DEPARTMENT OF BUSINESS AND PUBLIC

MANAGEMENT

COURSE CODE: BAF4209

COURSE TITLE: FINANCIAL MODELLING AND

FORECASTING

Instructional Material for BFM- Distance

Learning
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BAF4209: FINANCIAL MODELLING AND FORECASTING

Pre-requisites: BFM 312

Purpose: To introduce the learner methods and tools used in financial

modeling and forecasting

Expected Learning Outcomes of the Course

By the end of the course unit the learners should be able to:-

i) Explain the terms financial modeling and forecasting

ii) Describe methods and tools used in financial forecasting
iii) Apply the methods and tools in financial modeling and forecasting
iv) Apply computer packages in financial forecasting

Course Content:

Building blocks of financial forecasting; vertical and horizontal relationships

among parameters of financial statements; Statistical and graphical analysis
of past budget patterns; Setting parameters for future growth and/ or changes
of financial budgets; Profit and loss, balance sheet projected cash flow

Application of computer packages in financial forecasting

Teaching / Learning Methodologies: Lectures and tutorials; group

discussion; demonstration; Individual assignment; Case studies

Instructional Materials and Equipment: Projector; test books; design

catalogues; computer laboratory; design software; simulators

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Course Assessment

Examination - 70%; Continuous Assessment Test (CATS) - 20%;

Assignments - 10%; Total - 100%

Recommended Text Books:

i) Jae K. Shim, Joel G. Siegel (2005), Handbook of financial analysis,

forecasting and modeling,

Text Books for further Reading:

i) Carol Alexander (2008) , Practical Financial Econometrics( Series -

Market Risk Analysis ), John Wiley & Sons Inc
ii) Peiji Wang (2003), Financial Econometrics: Methods And
Models,Routledge
iii) Peter Christoffersen, (2003), Elements of Financial Risk Management
Academic Press

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CHAPTER ONE

INTRODUCTION

Forecast-an indication of what is going to happen at some future time.

A statement of future events based on some kind of knowledge or

judgments.

Financial Forecasting- Planning of future finances

Model –a representation or copy of something.

-a representative of the variables and relationships between them.

A model can be defined as an idealized representation of a real l life system.

This system could be already in existence or awaiting execution.

It is useful tool in planning.

Financial planning involves analyzingthe financial flows of the company,

forecasting the consequences of various investments financing and divided
decisions to weighing the effects of various alternatives.

FORECASTING METHODS.

Financial forecasting methods are techniques of determining in advance the

requirement and utilization of funds for a future period.

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Uses of financial forecasting

1. Helps to anticipate financial needs and effects on new policies thereby

avoiding emergency decisions.

2. Works as a control device in a firm as it provides a standard of financial

performance for the future.

3. It is an aid in explaining the requirements of funds for the firm together

with the funds of suppliers.

4. It helps to explain the proper requirements of funds and their optimum

utilization.

5. It is used to pretest the financial feasibility of various programmes.

6. It assists the firm for the successful financial planning by providing

significant information.

Forecasting methods

Qualitative approach forecasts based on judgment and opinion:

 Executive opinions

 Delphi technique

 Sales force po11ing

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 .
Consumer surveys

 Nominal Group Technique

 Market Research

Quantitative approach

Forecasts based on historical data

 Naive methods

 Moving average

 Exponential smoothing

 Trend analysis

 Decomposition of time series

Associative (causal) forecasts

 Simple regression

 Multiple regression

 Econometric modeling

Selection of Forecasting Method

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The choice . of a forecasting technique is influenced significantly by the stag
product life cycle and sometimes by industry for which a decision is being

made. In the beginning of the product life cycle, relatively small

expenditures are made for research and market investigation.

What forecasting technique or techniques to select depends on five

criteria

What is the cost associated with developing the forecasting model, compared

with potential gains resulting from its use? The choice is one of benefit-cost

trade-off.

 How complicated are the relationships that are being forecasted?

 Is it for short-run or long-run purposes’?

 How much accuracy is desired?

 Is there a minimum tolerance level of errors?

 How much data are available? Techniques vary in the amount of data

they require. -

Qualitative Forecasting Methods

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. (or judgmental) approach can be useful in formulating short
The qualitative

term forecasts can also supplement the projections based on the use of any of

the quantitative methods.

Qualitative forecasting techniques are generally more subjective than their

Quantative counterparts. Qualitative techniques are more useful in the earlier

stages of the product life cycle, when less past data exists for use in

quantitative methods.

Four of the better-known qualitative forecasting methods are executive

opinions, the Delphi method, sales-force polling, and consumer surveys.

Others are Nominal Group Technique and Market Research.

Executive Opinions

The subjective views of executives or experts from sales, production

finance, purchasing. and administration are averaged-to generate a-forecast

about future sales. Usually this method is used in conjunction with some

quantitative method, such as trend extrapolation. The management team

modifies the resulting forecast, based on their expectations.

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Advantages

a) The forecasting is done quickly and easily, without need of elaborate

statistics.

b) Also, the jury of executive opinions may be the only means of

forecasting feasible in the absence of adequate data.

Disadvantages

The disadvantages however, are that of “group think.” This is a set of

problems inherent to those who meet as a group. Foremost among these are;

a) High cohesiveness: With high cohesiveness, the group becomes

increasingly conforming through group pressure that helps stifle

dissension and critical thought

b) Strong leadership: Strong leadership fosters group pressure for

unanimous opinion.

c) Insulation of the group: Insulation of the group tends to separate the

group from outside opinions, if given.

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Delphi Technique

Delphi forecasting is a non-quantitative technique for forecasting. It draws

its name from the Oracles of Delphi, which in Greek Antiquity advised

people based on intuition and common sense. Unlike many other methods

that use so-called objective predictions involving quantitative analysis, the

Delphi method is based on expert opinions. It has been demonstrated that

predictions obtained this way can be at least as accurate as other procedures.

The essence of the procedure is to use the assessment of opinion and

predictions by a number of experts over a number of rounds in carefully

managed sequences.

One of The most important factors in Delphi forecasting is the selection of

experts. The persons invited to participate must be ‘knowledgeable about the

issue, and represent a variety of backgrounds. The number must not be too

small to make the assessment too narrowly based, nor too large to be

difficult to coordinate. It is widely considered that 10 to 15 experts can

provide a good base for the forecast.

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Procedure .
The procedure begins with the planner/researcher preparing a questionnaire

about the issue at hand, its character, causes and future shape. These are

distributed to the respondents separately who are asked to rate and respond.

The results are then tabulated and the issues raised are identified.

The results are then returned to the experts in a second round. They are

asked to rank or assess the factors, and justify why they made they their

choices. During a third or subsequent rounds their ratings along with the

group averages, and lists of comments are provided, and the experts are

asked to re-evaluate the factors. The rounds would continue until an agreed

level of consensus is reached. The literature suggests that by the third round

a sufficient consensus is usually obtained.

The procedure may take place in many ways. The first step is usually

undertaken by mail. After the initial results are obtained the subsequent

round could be undertaken at a meeting of experts. Assuming it would be

possible to bring them together physically. Or, the subsequent rounds could

be conducted again by mail, &Mail has greatly facilitated the procedure. The

basic steps are as follows:

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a) .
Identification of the problem: - Researcher identifies the problem

for which some predictions are required, e.g. what is the traffic of port

x likely to be in 10 years time. Researcher prepares documentation

regarding past and present traffic activity. Questionnaire is formulated

concerning future traffic estimates and factors that might influence

such developments. A level of agreement between the responses is

selected, i.e. if 80% of the experts can agree on a particular traffic

prediction.

b) Selection of experts: - In the case o’ a port scenario this might

include terminal managers, shipping line representatives, land

transport company representatives, intermediaries such as freight

forwarders, and academics. It is important to have a balance, so that

no one group is overly represented.

c) Administration of questionnaire: - Experts are provided with

background documentation and questionnaire. Responses are

submitted to researcher within a narrow time frame.

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d) .
Researcher summarizes responses: - Actual traffic predictions are

tabulated and means and standard deviations calculated for each

category of cargo as in the case of a port traffic prediction exercise.

Key factors suggested by experts are complied and listed.

e) Feedback:-The tabulations are returned to the experts either by mail

or in a meeting convened to discuss first round results. The advantage

of a meeting is that participants can confront each other to debate are

areas of disagreement over actual traffic predictions or of key factors

identified. The drawback is that influence over the discussion and

thereby .sway outcomes, a trend that the researcher must be alert to

and seek to mitigate. Experts are invited to review their original

estimates and choices of key factors in light of the results presented,

and submit a new round of predictions.

f) These new predictions are tabulated and returned to the experts either

by mail or immediately to the meeting, if the level of agreement does

not meet the predetermined level of acceptance. The specific areas of

disagreement are highlighted, and the experts are again requested to

consider their predictions in light of the panel’s overall views.

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g) The.. process is continued until the level of agreement has reached

the pre-determined value. If agreement is not possible after several

rounds, the researcher must terminate the process and try to pinpoint

,where the disagreements occur, and utilize the results to indicate

specific problems in the traffic prediction process in this case. This

method could be applied in a classroom setting, with students serving

as experts’ for a particular case study. The traffic at the local airport or

port might be an appropriate example. On the basis of careful

examination of traffic trends and factors influencing business activity,

the class could be consulted to come up with predictions that could

then be compared with those of some alternate method such as trend

extrapolation.

Advantages & Disadvantages of Delphi Method:

Delphi method has some exclusive advantages:

 It facilitates anonymity of the respondent’s identity. This enables

respondents to be frank and forthright in giving their views.

 It facilitates posing the problem to the experts at one time and has

their response nearly as good as pooling the panelists together. In

one case 620 experts from different background such as policy-

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makers, technologists, scientists, economists, administrators and

advisers were consulted.

However, Delphi method presumes these two conditions

a) Panelists must be rich in their expertise having wide knowledge of the

subject and are sincere and earnest in their disposition towards the

participants.

b) The conductors are objective in their job, possess skill to conceptualize

the problems for discussion to generate considerable thinking, stimulate

dialogue among panelists and make inferential analysis of the numerous

views of the participants

Sales Force Polling

Some companies use as a forecast source salespeople who have continual

contacts with customers. They believe that the salespeople who are closest to

the ultimate customers may have significant insights regarding the state of

the future market. Forecasts based on sales force polling may be averaged to

develop a future forecast. Or they may be used to modify other quantitative

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and/or .
qualitative forecasts that have been generated internally in the

company.

Advantages

 It is simple to use and understand.

 It uses the specialized knowledge of those closest to the action

 It can place responsibility for attaining the forecast in the hands of

those who most affect the actual results.

 The information can be broken down easily by territory, product,

customer, or salesperson.

Disadvantages

Salesperson’s being overly optimistic or pessimistic regarding their

predictions and inaccuracies due to broader economic events that are largely

beyond their control.

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Consumer . Survey
Some companies conduct their own market surveys regarding specific

consumer purchases. Surveys may consist of telephone contacts, personal

interviews, or questionnaires as a means of obtaining data. Extensive

statistical analysis usually is applied to survey results in order to test

hypotheses regarding consumer behavior.

