Finance for Business Workshop (Session-5)

8/6/2019 Finance for Business Workshop (Session-5)

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Finance for Business ProfessionalsFinance for Business ProfessionalsWorkshopWorkshop

SessionSession-- 55

Brief Overview of FinancialBrief Overview of FinancialForecastingForecasting

-- September 24, 2010September 24, 2010

Instructor: Saif RahmanInstructor: Saif Rahman


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What is Financial Forecasting?What is Financial Forecasting?

yy It is a Part of Planning process.It is a Part of Planning process.

yy They are inferences as to what the future may be.They are inferences as to what the future may be.

yy Extends over a time horizon.Extends over a time horizon.

yy Based on:Based on:

i.i. Economic assumptions (interest rate, inflation rate, growth rateEconomic assumptions (interest rate, inflation rate, growth rate

and so on).and so on).

ii.ii. Sales forecast.Sales forecast.

iii.iii. Pro forma statements of Income account and Balance sheet.Pro forma statements of Income account and Balance sheet.

iv.iv. Asset requirements.Asset requirements.

v.v. Financing plan.Financing plan.

vi.vi. Cash BudgetCash Budget2


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Financial ForecastingFinancial Forecasting

PurposePurpose

Financial managers must produce forecasts for theFinancial managers must produce forecasts for the

financial results of corporate plans to:financial results of corporate plans to:

Determine whether the corporate plans will require additional externalDetermine whether the corporate plans will require additional external

financingfinancing

Determine whether the corporate plans will produce surplus cashDetermine whether the corporate plans will produce surplus cash

resources that could be distributed to shareholders as dividendsresources that could be distributed to shareholders as dividends

Assess the financial forecasts to determine the financial feasibility ofAssess the financial forecasts to determine the financial feasibility of

corporate planscorporate plans if poor financial results are forecast, this givesif poor financial results are forecast, this gives

management the opportunity to reexamine and amend corporate plansmanagement the opportunity to reexamine and amend corporate plans

to produce better results before resources and people are committed.to produce better results before resources and people are committed.


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Financial Forecasting ProcessFinancial Forecasting Process

The basis for all financial forecasts is the salesThe basis for all financial forecasts is the salesforecast.forecast.

The most recent balance sheet values are the startingThe most recent balance sheet values are the starting

point.point.

Pro forma (forecast) balance sheets are projectedPro forma (forecast) balance sheets are projectedassuming some relationship with projected salesassuming some relationship with projected sales(constant percentage of sales)(constant percentage of sales)

Current liabilities are usually assumed to rise and fallCurrent liabilities are usually assumed to rise and fallin a constant percentage with salesin a constant percentage with sales we call themwe call themspontaneous liabilitiesspontaneous liabilities because they change without because they change withoutnegotiation with creditors.negotiation with creditors.


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Preparing Comprehensive Pro FormaPreparing Comprehensive Pro Forma

Financial StatementsFinancial Statements

Sales Forecast Production Forecast

Cash Flow Forecast

Pro Forma Income

Statement Pro Forma Balance Sheet

Sales, production and cash flow forecasts are usually done on

a monthly basis whereas pro forma income and balance sheets

are done an annual basis 5


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Financial ForecastingFinancial Forecasting

The Percentage of Sales MethodThe Percentage of Sales MethodThe percentage of sales method involves the following steps:The percentage of sales method involves the following steps:

1.1. Determine which financial policy variables you areDetermine which financial policy variables you areinterested ininterested in

2.2. Set all the nonSet all the non--financial policy variables as a percentage offinancial policy variables as a percentage of

salessales3.3. Extrapolate the balance sheet based on a percentage of salesExtrapolate the balance sheet based on a percentage of sales

4.4. Estimate future retained earningsEstimate future retained earnings

5.5. Modify and reModify and re--iterate until the forecast makes sense.iterate until the forecast makes sense.

This process most often results in a balance sheet that does notThis process most often results in a balance sheet that does notbalancebalance a plug (balancing) amount is the external fundsa plug (balancing) amount is the external fundsrequired (or surplus funds forecast)required (or surplus funds forecast)


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Percent of Sales MethodPercent of Sales Method

Suppose this years sales will total $32 million.

Next year, we forecast sales of$40 million.

Net income should be 5% of sales.

Dividends should be 50% of earnings.

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This yearThis year % of $32m% of $32m

AssetsAssets

Current AssetsCurrent Assets $8m$8m 25%25%

Fixed AssetsFixed Assets $16m$16m 50%50%

Total AssetsTotal Assets $24m$24m

LiabLiab. and Equity. and Equity

Accounts PayableAccounts Payable $4m$4m 12.5%12.5%

Accrued ExpensesAccrued Expenses $4m$4m 12.5%12.5%

Notes PayableNotes Payable $1m$1m n/an/a

Long Term DebtLong Term Debt $6m$6m n/an/a

Total LiabilitiesTotal Liabilities $15m$15mCommon StockCommon Stock $7m$7m n/an/a

Retained EarningsRetained Earnings $2m$2m

EquityEquity $9m$9m

TotalTotal LiabLiab & Equity& Equity $24m$24m 8


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Next yearNext year % of $40m% of $40m

AssetsAssets




Liab. and EquityLiab. and Equity






Retained EarningsRetained Earnings

EquityEquity

Total Liab & EquityTotal Liab & Equity 9


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Predicting Retained Earnings:Predicting Retained Earnings:

Next years projected retained earnings = lastNext years projected retained earnings = last

yearsyears $2 million$2 million, plus:, plus:

projected net incomeprojected net income cash dividendscash dividends

salessales salessales net incomenet income

$40 million x .05$40 million x .05 xx (1(1 -- .50).50)

= $2 million + $1 million == $2 million + $1 million = $3million$3million

xx xx ( 1( 1 -- ))

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AssetsAssets











EquityEquity

Total Liab & EquityTotal Liab & Equity 11


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AssetsAssets











EquityEquity $10m$10m

Total Liab & EquityTotal Liab & Equity $27m$27m 12


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AssetsAssets











EquityEquity $10m$10m

Total Liab & EquityTotal Liab & Equity $27m$27m

How much

Discretionary

Financing

will weNeed?

