Forecasting for Financial Planning 1
Learning Objectives The importance of forecasting to business success. The financial forecasting process. Preparation of pro forma financial statements. The importance of analyzing forecasts. 2
Why is forecasting important? Mistakes are costly: 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. 3
Forecasting Approaches Financial managers concentrate on three general approaches to financial forecasting: Experience Probability Correlation 4
Experience 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. 5
Probability 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. 6
Correlation 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. 7
The Sales Forecasting Process Marketing (sales estimate) Top Management (policy, strategy) Finance Department Production (capacity, schedules) Accounting (financial statements, depreciation, taxes) SALES FORECAST 8
Forecast future sales based on past sales growth Sales Plot of Past Sales 99 00 01 02 03 04 05 06 07 08 Time 9
Forecast future sales based on past sales growth Sales Trend Line 99 00 01 02 03 04 05 06 07 08 Time 10
Forecast future sales based on past sales growth Sales Sales Estimates for next 2 years Growth Rate 99 00 01 02 03 04 05 06 07 08 Time 11
Forecast future sales based on past sales growth Also include the effects of any events which are expected to impact future sales (new products or economic conditions) Sales New Product Introduced 99 00 01 02 03 04 05 06 07 08 Time 12
Forecast future sales based on past sales growth Also include the effects of any events which are expected to impact future sales (new products or economic conditions) Sales New Product Introduced 99 00 01 02 03 04 05 06 07 08 Time 13
Sales Growth Imposes Costs on the Firm Will require additional resources Current Assets: Inventory, A/R, Cash Fixed Assets: Plant and Equipment 2006 2007 14
Pro 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. 15
Producing Pro Formas Example Data for Marginal Product Inc. 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. 16
Producing Pro Formas Step 1: Income Statement Marginal Product Inc. figures in 000s Current Projected Sales $5,000 COGS 4,133 EBIT 867 Int 200 EBT 667 Tax (.40) 267 NI 400 $8,000 Determining Sales Growth $8 - $5 = 60% $5 Note: The projected sales will be determined after input from many different units or departments of the firm. 17
Producing Pro Formas Income Statement Marginal Product Inc. figures in 000s Current Projected Sales $5,000 $8,000 COGS 4,133 6,613 EBIT 867 1,387 Int 200 200 EBT 667 1,187 Tax (.40) 267 475 NI 400 712 Step 2: Calculate projected Net Income. New COGS = Old COGS x 1.6 = 6,613 Note: There is no increase yet in the interest charges since Marginal Product s managers have not yet decided how they will finance the growth. 18
Producing Pro Formas Step 3: Forecast increase in assets (% of sales) Assets Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected 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 19
Producing Pro Formas Assets Step 3: Forecast increase in assets (% of sales). If sales increase by 60%, so too will any asset that remains a constant percent of sales. Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected 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 $2.5(1+.60) = $4.0 20
Producing Pro Formas Step 3: Forecast increase in assets (% of sales) Assets Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected 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 +$3.30 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 $3.0(1+.60) = $4.8 21
Producing Pro Formas Step 4: Forecast increase in spontaneous liabilities. Assets Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5 Total $5.5 $8.8 Notes Payable 0.0 Current Liabilities $1.5 $1.0(1+.60) Long = Term $1.60 Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 22
Producing Pro Formas Step 4: Forecast increase in spontaneous liabilities. Assets Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5.8 Total $5.5 $8.8 Notes Payable 0.0 $0.5(1+.60) Current = Liabilities $0.80 $1.5 Long Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 Common Equity $2.0 Total Claims $5.5 23
Producing Pro Formas Step 5: Forecast increase in retained earnings. Balance Sheet Marginal Product Inc. figures in 000,000s Assets Current Projected Liabilities Current Projected New retained earnings Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 =Old retained earnings Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5.8 Total + additions $5.5 $8.8to ret. Notes earnings Payable 0.0 =1.5 + [NI x (1-div. payout)] Current Liabilities $1.5 =1.5 + [.712 x (1-.7)] Long = 1.7 Term Debt $2.0 Common Stock 0.5 Retained Earnings 1.5 1.7 Common Equity $2.0 Total Claims $5.5 24
Producing Pro Formas Step 6: Hold other accounts constant to see how much additional funds will be needed. Assets Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5.8 Total $5.5 $8.8 Notes Payable 0.0 0.0 Current Liabilities $1.5 2.4 Long Term Debt $2.0 2.0 Common Stock 0.5.5 Retained Earnings 1.5 1.7 Common Equity $2.0 2.2 Total Claims $5.5 $6.6 25
Producing Pro Formas Assets AFN = $8.8-6.6 = $2.2 mill. Step 7: Additional funds needed (AFN) = projected assets minus projected claims Balance Sheet Marginal Product Inc. figures in 000,000s Current Projected Liabilities Current Projected Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.0 4.8 Accrued Expenses 0.5.8 Total $5.5 $8.8 Notes Payable 0.0 0.0 Current Liabilities $1.5 2.4 Long Term Debt $2.0 2.0 Common Stock 0.5.5 Retained Earnings 1.5 1.7 Common Equity $2.0 2.2 Total Claims $5.5 $6.6 26
Producing Pro Formas minus projected claims Balance Sheet Marginal Product Inc. figures in 000,000s Assets Current Projected Liabilities Raise $2.2 Current million Projected Using: Notes Payable, and/or LT Current Assets $2.5 $4.0 Accounts Payable $1.0 $1.6 Net Fixed Assets 3.0 4.8 Accrued Debt, Expenses and/or Common 0.5 Stock.8 Total $5.5 $8.8 Notes Payable 0.0 0.0 AFN = $8.8-6.6 = $2.2 mill. Step 7: Additional funds needed (AFN) = projected assets Current Liabilities $1.5 2.4 Long Term Debt $2.0 2.0 Common Stock 0.5.5 Retained Earnings 1.5 1.7 Common Equity $2.0 2.2 Total Claims $5.5 $6.6 27
Producing 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. 28
Financing 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. 29