4
Financial
Forecasting
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies,
Inc. All rights reserved.
Chapter 4 - Outline
• What is Financial Forecasting?
• 3 Financial Statements for Forecasting
• Determining Production Requirements
• 2 Methods of Financial Forecasting
• Percent-of-Sales Method
• Methods to determine the amount of new funds
required in advance
1-2
What is Financial Forecasting?
LT 4-2
• Financial forecasting is looking ahead to develop a
financial plan for the future
• Provides lead time to make necessary adjustments
before actual events occur
• Helps to plan for significant growth in firm
• Can be used as a target for measuring performance
• Often required by bankers and other lenders
1-3
3 Financial Statements for
Forecasting
PPT 4-5
• Pro Forma Income Statement (I/S)
• Cash Budget
• Pro Forma Balance Sheet (B/S)
The first step is to develop a sales projection
1-4
Development of
Pro Forma Statements
1-5
Development of pro forma
statements
• Establish a sales projection
– Forecast economic conditions
– Survey sales personnel
• Determine production needs, COGs, and gross profit
–
–
–
–
Determine units to be produced
Determine the cost of producing the units
Compute cost of goods sold
Compute gross profit
• Compute other expenses
– General and administrative
– Interest expense
• Finally construct the pro forma income statement
1-6
Establish a Sales Projection
• Let us assume Goldman Corporation has
two primary products: wheels and casters
1-7
Determining Production
Requirements
LT 4-4
– Projected Units Sales
PLUS
– Desired Ending Inventory (EI) MINUS
– Beginning Inventory (BI)
EQUALS
– Production Requirements
– (or Units to be Produced)
1-8
Stock of Beginning Inventory
• Number of units produced will depend on
beginning inventory
1-9
Production Requirements
for Six Months
1-10
Unit Costs
• Cost to produce each unit:
1-11
Total Production Costs
1-12
Cost of Goods Sold
• Costs associated with units sold during the
time period
– Assumptions for the illustration:
• FIFO accounting is used
• First allocates the cost of current sales to beginning
inventory
• Then to goods manufactured during the period
1-13
Allocation of Manufacturing Cost
and Determination of Gross Profits
1-14
Value of Ending Inventory
1-15
Other Expense Items
• Must be subtracted from gross profits to
arrive at net profit
– Earning before taxes
• General and administrative expenses, and interest
expenses are subtracted from gross profit
– Aftertax income
• Taxes are deducted from the earning before taxes
– Contribution to retained earnings
• Dividends are deducted from the aftertax income
1-16
Actual Pro Forma Income Statement
1-17
Cash Budget
• Pro forma income statement must be
translated into cash flows
– The long-term is divided into short-term pro
forma income statement
– More precise time frames set to help anticipate
patterns of cash inflows and outflows
1-18
Cash budget
• Estimate cash sales and collection timing of credit sales
• Forecast cash payments
–
–
–
–
–
–
–
Payments for materials purchase according to credit terms
Wages
Capital expenditures
Principal payments
Interest payments
Taxes
Dividends
• Determine monthly cash flow (recepits minus payments)
• Construct cash budget
• Determine cash excess or need for borrowing
1-19
Monthly Sales Pattern
1-20
Cash Receipts
• In the case of Goldman Corporation:
– The pro forma income statement is taken for the
first half year:
• Sales are divided into monthly projections
– A careful analysis of past sales and collection
records show:
• 20% of sales is collected in the month
• 80% in the following month
1-21
Monthly Cash Receipts
1-22
Cash Payments
• Monthly costs associated with:
– Inventory manufactured during the period
• Material
• Labor
• Overhead
– Disbursements for general and administrative
expenses
– Interest payments, taxes, and dividends
– Cash payments for new plant and equipment
1-23
Component Costs
of Manufactured Goods
1-24
Cash Payments (cont’d)
• Assumptions for the next two tables:
– Costs are incurred on an equal monthly basis
over a six-month period
– Sales volume varies each month
– Employment of level monthly production to
ensure maximum efficiency
– Payment for material, once a month after
purchases have been made
1-25
Average Monthly
Manufacturing Costs
1-26
Summary of All
Monthly Cash Payments
1-27
Actual Budget
• Difference between monthly receipts and
payments is the net cash flow for the month
– Allows the firm to anticipate the need for funding
at the end of each month
1-28
Monthly Cash Budget
1-29
Cash Budget with Borrowing
and Repayment Provisions
1-30
Pro Forma Balance Sheet
• Represents the cumulative changes over
time
– Important to examine the prior period’s balance
sheet
– Some accounts will remain unchanged, while
others will take new values
• Information is derived from the pro forma income
statement and cash budget
1-31
Development of a
Pro Forma Balance Sheet
1-32
Construction of pro forma balance
sheet
• Assets (source of information)
–
–
–
–
–
–
Cash - (cash budget)
Marketable securities - (previous balance sheet and cash budget)
Accounts receivable - (sales forecast, cash budget)
Inventory - (COGS computation for pro forma income statement)
Plant and equipment - (previous balance sheet + purchase amortization)
• Liabilities and Net Worth
–
–
–
–
–
–
Account payable - (Cash budget work sheet)
Notes payable - (previous balance sheet and cash budget)
Long-term debt - (previous balance sheet plus new issues)
Common stock - (previous balance sheet plus new issues)
Retained earnings - ((previous balance sheet plus projected
addition from pro forma income statement)
1-33
Development of a
Pro Forma Balance Sheet (cont’d)
1-34
Explanation of
Pro Forma Balance Sheet
1-35
Analysis of Pro Forma Statement
• The growth ($25,640) was financed by
accounts payable, notes payable, and profit
– As reflected by the increase in retained earnings
Total assets (June 30, 2005)……$76,140
Total assets (Dec 31, 2004)…….$50,500
Increase…………………………...$25,640
1-36
2 Methods of Financial Forecasting:
– Using Pro Forma, or Projected, Financial
Statements (more exact, time consuming)
– Percent-of-Sales Method for the pro
forma Balance Sheet
1-37
Percent-of-Sales Method
LT 4-6
• A short-cut, less exact, easier method of determining
financing needs
• (The “quick and dirty” approach)
• Assumes that B/S accounts will maintain a constant
percentage relationship to sales
•
More sales will mean more assets which will require
more financing
• Can be summarized by using the Required New
Funding formula
1-38
Determine external financing
• Project assets levels on basis of forecasted sales
• Project spontaneous financing: Some financing is provided
spontaneously when asset levels increase: for example,
account payable and accrued expenses )
• Project internal financing from profit
• Determine external financing = required new assets to
support new sales - spontaneous financing - retained
earnings.