Nominal Group Technique

Nominal Group Technique is similar to the Delphi technique in that it

utilizes a group of participants, usually experts. After the participants

respond to forecast-related questions, they rank their responses in order of

perceived relative importance. Then the rankings are collected and

aggregated. Eventually, the group should reach a consensus regarding the

priorities of the ranked issues.

Market Research

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In market.. research, consumer surveys are used to establish potential

demand. Such marketing research usually involves constructing a

questionnaire that solicits personal, demographic, economic and marketing

information. On occasion, market researchers collect such information in

person at retail outlets and malls, where the consumer can experience—taste,

feel, smell, and see—a particular product. The researcher must be careful

that the sample of people surveyed is representative of the desired consumer

target.

Quantitative Forecasting Methods

Quantitative forecasting techniques are generally more objective than their

qualitative counterparts. Quantitative forecasts can be time-series forecasts

i.e., a projection of the past into the future) or forecasts based on associative

models (i.e., based on one or more explanatory variables). Time-series data

may have underlying behaviors that need to be identified by the forecaster.

In addition, the forecast may need to identify the causes of the behavior.

Some of these behaviors may be patterns or simply random variations.

Forecasts based historical data

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 Naive . methods
 Moving average (Covered in class)

 Exponential smoothing (Covered in class)

 Tend analysis (covered in class)

 Decomposition of time series ( covered in class)

Associative (causal) forecast

 Simple regression (covered in class)

 Multiple regression

 Econometric modeling

Econometric Forecasting

Econometric methods such as autoregressive integrated moving-average

model (APJMA) use complex mathematical equations to show past

relationships between demand and variables that influence the demand. An

equation is derived and then tested and fine-tuned to ensure that it is as

reliable a representation of the past relationship as possible. Once this is

done, projected values of the influencing variables (income, prices, etc.) are

inserted into the equation to make a forecast.

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REGRESSION. ANALYSIS

This is a statistical technique that identifies the relationship between two or

more variables where one variable called the dependent variable will be

predicted by an independent or explanatory variable.

In a simple regression analysis the following equation is used;

y = a + bx

In a multiple regression analysis the following equation may be used;

y = a + b1 x1+b2x2 + ………………………+ bnxn

In the equation Y a + bx

v is the dependent variable

x is the independent variable

a and b are constants

Underlying assumptions

Classical assumptions for regression analysis include:

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 The.. sample must be representative of the population for the inference

prediction.

 The error is assumed to be a random variable with a mean of zero

conditional on the explanatory variables.

 The variables are error-free. If this is not so, modeling may be done

using errors-in techniques.

 The predictors must be linearly independent, i.e. it must not be

possible to express any predictor as a linear combination of the others.

See Mu1ticollineairty.

 The errors are uncorrelated, that is, the variance-covariance matrix of

the errors is diagonal and each non-zero element is the variance of the

error.

 The variance of the error is constant across observations

(homoscedasticitv). If not, weighted least squares or other methods

might be used.

The least square method of regression

This method determines mathematically the regression line of best fit in

order to establish the required predictive equation.

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The normal . equation can be used as follows;
y=a+bx ……………………………………………….1

If you multiply equation 1 by x you obtain;

xyax+bx2 ………………………………………………2

Imposing summation sign we obtain

 y  an  b x.......... .......... .......... .......... 3

 xy  a x  b x2.......... .......... .......... 4

Equations 3 and 4 can then be solved simultaneously to obtain the values of

constants a and b.

Alternatively the following equations may be used to solve for a and b.

a   y  b x and

n n

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b  n xy ..  x  y

n x 2   x 
2

Example

Consider the following information about company ABC limited;

Month. Sales sh. 000 Advertisement sh.000

1 20 5

2 25 7

3 30 8

4 40 10

5 50 12

6 60 15

Required

1. Determine an equation of the form y=a +bx to predict sales from

advertisement.

2. Predict sales when advertisement is sh 20,000, 25,000 and 30,000

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Solution ..

Month Sales (y) sh Advertisement X2 sh000 xysh 000

000 (x) sh 000

1 20 5 25 100

2 25 7 49 175

3 30 8 64 240

-4 40 10 100 400

5 50 12 144 600

6 60 15 225 900

 y  225  x  57  x 2=607  xy  2415

 y  an  b x

 xy  a x  b x 2

225 =6a+57b

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241 5=57a+607b

Solving simultaneously

a =-2.7477

b =4.2366

The predictive equation is;

y=-2.7477 + 4.2366x

if x = 20 then, y -2.7477+ 4.2366 x 20

Hence y 81.98

If x = 25 then, y -2.7477+ 4.2366 x 25

Hence y= 103.167

If x = 30 then, y -2.7477+ 4.2366 X 30

Hence y 124.35

CORRELATION ANALYSIS

The regression analysis identifies a clear relationship between two variables.

However it does not explain the strength of the association. This strength can

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be determined. using a statistical measure known as the correlation
coefficient denoted by ρ.

ρ = cov(x,y)

δxδy

cov (x,y) =  ( x  x)  ( y  y ) = 277.5 = 55.5

n-1 6-1

Where cov( x,y) is the covariance between x and y

δx and δy are standard deviations of x and y respectively

n is the sample size from the previous example of XYZ limited the

correlation coefficient can be calculated as follows;

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Month . x Y x  x  y  y 

1 5 20 (5-9.5) (20-37.5) = 78.75

2 7 25 (7-9.5) (25-37.5) =3 1.25
3 8 30 (8-9.5) (30- 37.5) =11.25
4 10 40 (10-9.5)(40—37.5)= 1.25
5 12 50 (12-9.5) ( 50— 37.5) =3
1.25
6 15 60 (15- 9.5) ( 60—37.5)
=123.75
 x  57  y  225
 x  x  y  y   277.5

X=57/6=9.5

y= 225/6=37.5

 ( x  x)
2
δx = = 3.619

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n-1 .

 ( y  y)
2
δy = = 15.41

ρ = cov (x,y) = 55.5 = 0.995

δxδy 3.61 x 15.41

MULTIPLE REGGRESION

This involves three or more variables. There is still a dependent variable y

but now there are two or more independent variables. The function for y in

multiple regression is given by;

y=a+b1x1-1-b2x2

If you multiply through by x1

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x1y =ax1+.. b1x12+ b2x1x2

If you multiply through by X2

X2y + ax2+ b1x1x2+ b2x22

Then the normal equations become;

 y  an  b 1  x 1 = b2  x 2……………………………………………….1

 x1y=a  x1 + b1  x12 + b2  x1 x2………………………………….2

 x2y = a  x2 + b1  x1 x2 + b2  x 22…………………………….3

Example

MrOrina the marketing manager of Laingu limited is concerned about the

sales behavior of his product. He realizes that there are many factors that

may help explain the sales behavior but believes that advertising and prices

are the major determinants. He has collected the following data;

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Sales in 33 61 70 82 17 24

units

Advertising 3 6 10 13 9 6

(No of

adverts)

Prices (sh) 125 115 140 130 145 140

Required;

Determine the regression equation to predict sales from advertising and

prices

If advertising is 15 and price is 142 how many units would be sold?

Solution;

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. variable is sales in units(y) and the independent variables are
The dependent

advertising ( x1) and prices (x2).

X1 x2 Y x1y x12 x1x x2y x22

3 125 33 99 9 375 4125 15625

6 115 61 366 36 690 7015 13225

10 140 70 700 100 1400 9800 19600

13 130 82 1066 169 1690 10660 16900

9 145 17 153 81 1305 2465 21025

6 140 24 144 36 840 3360 19600

287= 6a+ 47bi+ 795b2

2528=47a+ 43 Ihl+6300b2

37425= 95a—63}bl—1O5974b2 Solving simultaneously a=219.6

bl=6.366

b2=-l .67

If v=a—b’x+b2x2 then;
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v=219.76+6.366x1 - 1.67x2

If advertising is 15 and price is 142 then

Y=219.76-t-6.366x 15+-1.67x 142

Hence sales 78.11

Limitations of regression analysis

1. Linear regression implements a statistical model that, when

relationships between the independent variables and the dependent

variable are almost linear, shows optimal results.

2. Linear regression is often inappropriately used to model non-linear

relationships.

3. Linear regression is limited to predicting numeric output.

4. A lack of explanation about what has been learned can be a problem.

EXERCISE

Question One

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Calculate ..the regression equation of X and Y and Y on X from the following

data:

X 1 2 3 4 5

Y 2 5 3 8 7

Question Two

In the following table are recorded data showing the test scores made by

salesmen on an intelligence test and their weekly sales:-

Salesmen 1 2 3 4 5 6 7 8 9 10

Test scores 40 70 50 60 80 50 90 40 60 60

Sales (sh’000’) 2.5 6.0 4.0 5.0 4.0 2.5 5.5 3.0 4.5 3.0

Calculate the regression line of sales on test scores and estimate the proable

weekly sales volume if a salesman makes a score of 100.

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Question Three

You have been presented with the data below

Units 24 27 30 33 36

of

output (x)

Cost 2,000 2,200 2,400 2,450 2,500

Required:

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i. compute . a linear cost function
ii. Compute the total cost if 80 units are produced.

Question Four

The following data relates to MeldinCo.Ltd in relations to sales and cost of

advertisement for the year ended 3jt May 2010.

Sales(y) 170 240 260 300 220 250

sh. 000’

Cost (x) 20 40 50 60 30 40

sh. 000’

Required:

i. Compute the relationship between sales and cost of advertisement.

ii. Forecast for sales if sh. 60,000 is spent on advertisement.

iii. what would be the forecast sales if advertisement cost is sh. 100,000

Question Five

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Abel Motors . specializes in the import and sale of sports cars in Kenya. The
marketing manager has bee; analyzing the demand for sports car over the

last three years. The table below shows the quarterly demand for the sports

cars and the seasonal multiplicative index for each quarter.

Number of sports car demanded

Year Quarter 1 Quarter 2 Quarter 3 Quarter 4

2007 8 17 12 6

2008 12 20 17 9

2009 16 28 25 14

Multiplicative 0.9093 1.434 1.1234 0.5317

index

Required

a) A linear regression equation for demand for sports cars

b) Forecast the quarterly demand for the year 2010 using the linear

regression cars

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c) .
Deseasonajise the demand data of the sports car using seasonal

multiplicative indices provided.

d) Fit a linear regression equation to the depersonalized demand in ©

above

e) Use the trend equation in (d) above to determine the seasonally

adjusted forecast for demand of each quarter in 2010

f) Give the actual sales for the year 2010 to be 21,32,28 and 20 sports

cars for quarters 1,2,3 and 4 respectively, determine which of the

forecasts in (bO or (cO above would be preferred.

CHAPTER TWO

BUILDING BLOCKS OF FINANCIAL FORECASTING.

There is no standard finance system for organizations. But there are some
basic building blocks, which must be in place to achieve good practice in
financial management. They include:

Accounting records

Every organization must keep an accurate record of financial transactions

that take place to show how funds have been used. Accounting records also
provide valuable information about how the organization is being managed
and whether it is achieving its objectives.

Financial planning

Financial plans (budgets)must be linked to the organizations strategic and

operational plans, the budget is the cornerstone of any financial management
system and pays an important role in monitoring the use of the funds.

