Chapter 12 Forecasting and Short- Term Financial Planning

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1 Chapter 12 Forecasting and Short- Term Financial Planning LEARNING OBJECTIVES 1. Understand the sources and uses of cash in building a cash budget. 2. Explain how companies use sales forecasts to predict cash inflow. 3. Understand how production costs vary in terms of cash flow timing. 4. Explain possible ways to cover cash deficits and invest cash surplus. 5. Prepare a pro forma income statement and a pro forma balance sheet. IN A NUTSHELL (Slide 12-2) Financial forecasting and planning are tasks that every financial manager must perform diligently so as to prevent cash flow problems and unnecessary higher costs of financing in the future. A cash budget is the basic financial planning tool for any individual or business, so the author begins by identifying the various sources and uses of cash that are part of a cash budget. With sales being the base variable, affecting almost all parts of a budget, the process of sales forecasting is covered next. This is followed by an explanation of the timing of various production costs and their consequential effects on possible cash deficits and surpluses. The alternative sources available to cover cash shortages and the possible options for investing surplus cash are then discussed. In the last section, the author illustrates the process of preparing a pro-forma income statement and balance sheet as part of short-term financial planning. LECTURE OUTLINE 12.1 Sources and Uses of Cash (Slides 12-3 to 12-5) Cash is considered to be the life-blood of a business. Cash shortages can be stifling and expensive while excesses can lead to poor returns. Since most businesses do not function on a pure cash basis, it is critical for them to forecast their needs for cash in advance. The cash budget is the analytical tool that estimates the future timing of cash inflow and cash outflow and projects potential shortfalls and surpluses. Table 12.1 presents the summary of a cash budget prepared for a hypothetical manufacturing firm, Bridge Water Pumps and Filters. 409

2 410 Brooks n Financial Management: Core Concepts, 2e Notice how despite setting up a cash reserve, the firm is projected to have cash shortfalls in 3 months and surpluses in 2 after all cash receipts and disbursements have been forecasted for the first half of Identifying all possible sources and uses of cash is essential for preparing a useful cash budget. Figure 12.1 lists the various avenues of cash inflow and outflow typically faced by a firm. This list can serve as a guide when preparing a cash budget Cash Budgeting and the Sales Forecast (Slides 12-6 to 12-10) Since sales revenue is the base variable driving almost all other items in the cash budget, it is important to forecast sales as objectively as possible. Moreover, since there is usually a time lag between when a sale is made and when the cash receipts come in, keeping track of when the firm receives cash from sales is as important as determining when the sales materialize.

3 Chapter 12 n Forecasting and Short- Term Financial Planning 411 Companies use internal data (information that is proprietary or unique to the firm) as well as external data (publicly available information) sources to come up with objective forecasts of sales (A) Cash Inflow from Sales: Firms typically sell products and services partially for cash and partially on credit. Thus, an analysis of a firm s collection policy can help project cash inflow from sales. It is quite common for firms to collect some of their receivables in the 2 months following the sale, i.e. November 2008 s credit sales will be partially collected in December and January. Table 12.2 presents an example of how the cash inflow from a firm s forecasted sales are allocated for the purpose of preparing a cash budget. Managers often figure in a small percentage of the forecasted sales as bad debts when preparing a cash budget (B) Other Cash Receipts: Besides sales, which are the main contributor to a firm s cash inflow, the timing and magnitude of other occasional sources of cash such as asset sales, funds raised through issuance and sale of securities, and income earned on investments (dividends, interest, etc.) must be forecasted when preparing a cash budget Cash Outflow from Production (Slide 12-11) The magnitude and timing of the various cash disbursements of a firm, depends to a large extent on its forecasted sales. These cash outflow items include payments for raw materials, labor costs, overheads such as utilities and rent, shipping costs, etc. As in the case of sales, there is often a time lag between when the firm receives and records the benefit, and when it actually makes the payment for it. The cash budget can be used as a handy planning document to keep track of the projected disbursements. Note: Students often assume that depreciation should be accounted for as a cash disbursement, which is incorrect, since depreciation is merely a tax write-off and not a cash outflow.

4 412 Brooks n Financial Management: Core Concepts, 2e 12.4 The Cash Forecast: Short- Term Deficits and Short- term Surpluses (Slides to 12-15) The main objective of developing a cash budget is to ensure that the firm has sufficient cash available from its revenues and other receipts to cover its periodic cash disbursements such as: 1. Accounts payables for materials and supplies; 2. Salaries, wages, taxes, other operating expenses; 3. Capital expenditures for plant, equipment, and machinery; and 4. Dividends, interest and floatation cost payments related to raising and servicing of capital. Over a short planning cycle, the total periodic cash inflow rarely matches the total periodic outflow, primarily due to seasonal fluctuations and time lags. This results in forecasted cash deficits and surpluses in certain periods. Firms can avail of a variety of options to fund deficits and invest surpluses (A) Funding Cash Deficits: Cash shortfalls can be handled in 4 ways: 1. Cash from savings 2. Unsecured loans (letters of credit) 3. Secured loans (using accounts receivable or inventories) 4. Other sources (commercial paper, trade credit, or banker s acceptance 12.4 (B) Investing Cash Surpluses: When a company has excess funds, it has 4 options: 1. Put the surplus in a savings account or invest it in marketable securities. 2. Repay lenders and owners (retire debt early or pay extra dividends). 3. Replace aging assets. 4. Invest in the company, accepting positive net present value projects Planning with Pro Forma Financial Statements (Slides to 12-27) Cash budgeting, although critical, is only one aspect of short-term financial planning. In addition, it is important for firms to forecast their operating cash flow and net income for the forthcoming period by developing pro forma financial statements. There are a variety of ways to produce pro forma statements, but the statements usually rely on two primary inputs: 1. The prior year s financial statements and the relationship of the account balances to each other, and 2. The projected sales for the coming year.

