Financial Analysis, Planning and Forecasting Theory and Application

1
Financial Analysis, Planning and
ForecastingTheory and Application
Chapter 18
Short-term Financial Analysis and Planning

• By
• Alice C. Lee
• San Francisco State University
• John C. Lee
• J.P. Morgan Chase
• Cheng F. Lee
• Rutgers University

2
Outline

• 18.1 Introduction
• 18.2 The components of working capital
• 18.3 The concept of cash flow
• 18.4 Cash flow vs. funds flow
• 18.5 Organizing for short-term financial planning
  principles
• 18.6 The cash flow cycle and its calculation
• 18.7 Cash flow forecasting, budgeting, and
  planning
• 18.8 The cash budget
• 18.9 Demand-driven, capital-driven, and
  cost-driven cash budgets
• 18.10 Users of cash forecasts and business plans
• 18.11 Planning horizons and time intervals of
  cash budgets
• 18.12 From forecasting to budgeting to planning
• 18.13 Summary
• Appendix 18A. Time-series components of sales

3
18.1 Introduction
4
18.2 The components of working
capital
5
18.3 The concept of cash flow

• Exhibit 18-1 Flow of Funds

6
18.4 Cash flow vs. funds flow
7
18.5 Organizing for short-term financial
planning principles

• Exhibit 18-2 Cash Planning and Management
  Resources

Size of Organization Officers in Charge Staff Size
Small President / Treasurer Vice President / Controller 0-2
Medium Treasurer Assistant Treasurer 1-10
Large Assistant Treasurer Over 10
8
18.5 Organizing for short-term financial
planning principles

• Figure 18-1
• Matching Maturities of Financing Sources and
  Assets

9
18.5 Organizing for short-term financial
planning principles

• Exhibit 18-3 Problems Associated with Balancing
  Liquidity and Profitability

Working Capital Component Forms Problem If Component Is Too Small Problem If Component Is Too Large
Cash Dollars Demand Deposits Risk of running out of cash illiquidity, insolvency Loss of return from money market investments
Marketable Securities Money market Investments (T-bills, CDs, commercial paper, etc.) Insufficient safety margin to meet excepted and unexpected cash requirements Misuse of scarce investor capital needed for real investment
Accounts Receivable Open-book accounts of customers Credit policy may be too strict and noncompetitive Demand for product or services is falling Credit policy may be over-generous Collection problems Costly use of resources
10
18.5 Organizing for short-term financial
planning principles
Exhibit 18-3 Problems Associated with Balancing
Liquidity and Profitability (Cont.)
Working Capital Component Forms Problem If Component Is Too Small Problem If Component Is Too Large
Inventory Raw Materials Work in process Finished goods Inability to meet demand Loss of sales Production interruptions Costs of carry storage insurance and handling will be higher than necessary Risk of obsolescence
Short-Term Financing Bank loans Lines of credit Commercial paper Not able to carry sufficient short-term assets to meet demand or operating requirements Very costly may be financing many idle assets that may not be productive
11
18.6 The cash flow cycle and its calculation

• (18-1)
• where average inventory (beginning
  inventoryending inventory)/ 2 average accounts
  receivable(AR)(beginning ARending AR)/2 and
  average accounts payable(AP)(beginning APending
  AP)/2.

12
18.6 The cash flow cycle and its calculation

• managerial actions
• inventory financing, collateral for loans,
• liquidation
• factoring, pledging, altering
• credit terms, tightening collection,
  policies,
• speeding up billing procedures
• - change payment frequency, stretch out
• payables (forego discounts)
  
• 
  (18-2)

13
18.6 The cash flow cycle and its calculation

• Exhibit 18-4 Speedy Maintenance, Inc., Financial
  Statement

Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet Balance Sheet
31 December 19XX 31 December 19X1 31 December 19XX 31 December 19X1
Cash 10,000 15,000 Wages payable 15,000 15,000
Marketable securities 5,000 5,000 Accounts payable 45,000 55,000
Accounts receivable 65,000 85,000 Mortgage payable 25,000 25,000
Inventory Bank note payable 130,000 130,000
Cleaning supplies 18,000 21,000 Common stock 50,000 50,000
Cleaning equipment 50,000 54,000 Retained earnings 8,000 25,000
Trucks(net) 80,000 75,000
Building ( office and garage) 45,000 45,000
Total Liabilities
Total Assets 273,000 300,000 Equity 273,000 300,000
14
18.6 The cash flow cycle and its calculation

• Exhibit 18-4 Speedy Maintenance, Inc., Financial
  Statement (Cont.)

