Chapter 11
Forecasting Financial Requirements
CHAPTER OUTLINE
Spotlight: Planning for Growth
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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)
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Chapter 11
Forecasting Financial Requirements

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
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Chapter 11
Forecasting Financial Requirements
 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 JanuaryMarch
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.
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Chapter 11
Forecasting Financial Requirements
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
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Chapter 11
Forecasting Financial Requirements
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 303304: 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.
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Chapter 11
Forecasting Financial Requirements
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:
Best Case Sales/Profit Effects:
Sales
200,000
$325,000
100,000
100,000
40,000
65,000
140,000
165,000
60,000
160,000
46,000
46,000
Depreciation Ex
4,000
4,000
Variable Op Exp
60,000
97,500
110,000
147,500
Operating profits (50,000)
12,500
CGS sold:
Fixed cost
Variable CGS
Total CGS
Gross Profits
Operating Exp
Fixed Op Exp
Total Op Exp
Interest Exp
8,000
8,000
Profits before tax (58,000)
20,500
Taxes (25%)
Net Profits
120
0
5,125
(58,000)
15,375
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Chapter 11
Forecasting Financial Requirements
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
78,000
126,750
Gross Fixed Asse
50,000
50,000
Accum Depr
(4,000)
(4,000)
Net fixed asse
46,000
46,000
124,000
172,750
16,000
26,000
8,000
13,000
Short-term line
14,500
000000
Total Curr Lia
33,500
39,000
Mortgage
27,000
27,000
Total Debt
60,500
66,000
116,500
100,875
Retained earnings (58,000)
5,875
Total Assets
A/P
Accrued Exp
Equity
Common stock
Total equity
58,500
106,750
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
$9,125.
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Chapter 11
Forecasting Financial Requirements
Situation 2
1. Prepare a monthly cash budget for the three-month period ending in December.
October
November
December
January
Monthly Sales
200,000
220,000
180,000
Inventory Purch
165,000
135,000
150,000
Monthly Sales
Cash Receipts
200,000
220,000
180,000
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
171,250
195,000
202,000
201,000
Cash Disburs
150,000
165,000
135,000
150,000
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
Pmts on
Purch
200,000
Inv.
Wages & Sala
Tax Prepayment
10,000
Interest on Bank
Note
1,500
Total Cash Disb
196,000
201,600
171,900
186,000
Cash flows from
Oper
(24,750)
(6,600)
30,100
15,000
Beg Cash Bal
7,000
Line of Credit
24,750
122
6,600
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Chapter 11
Forecasting Financial Requirements
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.
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Chapter 11
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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
Plus Depreciation
Less Income Taxes
Adjusted Income
Less increase in A/R
Less increase in inventories
Plus increase in A/P
Change in Net Working Capital
Cash Flows from Operations
3,245,000
2,050,000
(888,000)
4,407,000
(660,000)
90,000
(570,000)
3,837,000
Investment Activities:
Less increase in gross fixed assets
(7,700,000)
Financing Activities:
Less interest expense
Less dividends paid
Plus increase in short-term notes
Plus increase in long-term debt
Total Financing Activities
(1,025,000)
(100,000)
(800,000)
5,517,000
3,592,000
Increase in cash
271,000
2. 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
Total current liabilities
124
= 20,962,000 = 2.130
9,840,000
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publicly accessible website, in whole or in part.
Chapter 11
Forecasting Financial Requirements
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
Total Asset Turnover =
89,200,000
Sales
= 89,200,000 = 2.26
Total Assets
39,387,000
Debt Ratio = Total Debt = 22,405,000 = 56.88%
Total Assets
Return on Equity =
39,387,000
Net Profits
=
Owner’s Equity
1,920,000
= 11.30%
16,982,000
Current Ratio =
2.130
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.
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Chapter 11
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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 2.42. 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.
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