CHAPTER THREE
FINANCIAL PLANNING AND FORECASTING After completing this unit, you will be able to:
Describe the financial planning process; Prepare cash budget for a particular firm;
Explain the importance of projected or pro forma financial statements; and Prepare pro forma balance sheet and income statement
3.1. Strategic and Operating Plans
Chapters 2 described what financial statements are and showed how both managers and investors analyze them to evaluate a firm’s past performance. While this is clearly important, it is even more important to look ahead and to anticipate what is likely to happen in the future. So, both managers and investors need to understand how to forecast future results.
Strategic Plan
Our primary objective in this chapter is to explain what managers can do to make their companies more valuable. Managers must understand how investors determine the values of stocks and bonds if they are to identify, evaluate, and implement projects that meet or exceed investor expectations. However, value creation is impossible unless the company has a well-articulated plan. Companies begin with a mission statement, which is in many ways a condensed version of their strategic plan. Strategic planning involves developing a mission statement that captures why the organization exists and plans for how the organization will thrive in the future. Based on a very thorough assessment of the organization and the external environment, strategic objectives and corresponding goals are developed. Strategic planning is a formal process for establishing goals and objectives over the long run.
A lack of effective strategic planning is a commonly cited reason for financial distress and failure. As we will develop in this chapter, Strategic planning is a means of systematically thinking about the future and anticipating possible problems before they arrive. There are no magic mirrors, of course, so the best we can hope for is a logical and organized procedure for exploring the unknown.
Operating Plans
Strategic plans are implemented by developing an Operating or Action plan. A complete set of financial plans is included in the operating plans. Operating plans provide detailed implementation guidance, based on the corporate strategy, to help meet the corporate objectives. These plans can be developed for any time horizon. The plan explains in considerable detail that is responsible for each particular function, when specific tasks are to be accomplished, sales and profit targets, and the like. 3.2. Financial Plans
What is financial planning?
they take a long time to implement. In an uncertain world, this requires that decisions be made far in advance of their implementation. If a firm wants to build a factory in 2006, for example, it might have to begin lining up contractors and financing in 2004, or even earlier.
Nature of Financial Planning
Financial planning is an important aspect of the firm's operation and livelihood because it provides a framework for guiding, coordinating, and controlling the firm's actions to achieve its objectives..Financial planning is the process of estimating the required finance of a firm for its business decisions. It is a continuous process of directing and allocating financial resources to meet strategic goals and objectives. Financial planning starts at the top of the organization with strategic planning. Two aspects of the financial planning process are cash planning and preparation of projected or pro forma financial statements
Financial planning is concerned with identifying the need for funding, term of funding, and sources of funding.
Financial planning involves the following steps:
1. Identify major decisions or problems facing the firm
2. Construction of a planning model to investigate the consequences of alternative decisions or policies, which is the primary concern of this section
3. Selection of the best alternative course of action
4. Evaluation of subsequent performance against expectations The major uses of financial planning are:
1. to determine the most likely consequences of a given policy or decision 2. to investigate the consequences of possible risks or hazards
3. to effectively manage risk (risk management)
Financial plans help managers ensure that their financing strategies are consistent with their capital budgets. They highlight the financing decisions necessary to support the firm’s production and investment goals. The output from financial planning takes the form of budgets. The most widely used form of budgets is Pro Forma or Budgeted financial statement. The foundation for the budgeted financial statements is the detailed budget.
Financial Planning vs. Financial Forecasting
Financial forecasting is the process of identifying the opportunities in the future in terms of market Need for Funding
Initial investment Expansion Diversification Refinancing
(repayment of long-term debt)
Term of Funding Short-term Long-term
Sources of funding Internal sources
(Retained earnings) Spontaneous
sources
will happen in the future. As a process, financial forecasting involves estimating future business performance. It provides information of the organization’s future revenues and costs that is needed by senior management to project financing requirements. The “future” is the planning period that could be short-term (one or less), medium term (3-5 years), or long-term (over five years).
Some argue that financial planning and financial forecasting are one and the same. However, financial forecasting is the basis for financial planning. Financial planning is done effectively through financial forecasting.
