Financial Forecasting 4

Author’s Overview

Developing pro forma statements is a fairly involved process. However, the rewards to students
are high in terms of understanding the interaction of accounting data and financial forecasting.
The development of pro forma financial statements is an integrative exercise, so there is little
reward for a halfway approach. The use of an integrated Excel spreadsheet makes this process a
little more manageable. It should be emphasized than any student intending to start up a small
business will be required to prepare this type of statement for a bank loan or business plan. Often
management students see no reason to master this painstaking exercise, but, if they hope to
become entrepreneurs, it will be good for them to know it because a lender or investor will want
to see their proforma statements for any chance of a loan or investment.

The percent-of-sales method, presented at the end of the chapter, is a second approach to
financial forecasting. It is easily understood and quickly mastered, but it has many weaknesses
and does not have the full validity of developing pro forma statements. Choosing whether and
how to present the percent-of-sales method is really a matter of instructor preference.

Chapter Concepts

LO1. Recognize that financial forecasting is essential to the strategic growth of the firm.

LO2. List the three financial statements for forecasting.

LO3. Know the percent-of-sales method may also be used for forecasting on a less precise
basis.

LO4. Explain why the various methods of forecasting enable the firm to determine the amount
of new funds required in advance.

LO5. Understand the process of forecasting forces the firm to consider seasonal and other
effects on cash flow.
 Annotated Outline and Strategy

I. Introduction

A. Financial planning helps managers arrange increased funding requirements to

finance additional assets needed to support changes in marketing strategies and
growth.

B. Profit alone is insufficient to finance significant growth.

C. Financial forecasts are used to evaluate performance by comparing planned

outcomes against actual results.

D. Lenders frequently require evidence of planning prior to making funds available.

E. Financial planning is necessary, not only for success, but for survival as well.

II. Constructing Pro Forma Statements: The most comprehensive means of financial
planning is through the development of pro forma financial statements, namely the pro
forma income statement, the cash budget, and the pro forma balance sheet.

PPT Development of Pro Forma Statements (Figure 4-1)

Perspective 4-1: Indicate how the pro forma income statement and cash budget are used to
develop the pro forma balance sheet as presented in Figure 4-1. Then a more detailed coverage
of other tables and schedules can be given.

III. Pro Forma Income Statement: A projection of how much profit a firm will make over
a specific time period

1. Establish a sales projection

a. Forecast economic conditions
b. Survey sales personnel

PPT Projected Wheel and Caster Sales (Table 4-1)

Perspective 4-2: Many steps are necessary to convert the sales forecast into production
requirements, cost of goods sold, and gross profit. Tables 4-1 through 4-7 are all brought
together into one table (Table 4-8) to show all the relationships at once in the pro forma income
statement.

2. Determine a production schedule and the associated use of new material,

direct labor, and overhead to arrive at gross profit.
 PPT Stock of Beginning Inventory (Table 4-2)

Finance in Action: Tesla’s Sales Forecasts: Where Marketing and Finance Come Together
Students need to understand that many of the numbers financial managers use in their analysis
are provided by other functional areas in the firm. Sales forecasts are usually generated by the
marketing function, and projected sales for wheels and casters in Table 4-1 are derived outside
of the finance area. Tesla Motors is given as an example in this box.

PPT Production Requirements for Six Months (Table 4-3)

a. Determine units to be produced

+ Projected unit sales
+ Desired ending inventory
– Beginning inventory
= Production requirements

b. Determine the cost of producing the units

(1) Unit cost = materials + labor + overhead

(2) Total costs = number of units to be produced  unit cost

PPT Unit Costs (Table 4-4)

PPT Total Production Costs (Table 4-5)

c. Compute cost of goods sold

(1) Estimate unit sales

(2) Cost of goods sold = unit sales × unit cost (FIFO or LIFO)

d. Compute gross profit

PPT Allocation of Manufacturing Cost and Determination of Gross Profits

(Table 4-6)

PPT Value of Ending Inventory (Table 4-7)

3. Compute other expenses

a. General and administrative
b. Interest expense
c. Taxes
d. Dividends

4. Determine profit by completing the actual pro forma statement

 + Sales revenue
– Cost of goods sold
= Gross profit
– General and administrative expenses
= Operating profit (EBIT)
– Interest expense
= Earnings before taxes (EBT)
– Taxes
= Earnings after taxes (EAT)
– Common stock dividends
= Increase in retained earnings

PPT Income Statement (Table 4-8)