5 Chapter 12 n Forecasting and Short- Term Financial Planning 413 The percentage of each item either to sales (income statement) or to total assets (balance sheet) is computed for the prior year and then multiplied by the projected sales (income statement) or total assets (balance sheet) for the coming year to develop pro forma financial statements. For example, let s say that the cash balance for the prior year is $2 million and the total assets are $100m. So cash is 2% of total assets. For the Pro Forma Balance Sheet, we would forecast cash as 2% of the forecasted total assets as well, i.e. if total assets are forecasted to increase by 20%è $120mè Cash would be forecasted to be.02*120m = $24m (A) Pro Forma Income Statement: Figure 12.3 shows how each income statement item is expressed as a percentage of sales. Figure 12.4, shows how the Pro Forma Income Statement is developed, i.e. by multiplying the percentages of each item to sales by the forecasted sales for the next period. This approach, although a good first step, can be considered too simplistic in reality because many financial statement items do not vary proportionately with sales. In particular, depreciation decreases over time and cost of goods sold often declines due to economies of scale. The manager would have to fine-tune the forecasted values to make them more in line with reality.

6 414 Brooks n Financial Management: Core Concepts, 2e Fig.12.3

7 Chapter 12 n Forecasting and Short- Term Financial Planning 415 Fig (B) Pro Forma Balance Sheet: To develop the pro forma balance sheet, a similar procedure is used. Each prior year s balance sheet item is expressed as a percent of total assets, and then multiplied by the forecasted total assets figure for the next period. Items which are obviously either constant each period, or which vary at a different rate (for whatever reason) are accordingly adjusted for by the financial manager. If total assets exceed total liabilities and owner s equity, external financing is allocated according to some pre-determined ratio to serve as the plug variable.

8 416 Brooks n Financial Management: Core Concepts, 2e Figure 12.5 shows the balance sheet items of Bridge Water Pumps and Filters, expressed as a % of total assets. Based on the following assumptions, a pro forma balance sheet is developed in Figure 12.6.

9 Chapter 12 n Forecasting and Short- Term Financial Planning 417 Key calculations include: Finally, the pro forma cash flow statement (Figure 12.7) is prepared to tie together all the changes in operating, investment, and financing cash flows.

10 418 Brooks n Financial Management: Core Concepts, 2e Questions 1. What are a company s main sources of cash for a company? What are a company s main uses of cash? The sources of cash (cash receipts or cash inflow) are: (1) Cash Sales from products and services (2) Payments received on Accounts Receivables (mainly credit sales) (3) Cash sales of equipment or other assets of the company (4) Funding sources (bank loans, bond sales, or stock sales) The uses of cash (cash disbursements or cash outflow) are: (1) Cash purchases (supplies, inventories, etc.) (2) Accounts payable (to suppliers) (3) Wages and Salaries (4) Rent or lease or mortgage payments (5) Utility payments (water, electricity, phones, etc.) (6) Interest payments (7) Dividend payments (8) Paying off debt (loans and bonds) (9) Repurchases of stock

11 Chapter 12 n Forecasting and Short- Term Financial Planning What are two key timing issues with respect to predicting cash inflow for a sales forecast? The two key issues are the timing of the sale and the timing of the collection of the sale, the cash inflow from the sale. 3. What are some of the production costs that are tied to the sales forecast? Production costs include the wages paid to workers, the raw materials for manufacturing products, the overheads (such as electricity, water, plant space, and so on), and the shipping costs that get the product to the customer. 4. What is a line of credit? Why would a bank require a company with a line of credit to have a zero balance for at least sixty days a year in its line of credit? A line of credit is an unsecured bank loan whereby the bank agrees to lend a company up to a specific amount of cash, at the discretion of the company. In other words, it is just a pre-arranged loan. Often the bank will require the company to pay off the line of credit (return the balance to zero) and keep it there for a specific period of time each year. For example, a requirement might be that the line of credit remains at a zero balance for at least one sixty-day period each year. This is called the clean-up period. Banks require a clean-up period so the line of credit does not become a permanent loan to the company. 5. What is the difference between a secured and an unsecured loan? A secured loan has assets assigned to the loan to serve as collateral for the loan should the borrower default. An unsecured loan has no pledged assets and in the case of default, the lender is not entitled to any specific assets of the company. 6. Why can excess cash be an opportunity cost for a company? Excess cash is unemployed cash of the company. If the cash is not needed it can be invested in an interest bearing account or other assets that can produce income for the company and therefore is lost potential is an opportunity cost. 7. If a pro forma income statement has 5% for the net income line, what does this mean in terms of a company s total sales and per dollar sales? A 5% net income from a pro forma income statement means that for every dollar of sale generated by the company, five cents will eventually hit the net income line. Stated another way, for every dollar of sales, ninety-five cents is expensed in cost of goods sold, depreciation, interest expense, and taxes leaving five cents for the owners. 8. In a pro forma income statement, why would a finance manager make changes in the prior year s percentages for different line items? Give an example of a line item that you would expect to vary in percentage every year as sales forecasts grow. Not all expenses vary directly with sales. One example is fixed costs that by definition do not vary with sales or production changes. These costs are constant and in a pro forma statement should be adjusted by the finance manager. 9. In a pro forma balance sheet, what line item would you expect to be constant from year to year in dollar terms and decreasing in terms of percentage of total assets? When would this line item have a significant change in percentage?

12 420 Brooks n Financial Management: Core Concepts, 2e Plant, Property and Equipment (P P & E) should be constant from year to year given no capital spending for the year. P P & E is recorded at its original cost and this cost remains on the books until disposal. There can be a significant change in this item in years of significant capital spending. 10. Why are cash management and cash budgeting important to a company s survival? Failure to manage cash flow can lead to extra borrowing costs, unhappy workers if they are not paid on time, unhappy suppliers if payments are delayed and thus a poorly managed business. Eventually it may lead to failure of the business as expenses surpass income. Prepping for Exams 1. a 2. c 3. d 4. a 5. c 6. a 7. d 8. c 9. c 10. c Problems 1. Sales forecasts. For the prior three years, sales for National Beverage Company have been $21,962,000 (2007), $23,104,000 (2008), and $24,088,000 (2009). The company uses the prior two year s average growth rate to predict the coming year s sales. What were the sales growth rates for 2008 and 2009? What is the expected sales growth rate using a two-year average for 2010? What is the sales forecast for 2010? Recall growth rates, g = (ending value / beginning value) 1 / number of years 1 Growth rate 2008 = ($23,104 / $21,962) 1 = 5.2% Growth rate 2009 = ($24,088 / $23,104) 1 = 4.26% Two year average = ($24,088 / $21,962) 1/2 1 = % Sales Forecast 2010 = $24,088,000 (1+(24,088/21,962) 1/2 )) = $25,226,975 Note, the growth rate was not rounded in the final sales forecast answer.

