Chapter 4 Mc GrawHillIrwin Financial Forecasting Copyright 2011

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Chapter 4 Mc. Graw-Hill/Irwin Financial Forecasting Copyright © 2011 by The Mc. Graw-Hill Companies,

Chapter 4 Mc. Graw-Hill/Irwin Financial Forecasting Copyright © 2011 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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

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 -2

Financial Forecasting • Ability to plan ahead and make necessary adjustments before actual events

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 -3

Constructing Pro Forma Statements • Pro forma, or projected, financial statements enable a firm

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 -4

Development of Pro Forma Statements 4 -5

Development of Pro Forma Statements 4 -5

Pro Forma Income Statement • Provides a projection on the anticipation of profits over

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 -6

Establish a Sales Projection • Let us assume Goldman Corporation has two primary products:

Establish a Sales Projection • Let us assume Goldman Corporation has two primary products: wheels and casters Table 4 -1 4 -7

Determine a Production Schedule and the Gross Profit • Number of units produced will

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 -8

Stock of Beginning Inventory Goldman Corporation has in stock the items shown in the

Stock of Beginning Inventory Goldman Corporation has in stock the items shown in the Table below: Table 4 -2 4 -9

Production Requirements for Six Months Table 4 -3 4 -10

Production Requirements for Six Months Table 4 -3 4 -10

Unit Costs • Cost to produce each unit: Table 4 -4 4 -11

Unit Costs • Cost to produce each unit: Table 4 -4 4 -11

Total Production Costs Table 4 -5 4 -12

Total Production Costs Table 4 -5 4 -12

Cost of Goods Sold • Costs associated with units sold during the time period

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 -13

Allocation of Manufacturing Cost and Determination of Gross Profits Table 4 -6 4 -14

Allocation of Manufacturing Cost and Determination of Gross Profits Table 4 -6 4 -14

Value of Ending Inventory Table 4 -7 4 -15

Value of Ending Inventory Table 4 -7 4 -15

Other Expense Items • Must be subtracted from gross profits to arrive at net

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 -16

Actual Pro Forma Income Statement Table 4 -8 4 -17

Actual Pro Forma Income Statement Table 4 -8 4 -17

Cash Budget • Pro forma income statement must be translated into cash flows –

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 -18

Monthly Sales Pattern Table 4 -9 4 -19

Monthly Sales Pattern Table 4 -9 4 -19

Cash Receipts • In the case of Goldman Corporation: – The pro forma income

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 -20

Monthly Cash Receipts Table 4 -10 4 -21

Monthly Cash Receipts Table 4 -10 4 -21

Component Costs of Manufactured Goods Table 4 -11 4 -22

Component Costs of Manufactured Goods Table 4 -11 4 -22

Cash Payments • Monthly costs associated with: – Inventory manufactured during the period •

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 -23

Cash Payments (cont’d) • Assumptions for the next two tables: – Costs are incurred

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 -24

Average Monthly Manufacturing Costs Table 4 -12 4 -25

Average Monthly Manufacturing Costs Table 4 -12 4 -25

Summary of All Monthly Cash Payments Table 4 -13 4 -26

Summary of All Monthly Cash Payments Table 4 -13 4 -26

Actual Budget (Monthly Cash Flow) • Difference between monthly receipts and payments is the

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 -27

Cash Budget with Borrowing and Repayment Provisions • Assumptions: – The firm wishes to

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 Table 4 -15 4 -28

Pro Forma Balance Sheet • Represents the cumulative changes over time – Important to

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 -29

Development of a Pro Forma Balance Sheet Table 4 -16 4 -30

Development of a Pro Forma Balance Sheet Table 4 -16 4 -30

Development of a Pro Forma Balance Sheet (cont’d) 4 -31

Development of a Pro Forma Balance Sheet (cont’d) 4 -31

Pro Forma Balance Sheet 4 -32

Pro Forma Balance Sheet 4 -32

Explanation of Pro Forma Balance Sheet • Cash ( $5, 000 )—minimum cash balance

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 -33

Analysis of Pro Forma Statement • The growth ($25, 640) was financed by accounts

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 4 -34

Percent-of-Sales Method • Based on the assumption that: – Accounts on the balance sheet

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 4 -35

Balance Sheet of Howard Corporation 4 -36

Balance Sheet of Howard Corporation 4 -36

Percent-of-Sales Method (cont’d) • Funds required is ascertained • Financing is planned based on:

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 -37

Percent-of-Sales Method (cont’d) • Company operating at full capacity – needs to buy new

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) – PS 2(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; S 2 = 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 -38

Percent-of-Sales Method (cont’d) • Company not operating at full capacity - needs to add

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 4 -39