Financial

Forecasting
CHAPTER THREE

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 Introduction
From the past (Chapters 1 and 2) to the future. . .
◦ financial forecasting
◦ planning
◦ budgeting

This chapter describes techniques that are part of

planning.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 2

 Why financial forecasting?
Much of the language of business forecasting is
financial.
A key issue in any plan is determining whether it is
financially feasible.
Ensure the consistency of internal goals.
Be prepared for various possible outcomes.
Other reasons?

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 3

 Pro Forma Statements
Pro forma financial statements are a prediction of
what financial statements will look like in the
future.
A major purpose is to estimate the future need for
external funding.

External funding required = Total assets – (Liabilities + Owners’ equity)

Why do practitioners call

this the “plug”?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 4

 Percent of Sales
Forecast future sales, and tie other items in income
statement and balance sheet to the sales forecast
Works well for variable costs, most current assets,
and current liabilities
Not generally true for fixed assets

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 5

 Steps to Creating Pro Formas
1. Examine historical data to observe patterns.
2. Forecast sales.
3. Forecast items that grow in proportion to sales.
4. Forecast other financial statement items
5. Estimate external funding required
6. Evaluate how to cover the shortfall (or use the
surplus)

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 6

 Example: R&E Supplies
R&E Supplies, Inc. is a wholesaler of plumbing and
electrical supplies.
R&E has been a customer of Suburban National
Bank for many years.
Average deposits have been $30K.
Short-term renewable loan has been $50K, with a
5-year maturity.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 7

 R&E’s Current Situation
In late 2017, R&E asks that the loan amount for
2018 be increased to $500K.
R&E explains that because of growth, AP has gone
up and cash balances have gone down.
Suppliers are threatening to go to COD.
Why $500K?
Pro forma financial statements will give better
quantitative justification for R&E’s request.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 8

 Step 1: Examine R&E’s
Historical Data
Study R&E’s recent financial statements, Table 3.1.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 9

 TABLE 3.1 Income Statements for R&E Supplies
2014–2017

What’s happening with

R&E’s profitability?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 10

 TABLE 3.1 Balance Sheets for R&E Supplies Why is cash
December 31, 2014–2017 declining?

Why are AP
increasing?

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 11

 Step 2: Forecast R&E’s Sales
R&E projects 25% sales growth
◦ This number should be carefully determined with
input from many in the organization

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 12

 Step 3: Forecast Items that
Grow in Proportion to Sales
See historical and forecasted ratios, Table 3.2.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 13

 TABLE 3.2 Historical Financial Ratios for R&E Supplies
2014–2017 and 2018 Forecast

Are these forecasts

reasonable?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 14

 Step 4: Forecast Other Items
Not Closely Linked to Sales
Prepaid expenses = rough guess
Net fixed assets?
◦ capital budget of $43K already approved
◦ $50K depreciation
◦ $280K = $287K (prior year) + $43K – $50K

Bank loan initially set to $0, but only temporarily.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 15

 Additional Items
Current portion (100) of long-term debt is
contractual (760 = 660 + 100)
Note assumption that new loans = 0
Retained earnings?
◦ Prior year RE + income statement earnings – dividends

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 16

 TABLE 3.3 Pro Forma Income Statement for R&E Supplies,
2018

Why are projected

earnings so low
relative to 2017?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 17

 TABLE 3.3 Pro Forma Balance Sheet for R&E Supplies,
December 31, 2018

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 18

 You try it.
Project pro forma balance sheet items
Trapezoid Corporation
Balance Sheet Income Statement
actual Dec. 31, 2017 pro forma 2018
Current assets 800 Current liabilities 400 Sales 1,000
Net fixed assets 1,000 Long-term liabilities 1,100 COGS 600
Total assets 1,800 Shareholders' equity 300 Operating exp. 100
Total liab. & equity 1,800 Depreciation exp. 100
EBIT 200
Interest exp. 50
Taxes 50
Net income 100

1. Given the pro forma income statement, what would be Trapezoid’s

projected shareholders’ equity for Dec. 31, 2018? Assume a dividend
payout ratio of 25% and no new issues of equity.
2. What would be Trapezoid’s projected net fixed assets for Dec. 31, 2018?
Assume capital expenditures of $200 for 2018, and no sale or disposal of
assets.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 19

 Step 5: Estimating the
External Funding Required
Income statement measures profitability, and
garners most investors’ attention.
The CFO focuses on the balance sheet to estimate
funding needs.
External funding required = Assets – Liabilities and
Equity
In R&E’s first-stage pro formas, EFR = $1,422,000

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 20

 Banker’s Reaction?
EFR = $1.4 million >> $500K!
Not good news about the CFO
Still, AR = $3.6 million, which would provide
security.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 21

 Other Issues: Interest Expense
Circular reasoning
◦ Interest this year is based on debt this year.
◦ But interest this year feeds into earnings this year, and
therefore into balance sheet retained earnings.
◦ Debt this year, needs to be determined by the gap between
assets and liabilities in the balance sheet.

Can try a decent plug, such as basing the interest on

the prior year debt
Can iterate, because the two need to be determined
simultaneously (spreadsheets can handle this).
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 22

 Other Issues: Seasonality
External financing needed is only computed on the
date of the balance sheet.
What about points of time in between?
Do a series of these, quarterly, monthly, etc.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 23

 Pro Forma Statements &
Financial Planning
The initial financial plan, as embodied within the pro
forma, provides the starting point for a discussion
about operations.
If the external amount of financing is too large, what
kinds of operating changes need to be made, relative
to pro forma?
◦ Different level of investment?
◦ Sale of assets?
◦ Different working capital policy?
◦ Cutting costs, with associated impact on revenue?

