Financial Forecasting Prepared by: Terry Fegarty Seneca College Revised By P Chua McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Chapter 4 - Outline What is Financial Planning/Forecasting? PPT 4-2 Chapter 4 - Outline What is Financial Planning/Forecasting? Uses/Importance of Financial Planning/Forecasting Characteristics of a Good Financial Plan/Forecast 3 Financial Statements for Forecasting Pro Forma Income Statement Cash Budget Pro forma Balance Sheet Percent-of-Sales Method Summary and Conclusions

What is Financial Planning/Forecasting? Financial Planning/Forecasting is the process of predicting a firm’s short-run cash needs and profit/financial position. Its outcome are Short-term financial plans with periods usually ranging from 6 months to one year. Short-term financial plans are part of a firm’s overall Long-Term Strategic Plan which guide the formulation of the short-term Financial Plans. Long-Term Strategic Plan have time periods ranging from 1 to 10 years. Three key aspects of the financial planning/forecasting process. Cash Planning, forecasting the need for cash. Forecasting future profitability. Forecasting the need for financing. Its concrete outcomes are: Cash Budget Proforma Income Statement Proforma Balance Sheet

Uses/Importance of Financial Planning/Forecasting Financial Planning/Forecasting provides road maps for guiding, coordinating and controlling the firm’s actions to achieve its objectives. Financial Planning/Forecasting is vital to a firm’s short-run success. It allows financial managers to anticipate events before they occur; for one, it helps a firm plan to have sufficient cash to remain in business in the short-term. Anticipating the firm’s short-run cash inflows and outflows are crucial to its continuing success in the business. It helps firms avoid surprises in terms of cash needs.

Uses/Importance of Financial Planning/Forecasting Financial Planning/Forecasting is important because a firm’s success in the long-run depends on its ability to foresee and plan for its future in the short-run with certainty; that is, its ability to hedge against risk. Cash Budget is a very important tool used to measure/control a firm’s actual performance/expenditures. It is also used to determine borrowing needs. Financial Plans are required by bankers and other lenders to determine whether to extend loan to a firm Pro-forma Balance Sheets provide information as to the future capital/financing needs of a firm

Characteristics of a Good Financial Plan/Forecast Is accurate and realistic as possible; considers local and broad economic environment, social/political issues, technological changes, competitors’ strategies, product market outlook, production capacity, manpower availability, etc. Has the consensus or approval of all the stakeholders in the firm –marketing, production, treasury, accounting, etc. Is updated regularly as new developments are known but is still part of the overall long-term strategic plan

3 Financial Statements for Forecasting PPT 4-5 3 Financial Statements for Forecasting Pro Forma Income Statement (I/S) Cash Budget Pro Forma Balance Sheet (B/S) The first step is to develop a sales projection

Basis for Sales Projections PPT 4-7 Basis for Sales Projections External Factors Recession or boom Economic Indicators (GDP, disposable Personal Income, etc) and monetary indicators (Interest rates and growth in money supply) Competition Technology Social/Political climate etc. Internal Factors Based on the consensus of forecasts from all sales channels Final adjustment by the Sales Managers based on expert knowledge of product market Profit targets Production Capacity Manpower Availability etc

Figure 4-1 Development of pro forma statements PPT 4-6 Figure 4-1 Development of pro forma statements Cash budget Sales projection Production plan Pro forma income statement balance sheet Prior balance Other supportive budgets Capital budget 1 2 3

Steps in a Pro Forma Income Statement PPT 4-9 1. Establish a sales projection 2. Determine a production or purchases schedule 3. Forecast other expenses 4. Determine profit

Table 4-1 Projected wheel and caster sales (first six months, 2005) PPT 4-8 Table 4-1 Projected wheel and caster sales (first six months, 2005) Goldman Corporation Wheels Casters Quantity Sales price Sales revenue Total . . . . . . . . . . . . . . . 1,000 2,000 $30 $35 $30,000 $70,000 . . . . . . . . . . . . . . $100,000

Production (or Purchases) Schedule PPT 4-10 Production (or Purchases) Schedule Projected sales -in Units or $ PLUS Desired ending inventory MINUS Beginning inventory EQUALS Production (or Purchases)

Table 4-2 Stock of beginning inventory PPT 4-11 Table 4-2 Stock of beginning inventory Wheels Casters Quantity . . . 85 180 Cost . . . . $16 $20 Total value . . $1,360 $3,600 Total . . . . . . . . . . . . $4,960

Table 4-3 Production requirements for six months PPT 4-12 Table 4-3 Production requirements for six months Wheels Casters Projected unit sales (Table 4-1) . . . +1,000 +2,000 Desired ending inventory (assumed to represent 10% of unit sales for the time period) . . . . . . . . +100 +200 Beginning inventory (Table 4-2). . . – 85 –180 Units to be produced . . . . . . 1,015 2,020

Table 4-4 Unit costs Wheels Casters Materials . . . . $10 $12 PPT 4-13 Table 4-4 Unit costs Wheels Casters Materials . . . . $10 $12 Labour . . . . 5 6 Overhead . . . . 3 4 Total . . . . $18 $22