13 Chapter 12 n Forecasting and Short- Term Financial Planning Sales forecasts. For the prior three years, sales for California Cement Company have been $20,011,000 (2009), $21,167,000 (2010), and $22,923,000 (2011). CCC uses the prior two year s average growth rate to predict the coming year s sales. What were the sales growth rates for 2010 and 2011? What is the expected sales growth rate using a two-year average for 2012? What is the sales forecast for 2012? Recall growth rates, g = (ending value / beginning value) 1 / number of years 1 Growth rate 2009 = ($21,167 / $20,011) 1 = 5.78% Growth rate 2010 = ($22,923 / $21,167) 1 = 8.30% Two year average = ($22,923 / $20,011) 1/2 1 = % Sales Forecast 2011 = $22,923, = $24,534,250 Note, the growth rate was not rounded in the final sales forecast answer. 3. Sales forecast based on external data. Raspberry Phones uses external data to forecast the coming year s sales. Raspberry Phones have 8% of all new phone sales in the United States and 6% of all replacement phones. Industry forecasts predict an additional 18 million new phone buyers and replacement sales of 31 million phones in If the average Raspberry phone costs $85, what sales revenues is the company forecasting for 2010? New phones, 18,000, $85 = $122,400,000 Replacement phones, 31,000, $85 = $158,100,000 Total Sales 2010 = $122,400,000 + $158,100,000 = $280,500, Sales forecast based on external data. Nelson Heating and Ventilating Company estimates the coming year s sales revenue based on external data. The company s main business is new shopping mall construction, and uses the square footage of each mall as a yardstick for many financial statements and projections. The company does business in four Midwest states. Last year, it completed heating and ventilating systems on four shopping malls with an average square footage of 3,000,000 square feet for sales revenues of $9,600,000. Nelson is hired for one-third of the new malls in the four- state area. This coming year, nine new malls are being built with an average footage of 4,500,000 square feet. What is Nelson s anticipated sales revenue for the coming year? Sales per square foot = $9,600,000 / (4 3,000,000) = $0.80 per square foot Coming year hire, 9 / 3 = 3 malls Sales forecast = 3 4,500,000 $0.80 = $10,800,000

14 422 Brooks n Financial Management: Core Concepts, 2e 5. Sales receipts. National Beverage Company anticipates the following first-quarter sales for 2010: $1,800,000 (January), $1,600,000 (February), and $2,100,000 (March). It posted the following sales figures for the last quarter of 2009: $1,900,000 (October), $2,050,000 (November), and $2,200,000 (December). NBC sells 40% of its products on credit; 60% are cash sales. The credit sales are collected as follows: 30% in the following month, 50% two months later, 18% three months later, and 2% defaults. What are the anticipated cash inflows for the first quarter of 2010? October Sales, $1,900,000 Collected in October = $1,900, = $1,140,000 Collected in November = $1,900, = $228,000 Collected in December = $1,900, = $380,000 Collected in January = $1,900, = $136,800 Not collected (bad debt) = $1,900, = $15,200 November Sales $2,050,000 Collected in November = $2,050, = $1,230,000 Collected in December = $2,050, = $246,000 Collected in January = $2,050, = $410,000 Collected in February = $2,050, = $147,600 Not collected (bad debt) = $2,050, = $16,400 December Sales $2,200,000 Collected in December = $2,200, = $1,320,000 Collected in January = $2,200, = $264,000 Collected in February = $2,200, = $440,000 Collected in March = $2,200, = $158,400 Not collected (bad debt) = $2,200, = $17,600 January Sales $1,800,000 Collected in January = $1,800, = $1,080,000 Collected in February = $1,800, = $216,000 Collected in March = $1,800,000x = $360,000 Collected in April = $1,800, = $129,600 Not collected (bad debt) = $1,800, = $14,400 February Sales $1,600,000 Collected in February = $1,600, = $960,000 Collected in March = $1,600, = $192,000 Collected in April = $1,600,000x = $320,000 Collected in May = $1,600, = $115,200 Not collected (bad debt) = $1,600, = $12,800 March Sales $2,100,000 Collected in March = $2,100, = $1,260,000 Collected in April = $2,100, = $252,000 Collected in May = $2,100,000x = $420,000 Collected in June = $2,100, = $151,200

15 Chapter 12 n Forecasting and Short- Term Financial Planning 423 Not collected (bad debt) = $2,100, = $16,800 FROM January Receipts February Receipts March Receipts October $136,800 November $410,000 $147,600 December $264,000 $440,000 $158,400 January $1,080,000 $216,000 $360,000 February $960,000 $192,000 March $1,260,000 TOTAL $1,890,800 $1,763,600 $1,970, Sales receipts. California Cement Company anticipates the following fourth-quarter sales for 2009: $1,800,000 (October), $1,600,000 (November), and $2,100,000 (December). It posted the following sales figures for the third quarter of 2009: $1,900,000 (July), $2,050,000 (August), and $2,200,000 (September). CCC sells 90% of its products on credit; 10% are cash sales. The credit sales are collected as follows: 60% in the following month, 20% two months later, 19% three months later, and 1% defaults. What are the anticipated cash inflows for the last quarter of 2009? July Sales, $1,900,000 Collected in July = $1,900, = $190,000 Collected in August = $1,900, = $1,026,000 Collected in September = $1,900, = $342,000 Collected in October = $1,900, = $324,900 Not Collected (bad debts) = $1,900, = $17,100 August Sales, $2,050,000 Collected in August = $2,050, = $205,000 Collected in September = $2,050, = $1,107,000 Collected in October = $2,050, = $369,000 Collected in November = $2,050, = $350,550 Not Collected (bad debts) = $2,050, = $18,450 September Sales, $2,200,000 Collected in September = $2,200, = $220,000 Collected in October = $2,200, = $1,188,000 Collected in November = $2,200, = $396,000 Collected in December = $2,200, = $376,200 Not Collected (bad debts) = $2,200, = $19,800 October Sales, $1,800,000 Collected in October = $1,800, = $180,000

