Finance Skills for Managers - D076 UNIT 5

retention ratio or plowback ratio

(1 − b)the amount of retained earnings that are kept put back into the firm after dividends are paid.

in general, percent of sales forecasting uses

(1) a sales forecast and (2) historical relationships between sales and other variables to create pro forma statements (pro forma means "as if").

Which item is an example of a cash receipt in a personal budget?

A graduation gift of $100 from your grandmother

Which item represents an example of a cash disbursement a business might have this month?

A rent check paid and cashed for the warehouse the company uses

discretionary accounts

Accounts that do not vary automatically with sales but are left to the discretion of management. If extra funds are needed, management tries to find a way to manage additional financing needs without getting new loans or issuing new stock, if possible. These accounts do not increase automatically with sales but are left to the discretion of management.

What are spontaneous accounts?

Accounts that vary naturally with sales

When can the discretionary financing needed (DFN) be determined?

After pro-forma financial statements are forecasted using the percent of sales method.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.

Why is "put $50 in a savings account each month for Christmas gifts" a better budgeting goal than "save money for Christmas gifts"?

Because it is specific and measurable

Why would a monthly mortgage payment be considered a fixed expense?

Because the payment is the same amount each month

Cash Disbursements

Besides inventory-related expenses, the store may have to pay rent, taxes, interest, and other selling, general, and administrative expenses month-to-month, which should be a part of cash budgeting.

How far into the future do cash budgets usually forecast?

Between one month and one year

What are the three main uses of cash budgets?

Cash budgets are used to forecast future financial need, aid in performance evaluation, and show when corrective action is needed.

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?

Cash budgets increase the lender's trust in a firm by demonstrating the firm's ability to make profits and repay loans.

W&H Inc.'s labor costs each month are an example of which item in a cash budget?

Cash disbursement

What three things should be included in a cash budget for a business?

Cash receipts, cash disbursements, and borrowing

Which action would help you make your budget more efficient?

Compare your budgeted cash flows to your actual cash flows, and then revise the budget if necessary.

If a company expects sales to grow by 10% next year, which account might also increase by 10%?

Cost of goods sold

Which action increases a company's sustainable growth rate (SGR)?

Decreasing dividend payout Correct! Decreasing dividend payout increases earnings retention and thus increases the SGR.

Creating a cash budget is a matter of understanding your business, understanding the timing of cash flows, and keeping track of borrowing requirements. It can be broken down into three steps:

Determine cash receipts Estimate cash disbursements Create the cash budget

What is the correct order of the three steps necessary to create a cash budget?

Determine cash receipts, estimate cash disbursements, create the cash budget

What role does financial forecasting play in the future success and growth of a firm?

Financial forecasting supplements historical data with proposed investments or changes to allow for more accurate foresight.

Which account should be looked at first when examining capacity constraints to determine whether the discretionary financing needed (DFN) can be reduced?

Fixed assets 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.

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?

Forecasting spontaneous accounts Correct! Spontaneous accounts change in proportion to sales growth.

Which question is answered by financial forecasting?

How much financing will the firm need in the future?

How can a company reduce its discretionary financing needed (DFN)?

Increase the net margin. Correct! Increasing net margin increases the projected owners' equity, thus reducing the DFN.

Which action decreases the discretionary financing needed (DFN)?

Increasing the plowback ratio Correct! Increasing the plowback ratio increases projected owners' equity and thus decreases DFN.

How can a firm grow its fixed assets if it is expecting growth but has reached capacity with its fixed assets?

Invest a substantial amount of money at one time to increase capacity. Correct! Investments in fixed assets are capital-intensive, meaning they require large payments at one point in time.

How does financial forecasting help with financial decision-making?

It helps decision makers understand the impacts of today's actions on the future performance of the firm.

After W&H Inc. has developed a cash budget, what should the company do in the following months?

It should monitor its actual cash flows and then revise the cash budget if needed.

What are three principles of budgeting that are important to know before beginning the budgeting process?

Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives

There are six principles of effective budgeting that take all areas of budgeting into account.

Know Yourself Understand the Key Areas of Savings, Income, and Expenses. Develop Savings, Income, and Expense Strategies. Keep Records Use a Method That Meets Your Needs and Objectives. Eliminate Consumer Debt and Minimize Long-Term Debt.

How do the benefits of knowing the cash position for each period differ between businesses and individuals?