Financial monitoring

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Provided the . organization has set a budget and has kept and reconciled its
accounting records in a clear and timely manner, it is then possible and easy
to produce financial reports which allow the manager to assess the progress
of the organization against the plans.

Internal controls

Internal controls are mechanisms to enhance controls, checks and balances

in organization in order to :

-Safeguard the assets

-Manage internal risk

-Deter opportunistic theft or fraud

-To detect errors and omissions in accounting records.

(a)Proforma Financial Statements.

Financial statements which are meant to display the effects of future

circumstances are described as proformastatements. There are no rigid set of
rules for constructing pro-forma statements. Thus the formats vary with the
ingenuity of the financial executives.

There are two types of proforma financial statements.They are

i) Projected income statement

ii) projected balance sheet.

PROJECTED INCOME STATEMENTS.

This statement is a projection of income for a period of time in future. In

other words, projected income statement is a statement which furnishes a
fair and reasonable estimate of expected revenue,cost,profits,taxes,dividends
and other financial items.

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This statement. is built around the estimate of the expected sales for the
forecast period.

The sales may be estimated on the basis of the detailed analysis of

competitive firms, market research and professional economic surveys.

Production cost can be estimated on the basis of the formulated production

schedule. But this can be accurately predicted through the detailed analysis
of purchases, productive wages and overhead costs.

The finance should also estimate the administrative and selling expenses. As
both of them are usually budgeted beforehand, their estimates are seldom
correct.

The estimates should also be made for other incomes and expenses along
with interest for computing net income before taxes. For calculating net
income after taxes, income-taxes at the prescribed rate should also be
deducted.

Dividend payment should be predetermined at the appropriate level.Such

payments are required to be deducted from the estimated net income/profit
after tax.

A typical form of projected income statement with imaginary figures is

shown below:

Projected Income statement

For the year ended 31st December 2002

Revenue/Sales 1600000

Expenses

Cost of goods sold

Raw materials 400000

Direct wages 600000

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Factory. overheads 1000001100000

Gross Profit 500000

Administrative expenses 80000

Interest 20000

Selling and distribution expenses 60000

Depreciation 40000200000

Operating Profit/Net Income Before Tax 300000

Less Taxes 50% 150000 Profit after tax/Net

income 150000

Add: Retained Earnings b/d 50000

200000
Less: Dividends 100000

Retained Earnings C/D 100000

Although proforma income statement may serve as a satisfactory

estimate of profits for the projected period, it does not serve as a device to
control expenses.

PROJECTED BALANCE SHEET

The projected balance sheet is essentially a forecast of expected fund

flows.Its construction is based on the information available in the projected
income statement together with supporting schedules and budgets. The
following steps are involved in its preparation:

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a)Calculation. of the net investment in each of the assets of the company to
carry out operations at the planned level on the target date.

b)Calculation of the net worth of the company after adjusting the projected
income of the company from the period of forecasting.

c)Listing of the liabilities that can be relied upon without negotiation.

d)Comparison of the projected assets with the total sources of funds,i.e

liabilities and net worth.

Interpretation of Projected Balance Sheet Items

(a)Fixed Assets-As outlays of plant and machinery are generally planned

beforehand, the amount of fixed assets can be estimated without much
difficulty.However,adjustments are to be made for additions and sales of old
assets along with the amount of depreciation. Other assets such as prepaid
expenses, patents,goodwill etc will remain as they are unless it is specifically
mentioned.

(b) Current Assets.

(i) Cash-Usually a minimum amount of cash is to be maintained in

hand for meeting various needs of the firm. It can also be a
balancing or plug figure to equalize assets and liabilities. This is
particularly the case when borrowings from banks are taken as
fixed.
(ii) Sundry Debtors (Accounts Receivable)-Sales budget can be used
to forecast the magnitude of debtors. However it depends on the
number of days credit is allowed to customers. It can be computed
with the help of a formula;
(iii) Inventories –The inventory level in relation to production
programme is a unique item in the projected balance sheet.
Itsestimate is made on the basis of turnover ratio or through
careful estimates of purchase, production and selling schedules. It
is computed as under:
Stock turnover ratio=

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©Liabilities
1.Shareholders funds/networth:It consists of the amount of share
capital and reserves and surplus(fixed assets plus current assets
minus current and long term liabilities).Shareholders fund should
be computed by taking into consideration the items such as fresh
issue of shares, redemption of preference shares and retained
earnings from profit as well. The profit figures are taken from the
projected income statement. In case there is allocation of profit to
reserve, it can be incorporated in the respective reserves.
2.Creditors-They can be estimated by analyzing schedules of
purchases, payments for the period or by ascertaining the ratio of
accounts payable with purchases or cost of goods sold. Creditors
can be computed as follows:

3.Outstanding Liabilities-Outstanding or accrued liabilities can be

analyzed by examining the pattern of wage payment, tax payments
and interest obligations. Past and future data relating to these items
should also be considered for this purpose.

4.Provision for tax and dividends: The projected balance sheet

should be prepared only after providing proper provision for taxes
and dividends.However,these items also depend on past and future
data, the rate of tax and dividend etc.

Having estimated all the components of the projected balance

sheet,the financial an analyst should combine and present them in a
balance sheet.Further,all the balance sheet items can be estimated
by projecting financial ratios for the future.

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Illustration 1:

(b)Cash Budget
Cash budget is one of the most important tools in the budgetary kit
of the financial executive. It is prepared to estimate the expected
cash receipts and payments during a specified period infuture.
Thus cash budget is a forecast of how much cash will be required
during a particular period in future. However the estimates are
made on a day to day, week to week or month to month basis
depending on the requirement of cash.
The following are the main objectives of preparing a cash budget:
(i)To ensure the availability of adequate amount of cash for
thepurpose of various capital and revenue expenditures.

To arrange cash in advance in the case of expected shortage of

funds

To employ surplus amount of cash if any in any profitable

investment outside the business.

Benefits of Preparing Cash Budget

The various advantages which can be derived from the cash budget are as
follows:

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Cash . requirements: The cash budget provides a clear picture about the
quantum of cash requirements at a particular moment of time. This
helps the firm to make necessary arrangements for various purpose.

Additional cash requirements: The cash budget also informs the firm
the quantum of additional cash requirement during the peak period. It
also suggests the way in which such funds are to be mobilized.

Deficit or Surplus: The result of cash budget is either surplus or deficit

cash. Thus surplus cash if any can be invested properly.

Cash discount firm can derive the benefit of cash discount by making
payments before the date as the surplus amount of cash can be known
by the preparation of cash budget.

Methods of preparing cash budget

A cash budget is prepared in any of the following ways:

 Receipts and payments method

 The adjusted profit and loss method
 The balance sheet method

For short term forecasting, thereceipt and payment method is very useful as
the inflow and outflow of cash can be estimated by a proper analysis under
this method. However the adjusted profit and loss method and the balance
sheet method are useful for long term forecasting.

Receipts and payments method

Under this method, all the all the anticipated cash receipts and payments
during the budget period are considered. In other words the estimates of
sales, purchases,productionetc form the basis of cash budget.It considers
only cash receipts, regardless of their nature and period.Similarly,it
recognizes payments irrespective of the particular point of time at which the
liability for expenditure arises. Moreover the nature of cash payment is also
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irrelevant...But is needless to point out that the accrued expenses and
incomes are not to be considered at all in this budget.

Under this method, the budget is divided into two parts; receipts and
payments.

The receipts part of the budget is constructed in accordance with the sales
budget, as the chief sources of funds are from sales. But the payments part of
the budget is constructed as per other functional budgets.

The cash budget prepared under this method provides the following
information:

Information as to the quantum of sales to be made and also about the time-
lag in the case of credit sales.

Information about the raw materials to be bought. This is furnished from

purchase budget.

Information about the total amount of wages to be paid and the lag in
payment of wages.

Information about the amount to be paid for various overheads and the lag in
payment of overheads.

Information about the cost to be considered for acquiring fixed assets.This is

required for preparing capital expenditure budget.

All other information relating to receipts such as issue of shares,

overdrafts,etc and payments such as dividend,taxation,repayment of loans
etc are also available from cash budget.

Illustration 1

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Adjusted profit and loss method

Adjusted profit and loss method is practically useful for long term
forecasting which attempts to indicate the effect of proposed long range
plans such as acquisations,new product development and long range charges
on the company’s balance sheet three,five,or even ten years in the future.

The method is based on the assumption that profit is equivalent to cash and
both cash and non cash transactions are considered.

Illustration:

Balance sheet method

In this method a budgeted balance sheet is prepared by recording all

expected assets and expected liabilities except cash. In case the liabilities
side is more than the assets side, the difference will be cash balance. On the
contrary, ifthe assets side is higher than the liabilities side, the balance will
represent bank overdraft.

This method is highly useful for long term forecasting.

Illustration 1.

OTHER METHODS OF FINANCIAL FORECASTING

Percentage of sales method

It is the simplest forecasting technique and is suitable for long term

forecasting.

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This method . is commonly used in estimating the financial requirements of
the firm based on forecast of sales.

Under this method, each component of balance sheet item is expressed in

terms of percentage of sales. Financial data can now be developed for
projected sales at different levels.

BUDGETING

Course objectives

The main focus for budgeting is in planning. This represents steps taken by a
business to achieve their desired levels of profits. This is in part by preparing
a number of budgets which when put together forms an integrated business
plan often referred to as master budget.

The master budget is a vital management tool that communicates

management plan throughout the organization, allocate resources and
coordinate activities.

In budgeting, we often identify a limiting factor; this being a factor at any

given time effectively constraints the activities of the organization of the
customers demand or production capacity, labour shortages or shortages of
materials space or finance.

Profit centre is a section or part of the organization that is accountable for

both costs and revenues.

Budget centre is a section of an entity for which control may be exercised

and budgets prepared.

Cost centre is an identifiable section or part of organization for which costs

may be accumulated.
Budget definition:

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. expression of a plan of action prepared in advance of the
A quantifiable
period to which it relates.

-A quantitative statement for a defined which includes revenue expenses

assets liabilities.

It includes both financial and non financial aspects of the plan and it serves
as a blue print for the organization to follow in the upcoming period ahead

A budget may be prepared for the organization as a whole or for a

department or as financial resources items of cash, capital expenditure etc.

Budget provides for a plan or the forecast for the organization, aid in
coordination in activities and facilitates control and planning.

Planning is making of objectives and preparing budgets to achieve those

objectives. This is accomplished by use of a master budget (fixed or static)

Control represents the steps taken by management to change the likelihood

that the plans set at the planning stage are attained and that all parts of the
organization are working together towards that goal.

Control is exercised by comparing activities cost revenues with amount in

the flexible budget.

A variance is the difference between budgeted results and the actual

outcome. Afavorable variance arises when actual cost are less than the
budgeted costs while unfavorablevariance arises when actual costs exceed
the budgeted costs.

Companies prepare long term strategic plans sparing a period of five to ten
years that provide a roadmap for the future regarding potential opportunities
as new products, materials or investments. They are then fine tuned and
broken down into medium and and short term plans.

Short term plans are more operational in nature and translate strategic plans
into actions that are fairly concrete. They also contain specific objectives
and goals.

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Budget Administration.

