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Ch. 4: Financial Forecasting, Planning, and Budgeting PowerPoint PPT Presentation

Ch. 4: Financial Forecasting, Planning, and Budgeting Objectives Forecast Financial Statements with the Percentage of Sales Approach to determine Discretionary Financing Needed. Discuss Limitations of Percentage of Sales Approach. Determine Sustainable Growth Rate. What’s a cash budget?

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Ch. 4: Financial Forecasting, Planning, and Budgeting

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Ch 4 financial forecasting planning and budgeting l.jpg

Ch. 4: Financial Forecasting,Planning, and Budgeting


Objectives l.jpg

Objectives

  • Forecast Financial Statements with the Percentage of Sales Approach to determine Discretionary Financing Needed.

  • Discuss Limitations of Percentage of Sales Approach.

  • Determine Sustainable Growth Rate.

  • What’s a cash budget?


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Financial Forecasting

  • 1) Project sales revenues and expenses.


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Financial Forecasting

  • 1) Project sales revenues and expenses.

  • 2) Estimate current assets and fixed assets necessary to support projected sales.


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Financial Forecasting

  • 1) Project sales revenues and expenses.

  • 2) Estimate current assets and fixed assets necessary to support projected sales.

    • Percent of sales forecast


Our example zippy drives l.jpg

Our Example: Zippy Drives

  • Suppose this year’s sales will total $20 million.

  • Next year, we forecast sales of $25 million.

  • Net income should be 10% of sales.

  • Dividends should be 40% of earnings.

  • Our task: forecast balance sheet and determine discretionary (outside) financing needed.


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This year% of $20m

Assets

Current Assets$6m30%

Fixed Assets$10m50%

Total Assets$16m

Liab. and Equity

Accounts Payable$3m15%

Accrued Expenses$2m10%

Notes Payable$1mn/a

Long Term Debt$3mn/a

Total Liabilities$9m

Common Stock$4mn/a

Retained Earnings$3m

Equity$7m

Total Liab. & Equity$16m


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Next year% of $25m

Assets

Current Assets30%

Fixed Assets50%

Total Assets

Liab. and Equity

Accounts Payable15%

Accrued Expenses10%

Notes Payablen/a

Long Term Debtn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


Slide9 l.jpg

Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets50%

Total Assets

Liab. and Equity

Accounts Payable15%

Accrued Expenses10%

Notes Payablen/a

Long Term Debtn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


Slide10 l.jpg

Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets

Liab. and Equity

Accounts Payable15%

Accrued Expenses10%

Notes Payablen/a

Long Term Debtn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


Slide11 l.jpg

Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable15%

Accrued Expenses10%

Notes Payablen/a

Long Term Debtn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


Slide12 l.jpg

Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses10%

Notes Payablen/a

Long Term Debtn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


Slide13 l.jpg

Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payablen/a

Long Term Debtn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


Slide14 l.jpg

Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.00mn/a

Long Term Debt$3.00mn/a

Total Liabilities

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


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Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.00mn/a

Long Term Debt$3.00mn/a

Total Liabilities$10.25m

Common Stockn/a

Retained Earnings

Equity

Total Liab. & Equity


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Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.00mn/a

Long Term Debt$3.00mn/a

Total Liabilities$10.25m

Common Stock$4.00mn/a

Retained Earnings

Equity

Total Liab. & Equity


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Predicting Retained Earnings

  • Next year’s projected retained earnings = last year’s $3 million, plus:


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Predicting Retained Earnings

  • Next year’s projected retained earnings = last year’s $2 million, plus:

    projected net income cash dividends

    sales sales net income

xx ( 1 - )


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Predicting Retained Earnings

  • Next year’s projected retained earnings = last year’s $3 million, plus:

    projected net income cash dividends

    sales sales net income

    $25 million x .10 x(1 - .40)

xx ( 1 - )


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Predicting Retained Earnings

  • Next year’s projected retained earnings = last year’s $3 million, plus:

    projected net income cash dividends

    sales sales net income

    $25 million x .10 x(1 - .40)

    Proj. RE = $3m + $1.5m = $4.5 million

xx ( 1 - )


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Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.00mn/a

Long Term Debt$3.00mn/a

Total Liabilities$10.25m

Common Stock$4.00mn/a

Retained Earnings$4.50m

Equity$8.50m

Total Liab. & Equity


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Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.00mn/a

Long Term Debt$3.00mn/a

Total Liabilities$10.25m

Common Stock$4.00mn/a

Retained Earnings$4.50m

Equity$8.50m

Total Liab. & Equity$18.75m


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Oh, no! Here come the Accounting Police!

  • Projected Assets$20.00m

  • Projected Liabilities & Equity$18.75m

  • Discretionary Financing Needed $1.25m

  • Zippy must decide how to raise this financing.

  • Options: short and/or long term borrowing, sell new common stock, cut dividends.

  • Let’s assume Zippy will borrow an additional $0.25m through Notes Payable and an additional $1m through Long Term Debt.

  • Here’s Zippy’s complete projected balance sheet.


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Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.25m1m+0.25m

Long Term Debt$4.00m3m+1m

Total Liabilities$11.5m

Common Stock$4.00mn/a

Retained Earnings$4.50m

Equity$8.5m

Total Liab. & Equity$20.0m

Whew! Now,

the Accy Police

will be happy!


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Predicting Discretionary Financing Needs: A Formula Approach

  • The formula approach gives the same result as our first approach, but focuses on the projected changes in the balance sheet.

