CHAPTER 14

Financial Forecasting, Planning,

and Budgeting
CHAPTER ORIENTATION
This chapter is divided into two sections. The first section includes an overview of the role
played by forecasting in the firm’s planning process. The second section focuses on the
construction of detailed financial plans, including budgets and pro forma financial statements
for future periods of the firm’s operations. A budget is a forecast of future events and provides
the basis for taking corrective action and can also be used for performance evaluation. The
cash budget and pro forma financial statements provide the necessary information to determine
estimates of future financing requirements of the firm. These estimates are the key elements in
our discussion of financial planning and budgeting.

CHAPTER OUTLINE

I. Financial forecasting and planning

A. The need for forecasting in financial management arises whenever the future
financing needs of the firm are being estimated. There are three basic steps
involved in predicting financing requirements.
1. Project the firm’s sales revenues and expenses over the planning period.
2. Estimate the levels of investment in current and fixed assets which are
necessary to support the projected sales level.
3. Determine the financing needs of the firm throughout the planning
period.
B. The key ingredient in the firm’s planning process is the sales forecast. This
forecast should reflect (l) any past trend in sales that is expected to continue and
(2) the effects of any events which are expected to have a material effect on the
firm’s sales during the forecast period.
C. The traditional problem faced in financial forecasting begins with the sales
forecast and involves making forecasts of the impact of predicted sales on the
firm’s various expenses, assets, and liabilities. There are a number of
techniques that can be used to make these forecasts:

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 1. The percent of sales method involves projecting the financial variable as
a percent of projected sales.
2. A slightly more refined technique involves the use of a scatter diagram
in which the financial variable is plotted against corresponding levels of
sales (or another predictor variable). A line is then visually fitted to the
scatter plot and is used to predict the financial variable.
3. Regression analysis represents a method for mathematically "fitting" a
line to a scatter plot. The resulting equation can then be used to predict
the level of the subject financial variable. The regression method can be
used whenever there is a single "predictor" variable (referred to as the
independent variable, e.g., firm sales) and a single "predicted" variable
(referred to as the dependent variable, e.g., firm inventories).
Furthermore, a multiple regression analysis can be used whenever more
than one predictor (independent) variable is used to predict a single
financial variable.
II. Profitability, Dividend Policy, and Discretionary Financing Needs
A. A firm’s Discretionary Financing Needs (DFN) is the amount of financing the
firm needs to raise from discretionary (non-spontaneous) sources in order to
finance its assets.
B. Spontaneous sources of financing include accounts payable and other liabilities
(e.g., wages payable) that arise “spontaneously” as the firm conducts its
business plus the firm’s net income less any dividends it pays. Consequently,
the firm’s dividend policy has a direct impact on its sources of spontaneous
financing and consequently its needs for discretionary financing (DFN).
III. Revenue Growth, DFN, and the Sustainable Rate of Growth
A. Revenue growth has two effects on DFN. First, as revenues grow this requires
that the firm invests in additional working capital (current assets less current
liabilities). Furthermore, with growing revenues the firm’s profits generally
increase with the effect of increasing the availability of funds to be retained and
reinvested in the business.
B. The rate of growth in revenues that the firm can sustain (i.e., provide the needed
financing) from spontaneous sources, the retention of earnings, and new
discretionary financing that maintains the firm’s ratio of debt to assets is
commonly referred to as the firm’s Sustainable Rate of Growth. If we define b
to represent the proportion of firm earnings that is retained and reinvested in the
business and ROE as the rate of return earned on equity, then the Sustainable
Rate of Growth can be calculated as follows:
Sustainable Rate of Growth = ROE (1-b)

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VI. Financial planning and budgeting
A. In general, a business will use four types of budgets: physical, cost, profit, and
cash.
1. Physical budgets include budgets for unit sales, personnel or manpower,
unit production, inventories, and actual physical facilities. They are also
used as a basis for generating cost and profit budgets.
2. Cost budgets are prepared for every major expense category of the firm,
such as manufacturing or production cost, selling cost, and
administrative cost.
3. The profit budget is prepared based upon information generated from
the sales budget and cost budget.
4. The cash budget is generated by converting all budget information
previously discussed into a cash basis.
B. The cash budget represents a detailed plan of future cash flows and can be
broken down into four components: cash receipts, cash disbursements, net
change in cash for the period, and new financing needed. Cash budgets can
also be either fixed or variable.
1. In a fixed cash budget, cash flow estimates are made for a single set of
sales estimates.
2. The variable cash budget involves the preparation of several budgets
with each budget corresponding to a different set of sales estimates.
This budget fulfills the two following basic needs:
a. The variable budget gives management more information on the
range of possible financing needs of the firm.
b. Management is provided with a standard against which it can
measure the performance of subordinates responsible for various
cost and revenue items contained in the budget.
C. Although no strict rules exist, as a general rule, the budget period shall be long
enough to show the effect of management policies, yet short enough so that
estimates can be made with reasonable accuracy. For instance, the capital
expenditure budget may be properly developed for a 10-year period while a
cash budget may cover only 12 months.

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 ANSWERS TO
END-OF-CHAPTER QUESTIONS

14- 1. This rather simplistic forecast method assumes no other information is available which
would indicate a change in the observed relationship between sales and the expense
item, asset, or liability being forecast. Furthermore, the percent of sales method works
best for projected sales levels that are very close to the base level sales used to
determine the "percent of sales." The greater the difference in predicted and base level
sales, in general, the less accurate will be the percent of sales forecast.

14- 2. The probable effect on cash flows would be as follows:

a. increased cash inflow from sales but increased cash outflow to finance needed
increases in inventories and other assets.

b. increased supply of available cash.

c. decreased cash inflow.

d. immediate decrease in cash inflows (or a cash outflow).

14- 3. A cash budget can also be used to determine the amount of excess cash on hand that
will not be needed to finance future operations. This excess cash can then be invested
in securities or other profitable alternatives.

14- 4. The careful budgeting of cash is of particular importance to a seasonal operation

because cash flows are not continuous. The availability of cash resources must be
carefully planned so the normal operation of the firm can be continued during slow
periods. In addition, it is important to plan for future cash needs so that excess funds
may be invested.

