Financial

4 Forecasting

Chapter
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
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
4-3
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

4-4
 Development of
Pro Forma Statements

4-5
 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: wheels and casters

4-7
 Stock of Beginning Inventory
• Number of units produced will depend on
beginning inventory

4-8
 Determine a Production Schedule
and the Gross Profit
• To determine the production requirements:
Units
+ Projected sales
+ Desired ending inventory
– Beginning inventory
= Production requirements

4-9
Production Requirements
for Six Months

4-10
 Unit Costs
• Cost to produce each unit:

4-11
Total Production Costs

4-12
 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

4-13
 Allocation of Manufacturing Cost
and Determination of Gross Profits

4-14
Value of Ending Inventory

4-15
 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

4-16
Actual Pro Forma Income Statement

4-17
 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

4-18
Monthly Sales Pattern

4-19
 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

4-21
 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

4-22
 Component Costs
of Manufactured Goods

4-23
 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

4-24
 Average Monthly
Manufacturing Costs

4-25
 Summary of All
Monthly Cash Payments

4-26
 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

4-27
Monthly Cash Budget

4-28
Cash Budget with Borrowing
and Repayment Provisions

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

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

4-32
 Explanation of
Pro Forma Balance Sheet

4-33
 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

4-34
 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
 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
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
4-38
 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