16 424 Brooks n Financial Management: Core Concepts, 2e Collected in November = $1,800, = $972,000 Collected in December = $1,800, = $324,000 Collected in January = $1,800, = $307,800 Not Collected (bad debts) = $1,800, = $16,200 November Sales, $1,600,000 Collected in November = $1,600, = $160,000 Collected in December = $1,600, = $864,000 Collected in January = $1,600, = $288,000 Collected in February = $1,600, = $273,600 Not Collected (bad debts) = $1,600, = $14,400 December Sales, $2,100,000 Collected in December = $2,100, = $210,000 Collected in January = $2,100, = $1,134,000 Collected in February = $2,100, = $378,000 Collected in March = $2,100, = $359,100 Not Collected (bad debts) = $2,100, = $18,900 FROM October Receipts November Receipts December Receipts July $324,900 August $369,000 $350,550 September $1,188,000 $396,000 $376,200 October $180,000 $972,000 $324,000 November $160,000 $864,000 December $210,000 TOTAL $2,061,900 $1,878,550 $1,774, Production cash outflow. National Beverage Company produces its products two months in advance of anticipated sales and ships to warehouse centers the month before sale. The inventory safety stock is 10% of the anticipated month s sale. Beginning inventory in October 2009 was 267,143 units. Each unit costs $0.25 to make. The average selling price is $0.70 per unit. The cost is made up of 40% labor, 50% materials, and 10% shipping (to warehouse). Labor is paid the month of production, shipping the month after production, and raw materials the month prior to production. What is the production cash outflow for the month of October 2009 production, and in what months does it occur? Note: October production is based on December anticipated sales. Use the fourth-quarter sales forecasts from Problem 5.

17 Chapter 12 n Forecasting and Short- Term Financial Planning 425 Anticipated Sales in December is $2,200,000/$0.70 = 3,142,857 units Safety stock = 3,142, = 314,286 Desired Ending Inventory = 3,142, ,286 = 3,457,143 Beginning Inventory = 267,143 Required Production for October = 3,457, , 143 = 3,190,000 Production Costs: Labor = 3,190,000 $ = $319,000 Raw materials = 3,190,000 $ = $398,750 Shipping = 3,190,000 $ = $79,750 TOTAL OCTOBER PRODUCTION COSTS = 3,190,000 $0.25 = $797,500 Cash Outflow is in September for raw materials, $398,750 October for labor, $319,000 November for shipping, $79, Production cash outflow. California Cement Co. produces its products two months in advance of anticipated sales and ships to warehouse centers the month before sale. The inventory safety stock is 20% of the anticipated month s sale. Beginning inventory in September 2009 was 33,913 units. Each unit costs $2.80 to make. The average sales price per unit is $5.75. The cost is made up of 30% labor, 65% materials, and 5% shipping (to warehouse). Labor is paid the month of production, shipping the month after production, and raw materials the month prior to production. What is the production cash outflow for the month of September 2009 production, and in what months does it occur? Note: September production is based on November anticipated sales. Use the fourth-quarter sales forecasts from Problem 6. Anticipated Sales in November is $1,600,000 / $5.75 = 278,261 units Safety stock = 278, = 55,652 Desired Ending Inventory = 278, ,652 = 333,913 Beginning Inventory = 33,913 Required Production for September = 333,913 33,913 = 300,000 Production Costs: Labor = 300,000 $ = $252,000 Raw materials = 300,000 $ = $546,000 Shipping = 300,000 $ = $42,000 TOTAL September PRODUCTION COSTS = 300,000 $2.80 = $840,000 Cash Outflow is in August for raw materials, $546,000 September for labor, $252,000 October for shipping, $42,000

18 426 Brooks n Financial Management: Core Concepts, 2e 9. Pro forma income statement. Given the income statement below for National Beverage Company for 2009, and the sales forecast from Problem 1, prepare a pro forma income statement for National Beverage Company Income Statement for 2009 Sales Revenue $24,088,000 COGS 8,164,000 SG&A Expenses 7,616,000 Depreciation Expenses 2,388,000 EBIT $ 5,920,000 Interest Expense 220,000 Taxable Income $ 5,700,000 Taxes 2,498,000 Net Income $ 3,202,000 First find the percentage of each income statement line from 2009 as a percent of sales. National Beverage Company Income Statement for 2009 Sales Revenue $24,088, % COGS 8,164, % SG&A Expenses 7,616, % Depreciation Expenses 2,388, % EBIT $ 5,920, % Interest Expense 220, % Taxable Income $ 5,700, % Taxes 2,498, % Net Income $ 3,202, % Sales Forecast 2010 = $24,088, = $25,226,975 National Beverage Company Pro Forma Income Statement for 2010 Sales Revenue $25,226, % COGS 8,550, % SG&A Expenses 7,976, % Depreciation Expenses 2,500, % EBIT $ 6,199, % Interest Expense 230, % Taxable Income $ 5,969, % Taxes 2,616, % Net Income $ 3,353, % Note, the percentages used were not rounded, for example, the COGS is figured as ($8,164,000 / $24,088,000) $25,226,975 = $8,550,025.90

