The Essentials of Capital Budgeting in Financial Analysis
 
 

The Essentials of Capital Budgeting in Financial Analysis

I. Objectives:

  • Know why capital budgeting is an essential aspect of the firm.

  • Define capital expenditures and capital revenues.

  • Review cash flow analysis and the cash flow budget.

  • Know the other primary types of capital budgets used to aid in decision making.

II. CAPITAL BUDGETING

Capital budgeting involves selecting projects that add value to the firm. This may include a company's inadequate production capacity, or insufficient equipment. Capital budgeting decisions are important because they continue over extended periods of time. This may include fixed asset expenditures, such as land acquisition, new equipment and vehicle purchase, or retiring and replacing old machinery, or plant construction. This may also include revenue expenditures used for maintenance and repairs of fixed assets.

Expansion requires large expenditures. Effective capital budgeting improves the overall timing of the asset acquisition (cost savings) and quality of assets purchased.

CAPTIAL EXPENDITURES (CapEx)

Capital Expenditures (CapEx) are capital outlays for projects intended to maintain or expand the firm's operations, commonly classified as land, plant, and equipment. The capital expenditure must be capitalized, which entails distributing the fixed cost (the cost of the expenditure) over the useful life of the asset. When the expense is for maintaining the asset in its current condition, the cost is fully deducted in the year of the expense.

The amount of capital expenditures depends on the firm's industry. Firm's having high capital expenditures include manufacturing, utilities, and oil exploration. Capital expenditure projects are generally classified:

REPLACEMENT AND REPAIR OF EXISTING EQUIPMENT

  • Replacement Maintenance of Business – Replacements generally do not require the same level of analysis.

1. Equipment is replaced as necessary to continue current operations.

2. Outdated, broken, damaged, or worn equipment must be replaced. Time and money spent fixing equipment may exceed the total replacement cost, thereby justifying the purchase of new equipment.

3. Workplace improvements

4. Repairs and maintenance exceeding normal operating budget costs are included in the capital budget's long-term outlay.

5. Replacement of outdated equipment to lower labor, materials, utilities expenses

EXPANSION AND IMPROVEMENTS

  • Expansions and Improvements – Expansions and improvements require extensive analysis before adding them to your capital budget.

1. Expansion of existing markets or products to increase current output or expand outlets/distribution

2. Expenditures that make the business better without adding new products, structures, or equipment

REGULATORY MANDATES

  • Regulatory/Safety/Environmental Projects – Costs are included that are not reoccurring in the operational budget.

1. Improvements, repairs, additions, or adjustments necessary to comply with government codes are included in the capital budget plan.

2. Federal regulations or environmental industry changes to avoid fines and shutdowns must be included in the mandatory requirement category of the budget.

3. Insurance carriers' mandates

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ADDITIONS, ACQUISITIONS, OTHER

  • Additions and Acquisitions - Additions and acquisitions must coincide with the capital budget and strategic growth plans.

1. Expansion into new markets or products to produce a new product, new product line, or geographically expanded operations

2. Building additions, adding new equipment needed to produce a new product line

3. New and additional land, buildings, and services are all part of the capital budget for growth.

4. Other growth, such as parking lots, executive airplane, etc.

A Capital Expenditure Budget plan must be prepared for each capital expenditure project.

CASH FLOW TO CAPITAL EXPENDITURE RATIO (CF/CapEx)

The Cash Flow to Capital Expenditure Ratio (CF/CapEx) measures the firm's overall ability to acquire long-term assets using Free Cash Flow (FCF).


Free Cash Flow (FCF) is a measure of the firm's financial performance, or, the cash the firm produces after spending capital to maintain or expand its asset base. Free Cash Flow provides the opportunity to increase shareholder value.

FREE CASH FLOW = Cash Flow – Capital Expenditures

The CF/CapEx Ratio rises and falls as the firm experiences cycles of varying small and large capital expenditures. A high ratio indicates comparative financial strength (compared ONLY to other similar firms within the industry). The firm advantageously grows when it has the capacity to invest in itself through capital expenditure.

REVENUE EXPENDITURES

Revenue expenses are shorter-term, used for daily operational costs. They are basically the same as operating expenses. Revenue expenses are fully tax deductible and claimed in the year in which the expenses occur.

