Chapter
4
McGraw-Hill/Irwin
Financial
Forecasting
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Financial forecasting in a firm’s strategic
growth
• Three financial statements
• Percent-of-sales method
• Methods to determine the amount of new
funds required in advance
• Factors that affect cash flow
4-2
Financial Forecasting
• Ability to plan ahead and make necessary
adjustments before actual events occur
• Outcome of a firm through external events
might be a function of both:
– Risk-taking desires
– Ability to hedge against risk with planning
• No growth or a decline - not the primary
cause of shortage of funds
• A comprehensive financing plan must be
developed for a significant growth
4-3
Constructing Pro Forma Statements
• Pro forma, or projected, financial statements enable
a firm to estimate its future level of receivables,
inventory, payables, as well as its anticipated profits
and borrowing requirements.
• These statements are often required by bankers and
other lenders as a guide for the future.
• A systems approach to develop pro forma
statements consists of:
– Constructing income statement based on sales
projections and the production plan
– Translating it into a cash budget
– Assimilating all materials into a pro forma balance sheet
4-4
Development of
Pro Forma Statements
4-5
Pro Forma Income Statement
• Provides a projection on the anticipation of
profits over a subsequent period
• Four important steps include:
– Establishing a sales projection
– Determining production schedule and the associated use
of new material, direct labor, and overhead to arrive at
gross profit
– Computing other expenses
– Determining profit by completing actual pro forma
statement
4-6
Establish a Sales Projection
• Let us assume Goldman Corporation has
two primary products: wheels and casters
Table 4-1
4-7
Determine a Production Schedule
and the Gross Profit
• Number of units produced will depend on:
– Beginning inventory
– Sales projections
– Desired ending inventory
• To determine the production requirements:
Units
+ Projected sales
+ Desired ending inventory
– Beginning inventory
= Production requirements
4-8
Stock of Beginning Inventory
Goldman Corporation has in stock the items
shown in the Table below:
Table 4-2
4-9
Production Requirements
for Six Months
Table 4-3
4-10
Unit Costs
• Cost to produce each unit:
Table 4-4
4-11
Total Production Costs
Table 4-5
4-12
Cost of Goods Sold
• Costs associated with units sold during the
time period
– Assumptions for the illustration:
• FIFO accounting is used
• First allocates the cost of current sales to beginning
inventory
• Then to goods manufactured during the period
4-13
Allocation of Manufacturing Cost
and Determination of Gross Profits
Table 4-6
4-14
Value of Ending Inventory
Table 4-7
4-15
Other Expense Items
• Must be subtracted from gross profits to
arrive at net profit
– Earning before taxes
• General and administrative expenses, and interest
expenses are subtracted from gross profit
– Aftertax income
• Taxes are deducted from the earning before taxes
– Contribution to retained earnings
• Dividends are deducted from the aftertax income
4-16
Actual Pro Forma Income Statement
Table 4-8
4-17
Cash Budget
• Pro forma income statement must be
translated into cash flows
– The long-term pro forma is divided into smaller
– More precise time frames set to help anticipate
patterns of cash inflows and outflows
4-18
Monthly Sales Pattern
Table 4-9
4-19
Cash Receipts
• In the case of Goldman Corporation:
– The pro forma income statement is taken for the
first half year:
• Sales are divided into monthly projections
– A careful analysis of past sales and collection
records show:
• 20% of sales is collected in the month
• 80% in the following month
4-20
Monthly Cash Receipts
Table 4-10
4-21
Component Costs
of Manufactured Goods
Table 4-11
4-22
Cash Payments
• Monthly costs associated with:
– Inventory manufactured during the period
• Material
• Labor
• Overhead
– Disbursements for general and administrative
