CHAPTER 4 Financial Planning and Forecasting Financial Statements
Forecasting for Financial Planning
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Transcript of Forecasting for Financial Planning
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Forecasting forFinancial Planning
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Learning ObjectivesLearning Objectives
The importance of forecasting to business success.
The financial forecasting process.Preparation of pro forma financial
statements.The importance of analyzing forecasts.
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Why is forecasting important?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:
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Forecasting ApproachesForecasting Approaches
ExperienceProbabilityCorrelation
Financial managers concentrate on
three general approaches to financial
forecasting:
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ExperienceExperience
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.
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ProbabilityProbability
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.
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CorrelationCorrelation
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.
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Finance Department
The Sales Forecasting ProcessThe Sales Forecasting Process
Marketing(sales estimate)
Top Management(policy, strategy)
Production(capacity, schedules)
Accounting(financial statements,depreciation, taxes)
SALESSALESFORECASTFORECAST
994 95 96 97 98 99 00 01 02 03
Time
Sales
Plot of Past SalesPlot of Past Sales
Forecast future sales based on past sales growth
1094 95 96 97 98 99 00 01 02 03
Time
Sales
Forecast future sales based on past sales growth
Trend LineTrend Line
1194 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
Sales Estimates for next 2 years
1294 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
1394 95 96 97 98 99 00 01 02 03Time
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
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– Current Assets: Inventory, A/R, Cash– Fixed Assets: Plant and Equipment
2002200220032003
Sales Growth Imposes Costs on the FirmSales Growth Imposes Costs on the Firm
Will require additional resources
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Pro Forma Financial StatementsPro 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.
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Producing Pro FormasProducing 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.
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Producing Pro FormasProducing Pro Formas
Note:Note: The projected saleswill be determined after inputfrom many different units ordepartments of the firm.
Determining Sales Growth
= 60%$8 - $5 $5
StepStep 1:
Income StatementMarginal Product Inc.
Sales $5,000 COGS 4,133 EBIT 867Int 200EBT 667Tax (.40) 267NI 400
Current Projected
$8,000
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Calculate projected Net Income. New COGS =Old COGS x 1.6 = 6,613
Producing Pro FormasProducing Pro Formas
Note:Note: There is no increase yetin the interest charges sinceMarginal Product’s managershave not yet decided how theywill finance the growth.
StepStep 2:
Income StatementMarginal Product Inc.
Sales $5,000 $8,000COGS 4,133 6,613EBIT 867 1,387Int 200 200EBT 667 1,187Tax (.40) 267 475NI 400 712
Current Projected
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Producing Pro FormasProducing Pro Formas
Forecast increase in assets (% of sales)
StepStep 3:
Balance SheetMarginal Product Inc.
Current Assets $2.5 Accounts Payable $1.0 Net Fixed Assets 3.0 Accrued Expenses 0.5 Total $5.5 Notes Payable 0.0
Current Liabilities $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5
Assets Current Projected Liabilities Current Projected
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Balance SheetMarginal Product Inc.
Current Assets $2.5 $4.0 Accounts Payable $1.0 Net Fixed Assets 3.0 Accrued Expenses 0.5 Total $5.5 Notes Payable 0.0
Current Liabilities $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5
Assets Current Projected Liabilities Current Projected
Producing Pro FormasProducing 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.
StepStep 3:
$2.5(1+.60) = $4.0$2.5(1+.60) = $4.0
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Producing Pro FormasProducing Pro Formas
Forecast increase in assets (% of sales)
StepStep 3:
Balance SheetMarginal Product Inc.
Current Assets $2.5 $4.0 Accounts Payable $1.0 Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 Total $5.5 $8.8 Notes Payable 0.0
Current Liabilities $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5
Assets Current Projected Liabilities Current Projected
+$3.30
$3.0(1+.60) = $4.8$3.0(1+.60) = $4.8
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Producing Pro FormasProducing Pro Formas
Forecast increase inspontaneous liabilities.
StepStep 4:
Balance SheetMarginal Product Inc.
Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 Total $5.5 $8.8 Notes Payable 0.0
Current Liabilities $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5
Assets Current Projected Liabilities Current Projected
$1.0(1+.60) = $1.60$1.0(1+.60) = $1.60
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Producing Pro FormasProducing Pro Formas
Balance SheetMarginal Product Inc.
Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 .8Total $5.5 $8.8 Notes Payable 0.0
Current Liabilities $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5
Assets Current Projected Liabilities Current Projected
$0.5(1+.60) = $0.80$0.5(1+.60) = $0.80
Forecast increase inspontaneous liabilities.
StepStep 4:
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Producing Pro FormasProducing Pro Formas
Balance SheetMarginal Product Inc.
Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 .8Total $5.5 $8.8 Notes Payable 0.0
Current Liabilities $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 1.7Common 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 inretained earnings.
StepStep 5:
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Producing Pro FormasProducing Pro Formas
Balance SheetMarginal Product Inc.
Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 .8Total $5.5 $8.8 Notes Payable 0.0 0.0
Current Liabilities $1.5 2.4Long Term Debt $2.0 2.0Common Stock 0.5 .5Retained Earnings 1.5 1.7Common Equity $2.0 2.2Total Claims $5.5 $6.6
Assets Current Projected Liabilities Current Projected
Hold other accounts constant to see how much additionalfunds will be needed.
StepStep 6:
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Balance SheetMarginal Product Inc.
Assets Current Projected Liabilities Current Projected
AFN = $8.8 - 6.6 = $2.2 mill.
Producing Pro FormasProducing Pro Formas
Additional funds needed (AFN) = projected assetsminus projected claims
StepStep 7:
Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 .8Total $5.5 $8.8 Notes Payable 0.0 0.0
Current Liabilities $1.5 2.4Long Term Debt $2.0 2.0Common Stock 0.5 .5Retained Earnings 1.5 1.7Common Equity $2.0 2.2Total Claims $5.5 $6.6
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Producing Pro FormasProducing Pro Formas
Balance SheetMarginal Product Inc.
Assets Current Projected Liabilities Current Projected
AFN = $8.8 - 6.6 = $2.2 mill.
Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 .8Total $5.5 $8.8 Notes Payable 0.0 0.0
Current Liabilities $1.5 2.4Long Term Debt $2.0 2.0Common Stock 0.5 .5Retained Earnings 1.5 1.7Common Equity $2.0 2.2Total Claims $5.5 $6.6
Raise $2.2 million Using: Notes Payable, and/or LT Debt, and/or Common Stock
Raise $2.2 million Using: Notes Payable, and/or LT Debt, and/or Common Stock
Additional funds needed (AFN) = projected assetsminus projected claims
StepStep 7:
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Producing Pro Formas - SummaryProducing 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.
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Financing feedbackFinancing 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.