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 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

14- 1. 2008 % of Sales 2009

Sales $12,000,000 $15,000,000
Net Income 1,200,000 2,000,000
Current Assets 3,000,000 25% 3,750,000
Net fixed assets 6,000,000 50% 7,500,000
Total $ 9,000,000 $11,250,000
Liabilities and Owner’s Equity
Accounts payable $3,000,000 25% $3,750,000
Long-term debt 2,000,000 NA 2,000,000
Total Liabilities 5,000,000 5,750,000
Common stock 1,000,000 NA 1,000,000
Paid-in capital 1,800,000 NA 1,800,000
Retained earnings 1,200,000 3,200,000
Common equity 4,000,000 6,000,000
Total $9,000,000 $11,750,000
DFN = $(500,000)

14-2. a) Calculating the A/R balance for the end of April:

DATA
Credit sales 50%
Collection in the month after the sale 50%
Collection two months after the sale 50%

January February March April

Sales 15,000 20,000 25,000 30,000
Credit sales 7,500 10,000 12,500 15,000

Uncollected accounts receivable from sales in March (half

of March sales) $ 6,250
Uncollected account receivable from sales in April (half of
April sales) 15,000
Accounts receivable at the end of April $21,250

b) Cash realized during April from sales and collections:

Cash sales $15,000
Credit sales 15,000
Accounts receivable at the beginning of the month (end of
March) 17,500
Accounts receivable at the end of the month 21,250
Cash collected $26,250

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14- 3. Based upon the projections made, Sambonoza can expect to have total assets next year
equal to $1.8 million made up of the $1 million in fixed assets plus $800,000 (.2 x $4
million) in current assets. These assets will be financed by known sources of funding
comprised of $900,000 in common equity [$800,000 + (.5)(.05)($4 million) =
$900,000], plus payables and trade credit equal to 10% of projected sales ($400,000)
which totals $1.3 million. This leaves $500,000 ($1.8 million - $1.3 million), which
will need to be raised to meet the financing needs of the firm.

14- 4. Instructor’s Note: This is an introductory percent of sales financial forecasting

problem. Students should be able to solve it after a first reading of the chapter.
a. Projected Financing Needs = Projected Total Assets
= Projected Current Assets + Projected Fixed Assets
$5m
= x $20 m + $5m + $.1m = $11.77m
$15m

b. DFN = Projected Current Assets + Projected Fixed Assets

- Present LTD - Present Owner’s Equity
- [Projected Net Income - Dividends]
- Spontaneous Financing
$5m
= x $20m + $5.1m - $2m - $6.5m
$15m
$1.5m
- [.05 x $20m - $.5m] - x $20m
$15m
DFN = $6.67m + $5.1m - $8.5m - $.5m - $2m = $.77m

c. We first solve for the maximum level of sales for which DFN = 0:
DFN = .1833 SALES - $2.9M = 0
Thus, SALES = $15.82M

The largest increase in sales that can occur without a need to raise "discretionary
funds" is

$15.82M - $15M = $820,000.

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14-5. Given information:
Total asset turnover 1.5 times
Average collection period 15.0 days
Fixed asset turnover 5.0 times
Inventory turnover 3.0 times
Current ratio 2.0 times
Sales $3,000,000
COGS 75% of sales
Debt ratio 50%

Proforma Balance Sheet

Cash $525,000
Accts receivable 125,000
Inventories 750,000
Net fixed assets 600,000
Total assets $2,000,000

Current liabilities $700,000

Long-term debt 300,000
Total liabilities 1,000,000
Common equity 1,000,000
Total liabilities and common equity $2,000,000

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 14- 6. Cash Budget

Nov Dec Jan Feb Mar Apr May June July

Sales $220,000 $175,000 $190,000 $120,000 $135,000 $240,000 $300,000 $270,000 $225,000
Collections:
Month of sale (10%) 19,000 12,000 13,500 24,000 30,000 27,000 22,500
First month (60%) 105,000 114,000 72,000 81,000 144,000 180,000 162,000
Second month (30%) 66,000 52,500 57,000 36,000 40,500 72,000 90,000
Total Collections 190,000 178,500 142,500 141,000 214,500 279,000 274,500
Purchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000
Payments (one-month lag) 72,000 81,000 144,000 180,000 162,000 135,000 90,000
Cash Receipts
(collections) 190,000 178,500 142,500 141,000 214,500 279,000 274,500
Cash Disbursements
Purchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
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Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Tax Deposits 22,500 22,500
Interest on Short-Term
Borrowing (550)
Total Disbursements $102,000 $111,000 $196,500 $210,000 $192,675 $186,950 $120,000
Net Monthly Change $88,000 $67,500 ($54,000) ($69,000) $22,500 $92,050 $154,500
Beginning Cash Balance 22,000 110,000 177,500 123,500 54,500 22,000 169,050
Additional Financing
Needed (Repayment) (55,000) 55,000
Ending Cash Balance $110,000 $177,500 $123,500 $54,500 $ 22,000 $169,050 $323,550
Cumulative Borrowing 0 0 (55,000) 0 0
 1
14- 7. Cash NO
Marketable Securities NO
Accounts Payable YES
2
Notes Payable NO
Plant and Equipment NO
Inventories YES
1
Cash receipts follow sales with a lag related to the payment habits of the firm’s
customers and the firm’s policy regarding payments on its accounts payable.
2
Notes payable may well follow sales if the firm uses a line of credit to finance its
working capital needs (discussed in a later chapter).

14-8. DATA
Current assets 10.0
Net fixed assets 15.0
Total 25.0

Accts payable 5.0

Notes payable 0.0
Bonds payable 10.0
Common equity 10.0
Total 25.0

Sales 25,000,000
Expected sales 40,000,000

a) Proforma Balance Sheet

Current assets 16.0
Net fixed assets 15.0
Total 31.0

Accts payable 8.0

Notes payable 3.0
Bonds payable 10.0
Common equity 10.0
Total 31.0

b) New financing required for the coming year:

Total financing = 3.0

c) See the answer to question 14-1.

