Financial Forecasting and Management Decisions

• Chapter 1 - Forecasting Prerequisites
  • Learning Objectives
  • An Overview of the Forecasting Process
  • More on the Forecasting Process
    • Purpose of Forecasting
    • First-Pass Forecast
    • Simulation
    • Assumptions and Sensitivity Analysis
    • Planning and Forecasting
  • Budgets vs. Forecasted Financial Statements
    • Budgets
    • Forecasted Financial Statements
  • Financial Planning Prerequisites
  • Corporate Growth
  • Value of a Company
• Chapter 2 - Using the Basic Forecasting Model
  • Learning Objectives
  • Making Assumptions
  • Percent of Sales and Sales Forecasts
    • Sales Forecast and Forecasting
    • The Sales Forecast
    • Who Prepares the Sales Forecast?
  • The Basic Forecasting Model
    • Percent of Sales Method
  • Explanation of the Basic Model
  • Identification of Spontaneous and Quasi-Spontaneous Accounts
    • Spontaneous Assets
    • Spontaneous Liabilities
  • The Basic Model - An Example
    • Need for Funds
    • Internally Generated Sources
    • Impact of Profits on EFN
    • EFN and Sales Increases
  • Using the Basic Model for Planning
    • Dividends
    • Financing
    • Sales Growth
    • Estimating Sales
  • The Basic Model - Sensitivity Analysis
    • Example
    • Anomaly of Sales Growth
  • The Zeta Company Case
    • Case 2-1
  • The Balance Sheet - Percent of Sales Method
  • Forecasting the Balance Sheet - An Example
  • Using the Projected Balance Sheet for Decision Making - Capital Structure Decision
  • Methods of Financing EFN
    • External Sources
    • Internal Sources
  • Using the Projected Balance Sheet for Decision Making - Working Capital Decisions
    • Working Capital and Profits
    • Second Pass Forecast - Improving Working Capital
  • Using the Projected Balance Sheet for Decision Making - Retention Decisions
    • Third-Pass Forecast
  • Problems and Limitations Associated with the Basic Model
  • Case
    • Case 2-2
• Chapter 3 - Management Uses of the Forecasting Technique - A Case Analysis on Working Capital Planning
  • Learning Objective
  • The Davidson Toy Company
  • Worksheets
• Chapter 4 - Using Forecasting to Plan the Company's Capital Structure
  • Learning Objectives
  • Value of the Firm
  • The Effect of Debt on the Cost of Capital
    • Debt Effect
    • Conclusion
    • Risk Effect
  • Other Factors - Bankruptcy Costs
    • Bankruptcy Costs
    • Probability of Bankruptcy
  • Financing the EFN - Capital Structure Theory
    • Basic Ideas
  • Relation of Cost of Capital and Value to Debt Ratio
  • Optimal Capital Structure
    • How to Use This Idea
  • Factors Influencing Debt Usage
    • Sales Growth Rate
    • Sales Stability
    • Asset and Cost Structure and Operating Leverage
    • Control
    • Other Factors Influencing Debt Usage
  • Short vs. Long-Term Debt
  • Cases
    • Case 4-1 - Financing the EFN
    • Case 4-2 - Zeta Company
• Chapter 5 - Forecasting the Balance Sheet - Statistical Procedures
  • Learning Objectives
  • Statistical Procedure Regression
  • Advantages of Regression Analysis
  • Finding a Trend Line with Two Data Points
  • Regression Analysis
  • Using Regression - An Example
  • The Correlation Coefficient
  • Regression and Forecasting the Balance Sheet - An Example
    • Assume
  • Using Regression to Forecast the Income Statement
• Chapter 6 - Forecasting the Income Statement
  • Learning Objectives
  • How Expenses Vary with Sales Changes
    • Predicting Expenses
    • Prepare Forecast with Considerable Detail
    • Fixed Expenses
    • Changes in Fixed Expenses
    • Variable Expenses
    • Changes in Variable Rates
  • The Income Statement Percent of Sales Method
    • Fixed and Variable Expense Approach
    • Variable Expense Approach
  • Finding Fixed and Variable Expenses Graphically
  • Using Regression to Determine Fixed and Variable Expenses
  • Example of Using Regression to Determine Expense Components
  • Forecasting the Income Statement
  • Case
    • Case 6-1
• Chapter 7 - Reconciling the Income Statement and Balance Sheet
  • Learning Objectives
  • Why There Must Be a Reconciliation
  • Reconciliation of the Income Statement and the Balance Sheet
    • Procedure
    • Reconciliation - Example of Setting-Up the Reconciliation Equation
  • Reconciliation - A Complete Example
  • Forecasting and Reconciling the Income Statement - An Example
  • Reconciliation - An Example
  • Reconciliation - A Second Example
  • Case
    • Case 7-1
• Chapter 8 - Evidence of Growth Mismanagement
  • Learning Objectives
  • Evidence of Growth Mismanagement
  • Fixed Assets to Net Worth
  • Net Sales to Net Worth - The Trading Ratio
  • The Trading Ratio of Company A - An Example
  • Other Important Ratios to Monitor during Periods of Growth
    • Collection Period
    • Inventory Turnover
    • Profit Margin
  • Case
    • Case 8-1 - Using Forecasting to Aid Growth Planning
• Chapter 9 - Maximum Sustainable Growth
  • Learning Objectives
  • The Basic Model - Maximum Sustainable Growth
  • The Sustainable Growth Model
  • Maximum Sustainable Growth - An Example
  • Maximum Sustainable Growth - A Second Example
    • Assumptions
  • Improving Sustainable Growth
  • Case
    • Case 9-1
  • Sustainable Growth - Available External Equity
  • Sustainable Growth with Regression
• Chapter 10 - Forecasting Sales
  • Learning Objectives
  • Forecasting Sales - Sales Goal
  • The Best Guess Forecast - Bottoms-up
  • Compound Growth - An Example of Forecasting Sales
  • Fluctuating or Cyclical Sales
  • Using Regression to Predict Sales
  • Forecasting Sales - Regression Approach
  • Quick Mart Lumber Company
  • Case
    • Case 10-1
• Chapter 11 - Integrating the Percent of Sales with a Shorter-Term Forecast of Cash Needs.
  • Learning Objective
  • Shorter-Term Cash Needs
• Chapter 12 - Ethics Focus: Business and Industry
  • Ethics Overview
  • Recent Developments
  • Key Ethical Dilemmas
  • Addressing Ethical Dilemmas
  • Available Resources
• Chapter 13 - Latest Developments
• Appendix A - The Basic Forecasting Model
  • Objective
  • Key Words
  • The Need for a Sales Forecast
  • Forecasting the Balance Sheet
  • The Forecasted Income Statement
  • Reconciling the Two Pro Forma Financial Statements

