Two Short-Term Financial Planning Methods
The Additional funds needed forecast (AFN) constitutes the end-product of the shortterm financial operating forecasting exercise. At this stage we are not concerned how
the funds needed will be raised (i.e., debt or equity). Rather our concern here can
be stated as a simple question:
"What additional funds will be needed (AFN) from external sources so that the
firm's sales forecast can be achieved after allowing for funds generated
internally?"
Numerous techniques can provide this forecast. We will concentrate our discussion on
three such methods:
1. the Additional Funds Need formula
2. the pro forma Percent-of-Sales method
3. the monthly forecasted cash budget. A review of Part 4 on financial ratios will be
helpful before beginning this section.
Other assumptions: Our forecasting horizon will be one-year for numbers (1) and (2)
above; this will keep things simple and still reveal the basic principles involved in the
financial planning task. Longer horizons can be easily formulated using electronic
spreadsheets. We will also assume our hypothetical firm is operating at capacity—if
sales are going to increase, more core operating assets will be required. We will
assume the firm's financial ratios are at some normal or equilibrium level and are
expected to remain the same after the needed funds are obtained and used to purchase
core assets.
The Additional Funds Needed (AFN) formula
The AFN method is defined with the following formula:
Eqn 1: AFN = (A*/S0)∆S – (L*/S0)∆S – NPM(S1)(b)
The terms in Eqn 1 are defined as follows:
,
Summary: The AFN formula is intuitive. It is intuitive in the sense that it forces a direct
correlation between sales growth and the amount of assets that will be required to
accommodate that growth. For firms that are at capacity output and are not in the midst
of major structural alterations to assets and liabilities, the assumption of constant (A */S0)
and (L*/S0) ratios is acceptable. For firms experiencing stable growth the assumption of
a constant NPM and retention ratio is acceptable. Notice also that the first term in Eqn
1 represents a "use of funds" triggered by an increase in sales. The second term
represents a "source of funds" triggered by the same increase in sales. Finally the, third
term represents funds generated internally (i.e., retained earnings). An algebraic
summation of these three terms provides the additional funds that must be
raised externally.
The AFN formula is also a bit simplistic. This fact should be taken into account by
management. Its intent is only to provide a rough short-run idea of what additional
financial resources will be required for a projected increase in sales. If the assumptions
cited above about the assets needed per dollar of sales or the spontaneous liabilities
created per dollar of sales are not likely to be met then the formula will perform poorly.
Management should also take account of any economies of scale effects that might
come about due to the addition of core assets. This phenomenon would serve to alter
the assumed constant (A*/S0) ratio.
A problem using the AFN formula: This problem will use the balance sheet numbers
for the Zeos Corp. seen in Part 2. From the balance sheet for year 2010 we see total
assets equal $470 million. Spontaneous liabilities equals $58.5 million and is the sum of
accounts payable, notes payable, and accrued expenses. We exclude currently
maturing long-term debt since it is independent of sales. Sales for 2010 was $1,050 in
millions of dollars.
Thus the (A*/S0) ratio for Zeos Corp. = $470/$1,050 = 0.45 or 45%. This means that
assets must increase by $0.45 per dollar increase in sales. The spontaneous liabilities
ratio for Zeos is (L*/S0) = $58.5/$1,050 = 0.055 or 5.5%. This means that every dollar of
sales generates about $0.055 in spontaneous funds. The net profit margin for Zeos for
2010 = $79/$1,050 = 0.075 or about $0.075 cents per sales dollar. Finally in 2010 Zeos
retained (1.00 – payout ratio) = (1.00 – DPS/EPS) = [1.00 – ($0.85/$1.58)] = b = 0.462
or about 46.2 percent of earnings.
Question: If Zeos forecasts a 10 percent increase in sales for 2011, what will be the
additional (external) funds that will be needed (AFN)?
Answer: Note that a 10 percent increase in sales gives
∆S = S0(1 + .10) – S0 = 1050(1.10) – 1050 = 105.
