FINANCIAL FORECASTING

Transcription

1 4 CHA PTE R FINANCIAL FORECASTING Forecasting the future has never been easy, but today our vision of that future changes constantly. We must also consider the effects of changes (IFRS) in accounting practices in preparing pro forma statements. The Internet provides us with instant access to these changes; however, we have to be prepared to use this constant stream of information effectively. The old notion of the corporate treasurer working all night to find new avenues of financing before dawn is no longer realistic. One talent that is essential to the financial manager is the ability to plan ahead and to make necessary adjustments before actual events occur. We likely could construct the same set of external events for two corporations (inflation, recession, severe new competition, and so on), and one would survive, while the other would not. The outcome might be a function not only of their risk-taking desires, but also of their ability to hedge against risk with careful planning. Although we may assume that no growth or a decline in volume is the primary cause for a shortage of funds, this is not necessarily the case. A rapidly growing firm may witness a significant increase in accounts receivable, inventory, and plant and equipment to facilitate that growth, and these increasing investments in assets cannot be financed solely through profits. Suppliers, financial institutions, and perhaps the shareholders will be required to contribute more capital to the firm. A comprehensive financing plan with pro forma statements must be developed to anticipate these capital needs. Too often, small business, and sometimes big business, is mystified by an increase in sales and profits but a decrease of cash in the bank. Recognizing the differences between income statements and actual cash is often crucial to ensure the continuing success of a business. LEARNING OBJECTIVES LO1 LO2 Explain why financial forecasting is essential for the healthy growth of the firm. Prepare the four financial statements for forecasting the pro forma income statement, the pro forma statement of retained earnings, the cash budget, and the pro forma balance sheet. LO3 Perform the specific accounts method and the percent-of-sales method for forecasting on a less-precise basis. LO4 Determine the need for new funding resulting from sales growth. LO5 Calculate the required new funds (RNF) and sustainable growth rate (SGR). LO6 Assess and consider the effects of IFRS on forecasting financial statements. Practice and learn online with Connect.. Excel Templates are marked with

2 Real-Time Forecasts at Dell vs. MDG Computers Sales Centres FINANCE IN ACTION Dell Computers was founded in 1984 and today it has annual sales of US$57 billion. Its business model is to sell customized computers directly to the customer over the Internet, saving money and making the latest technology available quickly. This is the Dell Direct Model. Another key advantage of direct sales is that Dell is aware immediately of customer concerns and expectations. Sales information from across the globe is collected, summarized, and reported daily to Michael Dell, founder and CEO, in Texas. Being on top of the revenue side of the business is complemented on the variable-cost side by holding less than a week s worth of inventory these strategies, along with Dell s ability to deliver quickly have made it successful. Cost reductions can be passed on to customers immediately and inventory needs can respond to changing customer dynamics. In contrast, MDG Computers Canada expanded rapidly in the 90s by low-cost assembly of its products, easy financing for consumers, and low sale prices through numerous small outlets across Canada. Part of the key to its success is the hands-on style of management, allowing immediate corrective action for problems when identified. Another reason for its success is the low overhead and spreading of risks that come from franchising its sales outlets. In summary, both Dell s and MDG s business models have proven to be successful, despite following significantly different strategies. Currently, both companies experience lower sales and profits caused by lower demand for computer products in general and new suppliers competing in the industry. Q1 How does the Dell Direct Model contribute to its success? Compare Dell s model to MDG s model. Q2 How are Dell s latest financial results and its inventory control? dell.com Symbol: DELL (Nasdaq) mdgcomputers.ca THE FINANCIAL PLANNING PROCESS LO1 Financial planning is a key component in the development of a focused corporate strategy that is necessary for a firm s success. The strategic plan is like a road map that examines the different opportunities available for the trip, considers the trends that will influence the route taken and contemplates possible changes to how the trip has been taken in the past. The road map can be adapted as the trip progresses and as circumstances change with new information coming to light, but it serves as a communication device to suggest where one is going and the route(s) to take. With the rapid changes in today s environment, it provides a focus and a means to evaluate progress. Finance performs the critical analysis and modification of the alternatives and objectives suggested by the strategic planning process. Strategic planning and the financial planning process usually involve the following steps: Thinking. Consideration of the firm s current businesses, as well as its challenges and opportunities. Careful collection of data and analysis are required. Decisions. Key directions, strategic resource commitments, and business models evolve. Finance should play an important role evaluating alternatives by modelling asset values and risk with long term objectives. Planning. Priorities, objectives, and outcomes are established. Financial plans and budgets are developed with short term objectives. Performance. Work plans for all departments, monitoring, evaluating, and corrective action. The thinking and decision stages should incorporate good corporate governance practices and strong ethical standards as the mission and key business initiatives are established. Shareholder wealth maximization as examined in Chapter 1 is a major motivator for the firm, but there are other important considerations that contribute to the firm s success. 94 Part 2: Financial Analysis and Planning