It refers to the appropriate administrative procedures put in place to ensure

that the budget works appropriately. It should be tailored to a particular
organization and its circumstances.

There are three elements in budget administration:

Budget committee

Budget Reporting

Budget timing

A budget committee overseas the preparation of a budget. Budgets should

not just be handed down as top management final word. Budget figures and
estimates are usually more helpful when developed through a bottom-up
approach in which every department prepare their own budget which is then
handed over to budget committee for scrutiny, moderation and approval.

The committee is made up of departmental heads and other executives who

are responsible seeing that budgetary amounts are realistic.

There is need for continued communication from the originating

departments and the budget committee to ensure that both parties accept the
budget and estimates are reasonable, attainable and desirable.

Budget reports contain relevant information that companies actual results to

planned objectives. They may be prepared at any time and for any period.
They highlight variances between actual and budgeted targets which may
call for investigation and if need be remedial action.

Steps in budget process.

1) .Communicating details of the budgeting policy.

2) Determine the factors that restrict performance.
3) Prepare the sale budget.
4) Prepare the initial budget from the sub-units of the organization.

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5) .
Negotiate the budget with supervisors.
6) Coordination of review of budgets.
7) Summarising the section budgets into a master budget.
8) Budget review done periodically.

Types of Budgets.

1. Strategic plan-sets the overall goals and objectives of the organization.

2. Long range plans-Result from strategic plan and produces forecast
financial statements sparing five to ten years. Such plans involve
making decisions of design and allocation of new plant, acquisition of
items and buildings, long term commitments etc
3. Capital Budgets –Details the expenditure for facility requirement, new
product and other long term investments.
4. Master Budget- One year or twelve months, summarize all the
activities of all sub-units of an organization across all the functions
e.g.finance, production
5. Continuous or Rolling budget – Common form of a master budget that
adds a month or a quarter
6. Fixed budget –one designed to remain unchanged irrespective of the
volume of output achieved the period it relates to.It is therefore based
on a single predetermined amount of sales or output. The purpose of a
static budget is to help managers in planning future activities the
organization.
7. 7. Flexible budgets-Designed to adjust to the permitted cost levels so
as to suit the level of activity that is attained. Designed to recognize
various behavior patterns change and change of volume of activity.
It’s a report based on predicted amounts of revenues and expenses
corresponding to the actual level of output. Unlike fixed budget
flexible budget is prepared after the periods activities are are
complete. In order to prepare it, one must analyze cost as fixed or
variable elements so that the budget may be flexed or changed
according to the level of activity. The purpose of a flexible budget is

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to help . managers evaluate past performance which are used in the
control process.

Components of a master budget.

i. Operating budget –focuses on the income statement.comprises of

sales, purchases,and production budget, cost of sales budget, operating
expenses and budgeted income statement.
ii. Financial budget –represent that part of the master budget focusing on
the effect of operating budget and other plans which involve cost.

Approaches to overcoming Problems in budgeting

1. 1.Zero based budgeting
2. 2.Activity based budgeting
3. 3.Rolling or continuous budgeting

Zero based budgeting

All activities are re-evaluated every time a business is formulated. Each trial
budget begins with the assumption that the function doesn’t exist and any
change in cash must be justified by incremental benefit.

Useful for discretionally spending eg advertising costs.

Advantages

1) It results in more efficient resource allocation to activities especially

when properly carried out.
2) It focuses attention on value for money and makes explicit the
relationship between resources used and output.
3) It helps in furthering a questioning attitude and eliminates non
productive operations.
4) It also provides a systematic way of challenging the status quo –it
obliges the organization to examine alternative activities, existing

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. patterns. Provides a tool that responds tochanges in the
behavior
environment.

Demerits

Not always acceptable to staff and trade unions who may prefer cozy but
expensive status quo.They may view a detailed examination of alternatives
as a threat instead of challenge.

ZBB is difficult to sell to managers for two reasons:

1. Incremental costs and benefits over alternative methods can lead to

quantify accuracy.
2. Trade unions will restrict management ideas that change ways in
which budgeting is done.
3. The approach is time consuming and features a lot of paperwork.

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CHAPTER . THREE
VERTICAL AND HORIZONTAL RELATIONSHIPS AMONG
PARAMETERS OF FINANCIAL STATEMENTS

Objectives: at the end of the lecture the student should be able to

Identify the major changes (turning points in trends amounts relationship)

Common size analysis

Common size analysis involves expressing comparisons in percentages for

example if cash is ksh. 40,000 and total assets is ksh. 1,000,000, then cash is
4% of total assets.

The use of percentage is usually preferable to the use of absolute figures.

e.g if a firm A earns shs. 10,000 and firm B earns ks.1,000 which is more
profitable? Firm A probably your response. However, the total owners
equity of A is ksh. 1000,000 and B’s is ksh. 10,000 the return on owners
equity is as follows

Firm A firm B

Earnings sh. 10,000 = 1% sh. 1,000 = 10%

Owner’s equity sh. 1,000,000 sh. 10,000

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The use of common size analysis can make comparisons of firm’s of

different sizes much more meaning since the numbers are brought to a

common base; perfect.

Vertical analysis

In vertical analysis, a figure from a year is compared with a base selected

from the same year.

Eg.If advertising expenses were ksh. 1,000 in 1992 and sales were ksh.

100,000 the advertising would be 1% of sales.

Horizontal analysis

In horizontal analysis a dollar/shilling figure for an account is expressed in

terms of that same account figure for a selected base year. For example, if

sales were ksh. 400,000 in 1991 and ksh. 600,000 in 1992 then sales

increased t 150% of the 1991 level in 1992 an increase of 50%.

RATIO ANALYSIS

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Financial ..ratios are usually expressed in percentages or a ration is defined as

indicated quotient of two mathematical ‘times’ expressions.

Types of ratios

1. Liquidity ratios – measures a firm’s ability to meet its current

obligations. They may include the ratios that measure the efficiency of

the use of current assets

2. Leverage ratios – they are capital structure ratios. They measure the

financial risk. The degree of protection of supplies of long-term funds

3. Activity rations (turn over ratios) evaluate the efficiency with which

assets are utilized.

4. Profitability ratios- measure the earning ability of a firm including

the use of assets in general

-In financial analysis, a ratio is used as a benchmark for evaluating the

financial production.

Standards of comparison

Past ratios – calculated for the same firm

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Competition . values – selected firms at selected point in times
Industry – industry to which the firm belongs

Projected ratio – ratios from projected or proforma financial statements of

the same firm.

Ratio analysis is a very useful tool to raise relevant questions on a number of

managerial issues. It provides clues to investigate those issues. It provides
clues to investigate those issues in detail.
However, caution needs to be applied while interpreting ratios as they are

calculated from the accounting numbers. Accounting numbers suffer from

accounting policy changes arbitrary allocation procedures and inflation.

Liquidity ratios

Current ratio = current Assets

Current liabilities

Quick ratio = current assets – inventory

Current liabilities

Internal measure = current assets – inventory

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. Average daily cash operating expenses

Leverage ratios

Total debt ratio = Total Debt

Capital employed

Debt equity ratio = Net worth

Total debt

Capital equity ratio = capital employed or net assets

Net worth

Interest coverage = EBIDTA

Interest

Activity ratios

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Inventory ..turnover = cost of goods sold/sales

Inventory

No of days inventory = 360

Inventory turnover

Debtors turnover = credit sales on sales

Debtors

Collection period = 360

Debtors turnover

Assets turnover = sales

Net working capital

Profitability Ratios

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Gross margin. = gross profit or EBIT

Sales sales

Net margin =Profit after tax

Sales

Or EBIT (I-T)

Sales

PAT to EBIT ratio = PAT

EBIT

Return on Investment (ROI) before tax= EBIT/ net assets or capital

employed

Return on investment = EBIDTA

S(ROI) before tax Total assets or net assets

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Return on..equity (ROE) = profit after tax

Net worth

There exists a relationship between various ratios, for example, ROE can be

expressed as follows

ROE = sales x EBIT x PAT x Net assets

Net sales sales EBIT net worth

In practice, companies calculate many other ratios. Most important ratios

include other ratios. Most important ratios include

EDS = PAT

Number of shares

DPS= profit distributed

Number of shares

Payout = Dps

Eps

Price – earning ratio = market value of share

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Excellence in.. Financial Management
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EPS

Market value book value ratio = market value of share

book value of shares

CHAPTER FOUR
FINANCIALPLANNING AND FORECASTING

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1
Introduction

Financial planning is a continuous process of directing and allocating financial

resources to meet strategic goals and objectives. The output from financial planning
takes the form of budgets. The most widely used form of budgets is Pro Forma or
Budgeted Financial Statements. The foundation for Budgeted Financial Statements is
Detail Budgets. Detail Budgets include sales forecasts, production forecasts, and other
estimates in support of the Financial Plan. Collectively, all of these budgets are
referred to as the Master Budget.

We can also break financial planning down into planning for operations and planning
for financing. Operating people focus on sales and production while financial planners
are interested in how to finance the operations. Therefore, we can have an Operating
Plan and a Financial Plan. However, to keep things simple and to make sure we
integrate the process fully, we will consider financial planning as one single process
that encompasses both operations and financing.

Start with Strategic Planning

Financial Planning starts at the top of the organization with strategic planning. Since
strategic decisions have financial implications, you must start your budgeting process
within the strategic planning process. Failure to link and connect budgeting with
strategic planning can result in budgets that are "dead on arrival."

Strategic planning is a formal process for establishing goals and objectives over the
long run. Strategic planning involves developing a mission statement that captures why
the organization exists and plans for how the organization will thrive in the future.
Strategic objectives and corresponding goals are developed based on a very thorough
assessment of the organization and the external environment. Finally, strategic plans
are implemented by developing an Operating or Action Plan. Within this Operating
Plan, we will include a complete set of financial plans or budgets.

Financial Plans (Budgets)  Operating Plan  Strategic Plan

NOTE: Short Course 10 describes how to prepare a Strategic Plan.

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The Sales Forecast

In order to develop budgets, we will start with a forecast of what drives much of our
financial activity; namely sales. Therefore, the first forecast we will prepare is the Sales
Forecast. In order to estimate sales, we will look at past sales histories and various
factors that influence sales. For example, marketing research may reveal that future
sales are expected to stabilize. Maybe we cannot meet growing sales because of
limited production capacities or maybe there will be a general economic slow down
resulting in falling sales. Therefore, we need to look at several factors in arriving at our
sales forecast.

After we have collected and analyzed all of the relevant information, we can estimate
sales volumes for the planning period. It is very important that we arrive at a good
estimate since this estimate will be used for several other estimates in our budgets. The
Sales Forecast has to take into account what we expect to sell at what sales price.

EXHIBIT 1 — SALES FORECAST

Product Volume Price Total Sales

Lace Shoes 16,000 $ 45.00 $ 720,000

Percent of Sales

We now need to estimate account changes because of estimated sales. One way to
estimate and forecast certain account balances is with the Percent of Sales Method. By
looking at past account balances and past changes in sales, we can establish a
percentage relationship. For example, all variable costs and most current assets and
current liabilities will vary as sales change.

