1. Chapter 14

2. Short-term Financial Planning

3. Chapter Objectives Percent of sales method to forecast financing requirements Sustainable rate of growth Limitations of the percent of sales method Cash budgets

4. Financial Forecasting Process of attempting to estimate a firm’s future financing requirements Steps: 1. Project the firm’s sales revenues and expenses over the planning period 2. Estimate the levels of investment in current and fixed assets that are necessary to support the projected sales 3. Determine the firm’s financing needs throughout the planning period

5. Sales Forecast The key ingredient in a firm’s planning process is the sales forecast Reflects: 1. Past trend in sales 2. Anticipated events

6. Percent of Sales Method Estimating the level of an expense, asset, or liability for a future period as a percentage of the sales forecast. The percentages used can come from recent financial statements or from averages over past years

7. Spontaneous Financing The trade credit and other accounts payable that arise spontaneously in the firm’s day- to-day operations. Normally vary directly with the level of sales Accounts Payable and Accrued Expenses

8. Discretionary Financing (DFN) Require explicit decisions on the part of the firm’s management every time funds are raised. Do not normally vary directly with the level of sales Notes Payable, long-term debt, common stock, paid in capital

9. Calculation of DFN Four step process (Using percentage of sales method) 1.Covert each asset and liability account that varies directly with firm sales to a percentage of the current year’s sales – Current Assets/Sales 2.Project the level of each asset and liability account in the balance sheet using its percentage of sale multiplied by projected sales or by leaving the account balance unchanged when the account does not vary with the level of sales – Projected current assets = projected sales X (current assets/sales)

10. 3.Project the addition to retained earnings available to help finance the firm’s operations. This equals projected net income for the period less planned common stock dividends. Projected addition to retained earnings = projected sales X Net income X {1-(cash dividends Sales Net Income)} 4.Project the firm’s DFN as the projected level of total assets less projected liabilities and owners’ equity DFN = Projected total assets – projected total liabilities – projected owners’ equity

11. DFN Relationships DFN = Predicted change in total assets – Predicted change in spontaneous liabilities – Predicted change in retained earnings

12. External Financing Needs (EFN) All the firm’s needs for financing beyond the funds provided internally through the retention of earnings EFN = Predicted change in total assets – Predicted change in retained earnings

13. DFN and EFN DFN = Predicted change in total assets – Predicted change in spontaneous liabilities – Predicted change in retained earnings EFN = Predicted change in total assets – Predicted change in retained earnings Difference between DFN and EFN is the inclusion/exclusion of spontaneous liabilities

14. Sustainable Rate of Growth The rate at which a firm’s sales can grow if it wants to maintain its present financial ratios and does not want to resort to the sale of new equity shares. Sustainable rate of Growth (g) = ROE (1-b) ROE is return on equity or net income / common equity b is dividend payout ratio or dividends/net income (1-b) = plowback ratio or the fraction of earnings that are reinvested or plowed back into the firm

15. ROE Return on equity Net income / common equity ROE = (net income / sales) X (sales/assets) X (total assets/common equity) or NPM X Asset turnover X capital structure

16. Sustainable Rate of Growth FirmNPMAsset Leverage PlowbackSustainable turnover ratiorate of growth A15%1.001.250%9.0% B15%1.001.2100%18.0% C15%1.001.5100%22.5%

17. Limitations of the Percent of Sales Forecast Method Method provides reasonable estimates of financing requirements only when asset requirements and financing sources can be accurately forecast as a constant percent of sales Economies of scale are sometimes realized from investing in certain types of assets Some assets are lumpy assets or assets that must be purchased in large, nondivisible components

18. Budget Functions A budget is a forecast of future events Perform three functions: – Indicate the amount and timing of a firm’s needs for future financing – Provide the basis for taking corrective action in the event of variances – Provide the basis for performance evaluation and control

19. Cash Budget Detailed plan of future cash flows Composed of four elements: – Cash Receipts – Cash Disbursement – Net change in cash for the period – New financing needed