3 Long run investment and financing decisions of the firm are molded into the overall corporate strategy through the financial planning process that relies on financial forecasting. These decisions should be analyzed with the capital budgeting techniques examined in Chapter 12. Scenarios that cover the best case, worst case, and most likely case outcomes are often produced to enable management to better appreciate the possible results of the different investment alternatives, as they affect the short run operations of the firm. In the process of building a financial plan, it is important that consensus is built among all stakeholders of the company, such as the marketing, production, human resources, treasury, and accounting personnel. If certain stakeholders are alienated from the process of building the plan, it will not have their support, and the financial plan will likely fail. If stakeholders don t feel part of the process they will be reluctant or unwilling to contribute reliable information that will be needed to construct an effective plan. Financial forecasting tends to focus more on the short run, and is usually based on the overall strategies developed as part of the financial plan. Forecasting financial results, particularly over the next 12 months, are essential to ensure the firm has sufficient cash to remain in business. This helps the firm avoid surprises, and the forecasts can be used by the firm to measure performance. Difficulties arise in preparing the financial forecasts because there seldom are direct relationships between projected sales and cash requirements. Furthermore, sales projections, cost estimates, and the timing of cash flows often rely on the estimates of persons within the company, based on past experience, and these must be tempered with the changing business environment. This is why it is essential that all stakeholders see the value of the process and feel their participation gives tangible results. Results are usually different than forecasted, sometimes to a great extent. The importance of a forecasted plan is that it allows the firm to identify what went wrong and correct it in the future. Furthermore, a flexible plan allows the firm to adjust to changing conditions so the firm knows where it should be going and can identify when things go wrong. A good plan will be adapted continually as new information becomes available, but it allows the firm to better assess its past and future financial capabilities. CONSTRUCTING PRO FORMA STATEMENTS LO2 The most comprehensive means of financial forecasting is to develop a series of pro forma, or projected, financial statements. Projections should be based on knowledge of the local and global economic environment, on social and political change, on anticipation of competitors strategies, and on prediction of innovation in product markets. A systems approach to developing pro forma statements allows construction, as depicted in Figure 4 1, of A pro forma income statement (based on sales projections and a production plan) A pro forma statement of retained earnings A cash budget resulting from inflows (receipts) and outflows (payments) of cash A pro forma balance sheet Extensive financial planning and application templates are available through the Business Development Bank of Canada at bdc.ca. The projections allow us to anticipate asset and liability levels, profits, and borrowing requirements. Lenders will see how repayment will occur and financial officers can track actual events against the plan to make necessary adjustments. Without realistic financial forecasts, the small business in particular will likely Have liquidity problems (lack of funds) Demonstrate poor management planning and control measures Have difficulty securing business loans Face possible business failure Chapter 4: Financial Forecasting 95

4 Figure 4 1 Development of pro forma statements Prior balance sheet Sales projection Production plan 1 3 Pro forma income statement Pro forma balance sheet 2 Cash budget Other supportive budgets Capital budget The construction of pro forma statements is greatly enhanced by computerized spreadsheets, which will allow sensitivity (changes in variables such as sales and expenses) and scenario ( what if situation changes) analysis. These tools allow us to easily calculate multiple forecasts under different assumptions resulting in multiple levels of forecasted profits. We can also apply probability analysis to forecast the most likely levels of revenues and expenses, as covered in more detail in Chapter 13. There are numerous economic and political changes that occur during the year that has been forecasted; computer software can facilitate changes to the forecast as new events affect the original forecast, allowing management to take corrective action immediately. A flexible budget is essential given the frequent changes that occur in our global environment. PRO FORMA INCOME STATEMENT LO3 Assume the Goldman Corporation has been requested by its bank to provide pro forma financial statements for midyear The pro forma income statement provides a projection of how much profit the firm anticipates making over the ensuing time period. In developing the pro forma income statement, we will follow four important steps: 1. Establish a sales projection in dollars and units. 2. Determine a production schedule and the associated use of new material, direct labour, and overhead to calculate cost of goods produced and arrive at gross profit. 3. Compute other expenses, including indirect labour, supplies, and other costs. 4. Determine profit by completing the actual pro forma statement. Ultimately, a firm s continued success is written with income statement results showing an acceptable return to investors. However, it is the appropriate management of the firm s short term cash position that allows the long term success to be realized. 96 Part 2: Financial Analysis and Planning

5 ESTABLISH A SALES PROJECTION For purposes of analysis, we assume the Goldman Corporation has two primary products: wheels and casters. Our sales projection by the marketing department calls for the sale of 1,000 wheels and 2,000 casters at prices of $30 and $35, respectively. As indicated in Table 4 1, we anticipate total sales of $100,000. Table 4 1 Projected wheel and caster sales (first six months, 2015) Wheels Casters Total Quantity.... 1,000 2,000 Sales price... $ 30 $ 35 Sales revenue... $30,000 $70,000 Total... $100,000 Sales estimates are the cornerstone of the entire process of constructing pro forma statements. Sales revenue, we are reminded, is the product of demand for a company s products or services and their prices. A firm s financial results will likely prove to be sensitive to differences between projected demand and realized demand. Our concern for the precision of forecasted demand depends on the seriousness attached to a potential cash shortfall. This, in turn, determines if daily, weekly, or monthly estimates are required. The projected price is based on the firm s cost structure, the marketing effort, and the anticipated response of competitors to the firm s price. A forecast of the quantity sold needs to consider price, knowledge of the continuing and growing needs of a firm s clientele, and estimates of new clients. The forecast uses past relationships and ratios, builds on the estimates suggested by the sales force, and is influenced by economic, social, and political events. In addition, the limitations and opportunities of the production facilities and human resources must be considered. The forecasts vary according to the needs of the firm and the industry dynamics. Sales projections are best derived from both an external and an internal viewpoint. Using external factors, we analyze our prospective sales in light of economic conditions affecting our industry and our company. Statistical techniques such as regression and time series analysis may be employed in the process. Internal analysis calls for the sales department to survey our own salespeople within their territories. Ideally, we would proceed along each of those paths in isolation of the other and then assimilate the results into one meaningful projection. DETERMINE A PRODUCTION SCHEDULE AND THE GROSS PROFIT We determine the necessary production plan for the six month period based on anticipated sales. The number of units produced depends on the beginning inventory of wheels and casters, our sales projection, and the desired level of ending inventory. Assume that on January 1, 2015, the Goldman Corporation had in stock the items shown in Table 4 2. Table 4 2 Stock of beginning inventory Wheels Casters Total Quantity Cost... $ 16 $ 20 Total value... $1,360 $3,600 Total... $4,960 Chapter 4: Financial Forecasting 97