Financial planning is not just forecasting. Forecasting concentrates on the most likely future outcome. But financial planners are not concerned solely with forecasting. They need to worry about unlikely events as well as likely ones. If a financial planner thinks ahead about what could go wrong, then he/she is less likely to ignore the danger signals and he/she can react faster to trouble. Often financial planners work through the consequences of the plan under the most likely set of circumstances and then use sensitivity analysis to vary the assumptions one at a time.
Inputs for Preparing Financial Forecasts (Pro Forma Financial Statements) There are four major inputs for the preparation of Pro Forma Financial statements. 1. Data from prior financial statements
Previous sales levels and trends Past gross percentages
Operating as well as non-operating expenses
Trends in the company’s need to borrow to support various levels of inventory and trends in accounts receivable required to achieve previous sales volume
2. Unique Company Data Plant capacity Competition
Financial constraints Personnel availability 3. Industry-Wide Factors
Overall state of the economy (i.e. Boom, normal or recession) Economic status of the industry
Population growth
Elasticity of demand for the product or service the firm provides Availability of raw materials
4. Assumptions
3.3 Financial Forecasting Procedures
The following procedures may be used in predicting the future (financial forecasting). 1. Projection of Organization’s sales revenues
The level of economic activity
The firm’s probable market share in each distribution territory The firm’s production and distribution capacity
The competitor’s capacity
New product introduction by the firm and its competitors The firm’s pricing strategies
The effects of inflation on prices
Advertising campaign, promotional discounts, and credit terms The sales forecasting process is depicted below:
Sales Estimates
Financial Statements, Accounting conventions
2. Estimation of the level of investments in current assets and fixed assets
Once sales forecast is obtained, the next step is to estimate the levels of current and fixed assets that are necessary to support the projected sales.
3. Determination of the organization’s financing needs & sources of funds
This requires estimating additional resources required from external sources. Besides, it is essential to predict cash inflows and outflows in relation to operating, investing, and financing activities of the firm throughout the planning period.
4. Preparing pro forma or forecasted financial statements Pro forma income statement
Pro forma balance sheet Top
Management
Marketing
Finance Department
Sales Forecast
Accounting Goals, targets,
requirements, & plans
Production
The Financial Planning Models
Financial planners use financial planning models to help them explore the consequences of alternative financial strategies. These models may range from simple to complex which incorporates hundreds of equations. Financial planning models are useful in supporting the financial planning process. They make the preparation of pro forma financial statements easier and cheaper. They save time and labor in financial planning.
The major components of a financial planning model are classified in to three. a. Input (See inputs for preparing financial forecasts topic above)
b. The planning model: The planning model calculates the implications of the manager’s forecasts for profits, new investments, and financing. The model consists of equations relating output variables to forecasts.
c. Outputs: The outputs of the financial planning model are Pro Forma financial Statements such as income statements, balance sheet, and statements describing sources and uses of cash. Pro form Financial Statements are forecasted or projected financial statements. The outputs of financial models also include many of the financial ratios which indicate whether the firm will be financially fit and healthy at the end of the planning period.
There are different financial planning models. However, only two are discussed in this section. i. Percentage-of-Sales Model
The Percentage of Sales Method is a financial forecasting approach which is based on the premise that most Balance Sheet and Income Statement accounts vary proportionally with sales. Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified.
The first step is to express the Balance Sheet and Income Statement accounts which vary directly with Sales as percentages of Sales. This is done by dividing the balance for these accounts for the current year by sales revenue for the current year.
The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts Receivable, Inventory, Accounts Payable, and accruals. Fixed Assets are also often tied closely to Sales, unless there is excess capacity. (The issue of excess capacity will be addressed in Excess capacity adjustment section.) In this section, we will assume that Fixed Assets are currently at full capacity and, thus, will vary directly with sales.
Inputs
Prior financial statements of the firm
Unique company data Industry wide factors Assumptions
Planning Model Equations
specifying key relationships
Outputs Projected financial
statements Financial ratios
Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earnings which have been reinvested in the firm. Thus, the change in this account is linked to Sales; however, the link comes from relationship between Sales growth and Earnings
The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically with Sales. The changes in these accounts depend upon how the firm chooses to raise the funds needed to support the forecasted growth in Sales.
On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming that all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage of Sales. This indicates the Net Profit Margin.
Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends and Addition to Retained Earnings are expressed as a percentage of Net Income to determine the Payout and Retention Ratios respectively.
The percentage of sales model is useful first approximation for financial planning. It is also used to determine additional funds needed from external sources.
Under percentage-of-sales model, the following procedures can be used to estimate external capital requirements and, in turn, for the preparation of Pro forma financial statements:
1. Estimate increase in sales
2. Estimate additional investment in fixed assets.
If the firm is operating at full capacity, increase in sales requires proportional investment in fixed assets
Increase in Fixed Assets = Fixed Assets X Increase in sales Sales
3. Estimate increase in working capital or current assets
Increase in Current Assets = Current Assets X Increase in sales Current Sales
4. Estimate spontaneously generated funds
Spontaneously generated funds are funds that are obtained automatically from routine business transactions. They arise from the purchase of goods and services on credit, such as accounts payable, and accruals. Spontaneously generated funds are equal to increase in current liabilities that are directly proportional to sales. Spontaneously generated funds may be computed as follows:
Spontaneously Generated = Spontaneous Liabilities X Increase in sales
Funds Current Sales
5. Estimate Internally Generated Funds
Internal Generated Funds= Projected Net income – Projected Cash Dividends 6. Additional Funds Needed (AFN)
This refers to the amount funds that should be obtained from external sources in the form of long-term debt capital or equity capital.
AFN = Increase in + Increase in - Spontaneously + Internally
Fixed Assets current assets Generated Funds Generated Funds
Let’s consider the data presented below to illustrate the determination of external capital needed and the preparation of pro forma financial statements.
Assume that Top Company has prepared the following Balance Sheet and Income Statement for the year ended December 31, 2005.
1. Balance sheet
Assets Liabilities and Stockholders’ Equity
Cash 175000 As/P 140000
As/R 150000 Accrued liabilities 150000
Inventory 800000 Mortgage Ns/P 1410000
Plant Assets, Net 1500000 Common Stock 800000
Retained earnings 125000
Total 2625000 Total 2625000
2. Income Statement
Sales 2500000
Costs and Expenses except depreciation 1,400,000
Depreciation 200,000
Total costs and expenses 1,600,000
Income before taxes 900,000
Taxes (40%) 360,000
Net Income 540,000
Additional Information
1. The company plans to have dividend payout ratio of 45% 2. Sales are expected to increase by 25% during next year (2006).
3. All assets are affected by sales proportionately. Accounts Payable and accrued liabilities are also affected by sales.
4. All expenses are directly proportional to sales 5. The firm has been operating at full capacity. 6. The company has no preferred stock.
Assume that additional funds needed would be financed from bond issue and common stock in 40% and 60% respectively.
Solution :
a. Increase in sales = 2,500,000 x 25% = Br. 625,000 Projected Sales = Current sales + Planned increase in sales
= 2,500,000 + 625,000 = 3,125,000
b. Increase in fixed assets = 1,500,000 X 625,000 2,500,000
= 375,000
If sales increase by 25%, fixed assets should increase by Br. 375,000 c. Increase in current assets = 1,125,000 X 625000
2,500,000
= 281,250
Additional current assets of Br. 281,250 are needed if sales increase by 25%. Increase in assets as a result of increase in sales by Br. 625,000 is computed as the sum of increase in fixed assets and increase in current assets i.e. 656,250 = 375000 + 281,250.
