FINANCIAL FORECASTING

The planning process, ideally, begins with some idealistic objective, such as producing the best product at the lowest cost. This objective, in turn, dictates that certain long-term objectives be achieved, such as developing an innovative product that can be produced in an efficient manner. Similarly, the long-term objectives require that certain short-term objectives be realized, such as generating sufficient cash flows to fund the research and development required to come up with the innovative product.

Planning

Implementing

Conversely, realizing these goals must occur in the reverse order: if a positive cash flow is not generated, there will be no funding for R&D to develop the product that you want to produce.

Breakeven analysis and profit planning are short-term planning tools. In fact, many businesses do not breakeven for several years, let alone show a profit (witness many of the Internet companies). There are other tools available for evaluating such endeavors. Undoubtedly, one of the short-term objectives of such companies is to secure the financing sources required to survive until such time as a profit is realized.

Critical to the success of any business, is the planning of the cash flows; i.e., cash budgeting. A budget is a plan and budgeting refers to planning. You budget your time just as you budget your cash flows. Planning is an integral part of a management-by-objective style of business management. The alternative is management-by-crisis wherein all of one’s time is spent “putting out fires” – a reactive approach to management rather than a proactive approach. The budget provides the framework by which management intends to achieve its short-term goals.

For the financial manager, the cash budget aids in the performance of the job of making sure that funds are available when needed as well as planning for the efficient use of any surplus funds that exist. The ability to anticipate the financial needs of the firm allows time to find sources of funds.

The complexity of the cash flows can be illustrate by the use of a simple diagram that illustrates the nature of the numerous cash inflows and outflows that confront a firm. Let the Cash Reserve box represent the checking account of the company:

Short-termObjectives

Intermediate-termObjectives

Long-termObjectives

Cash Sales Credit Sales

Into the Cash Reserve go intermittant inflows of funds from lenders and shareholders, and money flows back in the form of interest and principal payments to lenders and dividends to stockholders. There are intermittant outflows of funds to pay wages, taxes and insurance as well. Occasionally, there are tax refunds, payment on insurance claims, etc., that result in cash flows returning to the company. Near Cash (or Near Money) represents investment in short-term marketable securities so that cash surpluses can earn a rate of return. This is a where short-term surpluses of cash are “stored”. Money is spent to purchase fixed assets, which are later sold when it is time to replace them. Accounts payable must be paid. The accounts payable arise from inventory purchases which are sold to customers on either a cash basis or on credit, in which case the receivables must be collected. There are returns by our customers to us, as well as our returns to suppliers, in which case refunds are paid.

As the number of suppliers, customers, lenders, etc., multiplies so does the complexity of the cash flows. Stories abound of companies that are showing a profit (in the accounting sense) but ultimately fail due to the lack of cash flow to make loan payments, pay suppliers, pay wages, taxes, and so on.

Short-term Forecasting – The Cash Budget

A detailed example of a cash budget is attached. A simple two-period example is presented here to illustrate the difference between the cash budgeting techniques taught in accounting courses and the cash budget utilized in finance is presented.

The cash budget in finance always starts with detailing the receipts of cash. Typically, receipts are comprised of cash sales and the collection of accounts receivable. Even the collection of receivables may require a separate worksheet. Note also that if

Intermittant Inflows (Debt, Equity)

CashReserve

Intermittant Outflows(Taxes, Insurance, Wages) Fixed Assets

NearCash

AccountsPayable

AccountsReceivable

Inventory

there is a 5% bad debt expense anticipated, the collections should only add up to 95%. That is, bad debt expense is not a cash outflow, it is a receipt that is not collected and, thus, not an item that appears on the cash budget since the budget only represents cash inflows and outflows. Other sources of cash inflows, such as the sale of stock that is anticipated, would also be reflected under the Receipts section of the cash budget.

The next category is Disbursements where we list any and all cash payments that are to be made including salaries, rent, interest and principal payments, dividends, purchases of fixed assets, but NOT depreciation (since it is not cash) – any cash outflow that is to be made. The difference between the Receipts and Disbursements is the Net Cash Gain (Loss). The various periods for which a cash budget is being prepared can be all be done at the same time up to this point. Beyond this point in the budgeting process, however, the periods must be taken sequentially since each period depends upon the previous one.