6 Oil Prices! How About a Forecast? FINANCE IN ACTION For oil producers and marketers, the future price of oil is very important for their projections of the firm s revenues and costs. It will also determine their spending plans and the returns to shareholders. In early 1999, oil was priced just above US$12 per barrel, while by mid-2008 it was over US$145, with several gyrations in between. The average price was about US$88 in 2010 and US$108 in July What is expected for the future? Being a finite resource, oil is expected to remain expensive to produce, and Canada is one of the few countries with substantial reserves. We should consider the past for guidance as to where oil prices might go in the future. (bp.com). In 1974, when the OPEC oil embargo was in its stage of infancy (or infamy), the price of oil had jumped to US$10.41, about the same as it was in early By 1980, the price of oil had reached US$36, and some were predicting that oil would reach US$100 a barrel before the end of the decade. In real USD per Barrel dollars the 1980 price was almost US$90. If we look at the price of a barrel of oil over the past 150 years we find that the average price, adjusted for inflation, has been about US$30. It would seem that the oil prices of the 1970s, the 1980s, and 2008 were abnormal by historical standards, but prices are likely to continue at fairly high levels. Estimates from various sources for average oil prices for the rest of 2014 ranged from $100 to $119. It is on these prices that oil firms would forecast their revenues and cash flows for the immediate future. Current oil prices can be found at bloomberg.com. Q1 Compare the current price of Platts Dubai, West Texas Intermediate (WTI), oil and Brent Crude. Q2 What is your forecast for the price of oil in one and two years? oil-price.net Min = (11 Dec 1998); Max = (4 Jul 2008) We add the projected quantity of unit sales for the next six months to our desired ending inventory and subtract our stock of beginning inventory (in units) to determine our production requirements. Units + Projected sales + Desired ending inventory - Beginning inventory = Production requirements In Table 4 3 we see a required production level of 1,015 wheels and 2,020 casters. Table 4 3 Production requirements for six months Wheels Casters Projected unit sales (Table 4 1) ,000 +2,000 Desired ending inventory (assumed to represent 10% of unit sales for the time period) Beginning inventory (Table 4 2) Units to be produced... 1,015 2,020 We must now determine the cost to produce these units. In Table 4 2 we saw that the cost of units in stock was $16 for wheels and $20 for casters. However, we assume the price 98 Part 2: Financial Analysis and Planning

7 of materials, labour, and overhead going into the products is now $18 for wheels and $22 for casters, as indicated in Table 4 4. Table 4 4 Unit costs Wheels Casters Materials... $10 $12 Labour Overhead Total... $18 $22 The total cost to produce the required items for the next six months is shown in Table 4 5. Table 4 5 Total production costs Wheels Casters Total Units to be produced (Table 4 3)... 1,015 2,020 Cost per unit (Table 4 4)... $ 18 $ 22 Total cost.... $18,270 $44,440 $62,710 We must also determine whether the firm has the production facilities to meet the projected demand. Sales and production should be the same only over the long term, as seasonal and cyclical patterns will cause demand to fluctuate. Inventory positions and price adjustments can be used to handle the short term differences between demand and production. However, without the required long run production capabilities, the firm must reconsider its sales projections or make capital investments (buildings, machinery, vehicles, etc.). Either of these possibilities affects financial forecasts. Capital investments in particular require large fundraising efforts with concurrent costs. Cost of Goods Sold The main consideration in constructing a pro forma income statement is the costs specifically associated with units sold during the time period. Note that in the case of wheels, we anticipate sales of 1,000 units, as indicated in Table 4 1, but are producing 1,015, as indicated in Table 4 3, to increase our inventory level by 15 units. For profit measurement purposes, we do not charge these extra 15 units against current sales. 1 Furthermore, in determining the cost of the 1,000 units sold during the current time period, we do not assume all of the items sold represent inventory manufactured in this period. We assume Goldman Corporation uses FIFO (first in, first out) accounting, and it first allocates the cost of current sales to beginning inventory and then to goods manufactured during the period. In Table 4 6 we look at the revenue, associated cost of goods sold, and gross profit for both products. For example, 1,000 units of wheels are to be sold at total revenue of $30,000. Of the 1,000 units, 85 units are from beginning inventory at a $16 cost (see Table 4 2), and the balance of 915 units are from current production at an $18 cost. The total cost of goods sold for wheels is $17,830, yielding a gross profit of $12,170. The pattern is the same for casters, with sales of $70,000, cost of goods sold of $43,640, and gross profit of $26,360. The combined sales for the two products are $100,000, with cost of goods sold of $61,470 and gross profit of $38, Later on in the analysis we show the effect these extra units have on the cash budget and the balance sheet. Chapter 4: Financial Forecasting 99