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14- 9. a. Estimating Future Financing Needs
Armadillo Dog Biscuit Co., Inc.
Projected Need for Discretionary Financing

Present % of Sales Projected Level

Level ($5m) (Based on $7m Sales)
$2m
Current Assets $2.0m = .40 or 40% .40 x $7m = $ 2.8m
$5m
$3m
Net Fixed Assets $3.0m = .60 or 60% .60 x $7m = $ 4.2m
$5m
Total $5.0m $ 7.0m
$.5m
Accounts Payable $.5m = .10 or 10% .10 x 7m = .7m
$5m
$5m
Accrued Expenses $.5m = .10 or 10% .10 x 7m = .7m
$5m
1
Notes Payable ---- --- Plug Figure = 1.11m
Current Liabilities $1.0m $ 2.51m
Long-Term Debt $2.0m No Change $2.00m
Common Stock .5m No Change .50m
2
Retained Earnings 1.5m $1.5m + .07 x $7m = $ 1.99m
Common Equity $2.0m $2.49m
Total $5.0m $ 7.00m
1
Notes payable is a balancing figure which equals discretionary financing needed, DFN,
which equals: Total Assets - Accounts Payable - Accrued Expenses - Long-Term Debt -
Common Stock - Retained Earnings = $7.0m - $0.7m - $0.7m - $2.0m - $0.5m - $1.99m =
$1.11m.
2
The projected retained earnings is the sum of the beginning balance of $1.5m plus net
income for the period (.07 x $7m) or $1.99 m.

b. Before After
$2m $2.8m
Current Ratio = 2 times = 1.12 times
$1m $2.51m

$3m $4.51m
Debt Ratio = .60 or 60% = .644 or 64.4%
$5m $7.0m

The growth in the firm’s assets (due to the projected increase in sales) was
financed predominantly with notes payable (a current liability). This led to a
substantial deterioration in both the firm’s liquidity (as reflected in the current
ratio) and an increase in its use of financial leverage.

442
 c. The slower rate of growth in sales would have allowed Armadillo to finance a
larger portion of the funds needed using retained earnings. For example, using
the 7% net profit margin, Armadillo would have .07 x $6m = $420,000 it could
reinvest after one-year’s operations plus .07 x $7 million = $490,000 from the
second year’s sales. The total amount of retained earnings over the two years
then would be $910,000 rather than only $490,000 as before. This would mean
that notes payable would be only $1.11m - .42m = $690,000. The resulting
level of current liabilities would be $2.09m. Thus, the post-sales growth
current ratio after two years would be 1.34 ($2.8m/2.09m = 1.34) compared to
1.12 with a one-year growth period. The debt ratio under the two-year growth
period will be only 62% compared to approximately 64% with the single-year
growth period. Thus, the slower growth pace would allow the firm to expand
its assets more gradually, thus requiring less external financing, since more
earnings can be retained.
14-10. Instructor’s Note: This problem differs from the text discussion of "discretionary
financing needed" in that it relies on the projected change in assets rather than the
projected level of total assets. Under these circumstances DFN = ∆TA - ∆SL - ∆RE
where ∆TA = the projected change in total assets which is the amount of new financing
needed (in total); ∆SL = the projected change in spontaneous liabilities; and ∆RE = the
projected change in retained earnings that will be available to finance a portion of the
firm’s needs for new funds.
First, we estimate that the projected change in assets during the coming year will be:
∆TA = .30 ∆Sales
= .30 ($500,000) = $150,000
Thus, total new financing of $150,000 must be obtained from somewhere during the
next year to support the growth in firm sales.
Next, we project the change in spontaneous liabilities (∆SL)
∆SL = .15 ∆Sales
= .15 ($500,000) = $75,000
Finally, we project new retained earnings (∆RE) that will be available to help finance
the firm’s operations during the next year,
∆RE = New Income - Dividends
= .05 x Projected Sales - .04 x Projected Sales
= .01 ($5,500,000)
∆RE = $55,000
Discretionary Financing Needed (DFN) can now be calculated as follows:
DFN = ∆TA - ∆SL - ∆RE
= $150,000 - 75,000 - 55,000
= $20,000
Note that this problem solution works with the change in financing needs rather than totals.
The same solution would result if we projected total assets, total spontaneous financing,
etc. However, in this problem we do not know the existing levels of the liabilities and
owner’s equity accounts. Thus, we cannot use this latter approach to solve this problem.

443
14-11.

Cash Budget for January thru June

Nov Dec Jan Feb Mar Apr May June July
220,000 175,000 100,000 120,000 150,000 300,000 275,000 200,000 200,000
Collections:
Month of sales 20,000 24,000 30,000 60,000 55,000 40,000 40,000
First month 87,500 50,000 60,000 75,000 150,000 137,500 100,000
Second month 66,000 52,500 30,000 36,000 45,000 90,000 82,500
Total collections 173,500 126,500 120,000 171,000 250,000 267,500 222,500
Purchases 65,000 78,000 97,500 195,000 178,750 130,000 130,000 97,500 65,000
Payments 65,000 78,000 97,500 195,000 178,750 130,000 130,000 117,000

Cash Receipts 173,500 126,500 120,000 171,000 250,000 267,500 222,500

(collections)

Cash Disbursements
Payments for Purchases 78,000 97,500 195,000 178,750 130,000 130,000 97,500
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 22,500 22,500
Interest on S-T 600 984 93 0
borrowing
Total Disbursements 108,000 127,500 247,500 209,350 160,984 182,593 127,500

Net Monthly Change 65,500 (1,000) (127,500) (38,350) 89,017 84,907 95,000

Analysis of Borrowing Needs

Beginning Cash Balance 28,000 93,500 92,500 25,000 25,000 25,000 100,573
Ending Cash (No Borrowing) 93,500 92,500 (35,000) (13,350) 114,017 109,907 195,573
Needed(Borrowing) 0 0 60,000 38,350 0 0 0
Loan Repayment 0 0 0 0 89,017 9,334 0
Ending Cash Balance 93,500 92,500 25,000 25,000 25,000 100,573 195,573
Cumulative Borrowing 0 0 60,000 98,350 9,334 0 0

a. Projections of Harrison's financing requirements for the next six months are
found in the table above. The firm expects to borrow $60,000 in March and an
additional $32,350 in April. However, by the end of June the firm will have
retired all its short-term borrowing and have an ending cash balance in excess
of $100,000. If Harrison's sales are 20% higher than anticipated (simply scale
sales projections up to 120% of their projected level) then the cash position is
even better than anticipated. However, if sales are only 80% of projected levels
then the firm will be able to retire all its debt but this will not occur until the
end of June.
b. Yes. Based on the expected set of revenues the ending cash balance for June
exceeds $100,000 and under the low (-20%) and high (+20%) sales revenue
scenarios the ending cash balance is adequate to retire the $20,000 note in June.

