Forecasting Financial Requirements

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1 CHAPTER OUTLINE Spotlight: Planning for Growth ( 1 The Purpose and Need for Financial Forecasting Describe the purpose and need for financial forecasting. Purpose of pro forma financial statements Statements that project a firm s financial performance and condition Purpose to answer three questions How profitable can you expect the firm to be, given the projected sales levels and the expected sales-expense relationships? How much and what type of financing (debt or equity) will be needed to finance a firm s assets? Will the firm have adequate cash flows? If so, how will they be used? If not, where will the additional cash come from? Projecting financials a challenge 2 Forecasting Profitability Develop a pro forma income statement to forecast a new venture s profitability Graphic presentation of an Income Statement (Exhibit 11-1) Amount of sales Cost of goods sold Operating expenses Interest expense Taxes Provide students with a blank income statement. Using the form, have students indicate personal forms of income (work and/or other sources) and expenses that could be used on the statement. Then have them forecast their income and expenses for the next month. Ask them why they might want to know their income and expenses from one month to the next. Have them keep their copy for the rest of the discussion. 3 Forecasting Asset and Financing Requirements Find asset/financial needs using a pro forma balance sheethave students make a list of the items they own and what they owe. They can list such assets as a car, their textbooks, etc. They may owe a loan on their car and a loan for their tuition. Compare these to assets and liabilities for a business. Concerns Definitions Working capital cash,, accounts receivable, and inventory required in dayto-day operations Net working capital current assets less current liabilities Tendency in small firms to underestimate the amount of capital the business requires (undercapitalizing) 115

2 Limited amount of working capital makes forecasting more important due to less room for error Must also consider owner s personal financial situation Understanding relationship between firm s projected sales and its assets vital Determining Asset Requirements Asset needs tend to increase as sales increase, therefore firm s asset requirements are often estimated as a percentage of sales Percentage-of-sales technique method of forecasting asset and financing requirements Important to understand the asset portion of balance sheet Determining Financing Requirements Principles governing financing of firms The more assets a firm needs, the greater the firm s financial requirements A firm should finance its growth in such a way as to maintain adequate liquidity Liquidity degree to which a firm has working capital available to meet maturing debt obligations Current ratio measure of a company s relative liquidity, that compares a firm s current assets to its current liabilities on a relative basis The amount of total debt that can be used in financing a business is limited by the amount of funds provided by the owners Debt ratio measure of the fraction of a firm s assets that are financed by debt, determined by dividing total debt by total assets Some types of short-term debt maintain a relatively constant relationship with sales Spontaneous debt financing short-term debts, such as accounts payable, that automatically increase in proportion to a firm s sales Equity ownership in a business comes from two sources Investments the owners make in the business Profits retained within the company rather than being distributed to owners (retained earnings) Line of credit a short-term loan 4 Forecasting Cash Flows Forecast a firm s cash flows. Have students create a list of items they would like to purchase for themselves in the next six months. They have them indicate how much these items cost. Ask them how they would like to pay for these items. If the items are very expensive, they need to decide whether they really need them and if they need them, how will they be able to pay for them. The concept of setting up a budget to be able to pay for items by either borrowing or saving ahead is an important one for a business owner. For example, if the business would like to expand in the future, they need to be preparing for that expansion. Pro Forma Statement of Cash Flows Change from working with historical numbers to projections of numbers 116

3 Exhibit 11-4 Pro Forma Cash Flow Statements for D&R Products, Inc. The Cash Budget A listing of cash receipts and cash disbursements usually for a relatively short time period, such as a weekor a month Exhibit 11-5 Three-Month Cash Budget for D&R Products, Inc., for January- March 5 Use Good Judgment When Forecasting Provide some suggestions for effective financial forecasting Financial Forecast Suggestions Develop realistic sales projections Build projections from clear assumptions about marketing and pricing plans Do not use unrealistic profit margins Don t limit your projections to an income statement Provide monthly data for the upcoming year and annual data for succeeding years Avoid providing too much financial information Be certain that the numbers reconcile and not by simply plugging in a figure Follow the plan ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 1. What determines a company s profitability? The company s profitability is affected by the relationship of sales levels and expected sales-expense relationships. The higher the sales to the expenses the more profitable the firm will be. 2. Discuss how asset and financing requirements might differ among a retail business, a service company, and an information system-based venture. Financing and asset requirements would probably be higher for a retail business than for a service company or an information system-based venture because the retail location would need physical items such as display equipment, décor related items, furniture, etc. that the other two businesses would not need. All three types of business would require office types of furniture and equipment. The retail business would also require cash registers in a larger quantity than the other two businesses (if they need cash registers rather than a computer program). 3. Why is it important to consider an entrepreneur s personal finances when conducting the short- and long-term financial forecasts of a firm? The personal financial situation is important to consider in the financial plan. Inadequate consideration of such things as living expenses as the business gets started will raise a red flag to any prospective investor. 117