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Predicting Discretionary FinancingPredicting Discretionary Financing

NeedsNeeds

Discretionary Financing Needed =Discretionary Financing Needed =

projectedprojected projectedprojected projectedprojectedtotaltotal -- totaltotal -- ownersowners

assetsassets liabilitiesliabilities equityequity

$30 million$30 million -- $17 million$17 million -- $10 million$10 million

== $3 million$3 million in discretionary financingin discretionary financing14


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Sustainable Rate of GrowthSustainable Rate of Growth

g* = ROE (1g* = ROE (1 -- b)b) wherewhere

b = dividend payout ratiob = dividend payout ratio

(dividends / net income)(dividends / net income)

ROE = return on equityROE = return on equity

(net income / common equity) or(net income / common equity) or

net income sales common equitynet income sales common equity

sales assets assetssales assets assetsROE = x xROE = x x

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Forecasting PriceForecasting Price

Forecasted price must be consistent with that upon which

any research into demand, including surveys, was based.

For companies with various product offerings, it is

useful to capture differences in the prices of these

offerings. For example, if you are forecasting sales for a car

wash, it is important that you capture the prices of the

different grades of washes. Rather than applying a

blended price of a typical car wash, this is better doneby explicitly forecasting the price and number of each

type of wash and computing revenues for each

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Expansion ofExpansion of

MonetaryMonetary Consumer Consumer

ConditionsConditions ConsumerConsumer ConsumerConsumer Goods/ServiceGoods/Service

ConfidenceConfidence SpendingSpending SectorsSectors IncreasedIncreased

CommercialCommercialBorrowing/Borrowing/

FewerFewer

Fiscal PolicyFiscal Policy BusinessBusiness BusinessBusiness Expansion ofExpansion of DefaultsDefaults

ConfidenceConfidence InvestmentInvestment IndustrialIndustrial

Other FactorsOther Factors Goods/ServiceGoods/ServiceGlobal GrowthGlobal Growth SectorsSectors

Technological InnovationsTechnological Innovations

Drivers of Economic GrowthDrivers of Economic Growth

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Forecasting Sales of Established FirmForecasting Sales of Established Firm

For a firm with a history of sales or where there existsa comparable firm with a history of sales, one canextrapolate trends

nominal growth rate

real growth rate (net out pricing changes and examinequantity of items sold)

could weight period of history more reflective offirms expected performance

growth rate of sales should be adjusted for relevantexpected changes in economic and industry factors

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Forecasting Sales of Established Firm:Forecasting Sales of Established Firm:Use of Quarterly Information and adjustment for seasonalityUse of Quarterly Information and adjustment for seasonality

Make use of quarterly information in forecasting sales

Consider case of Le Chateau (Cdn store sales in Millions) Forecasting Q3 and Q4 sales

Method #1: If one assumes that Q3 and Q4 will experience thesame quarter growth as did Q1 and Q2, then sales shouldincrease by 20%. This means Q3 Canadian sales will rise to$58.3 and Q4 Canadian sales will rise to $62.9. Estimate of totalannual sales is $211.2.

Year Ended Q1 Q2 Q3 Q4 Total

Jan 2003 40.9 49.1

Jan 2002 35.5 39.7 48.7 52.4 176.3

% Change 15% 24%

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Forecasting Sales of Established Firm:Forecasting Sales of Established Firm:Use of Quarterly InformationUse of Quarterly Information

Refinement #1: If same stores sales growth was 15% in Q1and Q2, but number of stores is 2% higher in Q3 and Q4,growth of sales for these quarters should be 17%.

0

Refinement #2: Use updated figures. Le Chateau statedthat first 6 weeks of Q3, Canadian store sales increased16%. Forecast growth at 16%.

Refinement #3: Use information from other firms inindustry. Recent information from another Canadianapparel retailer, La Senza, for its Q3 results indicated no

growth in comparable store sales. Its Q1 and Q2 2002same store figures had been 6.5% ahead of 2001. Onecould cut forecast Q3 and Q4 growth from 16% to 9%.

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Forecasting Gross Margins of Established FirmForecasting Gross Margins of Established Firm

Use of Quarterly InformationUse of Quarterly Information

Analysts often assume for retailers, that cost of goods soldAnalysts often assume for retailers, that cost of goods soldis ais a variable costvariable cost and selling, general and administrativeand selling, general and administrative

costs arecosts are fixedfixed

As shown below, gross margins tend to decrease in weakAs shown below, gross margins tend to decrease in weak

sales periods (when there is very keen competition) ; as ansales periods (when there is very keen competition) ; as anoffsetting effect, SGA is lower in low sales periodsoffsetting effect, SGA is lower in low sales periods

Le Chateau Q1 Q2 Q3

Sales 43.0 51.6 60.4

Gross Margin as % of Sales 34.6% 37.0% 36.6%

Selling, General and Administrative Costs $12.5 $13.4 $15.3

SGA as % of Sales 29.1% 26.0% 25.4%

EBITDA as % of Sales 5.5% 11.0% 11.2%

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Finance for Business Workshop (Session-5)