Forecasting for Financial Planning

1. Forecasting for Financial Planning Lecture # 2

2. Learning Objectives • The importance of forecasting to business success. • The financial forecasting process. • Preparation of pro forma financial statements. • The importance of analyzing forecasts.

3. Why is forecasting important? • Mistakes are costly: • If you produce too much of a product, or a product that no one wants to buy, you still must pay for materials, labor, and storage. • If you produce too little of a product, you will lose sales and possibly market share.

4. Forecasting Approaches Financial managers concentrate on three general approaches to financial forecasting: • Experience • Probability • Correlation

5. Experience • Managers who have been in the business for a long time have developed a sense for the patterns in sales, expenses, consumer demand factors, etc. • Example: Editors who work for book publishers regularly read submitted manuscripts and make judgements about whether their company should buy the rights to publish the books.

6. Probability • Past history often tells us a lot about what will happen in the future. • Managers can use this information to estimate the future. • Example: In the past, a 7-11 manager has found that she will lose 1% of candy inventory to shoplifters. She can use this information to estimate future losses and also to design better controls.

7. Correlation • Correlation is a measure of the relative movement of two variables relative to each other. • Example: If interest rates go up, a real estate agent knows that home sales will tend to fall (because the higher cost of financing makes it harder for buyers to qualify for mortgages). • Example: Sales of umbrellas are higher in rainy seasons.

8. Marketing (sales estimate) Top Management (policy, strategy) Finance Department Production (capacity, schedules) SALES FORECAST Accounting (financial statements, depreciation, taxes) The Sales Forecasting Process

9. Sales Time 94 95 96 97 98 99 00 01 02 03 • Forecast future sales based on past sales growth Plot of Past Sales

10. Forecast future sales based on past sales growth Sales Trend Line Time 94 95 96 97 98 99 00 01 02 03

11. Forecast future sales based on past sales growth Sales Estimates for next 2 years Sales Growth Rate Time 94 95 96 97 98 99 00 01 02 03

12. New Product Introduced • Forecast future sales based on past sales growth • Also include the effects of any events which are expected to impact future sales (new products or economic conditions) Sales Time 94 95 96 97 98 99 00 01 02 03

13. New Product Introduced • Forecast future sales based on past sales growth • Also include the effects of any events which are expected to impact future sales (new products or economic conditions) Sales Time 94 95 96 97 98 99 00 01 02 03

14. 2002 2003 Sales Growth Imposes Costs on the Firm • Current Assets: Inventory, A/R, Cash • Fixed Assets: Plant and Equipment • Will require additional resources

15. Pro Forma Financial Statements • Pro forma financial statements are forecasts of the firm’s future financial statements based on a certain set of assumptions about sales trends and the relationships between sales and various financial variables, and between other financial statement variables relative to each other.

16. Producing Pro Formas • Sales will increase from $5million to $8 million. • Production is at full capacity (24 hrs. per day). • Dividend payout will be 70% of NI. • Spontaneous balance sheet accounts. increase in a constant proportion to sales. Example Data for Marginal Product Inc.

17. Step 1: Determining Sales Growth Income Statement Marginal Product Inc. Current Projected Sales $5,000 COGS 4,133 EBIT 867 Int 200 EBT 667 Tax (.40) 267 NI 400 $8 - $5 $5 = 60% Producing Pro Formas Note: The projected sales will be determined after input from many different units or departments of the firm. $8,000

18. Calculate projected Net Income. New COGS =Old COGS x 1.6 = 6,613 Step 2: Income Statement Marginal Product Inc. Current Projected Sales $5,000 $8,000 COGS 4,1336,613 EBIT 867 1,387 Int 200 200 EBT 667 1,187 Tax (.40) 267 475 NI 400 712 Producing Pro Formas Note: There is no increase yet in the interest charges since Marginal Product’s managers have not yet decided how they will finance the growth.