The sales level expected in 2011 is 1050(1.10) = $1,155 million.
Plugging the numbers into the formula given by Eqn 1 we have:
AFN = (A*/S0)∆S – (L*/S0)∆S – NPM(S1)(b)
= (0.45)105 - (0.055)105 – (0.075)(1155)(0.462)
= $1.45
Summary Given the fixed ratios, the profit margin, and retention ratio, Zeos should
plan on acquiring about $1.45 million dollars in (new) external funding order to support
the 2011 projected sales increase of 10%. Notice that internally generated funds
($40.02 million) will not be sufficient to fully cover the funds needed.
While improbable, a firm's particular AFN formula could produce a negative AFN. This
could result if the internal productivity of the firm in generating earnings combined with
its payables policy outweighed the technological need for more assets. In this case the
firm might use the funds to reduce debt or retire stock or simply let it sit idle.
The pro forma Percent-of-Sales method:
The second method of forecasting the additional (external) funds needed uses the sales
forecast for the coming year and the so-called Percent-of-Sales method to generate
the pro formaincome statement and balance sheet for the coming year. In this context
the term pro forma means forecast. Basically, what the Percent-of-Sales method does
is hold the accounting structure of the income statement and balance sheet constant
and via a sales increase force this increase through these statements so as to produce
the AFN.
Here are some important definitions that we will later demonstrate numerically:

Percent-of-sales method—A forecasting method that forecasts sales and then
expresses the various income
statement and balance sheet items as percentages of forecasted sales.

Pro-forma income statement—A forecasted income statement based upon on
a forecasted sales level (for next year).

Pro-forma balance sheet—A forecasted balance sheet based upon the
projected sales and retained earnings increase as computed in the pro forma
income statement.
A chief assumption: A chief assumption of the Percent-of-Sales method is that key
accounts on the current income statement and balance sheet are driven by sales
activity in a linearfashion. The method also assumes a given account will remain
the same percent of sales for the forecasted year as it is for the current year. These
are reasonable assumptions if the firm is operating at capacity and if the financials are
in some kind of normal or equilibrium state. If this is not the case, management must
alter the assumptions accordingly. While the method allows management to
discretionarily alter key ratios as they see fit for the pro forma statements, a strict
application of the method takes each income statement and balance sheet account and
expresses it as a fixed sales ratio.
Example: Let's take just a few selected accounts from the Zeos Corporation's financials
as shown in the Part 1 to demonstrate how these percentages are constructed:

In 2010 Zeos had Sales of $1,050; COGS = $756; Selling & administrative
expenses = $105; Cash and marketable securities = $26.2; Accounts receivable
= $85; Accounts payable = $38.5.
Restating these amounts as percentages of sales for 2010 we have:
If these (and other) financial statement accounts can be expected to remain the same
for the coming (forecasted) year we can proceed to construct forecasted values for
these accounts.
Example: Sales for Zeos for 2010 were $1,050. Research and analysis leads
management to forecast a 10% increase in sales for 2011. The firm is currently
operating at capacity. Given the forecasted sales increase, what are the forecasted
values for the above accounts for 2011?
Solution: Using our Future Value equation from above we have a projected 2011 sales
amount of $1,155 as seen below:
FV2011 = PV2010 (1 + .10)
1155 = 1050 (1.10)
Using the percentages from above, our projected account values for 2011 are
accordingly:
If no sales ratio relationships are changed by management, other accounts can be
computed in a similar fashion. This provides the information for a full-blown pro
forma income statement and balance sheet.
The steps: The following is a listing of the steps involved in application of the method:
1. Determine the sales forecast for the coming year.
2. Using the sales forecast, construct the pro forma income statement and determine
the funds that will be generated internally given this forecast.
3. Construct the pro forma balance sheet.
4. Subtract pro forma total assets from pro forma total liabilities and equity. If the
difference is positive additional (external) funds will be needed for the coming year if
the sales forecast is to be met. This amount is often referred to as ExternaFunds
Required (EFN).