Table 4-5 Total production costs PPT 4-14 Table 4-5 Total production costs Wheels Casters Units to be produced (Table 4-3) . . 1,015 2,020 Cost per unit (Table 4-4) . . . . $18 $22 Total cost . . . . . . . . $18,270 $44,440 = $62,710

PPT 4-15 Table 4-6 Allocation of manufacturing costs and determination of gross profits Wheels Casters Combined Quantity sold (Table 4-1) . 1,000 2,000 3,000 Sales price . . . . . $ 30 $ 35 Sales revenue . . . . $30,000 $70,000 $100,000 Cost of goods sold: Old inventory (Table 4-2) Quantity (units) . . 85 180 Cost per unit . . . $16 $20 Total . . . . $ 1,360 $ 3,600 New inventory (the remainder) Quantity (units) . . 915 1,820 Cost per unit (Table 4-4) $18 $22 Total . . . . 16,470 40,040 Total cost of goods sold 17,830 43,640 $61,470 Gross profit . . . . $12,170 $26,360 $38,530

Pro Forma Income Statement PPT 4-17 Table 4-8 Pro Forma Income Statement June 30, 2005 Sales revenue . . . . . . . 100,000 Cost of goods sold . . . . . 61,470 Gross profit . . . . . . . 38,530 Selling, general and administrative expense 12,000 Operating profit (EBIT) . . . . 26,530 Interest expense . . . . . . 1,500 Earnings before taxes (EBT) . . . 25,030 Taxes (20%) . . . . . . . 5,006 Earnings aftertaxes (EAT) . . . 20,024 Common stock dividends . . . . 1,500 Increase in retained earnings . . . $ 18,524

Table 4-7 Value of ending inventory PPT 4-16 Table 4-7 Value of ending inventory Beginning inventory (Table 4-2) . $ 4,960 + Total production costs (Table 4-5) . 62,710 Total inventory available for sales . 67,670 - Cost of goods sold (Table 4-6) . 61,740 Ending inventory . . . . $ 6,200

PPT 4-18 Cash Budget The Cash Budget is a statement of the firm’s planned inflows and outflows of cash that is used to estimate its short-term cash requirements The Cash budget provides the firm with figures indicating whether a cash shortage or surplus is expected to result in each week/month covered by the forecast. It is therefore used as a basis for arranging financing Provides other useful information such as : Amount available for major expenditures Firm’s ability to repay debt Suggest possible changes in plans delay capital expenditures speed up collections reduce expenses

Table 4-9 Monthly sales pattern PPT 4-19 Table 4-9 Monthly sales pattern January February March April May June $15,000 $10,000 $15,000 $25,000 $15,000 $20,000

Table 4-10 Monthly cash receipts PPT 4-20 Table 4-10 Monthly cash receipts December January February Sales . . . . . . . $12,000 $15,000 $10,000 Collections: (20% of current sales) . $ 3,000 $ 2,000 (80% of previous month’s sales) . . . . 9,600 12,000 Total cash receipts . . $12,600 $14,000 March April May June Sales . . . . . . . $15,000 $25,000 $15,000 $20,000 (20% of current sales) . $ 3,000 $ 5,000 $ 3,000 $ 4,000 month’s sales . . . . 8,000 12,000 20,000 12,000 Total cash receipts . . $11,000 $17,000 $23,000 $16,000

Table 4-11 Component costs of manufactured goods PPT 4-21 Table 4-11 Component costs of manufactured goods Wheels Units Cost Total Produced per Unit Cost Materials . . . 1,015 $10 $10,150 Labour . . . 1,015 5 5,075 Overhead . . . 1,015 3 3,045 Casters Units Cost Total Combined Produced per Unit Cost Cost Materials . . . 2,020 $12 $24,240 $34,390 Labour . . . 2,020 6 12,120 17,195 Overhead . . . 2,020 4 8,080 11,125 $62,710

Table 4-12 Average monthly manufacturing costs PPT 4-22 Table 4-12 Average monthly manufacturing costs Total Time Average Costs Frame Monthly Cost Materials . . . $34,390 6 months $5,732 Labour . . . . 17,195 6 months 2,866 Overhead . . . 11,125 6 months 1,854

Table 4-13a Summary of all monthly cash payments (a) PPT 4-23 Table 4-13a Summary of all monthly cash payments (a) December January February From Table 4-12: Monthly material purchase . $4,500 $ 5,732 $ 5,732 Payment for material (prior month’s purchase) $ 4,500 $ 5,732 Monthly labour cost . . . 2,866 2,866 Monthly overhead . . . . 1,854 1,854 From Table 4-8: Selling, general and administrative expense ($12,000 over 6 months) . . . . . 2,000 2,000 Interest expense . . . . Taxes (two equal payments) Cash dividend . . . . . Also: New equipment purchases . 8,000 Total payments . . . . $11,220 $20,452

