FINANCIAL FORECASTING
The planning process, ideally, begins with some idealistic objective, such as
producing the best product at the lowest cost. This objective, in turn, dictates that
certain long-term objectives be achieved, such as developing an innovative product that
can be produced in an efficient manner. Similarly, the long-term objectives require that
certain short-term objectives be realized, such as generating sufficient cash flows to fund
the research and development required to come up with the innovative product.
Planning
Short-term
Objectives
Intermediate-term
Objectives
Long-term
Objectives
Implementing
Conversely, realizing these goals must occur in the reverse order: if a positive cash flow
is not generated, there will be no funding for R&D to develop the product that you want
to produce.
Breakeven analysis and profit planning are short-term planning tools. In fact,
many businesses do not breakeven for several years, let alone show a profit (witness
many of the Internet companies). There are other tools available for evaluating such
endeavors. Undoubtedly, one of the short-term objectives of such companies is to
secure the financing sources required to survive until such time as a profit is realized.
Critical to the success of any business, is the planning of the cash flows; i.e.,
cash budgeting. A budget is a plan and budgeting refers to planning. You budget your
time just as you budget your cash flows. Planning is an integral part of a managementby-objective style of business management. The alternative is management-by-crisis
wherein all of one’s time is spent “putting out fires” – a reactive approach to
management rather than a proactive approach. The budget provides the framework by
which management intends to achieve its short-term goals.
For the financial manager, the cash budget aids in the performance of the job of
making sure that funds are available when needed as well as planning for the efficient
use of any surplus funds that exist. The ability to anticipate the financial needs of the
firm allows time to find sources of funds.
The complexity of the cash flows can be illustrate by the use of a simple diagram
that illustrates the nature of the numerous cash inflows and outflows that confront a firm.
Let the Cash Reserve box represent the checking account of the company:
Intermittant Inflows
(Debt, Equity)
Intermittant Outflows
(Taxes, Insurance, Wages)
Near
Cash
Fixed Assets
Cash
Reserve
Accounts
Payable
Accounts
Receivable
Cash
Sales
Credit
Sales
Inventory
Into the Cash Reserve go intermittant inflows of funds from lenders and shareholders,
and money flows back in the form of interest and principal payments to lenders and
dividends to stockholders. There are intermittant outflows of funds to pay wages, taxes
and insurance as well. Occasionally, there are tax refunds, payment on insurance
claims, etc., that result in cash flows returning to the company. Near Cash (or Near
Money) represents investment in short-term marketable securities so that cash
surpluses can earn a rate of return. This is a where short-term surpluses of cash are
“stored”. Money is spent to purchase fixed assets, which are later sold when it is time to
replace them. Accounts payable must be paid. The accounts payable arise from
inventory purchases which are sold to customers on either a cash basis or on credit, in
which case the receivables must be collected. There are returns by our customers to us,
as well as our returns to suppliers, in which case refunds are paid.
As the number of suppliers, customers, lenders, etc., multiplies so does the
complexity of the cash flows. Stories abound of companies that are showing a profit (in
the accounting sense) but ultimately fail due to the lack of cash flow to make loan
payments, pay suppliers, pay wages, taxes, and so on.
Short-term Forecasting – The Cash Budget
A detailed example of a cash budget is attached. A simple two-period example is
presented here to illustrate the difference between the cash budgeting techniques taught
in accounting courses and the cash budget utilized in finance is presented.
The cash budget in finance always starts with detailing the receipts of cash.
Typically, receipts are comprised of cash sales and the collection of accounts receivable.
Even the collection of receivables may require a separate worksheet. Note also that if
there is a 5% bad debt expense anticipated, the collections should only add up to 95%.
That is, bad debt expense is not a cash outflow, it is a receipt that is not collected and,
thus, not an item that appears on the cash budget since the budget only represents cash
inflows and outflows. Other sources of cash inflows, such as the sale of stock that is
anticipated, would also be reflected under the Receipts section of the cash budget.
The next category is Disbursements where we list any and all cash payments
that are to be made including salaries, rent, interest and principal payments, dividends,
purchases of fixed assets, but NOT depreciation (since it is not cash) – any cash outflow
that is to be made. The difference between the Receipts and Disbursements is the Net
Cash Gain (Loss). The various periods for which a cash budget is being prepared can
be all be done at the same time up to this point. Beyond this point in the budgeting
process, however, the periods must be taken sequentially since each period depends
upon the previous one.