Notice the following important points with respect to the 4th step:

The amount of new financing that will be required is a plug number necessary to
make the pro forma balance sheet balance.

A positive number for external financing required suggests the firm will have to
use either more debt, more equity, or a combination of both in order to support
the additional assets that will be required to support the forecasted increase in
sales. A positive EFN will typically be the case if the firm is operating at capacity
since internally generated funds (i.e., the addition to retained earnings from the
pro forma income statement) will usually be less than what is required in total.

In order to isolate the additional (new) funds that will be required from the total
long-term non-spontaneous financing already being used by the firm,
the Percent-of-Sales method holds long-term debt, preferred stock, common
stock at par, and paid-in capital constant. The only equity account allowed to
change is the additional retained earnings amount generated from the pro forma
income statement. The purpose of holding these items constant is to allow
management to determine in an ex ante fashion how the EFN is going to be
raised (e.g., either more debt, more equity, or a combination of both). Since the
needed funds are determined prior to raising them via marketing the firm's
securities, the method allows management to engage in more accurate financial
planning. However, as mentioned above, the pro forma results do not specify
how the needed funds will be raised. This is a topic for subsequent management
consideration.
A problem: We will continue to use the financials for the Zeos Corp. originally
illustrated in Part 3.The specific objective is to determine the EFN for Zeos for 2011
assuming a sales increase of 10% from year 2010.
Actual and pro forma income statements: The actual and pro forma income
statements appear below in Table 6-1.
Table 6-1 Zeos Corporation: Actual income statement for year ending December
31, 2010 and the pro forma statement for 2011 ending December 31, 2011 (in
millions of dollars)
Comments and management assumptions: A few quick comments are in order about
the 2011 forecasted income statement. These comments are based upon the Percentof-Salesmethod and the need to blend assumptions and management discretion.
A large part of Selling & administrative expense is fixed. However, if the firm is
operating at normal capacity, management assumes a 10% increase in this expense is
justified. Given the fixed nature of some of the administrative expenses it is quite
possible that an amount less than a strict 10% increase will be required. The final
amount of the increase would be a decision that management would be required make
based upon their knowledge of the business and engineering and capacity
constraints. Management has decided to use the 10% increase estimate in selling and
administrative expenses as it represents the most that would be required.
The pro forma amount of depreciation expense will depend upon the type and dollar
amount of the fixed assets that are added to the firm's operating base. For this example,
management assumes that depreciation expense will equal 10 percent of Zeos' 2011
gross plant and equipment. As described in the next section, management forecasts
that gross fixed assets for 2011 will be $800. While this is a sizeable 68 percent
increase in gross assets from 2010 it is important to realize that management must take
a longer-run financial planning perspective than just one year when it comes to adding
expensive core earning assets. That's what Zeos' management appears to be doing in
the interest of minimizing the long-run cost of adding to its growth asset
base. Specifically, while in the long-run there is a relatively close relationship between
sales and fixed assets, it is usually cheaper and less cumbersome to add larger
amounts of fixed assets at one time than to add smaller "chunks" of these assets
incrementally in year-wise fashion. This will initially result in some over-capacity for
Zeos in the short-run but will reduce what would be a more expensive and more
cumbersome per year sequence of continually adding fixed assets as production needs
grow. Zeos, through sales growth, is expected to "grow" into the higher asset base. This
logic highlights the applied practice of longer-run financial planning followed by most
firms.
At this juncture, it is also instructive to refer back to the Part 2 where we saw the
balance sheet, the percentage change balance sheet, and the statement of cash flows
all indicating that Zeos was not committing funds to future growth. In 2010 the data
indicated that after allowing for depreciation the firm experienced negative fixed asset
growth of 15 percent. Perhaps the large $325 million investment in fixed assets planned
for 2011 reflects an attempt to correct this problem.
Interest expense does not change on the initial pro forma income statement since
management is uncertain at this time where the additional funds needed will come from.
