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MBF1223 | Financial ManagementPrepared by Dr Khairul Anuar

L10 - Forecasting and Short-Term Financial Planning

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Learning Objectives

1. Understand the sources and uses of cash in building a cash budget.

2. Explain how companies use sales forecasts to predict cash inflow.

3. Understand how production costs vary in terms of cash flow timing.

4. Explain possible ways to cover cash deficits and invest cash surplus.

5. Prepare a pro forma income statement and a pro forma balance sheet.

10.1 Sources and Uses of Cash

• Cash is considered to be the life-blood of a business. Cash shortages can be stifling and expensive while excesses can lead to poor returns.

• Since most businesses do not function on a pure cash basis, it is critical for them to forecast their needs for cash in advance.

• The cash budget is the analytical tool that estimates the future timing of cash inflow and cash outflow and projects potential shortfalls and surpluses.

10.1 Sources and Uses of Cash (continued)

Despite setting up a cash reserve, the firm is projected to have cash shortfalls in 3 months and surpluses in 2 after all cash receipts and disbursements have been forecasted for the first half of 2014.

Table 10.1 Bridge Water Pumps and Filters, Cash Budget for First Six Months of 2014 ($ in thousands)

10.1 Sources and Uses of Cash (continued)

Identifying all possible sources and uses of cash is essential for preparing a useful cash budget.

This list can serve as a guide when preparing a cash budget.

Figure 10.1 Cash inflows and cash outflows for a company.

10.2 Cash Budgeting and the Sales Forecast

Sales revenue base variable driving almost all other items in the cash budget, Must forecast sales as objectively as possible.

There is usually a time lag between when a sale is made and when the cash receipts come in Must keep track of collections timeline.

Need internal data (information that is proprietary or unique to the firm) as well as external data (publicly available information) sources for objective sales forecasts.

10.2 Cash Budgeting and the Sales Forecast (continued)

Figure 10.2 Marketing data for Bridge Water Pumps and Filters.

10.2 (A) Cash Inflow from Sales

• Firms typically sell products and services partially for cash and partially on credit.

• An analysis of a firm’s collection policy can help project cash inflow from sales.

• It is quite common for firms to collect some of their receivables in the 2 months following the sale, i.e. November 2014’s credit sales will be partially collected in December and January.

12.2 (A) Cash Inflow from Sales (continued)

Managers often figure in a small percentage of the forecasted sales as bad debts when preparing a cash budget.

Table 10.3 Bridge Water Pumps and Filters Cash Flow from Sales: January, February, and March 2014 Cash Flow Estimates

10.2 (B) Other Cash Receipts

• Besides sales, which are the main contributor to a firm’s cash inflow, need to forecast the timing and magnitude of other occasional sources of cash such as

– asset sales,

– funds raised through issuance and sale of securities, and

– income earned on investments (dividends, interest, etc.).

10.3 Cash Outflow from Production

• The magnitude and timing of the various cash disbursements of a firm depends mainly on forecasted sales.

– Payments for raw materials, labor costs, overheads such as utilities and rent, shipping costs, etc.

• Like sales, there is often a time lag between when the firm receives and records the benefit, and when it actually makes the payment for it.

• The cash budget can be used as a handy planning document to keep track of the projected disbursements.

• Depreciation is merely a tax write-off, not a cash disbursement, so should not be

included in a cash budget.

10.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses

The main objective of developing a cash budget Firm has sufficient cash available from its revenues and other receipts to cover its periodic cash disbursements such as:1. Accounts payables for materials and supplies; 2. Salaries, wages, taxes, other operating expenses; 3. Capital expenditures for plant, equipment, and

machinery; and4. Dividends, interest and floatation cost payments related

to raising and servicing of capital.