Receipts March April

Cash Sales 20 30 Collection of A/R 75 45

Total Receipts 95 75

Disbursements

Wages 35 35 Payment of A/P 50 40 Rent 15 15 Insurance 10 0Debt Payment 0 20 Dividends 0 5

Total Disbursements 110 115

Net Cash Gain (Loss) (15) (40)

Plus: Beginning Cash 10 (5)

Cumulative Cash (5) (45)

Less: Minimum Cash (5) (5)

Surplus (Deficit) (10) (50)

After calculating the Net Cash Gain (Loss) for each period, the Beginning Cash is added to determine the Cumulative Cash (or Ending Cash) on hand at the end of the period. This amount becomes the Beginning Cash for the following period. From the Cumulative Cash figure, we subtract the Minimum Cash that we desire to have on hand. This minimum could be a “safety stock” of cash or it could be a required amount that a lender mandates we keep available (and probably restricted in use). The remaining amount after subtracting the Minimum Cash Required is our Surplus (Deficit).

Unlike the cash budgets you have probably seen before, this is a cumulative cash budget. Notice that the Surplus (Deficit) is a cumulative amount that indicates what

the total position of the firm is at any point in time. Thus, our cash budget indicates that we will need $10 in financing for March and an additional $40 in April, for a total of $50 in financing requirements. The budget shows us our total financing requirements so that we can go to a bank, for example, and request a line of credit of $50 to cover our financing requirements. (Ideally, of course, the budget will also show how we intend to repay the loan as well.) The cumulative cash budget allows us to determine our total financial requirements in advance, allowing us time to find a willing supplier of funds. The only thing worse than having to find funding at the last minute, is having to go back and ask for more money at a later date. The lender will know in advance the level of commitment that must be made and, if we are turned down, we have time to line up another source of funds.

Detailed Cash Budget

The Simmons Company is planning to request a line of credit from its bank. The following sales forecasts have been made for parts of 2009 and 2010:

May 2009 $150,000June 150,000July 300,000August 450,000September 600,000October 300,000November 300,000December 75,000January 2010 150,000

Collection estimates obtained from the credit and collection department are as follows: collected within the month of sale, 5 percent; collected the month following the sale, 80 percent; collected the second month following the sale, 15 percent. Payments for labor and raw materials are typically made during the month following the month in which these costs are incurred. Total labor and raw materials costs are estimated for each month as follows:

May 2009 $ 75,000June 75,000July 105,000August 735,000September 255,000October 195,000November 135,000December 75,000

General and administrative salaries will amount to approximately $22,500 a month; lease payments under long-term lease contracts will be $7,500 a month; depreciation charges will be $30,000 a month; miscellaneous expenses will be $2,250 a month; income tax payments of $52,500 will be due in both September and December; and a progress payment of $150,000

on a new research laboratory must be paid in October. Cash on hand on July 1 will amount to $110,000 and a minimum cash balance of $75,000 will be maintained through-out the cash budget period.

A. Prepare a cash budget for the last six months of 2009 with an estimate of required financing (or excess funds).

B. Assume that receipts from sales come in uniformly during the month (that is, cash payments come in at the rate of 1/30th each day), but all outflows are paid on the fifth of the month. Will this have an effect on the cash budget (i.e., will the cash budget you have prepared be valid under these assumptions)? If not, what can be done to make a valid estimate of financing requirements?