19. Forecast increase in assets (% of sales) Step 3: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 Accounts Payable $1.0 Net Fixed Assets 3.0 Accrued Expenses 0.5 Total $5.5 Notes Payable 0.0Current Liabilities $1.5 Long Term Debt$2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 Producing Pro Formas

20. Forecast increase in assets (% of sales). If sales increase by 60%, so too will any asset that remains a constant percent of sales. Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 Net Fixed Assets 3.0 Accrued Expenses 0.5 Total $5.5 Notes Payable 0.0Current Liabilities $1.5 Long Term Debt$2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 Producing Pro Formas Step 3: $2.5(1+.60) = $4.0

21. Forecast increase in assets (% of sales) Step 3: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 Total $5.5 $8.8 Notes Payable 0.0Current Liabilities $1.5 Long Term Debt$2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 Producing Pro Formas $3.0(1+.60) = $4.8 +$3.30

22. Forecast increase in spontaneous liabilities. Step 4: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 Total $5.5 $8.8 Notes Payable 0.0Current Liabilities $1.5 Long Term Debt$2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 Producing Pro Formas $1.0(1+.60) = $1.60

23. Forecast increase in spontaneous liabilities. Step 4: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 .8 Total $5.5 $8.8 Notes Payable 0.0Current Liabilities $1.5 Long Term Debt$2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 Producing Pro Formas $0.5(1+.60) = $0.80

24. Forecast increase in retained earnings. Step 5: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 .8 Total $5.5 $8.8 Notes Payable 0.0Current Liabilities $1.5 Long Term Debt$2.0 Common Stock 0.5 Retained Earnings 1.5 1.7 Common Equity $2.0 Total Claims $5.5 Producing Pro Formas New retained earnings =Old retained earnings + additions to ret. earnings =1.5 + [NI x (1-div. payout)] =1.5 + [.712 x (1-.7)] = 1.7

25. Hold other accounts constant to see how much additional funds will be needed. Step 6: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 .8 Total $5.5 $8.8 Notes Payable 0.00.0Current Liabilities $1.5 2.4 Long Term Debt$2.0 2.0 Common Stock 0.5 .5 Retained Earnings 1.5 1.7 Common Equity $2.0 2.2 Total Claims $5.5 $6.6 Producing Pro Formas

26. Additional funds needed (AFN) = projected assets minus projected claims Step 7: Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected AFN = $8.8 - 6.6 = $2.2 mill. Producing Pro Formas Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 .8 Total $5.5 $8.8 Notes Payable 0.00.0Current Liabilities $1.5 2.4 Long Term Debt$2.0 2.0 Common Stock 0.5 .5 Retained Earnings 1.5 1.7 Common Equity $2.0 2.2 Total Claims $5.5 $6.6

27. Additional funds needed (AFN) = projected assets minus projected claims Step 7: Balance Sheet Marginal Product Inc. Producing Pro Formas Raise $2.2 million Using: Notes Payable, and/or LT Debt, and/or Common Stock Assets Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.04.8 Accrued Expenses 0.5 .8 Total $5.5 $8.8 Notes Payable 0.00.0Current Liabilities $1.5 2.4 Long Term Debt$2.0 2.0 Common Stock 0.5 .5 Retained Earnings 1.5 1.7 Common Equity $2.0 2.2 Total Claims $5.5 $6.6 AFN = $8.8 - 6.6 = $2.2 mill.

28. Producing Pro Formas - Summary • Determine sales growth. • Calculate projected net income. • Project assets needed to support the new sales level. • Project increases in spontaneous asset and liability accounts. • Project addition to retained earnings. • Determine the difference between projected assets and projected liabilities & equity.

29. Financing feedback • If outside financing is required, the new debt or equity may affect your original projections of the amount of the addition to retained earnings (due to increased interest or dividends on the income statement). • In this case, the pro forma should be recast with the new information to make final projections of AFN.