1. 1 Forecasting for Financial Planning

2. 2 Learning Objectives  The importance of forecasting to business success.  The financial forecasting process.  Preparation of pro forma financial statements.  The importance of analyzing forecasts.

3. 3 Why is forecasting important? – If you produce too much of a product, or a product that no one wants to buy, you still must pay for materials, labor, and storage. – If you produce too little of a product, you will lose sales and possibly market share.  Mistakes are costly:

4. 4 Forecasting Approaches  Experience  Probability  Correlation Financial managers concentrate on three general approaches to financial forecasting:

5. 5 Experience  Managers who have been in the business for a long time have developed a sense for the patterns in sales, expenses, consumer demand factors, etc. – Example: Editors who work for book publishers regularly read submitted manuscripts and make judgements about whether their company should buy the rights to publish the books.

6. 6 Probability  Past history often tells us a lot about what will happen in the future.  Managers can use this information to estimate the future. – Example: In the past, a 7-11 manager has found that she will lose 1% of candy inventory to shoplifters. She can use this information to estimate future losses and also to design better controls.

7. 7 Correlation  Correlation is a measure of the relative movement of two variables relative to each other. – Example: If interest rates go up, a real estate agent knows that home sales will tend to fall (because the higher cost of financing makes it harder for buyers to qualify for mortgages). – Example: Sales of umbrellas are higher in rainy seasons.

8. 8 Finance Department The Sales Forecasting Process Marketing (sales estimate) Top Management (policy, strategy) Production (capacity, schedules) Accounting (financial statements, depreciation, taxes) SALESFORECAST

9. 9 94 95 96 97 98 99 00 01 02 03 Time Sales Plot of Past Sales  Forecast future sales based on past sales growth

10. 10 94 95 96 97 98 99 00 01 02 03 Time Sales  Forecast future sales based on past sales growth Trend Line

11. 11 94 95 96 97 98 99 00 01 02 03 Time Sales Growth Rate  Forecast future sales based on past sales growth Sales Estimates for next 2 years

12. 12 94 95 96 97 98 99 00 01 02 03 Time Sales  Also include the effects of any events which are expected to impact future sales (new products or economic conditions)  Forecast future sales based on past sales growth New Product Introduced

13. 13 94 95 96 97 98 99 00 01 02 03 Time Sales  Also include the effects of any events which are expected to impact future sales (new products or economic conditions)  Forecast future sales based on past sales growth New Product Introduced

14. 14 – Current Assets: Inventory, A/R, Cash – Fixed Assets: Plant and Equipment 2002 2003 Sales Growth Imposes Costs on the Firm  Will require additional resources

15. 15 Pro Forma Financial Statements  Pro forma financial statements are forecasts of the firm’s future financial statements based on a certain set of assumptions about sales trends and the relationships between sales and various financial variables, and between other financial statement variables relative to each other.

16. 16 Producing Pro Formas  Sales will increase from $5million to $8 million.  Production is at full capacity (24 hrs. per day).  Dividend payout will be 70% of NI.  Spontaneous balance sheet accounts. increase in a constant proportion to sales. Example Data for Marginal Product Inc.

17. 17 Producing Pro Formas Note: Note: The projected sales will be determined after input from many different units or departments of the firm. Determining Sales Growth = 60% $8 - $5 $5 Step Step 1: Income Statement Marginal Product Inc. Sales $5,000 COGS 4,133 EBIT 867 Int 200 EBT 667 Tax (.40) 267 NI 400 CurrentProjected $8,000

18. 18 Calculate projected Net Income. New COGS = Old COGS x 1.6 = 6,613 Producing Pro Formas Note: Note: There is no increase yet in the interest charges since Marginal Product’s managers have not yet decided how they will finance the growth. Step Step 2: Income Statement Marginal Product Inc. Sales $5,000 $8,000 COGS 4,133 6,613 EBIT 867 1,387 Int 200 200 EBT 667 1,187 Tax (.40) 267 475 NI 400 712 CurrentProjected

19. 19 Producing Pro Formas Forecast increase in assets (% of sales) Step Step 3: Balance Sheet Marginal Product Inc. Current Assets$2.5Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total Claims$5.5 Assets Current Projected Liabilities Current Projected

20. 20 Balance Sheet Marginal Product Inc. Current Assets$2.5$4.0Accounts Payable$1.0 Net Fixed Assets3.0Accrued Expenses0.5 Total$5.5Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total Claims$5.5 Assets Current Projected Liabilities Current Projected Producing Pro Formas Forecast increase in assets (% of sales). If sales increase by 60%, so too will any asset that remains a constant percent of sales. Step Step 3: $2.5(1+.60) = $4.0