19 Chapter 12 n Forecasting and Short- Term Financial Planning Pro forma income statement. Given the income statement below for California Cement Company for 2009, and the sales forecast from Problem 2, prepare a pro forma income statement for CCC for California Cement Company Income Statement for 2009 Sales Revenue $22,923,000 COGS 11,713,000 SG&A Expenses 4,043,000 Depreciation Expenses 1,420,000 EBIT $ 5,747,000 Interest Expense 173,000 Taxable Income $ 5,574,000 Taxes 1,723,000 Net Income $ 3,851,000 First find the percentages of each income statement line as a percent of sales. California Cement Company Income Statement for 2009 Sales Revenue $22,923, % COGS 11,713, % SG&A Expenses 4,043, % Depreciation Expenses 1,420, % EBIT $ 5,747, % Interest Expense 173, % Taxable Income $ 5,574, % Taxes 1,723, % Net Income $ 3,851, % Sales Forecast for CCC from problem number two: Sales Forecast 2010 = $22,923, = $24,534,250 California Cement Company Pro Forma Income Statement for 2010 Sales Revenue $24,534, % COGS 12,536, % SG&A Expenses 4,327, % Depreciation Expenses 1,519, % EBIT $ 6,150, % Interest Expense 185, % Taxable Income $ 5,965, % Taxes 1,844, % Net Income $ 4,121, % Note, the percentages used were not rounded, for example, the COGS is figured as ($11,713,000 / $22,923,000) $24,534,250 = $12,536,302.85

20 428 Brooks n Financial Management: Core Concepts, 2e 11. Pro forma balance sheet. National Beverage Company Balance Sheet for the Year Ending 2009 Current Assets Cash $2,440,000 Marketable Securities 1,656,000 Accounts Receivable 2,704,000 Inventories 1,641,000 Total Current Assets $ 8,441,000 Long-term Assets Plant, Property & Equip. $13,686,000 Goodwill 1,403,000 Intangible Assets 6,433,000 Total Long-term Assets $21,522,000 TOTAL ASSETS $29,963,000 Current Liabilities Accounts Payable $ 5,622,000 Other Current Liabilities $ 3,268,000 Total Current Liabilities $ 8,890,000 Long-term Liabilities Long-Term Debt $ 1,314,000 Other Long-term Liab. $ 2,839,000 Total Long-Term Liabilities $ 4,153,000 TOTAL LIABILITIES $13,043,000 Owners Equity Common Stock $ 6,861,000 Retained Earnings $10,059,000 TOTAL OWNERS EQUITY $16,920,000 TOTAL LIABILITIES & OWNER S EQUITY $29,963,000 Next year, National Beverage Company will increase its Plant, Property, and Equipment (PPE) by $4,000,000 with a plant expansion. The inventories will grow by 30%, accounts receivable will grow by 20%, and marketable securities will be reduced by 50% to help finance the expansion. If all other asset accounts remain the same and long-term debt will be used to finance the remaining costs of the expansion (no change in common stock or retained earnings), prepare a pro forma balance sheet for How much additional debt will be estimated using this pro forma balance sheet? Start by changing the known asset accounts and then total up assets. Then use the total assets for total liabilities and owner s equity balance. Finally, make the required change in long-term debt to balance the balance sheet.

21 Chapter 12 n Forecasting and Short- Term Financial Planning 429 National Beverage Company Pro Forma Balance Sheet for the Year Ending 2010 Current Assets Cash $2,440,000 Marketable Securities 828,000 (down 50%) Accounts Receivable 3,244,800 (up 20%) Inventories 2,133,300 (up 30%) Total Current Assets $ 8,646,100 Long-term Assets Plant, Property & Equip. $17,686,000 Goodwill 1,403,000 Intangible Assets 6,433,000 Total Long-term Assets $25,522,000 TOTAL ASSETS $34,168,100 Current Liabilities Accounts Payable $ 5,622,000 Other Current Liabilities $ 3,268,000 Total Current Liabilities $ 8,890,000 Long-term Liabilities Long-Term Debt $ 5,519,100 Other Long-term Liab. $ 2,839,000 Total Long-Term Liabilities $ 8,358,100 TOTAL LIABILITIES $17,248,100 Owner s Equity Common Stock $ 6,861,000 Retained Earnings $10,059,000 TOTAL OWNER S EQUITY $16,920,000 TOTAL LIABILITIES & OWNER S EQUITY $34,168,100 Change in long-term debt is: $5,519,100 - $1,314,000 = $4,205, Pro forma balance sheet. California Cement Company Balance Sheet for the Year Ending 2010 Current Assets Cash $1,447,000 Marketable Securities 1,129,000 Accounts Receivable 3,769,000 Inventories 2,601,000 Total Current Assets $ 8,946,000 Long-term Assets Plant, Property & Equip. $ 6,760,000 Goodwill 4,082,000 Intangible Assets 1,506,000 Total Long-term Assets $12,348,000 TOTAL ASSETS $21,294,000

22 430 Brooks n Financial Management: Core Concepts, 2e Current Liabilities Accounts Payable $ 6,125,000 Other Current Liabilities $ 1,198,000 Total Current Liabilities $ 7,323,000 Long-term Liabilities Long-Term Debt $ 2,488,000 Other Long-term Liab. $ 1,524,000 Total Long-Term Liabilities $ 4,012,000 TOTAL LIABILITIES $11,335,000 Owner s Equity Common Stock $ 2,493,000 Retained Earnings $ 7,466,000 TOTAL OWNER S EQUITY $ 9,959,000 TOTAL LIABILITIES & OWNER S EQUITY $21,294,000 Next year, California Cement Company will increase its Plant, Property, and Equipment (PPE) by $6,000,000 with a plant expansion. The inventories will grow by 80%, accounts receivable will grow by 70%, and marketable securities will be reduced by 60% to help finance the expansion. If all other asset accounts remain the same and long-term debt will be used to finance the remaining costs of the expansion (no change in common stock or retained earnings), prepare a pro forma balance sheet for How much additional debt will be estimated using this pro forma balance sheet? Start by changing the known asset accounts and then total up assets. Then use the total assets for total liabilities and owner s equity balance. Finally, make the required change in long-term debt to balance the balance sheet. California Cement Company Pro Forma Balance Sheet for the Year Ending 2008 Current Assets Cash $1,447,000 Marketable Securities 451,600 Accounts Receivable 6,407,300 Inventories 4,681,800 Total Current Assets $12,987,700 Long-term Assets Plant, Property & Equip. $12,760,000 Goodwill 4,082,000 Intangible Assets 1,506,000 Total Long-term Assets $18,348,000 TOTAL ASSETS $31,335,700 Current Liabilities Accounts Payable $ 6,125,000 Other Current Liabilities $ 1,198,000 Total Current Liabilities $ 7,323,000 Long-term Liabilities Long-Term Debt $12,529,700