expenses
– Interest payments, taxes, and dividends
– Cash payments for new plant and equipment
4-23
Cash Payments (cont’d)
• Assumptions for the next two tables:
– Costs are incurred on an equal monthly basis
over a six-month period
– Maintain production level to ensure maximum
efficiency though sales volume varies from
month to month
– Payment for material, once a month after
purchases have been made
4-24
Average Monthly
Manufacturing Costs
Table 4-12
4-25
Summary of All
Monthly Cash Payments
Table 4-13
4-26
Actual Budget
(Monthly Cash Flow)
• Difference between monthly receipts and
payments is the net cash flow for the month
– Allows the firm to anticipate the need for funding
at the end of each month
Table 4-14
4-27
Cash Budget with Borrowing
and Repayment Provisions
• Assumptions:
– The firm wishes to maintain minimum cash balance
– If the balance goes below the minimum, the firm will borrow
– If the balance goes above the minimum, the firm will use the
excess to repay the loan
Table 4-15
4-28
Pro Forma Balance Sheet
• Represents the cumulative changes over
time
– Important to examine the prior period’s balance
sheet
– Some accounts will remain unchanged, while
others will take new values
• Information is derived from the pro forma income
statement and cash budget
4-29
Development of a
Pro Forma Balance Sheet
Table 4-16
4-30
Development of a
Pro Forma Balance Sheet (cont’d)
4-31
Pro Forma Balance Sheet
4-32
Explanation of Pro Forma Balance
Sheet
• Cash ( $5,000 )—minimum cash balance as shown in Table 4–15
• Marketable securities ( $3,200 )—remains unchanged from prior
period’s value in Table 4–16
• Accounts receivable ( $16,000 )—based on June sales of $20,000 in
Table 4–10 (80% of current month sales become accounts receivables)
• Inventory ( $6,200 )—ending inventory as shown in Table 4–7.
• Plant and equipment ( $27,740+ $18,000) $45,740
• Accounts payable ( $5,732 )—based on June purchases in Table 4–13
• Notes payable ( $5,884 )—the amount that must be borrowed to
maintain the cash balance of $5,000, as shown in Table 4–15
• Long-term debt ( $15,000 )—remains unchanged from prior period’s
value in Table 4–16
• Common stock ( $10,500 )—remains unchanged from prior period’s
value in Table 4–16
• Retained earnings ( $39,024 )—initial value plus pro forma income
($20,500 + $18,524)
4-33
Analysis of Pro Forma Statement
• The growth ($25,640) was financed by
accounts payable, notes payable, and profit
– As reflected by the increase in retained earnings
Total assets (June 30, 2011)……$76,140
Total assets (Dec 31, 2010)…….$50,500
Increase…………………………...$25,640
4-34
Percent-of-Sales Method
• Based on the assumption that:
– Accounts on the balance sheet will maintain a
given percentage relationship to sales
– Notes payable, common stock, and retained
earnings do not maintain a direct relationship
with sales volume
• Hence percentages are not computed
4-35
Balance Sheet
of Howard Corporation
4-36
Percent-of-Sales Method (cont’d)
• Funds required is ascertained
• Financing is planned based on:
– Notes payable
– Sale of common stock
– Use of long-term debt
4-37
Percent-of-Sales Method (cont’d)
• Company operating at full capacity – needs to buy new
plant and equipment to produce more goods to sell:
– Required new funds:
(RNF) = A (ΔS) – L (ΔS) – PS2(1 – D)
S
S
• Where: A/S = Percentage relationship of variable assets to sales;
ΔS = Change in sales; L/S = Percentage relationship of variable
liabilities to sales; P = Profit margin; S2 = New sales level; D =
Dividend payout ratio
RNF = 60% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $60,000 - $25000 - $18,000 (.50)
= $35,000 - $9000
= $26,000 required sources of new funds
4-38
Percent-of-Sales Method (cont’d)
• Company not operating at full capacity - needs to add more
current assets to increase sales:
RNF = 35% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $35,000 - $25,000 - $18,000 (.50)
= $35,000 - $25,000 - $9,000
= $1,000 required sources of new funds
4-39