Course 2: Financial

Planning
and Forecasting
  Strategy plan Long-Run growth target/ M&A/Spin-off
Start with Strategic
Planning
 Operation plan CAPEX with a new production line/Sales grow
 Financial plan Debt/equity financing
  Learn “how to make financial planning”
 what the firm can accomplish by developing a long-term financial
plan

 The percentage of sales approach

Financial plan
 Financial Plan
 A statement of what is to be done in the future
 Growth as a financial management goal
  Financial Plan
pro forma  Have a forecast balance sheet, income statement, and statement of
cash flows , so called “pro forma statements”
statements  Generate these statements based on projections of key items such
as sales
The projected  The projected balance sheet specify changes in total fixed assets
and net working capital
balance sheet  → the firm’s total capital budget
  When projected total assets will exceed projected total liabilities
and equity
plug variable  Necessary some of new financing

 New equity or New debt : plug variable

 Company A
Balance Sheet
Assets 600 Debt 400
Equity 200
Simple long- Total 600 Total 600
term planning Company A
models Income Statement
Sales 1500
Costs 1200
Net Income 300
 Sales Growth 20%

Income Income Statement

Pro Forma
Income Statement
statement Sales 1500 Sales 1800
Costs 1200 Costs 1440
with 20% Net Income 300 Net Income 360
growth
 Company A
Balance Sheet
Assets 600 Debt 400
Equity 200
Total 600 Total 600
What happens All variables grow by 20%

if every BS Pro Forma

components Balance Sheet with Dividend as a plug variable($320)

Assets 720 Debt 480
grow by 20%? Equity 240
Total 720 Total 720
此时Plug Variable是股
利320固定，所以是净
利润增⻓360，分配股
利之后留存收益增⻓40
导致权益增⻓40
 Company A
Balance Sheet
Assets 600 Debt 400
What happens Equity 200
to debt and Total 600 Total 600
All variables grow by 20%. If retained earning is the full $360
equity without
dividend Pro Forma
Balance Sheet with Debt as a plug variable($240)
payoff? Assets 720 Debt 160 将净利润全部再投资，
⼀部分作为资产增加⼀
Equity 560 部分作为偿还债务

Total 720 Total 720

  The percentage of sales method often is used to construct
forecasts of future business performance, often represented
by pro-forma -- or forward-looking -- financial statements.
 In this context, we assume that balance sheet accounts such
Percentage of as assets and liabilities generally will vary proportionately to
the variation in sales figures. In addition, the percentage of
sales method sales method for forecasting assumes that income statement
figures -- expenses and earnings -- will also be proportionate
to sales.
 And we use this method to determine if external finance is
needed.
  Advantages of the Percentage-of-Sales Method
 The advantages of the percentage-of-sales method are as follows:
• It is the quickest way to develop a forecast.
Percent of • It can yield high-quality forecasts for those items that closely
correlate with sales.
sales method
 Disadvantages of the Percentage-of-Sales Method
• Many expenses are fixed or have a fixed component, and so do not
correlate with sales. For example, rent expense does not vary with
sales. Many balance sheet items also do not correlate with sales,
such as fixed assets and debt.
Pro Forma  Next , we use a shoe maker example to show how to construct the
pro forma statement.
statement eg
  In order to develop budgets, we will start with a forecast of what
drives much of our financial activity; namely sales. Therefore, the
first forecast we will prepare is the Sales Forecast.
 Historical financial reports
 Industry analysis

Sales forecast
  We now need to estimate account changes because of estimated
sales. One way to estimate and forecast certain account balances is
with the Percent of Sales Method. By looking at past account
balances and past changes in sales, we can establish a percentage
relationship. For example, all variable costs and most current assets
and current liabilities will vary as sales change.
Percentage of
sales
  Budgeted income statement
Financial  Detailed budgets

 Budgeted balance sheet

budgets
 Budgeted cash flow statement
Income
statement
  Detail Budgets
 We also need to prepare several detail budgets for developing a
Budgeted Income Statement. For example, production must be
planned for our estimated sales of 16,000 units from Exhibit 1. The
Production Department will need to budget for materials, labor, and
overhead based on what we expect to sell and what we expect in
inventory.