A
L
RNF  S   (S )  PS 2 (1  b)
S1
S1
•
1-39
Balance Sheet
of Howard Corporation
1-40
Percent-of-Sales Method (cont’d)
• Funds required is ascertained
• Financing is planned based on:
– Notes payable
– Sale of common stock
– Use of long-term debt
1-41
Percent-of-Sales Method (cont’d)
• Company operating at full capacity – needs to buy new
plant and equipment to produce more goods to sell:
– Required new funds:
(RNF) = A (ΔS) – L (ΔS) – PS2(1 – D)
S
S
• Where: A/S = Percentage relationship of variable assets to sales; ΔS
= Change in sales; L/S = Percentage relationship of variable
liabilities to sales; P = Profit margin; S2 = New sales level; D =
Dividend payout ratio
RNF = 60% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $60,000 - $25000 - $18,000 (.50)
= $35,000 - $9000
= $26,000 required sources of new funds
1-42
PPT 4-13
Balance sheet with sales increase
HOWARD CORPORATION
Sales
$200,000
Sales increase
50.00%
$100,000
Assets
Before
Cash
Accounts receivable
Inventory
Total current assets
Equipment
Total assets
Increase
After
$
5,000
40,000
25,000
$ 70,000
50,000
$120,000
$ 2,500
20,000
12,500
35,000
25,000
$60,000
$ 7,500
60,000
37,500
105,000
75,000
$180,000
$ 40,000
10,000
15,000
$20,000
5,000
$ 60,000
15,000
15,000
26,000
$116,000
10,000
54,000
Liabilities and Shareholders’ Equity
Accounts payable
Accrued expenses
Notes payable
Required new funds
Total current liabilities
Common stock
Retained earnings
Total liabilities and shareholders’
equity
$ 65,000
10,000
45,000
$120,000
9,000
$34,000
180,000
Selected ratios
Debt/Total assets
Debt/Equity
Current ratio
65/120
65/(10+45)
70/65
=.054
=1.18
=1.08
116/180
116(10+54)
105/116
=.064
=1.81
=0.91
1-43
Percent-of-Sales Method (cont’d)
• Company not operating at full capacity - needs to add more
current assets to increase sales:
RNF = 35% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 – .50)
= $35,000 - $25,000 - $18,000 (.50)
= $35,000 - $25,000 - $9,000
= $1,000 required sources of new funds
1-44
Sustainable growth rate
D
P (1  b)(1  )
S
E
SGR 

A
D
S1
 P (1  b)(1  )
S1
E
1-45
Sustainable growth rate
ROE  (1  b)
SGR 
1  ROE  (1  b)
1-46
PPT 4-14
Balance sheet with sustainable sales increase
HOWARD CORPORATION
Sales
$200,000
Sales increase
12.24%
$ 24,480
Assets
Before
Cash
Accounts receivable
Inventory
Total current assets
Equipment
Total assets
Increase
$
5,000
40,000
25,000
$ 70,000
50,000
$120,000
$
612
4,896
3,060
8,568
6,120
$14,688
$ 40,000
10,000
15,000
$ 4,896
1,224
After
$ 5,612
44,896
28,060
78,568
56,120
$134,688
Liabilities and Shareholders’ Equity
Accounts payable
Accrued expenses
Notes payable
Required new funds
Total current liabilities
Common stock
Retained earnings
Total liabilities and shareholders’
equity
$ 65,000
10,000
45,000
$120,000
6,120
6,734
$12,854
$ 44,896
11,224
15,000
1,834
$ 72,954
10,000
51,734
$134,688
Selected ratios
Debt/Total assets
Debt/Equity
Current ratio
65/120
65/(10+45)
70/65
=0.54
=1.18
=1.08
73/135
73/(10+52)
79/73
=0.54
=1.18
=1.08
1-47
Internal Growth Rate
A
( S )  P ( S1  S )(1  b)
S1
A
( S )  PS1 (1  b)  sp (1  b)
S1
A
 P (1  b)]  PS1 (1  b)
S [
S1
P (1  b)
S

g* 
A
S1
 P (1  b)
S1
1-48
Internal Growth Rate
ROA (1  b)
g* 
1  ROA (1  b)
1-49