4 4. Describe the process for estimating the amount of assets required for a new venture. Assets are often estimated as a percentage of sales because asset needs increase as sales increase. Therefore, the amount of assets required affects the sales of that venture. Industries often publish the percentage-of-sales figures for the industry, which could be a comparison figure for asset requirements. The actual specific asset needs for the business must be researched. The amount of case, number of accounts receivable, and inventory must be determined and the percentage-of-sales for each of these must be estimated. 5. What are some of the basic principles that govern the financing of a firm? Why are they important? The more assets a firm needs, the greater the firm s financial requirements. This means that determining the assets for the firm is critical. The firm must finance growth that maintains adequate liquidity. Liquidity can be vital in small firms to allow the firm to meet debt obligations. The total amount of debt that can be used in financing a business is limited by the amount of funds provided by the owners. Since a bank will not provide all the financing (in some cases very little), the amount of finds the owners are able to invest may limit the business operations. Short-term debt relates directly to sales. Lower sales may be caused by the lack of products to sell which then limits profits and the ability to pay for additional products to sell in the future. The amount of investments the owners make in the business and the profits retained in the company (retained earnings) allow or limit the growth of the business. 6. How are a startup s financing requirements estimated? To forecast a company s financial requirements, an owner must understand that there must be a dollar of financing for every dollar of assets. The type of business as well as the size of the business affects this issue as well. If the business is a small size, with a limited amount of working capital, forecasting is critical because there is less room for error. The owner must determine his/her own personal financial situation as well. Understanding that projected sales affect future asset needs (you can t sell what you don t have!) is important in this process. Therefore, the owner and his/her management team must consider all assets required for the business to operate and compare those assets to the possible sales and how those sales may vary during the coming year. 7. Describe two ways for projecting a venture s cash flows, and discuss when each is appropriate to use. First information from the pro forma income statement and balance sheets may be used to develop a pro forma statement of cash flows, which provides an historical 118

5 view. The second method is to develop a cash budget (a listing of expected cash inflows and outflows). When the business is seasonal, using historical data would provide a better view of the cash flow. The chapter uses the example of a wholesale sunglass company. In such as case, a monthly or weekly picture of cash flow would allow better management of cash for the business. Using a cash budget would be very important for a small company to avoid cash flow problems causing cash to runs short/out or to anticipate short-term investment opportunities if excess cash becomes available. 8. When forecasting cash flows, why is it important to consider the time period covered by the forecast? What issues should the entrepreneur consider when doing financial forecasts? The time period is important when forecasting because the owner may not take such things as seasonal changes into consideration. The ebbs and flows of a business are important to consider to allow for periods of time when cash isn t coming in at the same rate as other periods of time while expenses continue. Issues such as good judgment and making specific assumptions that are known to management and employees allow better forecasting to take place. 9. Why is it important for an entrepreneur not only to create a cash budget but also to decide how it will be used within the firm? The chapter states that no single planning document is more important in the life of a small company. With the danger that using a cash budget could lead to inflexibility, it is important to decide how the cash budget will be used within the firm. The firm should avoid a use it or lose it mentality or use it strictly to contain costs. Instead the employees and management team should use the cash budget as a guide. 10. Choose three of the practical suggestions for making financial forecasts. Discuss the importance of the suggestions and the potential consequences of ignoring these suggestions. Answers will vary but should include three of the eight suggestions on pages : 1) Develop realistic sales projections; 2) Build projections from clear assumptions about marketing and pricing plans; 3) Do not use unrealistic profit margins; 4) Don t limit your projections to an income statement; 5) Provide monthly data for the upcoming year and annual data for succeeding years; 6) Avoid providing too much financial information; 7) Be certain that the numbers reconcile and not by simple plugging in a figure; and 8) Follow the plan. Students should discuss the suggestions and potential consequences. 119