If debt is to be used, interest expense will be higher than the 2010 level; if all equity is
used there will be no change in the 2011 interest expense relative to 2010; if a mix of
new debt and equity is used to fund the new fixed assets some added interest expense
will be indicated ex post. Under any scenario management does not believe these
possible changes to the 2010 posted interest expense will alter the general conclusions
of the analysis. Thus it is appropriate to carry the 2010 amount over to 2011 until the
actual financing mix is decided and until the cost of borrowing added funds is
determined.
The semi-contractual nature of preferred stock dividends indicates that the pro forma
2011 income statement should keep preferred stock dividends the same. For the
common shareholders Zeos has followed a stable common stock dividend policy in the
past and wishes to do so in the future. This dividend stability philosophy followed by
Zeos' management parallel's our discussion in the 'Probability' module which explained
the reasons firms tend to keep dividends reasonably constant over time. Hence they
will continue to pay $0.85 x 50 M = $42.5 million in common stock dividends.
The remaining $16.7 million in earnings (not paid out as dividends) will be closed out to
the pro forma 2011 balance sheet amount of retained earnings. This amount
represents internally-generated funds and will help reduce the amount of externallygenerated funds needed (EFN).
As you can see the pro forma income statement is critical to good financial
planning. While it is primarily based upon a set sales growth rate assumption, it is also
reflective of certain contractual, semi-contractual, and managerial discretionary
items. This statement is not etched in stone. Rather, it constitutes a flexible planning
device.
Actual and pro forma balance sheets: Zeos' actual and pro forma balance sheets for
2010 and 2011, respectively, appear below in Table 6-2.
Table 6-2 Zeos Corporation: Actual and Pro Forma Balance Sheets for years
2010 and 2011 ending December 31
Comments on the pro forma 2011 balance sheet: The forecasted balance sheet
shows current assets increasing by 10%, in line with the projected increase in
sales. After consulting with an engineering consultant and the production staff,
management has concluded a sizeable increase in core fixed assets will be
required. After pricing these assets (including installation and set-up) management has
determined a $325 million increase (= $800 - $475) in capital spending is
appropriate. As mentioned above, this increase will initially result in some overcapacity. However, management feels the over-capacity will not last long and based
upon their longer-run strategic financial plan they determine it is cheaper to over-add
fixed assets at one time than to do so incrementally. Depreciation is estimated to be 10
percent of gross fixed assets in 2011. This will leave $478.0 in net fixed assets.
Current liabilities will increase by 10% and is in line with the percentage sales
increase. Currently maturing debt is a recurring fixed charge and is unrelated to the
sales increase. Long-term debt and the equity accounts are carried over from 2010
given that management has not yet decided on how any new funds requirement will be
satisfied. However, there will be an addition to equity from 2010 retained earnings
amount ($16.7 million) that will be incorporated into the 2011 retained earnings
total. This represents internally generated funds and is an important piece of
information as management goes through the forecasting exercise.
As you can see the pro forma 2011 balance sheet does not balance; forecasted total
assets exceed forecasted total liabilities plus owners' equity. That is we have:
Conclusions and observations on EFN forecast Management now has some idea of
the external funding requirement that will be needed to support the projected 10 percent
sales increase in 2011. While an approximation, the EFN forecast is an important piece
of information, one that is better known now than when the funds are actually needed.
Other uses of the analysis: There are other uses of the EFN forecast for
management's financial planning task.The forecast does not indicate how the funds
might be raised. Hence such questions come to the fore:
1. Should debt be used? How are the firm's bonds trading and at what price will the
firm need to offer to sell additional bonds?
2. Should stock be used? How is the firm's stock trading and what required rate of
return does new equity need to offer potential stockholders so as to attract and retain
their capital?
3. What would flotation costs amount to with each type of financing?
4. How will the raising of funds impact the firm's target capital structure and the
firm's overall total cost of capital?
