handout 3 finlforecasting
TRANSCRIPT
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FinancialForecasting
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Introduction
From the past (Chapters 1 and 2) to thefuture.
Financial forecasting planning
Budgeting
Chapter describes techniques that arepartof planning.
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Pro Forma Statements
Pro forma = as if Much of the language of business
forecasting is financial. Many of the measures used to evaluate
plans are financial.
Key issue is determining whether a plan isfinancially feasible.
Implications for current environment.
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Bottom up detailed plans vs. top downbirds eye view plans.
Pro forma financial statements areforecasted financial statements.
Can stem from broad outlines or detailed
sub-plans. Future need for external funding, external
financing required (EFR).
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Percent of Sales
Forecast future sales, and tie other itemsin income statement and balance sheet to
the sales forecast. Works for variable costs, most current
assets and current liabilities.
Not generally true for fixed assets.
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Steps
1. Examine historical data to ascertain theextent to which percent-of-sales ratios
stay constant over time.2. Forecast sales.3. Do sensitivity analysis to see how
financial statements respond to differentpercent-of-sales parameters.
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Suburban National Bank
R&E Supplies, Inc. is a wholesaler ofplumbing and electrical supplies.
R&E has been a customer of the bank formany years.
Average deposits have been $30K.
Short-term renewable loan has been$50K, with a 5-year maturity.
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Increase in Loan
In late 2008, R&E asks that the loanamount for 2009 be increased to $500K.
R&E explains that because of growth, APhas gone up and cash balances have gonedown.
Suppliers are threatening to go to COD. Why $500K? Pay off most insistent creditors and rebuild
cash balances.
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Build a Pro Forma
Not enough quantitative justification. Build a pro forma.
Start with history, Table 3-1. Look at the ratios, Table 3-2. Whats happened to
cash/sales
AP/sales
earnings/sales
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TABLE 3-1 Financial Statements for R&E Supplies, Inc.,
December 31, 2005-2008 ($ thousands)
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TABLE 3-1 (Continued)
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Questions re Next 3 Slides
By how much are sales forecasted toincrease?
How has an unfavorable labor settlementimpacted the pro forma? What is the plan for Days Sales in Cash?
What is the plan for AP in terms ofPayables Period? What is the plan for net interest expense
and Earnings After Tax?
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TABLE 3-2 Selected Historical Financial Ratios for R&E Supplies,
Inc., 2005-2008, and Forecasts
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TABLE 3-3 Pro Forma Financial Statements for R&E
Supplies, Inc., December 31, 2009 ($ thousands)
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Estimating theExternal Funding Required
Income statement measures profitability,and garners most investors attention.
The CFO focuses on the balance sheet toestimate funding needs.
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Items
Prepaid expenses rough guess. New fixed assets?
capital budget of $43K already approved
$50K depreciation
280 = 287 (prior year) + 43 50
Bank loan initially set to $0, but onlytemporarily.
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Additional Items
Current portion (100) of long-term debt iscontractual (760 = 660 + 100)
Note assumption that new loans = 0.
Retained earnings? Prior year RE + income statement earnings
dividends
External funding required = Total assetsminus Total Liabilities and Owners Equity This temporary balance sheet does not
balance.
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TABLE 3-3 (Continued)
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Bankers Reaction?
EFR = $1.4 million > $500K! Not good news about the CFO.
Still, AR = $3.6 million, which wouldprovide security.
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Interest Expense
Circular reasoning. Interest this year is based on debt this year.
But interest this year feeds into earnings this year,and therefore into balance sheet retained earnings.
Debt this year, needs to be determined by the gapbetween assets and liabilities in the balance sheet.
Can try a decent plug, such as basing theinterest on the prior year debt. Can iterate, because the two need to be
determined simultaneously.
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Seasonality
External financing needed is onlycomputed on the date of the balance
sheet. What about in-between? Do a series of these, quarterly, monthly,
etc.
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Pro Forma Statements &Financial Planning
The initial financial plan, as embodied within thepro forma, provides the starting point for adiscussion about operations.