Solution to Handout #8 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10

Sales 150,000 150,000 300,000 450,000 600,000 300,000 300,000 75,000 150,000

Labor & Materials Purchase 75,000 75,000 105,000 735,000 255,000 195,000 135,000 75,000 Payment 75,000 75,000 105,000 735,000 255,000 195,000 135,000

Collection of A/R Worksheet May-09 22,500 Jun-09 120,000 22,500 Jul-09 15,000 240,000 45,000 Aug-09 22,500 360,000 67,500 Sep-09 30,000 480,000 90,000 Oct-09 15,000 240,000 45,000 Nov-09 15,000 240,000 Dec-09 3,750

CASH BUDGETRECEIPTSCollection of Accounts Receivable 157,500 285,000 435,000 562,500 345,000 288,750

Total Receipts 157,500 285,000 435,000 562,500 345,000 288,750

PAYMENTS Purchases 75,000 105,000 735,000 255,000 195,000 135,000 G & A Salaries 22,500 22,500 22,500 22,500 22,500 22,500 Lease Payment 7,500 7,500 7,500 7,500 7,500 7,500 Miscellaneous 2,250 2,250 2,250 2,250 2,250 2,250 Tax Payment 52,500 52,500 Progress Payment 150,000

Total Payments 107,250 137,250 819,750 437,250 227,250 219,750

NET CASH GAIN (LOSS) 50,250 147,750 (384,750) 125,250 117,750 69,000

PLUS: BEGINNING CASH 110,000 160,250 308,000 (76,750) 48,500 166,250

CUMULATIVE (ENDING) CASH 160,250 308,000 (76,750) 48,500 166,250 235,250

LESS: MINIMUM CASH BALANCE 75,000 75,000 75,000 75,000 75,000 75,000

SURPLUS CASH BALANCES 85,250 233,000 0 0 91,250 160,250LOANS REQUIRED TO MAINTAIN MINIMUM CASH BALANCE 0 0 (151,750) (26,500) 0 0

The detail of a cash budget is both an advantage and a hindrance to forecasting future financial requirements. The advantage is the fact that the actual timing of cash inflows and outflows is more precise than other methods and gives a more accurate picture of the firm’s financial situation, particularly when seasonality is involved. On the other hand, a lot more effort must be expended in order to develop a detailed cash budget. When a budget of short time periods is employed for forecasting purposes, the budget and income statement actually drive the construction of the projected balance sheets. To see this, consider the following one-month example:

MolecuGene, Inc., is planning next month's operations and has gathered the following past and projected sales data:

October $80,000November 60,000December 50,000January 55,000

40% of sales are cash sales. Of the remaining credit sales, half are collected in the first month following the sale and the rest is collected in the second month following the sale. Purchases of materials are 60% of sales and are acquired one month in advance. Purchases are paid for with cash to avoid financing charges. Staff salaries are $11,000 per month. Equipment rental fees are $1,200 per month, while MolecuGene owns the building and is depreciating it at a rate of $1,500 per month. Utilities average 5% of sales and are paid in the month following their incurrence. The Board of Directors has authorized dividends of $5,000 for common stockholders payable on December 31. The tax rate for MolecuGene is 20% and the next quarterly tax payment is due at the end of January.

A. Prepare a cash budget for December indicating the surplus (deficit) of cash as of December 31. The cash balance as of November 30 is $2,000.

B. Prepare a proforma income statement for December.

C. The balance sheet as of November 30 is as follows:

Cash $ 2,000 A/P (utilities) $ 3,000A/R 62,000 Taxes/P 4,320Inventory 45,000Plant & Equip. 170,000 Common Stock 85,000 Accum. Depr. ( 50,000) Retained Earnings 136,680Total Assets $ 229,000 Tot. Liab. & Equity $ 229,000

Create a balance sheet to reflect your firm's assets and liabilities as of December 31. (Note: If your cash budget shows a surplus, additional financing will be zero. If your cash budget shows a deficit, the cash account will be zero.)

Cash Budget

Receipts:Cash Sales $ 20,000 ($50,000 * 40%)Collection of A/R

October 24,000 ($80,000 * 60% * 50%)November 18,000 ($60,000 * 60% * 50%)

Total Receipts $ 62,000

Payments:Materials Purchases $ 33,000 ($55,000 * 60%)Salaries 11,000Equipment Rent 1,200Utilities 3,000 ($60,000 * 5%)Dividends 5,000

Total Payments $ 53,200

Net Cash Gain (Loss) $ 8,800

Plus: Beginning Cash $ 2,000

Ending Cash $ 10,800

Income Statement

Revenues $ 50,000Cost of Goods Sold 30,000 ($50,000 * 60%)

Gross Profit $ 20,000

Gen. & Admin. ExpenseSalaries $ 11,000 (fixed)Equipment Rent 1,200 (fixed)Depreciation 1,500 (given)Utilities 2,500 ($50,000 * 5%)

Total G&A $ 16,200

Operating Income (EBIT) $ 3,800

Taxes 760

Net Income $ 3,040

Balance Sheet

AssetsCash $ 10,800 (From Cash Budget)

Accounts Receivable 50,000 (Beg A/R + Credit Sales – Collections = $62,000 + $30,000 - $42,000)

Inventory 48,000 (Beg. Inv’y + Purchases - COGS = $45,000 + $33,000 - $30,000)

Plant & Equipment 170,000 (No P&E bought or sold – see Inc. Stmt.)

Accumulated Depreciation (51,500) ($50,000 + $1,500)

Total Assets $227,300

Liabilities & EquityAccounts Payable (Utilities) $ 2,500 (Beg. A/P + Credit Purchases – Payments

= $3,000 + $2,500 - $3,000)Taxes Payable 5,080 (Beg. Tax/P + Current Taxes – Payments

= $4,320 + $760 – 0)Common Stock 85,000 (Beg. C/S + stock sales –repurchases)

Retained Earnings 134,720 (Beg. R/E + Net Income – Dividends = $136,680 + $3,040 - $5,000)

Total Liabilities & Equity $227,300

Long-Term Forecasting – Percent-of-Sales or Constant Ratio Method

Cash budgeting is a short-term planning tool. It is equally important that long-term planning be periodically reviewed to ensure that the short-term goals are consistent with the long-term objectives, as well as to provide advance notice of the needs of the corporation so that appropriate decisions can be made and actions taken.

Suppose our Balance Sheet for the past year looked as follows:

2008 Balance Sheet:

Cash 50,000 Accounts Payable 100,000 Accounts Receivable 180,000 Bank Note 90,000 Inventory 200,000 ------------

------------ Total Current Liabs. 190,000 Total Current Assets 430,000

L-T Debt 220,000 Gross Fixed Assets 400,000 (Accum. Depr.) (130,000) Common Stock 10,000

------------ Retained Earnings 280,000 Net Fixed Assets 270,000 ------------

Total Equity 290,000

Total Assets 700,000 Total Liab. & Equity 700,000

The assets should reflect the consequences of the past year’s activities (particularly the receivables and payables) as well as expectations of the coming year’s sales. The primary factor that influences our asset and financing requirements is the level of sales that is anticipated. We must, therefore, get a realistic estimate of what our sales will be in the coming years in order to determine the amount of assets that will be required in order to support the anticipated sales. Once we have an estimate of the amount of assets that will be required, we need to determine what financing will be necessary for the projected asset levels.

Consider the income statement for 2008 as well as the projected income statement for 2009. The assumptions used to construct the projected income statement are listed next to each category:

Income Statements:

2008 2009 Actual Projected====== =========

Revenues 1,000,000 1,200,000 20% increaseCost of Goods Sold 500,000 600,000 50% of Sales

------------ ------------ Gross Profit 500,000 600,000

Gen. & Adm. Expense Salaries 220,000 226,600 3% inflation Rent 60,000 60,000 Contractual Repairs & Maintenance 14,000 14,420 3% inflation Travel 23,000 23,690 3% inflation Utilities 12,000 12,360 3% inflation Depreciation 40,000 44,000 MACRS determined

------------ ------------ EBIT 131,000 218,930

Interest Expense 30,000 30,000 ------------ ------------

Taxable Income 101,000 188,930

Taxes (35%) 35,350 66,126 ------------ ------------

Net Income 65,650 122,805

Less: Dividends 25,000 25,000 ------------ ------------

Addition to Retained Earnings 40,650 97,805

If we intend to be able to meet the growing demand, we need to be sure that we have the necessary assets on hand to support our projected level of sales, as well as the ability to finance these projected asset levels. The easiest means of projecting the balance sheet is to utilize the percent-of-sales method of projection. This technique takes each account on the balance sheet that varies with sales and expresses it as a percentage of sales. This percentage is then applied to the projected sales level to determine what levels can reasonably be expected for these accounts.

