Forecasting and Budgeting expenses, assets, and liabilities for a future
period as a percentage of sales.
Why do firms fail financially? 3. Estimate the firm’s financing needs. 1. Undercapitalization 2. Poor control over cash Using the proforma statements we can extract 3. Inadequate expense control the cash flow requirements of the firm. Financial Planning AFN = Additional Funds Needed to support the level of forecasted operations It provides and roadmap for guiding, coordinating, and controlling firms actions to Sources of Spontaneous Financing: achieve goals. Accounts Payable and Accrued Expenses Two Key aspects of Financial Planning: Accounts payable and accrued expenses, referred to as spontaneous financing sources 1. Cash Planning (Cash Budget) are typically the only liabilities that vary directly 2. Profit Planning (Proforma I/S) with sales. The percent of sales method can be 3. Financing Planning (Proforma B/S) used to forecast the levels of both these sources Corporate Financial Planning of financing.
Scenario Analysis – each division might be Sources of Discretionary Financing
asked to prepare three different plans for the Raising financing with notes payable, long term near term future: debt and common stock requires managerial a. Worst Case – making the worst possible discretion and hence these sources of financing assumptions about the company’s are called discretionary sources of financing. products and the state of economy. The retention of earnings is also a discretionary b. Normal Case – making most likely source as it is the result of firm’s discretionary assumptions about the company and dividend policy. economy. c. A best case – each division would be DFN = Proforma Assets required to work out a case base on the Less: Accounts Payable most optimistic assumptions. Accrued Expenses Notes Payable What will Financial Planning accomplish? Long-term debts 1. Interactions – the plan must make explicit Common Equity the linkages between investment Proforma Assets = Total Financing Needs proposals and the firm’s financing choices. DFN = Total Financing Needs – Projected 2. Options – the plan provides an Sources of Financing opportunity for the firm to weigh its Internal and Sustainable Growth various options. 3. Feasibility – the different plans must fit Internal growth is achieved by retained into the overall corporate objective of earnings. maximizing shareholder wealth. 4. Avoiding Surprises – nobody plans to fail, Sustainable growth is achieved if retained but many fail to plan. earnings are supplemented by external debt financing (while D/E ratio is maintained at Developing a Long Term Financial Plan present target) Forecasting a firm’s future financing needs Financial Policy and Growth using a long-term financial plan can be thought of in terms of three basic steps: A firm may not wish to sell any new equity
1. Construct a sales forecast. Debt capacity = the ability to borrow to increase
firm value Sales forecasts are usually based on the analysis of historic data. If a firm borrows to its debt capacity sustainable growth rate can be achieved. An accurate sales forecast is critical to the firm’s profitability. g* = ROE x R / (1 – ROE x R)
2. Prepare pro-forma financial statements. Factors that affect External Financial
Requirements Statements help forecast a firm’s asset requirements needed to support the forecast of 1. Sales Growth (Change in Sales) revenues. The most common technique is the 2. Capital Intensity (A* / S0) percent of sales method that expresses 3. Spontaneous Liabilities to sales ratio 2. If funds required to meet sales forecast (L* / S0) cannot be obtained, management can 4. Profit Margin (M) sale back projected levels of operations 5. Retention Ratio (RR) 3. If required funds can be raised, it is best to plan for their acquisition in advanced. AFN = Required Inc. in Assets – Spontaneous 4. Any deviation from projections needs to Liabilities – Inc. in Retained Earnings be handled to improve future forecasts. AFN = (A* / S0)Ch.S - (L* / S0)Ch.S – M(S1)(RR) Budget How would increase in Sales affect the AFN? Is a forecast of the future. A written estimation 1. Higher Sales – increases asset of the financial performance of a particular requirements, increases AFN. department, a specific project, a business unit 2. Higher Capital Intensity Ratio, (A* / S0)? or an organization. – Increases AFN: Need more assets for Budgeting given sales increase. 3. Pay suppliers in 60 days rather than 30 Primarily the activity of preparing the budgets. days? – Decrease AFN: trade creditors Types of budgeting: supply more capital, (L* / S0) increases. 4. Higher Profit Margin – Increases in funds 1. Zero Based Budgeting – current year’s internally, decreases AFN. budget is prepared from scratch without 5. Higher Retention Ratio – Decreases considering the budget of the previous AFN: due to increase in retained year. earnings. 2. Traditional Budgeting – it considers last year’s budget as the base. The changes Other considerations in Forecasting: Excess are done based on the inflation rate, Capacity consumer demand, market situation etc. Full Capacity Sales = Current Sales Level / 3. Incremental Budgeting – in this, current (Percent of capacity used to generate current year’s budget is prepared by making sales level) changes in the past year’s budget considering the inflation factor. It’s a Target Fixed Assets/Sales = Actual FA / Full quick and easy method of preparing capacity Sales budgets. Required Level of FA = (Target FA/Sales) * 4. Activity Based Budgeting – Activity based (projected Sales) budgeting is a budgeting method where budget is prepared after considering the Implications of AFN cost drivers. It does an in depth analysis 1. If AFN is positive, then you must secure of activities measuring cost. additional financing. Budgetary Control 2. If AFN is negative, then you have more financing than is needed. Is the establishment of Budgets relating to the a. Pay off debts responsibilities of executives of a policy and the b. Buy back stock continuous comparison of the actual with the c. But short term investments budgeted results, either to secure by individual action the objective of the policy or to provide Financing Control – Budgeting and Leverage basis for its revision. The phase in which financial plans are Characteristics: implemented; control deals with the feedback and adjustment processes required to ensure 1. Establishment of budgets the firm is following the right financial path to 2. Analysis of variations accomplish its goals, and, if not, to make 3. Taking remedial actions necessary corrections. 4. Revisions of budgets
Financial Control – a process in which a firm
periodically compares its actual revenues, costs and expenses with its budget. Importance of Budgeting and Control Functions 1. If projected operating results are not satisfactory, management can reformulate its plans.