Financial Forecasting and Cash Budgeting Chapter 7 Financial Forecasting and Cash Budgeting

Objectives of Financial Forecasting Adequate financial planning is a key element in the success of any business venture. Short-term and long-term planning: Common objective: development of financial planning and control system to guide financial future of firm Techniques employed differ in degree of detail developed in analysis

Objectives of Financial Forecasting Short-term forecasts focus on cash budgeting and cash flow planning Long-term forecasts focus on planning for future growth in sales and assets and for financing of this growth

Short-term Forecasts and Cash Budgeting Short-term forecast and cash budget: plan for near future expressed in monetary terms Objective: provide a planning and control system to guide next few months or quarters of operations Budget is not simply a device for controlling expenditures As general economic conditions and business opportunities changes, budget must change. As actual operations deviate from plan, financial manager can use cash budget to assess reason for variation and take corrective action where appropriate

Short-term Forecasts and Cash Budgeting General procedure results in dynamic short-term financial planning and cash budgeting system: Develop sales forecast for upcoming year Develop estimates of next year’s expected profitability Develop forecasted (pro-forma) income statement for upcoming year Estimate cash payment and collection lags Develop detailed cash collection and payments forecast Construct cash budget Develop forecasted (pro-forma) balance sheet for end of next year

Financial Forecast for the Cutler Toy Company Founded in 1999 Owners: William Cutler and Neville Hook If past successful growth were to continue into future, William and Neville needed to implement a formal financial planning system

Financial Forecast for the Cutler Toy Company Develop sales forecast (see exhibit 7.1) for 2008 Cutler is forecasting a total 2008 sales volume of $250,000 (150% increase over 2007 due to Cutler’s decision to make transition to full-time operation under control of new general manager) Buildings and fixtures will be expanded by 25% ($5,000) and this expansion will be financed by increase in long-term bank loan from $10,000 to $15,000 Actual income statement and balance sheet for 2007 (see exhibit 7.3) will be used as baseline for 2008 forecasts

Financial Forecast for the Cutler Toy Company Develop estimates for 2008’s expected profitability Make estimates based on past performance and expected future operating characteristics Based on actual income statement (see exhibit 7.2), gross profit margin for 2007 is estimated at 25% This should be relatively conservative estimate as small percentage changes in gross margin often result in large percentage changes in bottom line

Financial Forecast for the Cutler Toy Company (continued) Based on Cutler’s projections of 2008’s operations: Depreciation (policy variable determined by Cutler’s choice of depreciation methods) is fixed at $3,400 ($1,000 increase over 2007) Employee wages are estimated at $22,000 Other expenses are estimated at $1,800 Remaining wages for 2008 will be paid at $2,200 per month Other expenses will occur evenly at $150 per month Interest expense on long-term bank loan is payable quarterly at 12% per year Total payments of $1,500 will be made, with $300 due at end of March/June and $450 due at end of September/December

Financial Forecast for the Cutler Toy Company Develop forecasted (pro-forma) income statement for 2008 (see exhibit 7.4) End result of estimates in step 2 is pro-forma income statement for 2008 Gross margin of $62,500 is anticipated on $250,000 in sales Deducting depreciation expenses, employee wages, interest, and other expenses yields income before tax of $33,800 Deducting taxes of $7,400 leaves after-tax profit of $26,400

Financial Forecast for the Cutler Toy Company Estimate cash payment and collection lags for 2008 (see exhibit 7.5) Cutler mainly deals with department stores, toy specialty shops, and discount chains, all of which pay him no later than the month following sale “Lagging sales” one month: cash collections in one month will be equal to sales from previous month

Financial Forecast for the Cutler Toy Company Develop detailed cash collection and payments forecast (see exhibit 7.6) Establish inventory policy: determine required ending inventory and known quantity of inventory on hand at beginning of month For Cutler Toys, dollar value of inventory on hand at end of each month should be equal to next two months’ expected sales at cost Since gross profit margin is 25%, this policy results in target ending inventory equal to 75% of next two months’ sales at retail Consider amount of inventory expected to be used up during month to support current month’s sales: Since gross margin is 25%, inventory used up in any one month will be equal to 75% of current month’s sales at sale prices

Financial Forecast for the Cutler Toy Company (continued) Estimate required monthly purchases: add required ending inventory to inventory expected to be used up during month and deduct beginning inventory Required ending inventory for each month “moves ahead” to become estimate of beginning inventory for following month, and process is repeated

Financial Forecast for the Cutler Toy Company (continued) Required ending inventory for May equals $18,750 which is 75% of forecasted sales during June and July ($25,000) Expected sales during May of $10,000 (at sales prices) will use up $7,5000 of inventory (at cost) during May Total inventory requirements for May are $26,250 Subtracting beginning inventory of $15,000 results in purchases of $11,250 $11,250 cash outflow will occur during June May’s cash outflow will be equal to accounts payable balance on April 30 of $12,000 Required ending inventory at end of May is “moved forward” to become estimate of beginning inventory for June, and process is repeated

