1. CDA COLLEGE BUS235: PRINCIPLES OF FINANCIAL ANALYSIS Lecture 8 Lecture 8 Lecturer: Kleanthis Zisimos

2. Financial Forecasting Financial Forecasting Income statement forecast Income statement forecast The projected Balance sheet The projected Balance sheet Formula method for forecasting Formula method for forecasting Planning Planning Budgets Budgets BEP analysis BEP analysis Lecture Topic List

3. Financial Forecasting Financial forecasting is the quantitative expression of the business plan. Financial forecasting is the quantitative expression of the business plan. Financial forecasting help managers to scientifically project sales, analyze the cost of alternative strategies and choose the appropriate ones, communicate more clearly the targets for each employee and evaluate the performance by internal controls. Financial forecasting help managers to scientifically project sales, analyze the cost of alternative strategies and choose the appropriate ones, communicate more clearly the targets for each employee and evaluate the performance by internal controls. Financial control moves on to the implementation phase, dealing with the feedback and adjustment process that is required (1) to ensure that plans are followed and (2) to modify existing plans in response to changes in the operating environment Financial control moves on to the implementation phase, dealing with the feedback and adjustment process that is required (1) to ensure that plans are followed and (2) to modify existing plans in response to changes in the operating environment

4. Components of the Financial forecasting Financial forecasting consists of many separate forecasts that are inter depended. Financial forecasting consists of many separate forecasts that are inter depended. The two major parts are The projected income statement which has the following sub categories The projected income statement which has the following sub categories 1. Sales forecast. 2. Cost of goods sold forecast 3. Operation expenses forecast The projected Balance sheet The projected Balance sheet

5. Sales forecast Sales forecast is based on Sales forecast is based on 1. Past Sales 2. Market research studies 3. Industry trend 4. Pricing policy 5. Expected action of competition 6. New product development 7. Advertising and promotion Usually the first 12 months are presented analytically and sometimes when a month is ended another one is added making the forecast a continues forecast Usually the first 12 months are presented analytically and sometimes when a month is ended another one is added making the forecast a continues forecast

6. Cost of goods sold and Operation expenses forecast Cost of costs sold forecast projects all the expenditure which are included in the Trading account. If the company is a manufacturing company then the cost of production is added to the forecast Cost of costs sold forecast projects all the expenditure which are included in the Trading account. If the company is a manufacturing company then the cost of production is added to the forecast Operating forecast projects all the expenditure which are included in the Profit & Loss account. Operating forecast projects all the expenditure which are included in the Profit & Loss account.

7. Balance sheet forecast The Balance sheet forecast focuses on the effects that the following sub categories will have on cash: The Balance sheet forecast focuses on the effects that the following sub categories will have on cash: Capital Budget. Projection of capital expenditure Capital Budget. Projection of capital expenditure Working capital budget. Repayment of debts and projected receipts from customers Working capital budget. Repayment of debts and projected receipts from customers

8. Analysis of the Forecast The projected statements must be analyzed to determine whether the forecast meets the firm’s financial targets as laid down in the financial plan. The projected statements must be analyzed to determine whether the forecast meets the firm’s financial targets as laid down in the financial plan. If the statements do not meet the targets, then elements of the forecast must be changed. If the statements do not meet the targets, then elements of the forecast must be changed.

9. The Formula Method for Forecasting AFN (Additional Funds Needed) AFN = (A*/S)ΔS – (L*/S)ΔS – MS1(1 – d) AFN = Additional funds needed. AFN = Additional funds needed. A*/S = Assets that must increase if sales are to increase expressed as a percentage on sales. A*/S = Assets that must increase if sales are to increase expressed as a percentage on sales. L*/S = Liabilities that increase spontaneously. L*/S = Liabilities that increase spontaneously. S1 = Total sales projected for next year. S1 = Total sales projected for next year. ΔS = Change in sales. ΔS = Change in sales. M = Profit margin or rate of profit per €1 of sales. M = Profit margin or rate of profit per €1 of sales. d = percentage of earnings paid out in common dividends. d = percentage of earnings paid out in common dividends.

