financial adversity (Harrington and Wilson, 1989).

Profitability measures the extent to which a business generates a profit from the factors of production: labor, management and capital. Profitability analysis focuses on the relationship between revenues and expenses and on the level of profits relative to the size of investment in the business. Four useful measures of profitability are the rate of return on assets (ROA), the rate of return on equity (ROE), operating profit margin and net income (Hansen and Mowen, 2005). Repayment capacity measures the ability to repay debt from both operation and non-operation income. It evaluates the capacity of the business to service additional debt or to invest in additional capital after meeting all other cash commitments. Measures of repayment capacity are developed around an accrual net income figure. The short-term ability to generate a positive cash flow margin does not guarantee long-term survivability (Jelic and Briston, 2001).