Chapter 7
Financial Forecasting and Cash
Budgeting
Objectives of Financial Forecasting
• Adequate financial planning is a key element
in the success of any business venture.
• Short-term and long-term planning:
– Common objective: development of financial
planning and control system to guide financial
future of firm
– Techniques employed differ in degree of detail
developed in analysis
Objectives of Financial Forecasting
• Short-term forecasts focus on cash budgeting
and cash flow planning
• Long-term forecasts focus on planning for
future growth in sales and assets and for
financing of this growth
Short-term Forecasts and Cash
Budgeting
• Short-term forecast and cash budget: plan for
near future expressed in monetary terms
– Objective: provide a planning and control system to
guide next few months or quarters of operations
• Budget is not simply a device for controlling expenditures
– As general economic conditions and business
opportunities changes, budget must change.
– As actual operations deviate from plan, financial
manager can use cash budget to assess reason for
variation and take corrective action where
appropriate
Short-term Forecasts and Cash
Budgeting
• General procedure results in dynamic short-term
financial planning and cash budgeting system:
1. Develop sales forecast for upcoming year
2. Develop estimates of next year’s expected profitability
3. Develop forecasted (pro-forma) income statement for
upcoming year
4. Estimate cash payment and collection lags
5. Develop detailed cash collection and payments forecast
6. Construct cash budget
7. Develop forecasted (pro-forma) balance sheet for end of
next year
Financial Forecast for the Cutler
Toy Company
• The Cutler Toy Company
– Founded in 1999
– Owners: William Cutler and Neville Hook
– If past successful growth were to continue into
future, William and Neville needed to implement
a formal financial planning system
Financial Forecast for the Cutler
Toy Company
1. Develop sales forecast (see exhibit 7.1) for 2008
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Cutler is forecasting a total 2008 sales volume of
$250,000 (150% increase over 2007 due to Cutler’s
decision to make transition to full-time operation under
control of new general manager)
Buildings and fixtures will be expanded by 25% ($5,000)
and this expansion will be financed by increase in longterm bank loan from $10,000 to $15,000
Actual income statement and balance sheet for 2007 (see
exhibit 7.3) will be used as baseline for 2008 forecasts
Financial Forecast for the Cutler
Toy Company
2. Develop estimates for 2008’s expected profitability
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Make estimates based on past performance and
expected future operating characteristics
Based on actual income statement (see exhibit 7.2), gross
profit margin for 2007 is estimated at 25%
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This should be relatively conservative estimate as small
percentage changes in gross margin often result in large
percentage changes in bottom line
Financial Forecast for the Cutler
Toy Company
2. (continued)
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Based on Cutler’s projections of 2008’s operations:
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Depreciation (policy variable determined by Cutler’s choice of
depreciation methods) is fixed at $3,400 ($1,000 increase over
2007)
Employee wages are estimated at $22,000
Other expenses are estimated at $1,800
Remaining wages for 2008 will be paid at $2,200 per month
Other expenses will occur evenly at $150 per month
Interest expense on long-term bank loan is payable quarterly at
12% per year
Total payments of $1,500 will be made, with $300 due at end of
March/June and $450 due at end of September/December
Financial Forecast for the Cutler
Toy Company
3. Develop forecasted (pro-forma) income statement
for 2008 (see exhibit 7.4)
–
End result of estimates in step 2 is pro-forma income
statement for 2008
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Gross margin of $62,500 is anticipated on $250,000 in sales
Deducting depreciation expenses, employee wages, interest, and
other expenses yields income before tax of $33,800
Deducting taxes of $7,400 leaves after-tax profit of $26,400
Financial Forecast for the Cutler
Toy Company
4. Estimate cash payment and collection lags for 2008
(see exhibit 7.5)
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Cutler mainly deals with department stores, toy specialty
shops, and discount chains, all of which pay him no later
than the month following sale
“Lagging sales” one month: cash collections in one
month will be equal to sales from previous month
Financial Forecast for the Cutler
Toy Company
5. Develop detailed cash collection and payments
forecast (see exhibit 7.6)
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Establish inventory policy: determine required ending
inventory and known quantity of inventory on hand at
beginning of month
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For Cutler Toys, dollar value of inventory on hand at end of each
month should be equal to next two months’ expected sales at
cost
Since gross profit margin is 25%, this policy results in target
ending inventory equal to 75% of next two months’ sales at retail
Consider amount of inventory expected to be used up
during month to support current month’s sales:
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Since gross margin is 25%, inventory used up in any one month
will be equal to 75% of current month’s sales at sale prices
Financial Forecast for the Cutler
Toy Company
5. (continued)
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Estimate required monthly purchases: add required
ending inventory to inventory expected to be used up
during month and deduct beginning inventory
Required ending inventory for each month “moves
ahead” to become estimate of beginning inventory for
following month, and process is repeated
Financial Forecast for the Cutler
Toy Company
5. (continued)
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Required ending inventory for May equals $18,750 which is 75% of
forecasted sales during June and July ($25,000)
Expected sales during May of $10,000 (at sales prices) will use up
$7,5000 of inventory (at cost) during May
Total inventory requirements for May are $26,250
Subtracting beginning inventory of $15,000 results in purchases of
$11,250
$11,250 cash outflow will occur during June
May’s cash outflow will be equal to accounts payable balance on
April 30 of $12,000
Required ending inventory at end of May is “moved forward” to
become estimate of beginning inventory for June, and process is
repeated
Financial Forecast for the Cutler
Toy Company