6 COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 If all of D&R Products other relationships hold, how will Allen s worst-case and best-case projections affect the income statement and balance sheet in the first year? Worst Case Sales/Profit Effects: Sales 200,000 $325,000 CGS sold: Fixed cost 100, ,000 Variable CGS 40,000 65,000 Total CGS 140, ,000 Gross Profits 60, ,000 Operating Exp Fixed Op Exp 46,000 46,000 Depreciation Ex 4,000 4,000 Variable Op Exp 60,000 97,500 Total Op Exp 110, ,500 Operating profits (50,000) 12,500 Interest Exp 8,000 8,000 Profits before tax (58,000) 20,500 Taxes (25%) 0 5,125 Net Profits (58,000) 15,375 Best Case Sales/Profit Effects: 120

7 Adding an additional $5,000 to the short-term line of credit: Year 1a Year 1b Assets: Cash 8,000 13,000 Acct Receiv 20,000 32,500 Inventories 50,000 81,250 Total Curr Asse 78, ,750 Gross Fixed Asse 50,000 50,000 Accum Depr (4,000) (4,000) Net fixed asse 46,000 46,000 Total Assets 124, ,750 A/P 16,000 26,000 Accrued Exp 8,000 13,000 Short-term line 14, Total Curr Lia 33,500 39,000 Mortgage 27,000 27,000 Total Debt 60,500 66,000 Equity Common stock 116, ,875 Retained earnings (58,000) 5,875 Total equity 58, ,750 Total Debt/Equity 124,00 172,750 Year 1a uses a $200,000 sales figure while Year 1b uses a 325,000 sales figure for the first year of operation. With Year 1a, the Owner s Equity must increase by $6,500 to provide additional funding with the lower sales figure and the additional $5,000 must be borrowed on the short term line of credit as well. With Year 1b, the short-term line of credit may be paid off using the retained earnings (leaving $5,875 in retained earnings) and the Owner s Equity (common stock) may be decreased by $9,

8 Situation 2 1. Prepare a monthly cash budget for the three-month period ending in December. October November December January Monthly Sales 200, , , ,000 Inventory Purch 165, , ,000 Monthly Sales Cash Receipts 200, , , ,000 Month of Sale 50,000 55,000 45,000 50,000 1month later 61,250 70,000 77,000 63,000 2 months later 60,000 70,000 80,000 88,000 Total Cash Rec 171, , , ,000 Cash Disburs Pmts on Inv. Purch 150, , , ,000 Wages & Sala 25,000 25,000 25,000 25,000 Rental Exp 5,000 5,000 5,000 5,000 Utilities 6,000 6,600 5,400 6,000 Tax Prepayment 10,000 Interest on Bank Note 1,500 Total Cash Disb 196, , , ,000 Cash flows from Oper (24,750) (6,600) 30,100 15,000 Beg Cash Bal 7,000 Line of Credit 24,750 6,

9 2. If the firm s beginning cash balance for the budget period is $7,000, and this is its desired minimum balance, determine when and how much the firm will need to borrow during the budget period. The firm has a $50,000 line of credit with its bank, with interest (10 percent annual rate) paid monthly. For example, interest on a loan taken out at the end of September would be paid at the end of October and every month thereafter as long as the loan was outstanding. The line of credit would be used in October ($24,750) and November ($6,600) with payments on the loan starting in November. That would leave $18,650 available in the line of credit. A positive cash flow would be available in December to repay some of the loan ($30,100). Situation 3 1. What would you do, if you were Chang? Support your decision. Chang should request a sample of the organic parmesan from the second supplier to taste test for its product. That would allow Chang to use the second supplier if the product was acceptable. For the future, Change should develop a relationship with a second supplier and not purchase all of the supplies from one supplier since the first supplier has had difficulty meeting Chang s needs. 2. Is there anything Chang should do in the future to avoid, or at least anticipate, such a situation? Chang should develop a substitute product for the organic parmesan cheese as well as develop a relationship with the second supplier to provide an alternative delivery of the product for the organic kids meals. 3. What lesson should Chang learn from this situation? A business should not rely on only one supplier for a critical product. Alternative suppliers should be available for emergencies. 123

