4-1Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 4

Financial Forecasting

4-2

Chapter Outline• Financial forecasting in a firm’s strategic growth

• Three financial statements

• Percent-of-sales method

• Methods to determine the amount of new funds required in advance

• Factors that affect cash flow

4-3

Financial Forecasting

• Ability to plan ahead and make necessary adjustments 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

4-4

Constructing Pro Forma Statements

• Pro forma, or projected, financial statements enable a firm to estimate its future level of receivables, inventory, payables, as well as its anticipated profits and borrowing requirements.

• These statements are often required by bankers and other lenders as a guide for the future.

• A systems approach to develop pro forma statements consists of:

• Constructing income statement based on sales projections and the production plan

• Translating it into a cash budget

• Assimilating all materials into a pro forma balance sheet

4-5

Development of Pro Forma Statements

4-6

Pro Forma Income Statement

• Provides a projection on the anticipation of profits over a subsequent period

• Four important steps include:• Establishing a sales projection• Determining production schedule and the

associated use of new material, direct labor, and overhead to arrive at gross profit

• Computing other expenses• Determining profit by completing actual pro

forma statement

4-7

Establish a Sales Projection

• Let us assume Goldman Corporation has two primary products: wheels and casters

Table 4-1

4-8

Determine a Production Schedule and the Gross Profit

• Number of units produced will depend on: • Beginning inventory• Sales projections• Desired ending inventory

• To determine the production requirements:

Units

+ Projected sales

+ Desired ending inventory

– Beginning inventory

= Production requirements

4-9

Stock of Beginning Inventory

Goldman Corporation has in stock the items shown in the Table below:

Table 4-2

4-10

Production Requirements for Six Months

Table 4-3

4-11

Unit Costs• Cost to produce each unit:• Table 4-4

4-12

Total Production Costs

Table 4-5

4-13

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

4-14

Allocation of Manufacturing Cost and Determination of Gross

ProfitsTable 4-6

4-15

Value of Ending Inventory

Table 4-7

4-16

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

4-17

Actual Pro Forma Income Statement

Table 4-8

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Cash Budget

• Pro forma income statement must be translated into cash flows

• The long-term pro forma is divided into smaller

• More precise time frames set to help anticipate patterns of cash inflows and outflows

4-19

Monthly Sales Pattern

Table 4-9

4-20

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

4-21

Monthly Cash Receipts

Table 4-10

4-22

Component Costs of Manufactured Goods

Table 4-11

4-23

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

4-24

Cash Payments (cont’d)

• Assumptions for the next two tables:

• Costs are incurred on an equal monthly basis over a six-month period

• Maintain production level to ensure maximum efficiency though sales volume varies from month to month

• Payment for material, once a month after purchases have been made

4-25

Average Monthly Manufacturing Costs

Table 4-12

4-26

Summary of All Monthly Cash Payments

Table 4-13

4-27

Actual Budget (Monthly Cash Flow)

• 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

Table 4-14

4-28

Cash Budget with Borrowing and Repayment Provisions

• Assumptions:

– The firm wishes to maintain minimum cash balance

– If the balance goes below the minimum, the firm will borrow

– If the balance goes above the minimum, the firm will use the excess to repay the loan

4-29

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

4-30

Development of a Pro Forma Balance Sheet

Table 4-16

4-31

Development of a Pro Forma Balance Sheet

(cont’d)

4-32

Pro Forma Balance Sheet

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Explanation of Pro Forma Balance Sheet

• Cash ( $5,000 )-minimum cash balance as shown in Table 4–15• Marketable securities ( $3,200 )-remains unchanged from prior

period’s value in Table 4–16• Accounts receivable ( $16,000 )-based on June sales of $20,000

in Table 4–10 (80% of current month sales become accounts receivables)

• Inventory ( $6,200 )-ending inventory as shown in Table 4–7.• Plant and equipment ( $27,740+ $18,000) $45,740• Accounts payable ( $5,732 )-based on June purchases in Table

4–13• Notes payable ( $5,884 )-the amount that must be borrowed to

maintain the cash balance of $5,000, as shown in Table 4–15• Long-term debt ( $15,000 )-remains unchanged from prior

period’s value in Table 4–16• Common stock ( $10,500 )-remains unchanged from prior

period’s value in Table 4–16• Retained earnings ( $39,024 )-initial value plus pro forma

income ($20,500 + $18,524)

4-34

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, 2011)……$76,140

Total assets (Dec 31, 2010)…….$50,500

Increase…………………………...$25,640

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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

• Hence percentages are not computed

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Balance Sheet of Howard Corporation

4-37

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

4-38

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

4-39

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