1. Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 12 Forecasting and Short-Term Financial Planning

2. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-2 Learning Objectives 1.Understand the sources and uses of cash that are used in building a cash budget. 2.Explain how sales forecasts are used to predict cash inflow. 3.Understand how production costs vary in terms of cash flow timing. 4.Explain possible ways to cover cash deficits and invest cash surplus. 5.Prepare a pro forma income statement and a pro forma balance sheet.

3. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-3 12.1 Sources and Uses of Cash Cash is considered to be the life-blood of a business. Cash shortages can be problematic while cash excesses can lead to poor returns. Since most businesses do not function on a purely cash basis, it is critical for them to forecast their needs for cash in advance. The cash budget is the analytical tool that estimates the future timing of cash inflow and cash outflow and projects potential shortfalls and surpluses.

4. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-4 Despite setting up a cash reserve, the firm is projected to have cash shortfalls in 3 months and surpluses in 2 after all cash receipts and disbursements have been forecasted for the first half of 2010. 12.1 Sources and Uses of Cash (continued) TABLE 12.1 Bridge Water Pumps and Filters, Cash Budget for First Six Months of 2010 ($ in thousands)

5. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-5 Identifying all possible sources and uses of cash is essential for preparing a useful cash budget. This list can serve as a guide when preparing a cash budget. 12.1 Sources and Uses of Cash (continued) FIGURE 12.1 Cash inflows and cash outflows for a company.

6. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-6 12.2 Cash Budgeting and the Sales Forecast Sales revenue  base variable driving almost all other items in the cash budget,  Must forecast sales as objectively as possible. There is usually a time lag between when a sale is made and when the cash receipts come in  Must keep track of collections time-line. Need internal data (information that is proprietary or unique to the firm) as well as external data (publicly available information) as sources for objective sales forecasts.

7. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-7 12.2 Cash Budgeting and the Sales Forecast (continued) FIGURE 12.2 Marketing data for Bridge Water Pumps and Filters.

8. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-8 12.2 (A) Cash Inflow from Sales Firms typically sell products and services partially for cash and partially on credit. An analysis of a firm’s collection policy can help project cash inflow from sales. It is quite common for firms to collect some of their receivables in the 2 months following the sale, i.e., November 2008’s credit sales will be partially collected in December 2008 and January 2009.

9. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-9 12.2 (A) Cash Inflow from Sales (continued) Managers often figure in a small percentage of the forecasted sales as bad debts when preparing a cash budget. TABLE 12.2 Bridge Water Pumps and Filters Cash Flow from Sales: January, February, and March 2009 Cash Flow Estimates

10. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-10 12.2 (B) Other Cash Receipts Besides sales, which are the main contributor to a firm’s cash inflow, need to forecast the timing and magnitude of other occasional sources of cash such as – asset sales, –funds raised through issuance and sale of securities, and –income earned on investments (dividends, interest, etc.)

11. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-11 12.3 Cash Outflow from Production The magnitude and timing of the various cash disbursements of a firm depend mainly on forecasted sales. –Payments for raw materials, labor costs, overheads such as utilities and rent, shipping costs, etc. Like sales, there is often a time lag between when the firm receives and records the benefit, and when it actually makes the payment for it. The cash budget can be used as a handy planning document to keep track of the projected disbursements. Depreciation is merely a tax write-off, not a cash disbursement, so should not be included in a cash budgetDepreciation is merely a tax write-off, not a cash disbursement, so should not be included in a cash budget.

12. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-12 12.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses The main objective of developing a cash budget  Firm has sufficient cash available from its revenues and other receipts to cover its periodic cash disbursements such as: 1.Accounts payables for materials and supplies 2.Salaries, wages, taxes, and other operating expenses 3.Capital expenditures for plant, equipment, and machinery 4.Dividends, interest, and flotation cost payments related to the raising and servicing of capital Over a short planning cycle, the total periodic cash inflow rarely matches the total periodic outflow,  seasonal fluctuations and time lags.  This results in forecasted cash deficits and cash surpluses in certain periods.

13. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-13 12.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses (continued) TABLE 12.3 Monthly Cash Budget for Bridge Water Pumps and Filters

14. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-14 12.4 (A) Funding Cash Deficits Cash shortfalls can be handled in 4 ways: 1.Cash from savings 2.Unsecured loans (letters of credit) 3.Secured loans (using accounts receivable or inventories) 4.Other sources (commercial paper, trade credit, or banker’s acceptance).

15. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-15 12.4 (B) Investing Cash Surpluses When a company has excess funds, it has 4 options: 1.Put the surplus in a savings account or invest it in marketable securities. 2.Repay lenders and owners (retire debt early or pay extra dividends). 3.Replace aging assets. 4.Invest in the company, accepting positive net present value projects

16. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-16 12.5 Planning with Pro Forma Financial Statements Cash budgeting is only one aspect of short-term financial planning. It is equally important for firms to forecast their operating cash flow and net income for the forthcoming period by developing pro forma financial statements. There are a variety of ways to produce pro forma statements, but the statements usually rely on two primary inputs: –The prior year’s financial statements and the relationship of the account balances to each other –The projected sales for the coming year

17. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-17 12.5 Planning with Pro Forma Financial Statements (continued) We use the prior year’s financial statements to find the relative percentage of each line either to sales (income statement) or to total assets (balance sheet). We then multiply the percentages of each item to forecast sales or forecast total assets for the coming year to develop pro forma financial statements. –For example, let’s say that the cash balance for the prior year is $2 million and the total assets are $100 million. So cash is 2% of total assets. –For the Pro Forma Balance Sheet, we would forecast cash as 2% of the forecasted total assets as well, i.e., if total assets are forecasted to increase by 20%  $120m  Cash would be forecasted to be.02*120m = $24m.

18. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-18 12.5 (A) Pro Forma Income Statement (continued) Figure 12.3

19. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-19 12.5 (A) Pro Forma Income Statement (continued) This approach, although a good first step, is often too simplistic in reality because many financial statement items do not vary proportionately with sales. In particular, depreciation decreases over time and cost of goods sold often declines due to economies of scale. The manager would have to fine-tune the forecasted values to make them more in line with reality. Figure 12.4

20. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-20 Each prior year’s balance sheet item is expressed as a percent of total assets, and then multiplied by the forecasted total assets figure for the next period. Items that are obviously constant each period or that vary at a different rate (for whatever reason) are accordingly adjusted for by the financial manager. If total assets exceed total liabilities and owners’ equity, external financing is allocated according to some predetermined ratio to serve as the plug variable. 12.5 (B) Pro Forma Balance Sheet

21. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-21 12.5 (B) Pro Forma Balance Sheet (continued) Figure 12.5

22. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-22 12.5 (B) Pro Forma Balance Sheet (continued) Based on the following assumptions, a pro forma balance sheet is developed as shown in Figure 12.6. Net fixed assets will increase by $500,00 (capital expenditure). Cash balance account will be at $150,000. Accounts receivables will be 6% of forecasted sales, or $305,000. Total inventories will be 15% of prior year’s sales, $4,800,000, with one-third in raw materials and two-thirds in finished goods. All new financing will be long-term debt. Increase in retained earnings will be $380,000 (from the pro forma income statement).

23. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-23 12.5 (B) Pro Forma Balance Sheet (continued) Key calculations include the following: Cash is $150,000. Accounts receivable is $305,280 ($5,088,000  0.06 = $305,280), rounded to $305,000. Total inventory is $720,000 ($4,800,000  0.15 = $720,000). Raw materials are one-third of total inventory ($720,000  1/3 = $240,000). Finished goods are two-thirds of total inventory ($720,000  2/3 = $480,000). Net fixed assets are $4,953,000 + $500,000 = $5,453,000. The total assets will now be $6,628,000. Fill in the liabilities based on the same percentages as those of last year except for the common stock, which will not change (all new financing is debt); a targeted reduction in accounts payable to 5% of assets; and an increase in retained earnings ($380,000) projected by the pro forma income statement:

24. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-24 12.5 (B) Pro Forma Balance Sheet (continued) Accounts payable will be reduced to 5.0% of $6,628,000, or $331,400 (round to $331,000). Taxes payable will be 4.00% of $6,628,000, or $265,120 (round to $265,000). Retained earnings will be $380,000 + $2,688,000 = $3,068,000. Common stock will remain at $62,000. So, for the balance sheet to balance, long-term debt must be $2,902,000 ($6,628 – $331 – $265 – $62 – $3,068 = $2,902). Therefore, the long-term debt account needs to increase by $200,000 ($2,902,000 – $2,702,000). To complete the $500,000 funding for the project, outside funding of $200,000 will be needed; the other funding will come from internal funding sources.

25. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-25 12.5 (B) Pro Forma Balance Sheet (continued) Figure 12.6

26. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-26 12.5 (C) Pro Forma Cash Flow Statement Finally, the pro forma cash flow statement (Figure 12.7) is prepared to tie together all the changes in operating, investment, and financing cash flows.

27. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-27 12.5 (C) Pro Forma Cash Flow Statement (continued) Figure 12.7

28. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-28 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 Sales Forecast: You have been asked to forecast sales for the coming year. You are convinced that the compound average growth rate is the best way to forecast growth, and so you collect data for the prior three years, as listed below. Using the data, compute the compound growth rate for each of the years and then forecast next year’s sales by using the two-year average growth rate. Year Sales 2007$1,200,000 2008$1,750,000 2009$2,100,000 2010 ?

29. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-29 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (Answer) g = (ending value / beginning value) 1 / number of years – 1 2008 growth rate =[ (2008 Sales/2007 sales)] -1 = (1.75m/1.2m) -1 2008 growth rate = 45.83% 2009 growth rate = =[ (2009 Sales/2008 sales)] -1 = (2.1m/1.75m) - 1 2009 growth rate 20% 2-year average growth rate = (2009 Sales/2007 Sales) 1/2 =1= (2.1m/1.2m) 1/2 -1 2-year average growth rate =32.29% 2010 Sales Forecast =$ 2,100,000*(1.3229) = $2,778,090

30. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-30 ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 1/3 of its monthly sales on cash terms 40% of the sales are collected in the next month, 50% in 60 days, and 7% in 90 days, Sales Receipts: The financial manager of Hearty Cereals is in the process of preparing a cash budget for the first quarter of 2010. The firm typically sells 1/3 of its monthly sales on cash terms and the rest on credit. An analysis of the accounts receivable shows that on average, 40% of the sales are collected in the next month, 50% in 60 days, and 7% in 90 days, with the rest ending up as bad debts. As the manager’s assistant it is your job to project the sales receipts for the first quarter of 2010, using the monthly sales figures listed below. 2009 Sales2010 Forecasted Sales October$1,750,000January$1,850,000 November$2,000,000February$1,650,000 December$2,450,000 March$1,900,000

31. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-31 ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (Answer)

32. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-32 ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 Production cash outflow: The Creative Products Corporation produces its products two months in advance of anticipated sales and ships to warehouse centers the month before sale. The inventory safety stock is 15% of the anticipated month’s sale. Beginning inventory in October 2009 was 120,000 units. Each unit costs $1.50 to make. The average selling price is $2.50 per unit. The cost is made up of 60% labor, 30% materials, and 10% shipping (to warehouse). Labor is paid the month of production, shipping the month after production, and raw materials the month prior to production. What is the production cash outflow for the month of October 2009 production, and in what months does it occur? Assume that the sales forecast for December 2009 is $2,500,000.

33. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-33 Unit Sales Forecast for December 2009 = $2,500,000/$2.5  1 million units Safety stock required = 15% of December sales = 150,000 units Beginning Inventory (October 2009) = 120,000 units Production needed in October = Dec. ‘09 Sales + Safety Stock – Beg. Inventory Production needed in October = 1,000,000 + 150,000 – 120,000=970,000 units Cost of Production (Oct. 2009) = 970,000*$1.50= $1,455,000 Labor cost =.60*$1,455,000 = $873,000  paid in October 2009 Shipping cost =.10*$1,455,000 = $145,500  paid in November 2009 Material cost =.30*$1,455,000 = $436,500  paid in September 2009 ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (Answer)

34. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-34 ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 Pro forma income statement. Given the income statement below for Imperial Products Corporation for 2009 and a 20% growth in sales for 2010, prepare a pro forma income statement. Sales Revenue$28,8000,000 COGS11,4000,000 SG&A Expenses6,800,000 Depreciation Expenses2,3000,000 EBIT$8,300,000 Interest Expense1,200,000 Taxable Income$7,100,000 Taxes$2,414,000,000.00 Net Income$4,686,000.00 Imperial Products Corp. Income Statement for 2009

35. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-35 ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (Answer) First divide each item by sales Then multiply each proportion by forecast sales for 2010 Forecast sales = 28,800,000*(1.2) = $34,560,000 2009% of sales2010 Forecast Sales Revenue$28,8000,000 COGS11,4000,000 SG&A Expenses6,800,000 Depreciation Expenses2,3000,000 EBIT$8,300,000 Interest Expense1,200,000 Taxable Income$7,100,000 Taxes$2,414,000,000.00 Net Income$4,686,000.00 100.00% 39.58% 23.61% 7.99% 28.82% 4.17% 24.65% 8.38% 16.27% $34,560,000 $13,680,000 $8,160,000 $2,760,000 $9,960,000 $1,440,000 $8,520,000 $2,896,000 $5,623,200

36. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-36 ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 The Global Growth Corporation is planning for next year and wants you to help them prepare a Pro Forma Balance Sheet for 2011. Their current Balance Sheet is shown below, along with some predetermined changes in key balance sheet accounts. How will you proceed? Current Assets 2010 Cash$1,500,000 Marketable Securities830,000 Accounts Receivable3,450,000 Inventories2,500,000 Total Current Assets$8,280,000 Long-term Assets Plant, Property & Equip.$8,500,000 Goodwill3,500,000 Intangible Assets1,350,000 Total Long-term Assets$13,350,000 TOTAL ASSETS$21,630,000

37. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-37 ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (continued) Current Liabilities Long-Term Liabilities TOTAL LIABILITIES Owner Equity TOTAL OWNER’S EQUITY TOTAL LIABILITIES AND OWNER’S EQUITY Accounts Payable Other Current Liabilities Total Current Liabilities Long-Term Debt Other Long-Term Liabilities Total Long-Term Liabilities Common Stock Retained Earnings $5,125,000 $1,350,000 $6,475,000 $3,200,000 $1,650,000 $4,850,000 $11,325,000 $2,500,000 $7,805,000 $10,305,000 $21,630,000

38. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-38 ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (continued) Next year, the firm will increase its Plant, Property, and Equipment (PPE) by $7,000,000 with a plant expansion. The inventories will grow by 70%, but accounts payables will grow by 60%, and marketable securities will be reduced by 50% to help finance the expansion. If all other asset accounts remain the same and long-term debt will be used to finance the remaining costs of the expansion (no change in common stock or retained earnings), prepare a pro forma balance sheet for 2011. How much additional debt will be estimated using this pro forma balance sheet?

39. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-39 Start by changing the known asset accounts and then total up assets. Then use the total assets for total liabilities and owners’ equity balance. Finally, make the required change in long-term debt to balance the balance sheet. i.e., PPE will be $8,500,000+$7,000,000 = $15,500,000 Inventories = 70% higher  (1.7)*2500000=4,250,000 Accounts payables = 60% higher  5,125,000*1.6=8,200,000 Marketable Securities = 50% lower = 830,000*.5  415,000 ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (Answer)

40. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-40 ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (Answer continued) 20102011 pro forma Cash$1,500,000 Marketable Securities830,000415000 Accounts Receivable3,450,000 Inventories2,500,0004250000 Total Current Assets$8,280,000$9,615,000 Plant, Property & Equip.$8,500,000$15,500,000 Goodwill3,500,000 Intangible Assets1,350,000 Total Long-term Assets$13,350,000$20,350,000 Total Assets$21,630,000$29,965,000

41. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 12-41 ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (Answer continued)