Cash is King: Master Budgets to Inform a Credit Decision

Early one morning in March, Jordan Buford was preparing his daily work when his boss, Olivia Anton, approached him and announced, "Little Annin Flagmakers (LAF) has submitted an application for a line of credit (LOC) for April through June. I want you to prepare budgeted financial statements similar to the ones you prepared for our last LOC applicant. I need this by 3 PM today for the 4 PM credit committee meeting. Be prepared to make a loan recommendation and to address questions from the credit committee. I have cleared your schedule. Let me know if you need anything." Kent Bank is a state bank with multiple branches that offers a variety of services for personal and commercial needs. The bank has been serving the local community for over 110 years and prides itself on its personalized approach to provide financial services, local management, long-term stability and a full range of deposit and lending products and services. Commercial credit decisions at Kent Bank are made by the Commercial Credit Committee, which consists of the senior commercial credit analyst and two vice presidents. Jordan was recently hired by Kent Bank as a commercial credit analyst, to provide analysis for commercial loan applications. During his undergraduate studies, he studied accounting and finance and shortly after graduation passed the CMA exam. Jordan reports directly to Olivia Anton, the senior commercial credit analyst who has been with Kent Bank for ten years. As Jordan began the work, he recalled his last line of credit (LOC) analysis and how well received it was. He had taken the information provided by the company and developed master budgets in Excel that used an input section with numbers that could be changed for assessing different scenarios. The committee had specifically asked about the effect on the applicant's cash needs would be if sales were reduced by 2%, 5%, and 10%. He wanted to be prepared for these types of questions.

LITTLE ANNIN FLAGMAKERS BACKGROUND

Little Annin Flagmakers (LAF) manufactures one product, a large durable 8' x 12' American flag, which it sells for US$120. Because of the large size of the flag, this product is not sold in stores; rather, it is sold through a relatively small number of on-line retailers. Each quarter, retailers estimate sales for the upcoming five months, revising proximate sales as necessary. In general, the retailers are reasonably good at estimating their sales needs; however, some variation in demand does occur and the retailers expect to be able to adjust orders as needed. LAF allows retailers to adjust each month's purchases to 80-120 percent of the estimated sales levels. Flags are shipped to retail customers using JIT distribution so that the on-line retailers do not have to store inventory. Typical sales for the flag are 1,800 units per month with seasonal increases April through August. Sales estimates are 2,500 units in April, 6,000 units in May, 3,000 units in June, 2,500 units in July, and 2,000 units in August. Customers historically have paid 40 percent of their purchases in the month of the sale, 55 percent in the following month, and the remaining five percent is uncollectible.

MANUFACTURING AND SG&A COSTS

The flags are made in one plant which has a capacity of 6,200 units per month. LAF budgets to have 20 percent of next month's sales in finished goods inventory at the end of each month. There is plenty of storage space for finished goods. Fabric is the only direct material and each flag requires 5 pounds of fabric at US$7 per pound. LAF plans to have 40 percent of next month's fabric needs on hand at the end of the month. Fabric is purchased on credit with 40 percent paid in the month of purchase and 60 percent paid the next month. The standard direct labor hours to manufacture one flag is 0.50 hours at US$40 per hour. For simplicity, direct labor costs are budgeted as if they were paid when incurred. Manufacturing overhead rates are computed quarterly and applied based on direct labor hours. Fixed manufacturing overhead costs are estimated to be US$57,950 per month, of which US$20,000 is PPE depreciation. Variable manufacturing overhead, including indirect materials, indirect labor, and other costs, is estimated at US$10 per direct labor hour. The selling and administrative expenses include variable selling costs (primarily shipping) of US$1.25 per unit, and fixed costs of US$63,000 per month of which US$10,000 is deprecation of the administrative office building and equipment.

FINANCIAL STATEMENT DETAILS AND CASH PLANNING

LAF uses FIFO inventory valuation. As of March 31, the expected finished goods inventory is 410 units, valued at US$75 per unit. The company expects to have 4,600 pounds of fabric on hand, valued at US$7 per pound. Other expected account balances include: accounts payable at US$55,000, accounts receivable at 132,000, cash at US$ 37,745, land at US$520,000, and building and equipment at US$1,800,000 with accumulated depreciation of US$750,000. LAF has no long-term debt; common stock is valued at US$500,000 and is not expected to change during the quarter; expected retained earnings as of March 31 are US$1,247,695.

Exhibit 1. Excel Data Input Section A B Input Data (US$) 30 Selling & Administrative (S&A) Costs 31 Variable S&A cost per unit sold US$1.25 Budgeted Sales Expected 32 Fixed S&A cost per month US$63,000 April (units 2,500 33 Depreciation in fixed S&A cost US$10,000 May (units) 6,000 34 June (units) 3,000 35 Other Cash Outflows July (units) 2,500 36 Cash dividends paid each month JS$15,000 August (units) 2,000 37 Equipment purchases May JS$47,820 38 Equipment purchases June US$154,600 10 Selling price/unit US$120.00 39 11 40 Desired Ending Inventory 12 Cash Collection Pattern 41 Finished goods 20% 13 Month of sale 40% 42 Raw materials 10% 14 Following month 55% |43 Cast US$30,000 15 Uncollectible 5% 44 16 45 Beginning Account Balances on March 31 17 Cash Payments for Materials 146 Cash US$37,745 18 Month of purchase 40% 47 Accounts receivable US$132,000 19 Following month 60% |48 Finished goods inventory (at US$75/unit US$30,750 20 49 Finished goods cost per unit US$75.00 21 Production Requirements 50 Finished goods inventory (units) 410 22 Raw material per unit (Ib.) 5 51 Raw materials (at US$7.00/1b.) US$32,200 23 Raw material cost per lb IS$7.00 52 Raw materials (lb. 4,600 24 Direct labor hours per unit 0.5 53 Accounts payable US$55,000 25 Direct labor rate per hour US$40.00 54 26 Variable manufacturing overhead rate per US$10 55 Land US$520,000 direct labor hour 56 Buildings and equipment US$1,800,000 27 Fixed manufacturing overhead cost per month US$57.950 57 Accumulated depreciation (US$750,000) 28 Depreciation in Fixed manufacturing overhead US$20,000 58 Common stock JS$500,000 29 59 Retained earnings US$1,247,695 Exhibit 2. Sales at Different Levels Decreased by Budgeted Sales Expected 2% 5% 10% April (units) 2,50 2,450 2,375 2.250 May (units) 6,000 5,880 5,700 5,400 June (units) 3,000 2,940 2,850 2,700 July (units) 2,500 2.450 2,375 2.250 August (units) 2,000 1.960 1,90 1,800 IMA EDUCATIONAL CASE JOURNAL 3 VOL. 11, NO 4, ART 4, DECEMBER 2018