EXAMPLE 1 — ESTIMATED ACCOUNTS RECEIVABLE

Past history shows that accounts receivable runs around 30% of sales.
We have estimated that next year's sales will be $ 160,000. Therefore,
our estimated accounts receivable is $ 48,000 ($ 160,000 x .30).

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2 .

Detail Budgets
We also need to prepare several detail budgets for developing a Budgeted Income
Statement. For example, production must be planned for our estimated sales of 16,000
units from Exhibit 1. The Production Department will need to budget for materials,
labor, and overhead based on what we expect to sell and what we expect in inventory.

EXHIBIT 2 — PRODUCTION BUDGET

Planned Sales (Exhibit 1) 16,000

Desired Ending Inventory 1,500
Total Units 17,500
Less Beginning Inventory ( 3,000)
Planned Production 14,500

Once we have established our level of production (Exhibit 2), we can prepare a
Materials Budget. The Materials Budget attempts to forecast the level of purchases
required, taking into account materials required for production and inventory levels.
We can summarize materials to be purchased as:

Materials Purchased = Materials Required + Ending Inventory - Beginning Inventory

EXHIBIT 3 — MATERIALS BUDGET

Lace Shoes require .25 square yards of leather and leather is estimated
to costs $ 5.00 per yard next year. Materials Required = 14,500 (Exhibit
2) x .25 = 3,625 yards.

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Materials Required for Production 3,625
Desired Ending Inventory 375
Total Materials 4,000
Less Beginning Inventory ( 500)
Total Materials Required 3,500
Unit Cost for Materials x $ 5.00
Total Materials Purchased $ 17,500

The second component of production is labor. We need to forecast our labor needs
based on expected production. The Labor Budget arrives at expected labor cost by
applying an expected labor rate to required labor hours.

EXHIBIT 4 — LABOR BUDGET

Lace Shoes require .50 hours to produce one unit.

14,500 units x .50 = 7,250 hours.
The expected hourly labor rate next year is $ 12.00.

Estimated Production Hours 7,250

Hourly Labor Rate x 12.00
Total Labor Costs $ 87,000

As production moves up or down, support services and other costs related to

production will also change. These overhead costs represent the third major costs of
production. Each item that comprises overhead may warrant independent analysis so
that we can determine what drives the specific cost. For example, production rental
equipment may be driven by production orders while depreciation is driven by levels
of capital investment spending.

EXHIBIT 5 — OVERHEAD BUDGET (Based on Unique Drivers)

Estimated for each line item as follows:

Indirect Labor Costs * $ 12,000

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Utilities 5,000
Depreciation 3,000
Maintenance 1,000
Insurance and Taxes 4,000
Total Overhead Costs $ 25,000

*Production Supervision and Inspection

Once production costs (direct materials, direct labor, and overhead) have been
budgeted, we can work these numbers into our beginning inventory levels for Direct
Materials, Work In Progress, and Finished Inventory. Beginning inventory levels are
actual amounts from the last reporting period. We need to apply our costs based on
what we want ending inventory to be. The end-result is a Budget for Cost of Goods
Sold, which we will use for our Forecasted Income Statement.

EXHIBIT 6 — COST OF GOODS SOLD BUDGET

Direct Work In Finished
Materials Progress Inventory
Beginning Inventory $ 2,500 $ 16,000 $ 46,000
Purchases (Exhibit 3) 17,500
Less Ending Inventory ( 1,875)
Materials Required 18,125
Direct Labor (Exhibit 4) 87,000
Overhead (Exhibit 5) 25,000
Total Manufacturing Costs $ 130,125 130,125
Total Work In Progress 146,125
Less Ending Inventory ( 12,000)
Cost of Goods Manufactured $ 134,125 134,125
Cost of Goods Available for Sale 180,125

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Less Ending Inventory ( 36,000)
Cost of Goods Sold $ 144,125

We can now finish our estimate of expenses by looking at all remaining operating
expenses. The first major type of operating expense is marketing. Marketing and Sales
Manager's will prepare and submit a Marketing Budget to upper level management for
approval.

EXHIBIT 7 — MARKETING BUDGET

Estimated for each line item per the Marketing Department:

Marketing Personnel $ 75,000

Advertising & Promotion 42,000
Marketing Research 12,000
Travel & Personal Expenses 6,500
Total Marketing Expenses $ 135,500

The final area of operating expenses is the administrative costs of running the overall
business. These types of expenses will be estimated based on past trends and what we
expect to happen in the future. For example, if the company has plans for a new
computer system, then we should budget for additional technology related expenses.
Several department managers will be involved in preparing the General and
Administrative Expense Budget.

EXHIBIT 8 — GENERAL & ADMINISTRATIVE BUDGET

Estimated for each line item per Department Managers:

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Management Personnel $110,000
Accounting Personnel 55,000
Legal Personnel 40,000
Technology Personnel 45,000
Rent & Utilities 25,000
Supplies 15,000
Miscellaneous 7,500
Total G & A Expenses $ 297,500

Budgeted Financial Statements

Based on the detail budgets we have prepared (Exhibits 1 thru 8), we can finalize our
budgets in the form of a Budgeted Income Statement. A few new line items are added
to account for non-operating items, such as income received on investments and
financing costs. The Finance and Tax Departments will assist in estimating items like
financing expenses and income tax expenses. The Budgeted Income Statement will
pull together all revenue and expense estimates from our previously prepared detail
budgets.

EXHIBIT 9 — BUDGETED INCOME STATEMENT

Revenues (Exhibit 1) $720,000

Less Cost of Goods Sold (Exh 6) (144,125)
Gross Profit 575,875
Less Marketing (Exhibit 7) (135,500)
Less G & A (Exhibit 8) (297,500)
Operating Income 142,875
Less Interest on Debt ( 8,000)
Income Before Taxes 134,875
Taxes @ 37.5% ( 50,578)
Net Income $ 84,297

EXAMPLE 2 — BUDGETED INCOME STATEMENT

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Halton Company has compiled the following information:
Planned sales are 50,000 units at a price of $ 110.00 per unit.
Beginning Inventory consists of 5,000 units at a cost of $ 60.00 per unit.
Planned production is 55,000 units with the following production cost:
Direct Materials are $ 18.50 per unit
Direct Labor required is 4 hours per unit @ $ 12.00 per hour
Overhead is estimated at 20% of Direct Labor Cost
Desired Ending Inventory is 6,000 units under the LIFO Method.
Marketing Expenses are budgeted at $ 350,000
General & Administrative Expenses are budgeted at $ 400,000

< - - - - - - - - - - - - - - - Budgeted Income Statement - - - - - - - - - - - - - -

>

Sales (50,000 x $ 110)

$ 5,500,000
Less Cost of Goods Sold:
Beginning Inventory (5,000 x $ 60.00) $ 300,000
Direct Materials (55,000 x $ 18.50) 1,017,500
Direct Labor (55,000 x 4 hours x $ 12.00) 2,640,000
Overhead ($ 2,640,000 x .20) 528,000
Cost of Available Sales 4,485,500
Less Ending Inventory (1) ( 380,500)
Cost of Goods Sold
(4,105,000)
Gross Profits 1,395,000
Less Operating Expenses:
Marketing Expenses
( 350,000)
General & Administrative
( 400,000)
Net Income $ 645,000

(1) Under LIFO, last costs in are: $ 1,017,500 + $ 2,640,000 +

$ 528,000 = $ 4,185,500 / 55,000 = $ 76.10 x 5,000 = $ 380,500.

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Now that we ..have a Budgeted Income Statement, we can prepare a Budgeted Balance
Sheet. The Budgeted Balance Sheet will provide us with an estimate of how much
external financing is required to support our estimated sales.

The main link between the Income Statement and the Balance Sheet is Retained
Earnings. Therefore, preparation of the Budgeted Balance Sheet starts with an estimate
of the ending balance for Retained Earnings. In order to estimate ending Retained
Earnings, we need to project future dividends based on current dividend policies and
what management expects to pay in the next planning period.

EXHIBIT 10 — ESTIMATED RETAINED EARNINGS

Beginning Balance $ 270,000

Budgeted Net Income (Exhibit 9) 84,297
Less Estimated Dividends (55,000)
Ending Retained Earnings $ 299,297

Next, we need to account for the acquisition of fixed assets. As a business depletes its
asset base, it must re-invest to sustain assets which are the basis for generating
revenues. For example, do we need to purchase new machinery or computer
equipment? Do we plan to expand our production facilities? Operating personnel and
upper-level management will decide on future capital spending. Future capital
expenditures are summarized on the Capital Expenditures Budget.

EXHIBIT 11 — CAPITAL EXPENDITURES BUDGET

Purchase New Office Equipment $ 16,000

Replace Leather Cutting Machine 8,500
Total Capital Expenditures $ 24,500

Based on the beginning balance in assets and the budget for capital assets (Exhibit 11),
we can estimate an ending asset balance for the Budgeted Balance Sheet.

EXHIBIT 12 — CHANGE IN FIXED ASSETS

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Beginning Balance $ 886,000
New Acquisitions (Exhibit 11) 24,500
Less Depreciation for the Year (33,500)
Ending Fixed Assets $ 877,000

We will assume that liabilities and interest expense will remain the same. However,
after we have determined our level of external financing, we will need to revise these
amounts. Additionally, we need to analyze trends and ratios in order to ascertain
accounts that do not fluctuate with sales. For example, prepaid expense is a current
asset that has little to do with sales.

Since the Balance Sheet is a year-end estimate, it assumes that all other estimates have
been met. In a world of rapid change, annual forecasts are rarely close. Therefore, we
will simplify our preparation of the Budgeted Balance Sheet by relying on
relationships. Stable relationships over the last five years are particularly helpful. The
Budgeted Balance Sheet will show either a surplus (excess financing over assets) or a
deficit (additional financing needed to cover assets). This difference is derived from
the Accounting Equation: Assets = Liabilities + Equity.

EXHIBIT 13 — BUDGETED BALANCE SHEET

Cash $ 36,000 5% of Sales

Accounts Receivable 86,400 12% of Sales
Inventory 50,400 7% of Sales
Prepaid Expenses 11,000 5 year trend analysis
Fixed Assets 877,000 Exhibit 12
Total Assets $1,060,800

Accounts Payable 79,200 11% of Sales

Current Portion of LT Debt 6,000 Principal Paid
Long Term Debt 60,000 Subject to Revision
Total Liabilities 145,200
Common Stock 450,000 unchanged
Retained Earnings 299,297 Exhibit 10
Total Equity 749,297
Total Liab& Equity 894,497

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External Financing Required$ 166,303

We also can calculate External Financing Required (EFR) based on the relationships
between assets, liabilities, and sales. The following formula can be used:

EFR = (A / S x Sales) - (L / S x Sales) - (PM x FS x (1 - d))

A / S: Assets that change given a change in sales, expressed as a percentage of sales.
Sales: Change in sales between the last reporting period and the forecasted sales.
L / S: Liabilities that change given a change in sales, expressed as a percentage of sales.
PM: Profit Margin on Sales; i.e. net income / sales.
FS: Forecasted Sales
(1 - d): Percent of earnings retained after paying out dividends; d is the dividend
payout ratio.

