Handout 3 FinlForecasting

7/28/2019 Handout 3 FinlForecasting

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FinancialForecasting


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Introduction

From the past (Chapters 1 and 2) to thefuture.

Financial forecasting planning

Budgeting

Chapter describes techniques that arepartof planning.


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Pro Forma Statements

Pro forma = as if Much of the language of business

forecasting is financial. Many of the measures used to evaluate

plans are financial.

Key issue is determining whether a plan isfinancially feasible.

Implications for current environment.


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Bottom up detailed plans vs. top downbirds eye view plans.

Pro forma financial statements areforecasted financial statements.

Can stem from broad outlines or detailed

sub-plans. Future need for external funding, external

financing required (EFR).


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Percent of Sales

Forecast future sales, and tie other itemsin income statement and balance sheet to

the sales forecast. Works for variable costs, most current

assets and current liabilities.

Not generally true for fixed assets.


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Steps

1. Examine historical data to ascertain theextent to which percent-of-sales ratios

stay constant over time.2. Forecast sales.3. Do sensitivity analysis to see how

financial statements respond to differentpercent-of-sales parameters.


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Suburban National Bank

R&E Supplies, Inc. is a wholesaler ofplumbing and electrical supplies.

R&E has been a customer of the bank formany years.

Average deposits have been $30K.

Short-term renewable loan has been$50K, with a 5-year maturity.


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Increase in Loan

In late 2008, R&E asks that the loanamount for 2009 be increased to $500K.

R&E explains that because of growth, APhas gone up and cash balances have gonedown.

Suppliers are threatening to go to COD. Why $500K? Pay off most insistent creditors and rebuild

cash balances.


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Build a Pro Forma

Not enough quantitative justification. Build a pro forma.

Start with history, Table 3-1. Look at the ratios, Table 3-2. Whats happened to

cash/sales

AP/sales

earnings/sales


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TABLE 3-1 Financial Statements for R&E Supplies, Inc.,

December 31, 2005-2008 ($ thousands)


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TABLE 3-1 (Continued)


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Questions re Next 3 Slides

By how much are sales forecasted toincrease?

How has an unfavorable labor settlementimpacted the pro forma? What is the plan for Days Sales in Cash?

What is the plan for AP in terms ofPayables Period? What is the plan for net interest expense

and Earnings After Tax?


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TABLE 3-2 Selected Historical Financial Ratios for R&E Supplies,

Inc., 2005-2008, and Forecasts


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TABLE 3-3 Pro Forma Financial Statements for R&E

Supplies, Inc., December 31, 2009 ($ thousands)


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Estimating theExternal Funding Required

Income statement measures profitability,and garners most investors attention.

The CFO focuses on the balance sheet toestimate funding needs.


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Items

Prepaid expenses rough guess. New fixed assets?

capital budget of $43K already approved

$50K depreciation

280 = 287 (prior year) + 43 50

Bank loan initially set to $0, but onlytemporarily.


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Additional Items

Current portion (100) of long-term debt iscontractual (760 = 660 + 100)

Note assumption that new loans = 0.

Retained earnings? Prior year RE + income statement earnings

dividends

External funding required = Total assetsminus Total Liabilities and Owners Equity This temporary balance sheet does not

balance.


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Bankers Reaction?

EFR = $1.4 million > $500K! Not good news about the CFO.

Still, AR = $3.6 million, which wouldprovide security.


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Interest Expense

Circular reasoning. Interest this year is based on debt this year.

But interest this year feeds into earnings this year,and therefore into balance sheet retained earnings.

Debt this year, needs to be determined by the gapbetween assets and liabilities in the balance sheet.

Can try a decent plug, such as basing theinterest on the prior year debt. Can iterate, because the two need to be

determined simultaneously.


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Seasonality

External financing needed is onlycomputed on the date of the balance

sheet. What about in-between? Do a series of these, quarterly, monthly,

etc.


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Pro Forma Statements &Financial Planning

The initial financial plan, as embodied within thepro forma, provides the starting point for adiscussion about operations.

