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.

Topics Covered: Past lessons from Chapters 1 and 2, transitioning to future strategies in business through:
- Financial forecasting
- Planning
- Budgeting

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.

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.

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.

Examine Historical Data: Identify trends and patterns.
Forecast Sales: Determine projected growth or decline.
Forecast Financial Items: Project amounts that correlate with sales.
Estimate External Funding Required: Assess any funding needed based on forecasts.
Evaluate Shortfalls or Surpluses: Determine financial strategies to address any gaps in funding.

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.

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.
Balance Sheet Examination:
- Investigate current asset trends and liabilities.
- Questions arise regarding declining cash balances and increasing accounts payable.
Sales Forecasting:
- A projected sales growth of 25% for R and E Supplies, requiring input from various departments.
Ratio Analysis Tied to Sales:
- Historical ratios from 2018-2021 assist in projecting future financial norms.
Estimating Non-Sales Related Variables:
- Availability of capital budgets and previously established debt influences forecasts.
Evaluate Needs for External Financing:
- Initial calculations indicate $1.4 million in external funding required compared to $500,000 loan request.

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.

Pro Forma Statements: Provide overall planning structure.
Cash Flow Forecasts: Highlight sources and uses of cash with a focus on cash operations.
Cash Budgets: Detail projected cash collections and disbursements.

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.

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.

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.