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Financial Forecasting
Author's Overview
Developing pro forma statements is a fairly involved process. However, the rewards to students
are high in terms of understanding the interaction of accounting data and financial forecasting.
The development of pro forma financial statements is an integrative exercise, so there is little
reward for a halfway approach. The use of an integrated Excel spreadsheet makes this process a
little more manageable. It should be emphasized than any student intending to start up a small
business will be required to prepare this type of statement for a bank loan or business plan.
Often management students see no reason to master this painstaking exercise, but then they
think they will be entrepreneurs.
The percent-of-sales method, presented at the end of the chapter, is a second approach to
financial forecasting. It is easily understood and quickly mastered, but it has many weaknesses
and does not have the full validity of developing pro forma statements. It is really a matter of
instructor preference.
Chapter Concepts
LO1. Financial forecasting is essential to the strategic growth of the firm.
LO2. The three financial statements for forecasting are the pro forma income statement, the
cash budget and the pro forma balance sheet.
LO3. The percent-of-sales method may also be used for forecasting on a less precise basis.
LO4. The various methods of forecasting enable the firm to determine the amount of new
funds required in advance.
LO5. The process of forecasting forces the firm to consider seasonal and other effects on cash
flow.
Annotated Outline and Strategy
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4-1
4
I. Introduction
A. Financial planning helps managers arrange increased funding requirements to
finance additional assets needed to support changes in marketing strategies and
growth.
B. Profit alone is insufficient to finance significant growth.
C. Financial Forecasts are used to evaluate performance by comparing planed
outcomes against actual results.
D. Lenders frequently require evidence of planning prior to making funds available.
E. Financial planning is necessary not only for success but for survival as well.
II. Constructing Pro Forma Statements: The most comprehensive means of financial
planning is through the development of pro forma financial statements; namely the pro
forma income statement, the cash budget, and the pro forma balance sheet.
PPT Development of Pro Forma Statements (Figure 4-1)
Perspective 4-1: Indicate how the pro forma income statement and cash budget are used to
develop the pro forma balance sheet as presented in Figure 4-1. Then a more detailed coverage
of other tables and schedules can be given.
Finance in Action: Sales Forecasting: Where Marketing and Finance Come Together
Students need to understand that many of the numbers financial managers use in their analysis
are provided by other functional areas in the firm. Sales forecast are usually generated by the
marketing function and projected sales for wheels and casters in Table 4-1 are derived outside
of the finance area. Tesla Motors is given as an example in this box.
A. Pro Forma Income Statement: A projection of how much profit a firm will make
over a specific time period
1. Establish a sales projection
a. Forecast economic conditions
b. Survey sales personnel
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4-2
PPT Establish a Sales Projection (Table 4-1)
Perspective 4-2: Many steps are necessary to convert the sales forecast into production
requirements, cost of goods sold and gross profit. Tables 4–1 through 4–7 are all brought
together into one slide (Table 4-8) to show all the relationships at once in the pro forma income
statement.
2. Determine production needs, cost of goods sold, and gross profits based
on the sales forecast
PPT Stock of Beginning Inventory (Table 4-2)
PPT Production Requirements for Six Months (Table 4-3)
a. Determine units to be produced
+Projected unit sales
+Desired ending inventory
-Beginning inventory
=Production requirements
b. Determine the cost of producing the units
(1) Unit cost = materials + labor + overhead
(2) Total costs = number of units to be produced unit cost
PPT Unit Costs (Table 4-4)
PPT Total Production Costs (Table 4-5)
c. Compute cost of goods sold
(1) Estimate unit sales
(2) Cost of goods sold = unit sales X unit cost (FIFO or LIFO)
d. Compute gross profit
PPT Allocation of Manufacturing Cost and Determination of Gross Profit
(Table 4-6)
PPT Value of ending inventory (Table 4-7)
3. Compute other expenses
a. General and administrative
b. Interest expense
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4-3
4. Finally construct the pro forma income statement
+ Sales revenue
– Cost of goods sold
= Gross profit
– General and administrative expenses
= Operating profit
– Interest expense
= Earnings before taxes
– Taxes
= Earnings after taxes
– Common stock dividends
= Increase in retained earnings
B. Cash Budget: A summary of expected cash receipts and disbursements for a specific
period of time
PPT Actual Pro Forma Income Statement (Table 4-8)
1. Estimate cash sales and collection timing of credit sales
PPT Monthly Sales Pattern (Table 4-9)
PPT Monthly Cash Receipts (Table 4-10)
PPT Component Costs of Manufactured Goods (Table 4-11)
2. Forecast cash payments
a. Payments for materials purchase according to credit terms
b. Wages
c. General and administrative expenses
d. Capital expenditures
e. Principal payments
f. Interest payments
g. Taxes
h. Dividends
PPT Summary of Average Monthly Manufacturing Costs (Table 4-12)
PPT Summary of All Monthly Cash (Table 4-13)
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4-4
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4-5
3. Determine monthly cash flow (receipts minus payments)
PPT Monthly Cash Flow (Table 4-14)
PPT Cash Budgeting with Borrowing and Repayment (Table 4-15)
4. Construct cash budget
+ Total receipts (for each month, week, etc.)
