1. Financial Forecasting
Chapter 4
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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

3. Financial Forecasting
Ability to plan ahead and make necessary adjustments 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

4. Constructing Pro Forma Statements
Pro forma, or projected, financial statements enable a firm to estimate its future level of receivables, inventory, payables, as well as its anticipated profits and borrowing requirements.
These statements are often required by bankers and other lenders as a guide for the future.
A systems approach to develop pro forma statements consists of:
Constructing income statement based on sales projections and the production plan
Translating it into a cash budget
Assimilating all materials into a pro forma balance sheet

5. Development of Pro Forma Statements

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

7. Establish a Sales Projection
Let us assume Goldman Corporation has two primary products: wheels and casters
Table 4-1

8. Determine a Production Schedule and the Gross Profit
Number of units produced will depend on:
Beginning inventory
Sales projections
Desired ending inventory
To determine the production requirements:
Units
+ Projected sales
+ Desired ending inventory
– Beginning inventory
= Production requirements

9. Stock of Beginning Inventory
Goldman Corporation has in stock the items shown in the Table below:
Table 4-2

10. Production Requirements for Six Months
Table 4-3

11. Unit Costs
Cost to produce each unit:
Table 4-4

12. Total Production Costs
Table 4-5

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

14. Allocation of Manufacturing Cost and Determination of Gross Profits
Table 4-6

15. Value of Ending Inventory
Table 4-7

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

17. Actual Pro Forma Income Statement
Table 4-8

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

19. Monthly Sales Pattern
Table 4-9

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

21. Monthly Cash Receipts
Table 4-10

22. Component Costs of Manufactured Goods
Table 4-11

23. 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

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

25. Average Monthly Manufacturing Costs
Table 4-12

26. Summary of All Monthly Cash Payments
Table 4-13

27. Actual Budget (Monthly Cash Flow)
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
Table 4-14

28. Cash Budget with Borrowing and Repayment Provisions
Assumptions:
The firm wishes to maintain minimum cash balance
If the balance goes below the minimum, the firm will borrow
If the balance goes above the minimum, the firm will use the excess to repay the loan
Table 4-15

29. 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

30. Development of a Pro Forma Balance Sheet
Table 4-16

31. Development of a Pro Forma Balance Sheet (cont’d)

32. Pro Forma Balance Sheet

33. Explanation of Pro Forma Balance Sheet
Cash ( $5,000 )—minimum cash balance as shown in Table 4–15
Marketable securities ( $3,200 )—remains unchanged from prior period’s value in Table 4–16
Accounts receivable ( $16,000 )—based on June sales of $20,000 in Table 4–10 (80% of current month sales become accounts receivables)
Inventory ( $6,200 )—ending inventory as shown in Table 4–7.
Plant and equipment ( $27,740+ $18,000) $45,740
Accounts payable ( $5,732 )—based on June purchases in Table 4–13
Notes payable ( $5,884 )—the amount that must be borrowed to maintain the cash balance of $5,000, as shown in Table 4–15
Long-term debt ( $15,000 )—remains unchanged from prior period’s value in Table 4–16
Common stock ( $10,500 )—remains unchanged from prior period’s value in Table 4–16
Retained earnings ( $39,024 )—initial value plus pro forma income ($20,500 + $18,524)

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, 2011)……$76,140
Total assets (Dec 31, 2010)…….$50,500
Increase…………………………...$25,640

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

36. Balance Sheet of Howard Corporation

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

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) – PS2(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; S2 = 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

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