FM10

Financial Forecasting

1. to form accurate projected sales and financing needs 2. to see what complications or challenges arise from today's decisions 3. to avoid GIGO (Garbage in, Garbage out)

percent of sales method consists of six steps

1Project sales revenues and expenses -creating this projection would be a daunting task that depends upon market forces, our competitors' actions, and many other variables. 2.Forecast change in spontaneous balance sheet accounts -Growth requires increased investment. We will use sales growth as a proxy for total firm growth. As sales grow, the company asset base will have to expand to support the new, higher level of sales. 3.Deal with discretionary accounts 4.Calculate retained earnings (RE) 5.Determine total financing need/assets 6.Calculate DFN

Spontaneous accounts generally include

Accounts payable Accounts receivable Cash Inventory

proxy

An approximation measure for something else

plowback ratio

Another name for the retention ratio

Management of Hind Sight Solutions has revamped its operations. Looking forward to future growth, their new goal is to pay 8 percent of net income as dividends, reaching a net margin of 6 percent. Last year's information is as follows: sales $5,000,000; Inventory $3,500; total assets $4,500,000; total liabilities $3,000,000. Calculate their sustainable growth rate rounded to the nearest percent. (Hint: You will need to use the DuPont equation to solve this one.)

Answer: 18% NM 6% Payout ratio 8% Sales 5,000,000 Assets 4,500,000 Liabilities 3,000,000 Asset Turnover = 5,000,000/4,500,000 = 1.1% Equity Multiplier = 4,500,000/(4,500,000-3,000,000) = 3 SGR = .06 * 1.11 * 3 * (1-.08) = 18% Notice on this solution, we have to use the DuPont equation which states that ROE equals net profit margin times asset turnover times equity multiplier. Once we have ROE, we can use the standard SGR equation of SGR = ROE * plowback to complete the problem.

Given the following information, what is the sustainable growth rate for this company? Net income $2,000,000.00, Sales $20,000,000.00, Assets $4,000,000.00, Dividends $1,000,000.00, Equity $3,000,000.00, Liabilities: $1,000,000.00

Answer: 33% NI 2,000,000 Equity 3,000,000 Dividends 1,000,000 Payout ratio = 1,000,000/2,000,000 = .5 ROE = 2,000,000/3,000,000 = .667 SGR = .667 * .5 = 33.33%

GetStrong, Inc has net income of $10 million, equity on the balance sheet of $100 million, and pays an aggregate dividend of $3 million. Compute GetStrong's sustainable growth rate (SGR).

Answer: 7.0% NI 10 E 100 Div 3 ROE = 10/100 = 10.0% 1- Payout ratio = 1-(3/10) = .7 SGR = 10% * .7 = 7%

FarFromGrooving, Inc. has just been invited to bid on the contract of their dreams. Last year FarFromGrooving had a net margin of 1.96 percent, plowback ratio of 75 percent, ROA of 6.52 percent, and ROE of 11.9 percent. Using this information, calculate the company's SGR to the nearest percent.

Answer: 9% ROE 11.90% Plowback 75% SGR = .119 * .75 = .08925

To determine how much a spontaneous account will change we:

Answer: Divide last year's spontaneous account by last year's sales

Forecasting projected sales revenues and expenses is the final step in financial forecasting.

Answer: False Computing DFN is the last step.

Firms can always find ways to finance their growth.

Answer: False Capital constraints are a real problem for many firms.

Retained Earnings is a spontaneous account.

Answer: False False, we have to compute retained earnings based on the change in retained earnings over the forecast period. They do not vary directly with sales.

If your firm is operating at full capacity, in the real world, an increase in sales will increase fixed assets incrementally as sales increase.

Answer: False Fixed assets are lumpy. If we exceed 100% capacity, fixed assets will require a discretionary investment in additional production capacity and will not increase incrementally with sales.

Growth is only financed by increased revenue.

Answer: False Growth requires increased investment in the firm, in the form of retained earnings, or external equity or debt.

The dividend payout ratio is the reciprocal of the plowback ratio.

Answer: False Plowback = (1 - Dividend/Net Income) so it's not the reciprocal.

Which of the following questions are NOT estimated by financial forecasting?

Answer: How much have we made in the past? Historical financial statements show how much we have made in the past - this does not need to be forecasted.

If the company's asset accounts increase which of the following needs to happen?

Answer: Liability or equity accounts must increase by the same amount The balance sheet must balance, so if assets go up, then the sum of liabilities and equity must go up as well.

Projected Retained Earnings is most correctly calculated by:

Answer: Old RE + Change in RE

What is the first step in the percent of sales process?

Answer: Project future sales The steps are: Project sales revenues and expenses Forecast change in spontaneous balance sheet accounts Deal with discretionary accounts Calculate retained earnings (RE) Determine total financing need/assets Calculate DFN

Which of the following is not a step included in the Percent of Sales method?

