D076-Study-Guide-Unit-5
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D076-Finance Skills for Managers
Unit 5: Financial Forecasting and Budgeting
Unit Introduction: 1.
The financial manager of a firm has three main tasks: making investment decisions, making financing decisions, and managing working capital. Long-term tasks involve investment and cash flow, while short-term tasks focus on cash flow management. To make strategic decisions for cash and financing, you can use budgeting and financial forecasting.
Budgeting is crucial for short-term cash management at both business and personal levels. It helps predict cash needs and receipts, ensuring living within means and saving for the future. For businesses, maintaining enough cash reserves is vital to avoid short-
term loans.
Financial forecasting is a tool for long-term investment and financing needs. It projects future asset requirements and assesses the gap between the asset and financing sides of the balance sheet. You'll explore the importance of cash budgeting, learn steps to create a business cash budget, and apply these concepts to personal finance. Additionally, financial forecasting, using methods like the percent of sales, estimates long-term assets and financing needs.
Module 8: Budgeting
1. Lesson 28: Introduction to Budgeting
a.
Lesson Introduction
i.
At the beginning of this course, you learned the goals and applications of finance. Personal financial goals aim to maximize individual utility, similar to how firms aim to maximize owner wealth. People often set goals, but many struggle to achieve them. Budgeting is a helpful method to stay focused on goals, whether personal or financial.
In this lesson, you'll explore cash budgeting in organizations and apply these concepts to your personal budget. Budgeting is crucial for both personal and business finances. It involves estimating future income, needs, and cash requirements. Businesses, like individuals, plan budgets over specific periods, considering past earnings, expected growth, and potential expenses.
Budgeting provides an opportunity to assess past challenges and take corrective action. For instance, if you realize you've been spending too much on certain items in your personal budget, budgeting helps you make changes to reach financial goals. Lastly, budgets allow evaluation of
progress toward financial objectives, especially for firms aiming to increase shareholder value. Budgets serve as a proactive plan for the future while helping measure success in reaching financial goals.
b.
Why Cash Budgeting? i.
Cash budgets forecast future events, typically covering a shorter period, often between one month and one year, similar to household budgeting. They help estimate whether a company has enough cash for day-to-day operations. Cash budgets promote accountability, preventing unnecessary cash waste. They are valuable when negotiating with banks and short-term lenders for credit lines, ensuring the firm can meet
monthly cash needs while staying within acceptable borrowing limits. In such situations, the cash budget serves as the primary tool.
c.
Three Major Uses of Cash Budgeting
i.
Cash budgets serve three main purposes: indicating future financing needs, providing a basis for corrective action, and offering data for performance evaluation.
1.
Future Financing Needs:
a.
Cash budgets help identify the timing and amount of future
financing needs. By tracking expected cash inflows and outflows, a company can pinpoint when it will require the most borrowing throughout the year. Small businesses, especially those with limited cash, benefit from understanding their monthly cash position. This knowledge
aids in negotiating and renewing loans and credit lines, demonstrating the ability to repay borrowings.
2.
Corrective Action:
a.
Budgets form the basis for corrective action when actual figures deviate from the budgeted ones. For instance, a small business owner who created a cash budget and negotiated a $3 million line of credit might discover in March that the actual results differ from the forecast. Recognizing a peak borrowing need of $3.6 million in July provides advantages:
i.
Time to negotiate favorable terms with the bank.
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ii.
Increased trust from the bank due to proactive financial planning.
b.
Without a budget, a business owner might face a crisis in July, pleading for additional cash without prior planning. This desperate situation hinders negotiation and undermines the bank's confidence in the business owner.
3.
Performance Evaluation:
a.
Budgets offer a basis for evaluating performance by providing management's estimated cash flow. Variances from the budget signal whether certain managers or divisions are meeting targets, becoming a factor in periodic
performance evaluations.
d.
Key Principles for Effective Budgeting
i.
Budgeting is a valuable tool for achieving personal financial goals. Here are six principles to make budgeting effective:
1.
Know Yourself:
a.
Understand your personality, visions, goals, and plans. Set
important goals and work towards them. Ask yourself about
your accomplishments, sacrifices, and life aspirations. Knowing yourself helps you start with clear goals.
2.
Understand Key Areas:
a.
Comprehend savings, income, and expenses. Effectively budgeting expenses requires first budgeting income and savings. Balance these three key areas.
3.
Develop Strategies:
a.
Develop saving, income, and expense strategies to avoid financial pitfalls. Consider saving a portion of your earnings, improving job skills, or enhancing your attitude towards work. Expense strategies can include tracking spending, avoiding impulse buys, and reducing non-
essential expenses.
4.
Keep Records:
a.
Maintain accurate spending records for tax purposes and insights into spending behaviors. Good records help minimize tax payments.
5.
Choose a Method That Fits:
a.
Find a budgeting method that suits your needs and objectives. People are unique, so there's no one-size-fits-
all approach. Explore different methods for creating, monitoring, and revising a cash budget.
6.
Eliminate Consumer Debt:
a.
Consumer debt is a trap. It's economically costly, hinders growth and savings, and leads to high interest payments. Choose a budgeting approach that helps eliminate consumer debt and minimizes long-term debt. Putting financial decisions in perspective can guide better choices.
e.
Lesson Summary
i.
Budgeting is used to forecast future events, and it focuses on a specific time period in the short term of a few months up to a year.
ii.
Three major uses of budgeting are to predict future financing needs, to provide a basis or corrective action, and to provide information for performance evaluation.
iii.
Six key principles of budgeting personal finance are (1) Know yourself, (2)
Understand the key areas of savings, income, and expenses, (3) Develop
savings, income, and expense strategies, (4) Keep records, (5) Use a method that meets your needs and objectives, and (6) Eliminate consumer debt and minimize long-term debt.
f.
Skill Check
i.
When evaluating a company’s performance, what can variances on a company’s cash budget indicate?
1.
Variances are not useful for performance evaluation of certain managers or divisions.
2.
Variances show that expenses were necessarily greater than income for the budget horizon.
3.
Variances are expected and should never pose a concern for management.
4.
Variances show that certain managers or divisions are not meeting
targets.
a.
Correct! Cash budgets provide a basis for performance evaluation, and significant variance from predicted income,
saving, and expense predictions indicates that
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management has not accurately assessed company operations.
ii.
How far into the future do cash budgets usually forecast?
iii.
Between one month and one year
1.
Correct! Cash budgets are not useful if they forecast less than one
month, and it is not necessary for cash budgets to extend beyond one year in the future.
iv.
Between five and ten years
v.
Between one and two weeks
vi.
Between one and three years
vii.
What are three principles of budgeting that are important to know before beginning the budgeting process?
1.
Improve your credit score; understand the key areas of savings, income, and expenses; and categorize all expenses
2.
Eliminate debt, evaluate your personal financial performance, and consult a certified financial advisor
3.
Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives
a.
Correct! All three of these principles are included in the six principles of budgeting as discussed in the course. The other three principles are know yourself; understand the key areas of savings, income, and expenses; and eliminate
consumer debt and minimize long-term debt.
4.
Know yourself, reduce variance in spending, and consult a certified financial advisor
viii.
What are the three main uses of cash budgets?
1.
Cash budgets show lenders how effective the management of a business is, allow for corrective action when needed, and increase
a firm’s degree of leverage.
2.
Cash budgets allow periodic performance evaluation, inform investors of changes in net income, and allow businesses to gain access to credit.
3.
Cash budgets are used to forecast future financial need, aid in performance evaluation, and show when corrective action is needed.
a.
Correct! A good cash budget is used in these ways to help a firm operate more effectively and efficiently.
4.