21. 21 Producing Pro Formas Forecast increase in assets (% of sales) Step Step 3: Balance Sheet Marginal Product Inc. Current Assets$2.5$4.0Accounts Payable$1.0 Net Fixed Assets3.04.8Accrued Expenses0.5 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total Claims$5.5 Assets Current Projected Liabilities Current Projected +$3.30 $3.0(1+.60) = $4.8

22. 22 Producing Pro Formas Forecast increase in spontaneous liabilities. Step Step 4: Balance Sheet Marginal Product Inc. Current Assets$2.5$4.0Accounts Payable$1.0 $1.6 Net Fixed Assets3.04.8Accrued Expenses0.5 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total Claims$5.5 Assets Current Projected Liabilities Current Projected $1.0(1+.60) = $1.60

23. 23 Producing Pro Formas Balance Sheet Marginal Product Inc. Current Assets$2.5$4.0Accounts Payable$1.0 $1.6 Net Fixed Assets3.04.8Accrued Expenses0.5.8 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 Common Equity$2.0 Total Claims$5.5 Assets Current Projected Liabilities Current Projected $0.5(1+.60) = $0.80 Forecast increase in spontaneous liabilities. Step Step 4:

24. 24 Producing Pro Formas Balance Sheet Marginal Product Inc. Current Assets$2.5$4.0Accounts Payable$1.0 $1.6 Net Fixed Assets3.04.8Accrued Expenses0.5.8 Total$5.5$8.8Notes Payable0.0 Current Liabilities$1.5 Long Term Debt$2.0 Common Stock0.5 Retained Earnings1.5 1.7 Common Equity$2.0 Total Claims$5.5 Assets Current Projected Liabilities Current Projected New retained earnings =Old retained earnings + additions to ret. earnings =1.5 + [NI x (1-div. payout)] =1.5 + [.712 x (1-.7)] = 1.7 New retained earnings =Old retained earnings + additions to ret. earnings =1.5 + [NI x (1-div. payout)] =1.5 + [.712 x (1-.7)] = 1.7 Forecast increase in retained earnings. Step Step 5:

25. 25 Producing Pro Formas Balance Sheet Marginal Product Inc. Current Assets$2.5$4.0Accounts Payable$1.0 $1.6 Net Fixed Assets3.04.8Accrued Expenses0.5.8 Total$5.5$8.8Notes Payable0.0 0.0 Current Liabilities$1.5 2.4 Long Term Debt$2.0 2.0 Common Stock0.5.5 Retained Earnings1.5 1.7 Common Equity$2.0 2.2 Total Claims$5.5 $6.6 Assets Current Projected Liabilities Current Projected Hold other accounts constant to see how much additional funds will be needed. Step Step 6:

26. 26 Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected AFN = $8.8 - 6.6 = $2.2 mill. Producing Pro Formas Additional funds needed (AFN) = projected assets minus projected claims Step Step 7: Current Assets$2.5$4.0Accounts Payable$1.0 $1.6 Net Fixed Assets3.04.8Accrued Expenses0.5.8 Total$5.5$8.8Notes Payable0.0 0.0 Current Liabilities$1.5 2.4 Long Term Debt$2.0 2.0 Common Stock0.5.5 Retained Earnings1.5 1.7 Common Equity$2.0 2.2 Total Claims$5.5 $6.6

27. 27 Producing Pro Formas Balance Sheet Marginal Product Inc. Assets Current Projected Liabilities Current Projected AFN = $8.8 - 6.6 = $2.2 mill. Current Assets$2.5$4.0Accounts Payable$1.0 $1.6 Net Fixed Assets3.04.8Accrued Expenses0.5.8 Total$5.5$8.8Notes Payable0.0 0.0 Current Liabilities$1.5 2.4 Long Term Debt$2.0 2.0 Common Stock0.5.5 Retained Earnings1.5 1.7 Common Equity$2.0 2.2 Total Claims$5.5 $6.6 Raise $2.2 million Using: Notes Payable, and/or LT Debt, and/or Common Stock Additional funds needed (AFN) = projected assets minus projected claims Step Step 7:

28. 28 Producing Pro Formas - Summary  Determine sales growth.  Calculate projected net income.  Project assets needed to support the new sales level.  Project increases in spontaneous asset and liability accounts.  Project addition to retained earnings.  Determine the difference between projected assets and projected liabilities & equity.

29. 29 Financing feedback  If outside financing is required, the new debt or equity may affect your original projections of the amount of the addition to retained earnings (due to increased interest or dividends on the income statement).  In this case, the pro forma should be recast with the new information to make final projections of AFN.