If the external amount of financing is too large,what kinds of operating changes need to bemade, relative to pro forma?
Different level of investment? Sale of assets?
Different working capital policy?
Cutting costs, with associated impact on revenue?
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Max Loan = $1 Million?
Bank doesnt trust R&E managementsfinancial acumen.
What to do?
Where to shave $400K? Tighten up AR, so that DSO drops from 51 to
47?
Increase payables period from 59 to 60? These might lower sales growth (2520%)
and increase costs (SG&A 12-12.5%) fromforegone discounts .
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Check the Impact
See Table 3-4 next. What happens to external financing
required? What happens to earnings?
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TABLE 3-4 Revised Pro Forma Financial Statements for
R&E Supplies, Inc., December 31, 2009 ($ thousands)
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Earnings
Earnings drop by 34%, from 234 to 155.
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TABLE 3-4 (Continued)
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External Funding
EFR drops from 1.4 to below 1 (982K).
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Why Are Lenders So Conservative?
If expected loan returns are low, lenders cannotaccept high risk.
Look at the lending margin (spread) betweenpaying depositors and what the loan pays. Example on p. 100 shows a low net profit
margin.
So getting a high ROE requires high financialleverage (like 10-to-1).
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Prophetic Comments:
A Few Bad Apples?
Complete default by just a few borrowers
can erase a banks earnings. Why are lenders so conservative? Because the aggressive ones have long
since gone bankrupt.
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Computer-Based Forecasting
Table 3.5 lays out Excel spreadsheet withformulas.
Chapter problem C3.13 provides you withpractice in this skill.
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TABLE 3-5 Forecasting with a Computer Spreadsheet: Pro
Forma Financial Forecast for R&E Supplies, Inc. December 31, 2009
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TABLE 3-5 (Continued)
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TABLE 3-5 (Continued)
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Sensitivity Analysis
What if questions. What if sales growth is only 15%, instead
of 25%? What if COGS is 84% instead of 85%? Benefit #1: sensitivity analysis produces a
range of outcomes.
Benefit #2: sensitivity analysis inducesmanagers to prioritize their assumptionsaccording to importance.
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Scenario Analysis
In practice, forecast variables changetogether, not one at a time.
Develop a set of scenarios with differentco-movements.
Each scenario is built around a story or
narrative, such as losing a major customeror facing a new competitor.
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Simulation Analysis
Assign probability distributions to eachmajor variable.
Run many pro formas, with the variablevalues drawn from a Monte Carlo process.
Advantage: many scenarios.
Disadvantage: many managers do notthink in terms of probabilities, and theplanning issues are opaque.
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FIGURE 3-1 Simulating R&E Supplies Need for External
Funding: Frequency Chart
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FIGURE 3-1 (Continued) Distribution Gallery for Sales Growth
Source: Crystal Ball, Decisioneering, Inc.
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Cash Flow Forecasts
Sources and Uses of Cash Based on same assumptions as the interim
pro forma income statement and balancesheet.
EFR = Total uses Total sources
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TABLE 3-6 Cash Flow Forecast for R&E Supplies, Inc.
2009 ($ thousands)
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Cash Budgets
Pro forma statements rely on accrualaccounting.
Cash budgets are strictly cash accounting. Cash budgets require translation fromaccrual projections to cash projections.Adjust for timing of collections and payments.
Example: Jill Clair Fashions monthly cashbudget.
2%/10 net 30 factoring it in.
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TABLE 3-7 Cash Budget for Jill Clair Fashions, 3rd
Quarter, 2009 ($ thousands)
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TABLE 3.7 (Continued)
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Bottom Line
In the next slide, look at the bottom linecumulative EFR line, as well as the
changes.
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TABLE 3-7 (Concluded)
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Planning in Large Companies
Three stages to planning:1. Hammer out corporate strategy (SWOT),
with broad brush financial planning.
2. Translate qualitative goals into internaldivision activities, with rough financialforecasts.
3. Quantitative plans and budgets, bothoperating budgets and capital budgets.
Integration of #3 leads to thecorporations financial plan.