Cash budgets help companies know how much to invest in capital,
aid in expense tracking, and predict when additional financing is needed.
2. Lesson 29: Steps to Create a Cash Budget
a.
Creating a Cash Budget
i.
Creating a cash budget involves three simple steps:
1.
Determine Cash Receipts:
a.
Identify the cash coming in during the period, known as cash receipts. This is crucial for both businesses and
individuals to understand and plan their spending based on
their income.
2.
Estimate Cash Disbursements:
a.
Analyze and estimate the cash going out, or expenses. For
businesses, this involves paying suppliers, landlords, and utility bills. Individuals also need to estimate outflows to ensure they are living within their means.
3.
Create the Cash Budget:
a.
Build the budget by starting with the beginning cash balance, then adding the net cash flow. Net cash flow is the difference between cash receipts and cash disbursements. The resulting ending cash balance is vital for businesses to manage financial obligations and for individuals to assess their financial goals. It helps businesses analyze loan balances, borrowing needs, and repayments. On a personal level, knowing your cash position allows you to evaluate your financial goals and make adjustments to your expenses if needed.
b.
Application to Personal Finance
i.
Steps to create a personal budget:
1.
Understand Your Goals:
a.
Start by figuring out your life vision and specific goals, such
as earning a degree, getting a good job, providing for your family, or saving for your children's education.
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2.
Track Your Savings, Income, and Expenses:
a.
Use tools like Quicken or Mint.com to monitor your finances, including annual income, fixed expenditures (e.g., rent, loans), variable expenditures (e.g., food, utilities), and annual savings based on your goals.
3.
Develop Cash Budget (Plan):
a.
Create a cash budget, a plan that balances income, expenses, and savings. Allocate a fixed amount for savings
before paying expenses to ensure consistent progress toward your financial goals.
4.
Implement Your Plan:
a.
Test your budget plan for a month by recording all income and expenses in proper categories. Keep accurate records, and compare the total amounts to your budget for evaluation.
5.
Compare Budget to Actual Spending and Make Necessary Changes:
a.
Compare your actual cash flows to the budget, including savings, income, and spending. Adjust your budget if needed, revising expenses and finding areas to cut costs without compromising savings goals. Avoid reducing savings payments to ensure progress toward your financial
objectives.
c.
Develop a Budget That Works for You
i.
Creating a budget involves various methods, and here are some alternatives:
1.
50/30/20 Rule:
a.
Allocate 50% of your income to needs (like rent or insurance), 30% to wants (such as entertainment or clothing), and 20% to savings. This guideline helps distribute your income effectively.
2.
Alternative Budget Percentages:
a.
Explore different ways to allocate your money by reading an article that suggests budget percentages and offers tips
to ensure you stay within these limits.
3.
Overcoming Challenges:
a.
Sticking to your budget can be tough, especially with unexpected expenses or unplanned purchases. Despite challenges, don't give up! Budgeting may involve sacrifices, but the peace of mind from managing your money wisely is worth it.
Feel free to explore these methods and find the one that works best for you.
d.
Lesson Summary
i.
Cash budgeting in a business involves determining cash inflows, estimating cash outflows, and creating a budget plan.
ii.
While the basic steps for budgeting in personal and business finance are the same, personal budgeting involves understanding financial goals,
tracking cash flows, developing a plan, trying out the plan, and then making necessary adjustments.
e.
Skill Check
i.
What is the correct order of the three steps necessary to create a cash budget?
1.
Estimate cash disbursements, predict expenses, create the cash budget
2.
Determine cash receipts, estimate cash disbursements, create the
cash budget
a.
Correct! Doing these three things in this order can help you
understand your business, understand the timing of cash flows, and keep track of borrowing requirements.
3.
Evaluate income, create the cash budget, estimate cash disbursements
4.
Create the cash budget, determine cash receipts, estimate cash disbursements
ii.
Why is “put $50 in a savings account each month for Christmas gifts” a better budgeting goal than “save money for Christmas gifts”?
1.
Because “save money for Christmas gifts” is unattainable
2.
Because it is specific and measurable
a.
Correct! Effective financial goals provide a specific and concrete target to focus on.
3.
Because it demonstrates a knowledge of the correct steps of cash
budgeting
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4.
Because $50 is a realistic amount to save each month
iii.
Why would a monthly mortgage payment be considered a fixed expense?
1.
Because the payment is the same amount each month
a.
Correct! A mortgage is a fixed expense, meaning that the payment amount is the same each month. Knowing which of your expenses are the same from month to month will help you budget more accurately.
2.
Because you have control over the amount you pay each month
3.
Because the payments vary based upon the cost of the house
4.
Because the bank changes the payment amount each month
iv.
Which action would help you make your budget more efficient?
1.
Create only two categories for expenses: necessary and unnecessary.
2.
Every month, increase the allotted amounts for each category of your budget.
3.
Compare your budgeted cash flows to your actual cash flows, and
then revise the budget if necessary.
a.
Correct! This would allow you to keep your budget updated
and effective so you can make the best use of your money.
4.
Reduce your payments toward savings so you have enough for monthly expenses.
3. Lesson 30: Items Included in Budget Construction
a.
Items in a Cash Budget
i.
Creating a budget involves several steps:
1.
Starting Point:
a.
Begin with the net cash, which is the cash received minus cash spent during a specific period. Add this value to the beginning cash to determine the available cash.
2.
Minimum Cash Check:
a.
Compare the available cash with the minimum needed. This helps identify if there's enough cash for the period or if
there's a shortfall. Extra cash can be used to repay loans, while a shortfall may require borrowing or obtaining financing.
3.
Ending Cash Balance:
a.
After managing cash needs, the result is the ending cash balance in the budget.
ii.
Cash Receipts:
1.
Businesses get cash from sales, but not all sales are immediate cash transactions. Credit sales mean cash is received later when accounts receivable are collected. Collection timelines can vary.
iii.
Cash Disbursements:
1.
To make sales, businesses need materials from suppliers. Payments to suppliers occur at different times. Additionally, businesses have regular monthly expenses like rent, taxes, and other operational costs, which are part of cash budgeting.
iv.
Borrowing:
1.
After calculating net cash, businesses add it to the starting cash balance. If there's a cash shortfall, short-term borrowing may be
necessary. If no borrowing is needed but there's an existing loan, the business needs to make payments to repay the loan.
b.
Cash Budget Example: B&H Inc.
i.
In this example, B&H Inc. is creating a cash budget for January and February. Here's a simplified breakdown:
1.
Step 1: Cash Receipts
a.
January cash receipts: $90,000 (collected from December and January sales)
b.
February cash receipts: $70,000 (collected from January and February sales)
2.
Step 2: Cash Disbursements
a.
January cash disbursements: $95,000 (includes labor costs and material costs for December)
b.
February cash disbursements: $60,000 (includes labor costs and material costs for January)
3.
Step 3: Cash Budget
a.
January net cash flow: -$5,000 (subtracting disbursements from receipts)
b.
February net cash flow: $10,000
c.
January available cash: $20,000 (beginning cash + net cash flow)
d.
February available cash: $35,000
e.
January expected cash balance: -$5,000 (compared to the $25,000 minimum)
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f.
February expected cash balance: $10,000
g.
January borrowing: $5,000 (to meet the $25,000 minimum)
h.
February repayment: $5,000 (using excess cash to repay the loan)
i.
January ending cash balance: $25,000
j.
February ending cash balance: $30,000 (after repaying the
loan)
This budget helps B&H Inc. manage its cash flow, ensuring it meets minimum requirements and uses excess cash wisely.
c.
Categories in a Personal Budget
i.
Creating a personal budget is similar to business cash budgeting. Follow these steps:
1.