Definitions of Terms used in problems 14- 12 and 14- 13:

Return on Equity (ROE) = Net Income / Common Equity

Dividend Payout Ratio (b) = Dividends / Net Income
Sustainable rate of Growth (g*) = ROE ( 1 - b )
Sales growth rate for period t (g) = (Salest+1-Salest) ÷ Salest
Debt-to-assets ratio = Total liabilities ÷ Total Assets

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 Total Assets = Liabilities + Common Equity
14-12. a. Findlay’s sales and inventory balances are plotted in the figure below. Note
that the relationship between the two variables is very nearly linear. However,
the intercept for the relationship is not zero, consequently the percent of sales
projections is going to provide erroneous estimates of future sales.

1,260

1,240
Inventory (000)

1,220

1,200

1,180

1,160

1,140
- 10,000 20,000 30,000
Sales (000)

b. The average of the inventories as a percent of sales ratio for the last five years was
6.39%. Thus, we project inventories for a sales level of $30 million to be
$1,917,000. That is,
Average
Projected
Projected Inventories = percent x
sales
of sales
= .0639 x $30 million = $1,917,000
Similarly, using the most recent year’s percent of sales (5%) we calculate
inventories to be $1,500,000. That is,
Average
Projected
Projected Inventories = percent x
sales
of sales
= .05 x $30 million = $1,500,000
We can make a forecast of inventories using the relationship observed between
sales and inventories in part a by sketching a line through the observed
relationship and extrapolating the line to sales of $30,000,000.

445
 1,500

1,400

1,300

1,200

1,100

1,000
10,000 15,000 20,000 25,000 30,000 35,000
Sales

Using this graphical technique, we see that the level of inventories will probably be just
over $1,300,000. The substantial difference in the percent of sales forecast and the
"true relationship" forecast is a result of the implicit assumption made when using the
percent of sales forecast. That is, the percent of sales forecast is simply a linear
extrapolation of inventories based on sales where the intercept is assumed to be zero.
As we saw in part a, this assumption is not valid for this problem.

14-13 a.
Given:
Sales Growth Rate 20%
COGS/Sales 70%
Operating Expenses/Sales 15%
Depreciation Expense (000) $ 50
Interest Expense (000) $ 10
Tax Rate 35%
Dividends (000) $20.00
Income Statement (000)
2007 2008
Sales $1,500 1800
Cost of Goods Sold (1,050) (1,260)
Gross Profit 450 540
Operating Costs (225) (270)

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 Depreciation Expense (50) (50)
Net Operating Profit 175 220
Interest Expense (10) (10)
Earnings Before Taxes 165 210
Taxes (58) (74)
Net Income $ (107) $ (137)

Dividends $ 20 $ 20
Addition to Retained Earnings $ 87 $ (117)

b.
Given:
Sales Growth Rate 40%
COGS/Sales 70%
Operating Expenses/Sales 15%
Depreciation Expense (000) $ 58
Interest Expense (000) $ 15
Tax Rate 35%
Dividends (000) $20.00

Income Statement (000)

2007 2008
Sales $ 1,500 $ 2,100
Cost of Goods Sold (1,050) (1,470)
Gross Profit 450 630
Operating Costs (225) (315)
Depreciation Expense (58) (58)
Net Operating Profit 167 257
Interest Expense (15) (15)
Earnings Before Taxes 152 242
Taxes 53 85
Net Income $ 99 $ 157

Dividends $ 20 $ 20
Addition to Retained Earnings $ 79 $ 137

447
 SOLUTION TO COMPREHENSIVE PROBLEM
Historical data for Phillips Petroleum: 1986-92

1986 1987 1988 1989 1990 1991 1992

Sales 10,018 10,917 11,490 12,492 13,975 13,259 12,140
Net Income 228 35 650 219 541 98 270
Earnings per share 0.89 0.06 2.72 0.90 2.18 0.38 1.04
Dividends per share 2.02 1.73 1.34 0.00 1.03 1.12 1.12
Number of Common
Shares 259,615,385

Current Assets 2,802 2,855 3,062 2,876 3,322 2,459 2,349

Total Assets 12,403 12,111 11,968 11,256 12,130 11,473 11,468
Current Liabilities 2,234 2,402 2,468 2,706 2,910 2,503 2,517
Long-term Debt 5,758 5,419 4,761 3,939 3,839 3,876 3,718
448

Total Liabilities 10,409 10,289 9,855 9,124 9,411 8,716 8,411

Preferred Stock 270 205 0 0 0 0 359
Common Equity 1,724 1,617 2,113 2,132 2,719 2,757 2,698
Total 12,403 12,111 11,968 11,256 12,130 11,473 11,468

1993 1994 1995 1996 1997

Projected Sales
13,000 13,500 14,000 14,500 15,500

Note to the instructor: Since the answers to parts b through d depend upon the sales projections made here, you may wish to consider
supplying sales forecasts.
 a. Projected Net Income using the percent of sales method.

1986 1987 1988 1989 1990 1991 1992

Sales 10,018 10,917 11,490 12,492 13,975 13,259 12,140
Net Income 228 35 650 219 541 98 270
Net Income/Sales 2.2759% 0.3206% 5.6571% 1.7531% 3.8712% 0.7391% 2.2241%
Average Net 2.4059%
Income/Sales

1993 1994 1995 1996 1997

Projected Net Income 313 325 337 349 373

b. Projected total assets and current liabilities

450

1986 1987 1988 1989 1990 1991 1992

Sales 10,018 10,917 11,490 11,492 13,975 13,259 12,140
Total Assets 12,403 12,111 11,968 11,256 12,130 11,473 11,468
Current Liabilities 2,234 2,402 2,468 2,706 2,910 2,503 2,517

TA/Sales 123.81% 110.94% 104.16% 90.11% 86.80% 86.53% 94.46%

CL/Sales 22.30% 22.00% 21.48% 21.66% 20.82% 18.88% 20.73%

Average TA/Sales 99.54%

Average CL/Sales 21.13%

1993 1994 1995 1996 1997

Projected Total Assets 12,941 13,438 13,939 14,443 15,428
Projected C. Liabilities 2,746 2,852 2,958 3,063 3,274
 c. Projected discretionary financing requirements for 1993-97.