EXAMPLE 3 — CALCULATE EXTERNAL FINANCING NEEDED

Falcon Company has compiled the following information:

Assets of $ 900 (mostly current assets) from the last period change with
sales. Liabilities of $ 300 from the last period change with sales. Sales
were $ 3,000 for the last period. Forecasted sales are $ 3,900. Profit
margins on sales are 6% and 40% of earnings are paid-out as dividends.

A / S = $ 900 / $ 3,000 = .30

L / S = $ 300 / $ 3,000 = .10
Change in Sales = $ 3,900 - $ 3,000 = $ 900
EFR = .30($ 900) - .10($ 900) - .06($3,900)(1-.40) = $ 270 - $ 90 -
$ 140.4 = $ 39.6

EXAMPLE 4 — PREPARE BUDGETED BALANCE SHEET

Gilmer Company has compiled the following information:

 Sales for the last reporting period were $ 600,000

 Projected sales are $ 800,000

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 Profit Ratio is 5% of sales
 Dividend Payout Ratio is 40%
 Current Balance in Retained Earnings is $ 200,000
 Cash as a % of sales is 4%
 Accounts Receivable as a % of sales 10%
 Inventory as a % of sales is 30%
 Net Fixed Assets are budgeted at $ 300,000
 Accounts Payable as a % of sales is 7%
 Accrued Liabilities as a % of sales is 15%
 Common Stock will remain at $ 220,000

Budgeted Balance Sheet

Cash ($ 800,000 x .04) $ 32,000

Accounts Receivable ($ 800,000 x .10) 80,000
Inventory ($ 800,000 x .30) 240,000
Net Fixed Assets 300,000
Total Assets $ 652,000

Accounts Payable ($ 800,000 x .07) $ 56,000

Accrued Liabilities ($ 800,000 x .15) 120,000
Common Stock 220,000
Retained Earnings (1)
Total Liabilities & Equity 620,000
Total Additional Financing Required 32,000
Total Liabilities & Equity after financing $ 652,000

(1): Beginning Balance $ 200,000

Increase for New Income:
$ 800,000 x .05 (profit margin) 40,000
Less Dividends:
.40 x $ 40,000 Net Income (16,000)
Ending Balance $ 224,000

After we have prepared budgeted financial statements, it is very important to carefully

review these statements with management. For example, can we truly expect to raise
$ 166,303 in capital as indicated in Exhibit 13? Will the budgeted financial statements
meet the expectations of shareholders? Several critical questions must be asked before
we finalize our budgeted financial statements.

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Additionally, ..our budgets were prepared on an annual basis. Many unplanned events
can take place during the year, making our annual budgets extremely inaccurate.
Therefore, financial planning is often improved by simply forecasting on a monthly or
quarterly basis as opposed to an annual basis.

The Cash Budget

A good example of short-term financial planning is the Cash Budget. The Cash Budget
is an estimate of future cash inflows and outflows. Cash Budgets are often included
with the Budgeted Balance Sheet. However, it should be noted that Cash Budgets are
not widely used as a general forecasting tool since they are specific to one account,
namely cash. Instead, Cash Budgets are often used by Cash Managers and Treasury
personnel for managing cash.

We can use our previous forecasts to help us prepare a Cash Budget. For example, we
can get an idea of payable disbursements for manufacturing by looking at the Materials
Budget (Exhibit 3), Labor Budget (Exhibit 4), and the Overhead Budget (Exhibit 5).
We can start preparing a Cash Budget by simply looking at our stable cash flow
patterns, such as accounts receivable, accounts payable, payroll, etc. We also have
several predictable transactions, such as insurance payments, loan payments, etc.

EXHIBIT 14 — CASH BUDGET FOR JANUARY

Beginning Cash Balance $28,000

Cash Collections on Sales (60 day lag) $ 47,000
Sold old machine in January 3,000
Investment Revenues 2,000
Total Cash Inflows 52,000

Disbursements for Manufacturing (30 day lag) 12,400

Marketing Expenses 10,000
General & Administrative Expenses 26,000
Capital Expenditures -0-
Repayments on Debt 750
Debt Interest Payments 450
Dividend Payments -0-
Taxes Paid -0-
Total Cash Outflows 49,600

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Net Cash Inflow (Outflow) 2,400
2,400
Ending Cash Balance 30,400
Minimum Desired Cash Balance 10,000
Cash Surplus or (Deficit) $ 20,400

Summary of the Budgeting Process

We started our budgeting process by looking at strategic planning. Strategic Planning

should always be the starting point for financial planning. From the Strategic Plan, we
develop a Plan of Action so we can implement the Strategic Plan. This is often called
an Operating Plan. Within the Operating Plan, we will include a set of budgets for
successful implementation of the Strategic Plan. The entire set of budgets can be
categorized as follows:

< - - - - - - - - - - - - - - - - - - - - - - - - - - Master Budget - - - - - - - - - - - - - - - - - - - - - - -

-->
< - - - - - - - - - - - Operating Plan - - - - - - - ->< - - - - - - - - - Financial Plan - - - - - - - -
->
Sales Forecast (Exhibit 1) Budgeted Retained Earnings (Exhibit10)
Budgeted Production (Exhibit 2) Budgeted Capital Expenditures (Exhibit 11)
Budgeted Production Costs (Exhibits 3-5) Change in Fixed Assets (Exhibit 12)
Budgeted Cost of Goods Sold (Exhibit 6) Budgeted Balance Sheet (Exhibit 13)
Budgeted Operating Expenses (Exhibits 7-8) Cash Budget (Exhibit 14)
Budgeted Income Statement (Exhibit 9)

Additional Concepts inBudgeting

So far, we have emphasized simple approaches to preparing budgets, such as looking
at relationships between account balances and sales. We also should have a clear

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understanding.. of past financial performance to help us predict future financial
performance. Extending past trends and adjusting for what is expected is a common
approach to preparing a forecast. However, we can improve forecasting by using
several techniques. The first step is recognize certain fundamentals about forecasting:

1. Forecasting relies on past relationships and existing historical information. If these

relationships change, forecasting becomes increasingly inaccurate.
2. Since forecasting can be inaccurate due to uncertainty, we should consider
developing several forecast under different scenarios. We can assign probabilities
to each scenario and arrive at our expected forecast.
3. The longer the planning period, the more inaccurate the forecast. If we need to
increase reliability in forecasting, we should consider a shorter planning period.
The planning period depends upon how often existing plans need to be evaluated.
This will depend upon stability in sales, business risk, financial conditions, etc.
4. Forecasting of large inter-related items is more accurate than forecasting a specific
itemized amount. When a large group of items are forecast together, errors within
the group tend to cancel out. For example, an overall economic forecast will be
more accurate than an industry specific forecast.

Quantitative and Qualitative Techniques

You should forecast for a specific reason - to help make better decisions. Forecasting is
extremely difficult and you must pull from all relevant sources. We previously
discussed the Percent of Sales Method and Trend Analysis as a way of forecasting.
These forecasting techniques are quantitative. Quantitative techniques of forecasting
are best used when changes are infrequent. In today's world of rapid change,
quantitative techniques tend to be of little use.
We need to add more qualitative techniques into the budgeting process. Qualitative
techniques include surveys, interviews with people who are "in the know", market
reports, articles, and other information sources that allow us to make a better
judgement. Qualitative or Judgmental Forecasting can help improve the budgeting
process, especially if we are operating in a rapidly changing environment.

The Delphi Method is an example of a qualitative technique where a group of experts

gets together and reaches a consensus on what will happen in the future. A
questionnaire is sometimes used to facilitate the process. Two disadvantages of the
Delphi Method are low reliability with the consensus and inability to reach a clear
consensus.

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Smoothing out . the Numbers
One simple approach to forecasting is to setup a model that relies on averages from
past historical data. For example, we can take an average of the last five years. As we
move forward to the next planning period, a new moving average is calculated and
used as the forecast for the next planning period. Exponential smoothing can be used
whereby we place more weight on the most recent set of actual numbers. This can be
important where changes have occurred, making older data less reliable.

Regression Analysis

A statistical approach can be used for forecasting. We can rely on the average
relationships between a dependent variable and an independent variable. Simple
regressions look at one independent variable (such as sales pricing or advertising
expenses) whereas multiple regressions consider two or more variables (such as sales
pricing and advertising expenses together). Regression analysis is very popular for
forecasting sales since it helps us find the right fit over a range of observations. For
example, if we plot out the following observations, we can prepare a scatter graph and
find the right fit:

Advertising Expense Sales Dollars

$ 100 $ 1,500
150 1,560
180 1,610
220 1,655
270 1,685

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. Scatter Graph for
Five Observations

$1,700
Sales Dollars

$1,650
$1,600
$1,550
$1,500
$1,450
$0 $100 $200 $300
Advertising Dollars

Sensitivity Analysis

We can measure how sensitive our forecast is to changes in certain variables. We can
develop a range of possibilities under different assumptions and prepare alternative
plans. If Plan A fails, we can quickly move to Plan B. Sensitivity analysis also tells us
which assumptions have the biggest impact on the forecast. Managers can concentrate
most of their resources on the biggest impact areas for improving the forecast. The
main benefit of sensitivity analysis is to measure the possibility of errors in the forecast.

Financial Models

Budgets can be prepared with the use of formal models which take advantage of
techniques like regressions and sensitivity analysis. Models are built around the
collection of equations, logic, and data that flows according to the relationships
between operating variables and financial outputs. Financial variables (costs, sales,
investments, taxes, etc.) can be manipulated by the user so that the user can see the
outcome of a decision before it is made. This can help facilitate strategic thinking
within the budgeting process. Two types of financial models are simulation and
optimization. Simulation attempts to duplicate the effects of a decision and show its
impact. Optimization seeks to optimize (maximize or minimize) a forecast objective
(revenues, production costs, etc.).

Financial models provide decision support services for improvements within budgeting.
Some of the benefits of financial models include:

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 Shows the.. results of planning under a variety of assumptions, allowing the user to
assess the impacts of estimates that have been used.
 Generates the Budgeted Income Statement and Budgeted Balance Sheet as well as
forecasted financials by business unit or department.

In order to build a financial model, we need to establish variables, parameters, and

relationships. Additionally, we can divide variables into three types:

1. Control Variables: The inputs that the company can control, such as the level of
debt financing or the level of capital spending.
2. External Variables: Inputs that the company cannot control, such as economic
conditions, consumer spending, interest rates, etc.
3. Policy Variables: Goals and objectives of the company can impact the expected
outcomes. For example, management may set targets for sales, profitability, and
costs.

Parameters are the baselines or boundaries for the financial model. For example, the
level of debt may have a minimum and maximum value. We also will set our
beginning account balances within the financial model.

Relationships are the logic and specifications required for making things work. For
example, the Budgeted Balance Sheet will require that Assets = Liabilities + Equity.
Several equations will be used within the financial model. Many of these equations
will be relational; i.e. if we change sales prices, total revenues will change. Equations
are tested and added to the financial model to make it complete. Equations can be
expanded into business and decision rules so that users do not have to worry about
calculating things like return on equity. The financial model takes care of critical rules
for running the business or making decisions.

