FINANCE MANAGEMENT FIN 420 chp 4

Financial Forecasting

Chapter 4

Financial analysis and planning are useful both to help anticipate future conditions and, more importantly as a starting point for planning actions that will influence the future course of events.

After learning this chapter, you should be able able to:

1.

Distinguish the concept of financial analysis, planning and forecasting.

2.

Construct the sources and uses of cash flows statement.

3.

Construct the cash budget.

4.

Develop the pro forma financial statement i.e. the pro forma balance sheet and income statement.

5.

Analyse/interpret the company’s performance based on ratio and cash flows analysis.

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Chapter 4

4.0

Financial Forecasting Forecasting

INTRODUCTION

Financial forecasting concentrate on the expected outcomes from decisions committed by the firm's management and is a crucial part of the planning process. In essence, forecasting concern with the future or the financial consequences of present day decision committed by a financial manager. It is more of a prediction of the expected outcomes and therefore aids decision-maker decision-maker to fully f ully use the resources at hand to ensure the planned objectives are met. It is crucial that all various departments' forecasts are consistent with each other; that is the basis of forecast must be based on common forecast variables such as inflation, general level of economic activity, and level of interest to name a few. This is to ensure the various departments or units will work towards common objective and internal conflicts can be avoided.

The information-collected will provides managers the basis for planning and coordination of firm's scare resources to maximize the shareholders' wealth. Forecasting is therefore important to ensure that the firm is able to operate without any unnecessary delays or shut down due to mismanagement of resources. For example, in case of funds' shortages the company may have to discontinue its operations and other complications that may lead to technical insolvency and bankruptcy. This chapter will focus on forecasting of cash and funds requirements for the firm over a specified period.

4.1

CASH FLOW ANAL YSIS

The cash flow cycle shows how the actual net cash flows into and out of the firm during a specified period. It concerns only with the actual movement of the cash; and as such expenses on depreciation and sales on credit do not constitute as cash flows.

Figure 4-1; illustrate in details the cash flow cycle within a firm. It shows the effect of various transactions that causes the cash movement that tends to increase or decrease the funds accordingly. The shaded rectangle represents the balance sheet accounts where else clear rectangles represent income statement items. Please refer to Chapter 11 for additional materials on cash management. management.











Financial Forecasting Figure 4.1

Chapter 4

Cash and Materials Materials Flows

Sales

Inventories

Depreciation

Cash Sales

Use of labor and buy materials

Net fixed Assets

Accounts receivable receivable

Capital budgeting

Accounts payables payables and accruals

Collection of receivable

Cash and marketable securities

Payments to reduce payables and accruals

Issue shares

Pay dividends, Taxes and dividends

Loan repayments

4.2

EQUITY

DEBT

Preferred equity Common equity Retained earnings

Notes payable Long-term borrowings Bonds

Borrow funds

CASH FLOW CONCEPT

Cash flow means the difference between the number of dollars that came in and the number of dollars that went out.

Based on balance sheet identify, the value of a firm’s assets is equal to the value of its liabilities plus the value of its equity. Similarly, the cash flow from the firm’s assets must equal the sum of the cash flow to creditors and the cash flow to stockholders.

Therefore, the cash flow identify is known as











Chapter 4

a.


Cash Flow from Assets

It involves three components: operating cash flow, capital spending and change in net working capital

(i)

Operating cash flow

It refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Normally it consists of:

Earnings before interest and taxes (EBIT) + Depreciation - Taxes

Most of the time the firm must have a positive operating cash flow to show that a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows. If a company is having a negative operating cash flow it means that the company is in trouble.

(ii)

Capital Spending It refers to the net spending on fixed assets. The common items involve are: Ending net fixed assets - Beginning net fixed asset + Depreciation

If the net capital spending is positive, it means that the money spend to purchase fixed assets is than the money received from the sale of fixed assets. On the other hand, if net capital spending is negative, it means that the firm sold off more assets than it purchased.