Step 1: Track Income and Expenses
a.
Use tools like Excel to manage your budget.
b.
Categorize expenses (e.g., car, food).
c.
Compare budgeted and actual expenses.
2.
Step 2: Estimate Income and Expenses
a.
Analyze past income to predict future inflows (e.g., salary).
b.
Examine spending patterns and plan for future expenses (e.g., vacations, groceries).
c.
Consider various categories like car, housing, health, and entertainment.
3.
Step 3: Assess Monthly Cash Balance
a.
Understand inflows and outflows to evaluate your cash balance.
b.
Identify borrowing or repayment needs.
c.
Check if planned and actual cash flows align.
4.
Note: Be Prepared for the Unexpected
a.
Cars break down, emergencies happen, so allocate money
for unforeseen expenses.
b.
Establish a reserve account or rainy day fund.
c.
Keep it in a safe, liquid place, like an interest-bearing savings account.
5.
Benefits of Personal Budgeting
a.
Takes time and focus but leads to satisfying relationships, lower stress, and better health.
b.
Starting early and staying consistent with your budgeting efforts will pay off in the long run.
d.
Lesson Summary
i.
Cash receipts include cash sales and the collected portion of accounts receivable for businesses and include salary or wages for individuals.
ii.
Cash disbursements may be for suppliers of materials, interest, taxes, and so on for businesses. For individuals, cash disbursements come from
day-to-day expenditures such as groceries, gas, and insurance.
iii.
For both businesses and individuals, understanding cash receipts and disbursements help you know when you need to take out loans and make
loan payments.
e.
Skill Check
i.
Which item is an example of a cash receipt in a personal budget?
1.
A purchase of $53 for groceries and toiletries for the week
2.
A payment of $125 for an annual doctor’s visit
3.
A ski pass worth $65 that your roommate gives you in exchange for borrowing your car
4.
A graduation gift of $100 from your grandmother
a.
Correct! Since this is money, or income, coming into your cash budget, it represents a cash receipt.
ii.
Which item represents an example of a cash disbursement a business might have this month?
1.
A rent check paid and cashed for the warehouse the company uses
a.
Correct! Since this expense is being paid this month and the cash is being withdrawn from the company’s account, this represents an example of a cash disbursement.
2.
A collection of accounts receivable on sales made last month
3.
Interest earned on bank deposits held by the firm.
4.
A purchase of inventory on credit that will be paid off next month
iii.
What three things should be included in a cash budget for a business?
1.
Cash receipts, cash disbursements, and savings
2.
Income, expenses, and savings
3.
Sales, expenses, and borrowing
4.
Cash receipts, cash disbursements, and borrowing
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a.
Correct! All three of these things affect cash flows in a business and should be included in a cash budget.
iv.
Which items are considered cash disbursements for a business?
1.
Cash sales and accounts receivable
2.
Raw materials, rent, administrative expenses, interest, and selling expenses
a.
Correct! These are common products or services that a firm pays cash for during a specified period in order to generate sales.
3.
Rent, accounts receivable, accounts payable, and raw materials
4.
Dividends, investments, cash sales, and tax liabilities
v.
Why are sales not strictly considered to be the same thing as cash receipts?
1.
Sales are not liquid enough to be considered a form of cash flow.
2.
Sales are not measured on a monthly basis and thus cannot be included in a cash budget.
3.
Sales include both cash sales and credit sales.
a.
Correct! Sales made on credit are not considered a cash receipt until the time period in which they are collected.
4.
Sales include expenses outside of the cash budget.
4. Lesson 31: Tracking, Monitoring, and Revising a Budget
a.
Lesson Introduction
i.
Even though we put effort into budgeting, it often won't match the future exactly. That's why it's crucial to track, monitor, and adjust our budgets. Tracking helps us see the actual income and expenses compared to our expectations. Monitoring lets us evaluate if the budget meets our financial
needs and firm requirements. If necessary, we should revise the budget, either within a period or as we move forward. Remember, a budget is just a tool, and its effectiveness depends on accurate inputs. Use past experience and research for the best results.
b.
Tracking Cash Flows
i.
After creating a budget, it's crucial to track it for personal or business financial success. Setting a budget is a good start, but allocating money to categories isn't enough without accountability. Tracking helps recognize
where your money goes, and without it, you can't monitor or revise your budget. To accurately track cash flows, record them daily. Here are a few ways to track expenses:
1.
Envelope Method:
a.
Ideal for cash users.
b.
Label envelopes for different categories (e.g., groceries, gas).
c.
Put the budgeted cash for each category in its envelope.
d.
Spend from the specific envelope for each category.
e.
Track by taking pictures of receipts or keeping a journal.
2.
Spreadsheet Method:
a.
Use a computer spreadsheet application.
b.
Determine cash inflows and create spending categories.
c.
Maintain a daily expense journal.
d.
Regularly update the record for monitoring and revising.
3.
Computer Resources:
a.
Numerous financial tracking and budgeting apps are available.
b.
Examples: Mint.com, Goodbudget, Wally, YNAB, Mvelopes, Quicken, QuickBooks.
c.
Connect software to bank accounts for automatic updates.
d.
Choose based on preferences and convenience.
Remember, a budget is a financial plan, and tracking is essential for its success. No matter the method, make tracking your cash flows a habit to monitor, revise, and achieve your financial goals.
c.
Monitoring Cash Flows
i.
While tracking and monitoring may seem similar, they have distinct differences. Tracking involves keeping a record of your cash flows, while monitoring means using that record to compare cash flows against your target. Monitoring helps identify patterns, changes, and circumstances that may need correction. Regularly checking progress against your budget and objectives is crucial, especially in a business setting where reporting and authorizing mechanisms should be in place for effective budget management.
The monitoring process involves:
1.
Accessing past cash flow records and knowing future expenditure commitments.
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2.
Understanding the remaining balance in the monthly and yearly budget.
3.
Analyzing the budget for forecasting and making adjustments for any seasonal changes.
d.
Revising the Budget
i.
Budget revision is a crucial step that allows you to make changes to your budget and align it with your financial goals. Before revising, it's essential to track and monitor your budget to understand its current functioning, helping you determine necessary expenditures and earnings.
After monitoring, you can identify troubled areas, whether in expenditures or earnings. Issues with earnings might result from lower-than-expected sales or difficulties in collecting accounts receivable promptly. Expenditure
troubles could arise from overspending in unnecessary areas or inefficiencies in production. Look for changes in income and spending patterns to pinpoint potential problems, such as new competitors affecting
sales or seasonal variations in product demand.
Once trouble areas are identified, make gradual changes instead of making numerous adjustments at once. Prioritize changes and implement
them one by one to ensure effectiveness. This approach helps the transition go smoothly, especially with significant changes, and allows others in your company or family to adjust to the new budget. The tracking, monitoring, and revising processes continue to ensure the budget functions correctly and adapts to any observed patterns.
e.
Lesson Summary
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i.
Tracking is the process of recording cash flows.
ii.
Methods of tracking a budget include the envelope method, spreadsheets, and software.
iii.
Monitoring does not just mean checking to make sure that you are not overspending but also analyzing data and looking for any alarming patterns.
iv.
Revisions come after a careful analysis of a budget and should be implemented gradually to make sure that the changes are working.
f.
Skill Check
i.
What is the main reason why it is important to track and record cash flows?
1.
Tracking your cash flows allows you to increase your annual income by knowing your previous income.
2.
Tracking cash flows is important because it is impossible to refinance a loan without tracking your income and expenses.
3.
Tracking your cash flows allows you to recognize where and how your money is spent so you can monitor your cash flows and revise your budget as needed.
a.
