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:
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 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 / AprilCash 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 / 0
Debt Payment / 0 / 20
Dividends
/ 0 / 5Total 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 Minimimum 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 2006 and 2007:
May 2006$150,000
June 150,000
July 300,000
August 450,000
September 600,000
October 300,000
November 300,000
December 75,000
January 2007 150,000
Collection estimates obtained from the credit and collection department are as follows: collected within the month of sale, 5 percent; collected the month following the sale, 80 percent; collected the second month following the sale, 15 percent. Payments for labor and raw materials are typically made during the month following the month in which these costs are incurred. Total labor and raw materials costs are estimated for each month as follows:
May 2006$ 75,000
June 75,000
July 105,000
August 735,000
September 255,000
October 195,000
November 135,000
December 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 2006 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?
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$80,000
November 60,000
December 50,000
January 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 $2,000.
B.Prepare a proforma income statement for December.
C.The balance sheet as of November 30 is as follows:
Cash$ 2,000A/P (utilities)$ 3,000
A/R 62,000Taxes/P 4,320
Inventory 45,000
Plant & Equip. 170,000Common Stock 85,000
Accum. Depr. ( 50,000)Retained Earnings 136,680
Total Assets$ 229,000Tot. 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 11,000
Equipment Rent 1,200
Utilities 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$ 50,000
Cost of Goods Sold 30,000($50,000 * 60%)
Gross Profit$ 20,000
Gen. & Admin. Expense
Salaries$ 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
Assets
Cash$ 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$227,300
Liabilities & Equity
Accounts Payable (Utilities)$ 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:
2005 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 2005 as well as the projected income statement for 2006. The assumptions used to construct the projected income statement are listed next to each category:
Income Statements:2005 / 2006
Actual / Projected
======/ ======
Revenues / 1,000,000 / 1,200,000 / 20% increase
Cost 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 2005 above was about right for the level of sales of $1 million that we experienced in 2005, then we can project the balance sheet for 2006 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 2006. Since total assets must equal total liabilities and equity, we will use Additional Financing Required as a balancing figure.
2006 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 2006. It appears as follows:
2006 Statement of Cash FlowsFrom 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: