Ch.
4: Financial Forecasting,
Planning, and Budgeting
Objectives
Forecast Financial Statements with the
Percentage of Sales Approach to determine
Discretionary Financing Needed.
Discuss Limitations of Percentage of Sales
Approach.
Determine Sustainable Growth Rate.
What’s a cash budget?
Financial Forecasting
1)Project sales revenues and
expenses.
Financial Forecasting
1) Project sales revenues and
expenses.
2) Estimate current assets and fixed
assets necessary to support projected
sales.
Financial Forecasting
1) Project sales revenues and
expenses.
2) Estimate current assets and fixed
assets necessary to support projected
sales.
– Percent of sales forecast
Our Example: Zippy Drives
Suppose this year’s sales will total $20
million.
Next year, we forecast sales of $25
million.
Net income should be 10% of sales.
Dividends should be 40% of earnings.
Our task: forecast balance sheet and
determine discretionary (outside)
financing needed.
This year % of $20m
Assets
Current Assets $6m 30%
Fixed Assets $10m 50%
Total Assets $16m
Liab. and Equity
Accounts Payable $3m 15%
Accrued Expenses $2m 10%
Notes Payable $1m n/a
Long Term Debt $3m n/a
Total Liabilities $9m
Common Stock $4m n/a
Retained Earnings $3m
Equity $7m
Total Liab. & Equity $16m
Next year % of $25m
Assets
Current Assets 30%
Fixed Assets 50%
Total Assets
Liab. and Equity
Accounts Payable 15%
Accrued Expenses 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets 50%
Total Assets
Liab. and Equity
Accounts Payable 15%
Accrued Expenses 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets
Liab. and Equity
Accounts Payable 15%
Accrued Expenses 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable 15%
Accrued Expenses 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable n/a
Long Term Debt n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock n/a
Retained Earnings
Equity
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock $4.00m n/a
Retained Earnings
Equity
Total Liab. & Equity
Predicting Retained
Earnings
Next year’s projected retained earnings = last
year’s $3 million, plus:
Predicting Retained
Earnings
Next year’s projected retained earnings = last
year’s $2 million, plus:
projected net income cash dividends
sales
x sales
x (1 - net income )
Predicting Retained
Earnings
Next year’s projected retained earnings = last
year’s $3 million, plus:
projected net income cash dividends
sales
x sales
x (1 - net income )
$25 million x .10 x (1 - .40)
Predicting Retained
Earnings
Next year’s projected retained earnings = last
year’s $3 million, plus:
projected net income cash dividends
sales
x sales
x (1 - net income )
$25 million x .10 x (1 - .40)
Proj. RE = $3m + $1.5m = $4.5 million
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock $4.00m n/a
Retained Earnings $4.50m
Equity $8.50m
Total Liab. & Equity
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.00m n/a
Long Term Debt $3.00m n/a
Total Liabilities $10.25m
Common Stock $4.00m n/a
Retained Earnings $4.50m
Equity $8.50m
Total Liab. & Equity $18.75m
Oh, no! Here come the
Accounting Police!
Projected Assets $20.00m
Projected Liabilities & Equity $18.75m
Discretionary Financing Needed $1.25m
Zippy must decide how to raise this financing.
Options: short and/or long term borrowing, sell new
common stock, cut dividends.
Let’s assume Zippy will borrow an additional
$0.25m through Notes Payable and an additional
$1m through Long Term Debt.
Here’s Zippy’s complete projected balance sheet.
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.25m 1m+0.25m
Long Term Debt $4.00m 3m+1m
Total Liabilities $11.5m
Common Stock $4.00m Whew!
n/a Now,
Retained Earnings $4.50m the Accy Police
will be happy!
Equity $8.5m
Total Liab. & Equity $20.0m
Predicting Discretionary
Financing Needs: A Formula
Approach
The formula approach gives the same result as our
first approach, but focuses on the projected changes
in the balance sheet.
DFN = Proj. Inc. in Assets – Proj. Inc. in Liab – Proj
Retained Earnings
– Proj. Inc in Assets = Assetst/Salest x Chg in sales
– Proj Inc in Liab = Liabt/Salest x Chg in Sales
– Proj. RE = NPM x Proj Sales x (1 – b), where b is
dividend payout ratio = Divs/Net Income
Zippy DFN
Change in sales = 25m – 20m = 5m
Original sales = 20m
Change in Assets = (16m/20m) x 5m = 4m
Change in Liab = (3m+2m)/20m x 5m = 1.25m
Projected RE = 10% x 25m x (1-.4) = 1.5m
DFN = 4m – 1.25m – 1.5m = 1.25m
DFN dynamics
Recall, Zippy’s original DFN is 1.25m.