Income Statement Income Statement Income Statement Income Statement
(for year ending 31 December) (for year ending 31 December) (for year ending 31 December) (for year ending 31 December)
19XX 19X1
Sales 379,000 430,500
Cost of services supplied
Labor 250,222 290,000
Supplies 70,000 70,000
Operating expenses 50,000 50,000
Taxable income 9,600 20,500
Income tax 1,600 3,500
Net income 8,000 17,000

15
18.6 The cash flow cycle and its calculation

• Exhibit 18-5 Financing Costs of Speedys Cash
  Flow Cycle

Assets Average Amount Invested (beingend)/2 Average Investment period in Days Estimated Cost of Financing (average investment days interest rate 365) 10? 15? 20? Estimated Cost of Financing (average investment days interest rate 365) 10? 15? 20? Estimated Cost of Financing (average investment days interest rate 365) 10? 15? 20?

Cleaning supplies 19,500 102 545 817 1,090
Accounts receivable 75,000 64 1,315 1,973 2,630
Accounts payable 50,000 51 (699) (1,048) (1,397)
Total cost to finance Total cost to finance 115 1,161 1,742 2,323
16
18.6 The cash flow cycle and its calculation

• Exhibit 18-6 speedy Maintenance Contract XYZ
• Total contract 120,000 for one year
• Payment terms 10,000 on the last day of each
  month
• Cost of supplies per month 2,000
• Cost of labor per month 7,500 (workers paid
  weekly)

17
18.6 The cash flow cycle and its calculation

• Exhibit 18-6 speedy Maintenance Contract XYZ
  (Cont.)

Assets Average Amount Invested Average Investment period in Days Estimated Cost of Financing at 15? Estimated Cost of Financing at 15?
Cleaning supplies 1,000 15 6.16
Accounts receivable 5,000 15 30.82
Accounts payable 1,938 6 (4.78)
Total cost to finance 32.20
12
Total cost per year 386.40

Yearly Cost -
Suggested Modifications Effects

Make payments weekly Reduce A/R
Make payments biomonthly Increase A/R
Pay workers biomonthly Increase A/P
Pay workers monthly Increase A/P
18
18.7 Cash flow forecasting, budgeting, and
planning
19
18.8The cash budget
20
18.9 Demand-driven, capital-driven,
and cost-driven cash budgets

• Table 18-1

Sales and Cash Flow Sales and Cash Flow
Sales Nov. 100,000 Dec. 100,000 Jan. 100,000 Feb. 50,000 Mar. 75,000 Apr. 100,000 May. 100,000
Cash sales( 20?of current months sales) 20,000 10,000 15,000 20,000 20,000
Collection of A/R (70?of previous months) 70,000 70,000 35,000 52,500 70,000
Collection of A/R (10?of months t-2) 10,000 10,000 10,000 5,000 7,500
Cash from collection of Sales and A/R 100,000 90,000 60,000 77,500 97,500
21
18.10 Users of cash forecasts and business plans
22
18.11 Planning horizons and time intervals
of cash budgets

• Exhibit 18-7 Cash Flow Budgets and Planning
  Intervals

A. Monthly Planning Interval A. Monthly Planning Interval A. Monthly Planning Interval A. Monthly Planning Interval A. Monthly Planning Interval
Beginning cash balance 30,000
Cash inflows
A/R collections 55,000
Licensing fee collections 25,000
Sale of surplus assets 15,000
Total cash inflow 95,000
Total cash available 125,000

Cash outflows
Salaries and wages 24,000
Raw material purchases 19,500
Supplies 5,000
Rent 14,000
Income tax payment 25,000
Payroll taxes 7,500
Total cash outflows 95,000
Cash at end of month 30,000
23
18.11 Planning horizons and time intervals
of cash budgets

• Exhibit 18-7 Cash Flow Budgets and Planning
  Intervals (Cont.)