23 Chapter 12 n Forecasting and Short- Term Financial Planning 431 Other Long-term Liab. $ 1,524,000 Total Long-Term Liabilities $14,053,700 TOTAL LIABILITIES $21,367,700 Owner s Equity Common Stock $ 2,493,000 Retained Earnings $ 7,466,000 TOTAL OWNER S EQUITY $ 9,959,000 TOTAL LIABILITIES & OWNER S EQUITY $31,335,700 Change in Long-term debt: $12,529,700 - $2,488,000 = $10,041,700 Solutions to Advanced Problems for Spreadsheet Application 1. Cash flow forecasting. Regional Construction Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Actual and Projected Housing Starts Projected Cash Flows by Month 2010 JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV Revenue from Sale of Homes $ 8,100,000 $ 7,200,000 $ 4,950,000 $ 3,150,000 $ 5,400,000 $ 5,400,000 $ 7,200,000 $ 9,000,000 $ 14,400,000 $ 14,400,000 $ 13,500,000 Cash Outflows Raw Materials $ 2,340,000 $ 2,418,000 $ 3,120,000 $ 3,744,000 $ 5,304,000 $ 6,552,000 $ 7,332,000 $ 6,708,000 $ 5,928,000 $ 4,992,000 $ 4,056,000 Labor Costs $ 1,417,500 $ 1,165,500 $ 1,354,500 $ 1,638,000 $ 2,016,000 $ 2,772,000 $ 3,654,000 $ 3,969,000 $ 3,654,000 $ 3,150,000 $ 2,709,000 Fees and Licences $ 216,000 $ 288,000 $ 360,000 $ 576,000 $ 576,000 $ 540,000 $ 432,000 $ 396,000 $ 324,000 $ 216,000 $ 72,000 Legal and Title Transfer Costs $ 162,000 $ 162,000 $ 216,000 $ 270,000 $ 432,000 $ 432,000 $ 405,000 $ 324,000 $ 297,000 $ 243,000 $ 162,000 NET CASH FLOW $ 3,964,500 $ 3,166,500 $ (100,500) $ (3,078,000) $ (2,928,000) $ (4,896,000) $ (4,623,000) $ (2,397,000) $ 4,197,000 $ 5,799,000 $ 6,501,000 Negative Cash Flow Months yes yes yes yes yes yes 2. Pro forma income statements. SW ZIA Company Pro Forma Statement Adjusted Pro Forma Percent of Income Statement Revenue Revenue $ 12,345, % $ 12,900, $ 13,481, $ 14,087, $ 12,900, $ 13,481, $ 14,087, Returns $ 185, % $ 193, $ 202, $ 211, $ 193, $ 202, $ 211, NET REVENUE $ 12,159, % $ 12,707, $ 13,278, $ 13,876, $ 12,707, $ 13,278, $ 13,876, Costs COGS $ 5,555, % $ 5,805, $ 6,066, $ 6,339, $ 5,805, $ 6,066, $ 6,339, Fixed Costs $ 1,975, % $ 2,064, $ 2,156, $ 2,254, $ 1,975, $ 1,975, $ 1,975, S G & A $ 1,481, % $ 1,548, $ 1,617, $ 1,690, $ 1,548, $ 1,617, $ 1,690, Depreciation $ 988, % $ 1,032, $ 1,079, $ 1,127, $ 1,032, $ 1,079, $ 1,127, EBIT $ 2,159, % $ 2,256, $ 2,358, $ 2,464, $ 2,345, $ 2,540, $ 2,743, Interest Expense $ 802, % $ 838, $ 876, $ 915, $ 838, $ 876, $ 915, TAXABLE INCOME $ 1,357, % $ 1,418, $ 1,482, $ 1,548, $ 1,507, $ 1,663, $ 1,827, Taxes $ 515, % $ 538, $ 563, $ 588, $ 572, $ 632, $ 694, NET INCOME $ 841, % $ 879, $ 918, $ 960, $ 934, $ 1,031, $ 1,133, Growth in Net Inc. 4.50% 4.50% 4.50% 11.05% 10.40% 9.84%

24 432 Brooks n Financial Management: Core Concepts, 2e Solutions to Mini- Case Midwest Properties: Quarterly Forecasting In this mini-case, both the importance and the techniques of cash flow budgeting are emphasized by focusing on a business with highly seasonal cash flow patterns. The nature of the business is such that students should have a quick intuitive grasp of the issues. The case also requires construction of a pro-forma income statement based on the budget. This exercise requires the student to think about the difference between cash flows and accrual accounting measures. 1. Complete the following table of cash collections for the months of July, August, and September. Use Table 12.1 as a model. April May June July August September Occupied Direct Rental Units Collections from Direct Rentals $90,000 $90,000 $60,000 $45,000 $30,000 $94,500 Contract Rental Payments 75,000 78,750 Damage Assessments 0 0 7,500 5,000 5,000 2,500 Total Cash Flow $90,000 $90,000 $142,500 $50,000 $35,000 $175, Complete the following table of cash outflows for the months of July, August, and September. April May June July August September Total occupied units Payments for Supplies and Materials Purchases $5,000 $5,000 $5,000 $15,000 $15,000 $15,000 Salaries 8,000 8,000 8,000 8,000 8,000 8,000 Labor 2,000 2,000 10,000 10,000 10,000 2,000 Payments for Utilities