Financial Forecasting (iii)

Chapter 4

Change in networking capital It measures the net change in current assets over current liabilities for the period being examined. So, change in net working capital is equal to Ending net working capital - Beginning net working capital

This change in net working capital is often referred to as the ‘addition’ to networking capital.

b.

Cash Flow to Creditors and Stockholders It represents the net payments to creditors and owners during the year. The calculation for cash flow to creditors is equal to interest paid less net new borrowing and cash flow to stockholders (bondholders) is dividends paid less net new equity raised.

An exampl exam pl e of Cash Flo w Suppose that a company started the year with RM2,130 in current assets and RM1,620 in current liabilities, and the corresponding ending figures were RM2,260 and RM1,710. Beginning net fixed assets were RM500 and ending net fixed assets were RM750. During the year, the company had sales of RM600 and cost of goods sold of RM300. Depreciation was RM150 and interest paid was RM30. Taxes were RM41 and dividends paid were RM30. Suppose we also know that the company did not sell any new equity for the year. To calculate cash flow from assets based on the above example, we should start with: (i)

Operating cash flow (OCF) OCF

= EBIT + Dep – Taxes = RM150 + RM150 – RM41











Chapter 4

(ii)

Financial Forecasting Forecasting Net Capital Spending

= Ending Net Fixed Assets - Beginning net Fixed Assets + Depreciation = RM750 – RM500 + RM150 = RM400.00

(iii)

Change in Net Working Capital (NWC) = Ending net working capital - Beginning net working capital = [RM2260 – RM1710] – [RM2130 – RM1620] = RM550 – RM510 = RM40.00

Therefore, putting all the information together, we have cash flow assets = Operating cash flow (OCF) -

net capital spending

-

Change in NWC

= RM259 – RM400 – RM40 = -RM181 Next, to calculate cash flow to stockholders and creditors. Since there is no new equity has been raised, therefore cash flow to stockholders is just equal to cash dividend paid = RM30. From the cash identity, we know that:

Cash Flow from assets

= Cash flow to creditors + Cash flow to stockholders

- RM181 = Cash flow to creditors + RM30 Therefore, cash flow to creditors = -RM181 – RM30 = -RM211 Since cash flow to creditors is –RM211 and interest paid is RM30, then we can determine net new borrowing Cash flow to creditors

= Interest paid - net new borrowing














Chapter 4

This amount shows that the company must have borrowed RM241 during the year to help finance t he fixed asset expansion.

4.3

THE STATEMENT OF CASH FLOWS

Those activities that bring in cash are called sources of cash. Those activities that involve spending cash are called uses (or applications) of cash. We can summarize the sources and uses of cash in the form of a financial statement and is called the statement of cash flows. To get started, consider the balance sheets for a company in Table 4.1. Then trace the changes in the firm’s balance sheet to see how the firm obtained its cash and how the firm spent its cash during some time period. Next, identify either the changes is a use of cash or source of cash. By using a simple technique, any increase in an asset account or a decrease in liability account is a use of cash. On the other hand, any decrease in an asset account or an increase in a liability account is a source of cash. To further trace the flow of cash through the firm during the year, we need an income statement as shown in Table 4.2. So an addition to retained earnings in the balance sheet is just the difference between between the net income income and the dividend. dividend. Table 4.1 Era Mewah Balance Sheet as at 31/12/97 and 31/12/98 (000’s)

ASSETS 31/12/97 (RM’000) Cash Account receivable receivable

200 450

31/12/98 (RM’000) 150 425












Chapter 4

LIABILITIES AND OWNERS’ EQUITY 31/12/97 (RM’000)

31/12/98 (RM’000)

Account payable Notes payable – current (9%)

200 0

150 150

Current liabilities Bonds Owners’ equity Common stock Paid – in capital Retained earnings Total owners’ equity

200 600

300 600

300 600 700 1,600

300 600 800 1,700

Total liabilities and owner’s equity

2,400

2.600

Table 4.2 Era Mewah Income Income Statement (Year Ended 31/12/98)