d. Spontaneously generated funds = 290,000 X 625,000 2,500,000
= 72,500
e. Internally generated funds = Projected net Income – Projected cash dividend Projected net income = Current Net income X Projected Sales
Current sales
= 540,000 X 3,125,000 = 675,000 2,500,000
Projected Dividend = Projected net Income X Dividend Payout ratio = 675,000 X 0.45 = 303,750
Internally Generated Funds = 675,000 -303,750 = 371,250 f. Additional Funds (External Capital) Needed
AFN = Increase in + Increase in - Spontaneously + Internally Fixed Assets current assets Generated Funds Generated Funds
= (375,000 + 281,250) – (72,500 + 371,250) = 656,250 - 443,750
= 212,500
According to the financing policy, the company raises 40% of external capital requirement from bond issue and the remaining from the issuance of common stock. Accordingly,
Additional Bond issue = 212,500 X 0.40 = 85,000 Additional Common stock = 212,500 X 0.60 = 127,500
Projected Income statement items:
Sales 3,125,000
Costs and expenses except depreciation (1,400,000 x1.25) 1,750,000 Deprecation (200,000 x 1.25) 250,000
Top Company
Pro Forma Income Statement For the Year Ended December 31, 2006
Sales ……… ………3,125,000 Less: Costs and Expenses except depreciation ……. 1,750,000
Depreciation ……… 250,000
Total costs and expenses ………. 2,000,000
Income Before Taxes ……… 1,125,000
Less: Income Taxes (40%) ……….. 450,000
Net income ……… 675,000
Projected Balance Sheet items:
Cash (175,000 x1.25) 218,750 Accounts receivable (150,000 x 1.25) 187,500 Inventory (800,000 x 1.25) 1,000,000 Fixed Assets (1,500,000 x 1.25) 1,875,000 Accounts Payable (140,000 x 1.25) 175,000 Accrued liabilities (150,000 x 1.25) 187,500 Mortgage notes payable 1,410,000
Bonds Payable 85,000
Common Stock (800,000 + 127,500) 927,500 Retained Earnings:
Beginning Retained Earnings 125,000 Add: Projected Net Income 675,000
Subtotal……….. 800,000
Ded: Dividend ……….. 303,750
Retained Earning, December 31, 2006 496,250 Top Company Pro Forma Balance Sheet
December 31, 2006 Assets:
Current Assets:
Cash 218,750
Accounts receivable 187,500
Inventory 1,000,000
Total current assets 1,406,250
Fixed Assets 1,875,000
Total Assets 3,281,250
Liabilities & Stockholders’ Equity: Current Liabilities:
Accounts Payable 175,000
Accrued liabilities 187,500
Total current Liabilities 362,500
Long-term debts:
Mortgage notes payable 1,410,000
Bonds Payable 85,000 1,495,000
Total Liabilities 1,857,500
Stockholders’ Equity:
Common Stock 927,500
Retained Earnings 496,250 1,423,750
Total Liabilities and Stockholders’ Equity 3,281,250
Note that any excess fund may be used for short-term investment purpose or for repayment of liabilities, especially long-term liabilities.
ii. Additional Funds Needed Model
The second financial planning model is the Additional Funds Needed model. This model is used to compute external fund requirement and in turn used to prepare pro forma financial statements. The model is shown below:
AFN = Required Asset - Spontaneous Liability - Increase in Retained
Increase Increase Earnings
= A (∆ S) - L (∆ S) - M (S1) (1 – d) S0 S0
Where,
A = Assets that are tied directly to sales S0 = Current sales
∆ S = Change in sales
L = Liabilities that increase spontaneously
M = Net Profit margin = Current Net Income/Current Sales S1 = Projected sales
D = Dividend payout ratio
Using Top Company data, Additional Funds Needed is computed as follows
AFN= 2,625,000 625,000) - 290,000 (625,000) - 540,000 (3,125,000) (1 – 0.45) 2,500,000 2,500,000 2,500,000
Determinants of External Capital (Fund) Requirements 1. Sales growth rate
The higher the sales growth rate, the greater the need for external capital and vice versa
The financial feasibility of the expansion plans should be reconsidered if the company expects difficulties in raising the required capital.
2. Dividend payout ratio
The higher the payout ratio, the greater the need for external capital requirement
Management should balance between internally generated funds (by reducing payout ratio) and the need for increasing stock price because divided policy affects stock price.
3. Capital intensity
Capital intensity refers to the amount of asset required per Birr of sales Capital intensity Ratio = Assets
Sales
The lower capital intensity ratio, the lower the need for external capital Excess capacity Adjustments
The assumption of constant ratio between assets and sales may not always hold true. In that case, the percentage of sales model or Additional Funds Needed model is not appropriate.
What are the conditions under which constant ratios are not maintained between asset, and sales? 1. Economies of scale
Economies of scale imply that as a plant gets larger and volume increases, the average cost per unit of output drops. This is particularly due to lower operating and capital cost. A piece of equipment with twice that capacity of another piece typically does not cost twice as much to purchase or operate. Plants also gain efficiencies when they become large enough to fully utilize dedicated resources for tasks such as materials handling, computer equipment, and administrative support personnel.