What if Zippy’s profit margin was expected to be
only 5%?
What if Zippy’s profit margin was the original
10%, but it’s dividend payout ratio is only
expected to be 30%?
What if Zippy’s sales are expected to increase to
$28 million with original assumptions of 10%
profit margin and 40% dividend payout ratio?
Zippy DFN dynamic #1
Change in sales = 25m – 20m = 5m
Original sales = 20m
Change in Assets = (16m/20m) x 5m = 4m
Change in Liab = (3m+2m)/20m x 5m = 1.25m
Projected RE = 5% x 25m x (1-.4) = 0.75m
DFN = 4m – 1.25m – 0.75m = $2m
Lower profit margin = more DFN
Zippy DFN dynamic #2
Change in sales = 25m – 20m = 5m
Original sales = 20m
Change in Assets = (16m/20m) x 5m = 4m
Change in Liab = (3m+2m)/20m x 5m = 1.25m
Projected RE = 10% x 25m x (1- .3) = 1.75m
DFN = 4m – 1.25m – 1.75m = $1m
Lower dividend payout ratio = less DFN
Zippy DFN dynamic #3
Change in sales = 28m – 20m = 8m
Original sales = 20m
Change in Assets = (16m/20m) x 8m = 6.4m
Change in Liab = (3m+2m)/20m x 8m = 2m
Projected RE = 10% x 28m x (1- .4) = 1.68m
DFN = 6.4m – 2m – 1.68m = $2.72m
Higher Projected Sales = more DFN
The effects of other factors on
the AFN forecast.
Excess capacity:
– Existence lowers AFN.
Base stocks of assets:
– Leads to less-than-proportional asset increases.
Economies of scale:
– Also leads to less-than-proportional asset increases.
Lumpy assets:
– Leads to large periodic AFN requirements, recurring excess
capacity.
Sustainable Rate of Growth
The maximum sales growth rate a firm can
have while maintaining its capital structure
(financing mix).
Sustainable Rate of Growth
g* = ROE (1 - b) where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
Sustainable Rate of Growth
g* = ROE (1 - b) where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
net income sales assets
ROE = sales x assets x common equity
This year % of $20m
Assets
Current Assets $6m 30%
Fixed Assets $10m 50%
Total Assets $16m
Liab. and Equity
Accounts Payable $3m 15%
Accrued Expenses $2m 10%
Notes Payable $1m n/a
Long Term Debt $3m n/a
Total Liabilities $9m
Common Stock $4m n/a
Retained Earnings $3m
Equity $7m
Total Liab. & Equity $16m
Sustainable Growth rate for
Zippy.
Original Total Assets: $16m, Original Total Debt: $9m
Original Debt Ratio: 9/16 = 56.25%
Current Net income is 10% of $20m or $2m.
Current Equity = $7m
Dividend payout ratio = 40% or .4
G = 2m/7m x (1-.4) = 28.6% x .6 = 17.1%
Our forecast for Zippy: 25% growth in sales (20m to
25m) with the following balance sheet.
Next year % of $25m
Assets
Current Assets $7.5m 30%
Fixed Assets $12.5m 50%
Total Assets $20.0m
Liab. and Equity
Accounts Payable $3.75m 15%
Accrued Expenses $2.50m 10%
Notes Payable $1.25m 1m+0.25m
Long Term Debt $4.00m 3m+1m
Total Liabilities $11.5m
Common Stock $4.00m Whew!
n/a Now,
Retained Earnings $4.50m the Accy Police
will be happy!
Equity $8.5m
Total Liab. & Equity $20.0m
Zippy’s projected Debt Ratio
Projected Total Assets: $20m
Projected Total Debt/Liabilities: $11.5m
Projected Debt Ratio = 11.5/20 = 57.5%
Since the projected growth rate of 25% is
greater than the sustainable growth rate of
17.1%, the debt ratio increases from 56.25%
to 57.5%.
Budgets
Budget: a forecast of future events.
Budgets
Budgets indicate the amount and
timing of future financing needs.
Budgets provide a basis for taking
corrective action if budgeted and
actual figures do not match.
Budgets provide the basis for
performance evaluation.
Syllabus Change
Don’t worry about constructing cash
budgets!
Omit problems 4-6a and 4-11a