1998 (RM000’s) Sales Cost of goods sold Gross profit Operating expenses Depreciation Net operating income Interest expenses Net income before taxes Taxes (40%) Net income Dividend To retained earnings

1,450 850 600 40 200 360 60 300 120 180 80 100












Chapter 4

By referring to the balance sheets and income statement we can gather the sources and uses of cash. Era Mewah B alance alanc e Sheet as at 31/12/97 31/12/97 and 31/12/98 ASSETS 1997 1998 (RM’000) (RM’000) Cash Account receivable receivable Inventory Current assets *Plant and equipment Less: Accumulated Depreciation Net plant and equipment Total assets

200 450 550 1,200 2,200 1,000

150 425 625 1,200 2,600 1,200

1,200 2,400

1,400 2,600

Chang anges

-50 -25 +75 +400 +200

Sour Source ces s

Use Use

    

* For the fixed assets, we will take the gross for consideration not the net in order to find the current figure of fixed asset asset sold/purchase

LIABILITIES AND OWNERS EQUITY 1997 1998 Cha Changes nges (RM’000) (RM’000) Account payable payable Notes payablecurrent (9%) Current liabilities Bonds Owners equity Common stock Paid-in capital ** Retained earnings Total owners’ equity Total liabilities and Owners’ equity

200

150

-50

0 200 600

150 300 600

+150

300 600 700 1,600

300 600 800 1,700

2,400

2,600

no change no change no change neither a sources nor a use

Sourc ource es

Use

 











Chapter 4

Financial Forecasting Forecasting ERA MEWAH Cash Flow Statement For The Year Ended 31/12/98

Beginning cash balance

RM200.00

Net Income

RM180.00

Plus: Depreciation

RM200.00

Accounts receivable receivable

RM 25.00

Less: Inventory Accounts payable payable

(RM 75.00) (RM 50.00)

Net cash flow from operating activity

RM280.00

(Cash flow from Investment) Purchase of Gross Plant & Equipment

(RM400.00)

Net cash flow investment activity

(RM400.00)

(Cash flow from Financing) Dividend paid

(RM 80.00)

Plus: Notes payable

RM150.00

Net cash flow from financing activity

RM 70.00

Net activity decrease in cash

(RM 50.00)

Ending cash balance

RM150.00












Chapter 4

What What is the diff erence? erence? For the sources and uses of cash statement, we categories sources & Uses of cash in terms of operations, working capital and long-term financing.

ERA MEWAH Sources and Uses of Cash Statement For the year ended 31/12/98 (000’)

Cash beginning of year

RM200.00

Sources of cash Operations: Net Income

RM180.00

Depreciation

RM200.00 RM380.00

Working Capital: Dec. in accounts receivable

RM 25.00

Inc. in notes payable

RM150.00

Total Sources of cash

RM555.00

Uses of cash Working Capital: Inc. in inventory

RM 75.00

Dec. in accounts payable

RM 50.00

Long-term Financing: Fixed-term Financing: Fixed asset acquisitions

RM400.00













Chapter 4

4.4


CASH BUDGETING

The cash budgeting is a detail financial forecasting technique that identifies the cash receipts (inflows) and disbursements (outflows) relative to its amount and timings of occurrence. For example, let assume that all sales are on credit and collected equally in the month of sales and one month after. Thus, for July's sales, the cash budgets will recognize 50% of the cash flow involved in July and the balance is in August.

Thus, cash budget represents cash forecasting set forth the estimates of cash receipts and disbursements over a specified period of time. It will give indications to the management of any shortages or excess cash. It helps the financial managers to manage cash more effectively in order to maximize the firm's value. The development of cash budgets follows certain steps:

1.

Determine Determine the amount and timin g of cash receipts. The receipts. The cash inflows are normally from cash sales, account receivable and other non operating income; such as receipt of rental properties and dividends received from holding of other companies common stock.

