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Chapter

McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Forecasting

4

Chapter Outline

  • Financial forecasting in a firm’s strategic growth.
  • Three financial statements.
  • Percent-of-sales method.
  • Various methods to determine the amount of new funds required in advance.
  • Factors that affect cash flow.

Financial Forecasting

  • Ability to plan ahead and make necessary changes before actual events occur.
  • Outcome of a firm through external events might be a function of both:
  • Risk-taking desires.
  • Ability to hedge against risk with planning.
  • No growth or a decline - not the primary cause of shortage of funds.
  • A comprehensive financing plan must be developed for a significant growth.

Constructing Pro Forma Statements

  • A systems approach to develop pro forma statements consists of:
  • Constructing it based on:
  • Sales projections
  • Production plans
  • Translating it into a cash budget.
  • Assimilating all materials into a pro forma balance sheet.

Development of Pro Forma Statements

Pro Forma Income Statement

  • Provides a projection on the anticipation of profits over a subsequent period.
  • Establish a sales projection.
  • Determine a production schedule and the associated use of new material, direct labor, and overhead to arrive at a gross profit.
  • Compute other expenses.
  • Determine profit by completing the actual pro forma statement.

Establish a Sales Projection

  • Lets assume Goldman Corporation has two primary products: wheels and casters.

Stock of Beginning Inventory

  • Number of units produced will depend on beginning inventory.

Determine a Production Schedule and the Gross Profit

  • To determine the production requirements:

Units

+ Projected sales

+ Desired ending inventory

– Beginning inventory

= Production requirements

Production Requirements for Six Months

Unit Costs

  • Cost to produce each unit:

Total Production Costs

Cost of Goods Sold

  • Costs associated with units sold during the time period.
  • Assumptions for the illustration:
  • FIFO accounting is used
  • Therefore allocation of cost of current sales to beginning inventory
  • Then to goods manufactured during this period

Allocation of Manufacturing Costs and Determination of Gross Profit

Value of Ending Inventory

Other Expense Items

  • Other expense items must be subtracted from gross profits to arrive at net profit.
  • Earning before taxes
  • General and administrative expenses, interest expenses are subtracted from gross profit.
  • Earning after-taxes
  • Taxes are deducted from the above sum balance.
  • Contribution to retained earnings
  • Dividends are deducted from the above sum balance.

Actual Pro Forma Income Statement

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 are set to help in anticipating the patterns of cash outflows and inflows.

Monthly Sales Pattern

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 shows:
  • 20% of sales is collected in the month.
  • 80% in the following month.

Monthly Cash Receipts

Cash Payments

  • Monthly costs associated with:
  • Inventory manufactured during the period (material, labor and overhead).
  • Disbursements for general and administrative expenses.
  • Interest payments, taxes and dividends.
  • Cash payments for new plant and equipment.

Component Costs of Manufactured Goods

Cash Payments (cont’d)

  • Assumptions for the next two tables:
  • The costs are incurred on an equal monthly basis over a six-month period.
  • The sales volume however varies each month.
  • Employment of level monthly production to ensure maximum efficiency.
  • Payment for material, once a month after purchases have been made.

Average Monthly Manufacturing Costs

Summary of Monthly Cash Payments

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.

Monthly Cash Budget

Cash Budget with Borrowing and Repayment Provisions

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.

Development of a Pro Forma Balance Sheet

Pro Forma Balance Sheet (cont’d)

Explanation of Pro Forma Balance Sheet

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

Percent-of-Sales Method

  • Based on the assumption that:
  • Accounts on the balance sheet will maintain a given percentage relationship to sales.
  • Notes payable, common stock, and retained earnings do not maintain a direct relationship with sales volume.
  • Therefore percentages are not computed.

Balance Sheet of Howard Corporation

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 debts.

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) – P (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; = 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 source of new funds.

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 source of new funds.