5. If debt capital is used will the additional debt impact the firm's existing bond
covenant restrictions? How might more debt impact Zeos' bond ratings with its credit
analysts?
6. If more stock is used how will existing stockholders view the dilution to their
ownership?
7. How will the additional funds (however raised) impact the firm's financial ratios and
particularly its debt and debt coverage ratios and its profitability ratios? Perhaps
some pro forma liquidity, activity, debt/debt coverage, and profitability ratios might be
constructed once the method of financing is determined
8. Finally there's the cash flow implications of raising capital and then putting it to
work. Management must consider how quickly the raised capital can be expected to
start generatingcash. A projected statement of cash flows is in order once the
method of financing has been determined.
Management should consider the length of the time lag between the expenditure of
funds for new investment and when those investments will start to generate cash. This
is clearly asolvency issue that should be investigated simultaneously with the financial
forecasting phase of the EFN exercise.
Financial Forecasting and the Monthly Cash Budget
The two previously-discussed forecasting methods target the financial planning needs
necessary to expand and increase sales. The monthly cash budget is much more
short-sighted and for that reason just as important in terms of planning for financial
resources. Many companies may appear healthy going-concerns. However if their
monthly cash budgets do not produce a current string of cash surpluses, insolvency
can quickly result. This possibility is less likely for larger, established firms that have
large stores of idle cash or have quick access to short-term financial capital (e.g., shortterm bank loans, issuance of commercial paper, etc.). However smaller companies
usually do not have this access. Sudden and unexpected cash deficitscan be
particularly devastating for small growing businesses that have huge cash needs.
Many so-called early-stage companies grow by relying on pre-planned cash injections
byventure capitalists. Getting from one cash injection to the next can be problematic
when the company is not producing systematic flows of cash. These smaller up-starts
are particularly vulnerable to cash crunches, an outcome that can quickly result in
insolvency and bankruptcy.
The cash budget: The cash budget is defined as a financial statement showing the
firm's planned cash inflows and cash outflows per time period and the resulting
per period cash surplus or deficit.
A cash budget follows the matching principle as described in Part 4 —cash inflows are
matched with cash outflows per period of time. The cash budget gets to the nitty-gritty of
cash management damage control since it is concerned with highlighting any
pending cash deficits with enough lead time so that management can deal with the
projected imbalance(s). Without a cash budget management has no lead time and the
company can crash and burn.
Some particulars about the cash budget: To be useful for management's short-term
financial planning task, the cash budget is critical. The more seasonal and uncertain a
firm's sales-generated cash inflows and outflows, the greater the number of forecasted
intervals needed per year. Because many firms experience a seasonal sales pattern,
the typical cash budget is usually most useful when presented on a monthly basis. Cash
budgets with intervals longer than one or two months are probably useless in terms of
proper cash management.
A forecast: Understand that the cash budget is a forecast. Planning for adequate
cash is synonymous with planning for adequate short-term solvency. While an afterthe-fact analysis of a cash budget might be useful in analyzing what went right or what
went wrong, it has its greatest use as a prediction device showing projected cash
inflows and cash outflows.
Cash, not accrual based: The cash budget is not accrual-based; it is compiled using
the cash basis method discussed in the 'Probability' module. However the cash budget
is not quite synonymous with the statement of cash flows as described in Part 4 of the
'Money Flow' module .
The chief distinctions are that the cash budget:
1. is typically based upon monthly, not annual data
2. it does not distinguish between operating, investing, and financing cash flows
3. it does not "adjust" the accrual-based net income amount for non-cash items or for
accounts that do not appear on the income statement. The only requirement for a
business activity to be part of a cash budget is whether or not it will produce or
use cash during a given time period.
What accounts might appear in a forecasted cash budget?
The forecasted cash budget can be general or extremely detailed. Management must
decide based upon experience. Clearly a more detailed listing of projected inflows and
outflows is required if the short-term operating environment is uncertain. If the firm is
operating in a stable environment where historical analysis shows cash inflows and
outflows are reasonably predictable, a more general and less specific format can be
used.