2. Lumpy asset increments
Lumpy assets are assets that cannot be acquired in small increments, but must be obtained (added) in large, discrete units. Suppose, if we obtained that Br. 25,000 is needed for additional investment in fixed assets, it may be difficult to get fixed assets that exactly cost Br. 25,000. The minimum prices for the lowest capacity fixed asset may be Br. 45,000. Thus, if you decided to make additional investment in fixed assets, you need to purchase fixed assets of Br. 45,000 instead of Br. 25,000. 3. Excess assets due to forecasting errors.
Actual assets to sales ratio may be different from planed ratio because actual sales may be different from planed sales. Actual assets may be different from planned assets. Excess capacity may occur Plant assets and inventories.
1. Determine full capacity sales (FCS) FCS = Actual Sales
Current capacity utilization 2. Determine Target fixed assets (TFA) to sales ratio TFA/Sales ratio = Actual fixed Assets Full capacity sales
3. Determine the required level of fixed assets = TFA/Sales ratio x projected sales 4. Determine additional investment in fixed Assets
= Required level of Fixed assets - Actual fixed Assets
To illustrate, assume that the company has currently investment in fixed assets in the amount of Br. 600,000. It has been operating at 80% capacity. Its current sales amounted to Br. 1,000,000. The company’s projected sales for the coming year are Br. 1,400,000. Current assets to sales ratio is 15%, and Current liabilities to sales ratio is 9%. Current assets and Current liabilities increase in direct proportion to increase in sales. Net profit margin is 10% and the dividend payout ratio is 60%. Based on the above data, additional investments in fixed assets and additional funds needed are determined as follows:
a. Full capacity sales = 1,000,000 = Br. 1,250,000 0.08
b. TFA to sales ratio = 600,000 = 48% 1,250,000
c. Increase in sales without increase in Fixed Assets = Full capacity sales – current sales = 1,250,000 – 1,000,000 = 250,000
d. Required level of Fixed Assets = (TFA to sales ratio) x (projected sales) = 0.48 x 1,400,000 = 672,000
e. Additional Investment in Fixed Assets = (1,400,000 – 1,250,000) x 0.48 = 72,000 f. Increase in Current assets = 0.15 x 400,000 = 60,000
g. Spontaneously generated funds= 0.09 x 400,000 = 36,000 h. Internally generated funds = M (S1) (1-d)
= 0.10 (1, 400,000) (1 –0.60) = 0.10 (1, 400,000) (0.40) = 56,000
i. AFN = (72,000 + 60,000) – (36,000 + 56,000) = 132,000 – 92,000 = 40,000
Cash Planning: Cash Budget
The period covered is normally divided into smaller intervals. The number and type of intervals depend on the nature of the business. The more seasonal and uncertain a firm's cash flows, the greater the number of intervals of time periods. Because many firms are confronted with a seasonal cash flow pattern, the cash budget is quite often presented on a monthly basis. Firms with stable patterns of cash flow may use quarterly or annual time intervals.
Preparing the Cash Budget
The general format of the cash budget is presented in Table 3.1. The cash budget has different components. These are cash receipts, cash disbursements, net cash flow, end cash balance, required total financing/or cash shortage and excess cash balance. Now let us see each of these components turn by turn.
Cash Receipts: Cash receipts include all of a firm's cash inflows in a given financial period. The most common components of cash receipts are cash sales, collections of accounts receivable, and other cash receipts.
Cash Disbursements: Cash disbursements include all outlays of cash (cash outflow) by the firm during a given financial period. The most common cash disbursements are:
Cash purchases, Payment of accounts payable, Rent (and lease) payments, Wages and salaries, Tax payments, Fixed asset outlays, Interest payments, Cash dividend payments, Principal payments (loans), Repurchases or retirements of stock.
It is important to recognize, at this point, that depreciation, amortization and other expenses/or costs/ are not included in the disbursements section of the cash budget because they do not involve cash outlays.
Net Cash Flow: A firm's net cash flow is found by subtracting the cash disbursements from cash receipts in each period.
End Cash Balance: the firm's end cash balance is the sum of its beginning cash balance and its net cash flow for the period.
