1. Ch. 4: Financial Forecasting, Planning, and Budgeting

2. Objectives
Forecast Financial Statements with the Percentage of Sales Approach to determine Discretionary Financing Needed.
Discuss Limitations of Percentage of Sales Approach.
Determine Sustainable Growth Rate.
What’s a cash budget?

3. Financial Forecasting
1) Project sales revenues and expenses.

4. Financial Forecasting
1) Project sales revenues and expenses.
2) Estimate current assets and fixed assets necessary to support projected sales.

5. Financial Forecasting
1) Project sales revenues and expenses.
2) Estimate current assets and fixed assets necessary to support projected sales.
Percent of sales forecast

6. Our Example: Zippy Drives
Suppose this year’s sales will total $20 million.
Next year, we forecast sales of $25 million.
Net income should be 10% of sales.
Dividends should be 40% of earnings.
Our task: forecast balance sheet and determine discretionary (outside) financing needed.

7. This year % of $20m
Assets
Current Assets $6m 30%
Fixed Assets $10m 50%
Total Assets $16m
Liab. and Equity
Accounts Payable $3m 15%
Accrued Expenses $2m 10%
Notes Payable $1m n/a
Long Term Debt $3m n/a
Total Liabilities $9m
Common Stock $4m n/a
Retained Earnings $3m
Equity $7m
Total Liab. & Equity $16m

8. Next year % of $25m
Assets
Current Assets %
Fixed Assets %
Total Assets
Liab. and Equity
Accounts Payable %
Accrued Expenses %
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

9. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets %
Total Assets
Liab. and Equity
Accounts Payable %
Accrued Expenses %
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

10. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets
Liab. and Equity
Accounts Payable %
Accrued Expenses %
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

11. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable %
Accrued Expenses %
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

12. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses %
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

13. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

14. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

15. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity

16. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock $4.00m n/a
Retained Earnings
Equity
Total Liab. & Equity

17. Predicting Retained Earnings
Next year’s projected retained earnings = last year’s $3 million, plus:

18. Predicting Retained Earnings
Next year’s projected retained earnings = last year’s $2 million, plus:
projected net income cash dividends
sales sales net income
x x ( )

19. Predicting Retained Earnings
Next year’s projected retained earnings = last year’s $3 million, plus:
projected net income cash dividends
sales sales net income
$25 million x x ( )
x x ( )

20. Predicting Retained Earnings
Next year’s projected retained earnings = last year’s $3 million, plus:
projected net income cash dividends
sales sales net income
$25 million x x ( )
Proj. RE = $3m + $1.5m = $4.5 million
x x ( )

21. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock $4.00m n/a
Retained Earnings $4.50m
Equity $8.50m
Total Liab. & Equity

22. Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock $4.00m n/a
Retained Earnings $4.50m
Equity $8.50m
Total Liab. & Equity $18.75m

23. Oh, no! Here come the Accounting Police!
Projected Assets $20.00m
Projected Liabilities & Equity $18.75m
Discretionary Financing Needed $1.25m
Zippy must decide how to raise this financing.
Options: short and/or long term borrowing, sell new common stock, cut dividends.
Let’s assume Zippy will borrow an additional $0.25m through Notes Payable and an additional $1m through Long Term Debt.
Here’s Zippy’s complete projected balance sheet.

24. Next year % of $25m Assets Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.25m 1m+0.25m
Long Term Debt $4.00m 3m+1m
Total Liabilities $11.5m
Common Stock $4.00m n/a
Retained Earnings $4.50m
Equity $8.5m
Total Liab. & Equity $20.0m
Whew! Now,
the Accy Police
will be happy!

25. Predicting Discretionary Financing Needs: A Formula Approach
The formula approach gives the same result as our first approach, but focuses on the projected changes in the balance sheet.
DFN = Proj. Inc. in Assets – Proj. Inc. in Liab – Proj Retained Earnings
Proj. Inc in Assets = Assetst/Salest x Chg in sales
Proj Inc in Liab = Liabt/Salest x Chg in Sales
Proj. RE = NPM x Proj Sales x (1 – b), where b is dividend payout ratio = Divs/Net Income

26. Zippy DFN Change in sales = 25m – 20m = 5m Original sales = 20m
Change in Assets = (16m/20m) x 5m = 4m
Change in Liab = (3m+2m)/20m x 5m = 1.25m
Projected RE = 10% x 25m x (1-.4) = 1.5m
DFN = 4m – 1.25m – 1.5m = 1.25m

27. DFN dynamics Recall, Zippy’s original DFN is 1.25m.
What if Zippy’s profit margin was expected to be only 5%?
What if Zippy’s profit margin was the original 10%, but it’s dividend payout ratio is only expected to be 30%?
What if Zippy’s sales are expected to increase to $28 million with original assumptions of 10% profit margin and 40% dividend payout ratio?