Over a short planning cycle, the total periodic cash inflow rarely matches the total periodic outflow, seasonalfluctuations and time lags. Forecasted cash deficits and surpluses in certain periods

10.4 The Cash Forecast: Short-Term Deficits and Short-term Surpluses (continued)

Table 10.4 Monthly Cash Budget for Bridge Water Pumps and Filters

10.4 (A) Funding Cash Deficits

Cash shortfalls can be handled in 4 ways:

1. Cash from savings

2. Unsecured loans (letters of credit)

3. Secured loans (using accounts receivable or inventories)

4. Other sources (commercial paper, trade credit, or banker’s acceptance).

10.4 (B) Investing Cash Surpluses

When a company has excess funds, it has 4 options:

1. Put the surplus in a savings account or invest it in marketable securities.

2. Repay lenders and owners (retire debt early or pay extra dividends).

3. Replace aging assets.

4. Invest in the company, accepting positive net present value projects

10.5 Planning with Pro Forma Financial Statements

• Cash budgeting, is only one aspect of short-term financial planning. Equally important for firms to forecast their operating cash flow and net income for the forthcoming period by developing pro forma financial statements.

• There are a variety of ways to produce pro forma statements, but the statements usually rely on twoprimary inputs:

– The prior year’s financial statements and the relationship of the account balances to each other, and

– The projected sales for the coming year.

10.5 Planning with Pro Forma Financial Statements (continued)

• The percentage of each item either to sales (income statement) or to total assets (balance sheet) is computed for the prior year and then multiplied by the projected sales (income statement) or total assets (balance sheet) for the coming year to develop pro forma financial statements.

– For example, let’s say that the cash balance for the prior year is $2 million and the total assets is $100m. So cash is 2% of total assets.

– For the Pro Forma Balance Sheet, we would forecast cash as 2% of the forecasted total assets as well, i.e. if total assets are forecasted to increase by 20%$120mCash would be forecasted to be .02*120m = $24m.

10.5 (A) Pro Forma Income Statement (continued)

Figure 10.3

12.5 (A) Pro Forma Income Statement (continued)

This approach, -- a good first step, is often too simplistic in reality because many financial statement items do not vary proportionately with sales. In particular, depreciation decreases over time and cost of goods sold often declines due to economies of scale. The manager would have to fine-tune the forecasted values to make them more in line with reality.

Figure 10.4

10.5 (B) Pro Forma Balance Sheet

Each prior year’s balance sheet item is expressed as a percent of total assets, and then multiplied by the forecasted total assets figure for the next period.

Items which are obviously either constant each period, or which vary at a different rate (for whatever reason) are accordingly adjusted for by the financial manager.

If total assets exceed total liabilities and owner’s equity, external financing is allocated according to some pre-determined ratio to serve as the plug variable.

12.5 (B) Pro Forma Balance Sheet (continued)

Figure 10.5


Based on the following assumptions, a pro forma balance sheet is developed


Key calculations include:


Figure 10.6


Pro Forma Cash Flow Statement

• Finally, the pro forma cash flow statement (Figure 10.7) is prepared to tie together all the changes in operating, investment, and financing cash flows.


Figure 10.7

Additional Problems with AnswersProblem 1

Sales Forecast: You have been asked to forecast sales for the coming year. Being convinced that the compound average growth rate is the best way to forecast growth, you collect data for the prior three years as listed below. Using the data compute the compound growth rate for each of the years and then forecast next year’s sales by using the two-year average growth rate.

Year Sales

2012 $1,200,000

2013 $1,750,000

2014 $2,100,000

2015 ?