Receipts
March
April
Cash Sales
Collection of A/R
20
75
30
45
Total Receipts
95
75
35
50
15
10
0
0
35
40
15
0
20
5
110
115
Net Cash Gain (Loss)
(15)
(40)
Plus: Beginning Cash
10
(5)
Cumulative Cash
(5)
(45)
Less: Minimum Cash
(5)
(5)
(10)
(50)
Disbursements
Wages
Payment of A/P
Rent
Insurance
Debt Payment
Dividends
Total Disbursements
Surplus (Deficit)
After calculating the Net Cash Gain (Loss) for each period, the Beginning Cash is
added to determine the Cumulative Cash (or Ending Cash) on hand at the end of the
period. This amount becomes the Beginning Cash for the following period. From the
Cumulative Cash figure, we subtract the Minimum Cash that we desire to have on hand.
This minimum could be a “safety stock” of cash or it could be a required amount that a
lender mandates we keep available (and probably restricted in use). The remaining
amount after subtracting the Minimum Cash Required is our Surplus (Deficit).
Unlike the cash budgets you have probably seen before, this is a cumulative
cash budget. Notice that the Surplus (Deficit) is a cumulative amount that indicates what
the total position of the firm is at any point in time. Thus, our cash budget indicates that
we will need $10 in financing for March and an additional $40 in April, for a total of $50 in
financing requirements. The budget shows us our total financing requirements so that
we can go to a bank, for example, and request a line of credit of $50 to cover our
financing requirements. (Ideally, of course, the budget will also show how we intend to
repay the loan as well.) The cumulative cash budget allows us to determine our total
financial requirements in advance, allowing us time to find a willing supplier of funds.
The only thing worse than having to find funding at the last minute, is having to go back
and ask for more money at a later date. The lender will know in advance the level of
commitment that must be made and, if we are turned down, we have time to line up
another source of funds.
Detailed Cash Budget
The Simmons Company is planning to request a line of credit from its bank.
following sales forecasts have been made for parts of 2009 and 2010:
May 2009
June
July
August
September
October
November
December
January 2010
The
$150,000
150,000
300,000
450,000
600,000
300,000
300,000
75,000
150,000
Collection estimates obtained from the credit and collection department are as follows:
collected within the month of sale, 5 percent; collected the month following the sale, 80
percent; collected the second month following the sale, 15 percent. Payments for labor
and raw materials are typically made during the month following the month in which
these costs are incurred. Total labor and raw materials costs are estimated for each
month as follows:
May 2009
June
July
August
September
October
November
December
$ 75,000
75,000
105,000
735,000
255,000
195,000
135,000
75,000
General and administrative salaries will amount to approximately $22,500 a month;
lease payments under long-term lease contracts will be $7,500 a month; depreciation
charges will be $30,000 a month; miscellaneous expenses will be $2,250 a month;
income tax payments of $52,500 will be due in both September and December; and a
progress payment of $150,000 on a new research laboratory must be paid in October.
Cash on hand on July 1 will amount to $110,000 and a minimum cash balance of
$75,000 will be maintained through-out the cash budget period.
A.
Prepare a cash budget for the last six months of 2009 with an estimate of
required financing (or excess funds).
B.
Assume that receipts from sales come in uniformly during the month (that is,
cash payments come in at the rate of 1/30th each day), but all outflows are paid
on the fifth of the month. Will this have an effect on the cash budget (i.e., will the
cash budget you have prepared be valid under these assumptions)? If not, what
can be done to make a valid estimate of financing requirements?
