A.

OVERVIEW Motivation: What is the process of financial planning Long-term plans Short-term plans** Three outputs Cash budget Pro forma income statement Pro forma balance sheet (statement of external financing required) Discuss inputs needed to produce the outputs

CHAPTER 18: FINANCIAL PLANNING & FORECASTING

B. FINANCIAL PLANNING PROCESS Definition: Financial planning process refers to the development of long-term strategic financial plans that guide the preparation of short-term operating plans and budgets. Notes: Long term: 2-10 years Short term: < 2 years Short-term outputs 1. Cash budget 2. Pro forma income statement 3. Pro forma balance sheet 1. The cash budget Definition: It is the firms planned cash inflows and outflows. Notes:

Estimates firms short-term cash requirements Estimating cash inflow -- Sales forecast: External forecast: estimate sales using external factors (economic indicators) Internal forecast: estimate sales using internal factors (firm-level factors such as sales channels)

Example Prepare a cash budget for the first quarter for DMok Thermo-wear Inc., given the following data. Management has projected total and credit sales for the first three months of 2006 in the given table. Based on historical data, 25% of credit sales are collected in the month the sales were made, and 75% are collected the next month. Purchases are estimated to be 60% of the next months total sales, but are paid for in the month following the order. (Expenditure for inventory in each month is 60% of that months sales.) The beginning and target cash balance is $100,000. Month December January February march Year 2005 2006 2006 2006 Total sales Credit sales 825,000 730,000 840,000 920,000 770,000 690,000 780,000 855,000

Item Wages Rent Other Taxes Dividend Cap. Ex.

January 250,000 27,000 10,000 105,000 ---

February 290,000 27,000 12,000 --75,000

March 290,000 27,000 14,000 -40,000 --

Summary The Cash Budget: a statement of the firms planned inflows and outflows of cash estimate its short-term cash requirements Sales forecast: external vs. internal Two basic categories: Cash Receipts Cash Disbursements Produces: Net Cash Flows Ending period cash Any required total financing needs or excess cash balances Usefulness: Indicates expected cash shortage or surplus Handling uncertainties about sales forecasts: Sensitivity analysis 2. Pro forma income statement and balance sheet Definition: Pro forma statements are projected (forecasted) statements for analyzing future profitability and overall financial performance. Notes: Need: Financial statement from past years Sales forecast for forecast year Forecasts for other financial statement accounts Produce: Pro forma income statement Percent-of-sales approach Judgmental approach Pro forma balance sheet Statement of external financing required Example (Percent-of-sales) Use the operating statements below and the additional information given to prepare a pro forma income statement and balance sheet. The firm has estimated that its sales for 2006 will be $1,350,000. The firm expects to pay $52,000 in cash dividends in 2006. Taxes payable will be 25% of the tax liability on the pro forma income statement. All assets and current liabilities change as a percentage of sales. Prepare the three outputs in pro forma statements forecast.

DMok Inc. Income Statement Jan. 2005-Dec. 2005 Revenue Less: Cost of goods sold Gross margin Less: Operating expenses Earnings before taxes Less: Taxes (40%) Net income after taxes Less: Cash dividends Increase in retained earnings 1,200 900 300 150 150 60 90 30 60

DMok Inc. Balance sheet, year end December 2005 Assets Liabilities & Equity Cash Marketable securities Accounts receivable Inventory Total current assets Net fixed assets Total assets 48 36 216 144 444 540 984 Accounts payable Taxes payable Other current liabilities Total current liabilities Long-term debt Common shares Retained earnings 156 15 0 171 300 225 288

Total liabilities and equity 984

Weakness with percentage-of-sales approach: 3 weaknesses: It is unrealistic to assume all expenses will remain exactly the same percentage from year to year It essentially locks in a fixed profit margin It assumes all costs are variable Basing forecasts solely on past data tends to understate profits when sales increase, and overstate profits when sales decline

Judgmental approach: Definition: The Judgmental Approach is a method for developing the Pro Forma Balance Sheet where values of certain balance sheet accounts are estimated, and others are calculated, based on a ratio analysis. Note: Projected changes in assets from the latest fiscal year to the forecast year determines the Total Financing Required (TFR). Summary Pro Forma statements are vital for Management to evaluate the future expected financial position Investors and Creditors to evaluate the firms ability to provide a return on funds invested Three key outputs of forecasting: Pro forma income statement

Pro forma balance sheet Statement of external financing requirements Inputs: Financial statements from the previous year Sales forecast for the forecast year Forecasts for all other financial statement accounts Approach (pro forma income statement): Percentage-of-sales & its weaknesses Judgmental approach (pro forma balance sheet)