IV. Cash Budget: A summary of expected cash receipts and disbursements for a specific
period of time

1. Estimate cash sales and collection timing of credit sales

PPT Monthly Sales Pattern (Table 4-9)

PPT Monthly Cash Receipts (Table 4-10)

PPT Component Costs of Manufactured Goods (Table 4-11)

2. Forecast cash payments

a. Payments for materials purchased according to credit terms

b. Wages
c. General and administrative expenses
d. Capital expenditures
e. Principal payments
f. Interest payments
g. Taxes
h. Dividends

PPT Average Monthly Manufacturing Costs (Table 4-12)

PPT Summary of All Monthly Cash Payments (Table 4-13)

3. Determine monthly cash flow (receipts minus payments)

PPT Monthly Cash Flow (Table 4-14)

 PPT Cash Budget with Borrowing and Repayment Provisions
(Table 4-15)

4. Construct cash budget

+ Total receipts (for each month, week, etc.)

– Total payments (for each month, week, etc.)
= Net cash flow (for the period)
+ Beginning cash balance
= Cumulative cash balance

Note: The beginning cash balance for each period of the cash budget is
equal to the cumulative cash balance of the previous period in the absence
of borrowing or investing of cash balances.

5. Determine cash excess or need for borrowing

+ Desired cumulative cash balance

– Cumulative cash balance (at end of period)
+/– Loan required or cash excess
= Ending cash balance

V. Pro Forma Balance Sheet: An integrated projection of the firm’s financial position
based on its existing position, forecasted profitability (from pro forma income statement),
anticipated cash flows (cash budget), asset requirements, and required financing

1. Construction of pro forma balance sheet

a. Current Assets (source of information)

(1) Cash (cash budget)

(2) Marketable securities (previous balance sheet and cash
budget)
(3) Accounts receivable (sales forecast, cash budget)
(4) Inventory (COGS computation for pro forma income
statement)
(5) Plant and equipment (previous balance sheet + purchases –
depreciation)

b. Liabilities and Stockholders’ Equity

(1) Accounts payable (cash budget worksheet)

(2) Notes payable (previous balance sheet and cash budget)
(3) Long-term debt (previous balance sheet plus new issues)
(4) Common stock (previous balance sheet plus new issues)
 (5) Retained earnings (previous balance sheet plus projected
addition from pro forma income statement)

Perspective 4-3: Use Figure 4-2 to reinforce the pattern used to arrive at the pro forma
balance sheet.

PPT Development of a Pro Forma Balance Sheet (Figure 4-2)

PPT Balance Sheet December 31, 2021 (Table 4-16)

PPT Pro Forma Balance Sheet June 30, 2022 (Table 4-17)

Perspective 4-4: Table 4-17 is the last piece in the puzzle in that it represents the actual pro
forma balance sheet. The amounts in the 10 accounts in the table can be clarified in the
explanations following the table in the text.

Finance in Action: Pro Forma Financial Statements: A Critical Tool for Entrepreneurs
This box reemphasizes what we have stated in the overview and provides some important
reasons why pro forma financial statements are important. A point often overlooked by
entrepreneurs is that a firm can only grow if it has enough money available to increase its current
and fixed assets.

VI. Percent-of-Sales Method: Shortcut, less exact alternative for determining financial
needs

1. Assumes that balance sheet accounts maintain a given relationship to sales

Assets
= % of sales
Current Sales

PPT Balance Sheet and Percentage-of-Sales Table for Howard Corporation

(Table 4-18)

Perspective 4-5: Table 4-18 can be tied in with Formula 4-1 to demonstrate the percent-of-
sales method.

2. Project asset levels on basis of forecasted sales (percent of sales of each asset 
forecasted sales)

3. Project spontaneous financing: Some financing is provided spontaneously when

asset levels increase; for example, accounts payable increase when a firm buys
 additional inventory on credit.

4. Project internal financing from profit = profit margin  forecasted sales 

dividend payout ratio.

5. Determine external financing = required new assets to support sales –

spontaneous financing – the change in retained earnings. The relationship is
expressed as follows:

Where:
A/S = percentage relationship of variable assets to sales
S = change in sales
L/S = percentage relationships of variable liabilities to sales
P = profit margin
S2 = new sales level
D = dividend payout ratio

Perspective 4-6: Students often get confused about companies operating at full capacity and
those operating at less than full capacity. Be sure to emphasize the point that when at full
capacity, a company cannot increase output without adding more fixed costs. However, when
operating at less than full capacity, the firm can produce more goods without making additional
investments in plant and equipment.