Financial Forecasting - Financial Management

Financial forecasting consists of various techniques that can be used to determine the amount of additional financing a firm will require in the future. If internal sources of funds (cash) are not sufficient to achieve its goals, then the firm must seek to obtain external funding from the capital markets.

This section presents an overview of the financial forecasting process, with emphasis on the important role of pro forma financial statements. Pro forma financial statements, showing the results of some assumed event, rather than an actual event, are usually an integral part of a financial forecast. For example, an operating budget that shows the level of net income that can be expected if sales and expenses are at a given assumed level next year is a pro forma income statement.

Short -term forecasts, those that deal with one year or less, tend to be rather detailed, whereas long-term forecasts are more general. This section discusses the percentage of sales forecasting method, cash budgets, the pro forma statement of cash flows, computerized financial forecasting and planning models, and using financial ratios to forecast future financial performance.

Percentage of Sales Forecasting Method

The percentage of sales forecasting method permits a company to forecast the amount of financing it will need for a given increase in sales. This method is simple and can provide information useful in preparing pro forma financial statements and in estimating future funds needs.

Consolidated Statement of Cash Flows for PepsiCo, Inc., and Subsidiaries (in $ Millions)

Consolidated Statement of Cash Flows for PepsiCo, Inc., and Subsidiaries (in $ Millions)

The method assumes that (1) present asset levels are optimal with respect to present sales; and (2) most items on the balance sheet increase in proportion to sales increases. The use of this method is illustrated with the following example of the Industrial Supply Company (ISC). The present (2006) ISC balance sheet and income statement are shown in Table 4.4. Management forecasts that sales will increase by 25 percent, or $3,750,000, next year to $18,750,000 and that expenses, including interest and taxes, will increase to $17,750,000. One of management’s primary concerns is the amount of funds (cash) needed to finance this sales growth.

Until now, the company has financed its growth by using both internally and externally generated funds. The company has reinvested most of its past earnings, primarily into additional inventory. The company has also used external financing in the form of short -term borrowings from its bank.

To determine the amount of additional financing necessary to reach the expected $18,750,000 annual sales level, the ISC management has made the following observations about the company’s various assets and liabilities:

  1. Management feels that the company’s cash balances are generally adequate for the present sales level and would have to increase proportionately as sales increase.

    Industrial Supply Financial Statements

    Industrial Supply Financial Statements
  2. The company’s present average collection period is approximately 49 days.Management feels that the company’s present credit policies are appropriate for its type of business. As a result, they feel that the average collection period will remain approximately constant and that accounts receivable will increase proportionately as sales increase.
  3. Management feels that the company’s inventory is properly managed at present. Therefore, they feel inventory would have to increase proportionately for sales to increase.
  4. The company is a distributor with relatively few fixed assets (delivery trucks, forklifts, office equipment, storage racks, and so forth). Because the company’s fixed assets are being used at nearly full capacity, management feels that fixed assets will have to increase as sales grow. For financial planning purposes, management is willing to assume that the net fixed asset figure on the balance sheet will increase proportionately as sales increase.
  5. The company now maintains good relations with its suppliers.As the company purchases more inventory, its accounts payable balance will increase proportionately as sales increase.
  6. Notes payable and long-term debt. Notes payable and long-term debt do not necessarily have a direct relationship to the sales level. For example, a portion of the company’s future cash flows may be used to pay off the present debt. In summary, as the company’s sales increase, its assets will increase proportionately to support the new sales. In addition, the current liabilities that vary directly with sales, namely accounts payable, will also increase. The difference between the forecasted asset increase and the forecasted current liability increase is equal to the total financing the company will need. This relationship can be expressed in equation form as follows:
Total financing needed= Forecasted asset increase - Forecasted current liability increase = A/S(ΔS)-CL/S(ΔS)

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Financial Management Topics