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

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Ch. 4: Financial Forecasting, Planning, and Budgeting

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  1. Ch. 4: Financial Forecasting,Planning, and Budgeting

  2. 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?

  3. Financial Forecasting • 1) Project sales revenues and expenses.

  4. Financial Forecasting • 1) Project sales revenues and expenses. • 2) Estimate current assets and fixed assets necessary to support projected sales.

  5. Financial Forecasting • 1) Project sales revenues and expenses. • 2) Estimate current assets and fixed assets necessary to support projected sales. • Percent of sales forecast

  6. 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.

  7. This year % of $20m Assets Current Assets $6m 30% Fixed Assets $10m 50% Total Assets $16m Liab. and Equity Accounts Payable $3m 15% Accrued Expenses $2m 10% Notes Payable $1m n/a Long Term Debt $3m n/a Total Liabilities $9m Common Stock $4m n/a Retained Earnings $3m Equity $7m Total Liab. & Equity $16m

  8. Next year % of $25m Assets Current Assets 30% Fixed Assets 50% Total Assets Liab. and Equity Accounts Payable 15% Accrued Expenses 10% Notes Payable n/a Long Term Debt n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  9. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets 50% Total Assets Liab. and Equity Accounts Payable 15% Accrued Expenses 10% Notes Payable n/a Long Term Debt n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  10. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets Liab. and Equity Accounts Payable 15% Accrued Expenses 10% Notes Payable n/a Long Term Debt n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  11. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable 15% Accrued Expenses 10% Notes Payable n/a Long Term Debt n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  12. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses 10% Notes Payable n/a Long Term Debt n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  13. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable n/a Long Term Debt n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  14. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.00m n/a Long Term Debt $3.00m n/a Total Liabilities Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  15. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.00m n/a Long Term Debt $3.00m n/a Total Liabilities $10.25m Common Stock n/a Retained Earnings Equity Total Liab. & Equity

  16. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.00m n/a Long Term Debt $3.00m n/a Total Liabilities $10.25m Common Stock $4.00m n/a Retained Earnings Equity Total Liab. & Equity

  17. Predicting Retained Earnings • Next year’s projected retained earnings = last year’s $3 million, plus:

  18. 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 - )

  19. 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 - )

  20. 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 - )

  21. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.00m n/a Long Term Debt $3.00m n/a Total Liabilities $10.25m Common Stock $4.00m n/a Retained Earnings $4.50m Equity $8.50m Total Liab. & Equity

  22. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.00m n/a Long Term Debt $3.00m n/a Total Liabilities $10.25m Common Stock $4.00m n/a Retained Earnings $4.50m Equity $8.50m Total Liab. & Equity $18.75m

  23. 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.

  24. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.25m1m+0.25m Long Term Debt $4.00m3m+1m Total Liabilities $11.5m Common Stock $4.00m n/a Retained Earnings $4.50m Equity $8.5m Total Liab. & Equity $20.0m Whew! Now, the Accy Police will be happy!

  25. 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

  26. 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

  27. 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?

  28. 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

  29. 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

  30. 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

  31. 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.

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

  33. 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

  34. 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

  35. This year % of $20m Assets Current Assets $6m 30% Fixed Assets $10m 50% Total Assets $16m Liab. and Equity Accounts Payable $3m 15% Accrued Expenses $2m 10% Notes Payable $1m n/a Long Term Debt $3m n/a Total Liabilities $9m Common Stock $4m n/a Retained Earnings $3m Equity $7m Total Liab. & Equity $16m

  36. 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.

  37. Next year % of $25m Assets Current Assets $7.5m 30% Fixed Assets $12.5m 50% Total Assets $20.0m Liab. and Equity Accounts Payable $3.75m 15% Accrued Expenses $2.50m 10% Notes Payable $1.25m1m+0.25m Long Term Debt $4.00m3m+1m Total Liabilities $11.5m Common Stock $4.00m n/a Retained Earnings $4.50m Equity $8.5m Total Liab. & Equity $20.0m Whew! Now, the Accy Police will be happy!

  38. 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%.

  39. Budgets • Budget: a forecast of future events.

  40. 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.

  41. Syllabus Change • Don’t worry about constructing cash budgets! • Omit problems 4-6a and 4-11a