8 Table 4 6 Allocation of manufacturing cost and determination of gross profit Wheels Casters Combined Quantity sold (Table 4 1).... 1,000 2,000 3,000 Sales price... $ 30 $ 35 Sales revenue... $30,000 $70,000 $100,000 Cost of goods sold: Old inventory (Table 4 2) Quantity (units) Cost per unit... $ 16 $ 20 Total.... $ 1,360 $ 3,600 New inventory (the remainder): Quantity (units) ,820 Cost per unit (Table 4 4).... $ 18 $ 22 Total ,470 40,040 Total cost of goods sold 17,830 43,640 $ 61,470 Gross profit.... $12,170 $26,360 $ 38,530 At this point, we also compute the value of ending inventory for later use in constructing financial statements. As indicated in Table 4 7, the value of ending inventory is $6,200. Table 4 7 Value of ending inventory + Beginning inventory (Table 4 2)... $ 4,960 + Total production costs (Table 4 5)... 62,710 Total inventory available for sales... 67,670 - Cost of goods sold (Table 4 6)... 61,470 Ending inventory... $ 6,200 OTHER EXPENSE ITEMS Having computed total revenue, cost of goods sold, and gross profit, we must now subtract other expense items to arrive at a net profit figure. We deduct selling, marketing, general and administrative, research and development, and interest expenses from gross profit to arrive at earnings before taxes. We then subtract taxes to determine aftertax income, and finally we deduct dividends (these are not expenses but they do require cash outflow) to ascertain the net contribution to retained earnings. Goldman Corporation s selling, general, and administrative expenses are $12,000, interest expense is $1,500, and dividends are $1,500. LO6 ACTUAL PRO FORMA INCOME STATEMENT Combining the gross profit in Table 4 6 with our assumptions on other expense items, we arrive at the pro forma income statement presented in Table 4 8. We anticipate earnings after taxes of $20,024, dividends of $1,500, and an increase in retained earnings of $18,524. The following illustrations and formats are for private corporations. Public corporations are required to prepare actual and pro forma financial statements based on international standards (IFRS) effective January 1, The results and amounts would be significantly different, but would allow better comparisons with companies worldwide that are also using IFRS. 100 Part 2: Financial Analysis and Planning

9 Table 4 8 Pro forma income statement Pro Forma Income Statement June 30, 2015 Sales revenue... $100,000 Cost of goods sold... 61,470 Gross profit ,530 Selling, general, and administrative expense... 12,000 Operating profit (EBIT)... 26,530 Interest expense... 1,500 Earnings before taxes (EBT)... 25,030 Taxes (20%)... 5,006 Earnings after taxes (EAT)... $ 20,024 Change in retained earnings Common stock dividends declared.... 1,500 Increase in retained earnings... $ 18,524 Note: For simplicity amortization has not been included. CASH BUDGET The cash budget is perhaps the most important forecast. The ability to meet cash flow demands on a timely basis with efficient management of working capital, including having short term financing such as a line of credit available as required, allows a firm to survive in the long term. Profitable sales may generate accounts receivable in the short run but no immediate cash to meet financial obligations including suppliers and debt payments. Therefore, we must translate the pro forma income statement into cash flows, producing a cash budget. In this process, we divide the longer term pro forma income statement into smaller and more precise time frames to appreciate the seasonal and monthly patterns of cash inflows and outflows. Some months may present particularly high cash requirements from low sales volume, or less in regular payments such as dividends, taxes, or capital expenditures. The timing of cash flows is particularly crucial. One must consider the nature of the firm s business, terms of trade, and general economic conditions to appropriately reflect the timing of cash flows in the cash budget. The cash flow cycle, discussed further in Chapter 6, outlines the process from inventory to sale to accounts receivable to cash. CASH RECEIPTS In the case of the Goldman Corporation, we break down the pro forma income statement for the first half of 2015 into a series of monthly cash budgets. In Table 4 1 we showed anticipated sales of $100,000 over this time period; we shall now assume these sales can be divided into monthly projections, as indicated in Table 4 9. A careful analysis of past sales and collection records indicates that 20 percent of sales are collected in the month of sales and 80 percent are collected in the following month. The cash receipt pattern related to monthly sales is shown in Table It is assumed that sales for December 2014 were $12,000. The cash receipts could be adjusted to reflect any uncollectible accounts based on previous experience and future expectations. The cash inflows vary between $11,000 and $23,000, with the high point in receipts coming in May. We now examine the monthly outflows. Chapter 4: Financial Forecasting 101

