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Chapter 17 Financial Forecasting and Planning Copyright 2011 Pearson Prentice Hall. All rights reserved.

Slide Contents Learning Objectives 1. An Overview of Financial Planning 2. Developing a Long-term Financial Plan 3. Developing a Short-Term Financial Plan Key Terms Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-2

Learning Objectives 1. Understand the goals of financial planning. 2. Use the percent of sales method to forecast the financing requirements of a firm including its discretionary financing needs. 3. Prepare a cash budget and use it to evaluate the amount and timing of a firm’s short-term financing requirements. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-3

17.1 An Overview of Financial Planning Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Overview of Financial Planning What is the primary objective of preparing financial plans? – To estimate the future financing requirements in advance of when the financing will be needed. The process of planning is critical to force managers to think systematically about the future, despite the uncertainty of future. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-5

An Overview of Financial Planning (cont.) Most firms engage (use) in three types of planning: – Strategic planning, – Long-term financial planning, and – Short-term financial planning Strategic plan defines, in very general terms, how the firm plans to make money in the future. It serves as a guide for all other plans. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-6

An Overview of Financial Planning (cont.) The long-term financial plan generally encompasses a period of one to three/five years and incorporates estimates of the firm’s income statements and balance sheets for each year of the planning horizon. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-7

An Overview of Financial Planning (cont.) The short-term financial plan has got a period of one year or less and is a very detailed (particular) description of the firm’s anticipated (forecasted) cash flows. The format typically used is a cash budget, which contains revenue projections and expenses in the month in which they are expected to occur for each operating unit of the company. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-8

17.2 Developing a Long-Term Financial Plan Copyright 2011 Pearson Prentice Hall. All rights reserved.

Developing a Long-Term Financial Plan Forecasting a firm’s future financing needs using a long-term financial plan can be thought of in terms of three basic steps: 1. Construct a sales forecast 2. Prepare pro-forma financial statements 3. Estimate the firm’s financing needs Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-10

Developing a Long-Term Financial Plan (cont.) Step 1: Construct a Sales Forecast – Sales forecast is generally based on: 1. past trend in sales; and 2. the influence of any anticipated events that might materially affect that trend. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-11

Developing a Long-Term Financial Plan (cont.) Step 2: Prepare Pro Forma Financial Statements – Pro forma financial statements help forecast a firm’s asset requirements needed to support the forecast of revenues (step 1). – The most common technique is percent of sales method that expresses expenses, assets, and liabilities for a future period as a percentage of sales. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-12

Developing a Long-Term Financial Plan (cont.) Step 3: Estimate the Firm’s Financing Needs – Using the pro forma statements we can extract (introduce) the cash flow requirements of the firm. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-13

Financial Forecasting Example Table 17-1 illustrates how Ziegen, Inc. uses the percent of sales method to construct pro forma income statement and pro forma balance sheet. The company uses the three-step approach to financial planning. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-14

Financial Forecasting Example (cont.) Step 1: Forecast Revenues and Expenses – Zeigen’s financial analyst estimate the firm will earn 5% on the projected sales of 12 million in 2010. – Zeigen plans to retain (keep) half of its earnings and distribute the other half as dividends. – See Table 17-1 Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-15

Financial Forecasting Example (cont.) Step 2: Prepare Pro Forma Financial Statements – The firm’s need for assets to support firm sales is forecasted using percent of sales method, where each item in the balance sheet is assumed to vary in accordance with its percent of sales for 2010. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-16

Financial Forecasting Example (cont.) Step 3: Estimate the Firm’s Financing Requirements – This involves comparing the projected level of assets needed to support the sales forecast to the available sources of financing. – In essence, we now forecast the liabilities and owner’s equity section of the pro forma balance sheet. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-17

Financial Forecasting Example Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-18

Sources of Spontaneous Financing – Accounts Payable and Accrued Expenses Accounts payable and accrued expenses are typically the only liabilities that vary directly with sales. Accounts payable and accrued expenses are referred to as sources of spontaneous financing. The percent of sales method can be used to forecast the levels of both these sources of financing. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-19

Sources of Discretionary Financing Raising financing with notes payable, longterm debt and common stock requires managerial discretion and hence these sources of financing are called discretionary sources of financing. The retention of earnings is also a discretionary source as it is the result of firm’s discretionary dividend policy. Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-20

Summarizing Ziegen’s Financial Forecast (cont.) Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-21

Summarizing Ziegen’s Financial Forecast Discretionary Financing Needs (DFN) {Total Financing Needs} less {Projected Sources of Financing} { 7.2 m (increase in assets)} – { 2.4m in spontaneous financing 2.5m in short and long-term debt 1.8 million in equity} 7.2 million - 6.7 million 500,000 Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-22

Summarizing Ziegen’s Financial Forecast (cont.) The firm has to raise 500,000 with some combination of borrowing (short-term or long-term) or the issuance of stock. Since they require a managerial decision, they are referred to as the firm’s discretionary financing needs (DFN). Copyright 2011 Pearson Prentice Hall. All rights reserved. 17-23

An Overview of Financial Planning (cont.) Most firms engage (use) in three types of planning: -Strategic planning, -Long-term financial planning, and -Short-term financial planning Strategic plan defines, in very general terms, how the firm plans to make money in the future. It serves as a guide for all other plans.

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