Table 4-13b Summary of all monthly cash payments (b) PPT 4-24 Table 4-13b Summary of all monthly cash payments (b) March April May June From Table 4-12: Monthly material purchase . . $5,732 $ 5,732 $ 5,732 $ 5,732 Payment for material (prior month’s purchase) . . $5,732 $ 5,732 $ 5,732 $5,730* Monthly labor cost . . . . 2,866 2,866 2,866 2,866 Monthly overhead . . . . 1,854 1,854 1,854 1,854 From Table 4-8: Selling, general and administrative expense ($12,000 over 6 months) . . . . . . 2,000 2,000 2,000 2,000 Interest expense . . . . . 1,500 Taxes (two equal payments) . . 2,503 2,503 Cash dividend . . . . . . 1,500 Also: New equipment purchases . . 10,000 Total payments . . . . . $14,955 $12,452 $12,452 $27,953 *Adjusted for rounding.

Table 4-14 Monthly cash flow PPT 4-25 Table 4-14 Monthly cash flow January February March Total receipts (Table 4-10) . $12,600 $14,000 $11,000 Total payments (Table 4-13) . 11,220 20,452 14,955 Net cash flow . . . . . $ 1,380 ($ 6,452) ($ 3,955) April May June Total receipts (Table 4-10) . $17,000 $23,000 $16,000 Total payments (Table 4-13) . 12,452 12,452 27,953 Net cash flow . . . . . $ 4,548 $10,548 ($11,953)

Table 4-15 Cash budget with borrowing and repayment provisions PPT 4-26 Table 4-15 Cash budget with borrowing and repayment provisions Jan. Feb. March April May June 1. Net cash flow . . . . . . $1,380 ($6,452.) ($3,955.) $4,548 $10,548 ($11,953.) 2. Beginning cash balance . . 5,000.* 6,380 5,000 5,000 5,000 11,069 3. Cumulative cash balance . . 6,380 (72.) 1,045 9,548 15,548 (884.) 4. Monthly loan or (repayment) — 5,072 3,955 (4,548.) (4,479.). 5,884 5. Cumulative loan balance . . — 5,072 9,027 4,479 — 5,884 6. Ending cash balance . . . 6,380 5,000 5,000 5,000 11,069 5,000 * We assume the Goldman Corporation has a beginning cash balance of $5,000 on January 1, 2005, and it desires a minimum monthly ending cash balance of $5,000.

Figure 4-2 Development of a Pro Forma Balance Sheet PPT 4-27 Figure 4-2 Development of a Pro Forma Balance Sheet Prior balance sheet (Unchanged items) Marketable securities Long-term debt Common stock Pro forma income statement analysis Inventory Retained earnings Pro forma balance sheet Cash budget analysis Cash Accounts receivable Plant and equipment Accounts payable Notes payable

Liabilities and Shareholders’ Equity PPT 4-28 Table 4-16 Balance Sheet December 31, 2004 Assets Current assets: Cash . . . . . . . . . . . . . $ 5,000 Marketable securities . . . . . . . . 3,200 Accounts receivable . . . . . . . . 9,600 Inventory . . . . . . . . . . . . 4,960 Total current assets . . . . . . . . 22,760 Plant and equipment . . . . . . . . . 27,740 Total assets . . . . . . . . . . . . $50,500 Liabilities and Shareholders’ Equity Accounts payable . . . . . . . . . . $ 4,500 Long-term debt . . . . . . . . . . . 15,000 Common stock . . . . . . . . . . . 10,500 Retained earnings . . . . . . . . . . 20,500 Total liabilities and shareholders' equity . . . $50,500

Pro Forma Balance Sheet Liabilities and Shareholders' Equity PPT 4-29 Table 4-17 Pro Forma Balance Sheet June 30, 2005 Assets Current assets: 1. Cash . . . . . . . . . . . . $ 5,000 2. Marketable securities . . . . . . . 3,200 3. Accounts receivable. . . . . . . . 16,000 4. Inventory . . . . . . . . . . . 6,200 Total current assets . . . . . . 30,400 5. Plant and equipment . . . . . . . 45,740 Total assets . . . . . . . . . . . $76,140 Liabilities and Shareholders' Equity 6. Accounts payable . . . . . . . . $ 5,732 7. Notes payable . . . . . . . . . 5,884 8. Long-term debt . . . . . . . . . 15,000 9. Common stock . . . . . . . . . 10,500 10. Retained earnings . . . . . . . . 39,024 Total liabilities and shareholders' equity . . $76,140

2 Methods of Financial Forecasting: PPT 4-30 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

Percent-of-Sales Method PPT 4-31 Percent-of-Sales Method A short-cut, less exact method of determining financing needs Assumes that B/S accounts will maintain a constant percentage relationship to sales More sales will mean more assets which will require more financing

Summary and Conclusions PPT 4-36 Summary and Conclusions Financial forecasting is used to anticipate events in advance, particularly a need to raise more money for the business A complete forecast would include: a pro forma income statement a pro forma balance sheet a cash budget The basis for most forecasts is the sales projection Simplified forecasts can be prepared using the percent-of- sales method