If the external amount of financing is too large,what kinds of operating changes need to bemade, relative to pro forma?

Different level of investment? Sale of assets?

Different working capital policy?

Cutting costs, with associated impact on revenue?


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Max Loan = $1 Million?

Bank doesnt trust R&E managementsfinancial acumen.

What to do?

Where to shave $400K? Tighten up AR, so that DSO drops from 51 to

47?

Increase payables period from 59 to 60? These might lower sales growth (2520%)

and increase costs (SG&A 12-12.5%) fromforegone discounts .


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Check the Impact

See Table 3-4 next. What happens to external financing

required? What happens to earnings?


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TABLE 3-4 Revised Pro Forma Financial Statements for

R&E Supplies, Inc., December 31, 2009 ($ thousands)


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Earnings

Earnings drop by 34%, from 234 to 155.


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External Funding

EFR drops from 1.4 to below 1 (982K).


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Why Are Lenders So Conservative?

If expected loan returns are low, lenders cannotaccept high risk.

Look at the lending margin (spread) betweenpaying depositors and what the loan pays. Example on p. 100 shows a low net profit

margin.

So getting a high ROE requires high financialleverage (like 10-to-1).


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Prophetic Comments:

A Few Bad Apples?

Complete default by just a few borrowers

can erase a banks earnings. Why are lenders so conservative? Because the aggressive ones have long

since gone bankrupt.


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Computer-Based Forecasting

Table 3.5 lays out Excel spreadsheet withformulas.

Chapter problem C3.13 provides you withpractice in this skill.


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TABLE 3-5 Forecasting with a Computer Spreadsheet: Pro

Forma Financial Forecast for R&E Supplies, Inc. December 31, 2009


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Sensitivity Analysis

What if questions. What if sales growth is only 15%, instead

of 25%? What if COGS is 84% instead of 85%? Benefit #1: sensitivity analysis produces a

range of outcomes.

Benefit #2: sensitivity analysis inducesmanagers to prioritize their assumptionsaccording to importance.


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Scenario Analysis

In practice, forecast variables changetogether, not one at a time.

Develop a set of scenarios with differentco-movements.

Each scenario is built around a story or

narrative, such as losing a major customeror facing a new competitor.


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Simulation Analysis

Assign probability distributions to eachmajor variable.

Run many pro formas, with the variablevalues drawn from a Monte Carlo process.

Advantage: many scenarios.

Disadvantage: many managers do notthink in terms of probabilities, and theplanning issues are opaque.


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FIGURE 3-1 Simulating R&E Supplies Need for External

Funding: Frequency Chart


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FIGURE 3-1 (Continued) Distribution Gallery for Sales Growth

Source: Crystal Ball, Decisioneering, Inc.


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Cash Flow Forecasts

Sources and Uses of Cash Based on same assumptions as the interim

pro forma income statement and balancesheet.

EFR = Total uses Total sources


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TABLE 3-6 Cash Flow Forecast for R&E Supplies, Inc.

2009 ($ thousands)


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Cash Budgets

Pro forma statements rely on accrualaccounting.

Cash budgets are strictly cash accounting. Cash budgets require translation fromaccrual projections to cash projections.Adjust for timing of collections and payments.

Example: Jill Clair Fashions monthly cashbudget.

2%/10 net 30 factoring it in.


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TABLE 3-7 Cash Budget for Jill Clair Fashions, 3rd

Quarter, 2009 ($ thousands)


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TABLE 3.7 (Continued)


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Bottom Line

In the next slide, look at the bottom linecumulative EFR line, as well as the

changes.


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TABLE 3-7 (Concluded)


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Planning in Large Companies

Three stages to planning:1. Hammer out corporate strategy (SWOT),

with broad brush financial planning.

2. Translate qualitative goals into internaldivision activities, with rough financialforecasts.

3. Quantitative plans and budgets, bothoperating budgets and capital budgets.

Integration of #3 leads to thecorporations financial plan.

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Handout 3 FinlForecasting