2.

Determine Determine the amount and timin g of cash disbur sement. sement. All cash outflows whether it from operations and/or other bulk purchases such as the purchases of












Chapter 4

January

360.00

March

320.00

May

290.00

July

350.00

February

400.00

April

310.00

June

330.00

August

400.00

As a practice, Pearls Pearls Furniture: 1.

Requires 20 percent deposit on all orders one month before sales or delivery, and the balance can be collected equally in the month of sales and one month after.

2.

Cost of goods sold consists of wood products that equal 30 percent of sales.

3.

The materials are purchased one month before it is used and 20 percent is paid in the month of purchase and the balance one-month after.

4.

The nature of the operations incurs a high labor cost that accounts for 40 percent of sales and it is paid for in the month, which it occurs.

5.

6.

Other monthly fixed expenses are; a.

Rent RM5,500,

b.

General and administrative RM20,000, and

c.

Depreciation charges RM6, 500.

d.

Selling expenses is equal to 10 percent of sales each month.

Pearls also plans to purchase new equipment for RM50,000 in late June in which RM30,000 will be finance by bank loan with a monthly payment of RM570; of which RM70 is the interest. The old machine to be replaced can be sold for RM2, 000.











Chapter 4


1.

short-term borrowings (credit line) to cover the deficit, or

2.

postpone the purchase until July, or

3.

try to increase revenues and simultaneously simultaneously reduces expenses to avoid cash shortages.

The company will have cash excess in July that provides the opportunity for the firm to invest in marketable securities or made an early loan's repayment as it sees fit. If the strategy is to borrow money to cover the cash deficits, the firm will have to negotiate line of credit facilities of RM5, 700 for June and repays back in July. Under normal circumstances, the interest on short-term loan must be serviced monthly as shown in other non-operating expenses for July.

Table 4.3

Pearls Furniture: Completed Cash Budget for June and July

(In thousands of RM)

JUNE

JULY

Monthly sales tn

330.00

350.00

70.00

80.00

OPERATING RECEIPTS Deposits (20% of sales t Collection of receivable:

n+1)

Not es












Chapter 4

FACILITIES, TAXES AND OTHERS Plant and equipment expenditures

20.00 a

0.00

Taxes paid

20.00

0.00

Principle payment of debt

0.00

0.50 c

Dividend paid

0.00

0.00

Other non operating expenses (interest)

0.00

0.127 d Refer to note d

Less: Other non operating income

2.00 b

0.000

Refer to note b

38.00

0.627

Item 3

– 10.70

42.873

– 10.70

42.873

15.00

4.300

4.30

47.173

10.00

10.000

– 5.70

37.173

Total other expenditure

NET CASH FLOW

Refer to note a

Refer to note c

Item 4 = 1 – 2 – 3

CASH RECONCILIATION

Net cash flow Plus: Plus: Beginning cash balance Ending cash balance Less: Minimum cash balance Cash excess (– deficit)

Ending cash of t n-1

Minimum cash











Chapter 4


the four months' periods to avoid technical insolvency. The firm will borrow RM20,000 in February and increase its borrowings to the maximum amount of RM60,000 in March.

Consequently the company will pay back all of the borrowings and can plan for short term investments in marketable securities amounted to RM10,000 for at least one month depending on the cash position in the following periods.

The development of cash budget, therefore will provides management insight of the cash position and appropriate strategies can be developed to deal with any of the cash positions, whether it is a deficit or otherwise.

4.5

PRO-FORMA FINANCIAL FINANCIA L STATEMENTS

The most widely used method for forecasting the financial requirements is the percent of sales method. It is different from the cash budget as it focuses on funds forecasting. It uses pro-forma financial statements, particularly balance sheet with certain information from income statement to forecast the funds' requirements for the firm for a particular period.

This method works under the assumption that: 1.