If we assume that the balance sheet for 2008 above was about right for the level of sales of $1 million that we experienced in 2008, then we can project the balance sheet for 2009 given our projected sales of $1.2 million for the year:

Note that your bank doesn’t just automatically give you more money, nor are long-term bonds automatically issued. In fact, aside from accounts payable and other accruals (which are referred to as spontaneous sources of financing) which have a zero cost, how assets are financed is a decision variable (that we will look at in detail later). Thus, simply leave these accounts alone.

The only other account that is a direct function of sales is the retained earnings account which is a function of both our profitability and dividend policy. Recall the relationship between successive retained earnings accounts:

Beginning R/E + Net Income – Dividends = Ending Retained Earnings

$280,000 + $122,805 - $25,000 = $377,805

We now can fill in our entire projected balance sheet for 2009. Since total assets must equal total liabilities and equity, we will use Additional Financing Required as a balancing figure.

2009 Balance Sheet:

Cash 60,000 Accounts Payable 120,000 Accounts Receivable 216,000 Bank Note 90,000 Inventory 240,000 ------------

------------ Total Current Liabs. 210,000 Total Current Assets 516,000

L-T Debt 220,000 Gross Fixed Assets 480,000 (Accum. Depr.) (174,000) Common Stock 10,000

------------ Retained Earnings 377,805 Net Fixed Assets 306,000 ------------

Total Equity 387,805

Add’l Financing Req’d 4,196

Total Assets 822,000 Total Liab. & Equity 822,000

Ultimately, the Additional Financing Required figure must be reduced to zero. This is where decisions must be made. One source, for example may be that additional Fixed Assets are not require; i.e., there is sufficient unutilized capacity to accommodate the 20% increase in sales without any additions. This would reduce the asset requirements and, hence, the financial requirements of the firm. Another alternative might be to reduce the dividends being paid. Or additional bank loans may be taken out. In any event, we now know what our financing requirements are and we can begin looking for ways of covering our shortfall.

The final step we should take is to construct the Statement of Cash Flows for 2009. It appears as follows:

2009 Statement of Cash Flows

From Operations: Net Income 122,805 Depreciation 44,000

----------- Operating Cash Flow 166,805

Accounts Receivable ( 36,000) Inventory ( 40,000) Accounts Payable 20,000

----------- Working Capital ( 56,000)

Total From Operations 110,805

From Investment Activities:

Fixed Assets (80,000)------------

Total From Investments (80,000)

From Financing Activities:

Additional Financing Required 4,196 Dividends (25,000)

------------ Total From Financing (20,805)

Total Cash Flow 10,000

Plus: Beginning Cash 50,000

Ending Cash 60,000

The figures were calculated as follows:

Accounts Receivable = 180,000 – 216,000 = (36,000)Inventory = 200,000 – 240,000 = (40,000)Accounts Payable = 120,000 – 100,000 = 20,000Fixed Assets = 400,000 – 480,000 = (80,000)Add’l Fin. Required = 4,196 – 0 = 4,196Dividends = Beg. R/E + Net Income – End. R/E

= 280,000 + 122,805 – 377,805 = (25,000)

Speaking of the Fixed Assets, consider the following graph:

As may be observed, plant and equipment comes in “chunks” – you cannot build one-fifth of a plant. Thus, sometimes the percent-of-sales approach is not the best one.

As another example, consider inventories. Perhaps the best description of the relationship between inventories and sales is described by a linear (or simple) regression.

This illustrates some of the drawbacks to the percent-of-sales method.

Percent-of-Sales

Sales

Fixed Assets

The percent-of-sales method forces the line through the origin. In the case of the inventory regression, this results in an under-estimate of the requirements at low levels of sales and an over-estimate at high levels.

What would happen if we used a linear regression on Accounts Receivable?

Percent-of-Sales

LinearRegression

Under-estimate

Over-estimate

Sales

Inventory