B. Weekly Planning Interval B. Weekly Planning Interval B. Weekly Planning Interval B. Weekly Planning Interval B. Weekly Planning Interval
Week 1 Week 2 Week 3 Week 4
Beginning cash balance 30,000 (2,250) (9,500) (2,250)
Cash inflows
A/R collections 12,000 15,000 11,000 17,000
Licensing fee collections 25,000
Sale of surplus assets 10,000 5000
Total cash inflow 12,000 15,000 21,000 47,000
Total cash available 42,000 12,750 11,500 44,750
Cash outflows
Salaries and wages 6,000 6,000 6,000 6,000
Raw material purchases 5,500 5,000 4,000 5,000
Supplies 1,250 1,250 1,250 1,250
Rent 6,500 2,500 2,500 2,500
Income tax payment 25,000
Payroll taxes 7,500
Total cash outflows 44,250 22,250 13,750 14,750
Cash at end of month (2,250) (9,500) (2,250) 30,000
24
18.12 From forecasting to budgeting to planning

• Exhibit 18-8 Assumptions for Cash Inflows and
  Outflows

Worst Case Most Likely Best Case
Revenues 5? decline Same as last year 10?increase
Credit sales 95? of sales volume 90? of sales volume 85? of sales volume
Collection experience 80? in 30 days 85? in 30 days 100? in 30 days
10? in 60 days 10? in 60 days
10? in bad debts 5?in bad debts
Expenses 5? increase Same as last year 3? decline
Capital expenditures 0 100,000 in February 150,000 in February
25
18.12 From forecasting to budgeting to planning

• Exhibit 18-9 Six-Month Cash Flow Forecast

Most Likely Case Most Likely Case Most Likely Case Most Likely Case Most Likely Case Most Likely Case Most Likely Case Most Likely Case
January February March April May June
Beginning cash balance Beginning cash balance 20,000 16,000 (63,000) (3,000) (5,000) 25,000
Cash sales and collection of A/R Cash sales and collection of A/R 50,000 65,000 75,000 65,000 75,000 65,000
Insurance claims Insurance claims 25,000
Dividends and interests Dividends and interests 5,000 2,000 5,000 2,000
Total cash inflows Total cash inflows 55,000 67,000 100,000 70,000 75,000 67,000
Total cash available Total cash available 75,000 83,000 37,000 67,000 70,000 92,000
Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow
Labor wages 23,000 23,000 25,000 25,000 25,000 25,000 25,000
Salary 5,000 5,000 5,000 5,000 5,000 5,000 5,000
Raw material payment 4,000 4,000 16,000 10,000 15,000 15,000 10,000
Dividends 2,000 2,000 2,000
Income taxes 25,000 25,000 25,000
New equipment 100,000
Total cash outflow 59,000 59,000 146,000 40,000 72,000 45,000 40,000
Cash at end of month 16,000 16,000 (63,000) (3,000) (5,000) 25,000 52,000
26
18.12 From forecasting to budgeting to planning

• Exhibit 18-9 Six-Month Cash Flow Forecast (Cont.)

Worst Case Worst Case Worst Case Worst Case Worst Case Worst Case Worst Case
January February March April May June
Beginning cash balance 15,000 12,500 26,500 82,500 83,500 109,500
Cash sales and collection of A/R 47,500 62,000 70,000 62,000 70,000 62,000
Insurance claims 25,000
Dividends and interests 5,000 2,000 5,000 2,000
Total cash inflows 52,500 64,000 95,000 67,000 70,000 64,000
Total cash available 67,500 66,500 121,500 149,500 153,500 173,500
Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow
Labor wages 25,000 25,000 26,000 26,000 26,000 26,000
Salary 5,000 5,000 5,000 5,000 5,000 5,000
Raw material payment 3,000 10,000 8,000 13,000 13,000 10,000
Dividends 2,000 2,000
Income taxes 20,000 20,000
New equipment -
Total cash outflow 55,000 40,000 39,000 66,000 44,000 41,000
Cash at end of month 12,500 26,500 82,500 83,500 109,500 132,500
27
18.12 From forecasting to budgeting to planning

• Exhibit 18-9 Six-Month Cash Flow Forecast (Cont.)

Best Case Best Case Best Case Best Case Best Case Best Case Best Case
January February March April May June
Beginning cash balance 25,000 17,000 (112,000) (49,000) (55,000) 29,000
Cash sales and collection of A/R 55,000 70,000 85,000 73,000 78,000 73,000
Insurance claims 25,000
Dividends and interests 6,000 3,000 6,000 3,000
Total cash inflows 61,000 73,000 110,000 79,000 78,000 76,000
Total cash available 86,000 90,000 ( 2,000) 30,000 23,000 47,000
Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow Cash Outflow
Labor wages 25,000 27,000 27,000 27,000 27,000 27,000
Salary 5,000 5,000 5,000 5,000 5,000 5,000
Raw material payment 6,000 20,000 15,000 20,000 20,000 15,000
Dividends 3,000 3,000
Income taxes 30,000 30,000
New equipment 150,000
Total cash outflow 69,000 202,000 47,000 85,000 52,000 47,000
Cash at end of month 17,000 (112,000) (49,000) (55,000) 29,000 0
28
18.12 From forecasting to budgeting to planning

• Exhibit 18-10 Six-Month Most-Likely Cash Flow
  Plan

January February March April May June
Beginning cash balance 20,000 10,000 10,000 10,000 10,000 10,000
Cash inflows
Collection of A/R 50,000 65,000 75,000 65,000 75,000 65,000
Insurance claims 25,000
Dividends and interests 5,000 2,000 5,000 2,000
Maturing marketable securities 10,100 43,531 498 30,803
Total cash inflows 55,000 77,000 143,531 70,000 75,498 97,803
Total cash available 75,000 87,100 153,531 80,000 85,498 107,803
Cash Outflow
Labor wages 23,000 25,000 25,000 25,000 25,000 25,000
Salary 5,000 5,000 5,000 5,000 5,000 5,000
Raw material payment 4,000 16,000 10,000 15,000 15,000
Dividends 2,000 2,000
Income tax 25,000 25,000
Payoff line of credit 2,506
New equipment 100,000
Total cash outflow 55,000 34,000 146,000 69,506 45,000 45,000
Cash available 20,000 53,100 7,531 10,494 40,498 62,803
Minimum cash balance 10,000 10,000 10,000 10,000 10,000 10,000
Marketable securities at 12?/year 10,000 43,100 494 30,498 52,803
Short-term borrowing at 18?/year 2,469
29
18.13 Summary

• In Chapter 18, we have identified and defined
  cash flow and related it to the accounting-based
  concept of funds flow. The short-term financial
  manager is much more concerned with the actual
  cash flowing through the firm on a day-to-day
  basis than the long-term funds flow perspective.
• A three-scenario approach to short-term
  financial planning (using worst, most-likely, and
  best-case scenarios) is recommended because
  future events cannot always be forecasted with
  accuracy. For this reason, the initial step of
  the planning process involves making educated
  guesses about future cash flows that cover a
  reasonable range of possible situations. In both
  budgeting and planning, the cash flow manager
  should ask the following questions Dose this
  plan makes sense in light of my own experience?
  Does it coincide with what I expect to happen
  during the coming year?

30
18.13 Summary

• Throughout the planning process, there
  should be a feedback mechanism that enables the
  short-term financial planner to update the
  forecast in light of new information and/or a new
  understanding of the situation that may come
  about from actually preparing the budget and the
  plan. Cash flow managers must understand that the
  process itself is the most important aspect of
  short-term financial management. The final plan
  is not definitive. It serves only to guide future
  courses of action and decisions and is subject to
  continual revision.
• The final part of the chapter demonstrated
  the interrelationship of forecasting, budgeting,
  and planning. Once the problems have been
  defined, a financial planner must generate
  alternatives that will lead to satisfactory
  solutions. The material in the next two chapters
  expands on the possible alternatives available to
  the financial planner. In most cases, there is
  more than one way to solve a problem. Sometimes,
  it is worth the extra effort to look for the
  optimal solution sometimes it is not. With
  experience, the financial manager learns when to
  use a satisfactory solution that may not be the
  best one theoretically. It makes little sense to
  spend a lot of time and make many improvements on
  a plan that will only marginally improve
  performance.