6. Construct cash budget (see exhibit 7.7)
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Total tax bill of $7,400 is payable in quarterly installments
of $1,850 on April 15, June 30, September 30, and
December 31
Wages of $2,200 per month and other expenses of $150
must be paid
Minimum balance of $2,000 is maintained
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Since bank borrowing is anticipated to support seasonal
inventory needs, the bank supplying loan will most likely require
some minimal compensating balance
Cash budget assumes approval of credit line and is
designed as planning and control technique to monitor
credit line
Financial Forecast for the Cutler
Toy Company
6. (continued)
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Cash budget for May through December 2008
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Cash collections from sales come from cash payment and
collection lags
Cash outflows
Purchase payments are developed in cash collections and
payment forecast
Wages, other expenses, and interest are determined in
forecasted income statement
Taxes represent three quarterly payments remaining on 2008 tax
liability
Total inflows minus total outflows results in predicted net cash
gain or loss during month
Financial Forecast for the Cutler
Toy Company
6. (continued)
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Deducting loss from (or adding gain to) cash balance at
beginning of month yields cumulative end-of-month cash
balance if no outside financing is obtained
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If cash outflow continues to exceed inflows, then this account will
eventually become negative, indicating need for external financing
In May, cash balance is $12,750, including $2,000 minimum
End of July, cash loss of $7,350 subtracted from beginning cash of $7,000
results in cumulative cash without financing of negative $350
Deducting $2,000 minimum cash level from cumulative balance shows total
financing needs of $2,350
Additional cash loans will be required in August ($9,850), September
($14,650), and October ($17,350), so that cumulative end-of-October loan
balance is $44,200
In November, cash inflows exceed outflows following seasonal sales peak
(cash collections accelerate while purchases slow down) and net cash gain is
$15,150, which reduces outstanding loan balance to $29,050
Remainder of loan is paid off in December
Financial Forecast for the Cutler
Toy Company
6. (continued)
– Schedule for cash and loan balances for period
covered by cash budget (see exhibit 7.8):
explicitly lists amount and timing of beginning
cash, required bank borrowing, net cash gain or
loss, repayments, ending loan balance, and
ending cash balance
Financial Forecast for the Cutler
Toy Company
7. Develop forecasted (pro-forma) balance sheet for
year ending December 31, 2008 (see exhibit 7.9)
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Internal consistency: all accounts from balance sheet
follow directly from previous exhibits
Total assets are expected to be $79,150, with liabilities
of $20,250, and equity of $58,900
Financial Forecast for the Cutler
Toy Company
• Remember!
– Foregoing budgeting system is dynamic, not static
– Budget is a planning and control device in dollar terms
– As future planning period becomes current operating period,
budget becomes document for checking operations against
plans and either revising plan or controlling operations to agree
with plan
– Plan contains no provision for interest payments on credit line
– Cash inflows and outflows do not occur at a fairly uniform rate
during month
– Long-term forecasts differ from short-term forecasts primarily in
level of detail required
Long-term Financial Planning
• Long-term financial planning: concerns future
sales growth and devising plans to finance this
growth
• Percentage of sales technique
– As future sales grow, assets will also have to increase
to support sales increases
– Increased assets will be financed by reinvested
earnings and increases in so-called spontaneous
liabilities (i.e. accounts payable)
– Any shortages of financing sources will have to be
provided for from external financing sources (i.e. longterm debt, additional equity)
Long-term Financial Planning
• Cutler believes that sales can be expanded by
– 25% in 2009 and 2010
– 15% in 2011
– 10% in 2012
– 5% per year thereafter
Long-term Financial Planning
• Percentage of sales technique to develop fiveyear financial plan for Cutler Toys
1. Five-year profit forecast requires several key
estimates (see exhibit 7.10)
1. Cost of sales to remain at 75%
2. Expenses to increase from 11.5% to 16% of sales
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Allowance for hiring additional workers
3. After reinvesting profits from past two years,
Cutler and Hook plan to draw a salary from
expanded company
Long-term Financial Planning
2. Forecast Cutler’s balance sheet position at end of
each year (see exhibit 7.11)
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Objective: determine how much external financing will
be required to support expected sales levels
– Estimates as percentages of sales:
• Cash: 4%
• Accounts receivable: 12%
• Inventory: 10%
• Net fixed assets: 6%
• Accounts payable: 5%
• Principle amount due on long-term bank loan is
payable at rate of $5,000 per year for next three years
Long-term Financial Planning
2. Forecast Cutler’s balance sheet position at end of
each year (continued)
– Estimates (continued)
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Equity amount
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In absence of stock sales or redemptions, common stock
account will remain constant
Retained earnings account will increase by amount of aftertax profit earned each year
“Force” or “plug”: figure for external financing
requirements; amount of money required over and
above current liabilities and reinvested earnings to
finance expected future growth
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Forces total of liabilities and equity to equal total assets
Long-term Financial Planning
• Cutler’s forecast for balance sheet position at end of
each year indicates that external financing needs will
grow during high growth years 2009-2010, and then
begin to decline as growth levels off in 2011-2013.
– These external financing requirements are in addition to
normal seasonal fund requirements indicated on one-year
cash budget for 2008.
• These external requirements represent
permanent need for funds that will not begin
to decline until over three years from now.
Long-term Financial Planning
• Adequate financing can be covered by:
– Cutler and Hook’s salaries
– Long-term bank loan
– Potential private financing source (i.e. private
equity investment)