Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Forecasting 4

1-2 Chapter Outline Financial forecasting in a firm’s strategic growth Three financial statements Percent-of-sales method Methods to determine the amount of new funds required in advance Factors that affect cash flow

1-3 Financial Forecasting Ability to plan ahead and make necessary changes before actual events occur Outcome of a firm through external events might be a function of both: –Risk-taking desires –Ability to hedge against risk with planning No growth or a decline - not the primary cause of shortage of funds A comprehensive financing plan must be developed for a significant growth

1-4 Constructing Pro Forma Statements A systems approach to develop pro forma statements consists of: –Constructing it based on: Sales projections Production plans –Translating it into a cash budget –Assimilating all materials into a pro forma balance sheet

1-5 Development of Pro Forma Statements

1-6 Pro Forma Income Statement Provides a projection on the anticipation of profits over a subsequent period Four important steps include: Establishing a sales projection Determining production schedule and the associated use of new material, direct labor, and overhead to arrive at gross profit Computing other expenses Determining profit by completing actual pro forma statement

1-7 Establish a Sales Projection Let us assume Goldman Corporation has two primary products: wheels and casters

1-8 Stock of Beginning Inventory Number of units produced will depend on beginning inventory

1-9 Determine a Production Schedule and the Gross Profit To determine the production requirements: Units + Projected sales + Desired ending inventory – Beginning inventory = Production requirements

1-10 Production Requirements for Six Months

1-11 Unit Costs Cost to produce each unit:

1-12 Total Production Costs

1-13 Cost of Goods Sold Costs associated with units sold during the time period –Assumptions for the illustration: FIFO accounting is used First allocates the cost of current sales to beginning inventory Then to goods manufactured during the period

1-14 Allocation of Manufacturing Cost and Determination of Gross Profits

1-15 Value of Ending Inventory

1-16 Other Expense Items Must be subtracted from gross profits to arrive at net profit –Earning before taxes General and administrative expenses, and interest expenses are subtracted from gross profit –Aftertax income Taxes are deducted from the earning before taxes –Contribution to retained earnings Dividends are deducted from the aftertax income

1-17 Actual Pro Forma Income Statement

1-18 Cash Budget Pro forma income statement must be translated into cash flows –The long-term is divided into short-term pro forma income statement –More precise time frames set to help anticipate patterns of cash inflows and outflows

1-19 Monthly Sales Pattern

1-20 Cash Receipts In the case of Goldman Corporation: –The pro forma income statement is taken for the first half year: Sales are divided into monthly projections –A careful analysis of past sales and collection records show: 20% of sales is collected in the month 80% in the following month

1-21 Monthly Cash Receipts

1-22 Cash Payments Monthly costs associated with: –Inventory manufactured during the period Material Labor Overhead –Disbursements for general and administrative expenses –Interest payments, taxes, and dividends –Cash payments for new plant and equipment

1-23 Component Costs of Manufactured Goods

1-24 Cash Payments (cont’d) Assumptions for the next two tables: –Costs are incurred on an equal monthly basis over a six-month period –Sales volume varies each month –Employment of level monthly production to ensure maximum efficiency –Payment for material, once a month after purchases have been made

1-25 Average Monthly Manufacturing Costs

1-26 Summary of All Monthly Cash Payments

1-27 Actual Budget Difference between monthly receipts and payments is the net cash flow for the month –Allows the firm to anticipate the need for funding at the end of each month

1-28 Monthly Cash Budget

1-29 Cash Budget with Borrowing and Repayment Provisions

1-30 Pro Forma Balance Sheet Represents the cumulative changes over time –Important to examine the prior period’s balance sheet –Some accounts will remain unchanged, while others will take new values Information is derived from the pro forma income statement and cash budget

1-31 Development of a Pro Forma Balance Sheet

1-32 Development of a Pro Forma Balance Sheet (cont’d)

1-33 Explanation of Pro Forma Balance Sheet

1-34 Analysis of Pro Forma Statement The growth ($25,640) was financed by accounts payable, notes payable, and profit –As reflected by the increase in retained earnings Total assets (June 30, 2005)……$76,140 Total assets (Dec 31, 2004)…….$50,500 Increase…………………………...$25,640

1-35 Percent-of-Sales Method Based on the assumption that: –Accounts on the balance sheet will maintain a given percentage relationship to sales –Notes payable, common stock, and retained earnings do not maintain a direct relationship with sales volume Hence percentages are not computed

1-36 Balance Sheet of Howard Corporation

1-37 Percent-of-Sales Method (cont’d) Funds required is ascertained Financing is planned based on: –Notes payable –Sale of common stock –Use of long-term debt

1-38 Percent-of-Sales Method (cont’d) Company operating at full capacity – needs to buy new plant and equipment to produce more goods to sell: –Required new funds: (RNF) = A (ΔS) – L (ΔS) – PS 2 (1 – D) S S Where: A/S = Percentage relationship of variable assets to sales; ΔS = Change in sales; L/S = Percentage relationship of variable liabilities to sales; P = Profit margin; S 2 = New sales level; D = Dividend payout ratio RNF = 60% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 –.50) = $60,000 - $ $18,000 (.50) = $35,000 - $9000 = $26,000 required sources of new funds

1-39 Percent-of-Sales Method (cont’d) Company not operating at full capacity - needs to add more current assets to increase sales: RNF = 35% ($100,000) – 25% ($100,000) – 6% ($300,000) (1 –.50) = $35,000 - $25,000 - $18,000 (.50) = $35,000 - $25,000 - $9,000 = $1,000 required sources of new funds