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.

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?

Leave the notes payable account constant in the projected financial statements. Correct! Notes payable is a discretionary account. Thus, you should leave it constant in the projected financial statements.

What is the purpose of monitoring your cash flows?

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.

What is the difference between tracking and monitoring cash flows?

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.

Which processes help you identify and fix problems in your budget?

Monitoring your budget allows you to identify problems, and then gradual revision and implementation of new processes allow you to fix those problems.

Borrowing

Once a business has an idea of cash receipts and disbursements, it can calculate net cash for the month. The business adds this value to the beginning cash balance and then examines whether it has sufficient cash for the month or not

The percent of sales method consists of seven steps:

Project sales revenues and expenses Forecast change in spontaneous balance sheet accounts Deal with discretionary accounts Estimate fixed asset account Calculate retained earnings (RE) Determine total financing need (projected total assets) Calculate DFN

Which items are considered cash disbursements for a business?

Raw materials, rent, administrative expenses, interest, and selling expenses

Why are sales not strictly considered to be the same thing as cash receipts?

Sales include both cash sales and credit sales.

Which type of account changes with sales growth?

Spontaneous accounts

discretionary financing needed (DFN) known as the external financing needed (EFN) or additional funds needed (AFN

The additional financing needed given a firm's expectations for future growth.

Step 4: Estimate Fixed Asset Account

The change in fixed assets in response to a change in sales depends upon the firm's current production capacity utilization.

What is the sustainable growth rate (SGR)?

The growth rate that allows a firm to maintain its present financial ratios without issuing new equity

What is one of the fundamental purposes of financial forecasting?

To estimate how changes in cost structures or sales will impact the future cash flows and financing needs of the firm

What is the goal of financial forecasting?

To understand the implications of today's decisions on tomorrow's performance

What is the main reason why it is important to track and record cash flows?

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.

The five steps to create a budget for your personal finances are as follows:

Understand your goals Track your savings, income, and expenses Develop a cash budget (plan) Implement your plan Compare the cash budget to your actual spending and make necessary changes

Balance sheet forecasting

Using sales growth and the profit forecast to construct a pro forma balance sheet to understand the future implications of the sources and uses of finances. typically done in conjunction with projecting income statements. helps management understand the future implications of the company's financing strategies.

When evaluating a company's performance, what can variances on a company's cash budget indicate?

Variances show that certain managers or divisions are not meeting targets.

In what situation might the software method of tracking be preferable to the spreadsheet method of tracking?

When a person has a hard time remembering to record their cash flows and when they prefer to use a card to make purchases

Step 5: Calculate Retained Earnings (RE)

While the accounting behind this gets messy, there are basically three reasons why retained earnings requires special attention: Depreciation expense, Interest expense, Dividends

the 50/30/20 rule

a common guideline for distributing your income—50% of your income goes to your needs (such as rent, food, or insurance), 30% of your income goes to your wants (such as entertainment, new clothing, or car repairs), and 20% of your income goes to savings.

Cash budgets

a forecast of future events. They are usually prepared for a shorter time horizon—generally between one month and one year, similar to our household budgeting. They are generally used to estimate whether a company has a sufficient amount of cash for regular operations. In addition, they help companies and individuals to be accountable and make sure that cash is not wasted.

Budget revision

a process that allows you to make changes to the budget to meet your financial goals.

Forecasting requires a number of.....

assumptions, and the analyst needs to be careful with these assumptions or else the forecast will be inaccurate.

Step 1: Project Sales Revenues and Expenses

begins with a projection of sales revenue.

For this course, you should simply assume that

both net margin and dividend policy (the payout ratio) are constant when forecasting changes in the retained earnings account

The earnings change with

changes in production or service costs, depreciation policies, and taxes.

Controlling the variable that changes the SGR will

decrease the DFN

Cash budgeting in a business involves

determining cash inflows, estimating cash outflows, and creating a budget plan

By contrast, financial forecasting is an....

estimate of what will actually be achieved

variable expenditures

food, utilities, clothing, subscriptions, and so on.

Financial forecasting requires a number of assumptions. Key assumptions include....

future sales levels, the relationship between sales and assets, and the firm's profitability

Financial forecasting

helps decision makers understand how actions taken today can impact the firm's future performance. Combining historical relationships and proposed changes or investments allows managers to more accurately foresee possible complications and more completely understand the implications of today's decisions. Hence, careful forecasting is integral to future success and growth.