Answer: Secure financing for project The steps are: Project sales revenues and expenses Forecast change in spontaneous balance sheet accounts Deal with discretionary accounts Calculate retained earnings (RE) Determine total financing need/assets Calculate DFN

Management typically decides to change all of the following accounts EXCEPT:

Answer: Spontaneous accounts With the percent of sales forecast, spontaneous accounts are forecasted based on historical ratios and growth of sales. Discretionary accounts are based on management's choices and PP&E accounts are often at the discretion of the manager's based on the industry and the firm's needs.

Discretionary financing Need (DFN)

Answer: The difference between the forecasted asset accounts and the combination of the liability and equity accounts External financing is needed Answer: DFN = Projected total assets - projected total liabilities - projected owners' equity

Capacity constraints are usually examined carefully when DFN is too high.

Answer: True Examine capacity constraints. Recheck capacity analyses to verify whether the firm really does need as large an increase in fixed assets as was forecasted in the pro forma financial statements. It may be that, given the current capacity and usage, the firm can produce enough (or near enough) product without as large an investment in fixed assets. Fixed assets is an account that often gets scrutinized whenever the DFN needs reducing.

Management can dictate how spontaneous accounts should change.

Answer: True The text gives the example of management setting a goal for average collection period (ACP). Using the ACP ratio, management dictates what accounts receivable (AR) will be forecasted as.

Slow sales growth

By increasing the price of its product, a firm can slow sales growth and thus reduce DFN in two ways. First, higher prices will increase net margin, leading to higher net income and more cash retained within the firm. Second, lower sales will decrease forecasted assets in the pro forma balance sheet, thus reducing the expected future financing need.

non-spontaneous accounts

Financial accounts that do not vary directly with sales.

External financing Need (EFN)

Identifying the funds which must be raised in order to support the forecasted sales level is one of the key outputs of the forecasting process.

Lower dividend payout

In the preceding AJ, LLC example, we estimated that the firm will bring in $900,000 in earnings next year but only retain $225,000 of that within the firm. If the company were to lower its annual dividend payment, thereby increasing its retention ratio, more earnings would remain within the firm and the DFN would decrease.

Line items

Income statement numbers on each line.

Which of the following can be a discretionary account?

Notes Payable PP&E Long-term debt Common Stock

capacity

Percent of unused productivity of fixed assets

How do we compute projected RE?

Projected RE = Old RE + Change in RE Projected RE = Old RE + NI-Dividends Projected RE = Old RE + Projected sales x net margin x (1-payout ratio)

Which of the following are real methods to manage sales growth?

Raise prices Decrease/eliminate dividend payments Reduce costs through economies of scale

Examine capacity constraints

Recheck capacity analyses to verify whether the firm really does need as large an increase in fixed assets as was forecasted in the pro forma financial statements. It may be that, given the current capacity and usage, the firm can produce enough (or near enough) product without as large an investment in fixed assets.

Which of the following is NOT a way discussed to manage sales growth?

Slow sales growth Examine capacity constraints Lower dividend payout Increase net margin

Increase net margin

The larger the company's net margin, the higher the level of earnings per dollar of sales. Higher earnings lead to more cash retained within the company (even without changing the retention ratio as in number 3 above), which in turn decreases the DFN. Besides increasing the product sales price (see number 1 above),

mergers and acquisitions

The market for firms that buy and sell each other.

Why is it important to use accurate estimates for financial forecasting?

To form accurate projected sales and financing needs To see what complications or challenges arise from today's decisions To avoid GIGO

dividend payout ratio

equals dividends divided by net income (Div/NI) and is the fraction of earnings the firm pays out as dividends

pro forma statements

future or forecasted financial statements.

sustainable growth rate ( SGR )

is a company's maximum growth rate in sales using internal financial resources and without having to increase debt or issue new equity

equity multiplier

is a measurement of a company's financial leverage. Companies finance the purchase of assets either through equity or debt, so a high equity multiplier indicates that a larger portion of asset financing is being done through debt. The multiplier is a variation of the debt ratio

DuPont formula

is an expression which breaks ROE (return on equity) into three parts

dividend policy

is the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders. Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash.

discretionary accounts

non-spontaneous; dont automatically increase with sales but are left to the discretion of management to increase or decrease ie- long term debt, notes payable & common stock; typically fixed assets, PP & E Are accounts that increase incrementally as sales increase React immediately with demand for the product/services provided Include accounts such as cash, accounts payable, accrued expenses Are line items on the income statement

retention ratio

the percentage of net income plowed back in the firm as retained earnings= 1 dividends payout ratio

Garbage In, Garbage Out (GIGO)

used to express the idea that in computing and other spheres, incorrect or poor quality input will always produce faulty output.

Spontaneous accounts

vary automatically with sales ie-most current assets, AP, AR, cash, inventory, accurals (wages, taxes)

excess capacity

when fixed assets do not need to increase as sales increase

full capacity

when fixed assets have to increase if the firm wants to increase sales