Financial Forecasting, Planning, and Budgeting

1. Financial Forecasting, Planning, and Budgeting • Financial Forecasting: • Project sales revenues and expenses • Estimate current assets and fixed assets necessary to support projected sales • Percent of sales forecast

2. Percent of Sales Method • Suppose this year’s sales will total $32 million • Next year, we forecast sales of $40 million • Net income should be 5% of sales • Dividends should be 50% of earnings

3. Construction of Forecast Balance Sheet • All asset accounts are assumed to vary proportionally with sales • Accounts Payable and Accrued Expenses are the Current Liability accounts that vary with sales directly – remember liabilities and equity are financing sources for a firm • Because of this Accounts Payable and Accrued Expenses are called spontaneous sources of financing

4. Percent of Sales Method (Continued) This year% of $32m Assets Current Assets $8m 25% Fixed Assets $16m 50% Total Assets $24m Liab. and Equity Accounts Payable $4m 12.5% Accrued Expenses $4m 12.5% Notes Payable $1m n/a Long Term Debt $6m n/a Total Liabilities $15m Common Stock $7m n/a Retained Earnings $2m Equity $9m Total Liab. & Equity $24m

5. Percent of Sales Method (Continued) Next year% of $40m Assets Current Assets $10m 25% Fixed Assets $20m 50% Total Assets $30m Liab. and Equity Accounts Payable $5m 12.5% Accrued Expenses $5m 12.5% Notes Payable $1m n/a Long Term Debt $6m n/a Total Liabilities $17m Common Stock $7m n/a Retained Earnings ??? Equity ??? Total Liab. & Equity

6. Predicting Retained Earnings • Next year’s projected retained earnings = last year’s $2 million, plus: • $40 million x 0.05 x (1 - 0.50) • = $2 million + $1 million = $3million

7. Predicting Discretionary Financing Needs Next year% of $40m Assets Current Assets $10m 25% Fixed Assets $20m 50% Total Assets $30m Liab. and Equity Accounts Payable $5m 12.5% Accrued Expenses $5m 12.5% Notes Payable $1m n/a Long Term Debt $6m n/a Total Liabilities $17m Common Stock $7m n/a Retained Earnings $3m Equity $10m Total Liab. & Equity $27m How much Discretionary Financing will we Need?

8. Predicting Discretionary Financing Needs (Continued) • Discretionary Financing Needed = [Projected Total Assets] – [Projected Total Liabilities] – [Projected Shareholders’ Equity] • Alternatively: • DFN = [Projected Total Assets] – [Projected Liabilities & Shareholders’ Equity] • DFN = $30 million – $17 million – $10 million • DFN = $3 million in discretionary financing

9. Predicting Discretionary Financing Needs (Continued) • At this point corporation has to decide how to finance the DFN • The Company can sell Bonds (Long-Term Debt) or Equity • This is why we call Long-Term Debt and Equity as sources of external capital • Note that paid-in capital is the difference between selling price of equity and face value times the number of shares sold

10. Sustainable Rate of Growth • Sustainable rate of growth is the rate the sales can grow without selling new equity and maintaining debt ratio (this means that if a firm retains earnings it would need to issue new debt to maintain debt ratio) • g* = ROE (1 – b) where b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity)

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