10 Table 4 9 Monthly sales pattern January February March April May June $15,000 $10,000 $15,000 $25,000 $15,000 $20,000 Table 4 10 Monthly cash receipts December January February March April May June Sales... $12,000 $15,000 $10,000 $15,000 $25,000 $15,000 $20,000 Collections: (20% of current sales).... 3,000 2,000 3,000 5,000 3,000 4,000 Collections: (80% of previous month s sales)... 9,600 12,000 8,000 12,000 20,000 12,000 Total cash receipts... $12,600 $14,000 $11,000 $17,000 $23,000 $16,000 Operational Cash Flow Exceeds Earnings and Allows Capital Expenditures FINANCE IN ACTION Encana is one of world s largest oil and natural gas companies. Although the bulk of its activity is in Canada, it has operations around the world. Encana s drilling success rate is over 80 percent, which suggests capital expenditures on exploration should bring good returns. In January 1999, with crude oil prices slightly above US$12, energy companies were reducing their workforce and capital expenditures. In 2002, PanCanadian and Alberta Energy merged to form Encana. Then oil and gas prices began to pick up, cash flow improved, and capital expenditures once again increased significantly. The impact of oil and gas prices can be seen in Encana s results from 1998 to the period The weak prices of 1998 resulted in a drop in capital expenditures followed by increasing expenditures as prices improved. The current high price of oil is a significant variable in most firms operations and cash forecasts. Encana prepares a sensitivity analysis as part of a regular Guidance Report. It suggests how major variables will impact cash flow (unhedged). Cash Flow (US$ millions) Crude oil US$10/barrel (WTI) $300 Natural gas US$1/mcf 575 These projections, when tied in with forecasts of crude oil and natural gas prices, show the potential for weakened results at Encana if energy prices drop. More recently, Encana agreed to sell gas plants in Colorado for US$303 million to improve its cash position. Encana is able to offset declining prices by increased production and from its hedging activities. Hedging activities preset the prices on the future production of oil and gas. Q1 What are current oil and gas prices? Q2 Identify Encana s recent financial results. encana.com Symbol: ECA bloomberg.com (US$ millions) Revenue $5,858 $21,446 $16,339 $14,573 $2,986 Cash flow from operations... 2,229 8,429 7,973 7, Net income ,959 5,652 3, Capital expenditures... 2,712 8,737 6,600 6, ROE % 21% 34% 23% 6% Average oil price (/bbl).... $90.90 $72.41 $66.25 $56.70 $15.11 Average gas price (/mbtu)... $ 3.9 $ 6.86 $ 7.22 $ 8.62 $ 2.06 US$/C$ (year-end)... $ 1.16 $ 0.99 $ 0.86 $ 0.86 $ Part 2: Financial Analysis and Planning

11 CASH PAYMENTS The primary considerations for cash payments are monthly costs associated with inventory manufactured during the period (material, labour, and overhead) and disbursements for general and administrative expenses, interest payments, taxes, and dividends. We must also consider cash payments for any new plant and equipment, an item that does not show up on our pro forma income statement because it is a capital expenditure, not an expense. Costs associated with units manufactured during the period may be taken from the data provided in Table 4 5. In Table 4 11 we simply recast these data in terms of material, labour, and overhead. We see that the total costs for components in the two products are material, $34,390; labour, $17,195; and overhead, $11,125. We assume that all these costs are incurred on an equal monthly basis over the six month period. Even though the sales volume varies from month to month, we assume we are employing level monthly production to ensure maximum efficiency in the use of various productive resources. Average monthly costs for materials, labour, and overhead are as shown in Table We pay for materials one month after the purchase has been made. Labour and overhead represent direct monthly cash outlays. Other major expenses occur at less frequent but fairly predictable intervals. These include interest (coupon payments), taxes, dividends, and new equipment purchases. We summarize all of our cash payments in Table Past records indicate that $4,500 in materials was purchased in December. Table 4 11 Component costs of manufactured goods Units Produced Wheels Cost per Unit Total Cost Units Produced Casters Cost per Unit Total Cost Combined Cost Materials... 1,015 $10 $10,150 2,020 $12 $24,240 $34,390 Labour... 1, ,075 2, ,120 17,195 Overhead.. 1, ,045 2, ,080 11,125 $62,710 Table 4 12 Average monthly manufacturing costs Total Costs Time Frame Average Monthly Cost Materials... $34,390 6 months $5,732 Labour... 17,195 6 months 2,866 Overhead... 11,125 6 months 1,854 Chapter 4: Financial Forecasting 103

12 ACTUAL BUDGET We are now in a position to bring together our monthly cash receipts and payments into a cash flow statement, illustrated in Table The difference between monthly receipts and payments is net cash flow for the month. The primary purpose of the cash budget is to allow the firm to anticipate the need for outside funding at the end of each month. In the present case we assume the Goldman Corporation wishes to have a minimum cash balance of $5,000 at all times. If it goes below this amount, the firm borrows funds from the bank. If it goes above $5,000 and the firm has a loan outstanding, it uses the excess funds to reduce the line of credit. This pattern of financing is demonstrated in Table 4 15, which shows a fully developed cash budget with borrowing and repayment provisions. The first line in Table 4 15 shows net cash flow, which is added to the beginning cash balance to arrive at the cumulative cash balance. The fourth entry is the additional monthly loan or loan repayment, if any, required to maintain a minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry represents cumulative loans outstanding for all months. Finally, we show the cash balance at the end of the month, which becomes the beginning cash balance for the next month. Table 4 13 Summary of all monthly cash payments Dec. Jan. Feb. March April May June From Table 4 12: Monthly material purchase... $4,500 $5,732 $5,732 $5,732 $5,732 $5,732 $5,732 Payment for material (prior month s purchase) 4,500 5,732 5,732 5,732 5,732 5,730* Monthly labour cost... 2,866 2,866 2,866 2,866 2,866 2,866 Monthly overhead.... 1,854 1,854 1,854 1,854 1,854 1,854 From Table 4 8: Selling, general, and administrative expense 2,000 2,000 2,000 2,000 2,000 2,000 ($12,000 over 6 months).... Interest expense... 1,500 Taxes (two equal payments)... 2,503 2,503 Cash dividend... 1,500 Also: New equipment purchases... 8,000 10,000 Total payments.... $11,220 $20,452 $14,955 $12,452 $12,452 $27,953 *Adjusted for rounding. Note: Amortization should not be included in overhead because there is no cash outflow. Table 4 14 Monthly cash flow Jan. Feb. March April May June Total receipts (Table 4 10).... $12,600 $14,000 $11,000 $17,000 $23,000 $16,000 Total payments (Table 4 13) ,220 20,452 14,955 12,452 12,452 27,953 Net cash flow... $ 1,380 ($ 6,452) ($ 3,955) $ 4,548 $10,548 ($11,953) 104 Part 2: Financial Analysis and Planning