10 SUGGESTED SOLUTION TO CASE 11: MISSOURI SOLVENTS 1. Prepare a statement of cash flows for the 2010 projections, which will require you to use the projected 2010 income statement and the changes from 2009 to the projected 2010 balance sheet. Projected 2010 Operating Activities: Operating Income 3,245,000 Plus Depreciation 2,050,000 Less Income Taxes (888,000) Adjusted Income 4,407,000 Less increase in A/R (660,000) Less increase in inventories 90,000 Plus increase in A/P Change in Net Working Capital (570,000) Cash Flows from Operations 3,837,000 Investment Activities: Less increase in gross fixed assets (7,700,000) Financing Activities: Less interest expense (1,025,000) Less dividends paid (100,000) Plus increase in short-term notes (800,000) Plus increase in long-term debt 5,517,000 Total Financing Activities 3,592,000 Increase in cash 271, Prepare a report evaluating the alternatives and recommending a course of action. Use ratio analysis to support your evaluations and recommendation. Current ratio = Total current assets = 20,962,000 = Total current liabilities 9,840,

11 Return on assets = Operating Profits = 1,152,000 = 2.92% Total Assets 39,387,000 Operating Profit Marin = Operating Profits = 1,152,000 = 1.29% Sales 89,200,000 Total Asset Turnover = Sales = 89,200,000 = 2.26 Total Assets 39,387,000 Debt Ratio = Total Debt = 22,405,000 = 56.88% Total Assets 39,387,000 Return on Equity = Net Profits = 1,920,000 = 11.30% Owner s Equity 16,982,000 Current Ratio = Industry Average = 2.05 Return on Assets = 2.92% Industry Average = 6.38% Operating Profit Margin = 1.29% Industry Average = 5.10% Total Asset Turnover = 2.26 Industry Average = 2.42 Debt Ratio = 56.88% Industry Average = 50.48% Return on Equity = 11.30% Industry Average = 12.88% This information indicates that the firm has $2.13 in current assets for every $1 of short-term debt, compared to an industry average of $2.05 of current assets for every $1 in short-term debt. The firm is more liquid than the average firm in the industry. The firm has a lower return on assets (2.92%) than the industry average of 6.38%. This is a much lower rate than the industry average. 125

12 The operating profit margin of 1.29% compared to the industry average of 5.10% is much lower as well. The total asset turnover of 2.26 is lower than the industry average of This is somewhat better than the other ratios. The firm has a higher debt ratio (56.88%) than the industry average (50.48%). The return on equity is also lower (11.30%) than the industry average of 12.88%. This firm needs to improve asset turnover, improve its operating profit margin, lower its debt ratio, and increase the return on equity. The firm should consider improving sales training and look at the products sold to determine where the company can delete any unprofitable items in the inventory. The firm should consider concentrating on the more profitable products. 3. Would your recommendation change if the projected cash shortfall was for six or nine months rather than three months? Students answers will vary, but should include that the company basically is becoming more insolvent over the longer period of time. They have already become very dependent on debt financing that would probably only increase in the event that the cash shortfall was for six or nine months. This could lead to bankruptcy. A good discussion could center on the problem of a soft economy and how that would affect the company. In all probability, the vendors would notice the longer payment period on accounts payable and be more concerned in such an economy. 4. Is it ethical to delay payments to vendors beyond the agreed-on terms? Family, such as parents and spouses, generally offered the most support to the initial success of the featured entrepreneurs. Other network members were co-workers and partners in business ventures, past employers, business associates, customers, prospective suppliers, and local business owners. Family relationships offered encouragement, business partnerships, and sometimes financing for the entrepreneurs. Many entrepreneurs who shared their ideas often built their networks from people who were interested in the same line of work as the entrepreneur. Some entrepreneurs had to knock on doors, starting completely from scratch building a network of people who could become customers or investors. 126

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