25 Chapter 12 n Forecasting and Short- Term Financial Planning 433 Payment on debt 150, ,000 Property Taxes 31,500 31,500 Insurance 15,500 15,500 Total cash outflow $31,000 $31,000 $236,000 $43,000 $41,000 $228, Complete the following monthly cash flow estimate for the months of July, August, and September. Use Table 12.4 as a model. April May June July August September Beginning cash $25,000 $84,000 $143,000 $49,500 $56,500 $50,500 Incoming Collections from Direct Rentals $90,000 $90,000 $60,000 $45,000 $30,000 $94,500 Contract Rental Payments 75,000 78,750 Damage Assessments 0 0 7,500 5,000 5,000 2,500 Total In $90,000 $90,000 $142,500 $50,000 $35,000 $175,750 Outgoing Supplies, Materials 5,000 5,000 5,000 15,000 15,000 15,000 Salaries 8,000 8,000 8,000 8,000 8,000 8,000 Labor 2,000 2,000 10,000 10,000 10,000 2,000 Payments for Utilities 16,000 16,000 16,000 10,000 8,000 6,000 Payment on debt 150, ,000 Property Taxes 31,500 31,500 Insurance 15,500 15,500 Total Out 31,000 31, ,000 43,000 41, ,000 Net CF $ 59,000 $ 59,000 $ (93,500) $ 7,000 $ (6,000) $ (52,250) Ending Balance $84,000 $143,000 $49,500 $56,500 $50,500 ($1,750)

26 434 Brooks n Financial Management: Core Concepts, 2e 4. Your monthly cash flow estimate should show a small cash shortage at the end of September. Is this shortage a cause for concern? Based on Midwest s collection and payment patterns, would you expect a cash deficit or surplus by the end of October? No calculations are required, but briefly explain your prediction. The apartment buildings appear to generate strong positive net cash flows for 8 months a year and negative net cash flows for four months a year. October should look like April and May, or a little better because of the 5% increase in rents. If so, the deficit will disappear and Midwest should easily be able to repay any short-term loans in October or November. 5. Construct a pro forma income statement for the properties managed by Dennis for the third quarter (July, August, and September). Use Figure 12.4 as a model. Show dollar amounts and percent of revenues. September's expenses include $5,000 for supplies and materials and $16,000 for utilities. The payment on debt includes $105,000 in interest, and $45,000 toward retirement of the principal. Midwest's tax rate is 34%. Remember that the income statement is based on accrual rather than cash flow principles. Midwest Properties Income Statement Quarter Ending September X Revenues Amount Percentage Direct Rental $169, % Contract Rentals $78, % Total Revenues $248, % Expenses Materials(1) 35, % Salaries and Labor 46, % Utilities(1) 30, % Property Taxes 31, % Insurance 15, % Total Expenses $158, % Operating Profit $90, % Interest Expense $105, % Taxable Income ($14,750) -5.94% Taxes(2) (5,015) -2.02% Net Profit ($9,735) -3.92%

27 Chapter 12 n Forecasting and Short- Term Financial Planning 435 (1) Materials and utilities expenses are for the month preceding cash payments. (2) The "negative tax" assumes that losses will be applied to the preceding or following periods or to some other part of Midwest's operations. 6. Does the period July through September fairly represent Midwest s profitability? The income statement for the second quarter, July through September, covers the period where anticipated revenues are lowest and expenses are highest. The period represents an important part of Mid-West s financial picture, but should be considered in the context of an entire year. Additional Problems with Solutions 1. Sales forecast. You have been asked to forecast sales for the coming year. Being convinced that the compound average growth rate is the best way to forecast growth, you collect data for the prior three years as listed below. Using the data compute the compound growth rate for each of the years and then forecast next year s sales by using the two-year average growth rate (round off the growth rate to 2 decimal places). Year Sales 2007 $1,200, $1,750, $2,100, ? g = (ending value / beginning value) 1 / number of years growth rate =[ (2008 Sales/2007 sales)] -1 = (1.75m/1.2m) growth rate = 45.83% 2009 growth rate = =[ (2009 Sales/2008 sales)] -1 = (2.1m/1.75m) growth rate 20% (Slides to 12-29) 2-year average growth rate = (2009 Sales/2007 Sales) 1/2 =1= (2.1m/1.2m) 1/2-1 2-year average growth rate =32.29% (rounded at two decimals) Sales Forecast =$ 2,100,000*(1.3229) = $2,778, Sales receipts. The financial manager of Hearty Cereals is in the process of preparing a cash budget for the first quarter of The firm typically sells 1/3 of its monthly sales on cash terms and the rest on credit. An analysis of the accounts receivables shows that on average 40% of the sales are collected in the next month, 50% in 60 days, 7% in 90 days, with the rest ending up as bad debts. As the manager s assistant

28 436 Brooks n Financial Management: Core Concepts, 2e it is your job to project the sales receipts for the first quarter of 2010, using the monthly sales figures listed below Sales October $1,750,000 November $2,000,000 December $2,450, Forecasted Sales January $1,850,000 February $1,650,000 March $1,900,000 (Slides to 12-31) Oct Nov Dec Jan Feb March 1,750,00 0 2,000,00 0 2,450,00 0 1,850,000 1,650,00 0 1,900,00 0 Cash 1/ $583,333 $666,667 $816,667 $616,667 $550,000 $633,333 Credit 2/ $388,889 $444,444 $544,444 $411,111 $366,667 $422,222 Bad debt 3% of Credit sales 0.03 $11, $13,333 $16,333 $12,333 $11,000 $12,667 40% in 30 days =.4*Prior month's credit sales 0.4 $155,556 $177,778 $217,778 $164,444 $146,667 50%in 60 days=.6* 2 month earlier sales 0.5 $194,444 $222,222 $272,222 $205,556 7% in 90 days=.07 * 3 month earlier sales 0.07 $27,222 $31,111 $38,111 Total Receipts from Sales 1 $1,056,66 7 $986,667 $985,556

