Chapter Financial Forecasting

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1 Chapter Financial Forecasting

2 PPT 4-2 Chapter 4 - Outline What is Financial Forecasting? 3 Financial Statements for Forecasting Constructing Pro Forma Statements Basis for Sales Projections Steps in a Pro Forma Income Statement Production or Purchases Schedule Purposes of Cash Budgets Development of a Pro forma Balance Sheet Percent-of-Sales Method RNF and SGR formulas Summary and Conclusions

3 What is Financial Forecasting? PPT 4-3 Financial forecasting uses projections to anticipate shortterm financial results and position Provides lead time to make necessary adjustments before actual events occur Helps to plan for significant growth in firm Can be used as a target for measuring performance Often required by bankers and other lenders

4 Forecasting Vs. Planning Vs. Budgeting PPT 4-4 Planning - Setting operational and financial goals, and choosing strategies and actions for achieving goals Budgeting - Documenting expected route for achieving goals, and assigning responsibilities for achieving goals Forecasting - projecting future position and results without necessarily considering goals

5 PPT Financial Statements for Forecasting Pro Forma Income Statement (I/S) Cash Budget Pro Forma Balance Sheet (B/S) The first step is to develop a sales projection

6 Figure 4-1 Development of pro forma statements PPT 4-6 Prior balance sheet Sales projection Production plan 1 Pro forma income statement 3 Pro forma balance sheet 2 Cash budget Other supportive budgets Capital budget

7 Development of pro forma income statements Establish a sales projection Forecast economic conditions Survey sales personnel Determine production needs, COGs, and gross profit Determine units to be produced Determine the cost of producing the units Compute cost of goods sold Compute gross profit Compute other expenses General and administrative Interest expense Finally construct the pro forma income statement

8 PPT 4-7 Basis for Sales Projections External Factors Recession or boom? Export sales? Consumer spending? Competition? New technology? etc. Internal Factors New product lines? Turnover in people? Profit targets? Employee training? Price changes? etc

9 Table 4-1 Projected wheel and caster sales (first six months, 2003) PPT 4-8 Goldman Corporation Wheels Casters Quantity ,000 2,000 Sales price..... $30 $35 Sales revenue.... $30,000 $70,000 Total $100,000

10 Production (or Purchases) Schedule PPT 4-10 Projected sales -in Units or $ PLUS Desired ending inventory MINUS Beginning inventory EQUALS Production (or Purchases)

11 Table 4-2 Stock of beginning inventory PPT 4-11 Wheels Casters Quantity Cost.... $16 $20 Total value.. $1,360 $3,600 Total $4,960

12 Table 4-3 Production requirements for six months PPT 4-12 Wheels Casters Projected unit sales (Table 4-1)... +1,000 +2,000 Desired ending inventory (assumed to represent 10% of unit sales for the time period) Beginning inventory (Table 4-2) Units to be produced ,015 2,020

13 Table 4-4 Unit costs PPT 4-13 Wheels Casters Materials.... $10 $12 Labour Overhead Total.... $18 $22

14 Table 4-5 Total production costs PPT 4-14 Wheels Casters Units to be produced (Table 4-3).. 1,015 2,020 Cost per unit (Table 4-4).... $18 $22 Total cost $18,270 $44,440 = $62,710

15 Table 4-6 Allocation of manufacturing costs and determination of gross profits PPT 4-15 Wheels Casters Combined Quantity sold (Table 4-1). 1,000 2,000 3,000 Sales price..... $ 30 $ 35 Sales revenue.... $30,000 $70,000 $100,000 Cost of goods sold: Old inventory (Table 4-2) Quantity (units) Cost per unit... $16 $20 Total.... $1,360 $ 3,600 New inventory (the remainder) Quantity (units) ,820 Cost per unit (Table 4-4) $18 $22 Total ,470 40,040 Total cost of goods sold 17,830 43,640 $61,470 Gross profit.... $12,170 $26,360 $38,530

16 Table 4-7 Value of ending inventory PPT 4-16 Beginning inventory (Table 4-2). $ 4,960 + Total production costs (Table 4-5). 62,710 Total inventory available for sales. 67,670 - Cost of goods sold (Table 4-6). 61,740 Ending inventory.... $ 6,200

