Financial Forecasting

1. Financial Forecasting 4

2. 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

3. 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

4. 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

5. Development of Pro Forma Statements

6. 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

7. Establish a Sales Projection • Let us assume Goldman Corporation has two primary products: wheels and casters

8. 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)

9. Stock of Beginning Inventory • Number of units produced will depend on beginning inventory

10. Production Requirements for Six Months

11. Unit Costs • Cost to produce each unit:

12. Total Production Costs

13. 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

14. Allocation of Manufacturing Cost and Determination of Gross Profits

15. Value of Ending Inventory

16. 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

17. Actual Pro Forma Income Statement

18. 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

19. 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

20. Monthly Sales Pattern

21. 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

22. Monthly Cash Receipts

23. 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

24. Component Costs of Manufactured Goods

25. 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

26. Average Monthly Manufacturing Costs

27. Summary of All Monthly Cash Payments

28. 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

29. Monthly Cash Budget

30. Cash Budget with Borrowing and Repayment Provisions

31. 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

32. Development of a Pro Forma Balance Sheet

33. 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)

34. Development of a Pro Forma Balance Sheet (cont’d)

35. Explanation of Pro Forma Balance Sheet

36. 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

37. 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

38. 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

39. 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.

40. Balance Sheet of Howard Corporation

41. 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

42. 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

43. 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

44. 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

45. Sustainable growth rate

46. Sustainable growth rate

47. 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

48. Internal Growth Rate

49. Internal Growth Rate