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Chapter 2 - Using the Basic Forecasting Model

Learning Objectives

The purpose of this chapter is to introduce you to the basic forecasting model. After completing this chapter you should be able to

• Understand the importance of assumptions;

• Determine what “basic” assumptions are necessary in preparing the first pass forecast;

• Compute the EFN requirements for a company using the percent of sales method to prepare a sources and uses of cash equation;

• Determine when an asset or liability is spontaneous; and

• Prepare the first-pass pro forma balance sheet.

Making Assumptions

Assumptions are a necessary part of the forecasting process. Through them, we make the forecast workable, and through them, we begin to develop an understanding of how things interrelate in our company.

When we prepare our first-pass forecast we generally make very basic assumptions. The most common basic assumption is that we want the current or existing financial relationships to be maintained. (Remember, this is just our starting point. We can and should reevaluate these assumptions in later forecasting passes during our planning process.)

The most common way to operationalize these basic assumptions is to link various values to sales. This should make some sense to you because the company’s sales level is probably one of the biggest, if not the biggest, determinant of its future.

The basic model we use is called the percent of sales method. To prepare our first pass forecast we determine how each asset, liability, and expense should behave as sales change. Sometimes the changes in the assets, liabilities, and expenses occur on their own. For others, we must make the changes occur if the company is to be successful. Whether the changes occur on their own or whether we must force the change, before forecasting we must determine these relations. Generally, as a starting point in our first pass forecast, we assume that we want the past relationships between sales and the other accounts to remain as they are now.

As stated before, we can later change the assumptions. If, for example, we have been mismanaging our inventory, the basic assumption builds this mismanagement into the forecast. As we plan for the future, correcting this mismanagement would be a good idea. We build the correction into a second-pass forecast. By observing the first pass and the second pass, we can see the impact of continued mismanagement and the impact of the correction.

Percent of Sales and Sales Forecasts

Sales Forecast and Forecasting

To use the percent of sales model requires a sales forecast. This is the one area where a prediction is important. If your company has “no idea” where its sales are headed in the future, then this model should not be used. If you have no idea where your company’s sales are headed, there probably is not a planning model that will work for you.

The Sales Forecast

The sales forecast can be a simple number or it can be a range. In the model, we prepare a forecast with one sales prediction at a time. We can then recompute the model with other alternate sales predictions. We can then see the likely impact of the possible range of sales increases.

Who Prepares the Sales Forecast?

The answer to this question varies. The accountants and financial analysts (us) are generally not in the best position to forecast sales. After all, we tend to have less of a relationship with our customers and markets than others in the company. We therefore often must rely on sales forecasts generated by others.

Sometimes we must become involved in sales forecasting. This could occur if there is no one else in the company willing or able to generate the forecast. Or, it could occur if we believe the forecast we have been given is, in some way, flawed or unrealistic.

For much of the seminar, we will assume that the sales forecast is provided to us from others in the company. In a later chapter, we will return to the idea of sales forecasting for those instances where we need to become involved in it.

1 All organization names used in this course are purely fictitious as are the individuals depicted therein. Any similarity to real organizations or persons is purely coincidental.

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