10. Relationship between growth and financial requirements The faster the growth rate is sales the greater the need for additional financing The faster the growth rate is sales the greater the need for additional financing The higher the dividends payout ratio, the greater the requirements for external capital. The higher the dividends payout ratio, the greater the requirements for external capital. The higher the capital intensity ratio (A*/S), the greater the requirements for external capital. The higher the capital intensity ratio (A*/S), the greater the requirements for external capital.

11. Forecasting Financial Requirements when the Balance Sheet ratios are subject to change Both the AFN formula and the projected balance sheet method assume that the balance sheet ratios remain constant over time. Both the AFN formula and the projected balance sheet method assume that the balance sheet ratios remain constant over time. Some conditions though change this assumption and these conditions are Some conditions though change this assumption and these conditions are 1. Economies of Scale. There are economies of scale in the use of many kinds of assets, and when economies occur, the ratios are likely to change over time as the size of the firm increases.

12. 2. Lumpy Assets. Assets that can not be acquired in small increments but must be obtained in large amounts. 3. Excess assets due to forecasting errors. If actual sales are different from the projected then the actual asset/sales ratio is different from the planned ratio. Forecasting Financial Requirements when the Balance Sheet ratios are subject to change

13. What is Planning Planning or business plan is what we can call the identity of an organization. Planning or business plan is what we can call the identity of an organization. The Business plan defines the vision of the company, sets the overall goals and objectives, identifies strategies by allocating its recourses to each strategy for the success of each goal and evaluates the performance for improvement of the existing plan. The Business plan defines the vision of the company, sets the overall goals and objectives, identifies strategies by allocating its recourses to each strategy for the success of each goal and evaluates the performance for improvement of the existing plan.

14. How budgets facilitate planning Budget is the quantitative expression of the business plan. Budget is the quantitative expression of the business plan. Budgets help managers to scientifically project sales, analyze the cost of alternative strategies and choose the appropriate ones, communicate more clearly the targets for each employee and evaluate the performance by internal controls. Budgets help managers to scientifically project sales, analyze the cost of alternative strategies and choose the appropriate ones, communicate more clearly the targets for each employee and evaluate the performance by internal controls.

15. Types of Budgets Common base Budget. A budget that assumes that the expenditure of every activity will be approximately the same with the ones in the previous year. Common base Budget. A budget that assumes that the expenditure of every activity will be approximately the same with the ones in the previous year. Zero Base Budget. A budget that requires justification of expenditures for every activity. Zero Base Budget. A budget that requires justification of expenditures for every activity.

16. Master Budget The master budget is a combination of a common base and a zero base budget. The master budget is a combination of a common base and a zero base budget. The master budget is a comprehensive profit plan that ties together all phases of an organization’s operations, short term and long term. The master budget is a comprehensive profit plan that ties together all phases of an organization’s operations, short term and long term. Usually the first 12 months are presented analytically and sometimes when a month is ended another one is added making the budget a continues master budget Usually the first 12 months are presented analytically and sometimes when a month is ended another one is added making the budget a continues master budget

17. Components of a Master Budget The master budget consists of many separate budgets that are inter depended. The master budget consists of many separate budgets that are inter depended. The two major parts are the operating budget and financial budget. The two major parts are the operating budget and financial budget. The operating budget focuses on the income statement items. The operating budget focuses on the income statement items. The financial statement focuses on the balance sheet items. The financial statement focuses on the balance sheet items.

18. Operating budget The operating budget has the following sub budgets The operating budget has the following sub budgets 1. Sales forecast. Very difficult to do accurately 2. Cost of goods sold budget 3. Operation expenses budget The above 3 sub budgets are united in the end The above 3 sub budgets are united in the end and produce the operating budget or Budgeted Profit & Loss and produce the operating budget or Budgeted Profit & Loss

19. Financial Budget The Financial budget focuses on the effects that the operating budget and the following sub budgets will have on cash: The Financial budget focuses on the effects that the operating budget and the following sub budgets will have on cash: Capital Budget. Projection of capital expenditure Capital Budget. Projection of capital expenditure Working capital budget. Repayment of debts and projected receipts from customers Working capital budget. Repayment of debts and projected receipts from customers Cash budget. The effects of the operating budget will be presented in this budget Cash budget. The effects of the operating budget will be presented in this budget After the completion of the projections the 3 budgets are united in one budget called financial budget or Budgeted Balance sheet After the completion of the projections the 3 budgets are united in one budget called financial budget or Budgeted Balance sheet

