FINANCIAL FORECASTING

Financial forecasting is a process whereby the firm will estimates its total needs for future operations.
By doing so, funds can be obtained at the lowest interest cost and on the best possible terms because management has sufficient time for effective negotiations. Forecasting is one of the most important management activities, regardless of its size.

WHY DO WE NEED TO DO FORECASTING ?

BECAUSE WE WANT TO FIND

EXTERNAL/ ADDITIONAL FUND NEEDED BY

THE COMPANY IN ORDER TO EXPAND THEIR BUSINESS

METHODS OF FORECASTING
PERCENT OF SALES METHOD *

SCATTER DIAGRAM OR REGRESSION METHOD

Under this method external fund can be determined by using two ways:

a) Equation
b) Pro-Forma Balance sheet

Two situation have to be looked at before the amount of external fund needed is determined, they are: a) Firm is operating at full capacity b) Firm has not reached full capacity

PERCENT OF SALES METHOD

Which ever method is used the answer should be the same

When the company want to expand their business (acquire additional assets to support new sales or purchase additional assets) definitely more money (fund) would be needed to support the expansion. Funds can be generated from internal sources (retained earning) and external source

OPERATING AT FULL CAPACITY (EQUATION)

Operating at full capacity means all assets available in the company have been fully utilized. If the firm want to expand their business the only way is to increase all its assets (current and fixed asset) and certain liabilities.

By using EQUATION,
STEP 1: CALCULATE RETAINED EARNING (INTERNAL SOURCES OF FUND)

RETAINED EARNING = [ Net profit margin x retention ratio x forecasted sales ]

1 Dividend Payout Ratio

STEP 2: CALCULATE FUND NEEDED BY THE COMPANY IN ORDER TO EXPAND THEIR BUSINESS FUND NEEDED = [ X (Changes in sales) X (Changes in sales) ]

STEP 3: EXTERNAL/ADDITIONAL FUND NEEDED

EXTERNAL FUND NEEDED = FUND NEEDED

RETAINED EARNING

EXAMPLE OPERATING AT FULL CAPACITY (USING EQUATION)

BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSET CURRENT ASSET Cash Account Receivable Inventories
FIXED ASSET Net Fixed Asset

RM
10,000 85,000 100,000

LIABILITY CURRENT LIABILITY Account Payable Accrued Wages Notes Payable Mortgage Bonds EQUITY Common Stock Retained Earning

RM

50,000 25,000 30,000 40,000

150,000

345,000

100,000 100,000 345,000

QUESTION : Companys sales are running at about RM 500,000 a year which is its maximum capacity limit and the net profit margin after tax is 4%. During 1994 the company earned RM 20,000 after taxes and paid out RM 10,000 in dividend in the coming years. How much additional financing will be needed if sales expand to RM 800,000 during 1995 ?

SOLUTION
BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSETS CURRENT ASSETS Cash x 100% Acc Receivable Inventory FIXED ASSET Net fixed asset
LIABILITIES CURRENT LIABILITY Account Payable Accrued Wages 10% 5%

2%

17% 20%
30% 69% 15%

 STEP 1 : RETAINED EARNING

RETAINED EARNING = [0.04 x (1-0.5) x RM 800,000] = RM 16,000

STEP 2: FUND NEEDED BY THE COMPANY IN ORDER

TO EXPAND THEIR BUSINESS FUND NEEDED = 69% x (RM 800,000 RM 500,000) 15% x ( RM 800,000 RM 500,000) = 54% (RM 300,000) = RM 162,000 STEP 3: EXTERNAL FUND NEEDED EXTERNAL FUND NEEDED = RM 162,000 RM 16,000 = RM 146,000

OPERATING AT FULL CAPACITY (USING PRO-FORMA BALANCE SHEET)

STEP 1: CALCULATE PERCENTAGE INCREASE IN SALES

PERCENTAGE INCREASE IN SALES =

STEP 2: ITEM SUCH AS CURRENT ASSET AND FIXED ASSET AND CERTAIN LIABILITIES (FOR EXAMPLE ACCOUNT PAYABLE AND ACCRUED EXPENSES) WILL BE INCREASE ACCORDING TO INCREASE IN SALES. THE OTHER ITEM FOR EXAMPLE CURRENT LIABILITY (NOTES PAYABLE) AND LONG TERM LIABILITY (BOND, MORTGAGE, DEBENTURE AND OTHERS) WILL REMAIN THE SAME.

 STEP 3: CALCULATE NEW RETAINED EARNING

NEW RETAINED EARNING = OLD RETAINED EARNING + [NET PROFIT MARGIN x RETENTION RATIO x FORECASTED SALES]

STEP 4: THE DIFFERENCE BETWEEN ASSET, LIABILITIES AND EQUITIES WILL BE THE EXTERNAL/ADDITIONAL FUND NEEDED

EXAMPLE OPERATING AT FULL CAPACITY (USING PRO-FORMA)

BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSET CURRENT ASSET Cash Account Receivable Inventories
FIXED ASSET Net Fixed Asset

RM
10,000 85,000 100,000

LIABILITY CURRENT LIABILITY Account Payable Accrued Wages Notes Payable Mortgage Bonds EQUITY Common Stock Retained Earning

RM

50,000 25,000 30,000 40,000

150,000

345,000

100,000 100,000 345,000

QUESTION : Companys sales are running at about RM 500,000 a year which is its maximum capacity limit and the net profit margin after tax is 4%. During 1994 the company earned RM 20,000 after taxes and paid out RM 10,000 in dividend in the coming years. How much additional financing will be needed if sales expand to RM 800,000 during 1995 ?

