Financial Projection Essay Example For Students

Financial Projection Essay financial projection essential element of planning that is the basis for budgeting activities and estimating future financing needs of a firm. Financial projections (forecasts) begin with forecasting sales and their related expenses. The basic steps in financial forecasting are: (1) project the firms sales; (2) project variables such as expenses and assets; (3) estimate the level of investment in current and fixed assets that is required to support the projected sales; and (4) calculate the firms financing needs. The basic tools for financial forecasting include the percent-of-sales-method, regression analysis , and financial modeling. Financial Forecasting Financial Forecasting describes the process by which firms think about and prepare for the future. The forecasting process provides the means for a firm to express its goals and priorities and to ensure that they are internally consistent. It also assists the firm in identifying the asset requirements and needs for external financing. For example, the principal driver of the forecasting process is generally the sales forecast. Since most Balance Sheet and Income Statement accounts are related to sales, the forecasting process can help the firm assess the increase in Current and Fixed Assets which will be needed to support the forecasted sales level. Similarly, the external financing which will be needed to pay for the forecasted increase in assets can be determined. Firms also have goals related to Capital Structure (the mix of debt and equity used to finance the firms assets), Dividend Policy, and Working Capital Management. Therefore, the forecasting process allows the firm to determine if its forecasted sales growth rate is consistent with its desired Capital Structure and Dividend Policy. The forecasting approach presented in this section is the Percentage of Sales method. It forecasts the Balance Sheet and Income Statement by assuming that most accounts maintain a fixed proportion of Sales. This approach, although fairly simple, illustrates many of the issues related to forecasting and can readily be extended to allow for a more flexible technique, such as forecasting items on an individual basis. Concepts Percentage of Sales Method The Percentage of Sales Method is a Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i. e. , forecasted) can be constructed and the firms needs for external financing can be identified. The calculations illustrated on this page will refer to the Balance Sheet and Income Statement which follow. The forecasted Sales growth rate in this example is 25% Balance Sheet ($ in Millions)| Assets| 1999| Liabilities and Owners Equity| 1999| Current Assets| Â   | Current Liabilities| Â  | Cash| 200| Accounts Payable| 400 | Accounts Receivable| 400 | Notes Payable| 400 | Inventory| 600 | Total Current Liabilities| 800 | Total Current Assets| 1200 | Long-Term Liabilities| Â   | Â  | Â  | Long-Term Debt| 500| Fixed Assets| Â   | Total Long-Term Liabilities| 500| Net Fixed Assests| 800 | Owners Equity| Â  | | Â  | Common Stock ($1 Par)| 300| | Â  | Retained Earnings| 400| Â   | Total Owners Equity| 700| Total Assets| 2000 | Total Liab. and Owners Equity| 2000| | Income Statement ($ in Millions)| | 1999| Â  | Sales| 1200| Â  | Cost of Goods Sold| 900| Â  | Taxable Income| 300| Â  | Taxes| 90 | Â  | Net Income| 210| Â  | Dividends| 70| Â  | Addition to Retained Earnings| 140| Â  | | Percentages of Sales The first step is to express the Balance Sheet and Income Statement acc ounts which vary directly with Sales as percentages of Sales. This is done by dividing the balance for these accounts for the current year (1999) by sales revenue for the current year. The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts Receivable, Inventory, and Accounts Payable. Fixed Assets are also often tied closely to Sales, unless there is excess capacity. (The issue of excess capacity will be addressed in External Financing Needed section. ) For this example, we will assume that Fixed Assets are currently at full capacity and, thus, will vary directly will sales. Retained Earnings on the Balance Sheet represent the cumulative total of the firms earnings which have been reinvested in the firm. Thus, the change in this account is linked to Sales; however, the link comes from relationship betwen Sales growth and Earnings The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically with Sales. The changes in these accounts depend upon how the firm chooses to raise the funds needed to support the forecasted growth in Sales. On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming that all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage of Sales. This indicates the Profit Margin. Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends and Addition to Retained Earnings are expressed as a percentage of Net Income to determine the Payout and Retention Ratios respectively. Percentage of Sales Calculations | The examples in this box illustrate the calculations which were used to determine the percentages provided in the following Balance Sheet and Income Statement. Cash| Cash/Sales = $200/$1200 = . 1667 = 16. 67%| Inventory| Inventory/Sales = $600/$1200 = . 5 = 50%| Accounts Payable| (Accounts Payable)/Sales = $400/$1200 = . 3333 = 33. 33%| Costs| Costs/Sales = $900/$1200 = . 5 = 75%| Taxes| Taxes/(Taxable Income) = $90/$300 = . 3 = 30%| Net Income| (Net Income)/Sales = $210/$1200 = . 175 = 17. 5%| Dividends| Dividends/(Net Income) = $70/$210 = . 3333 = 33. 33%| | Balance Sheet ($ in Millions)| Assets| 1999| %| Liabilities and Owners Equity| 1999| %| Current Assets| Â   | Â   | Current Liabilities| Â  | Â  | Cash| 200| 16. 