A revenue expenditure is applied to expense as soon as the cost is incurred. This matching principle ties the expense incurred to revenues generated in the same accounting period, which creates a more accurate Income Statement.

Revenue expenditures may be:

  • Maintaining a revenue-generating asset - repair and maintenance expenses that support daily operations
  • Generating revenue - daily operation expenses (salaries, rent, utilities, etc.)
A. Cash Flow Analysis

Analysis of the Cash Flow Statement helps determine cash flows associated with expenditures. It essentially shows the difference between the cash available at the beginning of an accounting period, and the cash available at the end of the accounting period.

Cash represents solvency. The Cash Flow Statement does not indicate profitability, but rather, it indicates liquidity. It only shows cash inflows and outflows and lists cash flows that occurred during the previous accounting period.

Cash inflows typically come through financing, operations, or investing in the form of:

  • sales
  • loan proceeds, investments, and
  • sale of assets

Cash outflows typically result from expenses or investments. Cash outflows include:

  • operating and direct expenses
  • principal debt service, and
  • purchases of assets

A Cash Flow Statement is also concerned with the timing of the in- and out-flows, since many carry over multiple time periods.

Cash flow projections are based on past performance. Working capital is necessary to support operations and transactions. It is integral to a Cash Flow Analysis. Working capital provides a quick analysis of the liquidity of the firm over the future accounting period.

The Cash Flow Budget is a projection of future cash flows. If there appears to be sufficient working capital, developing a Cash Flow Budget may not be necessary. However, when the working capital appears insufficient, a Cash Flow Budget can help spot liquidity problems that may occur in the upcoming year.

B. Cash Flow Budget

A Cash Flow Budget is a compilation of all cash receipts and cash expenditures expected to occur within a determined period. Cash Flow Budgeting examines the movement of money, although not at net income or profitability. The Cash Flow Budget emphasizes the following operations:

  • Sales/revenue
  • Development expenses
  • Cost of goods
  • Capital requirements
  • Operating expenses

The Cash Flow Budget allows the projection of sources and fund allocations for future periods. Cash deficit periods may be determined well in advance, so appropriate actions may be taken to avoid financial pitfalls. Projected deficiencies may be mitigated by,

  • adjusting the timing of certain transactions
  • modifying the amount of borrowed cash
  • determining the best time to borrow

Cash flows are a quantitative account of past activities.

When periods of excess cash are identified, action may be taken to redirect the excess funds into interest-bearing assets to generate additional revenue, or make scheduled loan payments.

C. Capital Budgets

Capital budgeting is used to determine the acceptance of capital spending on long‐term projects, and those requiring significant capital investments. Capital is generally limited, which demands that proposed capital projects be quantitatively, as well as qualitatively, analyzed prior to commitment of funds.

Capital budgeting analysis uses various processes:

  • cash inflows and cash outflows

  • net income calculated using the accrual basis

  • net income plus depreciation and amortization

  • estimated cash inflows from customers

  • reduced costs

  • revenue from the sale of assets

  • salvage value, and others

Various capital budgets are used in decision-making to determine which projects will yield the most return over a given period.
In this section, Zero-Based Budget and Rolling, or Continuous, Budget types of capital budgeting decision-making tools will be discussed.
D. Zero-Based Budgeting (ZBB)

Zero-Based Budgeting (ZZB) reverses the functioning process of conventional budgeting. Typically, capital variances are compared with previous years and are based on the baseline assumption. A Zero-Based Budget begins with a "zero base" budget line every year. It requires all expenses to be justified, line by line, and the budget is built around the projected needs for the upcoming period. It disregards if the current budget is higher or lower than the previous one. And this process is not dependent on the total budget, or specific line items, increasing or decreasing.

ZBB allows executive-level strategic goals to be incorporated into the budgeting process by tying them to specific operative areas of the organization. This is where costs can first be grouped and then measured against previous results and current expectations.

Zero-Based Budgeting is more than just building a new budget from scratch (zero). It serves as a repetitive and continual process that allows the firm to construct a sustainable and structured cost management environment. ZZB effectively allows and encourages cost visibility, governance, and accountability. It contributes to clearly aligned goal attainment and incentives.

