Financial forecasting
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Financial Forecasting. 4. Chapter 4 - Outline. What is Financial Forecasting? 3 Financial Statements for Forecasting Determining Production Requirements 2 Methods of Financial Forecasting Percent-of-Sales Method Methods to determine the amount of new funds required in advance.

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Financial forecasting

Financial Forecasting

4


Chapter 4 outline

Chapter 4 - Outline

  • What is Financial Forecasting?

  • 3 Financial Statements for Forecasting

  • Determining Production Requirements

  • 2 Methods of Financial Forecasting

  • Percent-of-Sales Method

  • Methods to determine the amount of new funds required in advance


What is financial forecasting lt 4 2

What is Financial Forecasting? LT 4-2

  • Financial forecasting is looking ahead to develop a financial plan for the future

  • Provides lead time to make necessary adjustments before actual events occur

  • Helps to plan for significant growth in firm

  • Can be used as a target for measuring performance

  • Often required by bankers and other lenders


3 financial statements for forecasting

PPT 4-5

3 Financial Statements for Forecasting

  • Pro Forma Income Statement (I/S)

  • Cash Budget

  • Pro Forma Balance Sheet (B/S)

    The first step is to develop a sales projection


Development of pro forma statements

Development of Pro Forma Statements


Development of pro forma statements1

Development of pro forma statements

  • Establish a sales projection

    • Forecast economic conditions

    • Survey sales personnel

  • Determine production needs, COGs, and gross profit

    • Determine units to be produced

    • Determine the cost of producing the units

    • Compute cost of goods sold

    • Compute gross profit

  • Compute other expenses

    • General and administrative

    • Interest expense

  • Finally construct the pro forma income statement


Establish a sales projection

Establish a Sales Projection

  • Let us assume Goldman Corporation has two primary products: wheels and casters


Determining production requirements lt 4 4

Determining Production Requirements LT 4-4

  • Projected Units SalesPLUS

  • Desired Ending Inventory (EI)MINUS

  • Beginning Inventory (BI)EQUALS

  • Production Requirements

  • (or Units to be Produced)


Stock of beginning inventory

Stock of Beginning Inventory

  • Number of units produced will depend on beginning inventory


Production requirements for six months

Production Requirements for Six Months


Unit costs

Unit Costs

  • Cost to produce each unit:


Total production costs

Total Production Costs


Cost of goods sold

Cost of Goods Sold

  • Costs associated with units sold during the time period

    • Assumptions for the illustration:

      • FIFO accounting is used

      • First allocates the cost of current sales to beginning inventory

      • Then to goods manufactured during the period


Allocation of manufacturing cost and determination of gross profits

Allocation of Manufacturing Cost and Determination of Gross Profits


Value of ending inventory

Value of Ending Inventory


Other expense items

Other Expense Items

  • Must be subtracted from gross profits to arrive at net profit

    • Earning before taxes

      • General and administrative expenses, and interest expenses are subtracted from gross profit

    • Aftertax income

      • Taxes are deducted from the earning before taxes

    • Contribution to retained earnings

      • Dividends are deducted from the aftertax income


Actual pro forma income statement

Actual Pro Forma Income Statement


Cash budget

Cash Budget

  • Pro forma income statement must be translated into cash flows

    • The long-term is divided into short-term pro forma income statement

    • More precise time frames set to help anticipate patterns of cash inflows and outflows


Cash budget1

Cash budget

  • Estimate cash sales and collection timing of credit sales

  • Forecast cash payments

    • Payments for materials purchase according to credit terms

    • Wages

    • Capital expenditures

    • Principal payments

    • Interest payments

    • Taxes

    • Dividends

  • Determine monthly cash flow (recepits minus payments)

  • Construct cash budget

  • Determine cash excess or need for borrowing


Monthly sales pattern

Monthly Sales Pattern


Cash receipts

Cash Receipts

  • In the case of Goldman Corporation:

    • The pro forma income statement is taken for the first half year:

      • Sales are divided into monthly projections

    • A careful analysis of past sales and collection records show:

      • 20% of sales is collected in the month

      • 80% in the following month


Monthly cash receipts

Monthly Cash Receipts


Cash payments

Cash Payments

  • Monthly costs associated with:

    • Inventory manufactured during the period

      • Material

      • Labor

      • Overhead

    • Disbursements for general and administrative expenses

    • Interest payments, taxes, and dividends

    • Cash payments for new plant and equipment


Component costs of manufactured goods

Component Costs of Manufactured Goods


Cash payments cont d

Cash Payments (cont’d)

  • Assumptions for the next two tables:

    • Costs are incurred on an equal monthly basis over a six-month period

    • Sales volume varies each month

    • Employment of level monthly production to ensure maximum efficiency

    • Payment for material, once a month after purchases have been made


Average monthly manufacturing costs

Average Monthly Manufacturing Costs


Summary of all monthly cash payments

Summary of All Monthly Cash Payments


Actual budget

Actual Budget

  • Difference between monthly receipts and payments is the net cash flow for the month

    • Allows the firm to anticipate the need for funding at the end of each month


Monthly cash budget

Monthly Cash Budget


Cash budget with borrowing and repayment provisions

Cash Budget with Borrowing and Repayment Provisions


Pro forma balance sheet

Pro Forma Balance Sheet

  • Represents the cumulative changes over time

    • Important to examine the prior period’s balance sheet

    • Some accounts will remain unchanged, while others will take new values

      • Information is derived from the pro forma income statement and cash budget


Development of a pro forma balance sheet

Development of a Pro Forma Balance Sheet


Construction of pro forma balance sheet

Construction of pro forma balance sheet

  • Assets (source of information)