The monthly sales forecast: Since many items are related to the level of sales a key
input in cash budget forecasts will be the monthly sales forecast. As previously
discussed, a yearly sales forecast can come from historical data and/or internal and
external sources. For cash budgeting purposes it is critical to accurately break up the
yearly forecast into monthly intervals. This task may best be handled by the marketing
department and/or those employees actually dealing with customers in the field. They
can often see trends before higher levels of management. They will also be aware of
any systematic seasonal trends in sales.
Cash inflow forecasts: From sales forecasts management must distill projected cash
inflows and the timing of these inflows. To a large extent cash receipts from sales will
depend upon the firm's collection policies and the paying practices of its
customers. Some percent of sales may be collected in cash in the month of the sales
event and some percent from sales in the previous months. That is the dollar amount of
accounts receivable will be a function of both the percentage collection percentage and
time.
Other monthly cash receipts must be identified. For example, the firm may own
marketable securities and receive interest income. It may have an equity stake in
subsidiaries and receive dividend income. It may own bonds and receive interest
income. The firm may receive monthly rental income. These and other cash receipts
need to be forecasted both in terms of the amount and month of receipt. Collectively
they will be added to give total expected cash inflow for the month.
Cash disbursement forecasts: There can be many forms of monthly cash
disbursements. Perhaps the most important one for cash planning purposes will be
related to accounts payable. From Part 3 we learned that an accounts payable
constitutes a source of funds in that the firm is temporarily paying for its purchases via
an (implicit) short-term loan from its vendors. Like accounts receivable, a portion of
purchases may be paid in cash in the month of purchase with remaining percentages
paid in lagged sequence.
In determining cash disbursements it is probably best for management to separate
variable from fixed monthly expenses. A variable expense is a direct function of sales
(e.g., cost of goods sold or sales commissions). A fixed expense is independent of
sales. Given its constant recurring nature, fixed expenses are usually easier to forecast
than variable expenses.
Other cash disbursements might include interest payments on the firm's debt, the
planned repayment of outstanding debt, pending tax and dividend payments, or the
planned repurchase of stock. Any pending exercise of stock options should be worked
into the monthly budget since the firm will be required to pay cash for any exercised
stock options. Many other types of cash disbursements can be considered and would
be dependent upon the nature of the business.
Collectively these amounts will be added to give total expected cash outflows for the
month. Adding algebraically total expected inflows and outflows will produce a net
monthly positive or negative dollar amount. Positive amounts represent cash
surpluses and negative amounts cash deficits.
The minimum desired cash balance: An important type of "outflow" is the firm's
desired monthly minimum cash balance. The size of this balance is discretionary and is
a function of the uncertainty surrounding cash inflows and outflows and the availability
of ready short-term credit. It's sort of like an insurance premium to insure against the
firm running out of cash unexpectedly. Firms that have unstable sales or have a
penchant for random large cash outflows and the inability to quickly borrow on a shortterm basis will tend to choose larger minimum cash balances than firms with stable
sales and a ready access to credit. As described in our discussion of the statement of
cash flows in Part 3 regarding the balance sheet account "cash," the minimum cash
balance account is a residual amount intended to receive cash surpluses and cover
cash shortfalls. Before-the-fact the minimum cash floor is expected to cover any
shortfalls. If this floor, ex post, turns out to be insufficient for any shortfalls management
should have in place a means for quick, short-term borrowing at reasonable interest
rates. In practice management would hope that the floor is never reached. If it is
routinely exceeded then it needs to be increased or better coordination of operating
inflows and outflows needs to be achieved. This coordination is the essence of good
cash planning.
The cumulative cash balance: The final component of a cash budget is the
"running" cumulative cash balance. This dollar amount is just what it says—the
aggregate algebraic addition of each month's net cash balance after allowing for the
minimum cash balance. This moving window of the forecasted incremental monthly net
balances is particularly important in cash planning since it reveals the month when cash
shortfall are expected to occur. Management can then plan accordingly. Positive
cumulative amounts can be targeted for short-term investments; negative amounts can
be "headed off at the pass" via the arrangement of short-term financing (e.g., a bank
line of credit or the issuance of commercial paper or a short term bank loan).
