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BUS235: PRINCIPLES OF BUS235: PRINCIPLES OF FINANCIAL ANALYSISFINANCIAL ANALYSIS

Lecture 8Lecture 8

Lecturer: Kleanthis Zisimos Lecturer: Kleanthis Zisimos

Financial ForecastingFinancial Forecasting Income statement forecastIncome statement forecast The projected Balance sheetThe projected Balance sheet Formula method for forecastingFormula method for forecasting PlanningPlanning BudgetsBudgets BEP analysisBEP analysis

Lecture Topic ListLecture Topic List

Financial ForecastingFinancial Forecasting Financial forecastingFinancial forecasting is the quantitative is the quantitative

expression of the business plan.expression of the business plan. Financial forecastingFinancial forecasting help managers to help managers to

scientifically project sales, analyze the cost of scientifically project sales, analyze the cost of alternative strategies and choose the alternative strategies and choose the appropriate ones, communicate more clearly appropriate ones, communicate more clearly the targets for each employee and evaluate the targets for each employee and evaluate the performance by internal controls. the performance by internal controls.

Financial control Financial control moves on to the moves on to the implementation phase, dealing with the implementation phase, dealing with the feedback and adjustment process that is feedback and adjustment process that is required (1) to ensure that plans are followed required (1) to ensure that plans are followed and (2) to modify existing plans in response to and (2) to modify existing plans in response to changes in the operating environmentchanges in the operating environment

Components of the Financial Components of the Financial forecastingforecasting

Financial forecasting consists of many Financial forecasting consists of many separate forecasts that are inter separate forecasts that are inter depended. depended.

The two major parts areThe two major parts are The projected income statement The projected income statement which which

has the following sub categorieshas the following sub categories1.1. Sales forecast. Sales forecast. 2.2. Cost of goods sold forecastCost of goods sold forecast3.3. Operation expenses forecastOperation expenses forecast

The projected Balance sheetThe projected Balance sheet

Sales forecastSales forecast Sales forecast is based onSales forecast is based on1.1. Past SalesPast Sales2.2. Market research studiesMarket research studies3.3. Industry trend Industry trend 4.4. Pricing policyPricing policy5.5. Expected action of competitionExpected action of competition6.6. New product developmentNew product development7.7. Advertising and promotionAdvertising and promotion

Usually the first 12 months are presented Usually the first 12 months are presented analytically and sometimes when a month is analytically and sometimes when a month is ended another one is added making the forecast ended another one is added making the forecast a continues forecasta continues forecast

Cost of goods sold and Operation Cost of goods sold and Operation expenses forecastexpenses forecast

Cost of costs sold forecast projects all the Cost of costs sold forecast projects all the expenditure which are included in the expenditure which are included in the Trading account. If the company is a Trading account. If the company is a manufacturing company then the cost of manufacturing company then the cost of production is added to the forecastproduction is added to the forecast

Operating forecast projects all the Operating forecast projects all the expenditure which are included in the expenditure which are included in the Profit & Loss account.Profit & Loss account.

Balance sheet forecastBalance sheet forecast

The Balance sheet forecast focuses The Balance sheet forecast focuses on the effects that the following sub on the effects that the following sub categories will have on cash:categories will have on cash:

Capital Budget. Projection of capital Capital Budget. Projection of capital expenditureexpenditure

Working capital budget. Repayment Working capital budget. Repayment of debts and projected receipts from of debts and projected receipts from customerscustomers

Analysis of the ForecastAnalysis of the Forecast The projected statements must be The projected statements must be

analyzed to determine whether the analyzed to determine whether the forecast meets the firm’s financial targets forecast meets the firm’s financial targets as laid down in the financial plan.as laid down in the financial plan.

If the statements do not meet the targets, If the statements do not meet the targets, then elements of the forecast must be then elements of the forecast must be changed.changed.

The Formula Method for Forecasting AFN The Formula Method for Forecasting AFN (Additional Funds Needed)(Additional Funds Needed)

AFN = (A*/S)AFN = (A*/S)ΔΔS – (L*/S)S – (L*/S)ΔΔS – MS1(1 – d)S – MS1(1 – d)

AFN = Additional funds needed.AFN = Additional funds needed. A*/S = Assets that must increase if sales are to A*/S = Assets that must increase if sales are to

increase expressed as a percentage on sales.increase expressed as a percentage on sales. L*/S = Liabilities that increase spontaneously.L*/S = Liabilities that increase spontaneously. S1 = Total sales projected for next year.S1 = Total sales projected for next year. ΔΔS = Change in sales.S = Change in sales. M = Profit margin or rate of profit per €1 of M = Profit margin or rate of profit per €1 of

sales.sales. d = percentage of earnings paid out in common d = percentage of earnings paid out in common

dividends. dividends.

Relationship between growth and Relationship between growth and financial requirementsfinancial requirements

The faster the growth rate is sales the The faster the growth rate is sales the greater the need for additional financinggreater the need for additional financing

The higher the dividends payout ratio, the The higher the dividends payout ratio, the greater the requirements for external greater the requirements for external capital.capital.