1993 1994 1995 1996 1997

Total Assets 12,941 13,438 13,936 14,434 15,429

Current Liabilities 2,746 2,852 2,958 3,068 3,274

Non-current 5,894 5,894 5,894 5,894 5,894

Liabilities*

Preferred Stock 359 359 359 359 359

Common Equity** 2,720 2,754 2,800 2,858 2,940

451

Discretionary
Financing
Needed*** 1,221 1,579 1,925 2,259 2,961

* Note that all non-current liabilities for 1992 equal total liabilities of $8,411 less current liabilities of $2,517 or $5,894.

** Common dividends = $1.12 x the number of common shares outstanding in 1992 = 290,769,231

Thus, Common Equity (1993) = Common Equity (1992) + NI (1993) - Dividends (1993).

*** Discretionary Financing Needed = Projected Total Assets - Current Liabilities - Long-term Debt - Preferred Stock - Common
Equity
 ALTERNATIVE PROBLEMS AND SOLUTIONS
ALTERNATIVE PROBLEMS
14- 1A. (Financial Forecasting) Hernandez Trucking Company is evaluating its financing
requirements for the coming year. The firm has been in business for only three years,
and the firm’s chief financial officer (Eric Stevens) predicts that the firm’s operating
expenses, current assets, and current liabilities will remain at their current proportion of
sales.
Last year Hernandez had $20 million in sales with net income of $1 million. The firm
anticipates that next year’s sales will reach $25 million with net income rising to $2
million. Given its present high rate of growth, the firm retains all its earnings to help
defray the cost of new investments.
The firm’s balance sheet for the year just ended is found below:

Hernandez Trucking Company, Inc. Balance Sheet

12/31/00 % of Sales
Current assets $4,000,000 20%
Net fixed assets 8,000,000 40%
Total $12,000,000

Liabilities and Owners’ Equity

Accounts payable $3,000,000 15%

Long-term debt 2,000,000 NA
Total liabilities $5,000,000
Common stock 1,000,000 NA
Paid-in capital 1,800,000 NA
Retained earnings 4,200,000
Common equity 7,000,000
Total $12,000,000

Not applicable (NA). This figure does not vary directly with sales and is assumed to
remain constant for purposes of making next year’s forecast of financing
requirements.

Estimate Hernandez’ total financing requirements for 2001 and its net funding
requirements (discretionary financing needed).

451
14- 2A. (Pro Forma Accounts Receivable Balance Calculation) On March 31, 2000, the
Floydata Food Distribution Company had outstanding accounts receivable of $52,000.
Sales are roughly 40% credit and 60% cash, with the credit sales collected half in the
month after the sale and the remainder two months after the sale. Historical and
projected sales for Floydata Food are given below:
Month Sales
January $100,000
February 100,000
March 80,000
April (projected) 60,000
a. Under these circumstances, what would the balance in accounts receivable be at the
end of April?
b. How much cash did Floydata realize during April from sales and collections?
14- 3A. (Financial Forecasting) Simpson, Inc. projects its sales next year to be $5 million and
expects to earn 6 percent of that amount after taxes. The firm is currently in the process of
projecting its financing needs and has made the following assumptions (projections):
a. Current assets will equal 15% of sales, while fixed assets will remain at their current
level of $1 million.
b. Common equity is presently $0.7 million, and the firm pays out half its after-tax
earnings in dividends.
c. The firm has short-term payables and trade credit that normally equal 11% of sales
and has no long-term debt outstanding.
What are Simpson’s financing needs for the coming year?
14- 4A. (Financial Forecasting—Percent of Sales) Carson Enterprises is in the midst of its annual
planning exercise. Bud Carson, the owner, is a mechanical engineer by education and has
only modest skills in financial planning. In fact, the firm has operated in the past on a
“crisis” basis with little attention paid to the firm’s financial affairs until a problem arose.
This worked reasonably well for several years, until the firm’s growth in sales created a
serious cash flow shortage last year. Bud was able to convince the firm’s bank to come up
with the needed funds, but an outgrowth of the agreement was that the firm would begin to
make forecasts of its financing requirements annually. To support its first such effort, Bud
has made the following estimates for next year: Sales are currently $18 million with
projected sales of $25 million for next year. The firm’s current assets equal $7 million, while
its fixed assets are $6 million. The best estimate Bud can make is that current assets will
equal the current proportion of sales while fixed assets will rise by $100,000. At the present
time, the firm has accounts payable of $1.5 million, long-term debt of $2 million and
common equity totaling $9.5 million (including $4 million in retained earnings). Finally,
Carson Enterprises plans to continue paying its dividend of $600,000 next year and has a 5%
profit margin.
a. What are Carson’s total financing needs (that is, total assets) for the coming year?
b. Given the firm’s projections and dividend payment plans, what are its discretionary
financing needs?
c. Based on the projections given and assuming that the $100,000 expansion is
fixed assets will occur, what is the largest increase in sales the firm can support
without having to resort to the use of discretionary sources of financing?