29 Chapter 12 n Forecasting and Short- Term Financial Planning Production cash outflow. The Creative Products Corporation produces its products two months in advance of anticipated sales and ships to warehouse centers the month before sale. The inventory safety stock is 15% of the anticipated month s sale. Beginning inventory in October 2009 was 120,000 units. Each unit costs $1.50 to make. The average selling price is $2.50 per unit. The cost is made up of 60% labor, 30% materials, and 10% shipping (to warehouse). Labor is paid the month of production, shipping the month after production, and raw materials the month prior to production. What is the production cash outflow for the month of October 2009 production, and in what months does it occur? Assume that the sales forecast for December 2009 is $2,500,000 (Slides to 12-33) Unit Sales forecast for December 2009 = $2,500,000/$2.5è 1 million units Safety stock required = 15% of December sales = 150,000 units Beginning Inventory (October 2009) = 120,000 units Production needed in October = Dec. 09 Sales + Safety Stock Beg. Inventory Production needed in October = 1,000, , ,000=970,000 units Cost of Production (Oct. 2009) = 970,000*$1.50= $1,455,000 Labor cost =.60*$1,455,000 = $873,000 è paid in October 2009 Shipping cost =.10*$1,455,000 = $145,500 è paid in November 2009 Material cost =.30*$1,455,000 = $436,500 è paid in September 2009

30 438 Brooks n Financial Management: Core Concepts, 2e 4. Pro forma income statement. Given the income statement below for Imperial Products Corporation for 2009, and a 20% growth in sales for 2010, prepare a pro forma income statement. Imperial Products Corp. Income Statement for 2009 Sales Revenue $28,800,000 COGS 11,400,000 SG&A Expenses 6,800,000 Depreciation Expenses 2,300,000 EBIT $8,300,000 Interest Expense 1,200,000 Taxable Income $7,100,000 Taxes $2,414, Net Income $4,686, First divide each item by sales Then multiply each proportion by forecast sales for 2010 Forecast sales = 28,800,000*(1.2) = $34, 560, % of sales (Slides to 12-35) 2010 Forecast Sales Revenue $28,800, % $34,560,000 COGS 11,400, % $13,680,000 SG&A Expenses 6,800, % $8,160,000 Depreciation Expenses 2,300, % $2,760,000 EBIT $8,300, % $9,960,000 Interest Expense 1,200, % $1,440,000 Taxable Income $7,100, % $8,520,000 Taxes $2,414, % $2,896,800 Net Income $4,686, % $5,623,200

31 Chapter 12 n Forecasting and Short- Term Financial Planning Pro forma balance sheet. The Global Growth Corporation is planning for next year and wants you to help them prepare a Pro Forma Balance Sheet for Their current Balance Sheet is shown below along with some pre-determined changes in key balance sheet accounts. How will you proceed? The Global Growth Corporation Balance Sheet for the Year Ending 2010 Current Assets 2010 Long-term Assets Cash $1,500,000 Marketable Securities 830,000 Accounts Receivable 3,450,000 Inventories 2,500,000 Total Current Assets $8,280,000 Plant, Property & Equip. $8,500,000 Goodwill 3,500,000 Intangible Assets 1,350,000 Total Long-term Assets $13,350,000 TOTAL ASSETS $21,630,000 Current Liabilities Long-term Liabilities Accounts Payable $5,125,000 Other Current Liabilities $1,350,000 Total Current Liabilities $6,475,000 Long-Term Debt $3,200,000 Other Long-term Liab. $1,650,000 Total Long-Term Liabilities $4,850,000 TOTAL LIABILITIES $11,325,000 Owner s Equity Common Stock $2,500,000 Retained Earnings $7,805,000 TOTAL OWNER S EQUITY $10,305,000 TOTAL LIABILITIES & OWNER S EQUITY $21,630,000

32 440 Brooks n Financial Management: Core Concepts, 2e Next year, the firm will increase its Plant, Property, and Equipment (PPE) by $7,000,000 with a plant expansion. The inventories will grow by 70%, but accounts payables will grow by 60%, and marketable securities will be reduced by 50% to help finance the expansion. If all other asset accounts remain the same and long-term debt will be used to finance the remaining costs of the expansion (no change in common stock or retained earnings), prepare a pro forma balance sheet for How much additional debt will be estimated using this pro forma balance sheet? (Slides to 12-41) Start by changing the known asset accounts and then total up assets. Then use the total assets for total liabilities and owner s equity balance. Finally, make the required change in long-term debt to balance the balance sheet. i.e. PPE will be $8,500,000+$7,000,000 = $15,500,000 Inventories = 70% higher è (1.7)* =4,250,000 Accounts payables = 60% higher è 5,125,000*1.6=8,200,000 Marketable Securities = 50% lower = 830,000*.5 è 415,000

33 Chapter 12 n Forecasting and Short- Term Financial Planning 441 Current Assets 2010 Long-term Assets TOTAL ASSETS Current Liabilities Long-term Liabilities 2011 proforma Cash $1,500,000 $1,500,000 Marketable Securities 830, Accounts Receivable 3,450,000 3,450,000 Inventories 2,500, Total Current Assets $8,280,000 $9,615,000 Plant, Property & Equip. $8,500,000 $15,500,00 0 Goodwill 3,500,000 3,500,000 Intangible Assets 1,350,000 1,350,000 Total Long-term Assets $13,350,00 0 $21,630,00 0 Accounts Payable $5,125,000 $20,350,00 0 $29,965,00 0 $8,200, Other Current Liabilities $1,350,000 $1,350,000 Total Current Liabilities $6,475,000 $9,550,000 Long-Term Debt $3,200,000 $8,460,000 Other Long-term Liab. $1,650,000 $1,650,000 Total Long-Term Liabilities $4,850,000 $10,110,000 TOTAL LIABILITIES $11,325,000 $16,585,000 Owner s Equity Common Stock $2,500,000 $2,500,000 Retained Earnings $7,805,000 $7,805,000 TOTAL OWNER S EQUITY $10,305,000 $10,305,000 TOTAL LIABILITIES & OWNER S EQUITY $21,630,000 $29,965,000 CHANGE IN LONG_TERM DEBT =$8.46m -$3.2m = $5.26 m

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