The higher the capital intensity ratio The higher the capital intensity ratio (A*/S), the greater the requirements for (A*/S), the greater the requirements for external capital.external capital.

Forecasting Financial Requirements Forecasting Financial Requirements when the Balance Sheet ratios are when the Balance Sheet ratios are

subject to changesubject to change Both the AFN formula and the projected Both the AFN formula and the projected

balance sheet method assume that the balance sheet method assume that the balance sheet ratios remain constant over balance sheet ratios remain constant over time.time.

Some conditions though change this Some conditions though change this assumption and these conditions areassumption and these conditions are

1.1. Economies of Scale. There are economies of Economies of Scale. There are economies of scale in the use of many kinds of assets, and scale in the use of many kinds of assets, and when economies occur, the ratios are likely to when economies occur, the ratios are likely to change over time as the size of the firm change over time as the size of the firm increases.increases.

2.2. Lumpy Assets. Lumpy Assets. Assets that can not be Assets that can not be acquired in small increments but must acquired in small increments but must be obtained in large amounts.be obtained in large amounts.

3.3. Excess assets due to forecasting Excess assets due to forecasting errorserrors. If actual sales are different from . If actual sales are different from the projected then the actual asset/sales the projected then the actual asset/sales ratio is different from the planned ratio. ratio is different from the planned ratio.

Forecasting Financial Requirements Forecasting Financial Requirements when the Balance Sheet ratios are when the Balance Sheet ratios are

subject to changesubject to change

What is PlanningWhat is Planning

Planning or business plan is what we can Planning or business plan is what we can call the identity of an organization.call the identity of an organization.

The Business plan defines the vision of the The Business plan defines the vision of the company, sets the overall goals and company, sets the overall goals and objectives, identifies strategies by objectives, identifies strategies by allocating its recourses to each strategy allocating its recourses to each strategy for the success of each goal and for the success of each goal and evaluates the performance for evaluates the performance for improvement of the existing plan. improvement of the existing plan.

How budgets facilitate planningHow budgets facilitate planning

Budget is the quantitative expression of Budget is the quantitative expression of the business plan.the business plan.

Budgets help managers to scientifically Budgets help managers to scientifically project sales, analyze the cost of project sales, analyze the cost of alternative strategies and choose the alternative strategies and choose the appropriate ones, communicate more appropriate ones, communicate more clearly the targets for each employee and clearly the targets for each employee and evaluate the performance by internal evaluate the performance by internal controls. controls.

Types of BudgetsTypes of Budgets

Common base BudgetCommon base Budget. A budget that . A budget that assumes that the expenditure of every assumes that the expenditure of every activity will be approximately the same activity will be approximately the same with the ones in the previous year. with the ones in the previous year.

Zero Base BudgetZero Base Budget. A budget that requires . A budget that requires justification of expenditures for every justification of expenditures for every activity.activity.

Master BudgetMaster Budget

The master budget is a combination of a The master budget is a combination of a common base and a zero base budget. common base and a zero base budget.

The master budget is a comprehensive The master budget is a comprehensive profit plan that ties together all phases of profit plan that ties together all phases of an organization’s operations, short term an organization’s operations, short term and long term.and long term.

Usually the first 12 months are presented Usually the first 12 months are presented analytically and sometimes when a month analytically and sometimes when a month is ended another one is added making the is ended another one is added making the budget a budget a continues master budgetcontinues master budget

Components of a Master BudgetComponents of a Master Budget

The master budget consists of many The master budget consists of many separate budgets that are inter depended. separate budgets that are inter depended.

The two major parts are the operating The two major parts are the operating budget and financial budget.budget and financial budget.

The The operating budgetoperating budget focuses on the focuses on the income statement items.income statement items.

The The financial statementfinancial statement focuses on the focuses on the balance sheet items.balance sheet items.

Operating budgetOperating budget

The operating budget has the following sub The operating budget has the following sub budgetsbudgets

1.1. Sales forecast. Very difficult to do accurately Sales forecast. Very difficult to do accurately

2.2. Cost of goods sold budgetCost of goods sold budget

3.3. Operation expenses budgetOperation expenses budget

The above 3 sub budgets are united in the The above 3 sub budgets are united in the end end

and produce the operating budget or and produce the operating budget or Budgeted Profit & LossBudgeted Profit & Loss

Financial BudgetFinancial Budget The Financial budget focuses on the effects The Financial budget focuses on the effects

that the operating budget and the following that the operating budget and the following sub budgets will have on cash:sub budgets will have on cash:

Capital Budget. Projection of capital Capital Budget. Projection of capital expenditureexpenditure

Working capital budget. Repayment of Working capital budget. Repayment of debts and projected receipts from debts and projected receipts from customerscustomers

Cash budget. The effects of the operating Cash budget. The effects of the operating budget will be presented in this budgetbudget will be presented in this budget

After the completion of the projections the After the completion of the projections the 3 budgets are united in one budget called 3 budgets are united in one budget called financial budget or Budgeted Balance sheet financial budget or Budgeted Balance sheet

Case StudyCase Study

Prepare the master budget for 4 months of the Prepare the master budget for 4 months of the company “Cooking Hub”company “Cooking Hub” using the following using the following data.data.

