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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 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 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 Profits

  • 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 Profits

  • 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 Profits

  • 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 Profits

  • 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 Profits

  • 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 Profitsof Manufactured Goods


Cash payments cont d
Cash Payments (cont’d) Profits

  • 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 ProfitsManufacturing Costs


Summary of all monthly cash payments
Summary of All ProfitsMonthly Cash Payments


Actual budget
Actual Budget Profits

  • 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



Cash budget with borrowing and repayment provisions
Cash Budget with Borrowing Profitsand Repayment Provisions


Pro forma balance sheet
Pro Forma Balance Sheet Profits

  • 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 Profits Pro Forma Balance Sheet


Construction of pro forma balance sheet
Construction of pro forma balance sheet Profits

  • 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 ProfitsPro Forma Balance Sheet (cont’d)


Explanation of pro forma balance sheet
Explanation of ProfitsPro Forma Balance Sheet


Analysis of pro forma statement
Analysis of Pro Forma Statement Profits

  • 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 ProfitsMethods 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 Profits

  • 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 Profits

  • 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 Profitsof Howard Corporation


Percent of sales method cont d
Percent-of-Sales Method (cont’d) Profits

  • 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) Profits

  • 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 Profits

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) Profits

  • 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 Profits

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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