Correct! This is the first step in the budgeting process, and it is necessary in order to have an accurate budget going forward.
4.
Tracking cash flows is the main process by which a person can calculate the return they are receiving on their investments.
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ii.
In what situation might the software method of tracking be preferable to the spreadsheet method of tracking?
1.
When a person has a lot of free time and likes to record each cash
flow by hand
2.
When a person needs cash flow information for tax purposes
3.
When a person has a hard time remembering to record their cash flows and when they prefer to use a card to make purchases
a.
Correct! The software method is convenient for busy people who do not want to use cash or record cash flows by hand.
4.
When a person prefers to use cash to make purchases and is very
good about remembering to track cash flows
iii.
What is the purpose of monitoring your cash flows?
1.
Monitoring is the process by which firms prove to lenders that they
have sufficient cash flow to pay back a short-term loan.
2.
Monitoring allows you to evaluate whether your actual cash flows are in line with your goals and to understand when correction or revision is needed.
a.
Correct! If a business did not monitor its budget, then tracking cash flows would be useless, and the business would not know if it was on track to reach its goals.
3.
Monitoring is used to identify the degree to which a business is leveraged so that the business can determine when it will be most profitable to repay outstanding loans.
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4.
Monitoring allows you to implement changes to your budget gradually in such a way that the changes go smoothly and efficiently.
iv.
Which processes help you identify and fix problems in your budget?
1.
Monitoring your budget allows you to identify problems, and then gradual revision and implementation of new processes allow you to fix those problems.
a.
Correct! This assures that the budget is as effective as possible at helping you reach your financial goals.
2.
When you spend too much in a category of your budget, you have
identified a problem, which you can fix by increasing the allotted amount in that category for next month.
3.
Tracking allows you to identify problems, and then subsequent monitoring allows you to fix those problems.
4.
Revision allows you to identify problems in your budget, and then tracking allows you to fix those problems immediately so that you can then monitor progress.
5.
Module Summary
a.
Cash budgeting is used for short-term financial forecasting, and it is useful for keeping track of cash flows and negotiating with lenders such as banks and credit unions.
b.
Budgeting is especially useful for understanding future financing needs, planning corrective actions, and doing performance evaluations.
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c.
The basic steps of cash budgeting are (1) determine cash inflows, (2) estimate cash outflows, and (3) create a budget plan.
d.
Tracking, monitoring, and revising the budget are all necessary to make informed
changes to your budget and reach your financial goals.
6.
Module Quiz
a.
Use the following information to answer questions 1–3.
i.
W&H Company wants to create a cash budget to better manage its cash flows. The financial manager knows that the firm’s labor costs and materials costs are too high for the level of sales each month. The firm also needs to keep better track of its cash flows to assess its need for additional financing through short-term loans.
1.
W&H Inc.’s labor costs each month are an example of which item in a cash budget?
a.
Cash receipt
b.
Net cash for the month
c.
Minimum cash need
d.
Cash disbursement
i.
Correct! This is a cash disbursement for the firm because it represents cash going out during the month to pay employees.
2.
After W&H Inc. has developed a cash budget, what should the company do in the following months?
a.
It should invest any profits in new capital.
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b.
It should wait until the budgeted months are over and then make a new budget for the months following.
c.
It should begin tracking its cash inflows and outflows.
d.
It should monitor its actual cash flows and then revise the cash budget if needed.
i.
Correct! Monitoring and revising the cash budget will allow W&H Inc. to identify and fix any problems that may arise.
3.
Why would creating a cash budget be useful for W&H if the firm needs a loan from the bank or another short-term lender?
a.
Cash budgets help lenders identify a business’s investing strategy going forward, establishing confidence in future operations.
b.
Cash budgets increase the lender’s trust in a firm by demonstrating the firm’s ability to make profits and repay loans.
i.
Correct! Cash budgets are detailed plans that show
creditors that a firm will have enough cash from month to month to support its operations while staying within acceptable borrowing limits. A good cash budget allows creditors to feel secure in lending money to the firm.
c.
Cash budgets allow businesses to seek financing from multiple lenders at a time, increasing borrowing capabilities.
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d.
Cash budgets include a detailed credit report of the business’s operations, which proves that the company can use borrowed funds responsibly.
4.
How do the benefits of knowing the cash position for each period differ between businesses and individuals?
a.
Knowing the cash position allows businesses to know how much to invest each month, while it allows individuals to know how much to save each month.
b.
Knowing the cash position allows businesses to evaluate long-term cash accumulation, while it allows individuals to analyze loan balances.
c.
Knowing the cash position allows individuals to recognize when short-term loans are needed, while it allows business
to know when to repay their vendors.
d.
Knowing the cash position allows businesses to recognize when short-term loans are needed, while it allows individuals to analyze progress toward their personal financial goals.
i.
Correct! Individuals do not usually (and should not) need short-term loans.
5.
What is the difference between tracking and monitoring cash flows?
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a.
Tracking involves using envelopes or computer programs to record cash flows, whereas monitoring involves evaluating cash flows by hand.
b.
Monitoring involves using your tracking record to evaluate cash flows against your target, identify patterns and changes in cash flows, and gauge when correction is needed.
i.
Correct! By accessing cash flow records and knowing the remaining balance in the budget throughout the month and year, you will be able to monitor your budget in a way that will help you reach your financial goals.
c.
Tracking involves using your monitoring record to verify cash flows against your goals, discover changes and patterns in cash flows, and understand when correction may be needed.
d.
Monitoring is revising your budget, whereas tracking is identifying patterns and changes in your cash flows.
Module 9: Financial Forecasting
1. Lesson 32: Introduction to Financial Forecasting
a.
Why Financial Forecasting?
i.
Financial forecasting is a valuable tool for individuals and businesses, providing insights into financial questions and playing a crucial role in
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financial analysis. It involves looking at the present state of a firm, analyzing past events, making reasonable assumptions, and projecting into the future. The goal is not to create a detailed roadmap but to understand what is knowable, considering that the future is uncertain.
The key is to use what we know about the firm today, make informed assumptions, and project future outcomes. While we acknowledge that the future might unfold unexpectedly, financial forecasting helps avoid significant mistakes by focusing on what is knowable. It enables decision-
makers to optimize future decisions based on better-informed insights.
Financial statements and ratio analysis are retrospective, providing information about the past. However, decision-makers are more interested in the future. Financial forecasting allows them to understand how present actions can influence future performance. By combining historical data with anticipated changes or investments, managers can foresee potential challenges and fully grasp the consequences of current decisions. Therefore, careful forecasting is crucial for future success and growth.
b.
Key Forecasts
i.
Profit forecasting involves predicting future earnings by subtracting projected costs from projected sales. Earnings can vary based on factors like production or service costs, depreciation policies, and taxes. To make
an accurate profit forecast, a company needs to analyze economic and non-economic variables affecting sales and operational costs, influencing future profits.
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Another important forecast is the balance sheet forecast, often done alongside income statement projections. With insights into sales growth and profit forecasts, financial managers can create a pro forma balance sheet. This sheet helps understand how financial sources and uses change in a company. Balance sheet forecasting aids management in anticipating the future consequences of the company's financing strategies.
c.
Forecasting Financing Needs
i.
Financial forecasting provides a crucial understanding of future financing needs, especially for growth. Growth often involves increasing assets like working capital (inventory and receivables) and fixed assets (property, plant, equipment). This asset increase requires more financing, either through borrowing or raising equity. The key question forecasting answers
is, given expectations for growth, how much additional financing is needed? This is called discretionary financing needed (DFN) or external financing needed (EFN). Estimating DFN is a primary goal of forecasting, but it relies on assumptions, such as future sales, the relationship between sales and assets, and the firm's profitability. Careful and accurate assumptions are vital because forecasting accuracy depends on
them, following the "Garbage In, Garbage Out" (GIGO) principle. If assumptions are not made carefully, the resulting financial forecast may be inaccurate.
d.
