Higgins_13e_Ch_03_Accessible

Chapter 3: Financial Forecasting

• Authors: Robert C. Higgins, Jennifer L. Koski, Todd Mitton

• 13th Edition, © 2023 McGraw Hill, LLC.

• The chapter discusses financial forecasting, planning, and budgeting as vital components of financial management.

Introduction to Financial Forecasting

• Topics Covered: Past lessons from Chapters 1 and 2, transitioning to future strategies in business through:

  • Financial forecasting

  • Planning

  • Budgeting

Importance of Financial Forecasting

• Financial forecasting is crucial for various reasons:

  • Language of business often revolves around financial terms.

  • Assessing financial feasibility is paramount in planning.

  • It helps maintain consistency in achieving internal goals.

  • Prepares businesses for different possible outcomes.

Pro Forma Statements

• Definition: Pro forma financial statements predict the future state of financial documents.

  • Purpose: Estimate future external funding needs.

  • External Funding Required = Total Assets - (Liabilities + Owners’ Equity)

  • Often referred to as the "plug" in financial planning.

Percent of Sales Method

• This approach forecasts future sales and links other components of the income statement and balance sheet to sales projections.

  • Is effective for variable costs and current assets but less so for fixed assets.

Steps to Creating Pro Forma Financials

1. Examine Historical Data: Identify trends and patterns.

2. Forecast Sales: Determine projected growth or decline.

3. Forecast Financial Items: Project amounts that correlate with sales.

4. Estimate External Funding Required: Assess any funding needed based on forecasts.

5. Evaluate Shortfalls or Surpluses: Determine financial strategies to address any gaps in funding.

Case Study: R and E Supplies

• Business Overview: R and E Supplies is a wholesaler in plumbing and electrical supplies.

• Current Situation: Requesting a loan increase from $50K to $500K due to growth-related cash flow issues.

• Pro forma statements needed to justify the loan request.

Step-by-step Analysis for R and E Supplies

1. Historical Data Review:

   • Analyze recent financial statements to identify profitability trends.

   • Income statement review from 2018 to 2021 highlights growth in sales and variations in expenses.

2. Balance Sheet Examination:

   • Investigate current asset trends and liabilities.

   • Questions arise regarding declining cash balances and increasing accounts payable.

3. Sales Forecasting:

   • A projected sales growth of 25% for R and E Supplies, requiring input from various departments.

4. Ratio Analysis Tied to Sales:

   • Historical ratios from 2018-2021 assist in projecting future financial norms.

5. Estimating Non-Sales Related Variables:

   • Availability of capital budgets and previously established debt influences forecasts.

6. Evaluate Needs for External Financing:

   • Initial calculations indicate $1.4 million in external funding required compared to $500,000 loan request.

Issues and Considerations

• Lenders are conservative, often unable to take high risks unless expecting returns justify the risk.

• Circular reasoning in estimating interest expense complicates forecasting as it relies on existing debt levels.

• Seasonality impacts cash requirements, suggesting continuous regular evaluations and forecasts.

Financial Forecasting Techniques

1. Pro Forma Statements: Provide overall planning structure.

2. Cash Flow Forecasts: Highlight sources and uses of cash with a focus on cash operations.

3. Cash Budgets: Detail projected cash collections and disbursements.

Case Review: Jill Clair Fashions

• Monthly cash budget illustrations indicating projected surplus or deficits by month, detailing necessary loans and repayments.

  • Summary Actions: Need for a $40,000 loan in July, adjustment in August, surplus in September.

Conclusion: Comparing Techniques

• Each technique shows similar outcomes but serves different strategic purposes:

  • Pro forma statements are preferable for comprehensive planning.

  • Cash budgets excel in operational cash management.

  • Cash flow forecasts balance the two purposes.

Final Note

• Financial forecasting and the preparation of pro forma statements form the bedrock of sound financial management practices, allowing businesses to prepare for future financial landscapes effectively.