Revisions come after a careful analysis of a budget and should be

implemented gradually to make sure that the changes are working.

There are at least three key uses of the cash budget:

indicating future financing needs, providing a basis for corrective action, and providing the data for performance evaluation.

forecasting is related to...

investment and financing decisions.

steady state growth

level of growth where four key financial ratios—profitability, asset utilization, leverage, and payout—are constant and where the firm does not need to issue any new equity to fund the growth.

Financial forecasting uncovers important...

linkages given that expected actions are taken.

The percent of sales method to project fixed assets is unrealistic because

lumpy assets must be purchased as a whole.

If DFN turns out to be positive

meaning that you need additional financing, management may choose to obtain the needed financing by either increasing borrowing or issuing stock. That decision, however, is left to management's discretion and is to be made only after you calculate the required DFN

Step 3: Deal with Discretionary Accounts

only change when management takes deliberate actions to make them change. Notes payable, long-term financing accounts, and common stock/equity are all this type of account

Note that since net income is either

paid out as dividends or added to retained earnings, the payout ratio and the retention ratio must sum to 1

Estimating DFN is often the.....

primary objective of the forecasting process.

DFN is calculated as

projected assets minus projected liabilities minus projected owner's equity.

Pro forma statements

projected estimates of a company's financial statements for a future period

Performance Evaluation

provide a basis for performance evaluation. They contain management's best estimate of the firm's cash flow. Variances from the budget may indicate that certain managers or divisions are not meeting targets. This variance may become one aspect of that manager's or division's periodic performance evaluation.

Corrective Action

provide a basis for taking corrective action when budgeted and actual figures do not match.

In essence, a budget is a....

quantified expectation of what a business wants to achieve

Cash Receipts

sales are made not only on cash but also on credit. For cash sales, the business receives cash at the time sales are made to customers. For credit sales, cash is not received until accounts receivable are collected.

Fixed assets and retained earnings are

special accounts that are not treated like either spontaneous or discretionary accounts.

The payout ratio

tells you the percent of net income distributed to the shareholders

the plug

the account that is adjusted to make the pro forma balance sheet balance. will always be a discretionary addition because management decides how to finance any positive DFN and what to do with any surplus cash (negative DFN)

Step 7: Calculate DFN

the difference between the firm's total financing need (total projected assets) and financing currently in place constitutes the DFN

Methods of tracking a budget include

the envelope method, spreadsheets, and software.

Future Financing Needs

the firm can see when its borrowing needs will be highest during the year—when the firm will have its maximum borrowing need and when it can expect to be able to pay down its loan. For small businesses in which cash may be scarce, understanding the company's expected cash position from month to month is crucial. Managers who understand their cash position well are in a better position to negotiate and renew their loans and credit lines because they are able to demonstrate when the company will be able to repay its borrowings.

Step 6: Determine Total Financing Need

the firm's total projected assets must equal future total financing.

sustainable growth rate (SGR)

the growth rate at which a firm can grow without issuing new equity(profitability, asset utilization, leverage, and payout—are constant and where the firm does not need to issue any new equity to fund the growth.)

Profit forecasting

the projection of future earnings after all the projected costs are subtracted from the projected sales.

retention ratio, also called the plowback ratio

the proportion of earnings that are retained after dividends are paid

If DFN is negative,

then the forecast indicates that the firm will have adequate financing to fund the projected sales and will even have surplus assets

Fixed expenditures

things you do not have direct control over and that remain constant expenses from month to month, such as rent, membership fees, loan payments, insurance, and so on.

Spontaneous accounts

those that vary naturally with sales. That is, as sales increase, some accounts such as accounts receivable, inventory, and accounts payable automatically increase as well. The projected growth in spontaneous accounts is an important measure for companies to evaluate how much extra funding is needed to meet that growth.

Step 2: Forecast Change in Spontaneous Balance Sheet Accounts

to estimate changes in the balance sheet accounts given the predicted change in sales.

Tracking

to keep a record of your cash flows

he 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.

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.

The percent of sales

uses a sales forecast along with historical relationships between sales and other variables to produce pro forma financial statements.

monitoring

using that record to verify cash flows against your target, identify patterns and changes in cash flows, and understand circumstances that you may need to correct.