Financial Forecasting versus Budgeting
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i.
Budgeting and financial forecasting are tools used by companies to plan for the future. Budgeting focuses on the company's desired future performance, outlining specific goals. On the other hand, financial forecasting estimates future sales to understand the company's upcoming
financial needs. Budgets provide a detailed representation of expected results, financial position, and cash flows, allowing comparison with actual
results for adjustments. Financial forecasting, in contrast, is a broader estimate of the impact of current business decisions on future performance and guides immediate actions without variance analysis. In summary, budgeting outlines management's desired direction, while financial forecasting assesses if the company is meeting budget goals and predicts its future path.
e.
Lesson Summary
i.
Financial forecasting helps us understand the implications of today’s decisions on future performance.
ii.
DFN is the additional financing needed given a firm’s expectations for future growth, and finding DFN is one of the most important aspects of forecasting.
iii.
Forecasting requires a number of assumptions, and the analyst needs to be careful with these assumptions or else the forecast will be inaccurate.
f.
Skill Check
i.
What role does financial forecasting play in the future success and growth
of a firm?
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1.
Financial forecasts are much less important than cash budgets because cash budgeting is the only essential tool a firm needs to attain long-term success.
2.
Financial forecasting looks backward to provide historical data that
informs future operations.
3.
Financial forecasting supplements historical data with proposed investments or changes to allow for more accurate foresight.
a.
Correct! While understanding the past is key to moving forward, accounting for any proposals in your forecasts highlights where funding may be needed or where you might actually have more room to spend.
4.
Financial forecasts are only moderately useful because predicting the future is impossible.
ii.
What is the goal of financial forecasting?
1.
To provide a detailed map of a firm’s future
2.
To understand the implications of today’s decisions on tomorrow’s performance
a.
Correct! The goal of financial forecasting is to see the big picture of how financial decisions will affect future performance.
3.
To project net income and dividends for a firm
4.
To project sales so investors can adjust stock prices
iii.
Which question is answered by financial forecasting?
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1.
How will an increase in the firm’s tax rate affect the firm’s net income?
2.
What is the firm’s current market share?
3.
Which product will produce the most in sales over the next year?
4.
How much financing will the firm need in the future?
a.
Correct! Finance forecasting helps us determine how much
financing is needed in the future given today’s business decisions and growth.
iv.
How does financial forecasting help with financial decision-making?
1.
It helps decision makers understand the impacts of today’s actions
on the future performance of the firm.
a.
Correct! This is the purpose of financial forecasting.
2.
It helps managers analyze how the firm has been performing over the past several years.
3.
It helps decision makers see a detailed map of the future performance of the firm.
4.
It helps managers understand what key assumptions to make for the future.
2. Lesson 33: Goals of Financial Planning
a.
Understand Important Linkages
i.
In the upcoming lessons, you'll discover crucial connections in financial forecasting. These connections involve factors like revenues, expenses, and investments in fixed assets for growth, along with the financing of
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these assets. A robust financial model enables you to see how changes in
costs or sales growth impact future cash flows, financing needs, and cash
budgeting. Some linkages are easy to spot, but many are not, and a good
model brings them to light. For instance, investing in more efficient equipment can lower production costs, allowing for competitive pricing and increased sales. However, this decision may require funding for both the equipment and a new plant. Financial forecasting and modeling help financial managers navigate these complexities and work towards the firm's goal of maximizing owner wealth.
b.
Spontaneous and Discretionary Accounts
i.
When a company anticipates sales growth, it directly impacts various accounts. For instance, if sales are expected to increase by 10%, items like cost of goods sold (COGS) on the income statement would likely grow by a similar percentage. Similarly, balance sheet items such as cash, credit sales, and inventory would also increase by approximately 10%, as more materials need to be purchased to meet the higher sales volume. These accounts, which naturally vary with sales, are termed spontaneous accounts. They automatically accumulate due to a company's day-to-day business activities. For example, a car manufacturing company expecting sales growth would order more raw materials, leading to increased accounts payable, cash, and accounts receivable.
Understanding the projected growth in spontaneous accounts is crucial for assessing the extra funding needed to support that growth. On the other hand, non-spontaneous accounts, or discretionary accounts, don't
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automatically increase with sales. For instance, if the car company needs extra funds for the anticipated sales growth, management may explore options other than obtaining new loans or issuing new stock. These accounts require management discretion. The next lesson will cover assumptions about which accounts fall into the discretionary category.
c.
Lesson Summary
i.
Financial forecasting uncovers important linkages given that expected actions are taken.
ii.
Accounts that vary proportionally with sales are called spontaneous accounts.
iii.
Accounts that do not vary proportionally with sales but are decided upon by management are called discretionary accounts.
d.
Skill Check i.
What is one of the fundamental purposes of financial forecasting?
1.
To estimate how changes in cost structures or sales will impact the future cash flows and financing needs of the firm
a.
Correct! A solid financial model will allow you to see how changes in cost structures or sales growth will impact the firm’s future cash flows, financing needs, and cash budgeting.
2.
To ensure that the future period’s sales and costs will not exceed historical numbers
3.
To understand the link between asset requirements and industry
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4.
To create accurate financial reports that summarize the company’s
financial performance for the previous period
ii.
What are spontaneous accounts?
1.
Accounts that vary naturally with sales
a.
Correct! By definition, when sales increase, the increase must be matched in another account, such as receivables.
2.
Accounts that are optional to include when creating a financial forecast
3.
Accounts that do not vary with sales
4.
Accounts that are left to management’s discretion
iii.
What are spontaneous accounts?
1.
Accounts that vary naturally with sales
a.
Correct! By definition, when sales increase, the increase must be matched in another account, such as receivables.
2.
Accounts that are optional to include when creating a financial forecast
3.
Accounts that do not vary with sales
4.
Accounts that are left to management’s discretion
iv.
What are spontaneous accounts?
1.
Accounts that vary naturally with sales
a.
Correct! By definition, when sales increase, the increase must be matched in another account, such as receivables.
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2.
Accounts that are optional to include when creating a financial forecast
3.
Accounts that do not vary with sales
4.
Accounts that are left to management’s discretion
3. Lesson 34: The Percent of Sales Method: Determining Financing Needs from a Sales Forecast
a.
The Percent of Sales Method
i.
The percent of sales method is a common financial forecasting approach.
It involves projecting future financial statements based on a sales forecast
and historical relationships between sales and other variables. The goal is
to estimate financial statements for future periods as if sales grow as predicted. Here are the seven steps involved in the percent of sales method:
1.
Project Sales Revenues and Expenses:
a.
Begin with a sales projection provided by the marketing or sales department.
b.
Sales forecasts involve analyzing market trends, competitor actions, and other variables.
2.
Forecast Change in Spontaneous Balance Sheet Accounts:
a.
Estimate changes in balance sheet accounts based on the predicted sales growth.
b.
Current assets and liabilities (except notes payable) are considered spontaneous and are assumed to change proportionally with sales.
3.
Deal with Discretionary Accounts:
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a.
Accounts like notes payable, long-term financing, and common stock/equity are discretionary.
b.
Unlike spontaneous accounts, these don't automatically change with sales and are kept constant in projected financial statements.
4.
Estimate Fixed Asset Account:
a.
Changes in fixed assets depend on the firm's production capacity utilization.
b.
If sales growth exceeds current production capacity, fixed assets may grow more than the sales percentage.