Detail budget
  Once we have established our level of production (Exhibit 2), we can
prepare a Materials Budget. The Materials Budget attempts to
forecast the level of purchases required, taking into account
materials required for production and inventory levels. We can
summarize materials to be purchased as:
 Materials Purchased = Materials Required + Ending Inventory -
Beginning Inventory

MATERIALS BUDGET
  The second component of production is labor. We need to forecast
our labor needs based on expected production. The Labor Budget
arrives at expected labor cost by applying an expected labor rate

Labor budget
  As production moves up or down, support services and other costs
related to production will also change. These overhead costs
represent the third major costs of production. Each item that
comprises overhead may warrant independent analysis so that we
can determine what drives the specific cost. For example, production
rental equipment may be driven by production orders while
depreciation is driven by levels of capital investment spending.

Overhead
  Once production costs (direct materials, direct labor, and overhead)
have been budgeted, we can work these numbers into our beginning
inventory levels for Direct Materials, Work In Progress, and Finished
Inventory. Beginning inventory levels are actual amounts from the
last reporting period. We need to apply our costs based on what we
want ending inventory to be. The end-result is a Budget for Cost of
Goods Sold, which we will use for our Forecasted

COGS
  We can now finish our estimate of expenses by looking at all
remaining operating expenses. The first major type of operating
expense is marketing. Marketing and Sales Manager's will prepare
and submit a Marketing Budget to upper level management for
approval.

MARKETING BUDGET
  The final area of operating expenses is the administrative costs of
running the overall business. These types of expenses will be
estimated based on past trends and what we expect to happen in
the future. For example, if the company has plans for a new
computer system, then we should budget for additional technology
related expenses. Several department managers will be involved in
preparing the General and Administrative Expense Budget.

SG&A
Income budget
Income budget
eg
  The Last-In, First-Out (LIFO) method assumes that the last unit to
arrive in inventory or more recent is sold first.
 The First-In, First-Out (FIFO) method assumes that the oldest unit
of inventory is the sold first.
 LIFO is not realistic for many companies because they would not
LIFO and FIFO leave their older inventory sitting idle in stock.
 FIFO is the most logical choice since companies typically use their
oldest inventory first in the production of their goods.
 Due to the inflation, average cost of inventory increases. Using
LIFO leads to higher COGS than FIFO method.
FIFO vs LIFO
 COGS
Avg Cost=$76.1Avg Cost=$60 Avg Cost=$60 Avg Cost=$76.1Avg Cost=$76.1
55000 + 5000 = 5000 + 45000 + 6000 + 4000 FIFO Method
Production Old Inv sales sales New Inv Sales return/Def

Illustration COGS
Avg Cost=$76.1Avg Cost=$76.1Avg Cost=$60 Avg Cost=$76.1 LIFO Method
= 5000 + 45000 + 5000 + 1000 + 4000
sales sales New Inv New Inv Sales return/Def
  Need to forecast the following items
 Retained earnings
 Fixed assets
 Current assets and liabilities
 External Financing required

Balance sheet
statement Balance Sheet
Cash Current liabilities
Current assets LT debt
Fixed assets Total Liabilities
Common stocks
Retained earnings
Total equity
Total Liability & Equity
EFR
Total Total
  The main link between the Income Statement and the Balance
Sheet is Retained Earnings.
 Therefore, preparation of the Budgeted Balance Sheet starts with an
estimate of the ending balance for Retained Earnings. In order to
estimate ending Retained Earnings, we need to project future
dividends based on current dividend policies and what management
expects to pay in the next planning period.
Retained
earning
  Next, we need to account for the acquisition of fixed assets. As a
business depletes its asset base, it must re-invest to sustain assets
which are the basis for generating revenues. For example, do we
need to purchase new machinery or computer equipment? Do we
plan to expand our production facilities? Operating personnel and
upper-level management will decide on future capital spending.
Future capital expenditures are summarized on the Capital
Expenditures Budget.
Capital
expenditure
  Based on the beginning balance in assets and the budget for capital
assets (Exhibit 11), we can estimate an ending asset balance for the
Budgeted Balance Sheet.