– Total payments (for each month, week, etc.)
= Net cash flow (for the period)
+ Beginning cash balance
= Cumulative cash balance
Note: The beginning cash balance for each period of the cash budget is
equal to the cumulative cash balance of the previous period in the
absence of borrowing or investing of cash balances.
5. Determine cash excess or need for borrowing
+ Desired cumulative cash balance
– Cumulative cash balance (at end of period)
+/– Loan required or cash excess
= Ending cash balance
C. Pro Forma Balance Sheet: An integrated projection of the firm's financial
position based on its existing position, forecasted profitability (from pro forma
income statement), anticipated cash flows (cash budget), asset requirements and
required financing
1. Construction of pro forma balance sheet
a. Assets (source of information)
(1) Cash – (cash budget)
(2) Marketable securities – (previous balance sheet and cash
budget)
(3) Accounts receivable - (sales forecast, cash budget)
(4) Inventory – (COGS computation for pro forma income
statement)
(5) Plant and equipment – (previous balance sheet + purchases
- depreciation)
b. Liabilities and Net Worth
(1) Accounts payable – (cash budget work sheet)
(2) Notes payable – (previous balance sheet and cash budget)
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4-6
(3) Long-term debt – (previous balance sheet plus new issues)
(4) Common stock – (previous balance sheet plus new issues)
(5) Retained earnings – (previous balance sheet plus projected
addition from pro forma income statement)
Perspective 4-3: Use Figure 4-2 to reinforce the pattern used to arrive at the pro forma
balance sheet.
PPT Development of a Pro Forma Balance Sheet (Figure 4-2)
PPT Pro forma Balance Sheet (Table 4-16)
PPT Explanation of Pro Forma Balance Sheet (Table 4-17)
Perspective 4-4: Table 4-17 is the last piece in the puzzle in that it represents the actual pro
forma balance sheet. The amounts in the 10 accounts in the table can be clarified in the
explanations following the table in the text.
Finance in Action: Pro Forma Financial Statements: A Critical Tool For Entrepreneurs
This box reemphasizes what we have stated in the overview and provides some important
reasons why pro-forma financial statements are important. A point often overlooked by
entrepreneurs is that a firm can only grow if it has enough money available to increase its
current and fixed assets.
III. Percent-of-Sales Method: Shortcut, less exact, alternative for determining financial
needs
A. Assumes that balance sheet accounts maintain a given relationship to sales
Assets
= % of sales
Current Sales
PPT Balance Sheet and Percentage-of-Sales Table (Table 4-18)
Perspective 4-5: Table 4-18 can be tied in with formula 4-1 to demonstrate the
percent-of-sales method.
B. Project asset levels on basis of forecasted sales (percent of sales of each asset
forecasted sales)
C. Project spontaneous financing: Some financing is provided spontaneously when
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4-7
asset levels increase; for example, accounts payable increase when a firm buys
additional inventory on credit.
D. Project internal financing from profit = profit margin forecasted sales
dividend payout ratio.
E. Determine external financing = required new assets to support sales -
spontaneous financing – the change in retained earnings. The relationship is
expressed as follows:
Where:
A/S = percentage relationship of variable assets to sales
S = change in sales
L/S = percentage relationships of variable liabilities to sales
P = profit margin
S2 = new sales level
D = dividend payout ratio.
Perspective 4-6: Students often get confused about companies operating at full capacity and
those operating at less than full capacity. Be sure to emphasize the point that when at full
capacity, a company cannot increase output without adding more fixed costs. However when
operating at less than full capacity, the firm can produce more goods without making additional
investments in plant and equipment.
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4-8
2
Required new funds = ( ) ( ) (1 )
A L
S S D
PS
S S
D - D - -