5.
Calculate Retained Earnings (RE):
a.
Retained earnings are affected by depreciation expense, interest expense, and dividends.
b.
Assume net margin and dividend policy remain constant for simplicity.
c.
Project Retained Earnings: Formula: Projected RE = Old RE+(Projected Sales×Net Margin×Plowback Ratio) where Plowback Ratio=1−Payout Ratio and Payout Ratio=Dividends/Net Income
6.
Determine Total Financing Need:
a.
According to the balance sheet equation, total projected assets must equal future total financing.
b.
Total financing need is equivalent to total assets, balancing
liabilities and equity.
c.
Balance sheet equation: (Assets = Liabilities + Owner’s Equity)
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7.
Calculate Discretionary Financing Need (DFN):
a.
DFN is the difference between total financing need and financing in place.
b.
If DFN is positive, management needs to raise additional funds. If negative, there's surplus financing.
c.
Formula: DFN=Projected Total Assets−Projected Total Liabilities−Projected Owner’s Equity
Understanding these steps helps in creating pro forma financial statements and optimizing financing decisions based on projected sales growth.
b.
The Percent of Sales Method: Example
i.
B&H Inc. wants to forecast its future financial statements and determine its external financing need using the percent of sales method. Here's a simplified breakdown of the process:
1.
Sales Projection:
a.
In 20X7, B&H had sales of $32 million. The marketing department forecasts a 25% growth to $40 million in 20X8.
b.
Net margin is 5%, and the payout ratio is 50%.
2.
Forecasting Spontaneous Accounts:
a.
Identify spontaneous accounts (cash, accounts receivable,
inventory, accounts payable, accrued expense).
b.
Historical relationships show, for example, that cash is 10% of sales.
c.
Projected values for 20X8: Cash $4M, AR $4M, Inventory $2M, AP $5M, Accrued Expense $5M.
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3.
Dealing with Discretionary Accounts:
a.
Discretionary accounts (notes payable, long-term debt, common stock) remain constant. Assume current levels carry forward.
4.
Estimating Fixed Asset Account:
a.
Additional $2 million in fixed assets is needed. Add it to the
current level of $16 million for a projected net fixed asset of
$18 million in 20X8.
5.
Calculating Retained Earnings:
a.
Projected Retained Earnings = Old RE + (Projected Sales × Net Margin × (1 - Payout Ratio)).
b.
In this case, it's $3 million.
6.
Determining Total Financing Need:
a.
Calculate projected total assets for 20X8: $28 million.
7.
Calculating DFN:
a.
DFN = Projected Total Assets - Projected Total Liabilities - Projected Owner’s Equity.
b.
DFN is $1 million, indicating the need for additional financing to support higher sales.
This process helps B&H estimate the financial impact of sales growth and
plan for the necessary financing to achieve its forecasted goals.
c.
Lesson Summary
i.
Pro forma statements are projected estimates of a company’s financial statements for a future period.
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ii.
The percent of sales method uses a sales forecast along with historical relationships between sales and other variables to produce pro forma financial statements.
iii.
DFN is calculated as projected assets minus projected liabilities minus projected owner’s equity.
iv.
Fixed assets and retained earnings are special accounts that are not treated like either spontaneous or discretionary accounts.
d.
Skill Check
i.
When can the discretionary financing needed (DFN) be determined?
1.
After total revenue, alone, is projected
2.
After pro-forma financial statements are forecasted using the percent of sales method
a.
Correct! Once all the financial statements are projected according to a given set of assumptions, you can determine the financing required to fund the predicted growth in sales.
3.
After total financing need is determined
4.
After total revenue and expenses are projected
ii.
Which action decreases the discretionary financing needed (DFN)?
1.
Increasing the payback ratio
2.
Decreasing the net margin
3.
Decreasing the retention ratio
4.
Increasing the plowback ratio
a.
Correct! Increasing the plowback ratio increases projected owners’ equity and thus decreases DFN.
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iii.
You are a financial manager of a company, and you have projected sales increase for next year of 8%. Which action would you take when you conduct financial forecasting using the percent of sales method?
1.
Change the notes payable account in proportion to sales growth.
2.
Change the long-term liabilities account in proportion to sales growth.
3.
Leave the notes payable account constant in the projected financial statements.
a.
Correct! Notes payable is a discretionary account. Thus, you should leave it constant in the projected financial statements.
4.
Leave the cash account constant in the projected financial statements.
iv.
You are conducting financial forecasting for your firm given the projected sales. What are you doing if you are estimating changes in the balance sheet based on the predicted change in sales?
1.
Determining total financing need
2.
Projecting discretionary accounts
3.
Calculating retained earnings
4.
Forecasting spontaneous accounts
a.
Correct! Spontaneous accounts change in proportion to sales growth.
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4. Lesson 35: The Sustainable Growth Rate: Four Ways to Decrease DFN
a.
Lesson Introduction
i.
In the previous lesson, the firm projected a high growth rate of 25% for the next year. With our forecast assumptions, the firm's total financing need increased from $24 million in 20X7 to $28 million in 20X8. While the substantial sales growth is positive for profitability (projected net income of $2 million), it also means the company needs an extra $1 million in external funding. If the company can't secure this funding due to existing borrowings and tapped-out investor capital, it might need to explore ways to reduce the DFN. The lesson ahead will introduce the sustainable growth rate and its connection to DFN.
b.
Sustainable Growth Rate
i.
Now that you have a grasp of percent of sales forecasting, let's delve into a more comprehensive understanding. Forecasting involves more than just plugging in numbers; it's an integrated process. Sales growth leads to
asset growth, but how fast can assets grow? Can the firm borrow more money, and are there specific requirements from lenders or equity holders? These aspects are crucial in financial planning. In this section, we move on to explore the sustainability of a firm's growth through the sustainable growth rate (SGR) analyzed using the DuPont method. SGR is the growth rate that allows a firm to maintain its financial ratios without issuing new equity. It answers the question of how fast a firm can grow steadily. Steady state growth, where key financial ratios remain constant,
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is measured by SGR. It's calculated as SGR = ROE × (1 − b), where ROE
is return on equity, and (1 − b) is the retention ratio. The DuPont formula influences SGR by incorporating net margin, total asset turnover, and leverage multiplier. In an example with B&H, the SGR is 8.89%, indicating
the rate at which B&H can grow while maintaining financial ratios. However, forecasting growth beyond the SGR has implications, requiring adjustments in ratios or issuing new equity. SGR, composed of ROE and the dividend payout ratio, can be influenced by adjusting components like profitability, asset efficiency, leverage, and the dividend payout ratio. Maintaining a very high SGR in the long term is challenging for most companies due to market saturation and potential strains on financial resources, leading to increased financing needs. If a company fails to attain its SGR, it faces the risk of stagnation.
c.
Ways to Reduce DFN: Insights from the SGR
i.
Reducing DFN (external financing needs) for a firm can be challenging, but there are ways to achieve this without issuing new equity. Here are four methods:
1.
Slow Sales Growth:
a.
Lowering the aggressive sales forecast by increasing product prices directly reduces DFN.
b.
Higher prices boost net margin, increasing net income and retaining more cash within the firm.
c.
Lower sales also decrease forecasted assets, reducing future financing needs.
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2.
Examine Capacity Constraints:
a.
Evaluate the necessity of additional fixed assets; consider alternatives like a second production shift or outsourcing.
b.
Questions related to total asset turnover can help optimize sales per dollar in assets, decreasing DFN.
3.
Lower Dividend Payout:
a.
Decreasing the annual dividend payment increases the retention ratio, keeping more earnings within the firm.
b.
Note that shareholders may react negatively to reduced dividends, impacting the firm's image.