13 Table 4 15 Cash budget with borrowing repayment provisions Jan. Feb. March April May June 1. Net cash flow.... $1,380 ($6,452) ($3,955) $4,548 $10,548 ($11,953) 2. Beginning cash balance.... 5,000* 6,380 5,000 5,000 5,000 11, Cumulative cash balance.... 6,380 (72) 1,045 9,548 15,548 (884) 4. Monthly loan or (repayment)... 5,072 3,955 (4,548) (4,479) 5, Cumulative loan balance.... 5,072 9,027 4,479 5, Ending cash balance. 6,380 5,000 5,000 5,000 11,069 5,000 *We assume the Goldman Corporation has a beginning cash balance of $5,000 on January 1, 2015, and it desires a minimum monthly ending cash balance of $5,000. At the end of January, the firm has $6,380 in cash, but by the end of February, the cumulative cash position of the firm is negative, necessitating a loan of $5,072 to maintain a $5,000 cash balance. The firm has a loan on the books until May, at which time there is an ending cash balance of $11,069. During the months of April and May, the cumulative cash balance is greater than the required minimum cash balance of $5,000, so loan repayments of $4,548 and $4,479 are made to retire the loans completely in May. In June, the firm is once again required to borrow $5,884 to maintain a $5,000 cash balance. Adjustments could be made at this time. The cash budget indicates that operating loans will be required at certain times, which will necessitate the payment of monthly interest. Operating loans or self liquidating loans are required as temporary current assets are built up in a firm due to seasonal fluctuations in demand. This buildup requires the use of shortterm financing and is examined later in Chapters 6 and 8. We have included only interest on long term debt on the summary of cash payments. Offsetting the payment of interest on short term loans, to a certain extent, will be the receipt of interest from marketable securities received during periods with excess cash balances. These adjustments have not been included in our example. Before proceeding to the pro forma balance sheet, we may want to return to the income statement and make some adjustments based on the results from the cash budget. For example, severe cash shortages may require additional borrowing, which in turn would increase the interest expense. PRO FORMA BALANCE SHEET LO3 Now that we have developed a pro forma income statement and a cash budget, it is relatively simple to integrate all of these items into a pro forma balance sheet. Because the balance sheet represents cumulative changes in the corporation over time, we first examine the prior period s balance sheet and then translate these items through time to represent June 30, The last balance sheet, dated December 31, 2014, is shown in Table In constructing our pro forma balance sheet for June 30, 2015, some of the accounts from the old balance sheet remain unchanged, and others will take on new values, as indicated by the pro forma income statement and cash budget. The process is depicted in Figure 4 2. We present the new pro forma balance sheet as of June 30, 2015, in Table Chapter 4: Financial Forecasting 105

14 Table 4 16 Balance sheet (ASPE format for private corporations) Balance Sheet December 31, 2014 Assets Current assets: Cash... $ 5,000 Marketable securities.... 3,200 Accounts receivable.... 9,600 Inventory.... 4,960 Total current assets... 22,760 Plant and equipment... 27,740 Total assets.... $50,500 Liabilities and Shareholders Equity Accounts payable... $ 4,500 Long-term debt... 15,000 Common stock... 10,500 Retained earnings ,500 Total liabilities and shareholders equity... $50,500 Figure 4 2 Development of pro forma balance sheet Prior balance sheet (Unchanged items) Marketable securities Long-term debt Common stock Pro forma income statement analysis Inventory Retained earnings Pro forma balance sheet Cash budget analysis Cash Accounts receivable Plant and equipment Accounts payable Notes payable EXPLANATION OF PRO FORMA BALANCE SHEET Each item in Table 4 17 can be explained on the basis of a prior calculation or assumption. 1. Cash ($5,000) minimum cash balance as shown in Table Marketable securities ($3,200) remains unchanged from prior period s value in Table Note that firms will likely liquidate marketable securities positions before increasing short term borrowings. In that case, Table 4 15 would require revision. To simplify matters, that has not been done in this example. Furthermore, due to cash flow timing considerations, firms often have positions in marketable securities and short term loans on reporting dates. 106 Part 2: Financial Analysis and Planning

15 Table 4 17 Pro forma balance sheet (ASPE format) Pro Forma Balance Sheet June 30, 2015 Assets Current assets: 1. Cash.... $ 5, Marketable securities... 3, Accounts receivable , Inventory.... 6,200 Total current assets , Plant and equipment... 45,740 Total assets.... $76,140 Liabilities and Shareholders Equity 6. Accounts payable... $ 5, Notes payable... 5, Long-term debt... 15, Common stock , Retained earnings ,024 Total liabilities and shareholders equity... $76, Accounts receivable ($16,000) based on June sales of $20,000 in Table Twenty percent is collected that month and 80 percent becomes accounts receivable at the end of the month. $20,000 sales 80% receivables $16, Inventory ($6,200) ending inventory as shown in Table Plant and equipment ($45,740). Initial value (Table 4 16)... $27,740 Purchases* (Table 4 13)... 18,000 Plant and equipment... $45,740 *For simplicity, amortization is not explicitly considered. 6. Accounts payable ($5,732) based on June purchases in Table They are not to be paid until July and, thus, are accounts payable. 7. Notes payable ($5,884) the amount we must borrow to maintain our cash balance of $5,000, as shown in Table Long term debt ($15,000) remains unchanged from the prior period s value in Table The firm may increase long term debt to hedge the additional purchase of plant and equipment. The hedging concept is explored in Chapter Common stock ($10,500) remains unchanged from prior period s value in Table Retained earnings ($39,024). Initial value (Table 4 16)... $20,500 Transfer of pro forma income to retained earnings (Table 4 8)... 18,524 Retained earnings.... $39,024 Chapter 4: Financial Forecasting 107