  • DFN = Proj. Inc. in Assets – Proj. Inc. in Liab – Proj Retained Earnings

    • Proj. Inc in Assets = Assetst/Salest x Chg in sales

    • Proj Inc in Liab = Liabt/Salest x Chg in Sales

    • Proj. RE = NPM x Proj Sales x (1 – b), where b is dividend payout ratio = Divs/Net Income


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Zippy DFN

  • Change in sales = 25m – 20m = 5m

  • Original sales = 20m

  • Change in Assets = (16m/20m) x 5m = 4m

  • Change in Liab = (3m+2m)/20m x 5m = 1.25m

  • Projected RE = 10% x 25m x (1-.4) = 1.5m

  • DFN = 4m – 1.25m – 1.5m = 1.25m


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DFN dynamics

  • Recall, Zippy’s original DFN is 1.25m.

  • What if Zippy’s profit margin was expected to be only 5%?

  • What if Zippy’s profit margin was the original 10%, but it’s dividend payout ratio is only expected to be 30%?

  • What if Zippy’s sales are expected to increase to $28 million with original assumptions of 10% profit margin and 40% dividend payout ratio?


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Zippy DFN dynamic #1

  • Change in sales = 25m – 20m = 5m

  • Original sales = 20m

  • Change in Assets = (16m/20m) x 5m = 4m

  • Change in Liab = (3m+2m)/20m x 5m = 1.25m

  • Projected RE = 5% x 25m x (1-.4) = 0.75m

  • DFN = 4m – 1.25m – 0.75m = $2m

  • Lower profit margin = more DFN


Zippy dfn dynamic 2 l.jpg

Zippy DFN dynamic #2

  • Change in sales = 25m – 20m = 5m

  • Original sales = 20m

  • Change in Assets = (16m/20m) x 5m = 4m

  • Change in Liab = (3m+2m)/20m x 5m = 1.25m

  • Projected RE = 10% x 25m x (1- .3) = 1.75m

  • DFN = 4m – 1.25m – 1.75m = $1m

  • Lower dividend payout ratio = less DFN


Zippy dfn dynamic 3 l.jpg

Zippy DFN dynamic #3

  • Change in sales = 28m – 20m = 8m

  • Original sales = 20m

  • Change in Assets = (16m/20m) x 8m = 6.4m

  • Change in Liab = (3m+2m)/20m x 8m = 2m

  • Projected RE = 10% x 28m x (1- .4) = 1.68m

  • DFN = 6.4m – 2m –1.68m = $2.72m

  • Higher Projected Sales = more DFN


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The effects of other factors on the AFN forecast.

  • Excess capacity:

    • Existence lowers AFN.

  • Base stocks of assets:

    • Leads to less-than-proportional asset increases.

  • Economies of scale:

    • Also leads to less-than-proportional asset increases.

  • Lumpy assets:

    • Leads to large periodic AFN requirements, recurring excess capacity.


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Sustainable Rate of Growth

  • The maximum sales growth rate a firm can have while maintaining its capital structure (financing mix).


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Sustainable Rate of Growth

g* = ROE (1 - b)where

b = dividend payout ratio

(dividends / net income)

ROE = return on equity

(net income / common equity) or


Sustainable rate of growth34 l.jpg

Sustainable Rate of Growth

g* = ROE (1 - b)where

b = dividend payout ratio

(dividends / net income)

ROE = return on equity

(net income / common equity) or

net income sales assets

sales assets common equity

ROE = x x


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This year% of $20m

Assets

Current Assets$6m30%

Fixed Assets$10m50%

Total Assets$16m

Liab. and Equity

Accounts Payable$3m15%

Accrued Expenses$2m10%

Notes Payable$1mn/a

Long Term Debt$3mn/a

Total Liabilities$9m

Common Stock$4mn/a

Retained Earnings$3m

Equity$7m

Total Liab. & Equity$16m


Sustainable growth rate for zippy l.jpg

Sustainable Growth rate for Zippy.

  • Original Total Assets: $16m, Original Total Debt: $9m

  • Original Debt Ratio: 9/16 = 56.25%

  • Current Net income is 10% of $20m or $2m.

  • Current Equity = $7m

  • Dividend payout ratio = 40% or .4

  • G = 2m/7m x (1-.4) = 28.6% x .6 = 17.1%

  • Our forecast for Zippy: 25% growth in sales (20m to 25m) with the following balance sheet.


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Next year% of $25m

Assets

Current Assets$7.5m30%

Fixed Assets$12.5m50%

Total Assets$20.0m

Liab. and Equity

Accounts Payable$3.75m15%

Accrued Expenses$2.50m10%

Notes Payable$1.25m1m+0.25m

Long Term Debt$4.00m3m+1m

Total Liabilities$11.5m

Common Stock$4.00mn/a

Retained Earnings$4.50m

Equity$8.5m

Total Liab. & Equity$20.0m

Whew! Now,

the Accy Police

will be happy!


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Zippy’s projected Debt Ratio

  • Projected Total Assets: $20m

  • Projected Total Debt/Liabilities: $11.5m

  • Projected Debt Ratio = 11.5/20 = 57.5%

  • Since the projected growth rate of 25% is greater than the sustainable growth rate of 17.1%, the debt ratio increases from 56.25% to 57.5%.


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Budgets

  • Budget: a forecast of future events.


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Budgets

  • Budgets indicate the amount and timing of future financing needs.

  • Budgets provide a basis for taking corrective action if budgeted and actual figures do not match.

  • Budgets provide the basis for performance evaluation.


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Syllabus Change

  • Don’t worry about constructing cash budgets!

  • Omit problems 4-6a and 4-11a


  • Login