The firm's investment in certain assets will vary directly with sales;














Chapter 4

asset will only spontaneous if the firm is operating at full capacity. On the other hand, retained earnings and liabilities such as account payable and accruals are spontaneous, as it will generate more funds as the firm's activities increased with the increase in sales.

4.5.2 4.5.2

Non-spon taneous items . On the other hand, non-spontaneous items will remain constant regardless of the sales activity. Fixed assets are regarded as non-spontaneous non-spontaneous if the firm is operating below its capacity. Notes payable, long-term debt and equity are also non-spontaneous as the firm must negotiate and arrange for more borrowings and issues respectively. The preceding example deals with a simplified version of percent of sales method; that is disregarding certain limitations on essential financial ratios











Chapter 4


There are several ways to solve for additional f unds needed needed (AFN) (AFN) by the firm to support the sales increased. The most common is pro forma balance sheet approach and an AFN formula. 4.5.3 4.5.3

Pro for ma Balance Sheet Sheet There are several steps involved in developing pro forma balance sheet statement under percent of sales method:

1.

Determine Determine the sales growt h . The sales growth is stated in percentage, that is the ratio of change in sales from previous period; change in sales (S 1 – S0) divided by old sales (S 0).

2.

Determine Determine the spontaneous items. items . All spontaneous items in balance sheet must be identified disregarding the retained earnings











Financial Forecasting Table 4-5

Chapter 4

Sabilla Products: Pro forma Income Statement 19X2 (millions of RM)

Net Sales

151.500

101 00 (1.50)

Less: Cost of goods sold

106.050

151.50 (0.70)

Gross profit

45.450

Less: Other expenses

21.210

Operating profit

24.240

Taxes

9.696

Net profit

14.544

Dividends

3.636

Additions to retained retained earnings earnings Table 4-6

10.908

151.50 (0.14)

24.24 (0.40)

14.544 (0.25) 14.544 (1 – 0.25) 0.25)

Sabilla Products: Pro forma Balance Sheet 19X2 (millions of RM)











Chapter 4


Note that the value of new retained earnings from 19X2 is added directly to equity accounts since equity represents the summary of the firm’s preferred stock, common stock, paid in capital and retained earnings' accounts. It is necessary however to increase the retained earnings account only if equity accounts are itemized.

The balance sheet method as shown in Table 4.7 is relatively slow, especially if the pro forma f orma balance sheet is not required. The simplified method shown in Table 4-7 will result in the same answer, but less time consuming.

It will further illustrate the concepts of total funds' requirements to support the sales increase, and differentiate between the internal generated funds and external sources of funds. The calculations in Table 4.7, shows that the firm:











Financial Forecasting 4.5.4 4.5.4

Chapter 4

Add iti onal Funds Needed Needed Formu la Another method to solve for additional fund needed needed is to use a formula; formula; that equals to required increase in assets less increase in spontaneous liabilities less increase in retained earnings, less depreciation plus miscellaneous financing requirements:

AFN = (SA0 / S0)∆S – (SL0 / S0)∆S – (S1)(NPM)(1 – DPR) – Dep 1 + OF1

Where

SA0

: Amount of spontaneous assets that vary with sales.

S0

: Current sales.

S1

: Projected sales (total) for the following period.

∆S

: Change in sales; S 1 minus S0

SL0

: Amount of spontaneous liabilities that vary with sales.

NPM

: Net profit margin













Chapter 4


QUESTION 1 You are given the following balance sheets for Syarikat Ikhlas for 2001 and 2002:












Chapter 4

Income Statement for the Year Ending December 31, 2002 (RM’000) Sale

1200

Less : Cost of goods sold

500

Gross Profit

700

Less : Operating expenses

200

EBIT

500

Less : Interest

100











Chapter 4


QUESTION 3

a)

FAP Company expects its projected revenues and payments for the first half of year 2003 to be as follows:

January

Sales (RM)

Purc hases (RM)

10,000

8,000

FINANCE MANAGEMENT FIN 420 chp 4

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