Ch. 4: Financial Forecasting, Planning, and Budgeting

1
Ch. 4 Financial Forecasting,Planning, and
Budgeting
2
Objectives

• Forecast Financial Statements with the Percentage
  of Sales Approach to determine Discretionary
  Financing Needed.
• Discuss Limitations of Percentage of Sales
  Approach.
• Determine Sustainable Growth Rate.
• Whats a cash budget?

3
Financial Forecasting

• 1) Project sales revenues and expenses.

4
Financial Forecasting

• 1) Project sales revenues and expenses.
• 2) Estimate current assets and fixed assets
  necessary to support projected sales.

5
Financial Forecasting

• 1) Project sales revenues and expenses.
• 2) Estimate current assets and fixed assets
  necessary to support projected sales.
• Percent of sales forecast

6
Our Example Zippy Drives

• Suppose this years sales will total 20 million.
• Next year, we forecast sales of 25 million.
• Net income should be 10 of sales.
• Dividends should be 40 of earnings.
• Our task forecast balance sheet and determine
  discretionary (outside) financing needed.

7

• This year of 20m
• Assets
• Current Assets 6m 30
• Fixed Assets 10m 50
• Total Assets 16m
• Liab. and Equity
• Accounts Payable 3m 15
• Accrued Expenses 2m 10
• Notes Payable 1m n/a
• Long Term Debt 3m n/a
• Total Liabilities 9m
• Common Stock 4m n/a
• Retained Earnings 3m
• Equity 7m
• Total Liab. Equity 16m

8

• Next year of 25m
• Assets
• Current Assets 30
• Fixed Assets 50
• Total Assets
• Liab. and Equity
• Accounts Payable 15
• Accrued Expenses 10
• Notes Payable n/a
• Long Term Debt n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

9

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 50
• Total Assets
• Liab. and Equity
• Accounts Payable 15
• Accrued Expenses 10
• Notes Payable n/a
• Long Term Debt n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

10

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets
• Liab. and Equity
• Accounts Payable 15
• Accrued Expenses 10
• Notes Payable n/a
• Long Term Debt n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

11

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 15
• Accrued Expenses 10
• Notes Payable n/a
• Long Term Debt n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

12

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 10
• Notes Payable n/a
• Long Term Debt n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

13

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable n/a
• Long Term Debt n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

14

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.00m n/a
• Long Term Debt 3.00m n/a
• Total Liabilities
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

15

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.00m n/a
• Long Term Debt 3.00m n/a
• Total Liabilities 10.25m
• Common Stock n/a
• Retained Earnings
• Equity
• Total Liab. Equity

16

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.00m n/a
• Long Term Debt 3.00m n/a
• Total Liabilities 10.25m
• Common Stock 4.00m n/a
• Retained Earnings
• Equity
• Total Liab. Equity

17
Predicting Retained Earnings

• Next years projected retained earnings last
  years 3 million, plus

18
Predicting Retained Earnings

• Next years projected retained earnings last
  years 2 million, plus
• projected net income cash
  dividends
• sales sales net income

x x ( 1 - )
19
Predicting Retained Earnings

• Next years projected retained earnings last
  years 3 million, plus
• projected net income cash
  dividends
• sales sales net income
• 25 million x .10 x (1 - .40)

x x ( 1 - )
20
Predicting Retained Earnings

• Next years projected retained earnings last
  years 3 million, plus
• projected net income cash
  dividends
• sales sales net income
• 25 million x .10 x (1 - .40)
• Proj. RE 3m 1.5m 4.5 million

x x ( 1 - )
21

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.00m n/a
• Long Term Debt 3.00m n/a
• Total Liabilities 10.25m
• Common Stock 4.00m n/a
• Retained Earnings 4.50m
• Equity 8.50m
• Total Liab. Equity

22

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.00m n/a
• Long Term Debt 3.00m n/a
• Total Liabilities 10.25m
• Common Stock 4.00m n/a
• Retained Earnings 4.50m
• Equity 8.50m
• Total Liab. Equity 18.75m

23
Oh, no! Here come the Accounting Police!

• Projected Assets 20.00m
• Projected Liabilities Equity 18.75m
• Discretionary Financing Needed 1.25m
• Zippy must decide how to raise this financing.
• Options short and/or long term borrowing, sell
  new common stock, cut dividends.
• Lets assume Zippy will borrow an additional
  0.25m through Notes Payable and an additional
  1m through Long Term Debt.
• Heres Zippys complete projected balance sheet.

24

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.25m 1m0.25m
• Long Term Debt 4.00m 3m1m
• Total Liabilities 11.5m
• Common Stock 4.00m n/a
• Retained Earnings 4.50m
• Equity 8.5m
• Total Liab. Equity 20.0m

Whew! Now, the Accy Police will be happy!
25
Predicting Discretionary Financing Needs A
Formula Approach

• The formula approach gives the same result as our
  first approach, but focuses on the projected
  changes in the balance sheet.
• DFN Proj. Inc. in Assets Proj. Inc. in Liab
  Proj Retained Earnings
• Proj. Inc in Assets Assetst/Salest x Chg in
  sales
• Proj Inc in Liab Liabt/Salest x Chg in Sales
• Proj. RE NPM x Proj Sales x (1 b), where b is
  dividend payout ratio Divs/Net Income

26
Zippy DFN

• Change in sales 25m 20m 5m
• Original sales 20m
• Change in Assets (16m/20m) x 5m 4m
• Change in Liab (3m2m)/20m x 5m 1.25m
• Projected RE 10 x 25m x (1-.4) 1.5m
• DFN 4m 1.25m 1.5m 1.25m

27
DFN dynamics

• Recall, Zippys original DFN is 1.25m.
• What if Zippys profit margin was expected to be
  only 5?
• What if Zippys profit margin was the original
  10, but its dividend payout ratio is only
  expected to be 30?
• What if Zippys sales are expected to increase to
  28 million with original assumptions of 10
  profit margin and 40 dividend payout ratio?

28
Zippy DFN dynamic 1

• Change in sales 25m 20m 5m
• Original sales 20m
• Change in Assets (16m/20m) x 5m 4m
• Change in Liab (3m2m)/20m x 5m 1.25m
• Projected RE 5 x 25m x (1-.4) 0.75m
• DFN 4m 1.25m 0.75m 2m
• Lower profit margin more DFN

29
Zippy DFN dynamic 2

• Change in sales 25m 20m 5m
• Original sales 20m
• Change in Assets (16m/20m) x 5m 4m
• Change in Liab (3m2m)/20m x 5m 1.25m
• Projected RE 10 x 25m x (1- .3) 1.75m
• DFN 4m 1.25m 1.75m 1m
• Lower dividend payout ratio less DFN

30
Zippy DFN dynamic 3

• Change in sales 28m 20m 8m
• Original sales 20m
• Change in Assets (16m/20m) x 8m 6.4m
• Change in Liab (3m2m)/20m x 8m 2m
• Projected RE 10 x 28m x (1- .4) 1.68m
• DFN 6.4m 2m 1.68m 2.72m
• Higher Projected Sales more DFN

31
The effects of other factors on the AFN forecast.

• Excess capacity
• Existence lowers AFN.
• Base stocks of assets
• Leads to less-than-proportional asset increases.
• Economies of scale
• Also leads to less-than-proportional asset
  increases.
• Lumpy assets
• Leads to large periodic AFN requirements,
  recurring excess capacity.

32
Sustainable Rate of Growth

• The maximum sales growth rate a firm can have
  while maintaining its capital structure
  (financing mix).

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Sustainable Rate of Growth

• g ROE (1 - b) where
• b dividend payout ratio
• (dividends / net income)
• ROE return on equity
• (net income / common equity) or

34
Sustainable Rate of Growth

• g ROE (1 - b) where
• b dividend payout ratio
• (dividends / net income)
• ROE return on equity
• (net income / common equity) or
• net income sales
  assets
• sales assets
  common equity

ROE x x
35

• This year of 20m
• Assets
• Current Assets 6m 30
• Fixed Assets 10m 50
• Total Assets 16m
• Liab. and Equity
• Accounts Payable 3m 15
• Accrued Expenses 2m 10
• Notes Payable 1m n/a
• Long Term Debt 3m n/a
• Total Liabilities 9m
• Common Stock 4m n/a
• Retained Earnings 3m
• Equity 7m
• Total Liab. Equity 16m

36
Sustainable Growth rate for Zippy.

• Original Total Assets 16m, Original Total Debt
  9m
• Original Debt Ratio 9/16 56.25
• Current Net income is 10 of 20m or 2m.
• Current Equity 7m
• Dividend payout ratio 40 or .4
• G 2m/7m x (1-.4) 28.6 x .6 17.1
• Our forecast for Zippy 25 growth in sales (20m
  to 25m) with the following balance sheet.

37

• Next year of 25m
• Assets
• Current Assets 7.5m 30
• Fixed Assets 12.5m 50
• Total Assets 20.0m
• Liab. and Equity
• Accounts Payable 3.75m 15
• Accrued Expenses 2.50m 10
• Notes Payable 1.25m 1m0.25m
• Long Term Debt 4.00m 3m1m
• Total Liabilities 11.5m
• Common Stock 4.00m n/a
• Retained Earnings 4.50m
• Equity 8.5m
• Total Liab. Equity 20.0m

Whew! Now, the Accy Police will be happy!
38
Zippys projected Debt Ratio

• Projected Total Assets 20m
• Projected Total Debt/Liabilities 11.5m
• Projected Debt Ratio 11.5/20 57.5
• Since the projected growth rate of 25 is greater
  than the sustainable growth rate of 17.1, the
  debt ratio increases from 56.25 to 57.5.

39
Budgets

• Budget a forecast of future events.

40
Budgets

• Budgets indicate the amount and timing of future
  financing needs.
• Budgets provide a basis for taking corrective
  action if budgeted and actual figures do not
  match.
• Budgets provide the basis for performance
  evaluation.

41
Syllabus Change

• Dont worry about constructing cash budgets!
• Omit problems 4-6a and 4-11a