FINANCIAL FORECASTING
Breakeven analysis and cash budgeting are both short-term planning tools. It is
equally important that long-term 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:
2009 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 2009 as well as the projected income
statement for 2010. 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
2009
Actual
======
1,000,000
500,000
-----------500,000
2010
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 2009 above was about right for the level
of sales of $1 million that we experienced in 2009, then we can project the balance sheet
for 2010 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 2010. Since total assets
must equal total liabilities and equity, we will used Additional Financing Required as a
balancing figure.
2010 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
2010. It appears as follows:
2010 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:
Add'l Fin. 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?