452
14.5A. (Pro Forma Balance Sheet Construction) Use the following industry average ratios to
construct a pro forma balance sheet for the V. M. Willet Co.
Total asset turnover 2.5 times
Average collection period
(assume a 360-day year) 10 days
Fixed asset turnover 6 times
Inventory turnover
(based on cost of goods sold) 4 times
Current ratio 3 times
Sales (all on credit) $5 million
Cost of goods sold 80% of sales
Debt ratio 60%
Cash Current liabilities
Accounts receivables Long-term debt
Inventories Common stock plus
Net fixed assets $ Retained earnings $
$ $

14- 6A. (Cash Budget) The Carmel Corporation’s projected sales for the first eight months of
2001 are as follows:
January $100,000 May $275,000
February 110,000 June 250,000
March 130,000 July 235,000
April 250,000 August 160,000
Of Carmel’s sales, 20% is for cash, another 60% is collected in the month following
sale, and 20 percent is collected in the second month following sale. November and
December sales for 2000 were $220,000 and $175,000, respectively.
Carmel purchases its raw materials two months in advance of its sales equal to 70% of
its final sales price. The supplier is paid one month after it makes delivery. For
example, purchases for April sales are made in February, and payment is made in
March.
In addition, Carmel pays $10,000 per month for rent and $20,000 each month for other
expenditures. Tax prepayments for $23,000 are made each quarter beginning in
March.
The company’s cash balance at December 31, 2000, was $22,000; a minimum balance of
$20,000 must be maintained at all times. Assume that any short-term financing needed
to maintain cash balance would be paid off in the month following the month of
financing if sufficient funds are available. Interest on short-term loans (12%) is paid
monthly. Borrowing to meet estimated monthly cash needs takes place at the beginning
of the month. Thus, if in the month of April the firm expects to have a need for an
additional $60,500, these funds would be borrowed at the beginning of April with
interest of $605 (.12 x 1/12 x $60,500) owed for April and paid at the beginning of May.
a. Prepare a cash budget for Carmel covering the first seven months of 2001.
b. Carmel has $250,000 in notes payable due in July that must be repaid or
renegotiated for an extension. Will the firm have ample cash to repay the
notes?

453
14- 7A. (Percent of Sales Forecasting) Which of the following accounts would most likely
vary directly with the level of firm sales? Discuss each briefly.
Yes No Yes No
Cash Notes Payable
Marketable securities Plant and equipment
Accounts payable Inventories

14- 8A. (Financial Forecasting—Percent of Sales) The balance sheet of the Chavez Drilling
company (CDC) follows:
Chavez Drilling Company Balance Sheet for January 31, 2000 ($ millions)

Current assets $15 Accounts payable $10

Net fixed assets 15 Notes payable 0
Total $30 Bonds payable 10
Common Equity 10
Total $30

CDC had sales for the year ended 1/31/00 of $60 million. The firm follows a policy of
paying all net earnings out to its common stockholders in cash dividends. Thus, CDC
generates no funds from its earnings that can be used to expand its operations (assume
that depreciation expense is just equal to the cost of replacing worn-out assets).
a. If CDC anticipates sales of $80 million during the coming year, develop a pro
forma balance sheet for the firm for 1/31/01. Assume that current assets vary as
a percent of sales, net fixed assets remain unchanged, accounts payable vary as
a percent of sales, and use notes payable as a balancing entry.
b. How much “new” financing will CDC need next year?
c. What limitations does the percent of sales forecast method suffer from?
Discuss briefly.
14- 9A. (Financial Forecasting—Discretionary Financing Needed) Symbolic Logic
Corporation (SLC) is a technological leader in the application of surface mount
technology in the manufacture of printed circuit boards used in the personal computer
industry. The firm has recently patented an advanced version of its original path-
breaking technology and expects sales to grow from their present level of $5 million to
$8 million by the end of the coming year. Since the firm is at present operating at full
capacity, it expects to have to increase its investment in both current and fixed assets in
proportion to the predicted increase in sales.
The firm’s net profits were 7% of current year’s sales but are expected to rise to 8% of
next year’s sales. To help support its anticipated growth in asset needs next year, the
firm has suspended plans to pay cash dividends to its stockholders. In years past, a
$1.25 per share dividend has been paid annually.

454
 Symbolic Logic Corporation ($ millions)
Present Level Percent of Sales Projected Level
Current assets $2.5
Net fixed assets 3.0
Total $5.5
Accounts payable $1.0
Accrued expenses 0.5
Notes payable 0.5
Current liabilities $1.5
Long-term debt $2.0
Common stock 0.5
Retained earnings 1.5
Common equity $2.0
Total $5.5

SLC’s payables and accrued expenses are expected to vary directly with sales. In
addition, notes payable will be used to supply the funds needed to finance next year’s
operations and that are not forthcoming from other sources.
a. Fill in the table and project the firm’s needs for discretionary financing. Use
notes payable as the balancing entry for future discretionary financing needed.
b. Compare SLC’s current ratio and debt ratio (total liabilities/total assets) before
the growth in sales and after. What was the effect of the expanded sales on
these two dimensions of SLC’s financial condition?
c. What difference, if any, would have resulted if SLC’s sales had risen to $6
million in one year and $8 million after only two years? Discuss only; no
calculations are required.
14- 10A. (Forecasting Discretionary Financing Needs) Royal Charter, Inc. estimates that it
invests 40 cents in assets for each dollar of new sales. However, 5 cents in profits are
produced by each dollar of additional sales, of which 1 cent can be reinvested in the
firm. If sales rise from their present level of $5 million by $500,000 next year, and the
ratio of spontaneous liabilities to sales is .15, what will be the firm’s need for
discretionary financing? (Hint: In this situation, you do not know what the firm’s
existing level of assets is, nor do you know how those assets have been financed.
Thus, you must estimate the change in financing needs and match this change with the
expected changes in spontaneous liabilities, retained earnings, and other sources of
discretionary financing. Note that spontaneous liabilities are those liabilities that vary
with sales.)