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 24

 Step 6: Evaluate How to
Cover the Shortfall
One solution would be a $1.4 million loan from Suburban
National Bank.
This might be more than Suburban (or R&E) is
comfortable with.
What if loan is limited to $1 million?
Where to shave $400K?
◦ Tighten up AR, so that DSO drops from 51 to 47?
◦ Increase payables period from 59 to 60?
◦ These might lower sales growth (2520%) and increase costs
(SG&A 1212.5%) from foregone discounts .
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 25

 TABLE 3.4 Revised Pro Forma Income Statement for R&E
Supplies, 2018

How did the revised

plan affect profits?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 26

 TABLE 3.4 Revised Pro Forma Balance Sheet for R&E
Supplies, December 31, 2018

Is everybody
happy now?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 27

 Why Are Lenders So
Conservative?
If expected loan returns are low, lenders cannot accept
high risk.
Look at the lending margin (spread) between paying
depositors and what the loan pays.
So getting a high ROE requires high financial leverage
(like 10-to-1).
Complete default by just a few borrowers can erase a
bank’s earnings.
The aggressive lenders have long since gone bankrupt.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 28

 Forecasting with Spreadsheets
Spreadsheets allow for pro forma financial
statements to be prepared efficiently.
Specifying assumptions explicitly on the
spreadsheet builds flexibility into the model.
Table 3.5 lays out Excel spreadsheet with formulas
for the previous example of R&E Supplies.
(The formulas shown in the table would not be
visible in an actual spreadsheet.)

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 29

 TABLE 3.5 Forecasting with a Computer Spreadsheet: Pro
Forma Financial Forecast for R&E Supplies, 2018

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 30

 TABLE 3.5 Forecasting with a Computer Spreadsheet: Pro
Forma Financial Forecast for R&E Supplies, 2018 (cont.)

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 31

 Building the Spreadsheet:
Key points
Always create formulas by referring to the cells in the
assumptions box.
◦ For example, for sales: = B3+B3*C4
◦ Not: B3+B3*0.25

The spreadsheet can handle the interdependence

between interest expense and external funding
required.
◦ In Excel, go to File | Options | Formulas
◦ In “Calculation Options” click on “Enable iterative
calculation”

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 32

 You try it.
Write Excel equations for pro forma statements.

Write the equations for cells (a) C4, (b) C5, (c) C9, (d) G15, and (e) G17.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 33

 Sensitivity Analysis
“What if” questions:
◦ What if sales growth is only 15%, instead of 25%?
◦ What if COGS is 84% instead of 85%?

Benefit #1: sensitivity analysis produces a range of

outcomes.
Benefit #2: sensitivity analysis induces managers to
prioritize their assumptions according to
importance.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 34

 Scenario Analysis
In practice, forecast variables change together, not
one at a time.
Develop a set of scenarios with different co-
movements.
Each scenario is built around a story or narrative,
such as losing a major customer or facing a new
competitor.

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 35

 Simulation
Assign probability distributions to each major
variable.
Run many pro formas, with the variable values
drawn from a Monte Carlo process.
Advantage: many scenarios
Disadvantage: many managers do not think in
terms of probabilities, and the planning issues are
opaque

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 36

 FIGURE 3.1 Simulating R&E Supplies’ Need for External
Funding: Frequency Chart

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 37

 FIGURE 3.1 Distribution Gallery for Sales Growth

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 38

 Cash Flow Forecasts
A listing of anticipated sources and uses of cash
Based on same assumptions as the pro forma
income statement and balance sheet
EFR = Total uses – Total sources
Easily understood and commonly used
Not as informative as pro forma statements

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 39

 TABLE 3.6 Cash Flow Forecast for R&E Supplies, 2018

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 40

 Cash Budgets
A listing of projected cash receipts and disbursements
over a forecast period
Pro forma statements rely on accrual accounting.
Cash budgets are strictly cash accounting.
Cash budgets require translation from accrual
projections to cash projections.
◦ Adjust for timing of collections and payments.

Example: Jill Clair Fashions’ monthly cash budget

◦ 2%/10 net 30 days – factoring it in
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 41

 TABLE 3.7 Cash Budget for Jill Clair
Fashions 3rd Quarter, 2018

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 42

 TABLE 3.7 Cash Budget for Jill Clair
Fashions 3rd Quarter, 2018 (cont.)

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 43

 TABLE 3.7 Cash Budget for Jill Clair
Fashions, 3rd Quarter, 2018 (cont.)

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 44

 Bottom Line
The last line in Jill Clair Fashions’ monthly cash
budget shows the projected surplus (deficit) for
each month.
The budget projects that the treasurer:
◦ Needs to borrow $40,000 in July
◦ Can reduce loan to $10,000 in August
◦ Will have surplus funds of $30,000 in September

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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 45

 The Techniques Compared
Pro forma statements, cash flow forecasts, and cash
budgets all produce the same results.
Pro forma statements are often best for overall
planning purposes.
A cash budget is good for cash management.
Cash flow forecasts lie somewhere between.
Whichever technique is used, it is only part of the
overall planning process.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 3 46