17 PPT 4-17 Table 4-8 Pro Forma Income Statement June 30, 2003 Sales revenue ,000 Cost of goods sold ,470 Gross profit ,530 Selling, general and administrative expense 12,000 Operating profit (EBIT) ,530 Interest expense ,500 Earnings before taxes (EBT)... 25,030 Taxes (20%) ,006 Earnings aftertaxes (EAT)... 20,024 Common stock dividends.... 1,500 Increase in retained earnings... $ 18,524

18 Cash budget Estimate cash sales and collection timing of credit sales Forecast cash payments Payments for materials purchase according to credit terms Wages Capital expenditures Principal payments Interest payments Taxes Dividends Determine monthly cash flow (recepits minus payments) Construct cash budget Determine cash excess or need for borrowing

19 Purposes of Cash Budgets PPT 4-18 Identify cash shortage in advance Forecast amount available for major expenditures Basis for arranging financing Show ability to repay debt Suggest possible changes in plans delay capital expenditures speed up collections reduce expenses

20 Table 4-9 Monthly sales pattern PPT 4-19 January February March April May June $15,000 $10,000 $15,000 $25,000 $15,000 $20,000

21 Table 4-10 Monthly cash receipts PPT 4-20 December January February Sales $12,000 $15,000 $10,000 Collections: (20% of current sales). $ 3,000 $ 2,000 Collections: (80% of previous month s sales).... 9,600 12,000 Total cash receipts.. $12,600 $14,000 March April May June Sales $15,000 $25,000 $15,000 $20,000 Collections: (20% of current sales). $ 3,000 $ 5,000 $ 3,000 $ 4,000 Collections: (80% of previous month s sales.... 8,000 12,000 20,000 12,000 Total cash receipts.. $11,000 $17,000 $23,000 $16,000

22 Table 4-11 Component costs of manufactured goods PPT 4-21 Wheels Units Cost Total Produced per Unit Cost Materials... 1,015 $10 $10,150 Labour... 1, ,075 Overhead... 1, ,045 Casters Units Cost Total Combined Produced per Unit Cost Cost Materials... 2,020 $12 $24,240 $34,390 Labour... 2, ,120 17,195 Overhead... 2, ,080 11,125 $62,710

23 Table 4-12 Average monthly manufacturing costs PPT 4-22 Total Time Average Costs Frame Monthly Cost Materials... $34,390 6 months $5,732 Labour ,195 6 months 2,866 Overhead... 11,125 6 months 1,854

24 Table 4-13a Summary of all monthly cash payments (a) December January February From Table 4-12: Monthly material purchase. $4,500 $ 5,732 $ 5,732 Payment for material (prior month s purchase) $ 4,500 $ 5,732 Monthly labour cost... 2,866 2,866 Monthly overhead.... 1,854 1,854 From Table 4-8: Selling, general and administrative expense ($12,000 over 6 months) ,000 2,000 Interest expense.... Taxes (two equal payments) Cash dividend..... Also: New equipment purchases. 8,000 Total payments.... $11,220 $20,452 PPT 4-23

25 PPT 4-24 Table 4-13b Summary of all monthly cash payments (b) March April May June From Table 4-12: Monthly material purchase.. $5,732 $ 5,732 $ 5,732 $ 5,732 Payment for material (prior month s purchase).. $5,732 $ 5,732 $ 5,732 $5,730* Monthly labor cost.... 2,866 2,866 2,866 2,866 Monthly overhead.... 1,854 1,854 1,854 1,854 From Table 4-8: Selling, general and administrative expense ($12,000 over 6 months) ,000 2,000 2,000 2,000 Interest expense ,500 Taxes (two equal payments).. 2,503 2,503 Cash dividend ,500 Also: New equipment purchases.. 10,000 Total payments..... $14,955 $12,452 $12,452 $27,953 *Adjusted for rounding.