31
Appendix 18A. Time-series components of sales

• Figure 18A-1

32
Appendix 18A. Time-series components of sales

• Figure 18A-1 (Cont.)

33
Appendix 18A. Time-series components of sales

• Figure 18A-1 (Cont.)

34
Appendix 18A. Time-series components of sales

• (18A-1)
• Table 18A-1

Original Quarterly Sales Data for IBM, 1969 to 1982 (millions) Original Quarterly Sales Data for IBM, 1969 to 1982 (millions) Original Quarterly Sales Data for IBM, 1969 to 1982 (millions) Original Quarterly Sales Data for IBM, 1969 to 1982 (millions) Original Quarterly Sales Data for IBM, 1969 to 1982 (millions) Original Quarterly Sales Data for IBM, 1969 to 1982 (millions)
Original Series Year 1st quarter 2nd quarter 3rd quarter 4th quarter Total
1969 1,685 1,832 1,778 1,903 7,198
1970 1,721 1,874 1,914 1,996 7,505
1971 1,870 1,942 2,082 2,380 8,274
1972 2,312 2,365 2,334 2,522 9,533
1973 2,451 2,547 2,756 3,240 10,994
1974 3,002 3,260 3,125 3,288 12,675
1975 3,272 3,496 3,600 4,068 14,436
1976 3,815 4,014 3,957 4,519 16,305
1977 4,090 4,419 4,586 5,038 18,133
1978 4,432 4,921 5,284 6,439 21,076
1979 5,295 5,355 5,384 6,829 22,863
1980 5,748 6,181 6,481 7,805 26,215
1981 6,461 6,895 6,721 8,993 29,070
1982 7,066 8,053 8,171 11,074 34,364
35
Appendix 18A. Time-series components of sales

• Table 18A-2

Mean of the Absolute Average Percent Changes in Sales Related to Trend-Cycle, Seasonal, and Irregular Components for One-, Two, Three, and Four-Quarter Time Span, 1969 to 1982 (in percent) Mean of the Absolute Average Percent Changes in Sales Related to Trend-Cycle, Seasonal, and Irregular Components for One-, Two, Three, and Four-Quarter Time Span, 1969 to 1982 (in percent) Mean of the Absolute Average Percent Changes in Sales Related to Trend-Cycle, Seasonal, and Irregular Components for One-, Two, Three, and Four-Quarter Time Span, 1969 to 1982 (in percent) Mean of the Absolute Average Percent Changes in Sales Related to Trend-Cycle, Seasonal, and Irregular Components for One-, Two, Three, and Four-Quarter Time Span, 1969 to 1982 (in percent) Mean of the Absolute Average Percent Changes in Sales Related to Trend-Cycle, Seasonal, and Irregular Components for One-, Two, Three, and Four-Quarter Time Span, 1969 to 1982 (in percent)
Span in Quarters Original Trend Cycle Seasonal Irregular
1 9.25 3.19 7.29 1.9
2 9.54 6.31 6.26 1.44
3 12.73 9.47 7.59 1.57
4 12.89 12.78 0.44 1.45
36
Appendix 18A. Time-series components of sales


37
Appendix 18A. Time-series components of sales

• Table 18A-3

Relative Contributions of Components to Changes in IBM Sales for One-, Two-, Three-, and Four-quarter Time Spans, 1969 to 1982 (in percent) Relative Contributions of Components to Changes in IBM Sales for One-, Two-, Three-, and Four-quarter Time Spans, 1969 to 1982 (in percent) Relative Contributions of Components to Changes in IBM Sales for One-, Two-, Three-, and Four-quarter Time Spans, 1969 to 1982 (in percent) Relative Contributions of Components to Changes in IBM Sales for One-, Two-, Three-, and Four-quarter Time Spans, 1969 to 1982 (in percent) Relative Contributions of Components to Changes in IBM Sales for One-, Two-, Three-, and Four-quarter Time Spans, 1969 to 1982 (in percent)
Span in Quarters Trend-Cycle Seasonal Irregular Total
1 15.13 80.82 4.03 100
2 45.51 51.73 2.76 100
3 58.46 40.35 1.19 100
4 98.40 .14 1.46 100