A problem: XYZ Industries is a small manufacturer of summer wear and summer
related products. The company has been in business for five years as a sole
proprietorship and later as apartnership. Given XYZ's growth over this period of time
they have recently "gone public" with an Initial Public Offering (IPO). Using sales and
cost data from the previous five years management is in the process of preparing a
cash budget. At this time management feels that a six-month monthly cash budget is
appropriate (at the end of its first six months of operations a revised six-month budget
will be forthcoming).
The historical record over the past five years of operations shows that sales are
seasonal with the winter months showing a decline in sales followed by an upturn during
the summer months. The record shows that 20 percent of monthly sales are collected in
cash with a remaining 50 percent and 30 percent collected in months t + 1 and t + 2,
respectively. The record shows that bad debts are negligible and management has
chosen to omit them from the calculations. The firm also receives monthly interest,
dividend, and rental income. A one-time initial start-up cash flow is expected to be
made by the firm's major stockholders (the original owners of the business prior to going
public) in the first month of incorporation.
XYZ cash purchases equal 20 percent of sales paid in the month of purchase. The
remaining 60 and 20 percent of sales are paid in two accounts payable installments in
periods t + 1 and t + 2, respectively.
The firm estimates fixed expenses at $5 per month and variable expenses will be 10
percent of sales per month. Base (fixed) sales are estimated to be $10 per month and
commission sales will be 30 percent of sales. The firm expects to make quarterly
dividend payments of $4. It will make a quarterly sinking fund and tax payments of $5
and $10, respectively. The firm is committed to retiring $10 in outstanding debt every six
months. XYZ's management has decided on a minimum cash balance of $100 per
month.
Objective: Beginning in January 2011 compute the monthly cash budget for XYZ
Industries and interpret the results with attention paid to the cumulative cash balance
over the first six months of operations.
Solution: Table 6- 3A displays the forecasted cash budget for the Zeos Corporation for
the first six months of operations as a publicly-traded corporation.
Table 6-3A The cash budget for XYZ Industries for Jan – June, 2011 (the numbers
represent 0.10% of $1,000,000)
Comments, analysis, and evaluation: Line 3 shows the seasonal nature of sales.
Lines 7, 8, and 9 show the projected cash receipts per month including the amounts
collected from accounts receivable. Lines 10 – 12 are self explanatory. Line 13 shows
the one-time cash injection of $1000. If the firm was still a sole proprietorship or
partnership then this injection would be called venture capital. Line 15 shows total
expected cash inflows from January through June. The seasonal nature of sales is
reflected in these inflows.
Lines 19, 20, and 21 show the pattern of cash outflows related to purchases. Line 22
shows that fixed expense equals $5 per month and variable expenses constitute 10
percent of sales per month. Total wages are paid in two forms: Line 23 shows base
fixed salaries to be $10 per month. Line 24 shows commission sales are 30 percent of
sales for a given month. Again, notice the seasonal nature of commissions. Lines 25
though 28 are self-explanatory. Line 30 summarizes the cash outflows. You can see
that cash outflows are being impacted both by the seasonal nature of sales and the
quarterly payment of certain fixed financial obligations.
Line 32 shows the net monthly inflows. This is a very instructive string of numbers for
management's financial planning task. We see that after February the net inflows
decline steadily, turning negative in May and June. Subtracting Line 34, (the desired
minimum cash balance), only exacerbates this projected decline and causes the April
balance to become negative as well (Line 36).
However, it's the cumulative cash balance, shown in Line 38, that really tells the
story. The cumulative balances sequence carries forward the previous ending cash
balance so that it becomes the beginning cash balance of the subsequent
month. Line 38 shows the cash build-up months of January, February, and March
carrying forward to "fund" the negative monthly balances in April, May, and, to some
extent, June. Thus the meaningful cash crunch month is projected to be June with a
negative cumulative balance of $68.