26 Table 4-14 Monthly cash flow PPT 4-25 January February March Total receipts (Table 4-10). $12,600 $14,000 $11,000 Total payments (Table 4-13). 11,220 20,452 14,955 Net cash flow..... $ 1,380 ($ 6,452) ($ 3,955) April May June Total receipts (Table 4-10). $17,000 $23,000 $16,000 Total payments (Table 4-13). 12,452 12,452 27,953 Net cash flow..... $ 4,548 $10,548 ($11,953)

27 Table 4-15 Cash budget with borrowing and repayment provisions PPT 4-26 Jan. Feb. March April May June 1. Net cash flow $1,380 ($6,452.) ($3,955.) $4,548 $10,548 ($11,953.) 2. Beginning cash balance.. 5,000.* 6,380 5,000 5,000 5,000 11, Cumulative cash balance.. 6,380 (72.) 1,045 9,548 15,548 (884.) 4. Monthly loan or (repayment) 5,072 3,955 (4,548.) (4,479.). 5, Cumulative loan balance.. 5,072 9,027 4,479 5, Ending cash balance... 6,380 5,000 5,000 5,000 11,069 5,000 * We assume the Goldman Corporation has a beginning cash balance of $5,000 on January 1, 2003, and it desires a minimum monthly ending cash balance of $5,000.

28 Figure 4-2 Development of a Pro Forma Balance Sheet PPT 4-27 Prior balance sheet (Unchanged items) Marketable securities Long-term debt Common stock Pro forma income statement analysis Inventory Retained earnings Pro forma balance sheet Cash budget analysis Cash Accounts receivable Plant and equipment Accounts payable Notes payable

29 Construction of pro forma balance sheet Assets (source of information) Cash - (cash budget) Marketable securities - (previous balance sheet and cash budget) Accounts receivable - (sales forecast, cash budget) Inventory - (COGS computation for pro forma income statement) Plant and equipment - (previous balance sheet + purchase - amortization) Liabilities and Net Worth Account payable - (Cash budget work sheet) Notes payable - (previous balance sheet and cash budget) Long-term debt - (previous balance sheet plus new issues) Common stock - (previous balance sheet plus new issues) Retained earnings - ((previous balance sheet plus projected addition from pro forma income statement)

30 PPT 4-28 Table 4-16 Balance Sheet December 31, 2002 Assets Current assets: Cash $ 5,000 Marketable securities ,200 Accounts receivable ,600 Inventory ,960 Total current assets ,760 Plant and equipment ,740 Total assets $50,500 Liabilities and Shareholders Equity Accounts payable $ 4,500 Long-term debt ,000 Common stock ,500 Retained earnings ,500 Total liabilities and shareholders' equity... $50,500

31 PPT 4-29 Table 4-17 Pro Forma Balance Sheet June 30, 2003 Assets Current assets: 1. Cash $ 5, Marketable securities , Accounts receivable , Inventory ,200 Total current assets , Plant and equipment ,740 Total assets $76,140 Liabilities and Shareholders' Equity 6. Accounts payable $ 5, Notes payable , Long-term debt , Common stock , Retained earnings ,024 Total liabilities and shareholders' equity.. $76,140

32 2 Methods of Financial Forecasting: PPT 4-30 Using Pro Forma, or Projected, Financial Statements (more exact, time consuming) Percent-of-Sales Method for the pro forma Balance Sheet

33 Percent-of-Sales Method PPT 4-31 A short-cut, less exact, easier method of determining financing needs (The quick and dirty approach) Assumes that B/S accounts will maintain a constant percentage relationship to sales More sales will mean more assets which will require more financing Can be summarized by using the Required New Funding formula

34 Determine external financing Project assets levels on basis of forecasted sales Project spontaneous financing: Some financing is provided spontaneously when asset levels increase: for example, account payable and accrued expenses ) Project internal financing from profit Determine external financing = required new assets to support new sales - spontaneous financing - retained earnings. RNF = A S 1 L S ( ΔS ) ΔS) PS (1 b) 1 ( 2

