Finance Self Study Guide for Staff of Micro Finance Institutions

LESSON 7

CREATING A BUDGET
Objectives: The purpose of this lesson is to provide an overview of the budgeting process and the purpose for completing a budget. A sample budgeted Income Statement is provided. Implementation and analysis of the budget is described as well as how to calculate budget variance. You will develop an understanding of why budgeting is important and how each area of the branch is part of the budgeting process. Topics include:

Benefits of budgeting Who completes the budget? The budgeting process Implementation and Analysis Budget variance

Benefits of Budgeting
A budget is a prediction of the financial condition of an organization for a future time period. Budgets differ from cash flow forecasts in that they consider all items on the Balance Sheet and Income Statement, not just cash items (refer to the Accounting Study Guide - Statement of Changes in Financial Position). A budget provides a plan so that everyone in the organization has a similar vision of where the organization is going during the next time period. The budget projects assets, liabilities and equity as well as revenue and expenses for the future. Generally, budgeted Balance Sheets and Income Statements are produced on an annual basis whereas cash flow forecasts (as described in previous session) are produced on a more frequent basis. A budget motivates an organization to reach its goals and is a tool for monitoring progress towards those goals. It helps management make decisions about the organization, manage the financial resources of the organization and avoid certain problems before they occur. In addition, when the staff is involved in developing the budget, each employee feels a degree of ownership and is more committed to the success of the organization. An effective budget should:

state all of the assumptions be understandable and simple represent the combined judgment of staff and management cover a period for which reliable estimates can be made be flexible to permit adjustments

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Lesson 7

establish standards of performance provide motivation and guide performance guide management and staff toward objectives. 1

Generally, budgets are based on the previous years (or other time period) results. Ratios can be used to create a budget as long as the period which the ratio is based on is fairly typical of future periods and did not include any extraordinary income/events. Each item on the Balance Sheet and Income Statement must be projected individually taking into account previous results, the internal and external environment and the goals of the organization. Consider how you are involved in your organizations budgeting process. Do you feel that it is beneficial to you and to the organization? Does it affect your performance?

Who Completes the Budget?

To be effective, budgeting should involve everyone in the organization. Credit officers must determine individually how many loans they will disburse and of what value, to forecast the organizations largest asset its loan portfolio. They must also determine how many loans which loans will be repaid and when. The majority of the organizations revenue can then be budgeted, based on the loan portfolio. In addition, expenses must be budgeted. By adding together each credit officers' budgeted portfolio, the branch or organization manager is able to consolidate the branch portfolio and determine the associated expenses. Each area and region is then able to consolidate their branches and provide Head Office with budgeted amounts that can then be consolidated for the organization. At each step of the way, it is necessary to verify that the information is realistic and created in a consistent manner by all credit officers and branches.

Budgeting Process
Most organizations have specific methods (computer spreadsheets, off-sight planning sessions, etc.) of compiling a budget. This training does not put forth a budgeting model. Rather, it suggests guidelines and processes to create an effective budget. If it is available, the budget for the previous period (one year for the purposes of this session) should be compared to the actual results of that period and the variances analyzed. Was there a lot of variance? Are there valid reasons for the variances? Did the budget meet the organizations goals? Next the external environment needs to be analyzed with a focus on competitive and economic information. Relevant competitive information should be based on what other micro-finance organizations, NGOs and banks are doing in the region/country. Economic information should include both the national and local economy, population trends, government legislation and policies.

Jerving, Jim. Financial Management for Credit Union Managers and Directors. Madison: The World Council of Credit Unions. 1989. 2