Additional Problems with AnswersProblem 1 (Answer)

g = (ending value / beginning value)1 / number of years – 1

2013 growth rate =[ (2010 Sales/2009 sales)] -1 = (1.75m/1.2m) -1

2013 growth rate = 45.83%

2014 growth rate = =[ (2011 Sales/2010 sales)] -1 = (2.1m/1.75m) -1

2014 growth rate 20%

2-year average growth rate = (2014 Sales/2012 Sales)1/2 =1= (2.1m/1.2m)1/2 -1

2-year average growth rate =32.29%

2015 Sales Forecast =$ 2,100,000*(1.3229) = $2,778,090


Sales Receipts: The financial manager of Hearty Cereals is in the process of preparing a cash budget for the first quarter of 2015. The firm typically sells 1/3 of its monthly sales on cash terms and the rest on credit. An analysis of the accounts receivables shows that on average 40% of the sales are collected in the next month, 50% in 60 days, 7% in 90 days, with the rest ending up as bad debts. As the manager’s assistant it is your job to project the sales receipts for the first quarter of 2015, using the monthly sales figures listed below.

2014 Sales

October $1,750,000

November $2,000,000

December $2,450,000

2015 Forecasted Sales

January $1,850,000

February $1,650,000

March $1,900,000

Additional Problems with AnswersProblem 2 (Answer) Oct Nov Dec Jan Feb March

1,750,000 2,000,000 2,450,000 1,850,000 1,650,000 1,900,000

Cash 1/3 0.33 $583,333 $666,667 $816,667 $616,667 $550,000 $633,333

Credit 2/3 0.67 $388,889 $444,444 $544,444 $411,111 $366,667 $422,222

Bad debt

3% of

Credit sales 0.03 $11,666.67 $13,333 $16,333 $12,333 $11,000 $12,667

40% in 30

days =

.4*Prior

month's

credit sales 0.4

$155,556 $177,778 $217,778 $164,444 $146,667

50%in 60

days=.6* 2

month

earlier sales 0.5

$194,444 $222,222 $272,222 $205,556

7% in 90

days=.07 *

3 month

earlier sales 0.07

$27,222 $31,111 $38,111

1

Total

Receipts

from Sales $1,056,667 $986,667 $985,556


Production cash outflow. The Creative Products Corporation produces its products two months in advance of anticipated sales and ships to warehouse centers the month before sale.

The inventory safety stock is 15% of the anticipated month’s sale.

Beginning inventory in October 2014 was 120,000 units. Each unit costs $1.50 to make. The average selling price is $2.50 per unit. The cost is made up of 60% labor, 30% materials, and 10% shipping (to warehouse).

Labor is paid the month of production, shipping the month after production, and raw materials the month prior to production.

What is the production cash outflow for the month of October 2014 production, and in what months does it occur?

Assume that the sales forecast for December 2014 is $2,500,000


Unit Sales forecast for December 2014 = $2,500,000/$2.5

1 million units

Safety stock required = 15% of December sales = 150,000 units

Beginning Inventory (October 2014) = 120,000 units

Production needed in October = Dec. ‘14 Sales + Safety Stock – Beg. Inventory

Production needed in October = 1,000,000 + 150,000 – 120,000=1,030,000 units

Cost of Production (Oct. 2014) = 1,030,000*$1.50= $1,545,000

Labor cost = .60*$1,545,000 = $927,000 paid in October 2014

Shipping cost = .10*$1,545,000 = $154,500 paid in November 2014

Material cost = .30*$1,545,000 = $463,500 paid in September 2014


Pro forma income statement. Given the income statement below for Imperial Products Corporation for 2014, and a 20% growth in sales for 2015, prepare a pro forma income statement.

Imperial Products Corp. Income Statement for 2014

Sales Revenue $28,800,000

COGS

11,400,000

SG&A Expenses 6,800,000 Depreciation Expenses 2,300,000

EBIT

$8,300,000

Interest Expense 1,200,000

Taxable Income $7,100,000

Taxes

$2,414,000.00

Net Income $4,686,000.00


First divide each item by sales Then multiply each proportion by forecast sales for 2015 Forecast sales = 28,800,000*(1.2) = $34, 560,000

2014 % of sales

2015 Forecast

Sales Revenue $28,800,000 100.00% $34,560,000

COGS

11,400,000 39.58% $13,680,000

SG&A Expenses 6,800,000 23.61% $8,160,000

Depreciation Expenses 2,300,000 7.99% $2,760,000

EBIT

$8,300,000 28.82% $9,960,000

Interest Expense 1,200,000 4.17% $1,440,000

Taxable Income $7,100,000 24.65% $8,520,000

Taxes

$2,414,000.00 8.38% $2,896,800

Net Income $4,686,000.00 16.27% $5,623,200


The Global Growth Corporation is planning for next year and wants you to help them prepare a Pro Forma Balance Sheet for 2015. Their current Balance Sheet is shown below along with some pre-determined changes in key balance sheet accounts. How will you proceed?