Financial Forecast for the Cutler Toy Company Construct cash budget (see exhibit 7.7) Total tax bill of $7,400 is payable in quarterly installments of $1,850 on April 15, June 30, September 30, and December 31 Wages of $2,200 per month and other expenses of $150 must be paid Minimum balance of $2,000 is maintained Since bank borrowing is anticipated to support seasonal inventory needs, the bank supplying loan will most likely require some minimal compensating balance Cash budget assumes approval of credit line and is designed as planning and control technique to monitor credit line

Financial Forecast for the Cutler Toy Company (continued) Cash budget for May through December 2008 Cash collections from sales come from cash payment and collection lags Cash outflows Purchase payments are developed in cash collections and payment forecast Wages, other expenses, and interest are determined in forecasted income statement Taxes represent three quarterly payments remaining on 2008 tax liability Total inflows minus total outflows results in predicted net cash gain or loss during month

Financial Forecast for the Cutler Toy Company (continued) Deducting loss from (or adding gain to) cash balance at beginning of month yields cumulative end-of-month cash balance if no outside financing is obtained If cash outflow continues to exceed inflows, then this account will eventually become negative, indicating need for external financing In May, cash balance is $12,750, including $2,000 minimum End of July, cash loss of $7,350 subtracted from beginning cash of $7,000 results in cumulative cash without financing of negative $350 Deducting $2,000 minimum cash level from cumulative balance shows total financing needs of $2,350 Additional cash loans will be required in August ($9,850), September ($14,650), and October ($17,350), so that cumulative end-of-October loan balance is $44,200 In November, cash inflows exceed outflows following seasonal sales peak (cash collections accelerate while purchases slow down) and net cash gain is $15,150, which reduces outstanding loan balance to $29,050 Remainder of loan is paid off in December

Financial Forecast for the Cutler Toy Company (continued) Schedule for cash and loan balances for period covered by cash budget (see exhibit 7.8): explicitly lists amount and timing of beginning cash, required bank borrowing, net cash gain or loss, repayments, ending loan balance, and ending cash balance

Financial Forecast for the Cutler Toy Company Develop forecasted (pro-forma) balance sheet for year ending December 31, 2008 (see exhibit 7.9) Internal consistency: all accounts from balance sheet follow directly from previous exhibits Total assets are expected to be $79,150, with liabilities of $20,250, and equity of $58,900

Financial Forecast for the Cutler Toy Company Remember! Foregoing budgeting system is dynamic, not static Budget is a planning and control device in dollar terms As future planning period becomes current operating period, budget becomes document for checking operations against plans and either revising plan or controlling operations to agree with plan Plan contains no provision for interest payments on credit line Cash inflows and outflows do not occur at a fairly uniform rate during month Long-term forecasts differ from short-term forecasts primarily in level of detail required

Long-term Financial Planning Long-term financial planning: concerns future sales growth and devising plans to finance this growth Percentage of sales technique As future sales grow, assets will also have to increase to support sales increases Increased assets will be financed by reinvested earnings and increases in so-called spontaneous liabilities (i.e. accounts payable) Any shortages of financing sources will have to be provided for from external financing sources (i.e. long-term debt, additional equity)

Long-term Financial Planning Cutler believes that sales can be expanded by 25% in 2009 and 2010 15% in 2011 10% in 2012 5% per year thereafter

Long-term Financial Planning Percentage of sales technique to develop five-year financial plan for Cutler Toys Five-year profit forecast requires several key estimates (see exhibit 7.10) Cost of sales to remain at 75% Expenses to increase from 11.5% to 16% of sales Allowance for hiring additional workers After reinvesting profits from past two years, Cutler and Hook plan to draw a salary from expanded company

Long-term Financial Planning Forecast Cutler’s balance sheet position at end of each year (see exhibit 7.11) Objective: determine how much external financing will be required to support expected sales levels Estimates as percentages of sales: Cash: 4% Accounts receivable: 12% Inventory: 10% Net fixed assets: 6% Accounts payable: 5% Principle amount due on long-term bank loan is payable at rate of $5,000 per year for next three years

Long-term Financial Planning Forecast Cutler’s balance sheet position at end of each year (continued) Estimates (continued) Equity amount In absence of stock sales or redemptions, common stock account will remain constant Retained earnings account will increase by amount of after-tax profit earned each year “Force” or “plug”: figure for external financing requirements; amount of money required over and above current liabilities and reinvested earnings to finance expected future growth Forces total of liabilities and equity to equal total assets

Long-term Financial Planning Cutler’s forecast for balance sheet position at end of each year indicates that external financing needs will grow during high growth years 2009-2010, and then begin to decline as growth levels off in 2011-2013. These external financing requirements are in addition to normal seasonal fund requirements indicated on one-year cash budget for 2008. These external requirements represent permanent need for funds that will not begin to decline until over three years from now.

Long-term Financial Planning Adequate financing can be covered by: Cutler and Hook’s salaries Long-term bank loan Potential private financing source (i.e. private equity investment)