Solution to Handout #8
May-09
Sales
Labor & Materials
Purchase
Payment
Jun-09
Jul-09
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
Jan-10
150,000
150,000
300,000
450,000
600,000
300,000
300,000
75,000
150,000
75,000
75,000
75,000
105,000
75,000
735,000
105,000
255,000
735,000
195,000
255,000
135,000
195,000
75,000
135,000
Collection of A/R Worksheet
May-09
Jun-09
Jul-09
Aug-09
Sep-09
Oct-09
Nov-09
Dec-09
22,500
120,000
15,000
22,500
240,000
22,500
45,000
360,000
30,000
67,500
480,000
15,000
90,000
240,000
15,000
45,000
240,000
3,750
CASH BUDGET
RECEIPTS
Collection of Accounts Receivable
Total Receipts
PAYMENTS
Purchases
G & A Salaries
Lease Payment
Miscellaneous
Tax Payment
Progress Payment
Total Payments
NET CASH GAIN (LOSS)
PLUS:
BEGINNING CASH
CUMULATIVE (ENDING) CASH
157,500
285,000
435,000
562,500
345,000
288,750
157,500
285,000
435,000
562,500
345,000
288,750
75,000
22,500
7,500
2,250
105,000
22,500
7,500
2,250
735,000
22,500
7,500
2,250
52,500
255,000
22,500
7,500
2,250
195,000
22,500
7,500
2,250
135,000
22,500
7,500
2,250
52,500
437,250
227,250
219,750
147,750 (384,750) 125,250
117,750
69,000
48,500
166,250
166,250
235,250
150,000
107,250
50,250
137,250
819,750
110,000
160,250
308,000
(76,750)
160,250
308,000
(76,750)
48,500
LESS:
MINIMUM CASH BALANCE
SURPLUS CASH BALANCES
LOANS REQUIRED TO MAINTAIN
MINIMUM CASH BALANCE
75,000
75,000
75,000
75,000
75,000
75,000
85,250
233,000
0
0
91,250
160,250
0
0
0
0 (151,750) (26,500)
The detail of a cash budget is both an advantage and a hindrance to forecasting future
financial requirements. The advantage is the fact that the actual timing of cash inflows
and outflows is more precise than other methods and gives a more accurate picture of
the firm’s financial situation, particularly when seasonality is involved. On the other
hand, a lot more effort must be expended in order to develop a detailed cash budget.
When a budget of short time periods is employed for forecasting purposes, the budget
and income statement actually drive the construction of the projected balance sheets.
To see this, consider the following one-month example:
MolecuGene, Inc., is planning next month's operations and has gathered the following
past and projected sales data:
October
November
December
January
$80,000
60,000
50,000
55,000
40% of sales are cash sales. Of the remaining credit sales, half are collected in the first
month following the sale and the rest is collected in the second month following the sale.
Purchases of materials are 60% of sales and are acquired one month in advance.
Purchases are paid for with cash to avoid financing charges. Staff salaries are $11,000
per month. Equipment rental fees are $1,200 per month, while MolecuGene owns the
building and is depreciating it at a rate of $1,500 per month. Utilities average 5% of sales
and are paid in the month following their incurrence. The Board of Directors has
authorized dividends of $5,000 for common stockholders payable on December 31. The
tax rate for MolecuGene is 20% and the next quarterly tax payment is due at the end of
January.
A.
Prepare a cash budget for December indicating the surplus (deficit) of cash as of
December 31. The cash balance as of November 30 is $2,000.
B.
Prepare a proforma income statement for December.
C.
The balance sheet as of November 30 is as follows:
Cash
$ 2,000
A/R
62,000
Inventory
45,000
Plant & Equip.
Accum. Depr.
Total Assets
A/P (utilities)
$
3,000
Taxes/P
4,320
170,000
Common Stock
85,000
( 50,000)
Retained Earnings
136,680
$ 229,000
Tot. Liab. & Equity
$ 229,000
Create a balance sheet to reflect your firm's assets and liabilities as of December
31. (Note: If your cash budget shows a surplus, additional financing will be zero.
If your cash budget shows a deficit, the cash account will be zero.)
Cash Budget
Receipts:
Cash Sales
Collection of A/R
October
November
Total Receipts
$ 20,000
24,000
18,000
($80,000 * 60% * 50%)
($60,000 * 60% * 50%)
$ 62,000
Payments:
Materials Purchases $ 33,000
Salaries
11,000
Equipment Rent
1,200
Utilities
3,000
Dividends
5,000
Total Payments
($50,000 * 40%)
($55,000 * 60%)
($60,000 * 5%)
$ 53,200
Net Cash Gain (Loss)
$ 8,800
Plus: Beginning Cash
$ 2,000
Ending Cash
$ 10,800
Income Statement
Revenues
Cost of Goods Sold
$ 50,000
30,000
Gross Profit
$ 20,000
Gen. & Admin. Expense
Salaries
Equipment Rent
Depreciation
Utilities
$ 11,000
1,200
1,500
2,500
Total G&A
$ 16,200
Operating Income (EBIT)
$ 3,800
Taxes
Net Income
760
$ 3,040
($50,000 * 60%)
(fixed)
(fixed)
(given)
($50,000 * 5%)
Balance Sheet
Assets
Cash
$ 10,800
170,000
(Beg A/R + Credit Sales – Collections
= $62,000 + $30,000 - $42,000)
(Beg. Inv’y + Purchases - COGS
= $45,000 + $33,000 - $30,000)
(No P&E bought or sold – see Inc. Stmt.)
