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Ch. 4: Financial Forecasting, Planning, and Budgeting

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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  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

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