Required Total Financing /Cash Shortage
Required total financing or cash shortage is the amount of funds (or cash) needed by the firm if the ending cash balance for the period is less than the desired minimum cash balance. This shortage can be financed by issuing notes payable.
Excess Cash balance
Table 3.1 The General Format of The Cash Budget
Jan Feb . . . Nov. Dec
Cash Receipts ___ ___ . . . ___ ___
Deduct: Cash Disbursements ___ ___ . . . ___ ___
Net cash Flow ___ ___ . . . ___ ___
Add: Beginning cash ___ ___ . . . ___ ___
End cash balance ___ ___ . . . ___ ___
Deduct: Minimum cash balance ___ ___ . . . ___ ___
Required total Financing ___ ___ . . . ___ ___
Excess cash balance ___ ___ . . . ___ ___
Illustration of Cash Budget preparation
The actual sales and purchases of ABC Company for August and September 1996, along with its forecasted sales and purchases for October, November and December 1996, are as follows.
Year Month Sales Purchases
1996 August Br. 100,000 Br. 70,000
September 200,000 140,000
October 400,000 280,000
November 300,000 210,000
December 200,000 140,000
In the past, 20 percent of the total sales of the company had been for cash. Of the total sales, 50 percent were collected after 1 month of the sale, and the remaining 30 percent were collected 2 months after the sale. This cash collection pattern is expected to continue in the planning period. In December, the company will receive a Br. 30,000 dividend from investments made in another company.
The company pays cash for 10 percent of its purchases in the month of purchase. But 70 percent is paid in the month immediately following the month of purchase, and the remaining 20 percent is paid 2 months following the month of purchase.
The following additional information has been gathered for ABC Company: 1. A minimum cash balance of Br. 25,000 is desired.
2. Rent of Br. 5,000 will be paid each month. 3. Taxes of Br. 25,000 would be paid in December.
4. New machinery costing Br. 130,000 will be purchased and paid for in November. 5. An Interest payment of Br. 10,000 is due in December.
6. Cash dividends of Br. 20,000 will be paid in October. 7. A Br. 20,000 principal loan payment is due in December.
8. The company's wages and salaries are estimated to be 10 percent of each month's sales plus Br. 8,000.
9. The cash balance at October 1, 1996 is Br. 50,000. Required:
b) Determine the required total financing or excess cash balance for each month, (i.e. for October, November and December).
c) If a pro forma balance sheet dated at October, November and December were prepared from the information presented, give the balance of each of the following balance sheet accounts:
Cash
Notes payable
Marketable securities Solution
a. From the given information, a schedule of expected cash receipts for the ABC company during October, November, and December is presented as follows:
Schedule of projected cash receipts for ABC company ('000)
Month Aug Sept. Oct. Nov. Dec.
Sales forecast Br. 100 Br. 200 Br. 400 Br. 300 Br. 200
Cash sales (20% of sales) 20 40 80 60 40
Collection of A/R:
*Preceding month sales (0.5) *Sales made 2 months earlier (0.3)
50 100
30
200 60
150 120
Other cash receipts - - 30
Total cash receipts Br. 210 Br. 320 Br. 340
Schedule of projected cash Disbursements for ABC Company ('000)
Month Aug Sept. Oct. Nov. Dec.
Purchases Br. 70 Br. 140 Br. 280 Br. 210 Br. 140
Cash purchases (.10) 7 14 28 21 14
Payments of A/P:
*Preceding month purchase (.70) *Purchases made 2 months earlier (.20)
49 98
14
196 28
147 56
Rent payments 5 5 5
Wage & salaries 48 38 28
Tax payments 25
Fixed asset outlays 130
Interest payments 10
cash dividend payment 20
principal (loan) payments - - 20
Total cash disbursements Br 213 Br 418 Br. 305
Based on the schedule of projected cash receipts and cash disbursements, the following cash budget can be prepared for ABC Company:
Cash Budget ('000)
For the months of October, November and December of 1996 Oct. Nov. Dec.
