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

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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


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


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

  • 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

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


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

  • Number of units produced will depend on beginning inventory


Production Requirements for Six Months


Unit Costs

  • Cost to produce each unit:


Total Production Costs


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


Value of Ending Inventory


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


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 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


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


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


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


Summary of All Monthly Cash Payments


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


Cash Budget with Borrowing and Repayment Provisions


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


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)


Explanation of Pro Forma Balance Sheet


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:

  • 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

  • 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

  • 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


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’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


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’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


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


Internal Growth Rate


Internal Growth Rate


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