455
14- 11A. (Preparation of a Cash Budget) Halsey Enterprises has projected its sales for the first
eight months of 2001 as follows:

January $120,000 May $225,000

February 160,000 June 250,000
March 140,000 July 210,000
April 190,000 August 220,000

Halsey collects 30% of its sales in the month of the sale, 30% in the month following
the sale, and the remaining 40% two months following the sale. During November and
December of 2000, Halsey’s sales were $230,000 and $225,000, respectively.
Halsey purchases raw materials two months in advance of its sales equal to 75% of its
final sales. The supplier is paid in the month after delivery. Thus, purchases for April
sales are made in February, and payment is made in March.
In addition, Halsey pays $12,000 per month for rent and $20,000 each month for other
expenditures. Tax prepayments of $26,500 are made each quarter beginning in March.
The company’s cash balance as of December 31, 1995, was $28,000; a minimum
balance of $25,000 must be maintained at all times to satisfy the firm’s bank line of
12% per annum (1% per month) to be paid monthly. Borrowing to meet estimated
monthly cash needs takes place at the beginning of the month, but interest is not paid
until the end of the following month. Consequently, if the firm were to need to borrow
$50,000 during the month of April, then it would pay $500 (=.01 x $50,000) in interest
during May. Finally, Halsey follows a policy of repaying any outstanding short-term
debt in any month in which its cash balance exceeds the minimum desired balance of
$25,000.
a. Halsey needs to know what its cash requirements will be for the next six
months so that it can renegotiate the terms of its short-term credit agreement
with its bank, if necessary. To evaluate this problem, the firm plans to evaluate
the impact of a ± 20% variation in its monthly sales efforts. Prepare a six-
month cash budget for Halsey, and use it to evaluate the firm’s cash needs.
b. Halsey has a $200,000 note in July. Will the firm have sufficient cash to repay
the loan?

456
 SOLUTIONS FOR ALTERNATIVE PROBLEMS
14- 1A. 2000 % of Sales 2001
Sales 20,000,000 25,000,000
Net Income 1,000,000 2,000,000
Current Assets 4,000,000 20% 5,000,000
Net fixed assets 8,000,000 40% 10,000,000
Total 12,000,000 15,000,000
Liabilities and Owners’ Equity
Accounts payable 3,000,000 15% 3,750,000
Long-term debt 2,000,000 NA 2,000,000
Total Liabilities 5,000,000 5,750,000
Common stock 1,000,000 NA 1,000,000
Paid-in capital 1,800,000 NA 1,800,000
Retained earnings 4,200,000 6,200,000
Common equity 7,000,000 9,000,000
Total 12,000,000 14,750,000
DFN = 250,000

14- 2A. a. Credit Sales = 40% of Sales

Sales
February 100,000
March 80,000
April (estimated) 60,000
Accounts receivable (3/31/00) 52,000
plus cr sales (April) 24,000
less coll. from February (20,000)
less coll. from March (16,000)
Accounts receivable (4/30/00) 40,000

b. Cash collections (April) = 60% of April Sales + 20% of March Sales

+ 20% of February Sales = 36,000 + 16,000 + 20,000 = $72,000
14- 3A. Based upon the projections made, Simpson can expect to have total assets next year
equal to $1.75 million made up of the $1 million in fixed assets plus $.75 million in
current assets. These assets will be financed by known sources of funding comprised
of the firm’s common equity ($.7 million + $300,000 - $.150 million) plus payables
and trade credit equal to 11% of projected sales ($.55 million) which totals $1.4
million. This leaves $.35 million, which will need to be raised to meet the financing
needs of the firm.

457
14- 4A. Instructor’s Note: This is an introductory percent of sales financial forecasting
problem. Students should be able to solve it after a first reading of the chapter.
a. Projected Financing Needs = Projected Total Assets
= Projected Current Assets + Projected Fixed Assets
= $15,822,222
b. DFN = Projected Current Assets + Projected Fixed Assets
- Present LTD - Present Owners’ Equity
- [Projected Net Income - Dividends] - Spontaneous Financing
DFN = $1,588,889
c. We first solve for the maximum level of sales where DFN = 0:
DFN = .25556 Sales -4.8 million
Thus, SALES = $18,782,282
The largest increase in sales that can occur without a need to raise "discretionary
funds" is
$18,782,282 - $18m = $782,282.
14- 5A.
Cash $ .03m Current Liabilities $.39m
Accounts Receivable .14m Long-Term Debt .81m
Inventories 1.0m Common Equity .80m
Net Fixed Assets .83m
$2.0m $2.0m

14- 6A. a. CASH BUDGET

DATA
January 100,000 May 275,000
February 110,000 June 250,000
March 130,000 July 235,000
April 250,000 August 160,000

458
 The Carmel Corporation Cash Budget Worksheet
Nov Dec Jan Feb Mar Apr May June July
$220,000 $175,000 $100,000 $110,000 $130,000 $250,000 $275,000 $250,000 $235,000
Collections:
Month of sale (20%) 20,000 22,000 26,000 50,000 55,000 50,000 47,000
First month (60%) 105,000 60,000 66,000 78,000 150,000 165,000 150,000
Second month (20%) 44,000 35,000 20,000 22,000 26,000 50,000 55,000
Total Collections 169,000 117,000 112,000 150,000 231,000 265,000 252,000
Purchases 70,000 77,000 91,000 175,000 192,500 175,000 164,500 112,000 0
Payments (1 mo lag) 70,000 77,000 91,000 175,000 192,500 175,000 164,500 112,000
Cash Receipts
(collections) 169,000 117,000 112,000 150,000 231,000 265,000 252,000

Cash Disbursements
Purchases 77,000 91,000 175,000 192,500 175,000 164,500 112,000
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
459

Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Tax Deposits 23,000 23,000
Interest on Short-Term 560 1,291 1,044 579
Borrowing
Total Disbursements $107,000 $121,000 $228,000 $223,060 $206,291 $218,544 $142,579
Net Monthly Change $62,000 ($4,000) ($116,000) ($73,060) $24,709 $46,456 $109,421
Beginning Cash Balance 22,000 84,000 80,000 20,000 20,000 20,000 20,000
Additional Financing 56,000 73,060 (24,709) (46,456) (57,894)
Needed (Repayment)
Ending Cash Balance $84,000 $80,000 $20,000 $20,000 $20,000 $ 20,000 $71,527
Cumulative Borrowing 0 0 56,000 $129,060 $104,351 $57,894 0

b. The firm will not have sufficient funds to cover the $250,000 note payable due in July.
14- 7A. Cash No
Marketable Securities No
Accounts Payable Yes
Notes Payable No
Plant and Equipment No
Inventories Yes

14- 8A. a. Current assets $20.00m Accounts payable $13.33m

Net fixed assets 15.00m Notes payable 1.67m
$35.00m Bonds payable 10.00m
Common equity 10.00m
$35.00m
b. Total financing requirements = $35m—however, spontaneous financing accounts for all but
the $1.67m increase in notes payable (discretionary financing needed).
c. See answer to question 14- 1.