20. Case Study Prepare the master budget for 4 months of the company “Cooking Hub” using the following data. Prepare the master budget for 4 months of the company “Cooking Hub” using the following data. Sales in 2011 March 40 000 €. Sales in 2011 March 40 000 €. Projected sales. 40% cash and 60% received next month Projected sales. 40% cash and 60% received next month April 50000 € May 55000 € June 60000 € July 40000 €

21. Case Study Balance sheet of Cooking Hub as at 31 March 2011 Equipment 12200 Capital 78950 Other assets 12000 Creditors 16800 Stock 49800 Accrued commission paid 4250 cash 10000 Debtors 16000 Total Assets 100000

22. Case Study CHC plans to buy new furniture for 3000 € in July CHC plans to buy new furniture for 3000 € in July Rent 2000 € per month Rent 2000 € per month Insurance 200 € per month Insurance 200 € per month Depreciation 500 € per month Depreciation 500 € per month Salaries 5000 € per month Salaries 5000 € per month Cost of sales 50% on sales Cost of sales 50% on sales Accrued commission will be paid on April Accrued commission will be paid on April

23. Notes on BEP Analysis The Break Even Point analysis is based in the classification of cost as variable and fixed according to the activity performed The Break Even Point analysis is based in the classification of cost as variable and fixed according to the activity performed Activity refers to a measure of the organizations output of product Activity refers to a measure of the organizations output of product Variable Cost. It changes proportionately with the activity change but the unit variable cost remains the same. Variable Cost. It changes proportionately with the activity change but the unit variable cost remains the same. Fixed cost. It remains unchanged as activity changes but the unit fixed cost changes. Fixed cost. It remains unchanged as activity changes but the unit fixed cost changes.

24. The equation method of calculating BEP The break-even point is the level of sales at which revenue equals expenses and net income is zero The break-even point is the level of sales at which revenue equals expenses and net income is zero The equation method is the most general form of analysis, one you can adapt to any conceivable cost- volume-profit situation. We can express any income statement in equation form, or as a mathematical model, as follows: The equation method is the most general form of analysis, one you can adapt to any conceivable cost- volume-profit situation. We can express any income statement in equation form, or as a mathematical model, as follows: sales - variable expenses - fixed expenses = net income (0 for BEP) That is (Unit sales price x Q)-(Unit variable cost x Q)-fixed expenses=0

25. The equation method of calculating BEP If we isolate the quantity (Q) from the equation we have the following formula: Break even point in units (Q) = Fixed expenses Break even point in units (Q) = Fixed expenses Unit Price-Unit Variable cost Unit Price-Unit Variable cost If we want to find the BEP in sales then the following formula is applied Break even point in sales (S)= Fixed expenses Break even point in sales (S)= Fixed expenses 1-(VC/total Sales) 1-(VC/total Sales)

26. BEP example

27. Calculate sales volume to reach a target profit Suppose we considers € 1440 the minimum acceptable net income. How many units will she have to sell to justify the adoption of the vending machine? Suppose we considers € 1440 the minimum acceptable net income. How many units will she have to sell to justify the adoption of the vending machine? Target sales volume in units= Fixed expenses+ target income Target sales volume in units= Fixed expenses+ target income Unit Price-Unit Variable Cost Unit Price-Unit Variable Cost =18000+1440 =18000+1440 0,30 0,30 =64800 units =64800 units

28. Operating Leverage Operating leverage is the ratio of fixed cost to variable cost. Operating leverage is the ratio of fixed cost to variable cost. Operating Leverage= Fixed cost Operating Leverage= Fixed cost variable Cost variable Cost In highly leveraged companies (high fixed cost and low variable cost) small changes is sales volumes result in large changes in net income In highly leveraged companies (high fixed cost and low variable cost) small changes is sales volumes result in large changes in net income

29. Degree of operating Leverage To measure the effect of a change in volume on profitability, we calculate the degree of operating leverage (DOL). To measure the effect of a change in volume on profitability, we calculate the degree of operating leverage (DOL). DOL= % change in EBIT DOL= % change in EBIT % change in sales % change in salesOR DOL= Q x (Price –VC per unit) DOL= Q x (Price –VC per unit) Q x (Price –VC per unit)-Fixed costs Q x (Price –VC per unit)-Fixed costs