Chapter 17
Financial
Forecasting
and Planning
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Slide Contents
• Learning Objectives
1. An Overview of Financial Planning
2. Developing a Long-term Financial Plan
3. Developing a Short-Term Financial Plan
• Key Terms
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Learning Objectives
1. Understand the goals of financial
planning.
2. Use the percent of sales method to
forecast the financing requirements of a
firm including its discretionary financing
needs.
3. Prepare a cash budget and use it to
evaluate the amount and timing of a
firm’s short-term financing requirements.
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17.1 An Overview
of Financial
Planning
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An Overview of Financial Planning
• What is the primary objective of preparing
financial plans?
– To estimate the future financing requirements
in advance of when the financing will be
needed.
• The process of planning is critical to force
managers to think systematically about
the future, despite the uncertainty of
future.
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An Overview of Financial Planning
(cont.)
• Most firms engage in three types of
planning:
– Strategic planning,
– Long-term financial planning, and
– Short-term financial planning
• Strategic plan defines, in very general
terms, how the firm plans to make money
in the future. It serves as a guide for all
other plans.
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An Overview of Financial Planning
(cont.)
• The long-term financial plan generally
encompasses a period of three to five
years and incorporates estimates of the
firm’s income statements and balance
sheets for each year of the planning
horizon.
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An Overview of Financial Planning
(cont.)
• The short-term financial plan spans a
period of one year or less and is a very
detailed description of the firm’s
anticipated cash flows.
• The format typically used is a cash
budget, which contains detailed revenue
projections and expenses in the month in
which they are expected to occur for each
operating unit of the company.
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17.2 Developing
a Long-Term
Financial Plan
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Developing a Long-Term Financial
Plan
• Forecasting a firm’s future financing needs
using a long-term financial plan can be
thought of in terms of three basic steps:
1. Construct a sales forecast
2. Prepare pro-forma financial statements
3. Estimate the firm’s financing needs
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Developing a Long-Term Financial
Plan (cont.)
•
Step 1: Construct a Sales Forecast
–
Sales forecast is generally based on:
1. past trend in sales; and
2. the influence of any anticipated events that
might materially affect that trend.
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Developing a Long-Term Financial
Plan (cont.)
• Step 2: Prepare Pro Forma Financial
Statements
– Pro forma financial statements help forecast a
firm’s asset requirements needed to support
the forecast of revenues (step 1).
– The most common technique is percent of
sales method that expresses expenses,
assets, and liabilities for a future period as a
percentage of sales.
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Developing a Long-Term Financial
Plan (cont.)
• Step 3: Estimate the Firm’s Financing
Needs
– Using the pro forma statements we can extract
the cash flow requirements of the firm.
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Financial Forecasting Example
• Table 17-1 illustrates how Ziegen, Inc.
uses the percent of sales method to
construct pro forma income statement and
pro forma balance sheet.
• The company uses the three-step
approach to financial planning.
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Financial Forecasting Example
(cont.)
• Step 1: Forecast Revenues and Expenses
– Zeigen’s financial analyst estimate the firm will
earn 5% on the projected sales of $12 million
in 2010.
– Zeigen plans to retain half of its earnings and
distribute the other half as dividends.
– See Table 17-1
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Financial Forecasting Example
(cont.)
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Financial Forecasting Example
(cont.)
• Step 2: Prepare Pro Forma Financial
Statements
– The firm’s need for assets to support firm sales
is forecasted using percent of sales method,
where each item in the balance sheet is
assumed to vary in accordance with its percent
of sales for 2010.
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Financial Forecasting Example
(cont.)
• Step 3: Estimate the Firm’s Financing
Requirements
– This involves comparing the projected level of
assets needed to support the sales forecast to
the available sources of financing.
– In essence, we now forecast the liabilities and
owner’s equity section of the pro forma balance
sheet.
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Sources of Spontaneous Financing –
Accounts Payable and Accrued Expenses
• Accounts payable and accrued expenses
are typically the only liabilities that vary
directly with sales.
• Accounts payable and accrued expenses
are referred to as sources of
spontaneous financing. The percent of
sales method can be used to forecast the
levels of both these sources of financing.
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Sources of Discretionary Financing
• Raising financing with notes payable, longterm debt and common stock requires
managerial discretion and hence these
sources of financing are called
discretionary sources of financing.
• The retention of earnings is also a
discretionary source as it is the result of
firm’s discretionary dividend policy.
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Summarizing Ziegen’s Financial
Forecast
• Discretionary Financing Needs (DFN)
= {Total Financing Needs} less {Projected
Sources of Financing}
= {$7.2 m (increase in assets)} – {$2.4m in
spontaneous financing + $2.5m in short and
long-term debt + $1.8 million in equity}
= $7.2 million - $6.7 million = $500,000
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Summarizing Ziegen’s Financial
Forecast (cont.)
• The firm has to raise $500,000 with some
combination of borrowing (short-term or
long-term) or the issuance of stock.