SOLUTION
STEP 1 : PERCENTAGE INCREASE IN SALES

PERCENTAGE INCREASE IN SALES =

60%

SOLUTION
BALANCE SHEET OF TERAS COMPANY AS AT 31/12/95
ASSETS CURRENT ASSETS Cash (RM 10,000 x 60%) + RM 10,000
Acc Receivable(RM85,000 X 60%) + RM 85,000

RM
16,000
136,000
160,000
240,000

LIABILITIES CURRENT LIABILITY

Account Payable (RM50,000x60%) + RM50,000 Accrued Wages ( RM25,000x60%) + RM35,000

RM
80,000 40,000 30,000 40,000 100,000

Inventory(RM100,00 x 60%) + RM100,000

FIXED ASSET
Net fixed asset (RM150,000x60%) + RM150,000

Notes payable Mortgage bond Common Stock Retained Earning

116,000 406,000 146,000 552,000

EXTERNAL FUND NEEDED

552,000

 STEP 3: NEW RETAINED EARNING

NEW RETAINED EARNING = RM100,000 +[4% x ( ) x RM 800,000] = RM 100,000 + RM16,000 = RM 116,000

NOT OPERATING AT FULL CAPACITY (USING EQUATION)

Not operating at full capacity means the firm has not reached its full (maximum) capacity limit and hence some of its assets that is fixed assets can still be used to support the expansion. Thus, the firm does not have to increase its fixed assets. The increase will only be for current asset and certain liabilities (account payable and accrued expenses).

EXAMPLE NOT OPERATING AT FULL CAPACITY (USING EQUATION)

BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSET CURRENT ASSET Cash Account Receivable Inventories
FIXED ASSET Net Fixed Asset

RM
10,000 85,000 100,000

LIABILITY CURRENT LIABILITY Account Payable Accrued Wages Notes Payable Mortgage Bonds EQUITY Common Stock Retained Earning

RM

50,000 25,000 30,000 40,000

150,000

345,000

100,000 100,000 345,000

QUESTION : Companys sales are running at about RM 500,000 a year which has not reached its maximum capacity limit and the net profit margin after tax is 4%. During 1994 the company earned RM 20,000 after taxes and paid out RM 10,000 in dividend in the coming years. How much additional financing will be needed if sales expand to RM 800,000 during 1995 ?

SOLUTION
BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSETS CURRENT ASSETS Cash x 100% Acc Receivable Inventory
LIABILITIES CURRENT LIABILITY Account Payable Accrued Wages 10% 5%

2%

17% 20%

39%

15%

Note: Since FIXED ASSET will not increase thus we do not calculate percentage in FIXED ASSET

 STEP 1 : RETAINED EARNING

RETAINED EARNING = [0.04 x (1-0.5) x RM 800,000] = RM 16,000

STEP 2: FUND NEEDED BY THE COMPANY IN ORDER

TO EXPAND THEIR BUSINESS FUND NEEDED = 39% x (RM 800,000 RM 500,000) 15% x ( RM 800,000 RM 500,000) = 24% (RM 300,000) = RM 72,000 STEP 3: EXTERNAL FUND NEEDED EXTERNAL FUND NEEDED = RM 72,000 RM 16,000 = RM 56,000

EXAMPLE NOT OPERATING AT FULL CAPACITY (USING PRO-FORMA)

BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSET CURRENT ASSET Cash Account Receivable Inventories
FIXED ASSET Net Fixed Asset

RM
10,000 85,000 100,000

LIABILITY CURRENT LIABILITY Account Payable Accrued Wages Notes Payable Mortgage Bonds EQUITY Common Stock Retained Earning

RM

50,000 25,000 30,000 40,000

150,000

345,000

100,000 100,000 345,000

QUESTION : Companys sales are running at about RM 500,000 a year which has not reached its maximum capacity limit and the net profit margin after tax is 4%. During 1994 the company earned RM 20,000 after taxes and paid out RM 10,000 in dividend in the coming years. How much additional financing will be needed if sales expand to RM 800,000 during 1995 ?

SOLUTION
STEP 1 : PERCENTAGE INCREASE IN SALES

PERCENTAGE INCREASE IN SALES =

60%

SOLUTION
BALANCE SHEET OF TERAS COMPANY AS AT 31/12/94
ASSETS CURRENT ASSETS Cash (RM 10,000 x 60%) + RM 10,000
Acc Receivable(RM85,000 X 60%) + RM 85,000

RM
16,000
136,000
160,000

LIABILITIES CURRENT LIABILITY

Account Payable (RM50,000x60%) + RM50,000 Accrued Wages ( RM25,000x60%) + RM35,000

RM
80,000 40,000 30,000 40,000 100,000

Inventory(RM100,00 x 60%) + RM100,000

FIXED ASSET Net fixed asset

150,000

Notes payable Mortgage bond Common Stock Retained Earning

116,000 406,000 56,000 462,000

EXTERNAL FUND NEEDED

462,000

 STEP 3: NEW RETAINED EARNING

NEW RETAINED EARNING = RM100,000 +[4% x ( ) x RM 800,000] = RM 100,000 + RM16,000 = RM 116,000

EASY RIGHT ?