16 ANALYSIS OF PRO FORMA STATEMENT In comparing the pro forma balance sheet (Table 4 17) to the prior balance sheet (see Table 4 16) we note that assets are up by $25,640. Total assets (June 30, 2015).... $76,140 Total assets (Dec. 31, 2014)... 50,500 Increase... $25,640 The growth must be financed by accounts payable, notes payable, and profit (as reflected by the increase in retained earnings). Though the company enjoys a high degree of profitability, it must still look to bank financing. At the end of June, this amounts to $5,884 to support the increase in assets. This represents the difference between the $25,640 buildup in assets and the $1,232 increase in accounts payable, as well as the $18,524 buildup in retained earnings. However, the cash budget, Table 4 15, reveals that the borrowing need peaks at $9,027 in March. If Goldman has not anticipated this peak in borrowing need and had not made arrangements with the bank to advance funds to meet this peak requirement, there may be liquidity problems. The small business, by failing to properly anticipate the fluctuations in borrowing requirements, is often forced to return to the bank to renegotiate further loan advances. Bankers are obviously not too pleased by surprises resulting from poor forecasts and may view this as evidence of ineffective planning. This is not to say that forecasts turn out exactly as planned. However, by knowing the forecasts and the underlying assumptions, the firm is able to adapt its plan as conditions change. PERCENT-OF-SALES METHOD LO4 LO5 An alternative to tracing cash and accounting flows to determine financial needs as the firm grows is to assume that balance sheet accounts maintain a given percentage relationship to sales. As the sales level increases, we can ascertain our required financing needs if we rely on the assumption that certain assets and liabilities spontaneously increase with sales. This spontaneity without any conscious action by management is discussed in Chapter 7. This technique for determining financing needs is known as the percent of sales method. It makes some strong assumptions and is probably more applicable to longer term forecasting. For immediate cash needs, a budget is more exact. The Howard Corporation, introduced in Table 4 18, shows its balance sheet accounts in dollars and their percent of sales, based on a current sales volume of $200,000. For example, the cash balance of $5,000 represents 2.5 percent of the $200,000 in current sales. No percentages are computed for notes payable, common stock, and retained earnings, because they are not assumed to maintain a direct relationship with sales volume and often require a less spontaneous, more deliberate action to change. In this example we assume that equipment increases in proportion to sales. However, in most cases, capital asset investment is more tenuously connected to sales increases, expanding in a multi step fashion. If there is excess capacity, equipment (and/or plant) will not increase, and more deliberate action from management is required for capital assets to be acquired. In this example, if sales increase from $200,000 to $300,000, an increase of $100,000, additional financing will be required: A 60 percent spontaneous increase in assets Offset by a 25 percent spontaneous increase in current liabilities 108 Part 2: Financial Analysis and Planning

17 And offset by an increase in retained earnings (we assume the Howard Corporation has an aftertax return of 6 percent on sales and 50 percent of profits are paid out as dividends) 2 Table 4 18 Percent-of-sales table Howard Corporation Balance Sheet Assets Liabilities and Shareholders Equity Cash... $ 5,000 Accounts payable... $ 40,000 Accounts receivable ,000 Accrued expenses... 10,000 Inventory ,000 Notes payable... 15,000 Total current assets.... $ 70,000 Common stock... 10,000 Equipment... 50,000 Retained earnings ,000 Total assets.... $120,000 Total liabilities and equities... $120,000 $200,000 Sales Percent of Sales Cash... ($5/$200=) 2.5% Accounts payable...($40/$200=) 20.0% Accounts receivable....($40/$200=) 20.0 Accrued expenses...($10/$200=) 5.0 Inventory....($25/$200=) 12.5 Total current liabilities percent % Total current assets....($70/$200=) 35.0 Equipment...($50/$200=) 25.0 Total assets / sales percent % Therefore, the $100,000 sales increase requires new financing of Spontaneous asset increase $100,000 60% $60,000 Spontaneous liability increase $100,000 25% -25,000 Increase in retained earnings $300,000 6% (1-50%) - 9,000 $26,000 The financing alternatives for the $26,000 are identified in Figure It is worth noting that the asset and liability increases are based on the sales increase from the previous period, and the retained earnings increase is based on total sales. Our formula to determine the need for new funds (required new funds, or RNF) is RNF = Spontaneous increase in assets - Spontaneous increase in liabilities - Increase in retained earnings Where RNF = A (ΔS) - L S 1 S 1 (ΔS) - P S (1 - D) (4 1) 2 A = Percentage relationship of assets varying with sales to sales (60%) S 1 S = Change in sales ($100,000) L = Percentage relationship of liabilities varying with sales to sales (25%) S 1 P = Profit margin (6%) S 1 = Existing sales level S 2 = New sales level ($300,000) D = Dividend payout ratio 2 Some may wish to add back amortization under the percent of sales method. Most, however, choose the assumption that funds generated through amortization (in the sources and uses of funds sense) must be used to replace the capital assets to which amortization is applied. Chapter 4: Financial Forecasting 109