67% | Accounts Payable| 400 | 33. 33% | Accounts Receivable| 400 | 33. 33% | Notes Payable| 400 | N/A | Inventory| 600 | 50. 00% | Total Current Liabilities| 800 | | Total Current Assets| 1200 | | Long-Term Liabilities| Â   | Â   | Â  | Â  | Â  | Long-Term Debt| 500| N/A | Argumentative Abortion EssayBalance Sheet ($ in Millions)| Assets| 1999| Liabilities and Owners Equity| 1999| Current Assets| Â   | Current Liabilities| Â  | Cash| 200| Accounts Payable| 400 | Accounts Receivable| 400 | Notes Payable| 400 | Inventory| 600 | Total Current Liabilities| 800 | Total Current Assets| 1200 | Long-Term Liabilities| Â   | Â  | Â  | Long-Term Debt| 500| Fixed Assets| Â   | Total Long-Term Liabilities| 500| Net Fixed Assests| 800 | Owners Equity| Â  | | Â  | Common Stock ($1 Par)| 300| | Â  | Retained Earnings| 400| | Â   | Total Owners Equity| 700| Total Assets| 2000 | Total Liab. nd Owners Equity| 2000| | Income Statement ($ in Millions)| | 1999| Â  | Sales| 1200| Â  | Cost of Goods Sold| 900| Â  | Taxable Income| 300| Â  | Taxes| 90 | Â  | Net Income| 210| Â  | Dividends| 70| Â  | Addition to Retained Earnings| 140| Â  | | Full Capacity The equation used to calculate EFN when fixed assets are being utilized at full capacity is given below . (Please note that this equation is based on the same assumptions that underly the Percentage of Sales Method. Namely that the Profit Margin and the Retention Ratio are constant. ) where * S0 = Current Sales, S1 = Forecasted Sales = S0(1 + g), * g = the forecasted growth rate is Sales, * A*0 = Assets (at time 0) which vary directly with Sales, * L*0 = Liabilities (at time 0) which vary directly with Sales, * PM = Profit Margin = (Net Income)/(Sales), and * b = Retention Ratio = (Addition to Retained Earnings)/(Net Income). When the firm is utilizing its assets at full capcacity, A*0 will equal Total Assets. L*0 typically consists of Accounts Payable (and if present Accruals). The logic of underlying this equation can be explained as follows. * = the required increase in Assets, = the spontaneous increase in Liabilities, and * = the spontaneous increase in Retained Earnings. The incresed in Liabilities and Retained Earnings in the equation are considered spontaneous because the occu r essentially automatically as a consequence of the firm conducting its business. Full Capacity Example | Use the Balance Sheet and Income Statement above to determine the EFN given that Fixed Assets are being utilized at full capacity and the forecasted growth rate in Sales is 25%. Solution:First calculate the Forecasted Sales. S1 = 1200(1 + . 5) = $1500Next, solve using the EFN equation. Note that we are substituting (Net Income)/(Sales) for Profit Margin and (Addition to Retained Earnings)/(Net Income) for the Retention Ratio. | Excess Capacity If the firm has excess capacity in its Fixed Assets then the Fixed Assets may not have to increase in order to support the forecasted sales level. Moreover, if the Fixed Assets do need to increase in order to support the forecasted sales level, then they will not have to increase by as much as would be required if they were being used at full capacity. When a firm has excess capacity in its Fixed Assets the first step is to determine the sales level that the existing Fixed Assets can support. This can be determined by dividing Current Sales by the percentage of capacity at which the Fixed Assets are presently being utilized. This sales level is called Full Capacity Sales, SFC. If Forecasted Sales are less than Full Capacity Sales, then fixed assets do not need to increase to support the forecasted sales level. On the other hand, if Forecasted Sales are greater than Full Capacity Sales, then Fixed Assets will have to increase. We shall consider these two cases below. Case 1: S1 Less Than SFC When the Forecasted Sales are less than or equal to Full Capacity Sales, EFN can be determined in one step using the above equation. The only adjustment is that A*0 now only consists of Total Current Assets since Fixed Assets do not need to increase to suppor the forecasted sales level. Excess Capacity Example: S1 SFC | Use the Balance Sheet and Income Statement above to determine the EFN given that Fixed Assets are currently being utilized at 60% of capacity and the forecasted growth rate in Sales is 25%. Solution:First calculate the Forecasted Sales and Full Capacity Sales. S1 = 1200(1 + . 25) = $1500SFC = 1200/. 60 = $2000Since Forecasted Sales are less than Full Capacity Sales the EFN can be found in one step. Here A*0 is equal to Total Current Assets which equals $1200. | Case 2: S1 Greater Than SFC When the Forecasted Sales are greater than Full Capacity Sales, EFN can be determined in two steps. The first step, illustrated by the equation for EFN1 below, finds the EFN needed to get to Full Capacity Sales. The second step, illustrated by the equation for EFN2 below, finds the additional EFN to get from Full Capacity Sales to the Forecasted Sales. The total EFN is simply EFN1 plus EFN2. Excess Capacity Example: S1 SFC | Use the Balance Sheet and Income Statement above to determine the EFN given that Fixed Assets are currently being utilized at 90% of capacity and the forecasted growth rate in Sales is 25%. Solution:First calculate the Forecasted Sales and Full Capacity Sales. S1 = 1200(1 + . 25) = $1500SFC = 1200/. 90 = $1333. 33Since Forecasted Sales are greater than Full Capacity Sales the EFN has to be found in two steps. | Financial Forecasting Equations Forecasted Sales| S1 = S0(1 + g)| Full Capacity Sales| | External Financing Needed (S1 SFC)| | External Financing Needed (S1 SFC)| | .