28. Zippy DFN dynamic #1 Change in sales = 25m – 20m = 5m
Original sales = 20m
Change in Assets = (16m/20m) x 5m = 4m
Change in Liab = (3m+2m)/20m x 5m = 1.25m
Projected RE = 5% x 25m x (1-.4) = 0.75m
DFN = 4m – 1.25m – 0.75m = $2m
Lower profit margin = more DFN

29. Zippy DFN dynamic #2 Change in sales = 25m – 20m = 5m
Original sales = 20m
Change in Assets = (16m/20m) x 5m = 4m
Change in Liab = (3m+2m)/20m x 5m = 1.25m
Projected RE = 10% x 25m x (1- .3) = 1.75m
DFN = 4m – 1.25m – 1.75m = $1m
Lower dividend payout ratio = less DFN

30. Zippy DFN dynamic #3 Change in sales = 28m – 20m = 8m
Original sales = 20m
Change in Assets = (16m/20m) x 8m = 6.4m
Change in Liab = (3m+2m)/20m x 8m = 2m
Projected RE = 10% x 28m x (1- .4) = 1.68m
DFN = 6.4m – 2m – 1.68m = $2.72m
Higher Projected Sales = more DFN

31. The effects of other factors on the AFN forecast.
Excess capacity:
Existence lowers AFN.
Base stocks of assets:
Leads to less-than-proportional asset increases.
Economies of scale:
Also leads to less-than-proportional asset increases.
Lumpy assets:
Leads to large periodic AFN requirements, recurring excess capacity.

32. Sustainable Rate of Growth
The maximum sales growth rate a firm can have while maintaining its capital structure (financing mix).

33. Sustainable Rate of Growth
g* = ROE (1 - b) where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or

34. Sustainable Rate of Growth
g* = ROE (1 - b) where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
net income sales assets
sales assets common equity
ROE = x x

35. This year % of $20m
Assets
Current Assets $6m 30%
Fixed Assets $10m 50%
Total Assets $16m
Liab. and Equity
Accounts Payable $3m 15%
Accrued Expenses $2m 10%
Notes Payable $1m n/a
Long Term Debt $3m n/a
Total Liabilities $9m
Common Stock $4m n/a
Retained Earnings $3m
Equity $7m
Total Liab. & Equity $16m

36. Sustainable Growth rate for Zippy.
Original Total Assets: $16m, Original Total Debt: $9m
Original Debt Ratio: 9/16 = 56.25%
Current Net income is 10% of $20m or $2m.
Current Equity = $7m
Dividend payout ratio = 40% or .4
G = 2m/7m x (1-.4) = 28.6% x .6 = 17.1%
Our forecast for Zippy: 25% growth in sales (20m to 25m) with the following balance sheet.

37. Next year % of $25m Assets Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.25m 1m+0.25m
Long Term Debt $4.00m 3m+1m
Total Liabilities $11.5m
Common Stock $4.00m n/a
Retained Earnings $4.50m
Equity $8.5m
Total Liab. & Equity $20.0m
Whew! Now,
the Accy Police
will be happy!

38. Zippy’s projected Debt Ratio
Projected Total Assets: $20m
Projected Total Debt/Liabilities: $11.5m
Projected Debt Ratio = 11.5/20 = 57.5%
Since the projected growth rate of 25% is greater than the sustainable growth rate of 17.1%, the debt ratio increases from 56.25% to 57.5%.

39. Budgets
Budget: a forecast of future events.

40. Budgets
Budgets indicate the amount and timing of future financing needs.
Budgets provide a basis for taking corrective action if budgeted and actual figures do not match.
Budgets provide the basis for performance evaluation.

41. Syllabus Change Don’t worry about constructing cash budgets!
Omit problems 4-6a and 4-11a