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

ObjectivesObjectives

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?

Financial ForecastingFinancial Forecasting

1) Project sales revenues and expenses.

Financial ForecastingFinancial Forecasting

1) Project sales revenues and expenses.

2) Estimate current assets and fixed assets necessary to support projected sales.

Financial ForecastingFinancial Forecasting

1) Project sales revenues and expenses.

2) Estimate current assets and fixed assets necessary to support projected sales.– Percent of sales forecast

Our Example: Zippy DrivesOur 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.

This year % of $20m

AssetsCurrent Assets $6m 30%Fixed Assets $10m 50% Total Assets $16mLiab. and EquityAccounts Payable $3m 15%Accrued Expenses $2m 10%Notes Payable $1m n/aLong Term Debt $3m n/a Total Liabilities $9mCommon Stock $4m n/aRetained Earnings $3m Equity $7m Total Liab. & Equity $16m

Next year % of $25m

AssetsCurrent Assets 30%Fixed Assets 50% Total AssetsLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets 50% Total AssetsLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total AssetsLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable n/aLong Term Debt n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total LiabilitiesCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock n/aRetained Earnings Equity Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock $4.00m n/aRetained Earnings Equity Total Liab. & Equity

Predicting Retained Predicting Retained EarningsEarnings

Next year’s projected retained earnings = last year’s $3 million, plus:

Predicting Retained Predicting Retained EarningsEarnings

Next year’s projected retained earnings = last year’s $2 million, plus:

projected net income cash dividends

sales sales net income

xx xx ( 1 - ) ( 1 - )

Predicting Retained Predicting Retained EarningsEarnings

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 xx ( 1 - ) ( 1 - )

Predicting Retained Predicting Retained EarningsEarnings

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 xx ( 1 - ) ( 1 - )

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.50m Total Liab. & Equity

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.00m n/aLong Term Debt $3.00m n/a Total Liabilities $10.25mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.50m Total Liab. & Equity $18.75m

Oh, no! Here come the Oh, no! Here come the Accounting Police!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.

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.25m 1m+0.25mLong Term Debt $4.00m 3m+1m Total Liabilities $11.5mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.5m Total Liab. & Equity $20.0m

Whew! Now, the Accy Police will be happy!

Predicting Discretionary Predicting Discretionary Financing Needs: A Formula Financing Needs: A Formula

ApproachApproach 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

Zippy DFNZippy DFN

Change in sales = 25m – 20m = 5mOriginal sales = 20mChange in Assets = (16m/20m) x 5m = 4mChange in Liab = (3m+2m)/20m x 5m =

1.25mProjected RE = 10% x 25m x (1-.4) = 1.5mDFN = 4m – 1.25m – 1.5m = 1.25m

DFN dynamicsDFN 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?

Zippy DFN dynamic #1Zippy DFN dynamic #1

Change in sales = 25m – 20m = 5mOriginal sales = 20mChange in Assets = (16m/20m) x 5m = 4mChange in Liab = (3m+2m)/20m x 5m = 1.25mProjected RE = 5% x 25m x (1-.4) = 0.75mDFN = 4m – 1.25m – 0.75m = $2mLower profit margin = more DFN

Zippy DFN dynamic #2Zippy DFN dynamic #2

Change in sales = 25m – 20m = 5mOriginal sales = 20mChange in Assets = (16m/20m) x 5m = 4mChange in Liab = (3m+2m)/20m x 5m = 1.25mProjected RE = 10% x 25m x (1- .3) = 1.75mDFN = 4m – 1.25m – 1.75m = $1mLower dividend payout ratio = less DFN

Zippy DFN dynamic #3Zippy DFN dynamic #3

Change in sales = 28m – 20m = 8mOriginal sales = 20mChange in Assets = (16m/20m) x 8m = 6.4mChange in Liab = (3m+2m)/20m x 8m = 2mProjected RE = 10% x 28m x (1- .4) = 1.68mDFN = 6.4m – 2m – 1.68m = $2.72mHigher Projected Sales = more DFN

The effects of other factors on The effects of other factors on the AFN forecast.the AFN forecast.

Excess capacity:Excess capacity:– Existence lowers AFN.Existence lowers AFN.

Base stocks of assets: Base stocks of assets: – Leads to less-than-proportional asset increases.Leads to less-than-proportional asset increases.

Economies of scale:Economies of scale:– Also leads to less-than-proportional asset increases.Also leads to less-than-proportional asset increases.

Lumpy assets:Lumpy assets:– Leads to large periodic AFN requirements, recurring Leads to large periodic AFN requirements, recurring

excess capacity.excess capacity.

Sustainable Rate of GrowthSustainable Rate of Growth

The maximum sales growth rate a firm can have while maintaining its capital structure (financing mix).

Sustainable Rate of GrowthSustainable Rate of Growth

g* = ROE (1 - b) where

b = dividend payout ratio

(dividends / net income)

ROE = return on equity

(net income / common equity) or

Sustainable Rate of GrowthSustainable 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 equityROE = x xROE = x x

This year % of $20m

AssetsCurrent Assets $6m 30%Fixed Assets $10m 50% Total Assets $16mLiab. and EquityAccounts Payable $3m 15%Accrued Expenses $2m 10%Notes Payable $1m n/aLong Term Debt $3m n/a Total Liabilities $9mCommon Stock $4m n/aRetained Earnings $3m Equity $7m Total Liab. & Equity $16m

Sustainable Growth rate for Sustainable Growth rate for Zippy.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.

Next year % of $25m

AssetsCurrent Assets $7.5m 30%Fixed Assets $12.5m 50% Total Assets $20.0mLiab. and EquityAccounts Payable $3.75m 15%Accrued Expenses $2.50m 10%Notes Payable $1.25m 1m+0.25mLong Term Debt $4.00m 3m+1m Total Liabilities $11.5mCommon Stock $4.00m n/aRetained Earnings $4.50m Equity $8.5m Total Liab. & Equity $20.0m

Whew! Now, the Accy Police will be happy!

Zippy’s projected Debt RatioZippy’s projected Debt Ratio

Projected Total Assets: $20mProjected Total Debt/Liabilities: $11.5mProjected 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%.

BudgetsBudgets

Budget: a forecast of future events.

BudgetsBudgets

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.

Syllabus ChangeSyllabus Change

Don’t worry about constructing cash budgets!

Omit problems 4-6a and 4-11a