14- 9A.Instructor’s Note: This problem follows the text example very closely and provides an excellent
assigned exercise to accompany a first reading of the chapter.

a. Estimating Future Financing Needs

Symbolic Logic Corporation (SLC), Inc.
Projected Need for Discretionary Financing
Present % of Sales Projected Level
Level ($5m) (Based on $7m Sales)
$2.5m
Current Assets $2.5m = 50% .50 x $8m = $ 4.0m
$5.0m
$3m
Net Fixed Assets $3.0m = 60% .60 x 8m = $ 4.80m
$5m
Total $5.5m $ 8.80m
$1.0m
Accounts Payable $1.0m = 20% .20 x 8m = 1.60m
$5m
$.5m
Accrued Expenses $.5m = 10% .10 x 8m = .80m
$5m
Notes Payable* --- --- Plug Figure 1.84m
Current Liabilities $1.50m $ 4.24m
Long-Term Debt $2.00m No Change $2.00m
Common Stock .50m No Change .50m
Retained Earnings** 1.50m $1.5m + .07 x $8m = $ 2.06m
Common Equity $2.00m $2.56m
Total $5.50m $8.80m
* Notes payable is a balancing figure which equals discretionary financing needed, DFN or: Total
Assets - Accounts Payable - Accrued Expenses - Long-Term Debt - Common Stock - Retained
Earnings = $8.80m - 1.60m - .8m – 2.00m - 2.56m = $1.84m.
** The projected level of retained earnings equals the beginning balance of $1.50m plus net income for the
period (.07 x $8m).
460
 b. Before After
$2.5m $4.0m
Current Ratio = 1.67 times = .94 times
$1.5m $4.24m
$3.5m $6.24m
Debt Ratio = 64% = 71%
$5.5m $8.8m
The growth in the firm’s assets (due to the projected increase in sales) was financed
predominantly with notes payable (a current liability). This led to a substantial
deterioration in both the firm’s liquidity (as reflected in the current ratio) and an increase
in its use of financial leverage.
c. The slower rate of growth in sales would have allowed SLC to finance a larger portion of
the funds needed using retained earnings.

14- 10A. Instructor’s Note: This problem differs from the text discussion of "discretionary financing
needed" in that it relies on the projected change in assets rather than the projected level of total
assets. Under these circumstances, DFN = ∆TA - ∆SL - ∆RE where ∆TA = the projected change
in total assets which is the amount of new financing needed (in total); ∆SL = the projected
change in spontaneous liabilities; and ∆RE = the projected change in retained earnings that will
be available to finance a portion of the firm’s needs for new funds.
First, we estimate that the projected change in assets during the coming year will be:
∆TA = .40 ∆Sales
= .40 ($500,000) = $200,000
Thus, total new financing of $200,000 must be obtained from somewhere during the next year
to support the growth in firm sales.
Next, we project the change in spontaneous liabilities (∆SL)
∆SL = .15 x ∆Sales
= .15 ($500,000) = $75,000
Finally, we project new retained earnings (∆RE) that will be available to help finance the firm’s
operations during the next year,
∆RE = New Income - Dividends
= .05 x Projected Sales - .04 x Projected Sales
= .01 ($5,500,000)
∆RE = $55,000
Discretionary Financing Needed (DFN) can now be calculated as follows:
DFN = ∆TA - ∆SL - ∆RE
= $200,000 - 75,000 - 55,000
= $70,000
Note that this problem solution works with the change in financing needs rather than totals. The
same solution would result if we projected total assets, total spontaneous financing, etc.
However, in this problem, we do not know the existing levels of the liabilities and owners’
equity accounts. Thus, we cannot use this latter approach to solve this problem.

461
14- 11A. Minimum Cash Balance = 25,000
Beginning Cash Balance = 28,000

Historical Sales and Base Case Sales Predictions for Future Sales
January 120,000 May 225,000
February 160,000 June 250,000
March 140,000 July 210,000
April 190,000 August 220,000

Annual Interest
Purchases as a % Sales = 75% Rate = 12.00%
Collections: Current Mo. 1 Mo. Later 2 Mo. Later
30% 30% 40%

462
 a. Cash Budget for January thru June
Nov Dec Jan Feb Mar Apr May June July August
230,000 225,000 120,000 160,000 140,000 190,000 225,000 250,000 210,000 220,000
Collections:
Month of sales 36,000 48,000 42,000 57,000 67,500 75,000 63,000
First month 67,500 36,000 48,000 42,000 57,000 67,500 75,000
Second month 92,000 90,000 48,000 64,000 56,000 76,000 90,000
Total Collections 195,500 174,000 138,000 163,000 180,500 218,500 228,000
Purchases 90,000 120,000 105,000 142,500 168,750 187,500 157,500 112,500 75,000
Payments 90,000 120,000 105,000 142,500 168,750 187,500 157,500 112,500
Cash Receipts 195,500 174,000 138,000 163,000 180,500 218,500 228,000
(collections)

Cash Disbursements
Payments for Purchases 120,000 105,000 142,500 168,750 187,500 157,500 112,500
Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000
463

Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Tax Deposits 26,500 26,500
Interest on Short-Term 0 173 564 545
Borrowing
Total Disbursements $152,000 $137,000 $201,000 $200,750 $219,673 $216,564 $145,045

Net Monthly Change $43,500 $37,000 ($63,000) ($37,750) ($39,173) $1,936 $82,955

Analysis of Borrowing Needs

Beginning Cash Balance 28,000 71,500 108,500 45,500 25,000 25,000 25,000
Ending Cash (No Borrow) 71,500 108,500 45,500 7,750 (14,173) 26,936 107,955
Needed (Borrowing) 0 0 0 17,250 39,173 0 0
Loan Repayment 0 0 0 0 0 1,936 54,487
Ending Cash Balance $71,500 $108,500 $45,500 $25,000 $25,000 $ 25,000 $53,468
Cumulative Borrowing 0 0 0 $17,250 $56,423 $54,487 0

b. Halsey has an ending cash balance on June 30th of $25,000 which is insufficient to cover the repayment of the
$200,000 note.