EXHIBIT 15 — FINANCIAL MODEL FOR CASH

Relationships (Equations):
Cash(t) = Cash(t-1) + Cash Receipts(t) + Cash Disbursements(t)
Cash Receipts(t) = (a) x Sales(t) + (b) x Sales(t-1) + (c) x Sales(t-2) +
Loan(t)
Cash Disbursements(t) = Accounts Payable(t+1) + Interest(t) + Loan
Payment(t)

Input Variables in Dollars:

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Sales(t-1), Sales(t-2),
Loan(t), Loan Sales(t-3)
Payment(t)
(a): Accounts Receivable Collection Pattern in current period
(b): Accounts Receivable Collection Pattern one period ago
(c): Accounts Receivable Collection Pattern two periods ago
(a) + (b) + (c) < 1.0

Parameters (Initial Values in Dollars):

Cash(t-1), Sales(t-1), Sales(t-2), Bank Loan(t-1), Accounts Payable(t-1)

Making the Budgeting ProcessWork

Now that we understand what goes into financial planning, it is time to focus on how
to make the process into a value-added activity. Many organizations are attempting to
re-engineer budgeting practices since budgeting is usually a non-value added activity;
i.e. it does not add value to the decision making process. The goal is to make the entire
financial planning process into a decision support service within the organization
whereby the benefits of the process exceed the costs.

In order to fully comprehend the problems associated with budgeting, let's quickly list
the top ten problems with budgeting according to Controller Magazine:

1. Takes too long to prepare.

2. Doesn't help us run our business.

3. Budgets are out-of-date by the time we get them.

4. Too much playing with the numbers.

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5. Too many..iterations / repetitive tasks within the process.

6. Budgets are cast in stone in a constantly changing business environment.

7. Too many people are involved in the budgeting process.

8. Unable to control budget allocations.

9. By the time budgets are complete, I don't recognize the numbers.

10. Budgets do not match the strategic goals and objectives of the organization.

We will now discuss several ways of making budgeting into a value-added activity
within the organization.

Automate the Process

In order for budgeting to be value-added, it must accept revisions quickly and easily. A
highly automated budgeting process can help streamline the process for quick and easy
updating. As a minimum, budgets should be maintained on spreadsheets. A
spreadsheet (such as Excel, Lotus 1-2-3, etc.) can have an input panel for entering
variables and automatic generation of budgets within a fully integrated set of
spreadsheets. For example, we can use a formula to calculate interest expense as:

Interest Rate x (Beginning Long Term Debt + Current Portion of Long Term Debt +
External Financing Using Long Term Debt)
Spreadsheets also allow us to perform sensitivity analysis. We can simply enter new
variables into the input panel and review the impact on our budgets.
We can also use more formal software programs for budgeting. The best software
programs will give us the option of controlling the level of detail. For example, do we
want a cash budget by customer or do we want cash budgets by account or can we
simply enter the cash flow data ourselves? It is very important that we have control
over the detail since commercial programs sometimes over-analyze transactions and
provide way too much detail. This is why many financial planners prefer spreadsheets
over commercial programs.

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. in Budgeting
Ten Best Practices

Finally, here are some best practices that can transform budgeting into a value-added
activity:
1. Budgeting must be linked to strategic planning since strategic decisions usually
have financial implications.

2. Make budgeting procedures part of strategic planning. For example, strategic

assessments should include historical trends, competitive analysis, and other
procedures that might otherwise take place within the budgeting process.

3. The Budgeting Process should minimize the time spent collecting and gathering
data and spend more time generating information for strategic decision making.
4. Get agreement on summary budgets before you spend time preparing detail budgets.

5. Automate the collection and consolidation of budgets within the entire organization.
Users should have access to budgeting systems for easy updating.

6. Budgets need to accept changes quickly and easily. Budgeting should be a

continuous process that encourages alternative thinking.

7. Line item detail in budgets should be based on material thresholds and not rely on a
system of general ledger accounts.
8. Budgets should give lower level managers some form of fiscal control over what is
going on.
9. Leverage your financial systems by establishing a data warehouse that can be used
for both financial reporting and budgeting.

10. Multi-National Companies should have a budgeting system that can handle inter-
company elimination's and foreign currency conversions.

Summary
Financial Planning is a continuous process that flows with strategic decision making.
The Operating Plan and the Financial Plan will both support the Strategic Plan. The
best place to start in preparing a budget is with sales since this is a driving force behind
much of our financial activity. However, we have to take into account numerous
factors before we can finalize our budgets.

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Budgeting should. be flexible, allowing modification when something changes. For
example, the following will impact budgeting:

 Life cycle of the business

 Financial conditions of the business
 General economic conditions
 Competitive situation
 Technology trends
 Availability of resources

Budgeting should be both top down and bottom up; i.e. upper level management and
middle level management will both work to finalize a budget. We can streamline the
budgeting process by developing a financial model. Financial models can facilitate
"what if" analysis so we can assess decisions before they are made. This can
dramatically improve the budgeting process.
One of the biggest challenges within financial planning and budgeting is how do we
make it value-added. Budgeting requires clear channels of communication, support
from upper-level management, participation from various personnel, and predictive
characteristics. Budgeting should not strive for accuracy, but should strive to support
the decision making process. If we focus too much on accuracy, we will end-up with a
budgeting process that incurs time and costs in excess of the benefits derived. The
challenge is to make financial planning a value-added activity that helps the
organization achieve its strategic goals and objectives.

EXERCISE
Select the best answer for each question.

1. In order for budgeting to really work, we must link the budgeting process with:
a. Financial Statements

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b. . Transactions
Accounting

c. Strategic Planning

d. Operating Reports

2. The first forecast we will prepare for budgeting will be the:

a. Budgeted Income Statement

b. Sales Forecast

c. Cash Budget

d. Budgeted Balance Sheet

3. Taylor Manufacturing has compiled the following production information for

manufacturing jugs of beverages:

Planned production is 6,000 jugs

Materials required per jug: 10 pounds of powder
Desired Ending Inventory for Materials: 4,000 pounds
Beginning Inventory for Materials: 3,000 pounds
Purchase Cost for Materials: $ 2.00 per pound

Based on the above information, what is the total cost for planned materials
purchased?

a. $ 110,000
b. $ 120,000

c. $ 122,000
d. $128,000

4. Which of the following detail budgets will help us prepare the Budgeted Income
Statement?
a. Direct Labor Budget

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b. .
Cash Budget

c. Budgeted Balance Sheet

d. Year End Balance Sheet

5. If accounts payable have historically been 20% of sales and we have estimated
sales of $ 200,000, than estimated accounts payable must be:
a. $ 10,000

b. $ 20,000

c. $ 30,000
d. $ 40,000
6. Which budget is prepared for determining how much external financing we will
need to support estimated sales?
a. Cash Budget

b. Budgeted Income Statement

c. Budgeted Balance Sheet

d. Sales Forecast

7. A good place to start in preparing the Budgeted Balance Sheet is with the main link
between the Income Statement and the Balance Sheet. This link is:

a. Cash

b. Retained Earnings
c. Current Assets

d. Long Term Liabilities

8. One way to improve the budgeting process is to include qualitative techniques into
forecasting. Which of the following is an example of a qualitative technique?

a. 5 Year Trend Analysis

b. Ratio Analysis

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c. Percent.. of Sales Method

d. Interviewing the President of the Company

9. Statistical methods can be used to improve the accuracy of forecasting. This

approach is particularly useful for forecasting sales since we are searching for the
right fit based on several observations. One popular approach to finding the right
statistical fit is to use:

a. Exponential Smoothing
b. Regression Analysis

c. Executive Polling

d. Moving Average

10. Which of the following will contribute to making budgeting a non-value added
activity; i.e. the cost of budgeting exceeds the benefit?

a. The budgeting process is included within the strategic planning process.

b. Detail and Summary Budgets are prepared at the same time and are distributed
to management for approval.

c. Budgets throughout the organization are automated for enterprise-wide

consolidation.

d. Line item detail in budgets is based on material thresholds.

CHAPTER FIVE

Cash flow forecasting

Definition

A cash flow forecast aims to predict a company’s future financial liquidity over a
specific period of time, using tried and tested financial models.

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(i) In.. a corporate finance sense, cash flow forecast is he modeling of a
company or asset’s future financial liquidity over a specific timeframe
while cash normally refers to the liquid assets in a company’s bank
account, the forecast usually estimates its treasury position, which is
cash plus short-term investments minus short-term debt. The cash flow
itself refers to the change in the cash or treasury position from one
period to the next. The cash flow forecast is an important way to value
assets, work out budgets, and determine appropriate capital structures.
It will provide a good indicator of a company’s financial health for
potential investors.
(ii) In context of the entrepreneur or manager, forecasting what cash will
come into the business or business unit in order to ensure that outgoing
cash can be managed so as to avoid them exceeding cash flow coming
in. If there is one thing entrepreneurs learn fast, it is to become very
good at cash flow
Forecasting.

Cash flow projection methods

Several methods are generally used to forecast cash flow one direct. The direct
method is most suitable for short-term forecasts of anywhere from 30 days up to a
year, since it is based on actual data from which the projections are extrapolated.
The data used are the company’s cash receipts and disbursements (R&D). Receipts
primarily include accounts from recent sales of other assets, proceeds of financing,
etc. Disbursements include salaries, payments for recent purchases, dividends, and
debt servicing. Many of the R&D entries are based on projected future sales.

The other methods all use a company’s projected income statements and balance
sheet as their basis. The first method is adjusted net income (ANI),which first
examines the operating income or earnings before interests and tax (EBIT) or
earnings before interests, tax, depreciation and amortization (EBITDA), then looks
at changes on the balance sheet such as receivables, payables, and inventory to
forecast cash flow.

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The pro forma . balance sheet (PBS) method looks at the projected book cash
account if the projections for all other balance sheet accounts are correct, then the
cash flow will also be correct. Both these methods can be used to make short-term
(up to 12 months) and long-term (multiple year) forecasts. Since they use the
monthly or quarterly intervals of a company’s financial plan, they must be adjusted
to account for the differences between the book cash and the actual bank balance,
and this may be significantly different.

The third method uses the accrual reversal method (ARM), which reverses large
accruals (revenue and expences that are recognized when they are earned or
incurred, disregarding the actual receipt or dispersal of cash) and calculates the
cash effects based on statistical distributions and alogarithms. This allows the
forecasting period to be weekly or even daily. It can also be used to extend the
R&D method beyond the 30 day horizon because it eliminates the inherent
cumulative errors. This is the most complicated of all methods and is best suited
for medium-term forecasts.

Advantages

 Cash flow projections offer a useful indicator of a company’s financial

health.
 Cash flow forecasts enable one to predict the peaks and troughs in the
cash balance, and helps to plan borrowings, and they tell how much
surplus cash the company may have at a given time. Most banks insist on
forecasts before considering a loan.
Disadvantages

A cash flow forecast never tells the whole story about a company’s financial
situation and should not be relied on as the sole indicator.