Fixed assets
  Relying on the assets management ratios we learned from last
Current assets week.
 Days in Account receivable= Average account receivable/Sales*365
and liabilities  Days in Inventory= Average inventory/COGS *365
 Days payable outstanding= Average account payable/COGS*365
 ValueCo Corporation
Working Capital Projections
($ in millions)

Historical Period Projection Period

2005 2006 2007 2008 2009 2010 2011 2012 2013
Sales $780.0 $850.0 $925.0 $1,000.0 $1,080.0 $1,144.8 $1,190.6 $1,226.3 $1,263.1
Cost of Goods Sold 471.9 512.1 555.0 600.0 648.0 686.9 714.4 735.8 757.9

Current Assets
Accounts Receivable 123.2 141.1 152.6 165.0 178.2 188.9 196.4 202.3 208.4

Current assets
Inventories 94.6 104.0 115.6 125.0 135.0 143.1 148.8 153.3 157.9
Prepaid Expenses and Other 7.1 8.5 9.3 10.0 10.8 11.4 11.9 12.3 12.6
Total Current Assets $224.9 $253.6 $277.5 $300.0 $324.0 $343.4 $357.2 $367.9 $378.9

and liabilities Current Liabilities

Accounts Payable
Accrued Liabilities
65.2
69.9
66.0
83.2
69.4
92.5
75.0
100.0
81.0
108.0
85.9
114.5
89.3
119.1
92.0
122.6
94.7
126.3
Other Current Liabilities 15.6 20.4 23.1 25.0 27.0 28.6 29.8 30.7 31.6
Total Current Liabilities $150.7 $169.6 $185.0 $200.0 $216.0 $229.0 $238.1 $245.3 $252.6

Net Working Capital $74.2 $84.0 $92.5 $100.0 $108.0 $114.5 $119.1 $122.6 $126.3
% sales 9.5% 9.9% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%

(Increase) / Decrease in NWC ($9.8) ($8.5) ($7.5) ($8.0) ($6.5) ($4.6) ($3.6) ($3.7)

Assumptions
Days Sales Outstanding 57.7 60.6 60.2 60.2 60.2 60.2 60.2 60.2 60.2
Days Inventory Held 73.2 74.1 76.0 76.0 76.0 76.0 76.0 76.0 76.0
Prepaids and Other CA (% of sales) 0.9% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%

Days Payable Outstanding 50.4 47.0 45.6 45.6 45.6 45.6 45.6 45.6 45.6
Accrued Liabilities (% of sales) 9.0% 9.8% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Other Current Liabilities (% of sales) 2.0% 2.4% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5%
  Since the Balance Sheet is a year-end estimate, it assumes that all
other estimates have been met. In a world of rapid change, annual
forecasts are rarely close. Therefore, we will simplify our preparation
of the Budgeted Balance Sheet by relying on relationships. Stable
relationships over the last five years are particularly helpful. The
Budgeted Balance Sheet will show either a surplus (excess
financing over assets) or a deficit (additional financing needed to
cover assets). This difference is derived from the Accounting
Equation: Assets = Liabilities+ Equity.
EFR
  We also can calculate External Financing Required (EFR) based on
the relationships between assets, liabilities, and sales. The following
formula can be used:
 EFR = (A / S x Sales) - (L / S x  Sales) - (PM x FS x (1 - d))
 A / S: Assets that change given a change in sales, expressed as a
percentage of sales.

Eg   Sales: Change in sales between the last reporting period and the
forecasted sales.
 L / S: Liabilities that change given a change in sales, expressed as a
percentage of sales.
 PM: Profit Margin on Sales; i.e. net income / sales.
 FS: Forecasted Sales
 (1 - d): Percent of earnings retained after paying out dividends; d is the
dividend payout ratio.
EFR
Balance sheet
Example
  Lastly, we need the cash budget of estimated future cash in flows
and outflows
 Find if short-term liquidity is needed
 Factor in the additional interest obligation from the EFR
 Prepare for different time interval: weekly, monthly, annual

Cash budget  We can start preparing a Cash Budget by simply looking at

 stable cash flow patterns: such as accounts receivable, accounts
payable, payroll, etc.
 or predictable transactions: such as insurance payments, loan
payments, etc
Cash budget
  We started our budgeting process by looking at strategic planning.
Strategic Planning should always be the starting point for financial
planning. From the Strategic Plan, we develop a Plan of Action so
we can implement the Strategic Plan. This is often called an
Operating Plan.
 Within the Operating Plan, we will include a set of budgets for
successful implementation of the Strategic Plan. The entire set of
budgets can be categorized as follows:

Summary of the
Budgeting Process
  In percent of sales method, we rely on past financial performance to
help us predict future financial performance. Extending past trends
and adjusting for what is expected is a common approach to
preparing forecast. However, we can improve forecasting by using
several techniques. The first step is recognize certain fundamentals
about forecasting:
 1. Forecasting relies on past relationships and existing historical
information. If these relationships change, forecasting becomes
increasingly inaccurate.
 2. Since forecasting can be inaccurate due to uncertainty, we should
consider developing several forecast under different scenarios. We can
Additional assign probabilities to each scenario and arrive at our expected
forecast.
 3. The longer the planning period, the more inaccurate the forecast. If
we need to increase reliability in forecasting, we should consider a
shorter planning period. The planning period depends upon how often
existing plans need to be evaluated. This will depend upon stability in
sales, business risk, financial conditions, etc.
 4. Forecasting of large inter-related items is more accurate than
forecasting a specific itemized amount. When a large group of items
are forecast together, errors within the group tend to cancel out. For
example, an overall economic forecast will be more accurate than an
industry specific forecast.
eg  DCF excel sheet
  A statistical approach can be used for forecasting. We can rely on
the average relationships between a dependent variable and an
independent variable. Simple regressions look at one independent
variable (such as sales pricing or advertising expenses) whereas
multiple regressions consider two or more variables (such as sales
pricing and advertising expenses together). Regression analysis is
very popular for forecasting sales since it helps us find the right fit
over a range of observations. For example, if we plot out the
following observations, we can prepare a scatter graph and find the
right fit:
Regression Analysis
  Now that we understand what goes into financial planning, it is time to focus
on how to make the process into a value-added activity. Many organizations
are attempting to re-engineer budgeting practices since budgeting is usually a
non-value added activity; i.e. it does not add value to the decision making
process. The goal is to make the entire financial planning process into a
decision support service within the organization whereby the benefits of the
process exceed the costs.
 In order to fully comprehend the problems associated with budgeting, let's
quickly list the top ten problems with budgeting according to Controller
Making the Magazine:
 1. Takes too long to prepare.
Budgeting 

2. Doesn't help us run our business.
3. Budgets are out-of-date by the time we get them.
Process Work 

4. Too much playing with the numbers.
5. Too many iterations / repetitive tasks within the process.
 6. Budgets are cast in stone in a constantly changing business environment.
 7. Too many people are involved in the budgeting process.
 8. Unable to control budget allocations.
 9. By the time budgets are complete, I don't recognize the numbers.
 10. Budgets do not match the strategic goals and objectives of the organization.
We will now discuss several ways of making budgeting into a value-added activity
within the organization.
  Finally, here are some best practices that can transform budgeting into a
value-added activity:
 1. Budgeting must be linked to strategic planning since strategic decisions usually
have financial implications.
 2. Make budgeting procedures part of strategic planning. For example, strategy
assessments should include historical trends, competitive analysis, and other
procedures that might otherwise take place within the budgeting process.
 3. The Budgeting Process should minimize the time spent collecting and gathering
data and spend more time generating information for strategic decision making.
Ten Best  4. Get agreement on summary budgets before you spend time preparing detail
budgets.
Practices in  5. Automate the collection and consolidation of budgets within the entire
organization. Users should have access to budgeting systems for easy updating.

Budgeting  6. Budgets need to accept changes quickly and easily. Budgeting should be a
continuous process that encourages alternative thinking.
 7. Line item detail in budgets should be based on material thresholds and not rely
on a system of general ledger accounts.
 8. Budgets should give lower level managers some form of fiscal control over what
is going on.
 9. Leverage your financial systems by establishing a data warehouse that can be
used for both financial reporting and budgeting.
 10. Multi-National Companies should have a budgeting system that can handle
intercompany elimination's and foreign currency conversions.
  Summary
Summary  Percent of sales method
 Pro forma statement
 Best practice and things to avoid