Total cash Receipts Br. 210 Br. 320 Br. 340
Less: Total cash disbursements 213 418 305
Net cash Flow Br(3) Br (98) Br. 35
Add: Beginning cash 50 47 (51)
End cash Br. 47 Br.(51) Br. (16)
Less: minimum cash balance 25 25 25
Required total financing (Notes payable)
- Br. 76 Br. 41
Execs cash balance (market table
securities) Br. 22 __ __
b. From the above cash budget, required total financing (notes payable) for each month: Months Required total financing (notes payable)
October November Br. 76 December Br. 41
c. The excess cash balance in October can be invested in marketable securities. The cash deficits in November and December will have to be financed, typically, by short-term borrowing (Notes payable). At the end of each of the 3 months, ABC Company expects the following balance in cash, marketable securities, and notes payable.
End-of month’s balance ('000)
Account Oct. Nov. Dec.
Cash Br. 25 Br. 25 Br. 25
Marketable securities 22 0 0
Exercise 1
The following financial statements were prepared by Fraol Company as of December 31, 2004: Balance Sheet ($ in Millions)
Assets 2004 Liabilities and
Owners' Equity
2004 Current Assets Current Liabilities
Cash 200 Accounts Payable 400
Accounts Receivable 400 Notes Payable 400 Inventory 600 Total Current
Liabilities 800
Total Current Assets 1200 Long-Term Liabilities Long-Term Debt 500
Fixed Assets Total Long-Term
Liabilities 500
Net Fixed Assets 800 Owners' Equity
Common Stock ($1 Par) 300 Retained Earnings 400 Total Owners' Equity 700 Total Assets 2000 Total Liab. and
Owners' Equity
2000 Income Statement ($ in Millions)
2004
Sales 1200
Cost of Goods Sold & other
expenses 900
Taxable Income 300
Income Taxes 90
Net Income 210
Dividends 73.5
Addition to Retained Earnings 136.5 Additional Information
1. The company plans to maintain dividend payout ratio of 2004 2. Sales are expected to increase by 30% during next year (2005).
3. All assets are proportional to sales. Accounts Payable is the only spontaneous liability. 4. All expenses are proportional to sales
5. The firm has been operating at full capacity.
6. Any external capital required will be raised as follows: Short-term notes payable, 20%; bonds, 35%; common stock, 45%.
Required:
a. Using Percentage of sales model,
2. Determine external capital required, if any 3. Prepare pro forma financial statements for 2005
Exercise 2
Assume that sales are expected to increase from Br. 5 million in 2004 to Br 6 million in 2005.The assets totaled Br. 3 million at the end of 2004. The company is operating at full capacity. As a result, its assets must grow in proportion to projected sales. At the end of 2004, current liabilities were Br 1 million, consisting of Br 250,000 of As/P, Br 500,000 of notes payable, and Br 250,000 of accruals. The after-tax profit margin is forecasted to be 5% and the forecasted payout ratio is 70%.
Required: Determine:
A. Additional funds needed for the coming year. B. Capital intensity ratio
C. Additional funds needed if the company’s assets were Br. 4 million instead of Br. 3 million. Exercise 3
At year-end 2004, total assets for Top Company were Br. 1.2 million and As/P were Br. 375,000. Sales, which in year 2004 were Br. 2.5 million, are expected to increase by 30% in year 2005. Total assets and As/P are proportional to sales and that relationship will be maintained. There are no other current liabilities other than As/P. Common stock amounted to Br 425,000 in 2004 and retained earnings were Br 295,000. Top company plans to sell new common stock in the amount of Birr 75,000. The firm’s profit margin on sales is 6%. 40% of earnings will be distributed to share holders as dividends.
Required: Determine the following: a. Total debt in 2004
b. Additional funds needed in 2005. c. Spontaneously generated funds d. Internally generated funds
e. New long term debt financing in 2005
Exercise 4 Grace Company’s sales are expected to increase from Br 1 million in 2003 to Br 2 million in 2004. Balance sheet of December 31, 2003 is shown below (in thousands).