(51,500)
($50,000 + $1,500)
Accounts Receivable
50,000
Inventory
48,000
Plant & Equipment
Accumulated Depreciation
Total Assets
(From Cash Budget)
$227,300
Liabilities & Equity
Accounts Payable (Utilities) $
2,500
Taxes Payable
5,080
Common Stock
85,000
Retained Earnings
Total Liabilities & Equity
134,720
$227,300
(Beg. A/P + Credit Purchases – Payments
= $3,000 + $2,500 - $3,000)
(Beg. Tax/P + Current Taxes – Payments
= $4,320 + $760 – 0)
(Beg. C/S + stock sales –repurchases)
(Beg. R/E + Net Income – Dividends
= $136,680 + $3,040 - $5,000)
Long-Term Forecasting – Percent-of-Sales or Constant Ratio Method
Cash budgeting is a short-term planning tool. It is equally important that longterm planning be periodically reviewed to ensure that the short-term goals are consistent
with the long-term objectives, as well as to provide advance notice of the needs of the
corporation so that appropriate decisions can be made and actions taken.
Suppose our Balance Sheet for the past year looked as follows:
2008 Balance Sheet:
Cash
Accounts Receivable
Inventory
Total Current Assets
50,000
180,000
200,000
-----------430,000
Accounts Payable
Bank Note
Total Current Liabs.
100,000
90,000
-----------190,000
L-T Debt
Gross Fixed Assets
(Accum. Depr.)
Net Fixed Assets
400,000
(130,000)
-----------270,000
Common Stock
Retained Earnings
Total Equity
Total Assets
700,000
220,000
10,000
280,000
-----------290,000
Total Liab. & Equity
The assets should reflect the consequences of the past year’s activities (particularly the
receivables and payables) as well as expectations of the coming year’s sales. The
primary factor that influences our asset and financing requirements is the level of sales
that is anticipated. We must, therefore, get a realistic estimate of what our sales will be
in the coming years in order to determine the amount of assets that will be required in
order to support the anticipated sales. Once we have an estimate of the amount of
assets that will be required, we need to determine what financing will be necessary for
the projected asset levels.
Consider the income statement for 2008 as well as the projected income
statement for 2009. The assumptions used to construct the projected income statement
are listed next to each category:
700,000
Income Statements:
Revenues
Cost of Goods Sold
Gross Profit
Gen. & Adm. Expense
Salaries
Rent
Repairs & Maintenance
Travel
Utilities
Depreciation
EBIT
Interest Expense
Taxable Income
Taxes (35%)
Net Income
Less: Dividends
Addition to Retained Earnings
2008
Actual
======
1,000,000
500,000
-----------500,000
2009
Projected
=========
1,200,000
600,000
-----------600,000
220,000
60,000
14,000
23,000
12,000
40,000
-----------131,000
226,600
60,000
14,420
23,690
12,360
44,000
-----------218,930
30,000
-----------101,000
30,000
-----------188,930
35,350
-----------65,650
66,126
-----------122,805
25,000
-----------40,650
25,000
-----------97,805
20% increase
50% of Sales
3% inflation
Contractual
3% inflation
3% inflation
3% inflation
MACRS determined
If we intend to be able to meet the growing demand, we need to be sure that we
have the necessary assets on hand to support our projected level of sales, as well as the
ability to finance these projected asset levels. The easiest means of projecting the
balance sheet is to utilize the percent-of-sales method of projection. This technique
takes each account on the balance sheet that varies with sales and expresses it as a
percentage of sales. This percentage is then applied to the projected sales level to
determine what levels can reasonably be expected for these accounts.