4.
Increase Net Margin:
a.
Boosting the net margin ratio, indicating higher earnings per sales dollar, decreases DFN.
b.
Strategies include raising product prices or cutting costs, with increased sales volume benefiting from economies of scale.
Each of these methods involves trade-offs and considerations, and the choice depends on the specific circumstances and goals of the firm
d.
Limitations of Sustainable Growth Rate
i.
Achieving the Sustainable Growth Rate (SGR) is a key objective for every
company, but certain factors can hinder this goal. External influences like consumer trends and economic conditions can impact a company's ability
to reach its optimal SGR. For instance, in a market where consumers have limited budgets due to lower income, a business might cut prices to
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stay competitive. However, investing in new products to retain customers and gain market share can increase costs and impede SGR attainment.
Poor forecasting and business planning can also undermine a company's long-term growth. If a company misunderstands its growth strategy or miscalculates its growth capability, it may incorrectly determine its optimal
SGR. While a company may experience short-term growth with a flawed plan, sustained growth requires reinvestment. Introducing new products or expanding production capacity involves purchasing fixed assets, necessitating additional financing for long-term growth.
Some companies, especially in capital-intensive industries, rely on a mix of debt and equity financing due to the high cost of equipment. Although SGR is often viewed as a firm's goal, simply calculating and pursuing this rate may not be the optimal approach. Each company must consider various economic and non-economic factors when utilizing the SGR to ensure effective and realistic growth planning.
e.
Lesson Summary
i.
The SGR is the growth rate at which a firm can grow without issuing new equity.
ii.
The components of SGR are profitability, asset use efficiency, capital structure, and dividend policy.
iii.
Controlling the variable that changes the SGR will decrease the DFN.
f.
Skill Check
i.
What is the sustainable growth rate (SGR)?
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1.
Accounts that do not vary with sales but are up to management’s discretion
2.
The external financing needed to meet the projected growth
3.
Accounts that vary with the change in sales
4.
The growth rate that allows a firm to maintain its present financial ratios without issuing new equity
a.
Correct! The SGR is the growth rate that allows a firm to maintain its present financial ratios without issuing new equity.
ii.
How can a company reduce its discretionary financing needed (DFN)?
1.
Increase the dividend payout.
2.
Reduce retention of earnings.
3.
Increase the net margin.
a.
Correct! Increasing net margin increases the projected owners’ equity, thus reducing the DFN.
4.
Reduce prices.
iii.
Which action increases a company’s sustainable growth rate (SGR)?
1.
Decreasing the leverage the company uses
2.
Decreasing asset use efficiency
3.
Decreasing profitability
4.
Decreasing dividend payout
a.
Correct! Decreasing dividend payout increases earnings retention and thus increases the SGR.
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iv.
Which account should be looked at first when examining capacity constraints to determine whether the discretionary financing needed (DFN) can be reduced?
1.
Notes payable
2.
Fixed assets
a.
Correct! You can recheck capacity analyses to verify whether the firm really needs as large of an increase in fixed assets as projected in the forecast.
3.
Long-term debt
4.
Accounts receivable
5. Lesson 36: Using Forecasting to Determine Fixed Asset Requirements
a.
Sales and Fixed Asset Growth
i.
When forecasting asset needs, it's crucial to recognize that not all assets grow in proportion to sales. Take fixed assets, for example, like a machine
with a specific capacity, say 1,000 units. As long as sales stay below 1,000 units, the machine suffices. But when sales grow, acquiring another
machine becomes necessary, leading to a capacity jump (e.g., 2,000 units). This process repeats in a "chunky" manner—capacity doesn't increase proportionally with sales.
Planning for this involves anticipating sales amounts, the corresponding fixed asset needs, and when these needs arise. If a firm expects 15% sales growth, assuming a linear relationship with fixed asset growth isn't realistic. Fixed assets, like factories and equipment, aren't increased by a
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percentage; they're acquired in their entirety. This approach, known as "lumpy assets," involves a lump sum investment for substantial capacity expansion when the firm nears full capacity.
b.
Sales Capacity
i.
To decide whether to invest in fixed assets, consider the firm's sales capacity—the ability to grow sales within the current production capacity. Calculate sales capacity by dividing actual sales by the percentage of capacity used. If the firm must invest $5 million when exceeding this capacity, assess if the current capacity is sufficient.
1.
Formula: Sales Capacity=Actual Sales/% of Capacity
For instance, if the firm is operating at 80% capacity, with current sales at $240 million, the sales capacity is $300 million ($240 million / 0.80). This means the firm can grow by $60 million or 25% without needing additional
fixed assets. If a 10% sales growth is projected, no new fixed asset investment is necessary. However, with an expected 30% growth, exceeding capacity by $12 million, a $5 million fixed asset investment becomes required.
c.
Lesson Summary
i.
The percent of sales method to project fixed assets is unrealistic because
lumpy assets must be purchased as a whole.
ii.
The sales capacity calculation given the current sales and current capacity is a tool to understand how much room a firm has for growth without additional investment in fixed assets.
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d.
Skill Check
i.
How can a firm grow its fixed assets if it is expecting growth but has reached capacity with its fixed assets?
1.
Continue to invest in capital through small increments over time.
2.
Invest a substantial amount of money at one time to increase capacity.
a.
Correct! Investments in fixed assets are capital-intensive, meaning they require large payments at one point in time.
3.
Use the percent of sales method to forecast fixed assets.
4.
Increase the net margin.
ii.
What does the sales capacity equation tell you?
1.
How much room a firm has to grow without additional investment in fixed assets
a.
Correct! By using the ratio of actual sales to percent of capacity, you can determine how much sales growth the firm can support without needing to invest in further fixed assets.
2.
The limit for a firm’s sales growth
3.
The minimum amount of fixed assets required to support current sales
4.
How much the firm can grow without issuing new equity
6.
Module Summary
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a.
Financial forecasting is used for long-term planning.
b.
Financial forecasting helps us understand the implications of today’s decisions on future performance.
c.
You learned the percent of sales method with its seven steps, from sales estimation to calculation of DFN.
d.
Spontaneous accounts are those that vary with the sales growth, while discretionary accounts are based on management discretion.
e.
Fixed assets and retained earnings are special accounts that you need to pay attention to and are classified as neither spontaneous nor discretionary.
f.
The SGR is the rate at which a firm can grow without issuing new equity and gives insights on how to reduce the DFN.
g.
Calculating sales capacity can help you estimate whether you need to invest a lump sum in fixed assets to keep up with sales growth.
7.
Module quiz
a.
What is discretionary financing needed (DFN)?
i.
The total projected assets needed given a firm’s expected future growth
ii.
The additional projected owners’ equity needed given a firm’s expected future growth
iii.
The additional financing needed given a firm’s expected future growth
1.
Correct! DFN is how much additional financing the firm will need given its expectations for future growth.
iv.
The total projected liabilities needed given a firm’s expected future growth
b.
You are a financial manager of a company. The marketing department has informed you that the projected sales growth for the upcoming year is 10%. As
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you conduct financial forecasting, you keep the long-term liabilities the same amount as the previous year and will discuss this account with the other managers later. What type of account is long-term liabilities?
i.
Projected asset account
ii.
Discretionary account
1.
Correct! Discretionary accounts do not vary automatically with sales but are left to the discretion of management. In this scenario, you kept the long-term liabilities account the same.
iii.
Projected owners’ equity account
iv.
Spontaneous account
c.
What does the discretionary financing needed (DFN) tell us?
i.
The total amount of owners’ equity that a firm is projected to have
ii.
The total amount of liabilities that a firm is projected to have
iii.