18 Plugging in the values, we show RNF = 60% ($100,000) - 25% ($100,000) - 6% ($300,000)(1-0.5) = $60,000 - $25,000 - $18,000(0.5) = $35,000 - $9,000 = $26,000 required sources of new funds Presumably, the $26,000 can be financed at the bank or through some other appropriate source. We can see how this formula works by comparing pro forma balance sheets before and after the sales expansion, as in Table The spontaneous increase in current assets and capital assets (equipment) from the increased sales is $60,000 and is the first term in the formula. This requirement for new funding is partially offset by the increase in current liabilities of $25,000 and by the increase in retained earnings of $9,000. The increase in retained earnings is based on the profit generated from total sales less the dividend payout. These increases are tied to the sales increase by a fixed percentage, but could be changed if we have superior knowledge. Table 4 19 RNF with sales expansion (percent-of-sales method) HOWARD CORPORATION Sales $200,000 Sales increase 50.00% $100,000 Assets Before Increase RNF After Cash... $ 5,000 $ 2,500 $ 7,500 Accounts receivable ,000 20,000 60,000 Inventory ,000 12,500 37,500 Total current assets.... $ 70,000 $35,000 $105,000 Equipment... 50,000 25,000 75,000 Total assets... $120,000 $60,000 $180,000 Liabilities and Shareholders Equity Accounts payable... $ 40,000 $20,000 $ 60,000 Accrued expenses... 10,000 5,000 15,000 Notes payable... 15, ,000 41,000 Total liabilities.... $ 65,000 25,000 $116,000 Common stock... 10,000 10,000 Retained earnings ,000 9,000 54,000 Total liabilities and shareholders equity.... $120,000 $34,000 $180,000 Required new funds (RNF) $26,000 26,000 Selected Ratios Debt/Total assets 65/120 = /180 = 0.64 Debt/Equity 65/(10+45) = /(10+54) = 1.81 Current ratio 70/65 = /116 = 0.91 We notice in Table 4 19 that in order to achieve balance, the amount of RNF, $26,000, is entered on the new balance sheet as notes payable. These RNF are needed to support the sales expansion and are the same value given by the formula. If the firm was not operating at capacity and did not require the $25,000 in additional equipment to support the new sales the RNF would only be $1,000. Therefore, our assumptions about what assets will increase proportionately with a sales increase are quite important. 110 Part 2: Financial Analysis and Planning

19 3 A derivation follows: A ΔS [ D) ( S 1 (ΔS) - P(1-1 + D T ΔS [ A D) ( S 1 - P(1-1 + _ D _ T If the RNF are financed through operating loans (notes payable), as is suggested in this example, there will be a significant change in certain relevant ratios. The debt to total assets increases from 0.54 to 0.64 and the current ratio decreases from 1.08 to This would likely be interpreted as deterioration in these ratios. It is important to determine if the firm can obtain this funding from its financial institution(s). If the firm cannot obtain additional short term financing or perhaps long term financing, sales and growth will have to be scaled back or, alternatively, additional equity contributions will have to be made by shareholders with a cash injection or by decreasing the dividend payout. Alternatively, the firm might improve its asset utilization ratios, which would generate additional cash flow. These utilization ratios were identified in Chapter 3. It may be appropriate in this example to obtain long term financing to match the increase in capital assets. This matching of the maturity of assets with liabilities is called a hedging approach and is discussed in Chapter 6. For the Howard Corporation, long term funding has already been supplied by equity of $9,000. Further long term financing of $16,000 would match the long term investment in capital assets totalling $25,000. With this mix of longterm debt and a smaller portion of short term debt, the current ratio would improve. Observe that using the percent of sales method is much easier than tracing through the various cash flows to arrive at the pro forma statements. Nevertheless, the output is much less meaningful, and we do not get a month to month breakdown of the data. The percent of sales method is a broad brush approach, whereas the detailed development of pro forma statements is more exact. Of course, whatever method we use, the results are only as meaningful or reliable as the assumptions about sales and production that went into the numbers. SUSTAINABLE GROWTH RATE From the preceding discussion, the question arises: What level of growth can the corporation attain and still be able to raise the RNF through additional bank borrowings? The general answer is that highly profitable companies can sustain a high rate of growth, but marginally profitable companies can sustain only low growth. We use the following formula to determine the maximum rate of growth obtainable without increasing the debt ratio. The formula, known as the sustainable growth rate (SGR), assumes that the performance ratios and balance sheet to sales ratios remain the same and that no new shares are issued. 3 SGR = ΔS P(1 - D) ( 1 + D T S 1 = E ) A S 1 ( - P(1 - D) 1 + D (4 2) T E ) where D T = Debt to equity ratio E A D) ( S 1 (ΔS) = P( S + ΔS)(1 - D) + P( S + ΔS)(1 - D T 1 1 E ) A D) ( S 1 (ΔS) = P( S + ΔS)(1-1 + D T 1 E ) A [ D) ( S 1 (ΔS) = S P(1-1 + D T 1 [ D) ( E ) ] = S P(1-1 + D T 1 E E ] [ D) ( ) = S P(1-1 + _ D _ T 1 E ΔS [ D) ( E ) ] + P(1-1 + D T E ) ] ) ] ) ] SGR = ΔS P(1 - D) ( 1 + D T S 1 = E ) A D) ( S 1 - P(1-1 + D T E ) An approximate formula is SGR = ROE (1 D). In other words, the lower the level of current debt, the greater the potential for the firm to borrow more funds for higher future growth. Chapter 4: Financial Forecasting 111