Factors Affecting Pro Forma Statements

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Preparation of forecast (pro forma statements) requires assembling a wide array of
pertinent, verifiable facts affecting the business and its past performance. These
include:

Data from prior financial statements, particularly:

1. Previous sales levels and trends

2. Past gross percentages
3. Average past general, administrative, and selling expenses necessary to
generate your former sales volumes
4. Trends in the company’s need to borrow (supplier, trade credit, and
bank credit) to support various levels of inventory and trends in
accounts receivable required to achieve previous sales volumes

Unique company data, particularly:

1. Plant capacity
2. Competition
3. Financial constraints
4. Personnel availability

Industry-wide factors, including:

1. Overall state of the economy

2. Economy status of your industry within the economy
3. Population growth
4. Elasticity of demand for the product of service your business
provides (demand is said to be “elastic” if it is decreased as the
prices increase, a demonstration that consumers can do without or

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with less of the goods or service. If demand for something is
relatively steady as prices increase, it is “inelastic”)
5. Availability of raw materials

Once this factors are identified, they may be used in Pro Formas, which estimates
the level of sales, expense, and profitability that seem possible in a future period of
operations.

Uses of Pro Forma Statements

Business Planning: A company uses pro forma statements in the process of

business planning and control. Because pro forma statements are presented in a
standardized, columnar format, management employs them to compare and
contrast alternative business plans. By arranging the data for the operating and
financial statement side-by-side, management analyzes the projected results of
competing plans in order to decide which best serves the interests of the business.

In constructing pro forma statements, a company recognizes the uniqueness and

distinct financial characteristics of each proposed plan or project. Pro forma
statements allows management to:

 Identify the assumptions about the financial and operating

characteristics that generate the scenarios.
 Develop the various sales and budget (revenue and expense)
projections.
 Translate this data into cash-flow projections.
 Assemble the results in profit and loss projections.
 Compare the resulting balance sheet.
 Perform ratio analysis to compare projections against each other
and against those of similar companies.
 Review proposed decision in marketing, production, research
and development, etc., and assess their impact on probability
and liquidity.

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Simulating competing plans can be quite useful in evaluating the financial effects
of the different alternatives under consideration. Based on different sets on
assumptions, these plans propose.

Various scenarios of sales, production costs, profitability, and viability. Pro-Forma

statements for each plan provide important information about future expectations,
including sales and earnings forecasts, cash flows, balance sheets, proposed
capitalization, and income statements.
Management also uses this procedure in choosing among budget alternatives.
Planners present sales revenues, production expenses, balance sheet and cash flow
statements for competing plans with the underlying assumptions explained. Based
on an analysis of these figures, management selects an annual budget. After
choosing a course of action, it is common for management to examine variations
within the plan.
If management considers a flexible budget most appropriate for its company, it
would establish range of possible outcomes generally categorized as normal
(expected results), above normal (best case), and below normal (worst case).
Management examines contingency plans for the possible outcomes at input/output
levels specified within the operating range. Since these three budgets are
projections appearing in a standardized, columnar format and for a specified time
period, they are pro forma.
During the course of the fiscal period, management evaluates its performance by
comparing actual results to the expectations of the accepted plan using a similar
pro forma format. Management's appraisal tests and re-tests the assumptions upon
which it based its plans. In this way pro forma statements are indispensable to the
control process.

Financial Modeling: Pro forma statements provide data for calculating financial
ratios and for performing other mathematical calculations. Financial models built
on pro form projections contribute to the achievement of corporate goals if they:
i) Test the goals of the plans;
ii) Furnish findings that are readily understandable; and
iii) Provide time, quality, and oost advantages over other methods.
Financial modeling tests the assumptions and relationships of proposed plans by
studying the impact of variables in the prices of labor, materials, and overhead;
cost of goods sold; cost of borrowing money; sales volume; and inventory
valuation on the company in question.
Computer-assisted modeling has made assumption testing more efficient. The use
of powerful processors permits online, real-time decision making through

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immediate .
calculations of alternative cash flow statements, balance sheets, and
income statements.

Assessing the Impact of Changes: A company prepares pro forma financial

statements when it expects to experience or has just experienced significant
financial changes. The pro-forma financial statements present the impact of these
changes on the company's financial position as depicted in the income statement,
balance sheet, and the cash-flow statement. For example, management might
prepare pro forma statements to gauge the effects of a potential merger or joint
venture. It also might prepare pro forma statements to evaluate the consequences of
refinancing debt through issuance of preferred stock, common stock, or other debt.

Eternal Reporting; Businesses also use pro forma statement in external reports
prepared for owners (stockholders)- creditors, and potential investors. For
companies listed on the stock exchanges, the regulatory authorities (e.g. CMA)
require pro forma statements with any filing,
registration statements, or proxy statements (Document intended to provide
shareholders with information necessary to vote in an informed manner on matters
to be brought up at a - stockholders' meeting). The authorities and organizations
governing accounting practices require companies to prepare pro forma statements
when essential changes in the character of a business’s financial statements have
occurred or will occur. Financial statements may change because of:

 Changes in accounting principles due to adoption of a generally accepted

accounting principle different from one used previously for financial
accounting.
 A change in accounting estimates dealing with the estimated economic life
and net residual value of assets.
 A change in the business entity resulting from the acquisition or disposition
of an asset or
investment, and/or the pooling of interests of two or more existing businesses.
 A correction of an error made in report or filing of a previous period

Management's decision to change accounting principles may be based on

theissuance of a new accounting principle by the IASB or KASB; internal
considerations taking advantage of revised valuations or tax codes; or the
accounting needs of a new business combination. By changing its accounting
practices, a business might significantly affect the presentation of its financial
position and the results of its operations. The change also might distort the

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earnings trend . reported in the income statements for earlier years. Some examples
of changes in accounting principles might include valuation of inventory via a
first-in, first-our (FIFO) method or a last-in, first-out method (LIFO), or recording
of depreciation via a straight-line method or an accelerated method.
When a company changes an accounting method, it uses pro forma financial
statements to report the cumulative effect of the change for the period during
which the change occurred. To enable comparison of the pro forma,financial
statements with previous financial statements, the company would present the
financial statements for prior periods as originally reported, show the cumulative
effect of the change on net income and retained earnings, and show net income on
a pro forma basis as if the newly adopted accounting principle had been used in
prior periods.

A change in accounting estimate may be required as new events occur and as better
information becomes available about the probable outcome of future events. For
example, an increase in the percentage used to estimate doubtful accounts, a major
write-down of inventories, a change in the economic lives of plant assets, and a
revision in the estimated liability for outstanding product warranties would require
pro forma statements.

The Forma Income Statement

In preparing the Pro Forma Income Statement, the estimate of total sales during a
selected period is the most critical “guesstimate” A manager should;
i) Employ business experiences from past financial statements.
ii) Get help from management and salespeople in developing this all-
important number.

Then assume, for example, that a 10 percent increase in sales volume is a realistic
and attainable goal. Multiply last year's net sales by 1.10 to gee this year's estimate
of total net sales. Next, break down this total, month by month, by looking at the
historical monthly sales volume. From this one can determine what percentage of
total annual sales fell on the average in each of those months over a minimum of
the past three years. One may find that 75 percent of total annual Sales volume was
realized during the six months from July through December in each of those years
and that the remaining 25 percent of sales; was spread fairly evenly over the First
six months of the year.

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Comparison..with Actual Monthly Performance
Putting together this information month by month for a year into the future will
result in the business's Pro Forma Statement of Income. Use it to compare with the
actual monthly results from operations. Preparation of the information is
summarized below:
Revenue (Sales)
 List the departments within the business. For example, if the business is
appliance sales and service, the departments would include new appliances,
used, appliances, parts., in-shop service, on-site service.
 In the "Estimate" columns, enter a reasonable projection of monthly sales for
each department of the business. Include cash and on-account sales. In the
"Actual" columns, enter the actual sales for the month as they become
available.
 Exclude from the Revenue section any revenue not strictly related to the
business.

Cost of sales
 Cite costs by department of the business, as above.
 In the "Estimate" columns, enter the cost of sales estimated for each month
for each department. For product inventory, calculate the cost of the goods
sold for each department (beginning inventory plus purchases and
transportation costs during the month minus the inventory). Enter "Actual"
costs each month as they accrue.

Gross profit
Subtract the total cost of sales from the total revenue

Expenses
 Salary Expenses: Base pay plus overtime.
 Payroll Expenses; Include paid vacations, sick leave, health insurance,
unemployment ,insurance. Social Security taxes.
 Outside Services; Include costs of subcontracts, overflow work farmed-out,
special or one-time services.
 Supplies: Services and items purchased for use in the business, not for
resale.
 Repairs and Maintenance: Regular maintenance- and repair, including,
periodic large expenditures, such as painting or decorating.
 Advertising: Include desired sales volume, classified directory listing
expense, etc.

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 Car, .
Delivery and Travel: Include charges if personal car is used in the
business. Include parking, toils, mileage on buying trips, repairs, etc.
 Accounting and Legal: Outside professional services.
 Rent: List only real estate used in the business.
 Telephone.
 Utilities; Water, heal, light, etc.
 Insurance: Fire or liability on property or products, worker’s compensation.
 Taxes: Inventory, sales., excise, real estate, others,
 Interest.
 Depreciation: Amortization of capital assets.
 Other Expenses (specify each): Tools, leased equipment, etc.
 Miscellaneous (unspecified}: Small expenditures without separate accounts.

Net profit
To find net profit, subtract total expenses from gross profit.
The Pro Forma Statement of Income, prepared on a monthly basis and culminating
in an annual projection for the next business fiscal year, should be revised' not less
than quarterly. It must reflect the actual performance achieved in the immediately
preceding three months ;o ensure its continuing usefulness as one of she two most
valuable planning tools available to management.`
Should the pro forma reveal that the business will nicely not generate a profit from
operations, plans must immediately be developed lo Identify what to do to at least
break even - increase volume, decrease expenses, or put more owner capital in to
pay some debts and reduce interest expenses.

Break-Even Analysis

‘’ Break – Even’’ mean level of operations at which a business neither makes a

profit nor sustains a loss. At this point, revenue is just enough to covet expenses.
Break-Even Analysis enables you to study the relationship of volume, costs, and
revenue.

Break-Even requires the business owner/manager to define a sales level - either in

terms of revenue shillings to be earned or in units to be sold within a given
accounting period - at which the business would earn, a before rax net profit of!
zero. This may be done by employing one of various formula calculations to the

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estimated sales volume, estimated fixed cost:, and estimated variable
costs.

 A change in sales volume will not affect the selling price per unit;
 Fixed expenses (rent, salaries, administrative and office expenses
interest and depreciation) will remain the same at all volume levels; and
 Variable expenses (cost of goods sold, variable labor costs, including,
overtime wages and sales commissions) (will increase or decrease in direct
proportion to any increase or decrease in sales volume.
Two methods are generally employed in Break – Even Analysis, depending on
wheather the break – even point is calculated in items of sales shillings volume or
in number of units that must be sold.
 Obtain a list of expenses incurred by diecompany during its past fiscal year.

 Separate the expenses listed in Step 1 into either a variable or a fixed

txper.se
classification.

 Express the variable expenses as a percentage of sales.

 Substitute the information gathered m the preceding steps in the basic break-
even formula
to calculate the break-even point.
Note : Increased sales do not necessary mean increased profits. If one needs to
know the company’s break – even, then she/he will know how to price the product
to make a profit. If an acceptable is not made, alter or sell the business before the
retained earnings are lost.

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