35 PPT 4-32 Table 4-18 HOWARD CORPORATION Balance Sheet and Percent-of-Sales Table Assets Cash $ 5,000 Liabilities and Shareholders' Equity Accounts payable...$ 40,000 Accounts receivable. 40,000 Accrued expenses... 10,000 Inventory ,000 Notes payable ,000 Total current assets 70,000 Common stock... 10,000 Equipment ,000 Retained earnings.. 45,000 Total assets.... $120,000 Total liabilities and shareholders' equity $120,000 $200,000 sales Percent of Sales Cash % Accounts payable % Accounts receivable Accrued expenses Inventory % Total current assets 35.0 Equipment %

36 PPT 4-33 Table 4-19 Balance sheet with sales increase HOWARD CORPORATION Sales $200,000 Sales increase 50.00% $100,000 Assets Before Increase RNF After Cash $ 5,000 $ 2,500 $ 7,500 $ 7,500 Accounts receivable 40,000 20,000 60,000 60,000 Inventory 25,000 12,500 37,500 37,500 Total current assets $ 70,000 35, , ,000 Equipment 50,000 25,000 75,000 75,000 Total assets $120,000 $ 60,000 $180,000 $180,000 Liabilities and Shareholders Equity Accounts payable $ 40,000 $20,000 $ 60,000 $ 60,000 Accrued expenses 10,000 5,000 15,000 15,000 Notes payable 15, ,000 41,000 Total current liabilities $ 65,000 25,000 $90,000 $116,000 Common stock 10,000 10,000 10,000 Retained earnings 45,000 9,000 54,000 54,000 Total liabilities and shareholders equity $120,000 $34,000 $154,000 $180,000 Required new funds 26,000 Selected ratios Debt/Total assets 65/120 = /180 =.064 Debt/Equity 65/(10+45) = /(10+54) =1.81 Current ratio 70/65 = /116 =0.91

37 Sustainable growth rate SGR = ΔS S 1 = A S 1 P(1 P(1 b)(1 + D E b)(1 + ) D E )

38 Sustainable growth rate SGR = 1 ROE (1 b) ROE (1 b)

39 Table 4-20 Balance sheet with sustainable sales increase HOWARD CORPORATION Sales $200,000 Sales increase 12.24% $ 24,480 Assets Before Increase RNF After Cash $ 5,000 $ 612 $ 5,612 $ 5,612 Accounts receivable 40,000 4,896 44,896 44,896 Inventory 25,000 3,060 28,060 28,060 Total current assets $ 70,000 8,568 78,568 78,568 Equipment 50,000 6,120 56,120 56,120 Total assets $120,000 $14,688 $134,688 $134,688 Liabilities and Shareholders Equity PPT 4-34 Accounts payable $ 40,000 $ 4,896 $ 44,896 $ 44,896 Accrued expenses 10,000 1,224 11,224 11,224 Notes payable 15, ,000 16,834 Total current liabilities $ 65,000 6,120 $ 71,120 $ 72,954 Common stock 10,000 10,000 10,000 Retained earnings 45,000 6,734 51,734 51,734 Total liabilities and shareholders equity $120,000 $12,854 $132,854 $134,688 Required new funds 1,834 Selected ratios Debt/Total assets 65/120 = /135 =0.54 Debt/Equity 65/(10+45) = /(10+52) =1.18 Current ratio 70/65 = /73 =1.08

40 Internal Growth Rate ) (1 ) (1 * ) (1 )] (1 [ ) (1 ) (1 ) ( ) )(1 ( ) ( b P S A b P S S g b PS b P S A S b sp b PS S S A b S S P S S A = Δ = = Δ Δ + = Δ Δ + = Δ

41 Internal Growth Rate ROA(1 b) g* = 1 ROA(1 b)

42 Review of Formulas PPT 4-35 RNF = A S 1 L ( ΔS) ( ΔS) PS 2(1 S1 D) 4-1 SGR = A S 1 P (1 P (1 D ) 1 D ) + 1 D E + T D E T 4-2

43 Summary and Conclusions PPT 4-36 Financial forecasting is used to anticipate events in advance, particularly a need to raise more money for the business A complete forecast would include: a pro forma income statement a pro forma balance sheet a cash budget The basis for most forecasts is the sales projection Simplified forecasts can be prepared using the percent-of- sales method The SGR and RNF formulas provide insight on the impact of sales growth on funding requirements

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