If we assume that the balance sheet for 2008 above was about right for the level
of sales of $1 million that we experienced in 2008, then we can project the balance sheet
for 2009 given our projected sales of $1.2 million for the year:
Cash =
$50,000
= 5% * $1,200,000 = $60,000
$1,000,000
A/R =
$180,000
= 18% * $1,200,000 = $216,000
$1,000,000
Inventory =
$200,000
= 20% * $1,200,000 = $240,000
$1,000,000
Fixed Assets =
A/P =
$400,000
= 40% * $1,200,000 = $480,000
$1,000,000
$100,000
= 10% * $1,200,000 = $120,000
$1,000,000
Note that your bank doesn’t just automatically give you more money, nor are long-term
bonds automatically issued. In fact, aside from accounts payable and other accruals
(which are referred to as spontaneous sources of financing) which have a zero cost, how
assets are financed is a decision variable (that we will look at in detail later). Thus,
simply leave these accounts alone.
The only other account that is a direct function of sales is the retained earnings
account which is a function of both our profitability and dividend policy. Recall the
relationship between successive retained earnings accounts:
Beginning R/E + Net Income – Dividends = Ending Retained Earnings
$280,000 + $122,805 - $25,000 = $377,805
We now can fill in our entire projected balance sheet for 2009. Since total assets
must equal total liabilities and equity, we will use Additional Financing Required as a
balancing figure.
2009 Balance Sheet:
Cash
Accounts Receivable
Inventory
Total Current Assets
60,000
216,000
240,000
-----------516,000
Accounts Payable
Bank Note
Total Current Liabs.
L-T Debt
Gross Fixed Assets
(Accum. Depr.)
Net Fixed Assets
480,000
(174,000)
-----------306,000
Common Stock
Retained Earnings
Total Equity
Add’l Financing Req’d
Total Assets
822,000
Total Liab. & Equity
Ultimately, the Additional Financing Required figure must be reduced to zero. This is
where decisions must be made. One source, for example may be that additional Fixed
Assets are not require; i.e., there is sufficient unutilized capacity to accommodate the
20% increase in sales without any additions. This would reduce the asset requirements
and, hence, the financial requirements of the firm. Another alternative might be to
reduce the dividends being paid. Or additional bank loans may be taken out. In any
event, we now know what our financing requirements are and we can begin looking for
ways of covering our shortfall.
The final step we should take is to construct the Statement of Cash Flows for
2009. It appears as follows:
2009 Statement of Cash Flows
From Operations:
Net Income
Depreciation
Operating Cash Flow
Accounts Receivable
Inventory
Accounts Payable
Working Capital
Total From Operations
122,805
44,000
----------166,805
( 36,000)
( 40,000)
20,000
----------( 56,000)
110,805
120,000
90,000
-----------210,000
220,000
10,000
377,805
-----------387,805
4,196
822,000
From Investment Activities:
Fixed Assets
Total From Investments
(80,000)
-----------(80,000)
From Financing Activities:
Additional Financing Required
Dividends
Total From Financing
4,196
(25,000)
-----------(20,805)
Total Cash Flow
10,000
Plus: Beginning Cash
50,000
Ending Cash
60,000
The figures were calculated as follows:
Accounts Receivable = 180,000 – 216,000 = (36,000)
Inventory = 200,000 – 240,000 = (40,000)
Accounts Payable = 120,000 – 100,000 = 20,000
Fixed Assets = 400,000 – 480,000 = (80,000)
Add’l Fin. Required = 4,196 – 0 = 4,196
Dividends = Beg. R/E + Net Income – End. R/E
= 280,000 + 122,805 – 377,805 = (25,000)
Speaking of the Fixed Assets, consider the following graph:
Fixed Assets
Percent-of-Sales
Sales
As may be observed, plant and equipment comes in “chunks” – you cannot build onefifth of a plant. Thus, sometimes the percent-of-sales approach is not the best one.
As another example, consider inventories. Perhaps the best description of the
relationship between inventories and sales is described by a linear (or simple)
regression.
Inventory     (Sales)
This illustrates some of the drawbacks to the percent-of-sales method.
Inventory
Percent-of-Sales
Overestimate
Linear
Regression
Underestimate
Sales
The percent-of-sales method forces the line through the origin. In the case of the
inventory regression, this results in an under-estimate of the requirements at low levels
of sales and an over-estimate at high levels.
What would happen if we used a linear regression on Accounts Receivable?