    • Cash - (cash budget)

    • Marketable securities - (previous balance sheet and cash budget)

    • Accounts receivable - (sales forecast, cash budget)

    • Inventory - (COGS computation for pro forma income statement)

    • Plant and equipment - (previous balance sheet + purchase -

    • amortization)

  • Liabilities and Net Worth

    • Account payable - (Cash budget work sheet)

    • Notes payable - (previous balance sheet and cash budget)

    • Long-term debt - (previous balance sheet plus new issues)

    • Common stock - (previous balance sheet plus new issues)

    • Retained earnings - ((previous balance sheet plus projected

    • addition from pro forma income statement)


Development of a pro forma balance sheet cont d

Development of a Pro Forma Balance Sheet (cont’d)


Explanation of pro forma balance sheet

Explanation of Pro Forma Balance Sheet


Analysis of pro forma statement

Analysis of Pro Forma Statement

  • The growth ($25,640) was financed by accounts payable, notes payable, and profit

    • As reflected by the increase in retained earnings

      Total assets (June 30, 2005)……$76,140

      Total assets (Dec 31, 2004)…….$50,500

      Increase…………………………...$25,640


2 methods of financial forecasting

2 Methods of Financial Forecasting:

  • Using Pro Forma, or Projected, Financial Statements (more exact, time consuming)

  • Percent-of-Sales Method for the pro forma Balance Sheet


Percent of sales method lt 4 6

Percent-of-Sales Method LT 4-6

  • A short-cut, less exact, easier method of determining financing needs

  • (The “quick and dirty” approach)

  • Assumes that B/S accounts will maintain a constant percentage relationship to sales

  • More sales will mean more assets which will require more financing

  • Can be summarized by using the Required New Funding formula


Determine external financing

Determine external financing

  • Project assets levels on basis of forecasted sales

  • Project spontaneous financing: Some financing is provided spontaneously when asset levels increase: for example, account payable and accrued expenses )

  • Project internal financing from profit

  • Determine external financing = required new assets to support new sales - spontaneous financing - retained earnings.


Balance sheet of howard corporation

Balance Sheet of Howard Corporation


Percent of sales method cont d

Percent-of-Sales Method (cont’d)

  • Funds required is ascertained

  • Financing is planned based on:

    • Notes payable

    • Sale of common stock

    • Use of long-term debt


Percent of sales method cont d1

Percent-of-Sales Method (cont’d)

  • Company operating at full capacity – needs to buy new plant and equipment to produce more goods to sell:

    • Required new funds:

      (RNF) = A (ΔS) – L (ΔS) – PS2(1 – D)

      S S

  • Where: A/S = Percentage relationship of variable assets to sales; ΔS = Change in sales; L/S = Percentage relationship of variable liabilities to sales; P = Profit margin; S2 = New sales level; D = Dividend payout ratio

    RNF = 60% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)

    = $60,000 - $25000 - $18,000 (.50)

    = $35,000 - $9000

    = $26,000 required sources of new funds


Balance sheet with sales increase

PPT 4-13

Balance sheet with sales increase

HOWARD CORPORATION

Sales $200,000

Sales increase50.00% $100,000

AssetsBefore Increase After

Cash $ 5,000 $ 2,500 $ 7,500

Accounts receivable 40,00020,000 60,000

Inventory25,00012,50037,500

Total current assets $ 70,00035,000105,000

Equipment50,00025,00075,000

Total assets $120,000 $60,000 $180,000

Liabilities and Shareholders’ Equity

Accounts payable $ 40,000 $20,000$ 60,000

Accrued expenses10,000 5,000 15,000

Notes payable15,000 15,000

Required new funds26,000

Total current liabilities $ 65,000 $116,000

Common stock10,000 10,000

Retained earnings45,0009,00054,000

Total liabilities and shareholders’

equity $120,000 $34,000 180,000

Selected ratios

Debt/Total assets65/120 =.054 116/180 =.064

Debt/Equity65/(10+45) =1.18 116(10+54) =1.81

Current ratio70/65 =1.08 105/116 =0.91


Percent of sales method cont d2

Percent-of-Sales Method (cont’d)

  • Company not operating at full capacity - needs to add more current assets to increase sales:

    RNF = 35% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)

    = $35,000 - $25,000 - $18,000 (.50)

    = $35,000 - $25,000 - $9,000

    = $1,000 required sources of new funds


Sustainable growth rate

Sustainable growth rate


Financial forecasting

Sustainable growth rate


Balance sheet with sustainable sales increase

PPT 4-14

Balance sheet with sustainable sales increase

HOWARD CORPORATION

Sales $200,000

Sales increase12.24% $ 24,480

AssetsBefore Increase After

Cash $ 5,000 $ 612 $ 5,612

Accounts receivable 40,000 4,896 44,896

Inventory25,0003,06028,060

Total current assets $ 70,000 8,568 78,568

Equipment50,0006,12056,120

Total assets $120,000 $14,688 $134,688

Liabilities and Shareholders’ Equity

Accounts payable $ 40,000 $ 4,896$ 44,896

Accrued expenses10,000 1,224 11,224

Notes payable15,000 15,000

Required new funds1,834

Total current liabilities $ 65,000 6,120 $ 72,954

Common stock10,000 10,000

Retained earnings45,0006,73451,734

Total liabilities and shareholders’

equity $120,000 $12,854$134,688

Selected ratios

Debt/Total assets65/120 =0.54 73/135 =0.54

Debt/Equity 65/(10+45) =1.18 73/(10+52) =1.18

Current ratio70/65 =1.08 79/73 =1.08


Financial forecasting

Internal Growth Rate


Financial forecasting

Internal Growth Rate


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