STEP-BY-STEP

All costs are considered as if the programs were initiated for the first time. No costs are ongoing, and all costs must be justified by management. Proposed budget costs for the upcoming period are presented as parts of decision packages, listing activities considered to be relatively important, to relatively least important. When a step-by-step approach is implemented, ZBB allows top management to evaluate each decision package separately, and conclude which areas are less critical and not well justified in terms of cost distribution or allocation. This method cost management can eventually be integrated into lower levels of the organization and become part of daily budgeting, accounting, and financial analysis routines.

In-depth reviews of department budget costs is common. The difference in using the Zero-Base Budgeting process is the frequency in which the reviews are performed. It is accepted that ZBB reviews be done annually. Management is compelled to thoroughly examine all spending and the justification of every expense item.

ZBB ADVANTAGES

  • It allows resources to be more efficiently allocated; ZBB is not based on history, but rather on present and projected needs and growth.
  • It targets weaknesses and overspending – Results of the ZBB process encourages management to devise more cost effective methods of operating.
  • It exposes inflated budgets.
  • It increases motivation – Internal motivation is generated through information provided from ZBB results; It promotes the incentive to gain control of activities and operations to cut waste, assume more responsibility for individual contributions to the overall mission, and encourage participation in decision-making that impacts the overall growth of the firm.
  • It increases internal communications and coordination.
  • It identifies obsolete operations for improvement or elimination.
  • It identifies outsourcing / offshoring opportunities.
  • It obliges financing centers to identify their mission and intent to achievement of the business goals.

ZBB DISADVANTAGES

  • It is a more time-consuming process than incremental budgeting – ZBB is typically performed annually;
  • It capably justifies areas of direct revenues or production, but tends minimize client services or R&D contributions that are more difficult to quantify;
  • It has more difficulty justifying every line item - Intangible outputs are difficult to quantify;
  • It is a more complex budgeting process – Some initial training may be required, and
  • It must process a vast amount of information collected from all departments and compile it into a comprehensive budget report.

OVERALL RESULTS

Zero-Based Budgeting targets and identifies areas of expenditure waste. It also serves as a management guide in proposing and implementing cost cutting, cost effective, and growth promoting courses of action.

Results may require the firm to fundamentally redesign their cost structures to increase competitiveness. Operations may need to be standardized, streamlined, or automated.

Outsourcing and offshoring may be considered in an effort to reduce overall costs, including facilities and manpower, or to increase production at lower production cost and taxes.

Resource allocation may need to be realigned, reallocated, or redistributed to meet strategic goals at less expenditures.

Although ZBB can be time consuming, and resources such as R&D difficult to quantify, this budgeting and decision-making process has been proved to reduce costs by avoiding comprehensive increases or decreases across the entire organization in response to a prior period's budget.

Because of its detail-oriented nature, Zero-Based Budgeting may be used as a rolling process that extends over the course of several years, only reviewing a few functional areas at any one time.

E. Rolling/Continuous/ Perpetual Budgets

A Rolling Budget may be more commonly referred to as a Continuous Budget, or a Perpetual Budget. This is so called because the budget begins as a designated (typically 12 months) period, and continually adds a new month as the current month ends. The basic idea and intent of using this type of budget is to help ensure the firm is constantly planning its growth and progress 12 months in advance.

Essentially, the Continuous Budget attempts to stabilize the planning horizon. Its primary advantage is that it continuously shows one full year of anticipated budget expenditures, revenues, and other activities. The Continuous Budgeting process creates budgets for future periods and continually revises and updates them during current periods. They are adjusted at the end of the period to show the current order of capital allocations.

Budgets may typically be prepared monthly, quarterly, or annually. It is not uncommon for a company to prepare a weekly budget to track sales, deliveries, and distributions. These budgetary plans are used to establish current financial and performance goals. They are equally important in setting benchmarks for the future. As the current period ends, a new budget is added to carry over the process, thus providing a new plan for the upcoming period.

A Continuous Budget may use three-month periods (quarters) for short-term budgeting or have a five-year rolling budget plan for capital expenditures.

 
 
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