• Since they require a managerial decision,
they are referred to as the firm’s
discretionary financing needs (DFN).
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Summarizing Ziegen’s Financial
Forecast (cont.)
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Analyzing the Effects of Profitability and
Dividend Policy on the Firm’s DFN
• After projecting DFN, we can easily
evaluate the sensitivity of DFN to changes
in key variables.
• The table (on next slide) shows that as
dividend payout ratios and net profit
margin vary, DFN also changes
significantly from a negative $40,000 to
$764,000.
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Analyzing the Effects of Profitability and
Dividend Policy on the Firm’s DFN (cont.)
DFN for Various Net Profit Margins and
Dividend Payout Ratio (DPR)
Net Profit
Margin
DPR =30%
DPR=50%
DPR=70%
1%
$716,000
$740,000
$764,000
5%
$380,000
$500,000
$620,000
10%
$(40,000)
$200,000
$440,000
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Analyzing the Effects of Sales
Growth on a Firm’s DFN
• Table 17-2 considers the impact of sales
growth rates of 0%, 20% and 40% on
DFN.
• It is observed that DFN ranges from
($250,000) at 0% growth rate to
$1,250,000 at 40% growth rate. A
negative DFN indicates that the firm has
surplus dollars in financing.
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Checkpoint 17.1
Estimating Discretionary Financing Needs
The Pendleton Chemical Company manufactures a line of
personal health care products used in preventing the spread of
infectious diseases. The company’s principal product is a germkilling hand sanitizer called “Bacteria-X”. In 2010, Pendleton
had $5 million in sales, and anticipates an increase of 15% in
2011. After performing an analysis of the firm’s balance sheet,
the firm’s financial manager prepared the following pro forma
income statement and balance sheet for next year:
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Checkpoint 17.1
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Checkpoint 17.1
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Checkpoint 17.1
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Checkpoint 17.1
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Checkpoint 17.1
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Checkpoint 17.1: Check Yourself
• Pendleton’s management estimates that
under the most optimistic circumstances it
might experience a 40% rate of growth of
sales in 2011. Assuming that net income
is 5% of firm sales and that both current
and fixed assets are equal to a fixed
percent of sales (as found in the above
forecast), what do you estimate the firm’s
DFN to be under these optimistic
circumstances?
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Step 1: Picture the Problem
• The firm’s DFN is equal to the financing
the firm requires for the year that is not
provided by spontaneous sources such as
accounts payable and accrued expenses
plus retained earnings for the period.
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Step 2: Decide on a Solution
Strategy
• We can calculate the DFN using the
following equation:
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Step 3: Solve
Line
Performa Income Statement for 2011
1
Growth Rate
2
Sales
3
Net Income
40%
$7,000,000.00
Performa Balance Sheet for 2011
Multiple Computation
4
Current Assets
0.20
$1,400,000.00
5
Net Fixed Assets
0.6
$4,200,000.00
6
Total
7
Accounts Payable
0.2
$1,150,000.00
8
Accrued Expenses
0.1
$575,000.00
9
Notes Payable
10
Current Liabilities
11
Long-term Debt
12
Common Stock (par)
$100,000.00
13
Paid-in-capital
$200,000.00
14
Retained Earnings
15
Common Equity
4+5
$5,600,000.00
$500,000.00
7+8+9
$2,225,000.00
$1,000,000.00
$1,050,000.00
12+13+14
$1,350,000.00
$987,500 + Line3 - $287,500
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Step 4: Analyze
• If the firm experiences a 40% growth rate
in sales, Pendleton can expect to raise
$1,025,000 during the coming year.
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17.3
Developing a
Short-Term
Financial Plan
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Developing a Short-Term Financial
Plan
• Unlike a long-term financial plan that is
prepared using pro forma income
statements and balance sheets, short-term
financial plan is typically presented in the
form of a cash budget that contains details
concerning the firm’s cash receipts and
disbursements.
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Developing a Short-Term Financial
Plan (cont.)
• Cash budget includes the following main
elements:
–
–
–
–
Cash receipts,
Cash disbursements,
Net change in cash, and
New financing needed.
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Uses of the Cash Budget
1. It is a useful tool for predicting the
amount and timing of the firm’s future
financing requirements.
2. It is a useful tool to monitor and control
the firm’s operations.
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Uses of the Cash Budget (cont.)
• The actual cash receipts and
disbursements can be compared to
budgeted estimates, bringing to light any
significant differences.
• In some cases, the differences may be
caused by cost overruns or poor collection
from credit customers. Remedial action
can then be taken.
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Key Terms
•
•
•
•
•
•
•
Cash budget
Discretionary financing needs (DFN)
Discretionary sources of financing
Long-term financial plan
Percent of sales method
Pro forma balance sheet
Pro forma income statement
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Key Terms (cont.)
• Short-term financial plan
• Sources of spontaneous financing
• Strategic plan
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