Sales in 2011 March 40 000 Sales in 2011 March 40 000 €. €. Projected sales. 40% cash and 60% received Projected sales. 40% cash and 60% received

next month next month

April 50000 April 50000 €€

May 55000 May 55000 €€

June 60000 June 60000 €€

July 40000 July 40000 €€

Case StudyCase Study

Balance sheet of Cooking Hub as at 31 Balance sheet of Cooking Hub as at 31 March 2011March 2011

Equipment   12200 Capital 78950

Other assets 12000  Creditors 16800

Stock 49800 

Accrued Accrued commission paidcommission paid 4250 

cash   10000  

Debtors   16000  

   

Total AssetsTotal Assets   10000010000

0

     

Case StudyCase Study

CHC plans to buy new furniture for 3000 € in CHC plans to buy new furniture for 3000 € in JulyJuly

Rent 2000 € per monthRent 2000 € per month Insurance 200 € per monthInsurance 200 € per month Depreciation 500 € per monthDepreciation 500 € per month Salaries 5000 € per monthSalaries 5000 € per month Cost of sales 50% on salesCost of sales 50% on sales Accrued commission will be paid on AprilAccrued commission will be paid on April

Notes on BEP AnalysisNotes on BEP Analysis

The Break Even Point analysis is based in The Break Even Point analysis is based in the classification of cost as variable and the classification of cost as variable and fixed according to the activity performedfixed according to the activity performed

Activity refers to a measure of the Activity refers to a measure of the organizations output of productorganizations output of product

Variable Cost. It changes proportionately Variable Cost. It changes proportionately with the activity change but the unit with the activity change but the unit variable cost remains the same.variable cost remains the same.

Fixed cost. It remains unchanged as Fixed cost. It remains unchanged as activity changes but the unit fixed cost activity changes but the unit fixed cost changes.changes.

The equation method of calculating The equation method of calculating BEPBEP

The break-even point is the level of sales at which The break-even point is the level of sales at which revenue equals expenses and net income is zerorevenue equals expenses and net income is zero

The equation method is the most general form of The equation method is the most general form of analysis, one you can adapt to any conceivable analysis, one you can adapt to any conceivable cost-volume-profit situation. We can express any cost-volume-profit situation. We can express any income statement in equation form, or as a income statement in equation form, or as a mathematical model, as follows:mathematical model, as follows:

sales - variable expenses - fixed expenses = net income (0 sales - variable expenses - fixed expenses = net income (0

for BEP)for BEP)

That isThat is(Unit sales price x Q)-(Unit variable cost x Q)-fixed (Unit sales price x Q)-(Unit variable cost x Q)-fixed

expenses=0expenses=0

The equation method of calculating The equation method of calculating BEPBEP

If we isolate the quantity (Q) from the equation we have If we isolate the quantity (Q) from the equation we have the following formula:the following formula:

Break even point in units (Q)Break even point in units (Q) = = Fixed expenses Fixed expenses

Unit Price-Unit Variable costUnit Price-Unit Variable cost

If we want to find the BEP in sales then the following If we want to find the BEP in sales then the following formula is appliedformula is applied

Break even point in sales (S)=Break even point in sales (S)= Fixed expensesFixed expenses

1-(VC/total Sales)1-(VC/total Sales)

BEP exampleBEP example

€

Selling price 1,5

Variable cost of each item 1,2

Selling price less variable cost 0,3

Monthly fixed expensesRent 3000

Wages 13500

Other Fixed Exp 1500

Total Fixed Expenses 18000

Calculate sales volume to reach a Calculate sales volume to reach a target profittarget profit

Suppose we considers Suppose we considers €€ 1440 the minimum 1440 the minimum acceptable net income. How many units will she acceptable net income. How many units will she have to sell to justify the adoption of the vending have to sell to justify the adoption of the vending machine?machine?

Target sales volume in units= Target sales volume in units= Fixed expenses+ target incomeFixed expenses+ target income

Unit Price-Unit Variable CostUnit Price-Unit Variable Cost

==18000+144018000+1440

0,300,30

=64800 units=64800 units

Operating LeverageOperating Leverage

Operating leverage is the ratio of fixed Operating leverage is the ratio of fixed cost to variable cost.cost to variable cost.

Operating Leverage= Operating Leverage= Fixed costFixed cost

variable Cost variable Cost

In highly leveraged companies (high fixed In highly leveraged companies (high fixed cost and low variable cost) small changes cost and low variable cost) small changes is sales volumes result in large changes in is sales volumes result in large changes in net incomenet income

Degree of operating LeverageDegree of operating Leverage

To measure the effect of a change in To measure the effect of a change in volume on profitability , we calculate the volume on profitability , we calculate the degree of operating leverage (DOL).degree of operating leverage (DOL).

DOL= DOL= % change in EBIT% change in EBIT

% change in sales% change in sales

OROR DOL= DOL= Q x (Price –VC per unit)Q x (Price –VC per unit)

Q x (Price –VC per unit)-Fixed costsQ x (Price –VC per unit)-Fixed costs