Current Assets 2014Cash $1,500,000

Marketable Securities 830,000Accounts Receivable 3,450,000Inventories 2,500,000Total Current Assets $8,280,000

Long-term Assets

Plant, Property & Equip. $8,500,000 Goodwill 3,500,000Intangible Assets 1,350,000

Total Long-term Assets $13,350,000 TOTAL ASSETS $21,630,000

Additional Problems with AnswersProblem 5 (continued)

Current Liabilities

Accounts Payable $5,125,000

Other Current Liabilities $1,350,000

Total Current Liabilities $6,475,000

Long-term Liabilities

Long-Term Debt $3,200,000

Other Long-term Liab. $1,650,000

Total Long-Term Liabilities $4,850,000

TOTAL LIABILITIES

$11,325,000

Owner’s Equity

Common Stock $2,500,000

Retained Earnings $7,805,000

TOTAL OWNER’S EQUITY

$10,305,000

TOTAL LIABILITIES & OWNER’S EQUITY $21,630,000

Additional Problems with AnswersProblem 5 (continued)

Next year, the firm will increase its Plant, Property, and Equipment (PPE) by $7,000,000 with a plant expansion.

The inventories will grow by 70%, but accounts payables will grow by 60%, and marketable securities will be reduced by 50% to help finance the expansion.

If all other asset accounts remain the same and long-term debt will be used to finance the remaining costs of the expansion (no change in common stock or retained earnings), prepare a pro forma balance sheet for 2015. How much additional debt will be estimated using this pro forma balance sheet?


Start by changing the known asset accounts and then total up assets. Then use the total assets for total liabilities and owner’s equity balance. Finally, make the required change in long-term debt to balance the balance sheet.

i.e. PPE will be $8,500,000+$7,000,000 = $15,500,000

Inventories = 70% higher (1.7)*2500000=4,250,000

Accounts payables = 60% higher 5,125,000*1.6=8,200,000

Marketable Securities = 50% lower = 830,000*.5 415,000

Additional Problems with AnswersProblem 5 (Answer) (continued)

2014 2015 proforma

Cash $1,500,000 $1,500,000

Marketable Securities 830,000 415000

Accounts Receivable 3,450,000 3,450,000

Inventories 2,500,000 4250000

Total Current Assets $8,280,000 $9,615,000

Plant, Property & Equip. $8,500,000 $15,500,000

Goodwill 3,500,000 3,500,000

Intangible Assets 1,350,000 1,350,000

Total Long-term Assets $13,350,000 $20,350,000

Total Assets $21,630,000 $29,965,000

Additional Problems with AnswersProblem 5 (Answer) (continued)

2014 2015 Pro Forma

Accounts Payable $5,125,000 $8,200,000.0 Other Current Liabilities $1,350,000 $1,350,000

Total Current Liabilities $6,475,000 $9,550,000

Long-Term Debt $3,200,000 $8,460,000 Other Long-term Liab. $1,650,000 $1,650,000

Total Long-Term Liabilities $4,850,000 $10,110,000

$11,325,000 $16,585,000

Common Stock $2,500,000 $2,500,000 Retained Earnings $7,805,000 $7,805,000

Shareholders’ Equity $10,305,000 $10,305,000

Total Liab. And Sh. Equity $21,630,000 $29,965,000

Table 10.2 McDonald’s Sales Revenues 2008 to 2013

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