The total amount of funding that management will need to obtain through discretionary financing sources
1.
Correct! DFN is the difference between the projected total assets and the projected total liabilities plus owners’ equity. Any discrepancy between the sources and uses of finance is extra financing that management must obtain.
iv.
The total amount of investment needed for future years
d.
Company ABC would like to continue to grow, but in order to maintain control of all decisions and ownership, it wants to avoid issuing new stock. Which calculation will show the company’s leadership the fastest that ABC can grow?
i.
Discretionary financing needed
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ii.
Return on equity
iii.
Key growth indicator
iv.
Sustainable growth rate
1.
Correct! Sustainable growth rate is defined as the rate at which a firm can grow without issuing new equity. It implies that the firm’s growth comes from the return on equity less any dividends.
e.
What is the major purpose of financial forecasting?
i.
To make operational changes within a company
ii.
To show the company's growth over the past several years
iii.
To inform a company how business decisions will impact future growth
1.
Correct. Financial forecasting helps decision makers understand how actions taken today can impact the firm’s future performance.
iv.
To produce a short-term budget for a company or individual
Unit Summary 1.
This unit discussed two financial forecasting tools that are commonly used in the business world: cash budgeting and financial forecasting. These tools are essential for the financial manager of a firm to achieve the main goal of the organization: to maximize shareholder or owner wealth. As financial managers make important investment decisions and manage working capital, they can prepare to make informed financing decisions.
Cash budgeting helps the financial manager understand short-term cash flows. Well-
constructed cash budgeting will allow a firm to receive favorable terms on a loan when
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the firm negotiates with a financial institution. Budgeting can also help the financial manager identify when the firm needs a short-term loan from a bank.
Cash budgeting is used not only in businesses but also in personal finance. Budgeting helps you keep track of cash flows, monitor for any new patterns or cash shortfalls, and adjust your plans based on our monitoring. As a whole, budgeting helps you achieve your financial goals as you manage your cash flows wisely.
Financial forecasting is another tool that the financial manager of a firm uses to understand long-term financing needs. While budgeting is used for periods of one year or less, financial forecasting assesses cash flows over a longer term, between two and five years. Understanding future financing needs will help the manager know how to fill the gap between the total financing needs and projected financing sources of the firm. The sustainable growth rate then helps the manager understand how to fill the gap between uses and sources of capital in the future without issuing new stocks.
There was a lot of new material covered in this unit, so please make sure that you are connecting the dots. If you can think of “why” questions and determine the answers to them, you can connect seemingly abstract ideas to flow together. For example, you might ask, “Why do spontaneous accounts vary with sales growth?” Thinking through the
answers to questions like this will help you understand rather than just memorize this material.
Unit Summary
1.
What is the name for a forecast of short-term events that helps a company understand if it has sufficient cash?
a.
Sustainable growth rate
b.
Cash budget
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i.
Correct! A cash budget is a short-term forecast of future events that helps a company understand whether it has sufficient cash for regular operations.
c.
Percent of sales forecast
d.
Time value of money
2.
What is the purpose of a monthly cash budget?
a.
To have documentation for tax and lending
b.
To ensure that you have enough cash each month to pay your fixed expenses
c.
To control cash inflows and outflows so you can balance income with expenditures and savings
i.
Correct! Controlling cash inflows and outflows allows you to use your money in the most effective way possible.
d.
To know how much cash you spend on both a monthly and yearly basis so you can determine how much you have left over to invest
3.
In which situation would a firm need to borrow cash?
a.
When the firm’s cash receipts are negative
b.
When the beginning cash balance plus the net cash is less than the minimum cash balance required for the month
i.
Correct! This indicates to a firm that additional financing will be needed during the period to operate effectively.
c.
When the minimum cash balance for the period has been met, but the firm wants
to make sure it has enough cash to cover the beginning cash required for next month
d.
When the net cash balance is less than or equal to zero
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4.
How can you use the envelope method of budgeting to monitor cash flows?
a.
Put the amount of money budgeted for each category of your expenses into labeled envelopes and then spend the money in each envelope on expenses in that category.
i.
Correct! This method will help you plan and monitor your cash flows.
b.
Use Excel to record all of your income, savings, and expenses.
c.
Put cash equal to the total sum of your expenses in one envelope, use that cash for all your expenses, and then write down what you spent it on.
d.
Connect budgeting software to your financial accounts.
5.
How should you go about making changes to your budget?
a.
Implement every possible change you can think of as soon as you can so that you don’t lose any profits due to an inefficient budget.
b.
Prioritize the changes you want to make and then implement them gradually one by one to make sure they work.
i.
Correct! Revising your budget in this way will help changes go smoothly and help your company or family members become familiar with the changes.
c.
Carefully evaluate the changes you want to make and then implement them all simultaneously so that your budget is the most effective it can be as soon as possible.
d.
Make a few changes at a time, grouping them together by how much profit they are likely to bring you.
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6.
You are a financial manager of a company. The marketing department has informed you that the projected sales growth for the upcoming year is 15%. As you conduct financial forecasting, you increase cash, accounts receivable, and inventory accounts by 15%—
the same as the projected sales growth. What type of accounts are these?
a.
Non-spontaneous accounts
b.
Discretionary accounts
c.
Fixed assets accounts
d.
Spontaneous accounts
i.
Correct! Spontaneous accounts vary naturally with sales. Since they increase proportionally with sales growth, they are examples of spontaneous accounts.
7.
What does it mean when a firm’s calculated discretionary financing needed (DFN) is negative?
a.
The firm will have enough financing to fund projected sales.
i.
Correct! If total projected liabilities and owners’ equity are greater than total projected assets, then no additional financing is needed.
b.
The firm should consider getting extra financing by issuing new stocks.
c.
The firm needs to consider getting extra financing from the bank.
d.
The firm’s balance sheet will be in balance at that point in the forecast.
8.
Which account is a spontaneous account?
a.
Long-term debt
b.
Accounts payable
i.
Correct! Accounts payable is a spontaneous account that varies with sales.
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c.
Notes payable
d.
Common stock
9.
Why is the sustainable growth rate (SGR) useful?
a.
It gives the maximum growth rate that allows a firm to maintain its current financial ratios without issuing new equity.
i.
Correct! The SGR is ROE times the plowback ratio, and it demonstrates the level of growth at which those ratios remain constant.
b.
It demonstrates where discretionary financing should be sourced if it is needed.
c.
It provides the firm with the necessary growth rate to maintain sales.
d.
It determines the discretionary financing needed.
10. You are analyzing fixed assets to create pro forma financial statements for your company. You realize that, since sales will increase next year, you will also need your manufacturing capacity to increase by the same amount. Currently, you are operating at maximum capacity. You buy an entire new factory and multiple pieces of equipment that increase capacity to much more than you need to meet the sales growth. Which concept
describes why such a large purchase was necessary?
a.
Fixed assets are spontaneous accounts.
b.
Fixed assets are lumpy.
i.
Correct! You cannot purchase only part of a factory and equipment to meet the sales growth. Instead, you must purchase the entire factory along with all the equipment to meet the sales growth. We call the increase of fixed assets as the firm approaches its full capacity “lumpy assets” because it requires a lump sum purchase.
c.
Sales are uncertain for the future year.
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d.
Additional financing could not be obtained.
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Impact on long-term planning
Write their responses and your takeaways from this conversation in the third output of this component, ‘Interview with an industry professional: Use of Cashflow statements.
Ensure to specify the details of the industry expert’s email ID, mobile, etc. to support the research; missing.
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B. process of evaluating the profitability of a business
C. process of making pricing decisions for products
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arrow_forward
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working capital and wants to reflect
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What is an appropriate plan of
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