Financial Forecasting

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

4Chapter

4-2

Chapter Outline

• Financial forecasting in a firm’s strategic growth

• Three financial statements

• Percent-of-sales method

• Methods to determine the amount of new funds required in advance

• Factors that affect cash flow

4-3

Financial Forecasting

• Ability to plan ahead and make necessary adjustments before actual events occur

• Outcome of a firm through external events might be a function of both:– Risk-taking desires– Ability to hedge against risk with planning

• No growth or a decline - not the primary cause of shortage of funds

• A comprehensive financing plan must be developed for a significant growth

4-4

Constructing Pro Forma Statements

• Pro forma, or projected, financial statements enable a firm to estimate its future level of receivables, inventory, payables, as well as its anticipated profits and borrowing requirements.

• These statements are often required by bankers and other lenders as a guide for the future.

• A systems approach to develop pro forma statements consists of: – Constructing income statement based on sales

projections and the production plan– Translating it into a cash budget – Assimilating all materials into a pro forma balance sheet

4-5

Development of Pro Forma Statements

4-6

Pro Forma Income Statement

• Provides a projection on the anticipation of profits over a subsequent period

• Four important steps include:– Establishing a sales projection– Determining production schedule and the associated use

of new material, direct labor, and overhead to arrive at gross profit

– Computing other expenses– Determining profit by completing actual pro forma

statement

4-7

Establish a Sales Projection

• Let us assume Goldman Corporation has two primary products: wheels and castersTable 4-1

4-8

Determine a Production Schedule and the Gross Profit

• Number of units produced will depend on: – Beginning inventory– Sales projections– Desired ending inventory

• To determine the production requirements:

Units

+ Projected sales

+ Desired ending inventory

– Beginning inventory

= Production requirements

4-9

Stock of Beginning Inventory

Goldman Corporation has in stock the items shown in the Table below:

Table 4-2

4-10

Production Requirements for Six Months

Table 4-3

4-11

Unit Costs

• Cost to produce each unit:Table 4-4

4-12

Total Production Costs

Table 4-5

4-13

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

4-14

Allocation of Manufacturing Cost and Determination of Gross Profits

Table 4-6

4-15

Value of Ending Inventory

Table 4-7

4-16

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

4-17

Actual Pro Forma Income Statement

Table 4-8

4-18

Cash Budget

• Pro forma income statement must be translated into cash flows– The long-term pro forma is divided into smaller– More precise time frames set to help anticipate

patterns of cash inflows and outflows

4-19

Monthly Sales Pattern

Table 4-9

4-20

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

4-21

Monthly Cash Receipts

Table 4-10

4-22

Component Costs of Manufactured Goods

Table 4-11

4-23

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

4-24

Cash Payments (cont’d)

• Assumptions for the next two tables:– Costs are incurred on an equal monthly basis

over a six-month period– Maintain production level to ensure maximum

efficiency though sales volume varies from month to month

– Payment for material, once a month after purchases have been made

4-25

Average Monthly Manufacturing Costs

Table 4-12

4-26

Summary of All Monthly Cash Payments

Table 4-13

4-27

Actual Budget (Monthly Cash Flow)

• 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

Table 4-14

4-28

Cash Budget with Borrowing and Repayment Provisions

Table 4-15

• Assumptions:– The firm wishes to maintain minimum cash balance– If the balance goes below the minimum, the firm will borrow– If the balance goes above the minimum, the firm will use the

excess to repay the loan

4-29

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

4-30

Development of a Pro Forma Balance Sheet

Table 4-16

4-31

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

4-32

Pro Forma Balance Sheet

4-33

Explanation of Pro Forma Balance Sheet

• Cash ( $5,000 )—minimum cash balance as shown in Table 4–15• Marketable securities ( $3,200 )—remains unchanged from prior

period’s value in Table 4–16• Accounts receivable ( $16,000 )—based on June sales of $20,000 in

Table 4–10 (80% of current month sales become accounts receivables)• Inventory ( $6,200 )—ending inventory as shown in Table 4–7.• Plant and equipment ( $27,740+ $18,000) $45,740 Tables 4-13,4-16• Accounts payable ( $5,732 )—based on June purchases in Table 4–13• Notes payable ( $5,884 )—the amount that must be borrowed to

maintain the cash balance of $5,000, as shown in Table 4–15• Long-term debt ( $15,000 )—remains unchanged from prior period’s

value in Table 4–16• Common stock ( $10,500 )—remains unchanged from prior period’s

value in Table 4–16• Retained earnings ( $39,024 )—initial value plus pro forma income

($20,500 + $18,524) Tables 4-8,4-16

4-34

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, 2011)……$76,140

Total assets (Dec 31, 2010)…….$50,500

Increase…………………………...$25,640

4-35

Percent-of-Sales Method

• Based on the assumption that:– Accounts on the balance sheet will maintain a

given percentage relationship to sales– Notes payable, common stock, and retained

earnings do not maintain a direct relationship with sales volume

• Hence percentages are not computed

4-36

Balance Sheet of Howard Corporation

4-37

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

4-38

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