Financial Forecasting - Finance - Lecture Slides, Slides of Finance

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Financial Forecasting

Financial Statement Analysis and

Forecasting

Financial Forecasting

Purpose

Financial managers must produce forecasts for the

financial results of corporate plans to:

– Determine whether the corporate plans will

require additional external financing

– Determine whether the corporate plans will

produce surplus cash resources that could be

distributed to shareholders as dividends

– Assess the financial forecasts to determine the

financial feasibility of corporate plans – if poor

financial results are forecast, this gives

management the opportunity to reexamine and

amend corporate plans to produce better results

before resources and people are committed.

Financial Forecasting

The Percentage of Sales Method

The percentage of sales method involves the following

steps:

1. Determine which financial policy variables you are interested in
2. Set all the non-financial policy variables as a percentage of sales
3. Extrapolate the balance sheet based on a percentage of sales
4. Estimate future retained earnings
5. Modify and re-iterate until the forecast makes sense.

This process most often results in a balance sheet that does not balance – a

‘plug’ (balancing) amount is the external funds required (or surplus funds

forecast)

Financial Forecasting

The Percentage of Sales Method

Cash 5 Accruals 5 Securities 10 Payables 5 Receivables 10 Bank debt 20 Inventory 25 Current assets 50 Current liabilities 30 Net fixed assets 100 Long-term debt 40 Common equity 80

Total assets (^150) Total Liabilities 150

Table 4-11 Balance Sheet

The historical balance sheet.

If sales

increase,

assets

used to

produce

those

sales

must

grow.

Spontaneous

liabilities

Policy

variables

requiring

decision.

Percentage of Sale Method

Improving the Pro Forma Balance Sheet

• The prior pro form balance sheet was developed

using very naïve assumptions:

– Policy variables held constant

– Asset growth in all accounts held at the same

percentage of sales

– Spontaneous liabilities increased at a constant

percentage of sales.

• One improvement is to realize that the firm’s

equity will grow by the amount of retained

earnings.

(See the following income statement)

Financial Forecasting

The Percentage of Sales Method

Sales 120

Gross operating profit 48

Fixed costs 31

EBIT 17

Interest 5

Taxes @ 50% 6

Net Income 6

Dividends 3

Table 4-13 Income Statement

Retained

earnings = net

income less

dividends.

Assuming the

firm holds this

percentage

constant we can

project increases

in equity on the

balance sheet as

50% of the 5%

profit margin or

2.5% of sales.

Percentage of Sale Method

Second Revision the Pro Forma Balance Sheet

• Further improvements to the pro forma balance sheet include:
  • Recognizing that cash balances may not have to rise as a pure constant

percentage of sales

• Cash balances are required for a variety of reasons
  • To support transaction
  • As a safety cushion against unforeseen cash needs
  • As a speculative balance to take advantage of unforeseen opportunities
• Even at low levels of sales, cash balances are required
• As sales increase, additional cash on hand may be required, but at a lower percentage of sales. (lower slope to the trend line between cash balances and sales)

(See Figure 4 – 3 on the following slide for a more realistic forecast for cash)

Percentage of Sales Method

Second Revision the Pro Forma Balance Sheet

4 - 3 FIGURE 4-3 FIGURE

Cash

Sales

14.

12.

10.

8.

6.

4.

2.

0. 0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300

Cash Forecast

Linear with

constant

Simple %

Financial Forecasting

The Percentage of Sales Method

Sales 120 100.0% 132 145 160

Cash 5 4.2% 5.0 5.0 5. Securities 10 8.3% 0.0 0.0 0. Receivables 10 8.3% 11.0 12.1 13. Inventory 25 20.8% 27.5 30.2 33. Net fixed assets 100 83.3% 100.0 90.0 80. Total assets 150 125.0% 143.5 137.3 131.

Accruals 5 4.2% 5.5 6.0 6. Payables 5 4.2% 5.5 6.0 6. Short-term debt 20 16.7% 20.0 20.0 20. Long-term debt 40 33.3% 40.0 40.0 40. Equity 80 66.7% 83.3 86.9 90. Total liabilities and equity 150 125.0% 154.3 159.0 164. Cumulative (EFR) -10.8 -21.7 -32.

Table 4-15 Second Revision of Forecast Assuming

cash remains

constant, we

liquidate

marketable

securities and

we retain 50%

of our profits

dramatically

affects the

forecast.

We now have

surplus

resources!

Percentage of Sale Method

Final Revisions to the Pro Forma Income Statement

• Given our assumptions about capacity, and there being no need for further

expansion in plant and equipment to support anticipated sales growth, we can

reexamine our assumptions about the cost structure of the firm.

Variable Costs

• Variable costs (direct materials and direct labour) will likely grow in proportion to sales.

Fixed Costs

• Fixed costs, however should remain fixed.
• By modifying the income statement for this change in assumptions, we see the net result of this is an

increase in forecast net income.

Dividends

• Most firms do not follow a constant payout ratio, but hold dividends constant over multiple years.
• Assume that we hold dividends at $3 for the next three years.

(See the effects of these changes on the final pro forma income statement on the following slide)

Percentage of Sale Method

Final Revisions to the Pro Forma Balance Sheet

• Given our modified income statement and assumptions regarding

net profit and cash dividends we can prepare a final revised balance

sheet

• This balance sheet now shows that we forecast significant surplus

cash resources and must make some decisions about how we will

manage them:

• Investment temporarily in marketable securities in anticipation of further investment opportunities in growing the firm?
• Distribute them in the form of cash dividends?

(See the effects of these changes on the final pro forma balance sheet on the following slide)

Financial Forecasting

The Percentage of Sales Method

• Sales 120 100.0% %
• Cash 5 4.2% 5.0 5.0 5.
• Securities 10 8.3% 0.0 0.0 0.
• Receivables 10 8.3% 11.0 12.1 13.
• Inventory 25 20.8% 27.5 30.2 33.
• Net fixed assets 100 83.3% 100.0 90.0 80.
• Total assets 150 125.0% 143.5 137.3 131.
• Accruals 5 4.2% 5.5 6.0 6.
• Payables 5 4.2% 5.5 6.0 6.
• Short-term debt 20 16.7% 20.0 20.0 20.
• Long-term debt 40 33.3% 40.0 40.0 40.
• Equity 80 66.7% 85.5 93.5 104.
• Total liabilities and equity 150 125.0% 156.5 165.6 177.
  • Cumulative (EFR) -13.0 -28.3 -46.