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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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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 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 Sales PLUS
  • 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
unit costs
Unit Costs
  • Cost to produce each unit:
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
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
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
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
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
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
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
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
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)
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.
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 increase 50.00% $100,000

Assets Before Increase After

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

Accounts receivable 40,000 20,000 60,000

Inventory 25,00012,50037,500

Total current assets $ 70,000 35,000 105,000

Equipment 50,00025,00075,000

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

Liabilities and Shareholders’ Equity

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

Accrued expenses 10,000 5,000 15,000

Notes payable 15,000 15,000

Required new funds26,000

Total current liabilities $ 65,000 $116,000

Common stock 10,000 10,000

Retained earnings 45,0009,00054,000

Total liabilities and shareholders’

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

Selected ratios

Debt/Total assets 65/120 =.054 116/180 =.064

Debt/Equity 65/(10+45) =1.18 116(10+54) =1.81

Current ratio 70/65 =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

balance sheet with sustainable sales increase

PPT 4-14

Balance sheet with sustainable sales increase

HOWARD CORPORATION

Sales $200,000

Sales increase 12.24% $ 24,480

Assets Before Increase After

Cash $ 5,000 $ 612 $ 5,612

Accounts receivable 40,000 4,896 44,896

Inventory 25,0003,06028,060

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

Equipment 50,0006,12056,120

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

Liabilities and Shareholders’ Equity

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

Accrued expenses 10,000 1,224 11,224

Notes payable 15,000 15,000

Required new funds1,834

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

Common stock 10,000 10,000

Retained earnings 45,0006,73451,734

Total liabilities and shareholders’

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

Selected ratios

Debt/Total assets 65/120 =0.54 73/135 =0.54

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

Current ratio 70/65 =1.08 79/73 =1.08

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