Cash 100 As/p 50
As/R 200 Notes payable 150
Inventory 200 Accruals 50
Total Current asset 500 Total current Liabilities 250
Net Fixed Assets 500 Long term debt 400
Common Stock 100
Retained earnings 250 Total Assets 1000 Total Liab. & Equity 1,000
Required:
I. Compute the following:
a. Percentage increase in sales b. Increase in working capital
c. Projected total current assets in 2004 d. Spontaneously generated funds e. Increase in net working capital f. Additional funds needed g. Internally generated funds h. External capital required
II. Prepare pro forma income statement and pro forma balance sheet
Exercise 5 Assume that Garden Corporation generated Br 2 million in sales during year 2 and its year-end total assets were Br 2.5 million (Br. 1 million of fixed assets). Also, at end of year 2, current liabilities were Br, 500,000 consisting of Br 200,000 of Ns/P, Br 200,000 of As/P and Br 100,000 of accruals. Looking ahead to year 3, the company estimates that its current assets must increase 75 cents for every Br 1 increase in sales. Net profit margin is 5% and its payout ratio is 60% of net income. Assets were operated at 90% capacity in year 2. Only accounts payable and accruals are proportionally affected by sales. Projected sales will be Br 2.6 million.
Required: Determine the following:
a. The amount by which sales can increase without having additional investment in fixed assets. b. Increase in current assets and current liabilities
c. Increase in working capital d. Required increase in fixed assets e. Projected profit (net income) for year 3 f. Projected Dividend payment in year 3 g. Internally generated funds
h. External funds required Exercise 6
XYZ Company is a merchandising business. The financial manager is preparing financial forecast for the next year. The following balance sheet is given for the year ended December 31, 2005.
Current Assets Current Liabilities
Cash $120,000.00 A/Payable $100,000.00
As/ Receivable $100,000.00 Salaries &Wages Payable $80,000.00
Inventory $300,000.00 Notes Payable $90,000.00
Total Current Assets $520,000.00 Total Current Liabilities $270,000.00
Fixed Assets Long term Liabilities
Land $250,000.00 Mortgage payable (10%) $300,000.00
Building $770,000.00 Bonds Payable (12%) $200,000.00
Plant & Equipment $230,000.00 Total Liabilities $770,000.00 Total Fixed Asset $1,250,000.00 Shareholders’ Equity
Retained Earnings $320,000.00 Total Assets $1,690,000.00 Total Liabilities &SHE $1,690,000.00 Additional Information
Sales for the last year were $3,000,000 and all assets and spontaneous liabilities will vary directly with sales. Sales are expected to increase by 20% in the coming year. There are no preferred stocks outstanding during the year. The firm’s dividend payout ratio is 60%. The firm’s operating costs and expenses were $2,350,000 and are expected increase proportionally with sales. Assume that the company’s interest expense will be the same as last year and the company is operating at a tax rate of 34%
Required
a. Determine additional funds needed using percentage of sales method assuming the company is operating at full capacity.
b. Determine AFN using formula method (assume full capacity)
c. Produce Performa financial statements (Balance sheet, & Income statement) for the next year. (Assume AFN to be financed through issuance of bonds.)
d. Assume that excess capacity exist in fixed asset assets in the year 2005. Specifically, assume that fixed assets in the year 2005 were being utilized to only 80% capacity. Determine AFN, if any.
Exercise 7
Assume that National Company has prepared the following Balance sheet and Income statement for the year ended December 31, 2006. Planned increase in sales would be 15%.
1. Balance Sheets
Accounts Receivable….. Inventory……….. Plant Assets (Net)……...
Total………
180,000 960,000 1,800,000
0000000000
Br.3,150,000
Accrued Liabilities………..…… NotesPayable………. Mortgage Notes Payable…... Common Stock……….. Retained Earnings………..……. Total………
132,000 48,000 1,692,000 960,000 150,000 Br.3,150,000
2. Income Statement
Sales……… Less: Costs & Expenses………. ……….
Income before taxes……….……… Less: Taxes(40%)………..……… Net Income………..……….
……… ……… ………. ………. ……….
Br. 3,000,000
1,920,000 Br. 1,080,000 432,000 Br. 648,000 Additional Information:
a) The company has no preferred stock
b) The firm has been operating at full capacity c) All expenses are directly proportional to sales
d) All current liabilities (except notes payable) are proportional to sales e) All assets are affected by sales proportionately
f) The company plans to have dividend payout ratio of 45%
Assume that the additional fund would be financed from, Notes payable, Bonds, and common stock in 10%, 25%, and 65% respectively. Any excess fund is expected to be placed in short-term
investments.
Required: Based on the above data and additional information, prepare: a) Proforma balance sheet