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By analyzing the internal environment, the organizations (or the branchs) strengths and weaknesses can be determined. Looking at the financial picture of each branch and the organization as a whole provides helpful information. Studying the client mix in terms of the number of years as clients and loan maturity, as well as staff requirements at the branch level is also important. Think of some examples of both external and internal events or policies that would affect the budgeting process. External examples: density and type of financial institutions or other credit providers, types of economic activities financed, cultural factors, market demand, legal environment, inflation/market rates for debt, foreign exchange issues for donor funds. Internal examples: number of staff, communication between staff/branches, quality of staff, flow of information. After analyzing the external and internal environments, existing policies and results should be reviewed to determine the effectiveness of policies and the need for new or different policies, all of which will affect the budget calculations. The next step is to develop goals for the upcoming year/period. Generally, goals for the organization will be determined at the Head Office level and should consider both outreach goals and financial goals. In addition, each department or branch should develop goals of their own (in accordance with Head Office goals) and determine how their operations will be affected by these goals. Studying past trends such as client growth, portfolio growth, delinquency rates, etc., will give an indication of what may occur in the future. List goals that you would like to achieve for your specific areas. Are these goals realistic? What steps would be necessary to achieve them? Once the implications of external and internal environmental factors have been determined, and the organizations goals are set, a working budget can be created. This is done by allocating figures to meet the goals and pay for operating expenses. For example, if one goal is to increase loans outstanding by 5%, then the previous years portfolio outstanding would be multiplied by 105% to provide the budgeted amount of portfolio outstanding for the upcoming year. 2 Projected Loan Increase Total portfolio outstanding at 31 Dec 94 Projected growth for budget year (5%) Budgeted portfolio outstanding for 1995 P7,340,000 367,000 P7,707,000

Increases or decreases in various line items can be calculated in a similar manner. It is generally helpful to begin by budgeting the portfolio size (asset), which is usually set as a goal of the organization; revenues are then based on the targeted portfolio size. It is then possible to calculate the operating expenses required to reach the goal.

Note that to increase average loans outstanding by 5%, loan disbursements will have to increase by more than 5% depending on the loan term. That is, if loan principal is repaid at 8% to 9% per month, then loan disbursements must increase by twice the amount of the desired increase in portfolio outstanding. 3

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The following steps are suggested for developing a working budget: Portfolio Budget determine the monthly loan disbursement amounts according to the age of the branch and past history determine the loan portfolio outstanding for the year taking into account the current and Past Due loans and the portfolio turnover (affected by loan term) determine the amount of loan repayment determine the revenue on the basis of the loan portfolio estimate all operating expenses for the period estimate Loan loss provision required estimate financing costs for the period

Expense Budget

Once the working budget(s) have been reviewed, revised and finalized, a final budget is developed. Budgeting is an iterative process between Head Office and the branches or departments. Approval of each branch budget is made at a higher level and is used to evaluate the performance of the branch during and at the end of the period. An example budgeted Income Statement is shown on the following page. A complete budget includes a Balance Sheet but this involves estimating funding requirements (debt or equity) and is beyond the scope of this study guide.

Implementation and Analysis

Implementing the budget is an important component of budgeting. Management must work with staff to make sure that the budget projections become a reality. To be effective, reports against budget must be easily understood and timely. At a minimum, budget reports should be prepared at the end of each quarter. They should also be flexible enough to adapt to the needs of various levels of staff and the board. Regardless of how carefully a budget is developed, actual figures will differ from those projected. Variances should be explained as they occur.

Budget Variance
Budget variance analysis refers to comparing actual results with those budgeted at a specific period of time. When analyzing budget variances, two additional columns are included in the budget: in the first column, actual figures are reported for each item; the second column shows the difference between budget and actual. This is referred to as the variance and it can be positive or negative. Any significant variances must be explained. If the variance was caused by a non-recurring event, then future budgets need not be adjusted, although the variance must still be explained. If the variance is caused by poor budgeting, then the reasons underlying the mistake should be determined in order to avoid such mistakes in future budgets. If the variance is due to inefficient operations or inadequate staff efforts/workload, then credit policies, staff expectations, staff incentives, etc. should be modified.

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SAMPLE BUDGET INCOME STATEMENT

Jan Loan Portfolio Outstanding: Current loans Past Due loans Restructured loans Financial Income: Interest on current and past due loans Interest on restructured loans Interest on investments Loan fees/service charges Total Financial Income Financial Costs: Interest on debt Interest paid on deposits Total Financial Costs Gross Financial Margin Provision for Loan Losses Net Financial Margin Operating Expenses Salaries and benefits Administration expenses Travel and transportation Occupancy expense Office Expenses Other Total Operating Expenses Net Income From Operations Grant Revenue for Credit Operations Excess of Income over Expenses 43,000 13,000 0 575 260 835 170 0 170 665 665 283 60 110 120 20 0 593 72 72 Feb 47,000 13,000 0 600 260 860 170 0 170 690 690 283 60 110 120 20 0 593 97 97 Mar 50,000 14,000 0 625 75 260 960 170 0 170 790 790 283 60 110 120 20 0 593 197 197 Apr 51,000 14,000 0 630 260 890 170 0 170 720 720 283 60 110 120 20 0 593 127 127 May 54,000 11,000 2,000 655 260 915 170 0 170 745 745 283 60 110 120 20 0 593 152 152 Jun 57,000 11,000 2,000 675 75 260 1,010 170 0 170 840 840 283 160 110 120 20 0 693 147 147 Jul 59,000 9,000 2,000 690 70 260 1,020 170 0 170 850 850 283 560 110 120 20 0 1,093 (243) (243) Aug 62,000 11,500 2,000 720 260 980 170 0 170 810 810 283 60 110 120 22 0 595 215 215 Sep 64,000 11,500 2,000 730 260 990 170 0 170 820 820 283 60 110 120 22 0 595 225 225 Oct 65,000 12,000 2,000 735 75 260 1,070 170 0 170 900 900 283 140 110 120 22 0 675 225 225 Nov 67,000 10,000 1,000 750 250 1,000 150 0 150 850 850 283 70 110 120 22 0 605 245 245 Dec 70,000 10,000 1,000 775 75 250 1,100 150 0 150 950 (1,400) (450) 287 270 120 120 22 0 819 (1,269) (1,269) TOTAL (Average) 57,400 11,500 1,000 8,160 70 300 3,100 11,630 2,000 0 2,000 9,630 (1,400) 8,230 3,400 1,620 1,330 1,440 250 0 8,040 190 190

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Finance Study Guide

Lesson 7

Complete the following Budget Exercises.

Creating a Budget EXERCISES

1. What are the benefits of budgeting?

2.

What are the characteristics of an effective budget?

3.

Describe the budgeting process.

4.

How is the budget implemented and analyzed?

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5.

Using the following assumptions, prepare a budget for the year ending 1995. current portfolio and income on current loans increase by 15% no grants for operations interest on debt increases by 200 write off loans for 500 restructured loans and interest on restructured loans double past due portfolio remains the same interest on investments decreased by 500 (due to lower interest rates) no change in late fees all operating expenses increase by 10% Loan loss reserve increase by 2,000 loan fees increase by 7.5%

Compare the budget with actual figures (from the Income Statement in the Sample Account Analysis) and calculate the variance, stating whether it is a positive or a negative variance.

Actual 1994 Loans Outstanding Current Past-Due Restructured Total Loans Outstanding Financial Income Interest on Current & Past Due Loans Interest on Restructured Loans Interest on Investments Loan Fees/Service Charges Late fees on loans Total Financial Income Financial Costs Interest on debt Interest paid on deposits Total Financial Costs GROSS FINANCIAL MARGIN Provision for loan losses NET FINANCIAL MARGIN Operating Expenses Salaries and benefits Administrative expenses Occupancy expense Travel Depreciation Other Total Operating Expenses NET INCOME FROM OPERATIONS Grant Revenue for Operations Excess Of Income Over Expenses 50,000 19,500 500 70,000

Budget 1995

Actual 1995 66,000 17,000 1,000 84,000

Variance

Explanation

12,000 50 1,500 5,000 300 18,850 3,500 0 3,500 15,350 3,000 12,350 5,000 2,500 2,500 2,500 300 300 13,100 (750) 950 200

15,400 100 500 5,300 200 21,500 3,700 0 3,700 17,800 2,500 15,300 6,000 2,600 2,500 2,500 400 300 14,300 1,000 0 1,000

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