Damage control: Based upon these forecasts made in January, management should
have adequate short-term funding ready to go for June. It's better to know this outcome
in January than in the month of the cash shortfall. That's the beneficial outcome of cash
budgeting.
Of course, seeing this June shortfall management could take other steps. The most
obvious step would be to increase the receipt of accounts receivable. Perhaps
eliminating accounts payable in period t + 2 might help assuming such a request does
not alienate customers. Since most of the other accounts are reasonably set, this
seems like the only account that might be altered.
Short-term external funds policy: Note that XYZ has a policy of first liquidating
its marketable securities to meet deficits and then borrowing with notes payable if
additional financing is needed. Since XYZ is not expected to let the cumulative cash
balance sit around in petty cash the company is expected to invest these funds in shortterm earning assets that provide a minimal rate of return and instant liquidity.
We have excluded the earned interest on these balances for convenience and because
the after-tax interest would be negligible. Had the problem allowed for these invested
balances the cumulative balance would be a bit higher. As Table 6-3A is constructed
XYZ will be issuing notes payable of $68 in June of 2011.
Sample Quiz Questions for Chapter 4
Financial Planning and Forecasting
Question 4-1:
A company is forecasting an increase in sales and is using the AFN model to forecast the additional capital that they
need to raise. Which of the following factors are likely to increase the additional funds needed (AFN)?
a. The company has a lot of excess capacity.
b. The company has a high dividend payout ratio.
c. The company has a lot of spontaneous liabilities that increase as sales increase.
d. The company has a high profit margin.
e. All of the answers above are correct.
Question 4-2:
Jill's Wigs Inc. had the following balance sheet last year:
Cash
800
Accounts payable
Accounts receivable
450
Accrued wages
150
Inventory
950
Notes payable
2,000
Net fixed assets
$
34,000
Mortgage
$
350
26,500
Common stock
3,200
Retained earnings
4,000
Total liabilities
.
Total assets
$36,200
=======
and equity
$36,200
=======
Jill has just invented a non-slip wig for men which she expects will cause sales to double, increasing net income to
$1,000. She feels that she can handle the increase without adding any fixed assets. (1) Will Jill need any outside
capital if she pays no dividends? (2) If so, how much?
a. No; zero
b. Yes; $7,700
c. Yes; $1,700
d. Yes; $700
e. No; there will be a $700 surplus.
Question 4-3:
The constant ratio method produces accurate results unless which of the following conditions is (are) present?
a. Fixed assets are "lumpy."
b. Strong economies of scale are present.
c. Excess capacity exists because of a temporary recession.
d. Answers a, b, and c all make the constant ratio method inaccurate.
e. Answers a and c make the constant ratio method inaccurate, but, as the text explains, the assumption of increasing
economies of scale is built into the constant ratio method.
Answer 4-1:
b. The company has a high dividend payout ratio.
Additional funds needed
Only answer b will increase AFN; the other statements will decrease
AFN.
Answer 4-2:
d. Yes; $700
Additional funds needed
Balance Sheet solution:
Pro Forma Balance Sheet
Cash
$ 1,600
Accounts receivable
Inventory
Net fixed assets
Accounts payable
$
700
900
Accrued wages
300
1,900
Notes payable
2,000
34,000
Mortgage
26,500
Common stock
3,200
Retained earnings
5,000
Total liabilities
.
Total assets
$38,400
& equity
=======
AFN = $38,400 - $37,700 = $700.
Formula solution:
S™ = •S; MS• = $1,000.
.
A*
L*
.AFN = ÄÄ(•S) - ÄÄ(•S) - MS•(1 - d) = $2,200 - $500 - $1,000(1) =
S
$700.
S
$37,700
=======
Answer 4-3:
d. Answers a, b, and c all make the constant ratio method inaccurate.
Constant ratio method