1. Copyright © 2011 Pearson Prentice Hall. All rights reserved. Financial Forecasting and Planning Chapter 17

2. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-2 Slide Contents Learning Objectives 1.An Overview of Financial Planning 2.Developing a Long-term Financial Plan 3.Developing a Short-Term Financial Plan Key Terms

3. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-3 Learning Objectives 1.Understand the goals of financial planning. 2.Use the percent of sales method to forecast the financing requirements of a firm including its discretionary financing needs. 3.Prepare a cash budget and use it to evaluate the amount and timing of a firm’s short-term financing requirements.

4. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17.1 An Overview of Financial Planning

5. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-5 An Overview of Financial Planning What is the primary objective of preparing financial plans? –To estimate the future financing requirements in advance of when the financing will be needed. The process of planning is critical to force managers to think systematically about the future, despite the uncertainty of future.

6. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-6 An Overview of Financial Planning (cont.) Most firms engage in three types of planning: –Strategic planning, –Long-term financial planning, and –Short-term financial planning Strategic plan defines, in very general terms, how the firm plans to make money in the future. It serves as a guide for all other plans.

7. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-7 An Overview of Financial Planning (cont.) The long-term financial plan generally encompasses a period of three to five years and incorporates estimates of the firm’s income statements and balance sheets for each year of the planning horizon.

8. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-8 An Overview of Financial Planning (cont.) The short-term financial plan spans a period of one year or less and is a very detailed description of the firm’s anticipated cash flows. The format typically used is a cash budget, which contains detailed revenue projections and expenses in the month in which they are expected to occur for each operating unit of the company.

9. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17.2 Developing a Long-Term Financial Plan

10. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-10 Developing a Long-Term Financial Plan Forecasting a firm’s future financing needs using a long-term financial plan can be thought of in terms of three basic steps: 1.Construct a sales forecast 2.Prepare pro-forma financial statements 3.Estimate the firm’s financing needs

11. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-11 Developing a Long-Term Financial Plan (cont.) Step 1: Construct a Sales Forecast –Sales forecast is generally based on: 1.past trend in sales; and 2.the influence of any anticipated events that might materially affect that trend.

12. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-12 Developing a Long-Term Financial Plan (cont.) Step 2: Prepare Pro Forma Financial Statements –Pro forma financial statements help forecast a firm’s asset requirements needed to support the forecast of revenues (step 1). –The most common technique is percent of sales method that expresses expenses, assets, and liabilities for a future period as a percentage of sales.

13. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-13 Developing a Long-Term Financial Plan (cont.) Step 3: Estimate the Firm’s Financing Needs –Using the pro forma statements we can extract the cash flow requirements of the firm.

14. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-14 Financial Forecasting Example Table 17-1 illustrates how Ziegen, Inc. uses the percent of sales method to construct pro forma income statement and pro forma balance sheet. The company uses the three-step approach to financial planning.

15. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-15 Financial Forecasting Example (cont.) Step 1: Forecast Revenues and Expenses –Zeigen’s financial analyst estimate the firm will earn 5% on the projected sales of $12 million in 2010. –Zeigen plans to retain half of its earnings and distribute the other half as dividends. –See Table 17-1

16. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-16 Financial Forecasting Example (cont.)

17. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-17 Financial Forecasting Example (cont.) Step 2: Prepare Pro Forma Financial Statements –The firm’s need for assets to support firm sales is forecasted using percent of sales method, where each item in the balance sheet is assumed to vary in accordance with its percent of sales for 2010.

18. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-18 Financial Forecasting Example (cont.) Step 3: Estimate the Firm’s Financing Requirements –This involves comparing the projected level of assets needed to support the sales forecast to the available sources of financing. –In essence, we now forecast the liabilities and owner’s equity section of the pro forma balance sheet.

19. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-19 Sources of Spontaneous Financing – Accounts Payable and Accrued Expenses Accounts payable and accrued expenses are typically the only liabilities that vary directly with sales. Accounts payable and accrued expenses are referred to as sources of spontaneous financing. The percent of sales method can be used to forecast the levels of both these sources of financing.

20. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-20 Sources of Discretionary Financing Raising financing with notes payable, long- term debt and common stock requires managerial discretion and hence these sources of financing are called discretionary sources of financing. The retention of earnings is also a discretionary source as it is the result of firm’s discretionary dividend policy.

21. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-21 Summarizing Ziegen’s Financial Forecast Discretionary Financing Needs (DFN) = {Total Financing Needs} less {Projected Sources of Financing} = {$7.2 m (increase in assets)} – {$2.4m in spontaneous financing + $2.5m in short and long-term debt + $1.8 million in equity} = $7.2 million - $6.7 million = $500,000

22. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-22 Summarizing Ziegen’s Financial Forecast (cont.) The firm has to raise $500,000 with some combination of borrowing (short-term or long-term) or the issuance of stock. Since they require a managerial decision, they are referred to as the firm’s discretionary financing needs (DFN).

23. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-23 Summarizing Ziegen’s Financial Forecast (cont.)

24. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-24 Analyzing the Effects of Profitability and Dividend Policy on the Firm’s DFN After projecting DFN, we can easily evaluate the sensitivity of DFN to changes in key variables. The table (on next slide) shows that as dividend payout ratios and net profit margin vary, DFN also changes significantly from a negative $40,000 to $764,000.

25. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-25 Analyzing the Effects of Profitability and Dividend Policy on the Firm’s DFN (cont.) DFN for Various Net Profit Margins and Dividend Payout Ratio (DPR) Net Profit Margin DPR =30%DPR=50%DPR=70% 1%$716,000$740,000$764,000 5%$380,000$500,000$620,000 10%$(40,000)$200,000$440,000

26. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-26 Analyzing the Effects of Sales Growth on a Firm’s DFN Table 17-2 considers the impact of sales growth rates of 0%, 20% and 40% on DFN. It is observed that DFN ranges from ($250,000) at 0% growth rate to $1,250,000 at 40% growth rate. A negative DFN indicates that the firm has surplus dollars in financing.

27. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-27

28. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-28

29. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-29 Checkpoint 17.1 Estimating Discretionary Financing Needs The Pendleton Chemical Company manufactures a line of personal health care products used in preventing the spread of infectious diseases. The company’s principal product is a germ- killing hand sanitizer called “Bacteria-X”. In 2010, Pendleton had $5 million in sales, and anticipates an increase of 15% in 2011. After performing an analysis of the firm’s balance sheet, the firm’s financial manager prepared the following pro forma income statement and balance sheet for next year:

30. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-30 Checkpoint 17.1

31. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-31 Checkpoint 17.1

32. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-32 Checkpoint 17.1

33. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-33 Checkpoint 17.1

34. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-34 Checkpoint 17.1

35. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-35 Checkpoint 17.1: Check Yourself Pendleton’s management estimates that under the most optimistic circumstances it might experience a 40% rate of growth of sales in 2011. Assuming that net income is 5% of firm sales and that both current and fixed assets are equal to a fixed percent of sales (as found in the above forecast), what do you estimate the firm’s DFN to be under these optimistic circumstances?

36. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-36 Step 1: Picture the Problem The firm’s DFN is equal to the financing the firm requires for the year that is not provided by spontaneous sources such as accounts payable and accrued expenses plus retained earnings for the period.

37. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-37 Step 2: Decide on a Solution Strategy We can calculate the DFN using the following equation:

38. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-38 Step 3: Solve $987,500 + Line3 - $287,500 LinePerforma Income Statement for 2011 1Growth Rate40% 2Sales$7,000,000.00 3Net Income Performa Balance Sheet for 2011 Multiple Computation 4Current Assets0.20$1,400,000.00 5Net Fixed Assets0.6$4,200,000.00 6Total4+5$5,600,000.00 7Accounts Payable0.2$1,150,000.00 8Accrued Expenses0.1$575,000.00 9Notes Payable$500,000.00 10Current Liabilities7+8+9$2,225,000.00 11Long-term Debt$1,000,000.00 12Common Stock (par)$100,000.00 13Paid-in-capital$200,000.00 14Retained Earnings$1,050,000.00 15Common Equity12+13+14$1,350,000.00

39. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-39 Step 4: Analyze If the firm experiences a 40% growth rate in sales, Pendleton can expect to raise $1,025,000 during the coming year.

40. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17.3 Developing a Short-Term Financial Plan

41. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-41 Developing a Short-Term Financial Plan Unlike a long-term financial plan that is prepared using pro forma income statements and balance sheets, short-term financial plan is typically presented in the form of a cash budget that contains details concerning the firm’s cash receipts and disbursements.

42. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-42 Developing a Short-Term Financial Plan (cont.) Cash budget includes the following main elements: –Cash receipts, –Cash disbursements, –Net change in cash, and –New financing needed.

43. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-43

44. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-44 Uses of the Cash Budget 1.It is a useful tool for predicting the amount and timing of the firm’s future financing requirements. 2.It is a useful tool to monitor and control the firm’s operations.

45. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-45 Uses of the Cash Budget (cont.) The actual cash receipts and disbursements can be compared to budgeted estimates, bringing to light any significant differences. In some cases, the differences may be caused by cost overruns or poor collection from credit customers. Remedial action can then be taken.

46. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-46 Key Terms Cash budget Discretionary financing needs (DFN) Discretionary sources of financing Long-term financial plan Percent of sales method Pro forma balance sheet Pro forma income statement

47. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 17-47 Key Terms (cont.) Short-term financial plan Sources of spontaneous financing Strategic plan