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    CamScanner 06-05-2024 10.08

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    150 Chapter = Financial Management INTRODUCTION Forecasting represents an integral part of any planning process that is undertaken by all firms, Firms must make decisions today that will affect the firm in the future. This is part and parcel of the overall objective of the firm (and that ofthe finance manager in particular) as discussed earlier which is to maximize shareholders’ wealth. If the firm does not plan for its future, then the management of the firm would end up fire- fighting most of the time, ie. the management waits for problems to crop up, and only then will corrective actions be taken. In this age of hypercompetitive economic environment, this may prove too little too late, To be able plan forthe future, forecasts must be made of what the future might look like However, many authors have argued that it is not always easy to forecast and plan for the future, as there exists many uncertainties surrounding the future and many assumptions of what shall take place then, must be made today. After all, if one could predict the future with certainty, there would not be a need to plan as then, there ‘ought to be only one possible outcome and the finance manager’s work would be easily cut out for him or her to meet and ensure that the firm achieves that one and only outcome. If forecasting the future is dificult and fraught with uncertainties, the obvious ‘question arises: Why bother to forecast? The answer is simple. The act of forecasting and hence, planning for the future, is a discipline in itself. tis very much hoped that the management of the firm, when undertaking such an activity, would take pains to consider the internal aspects ofthe firm, the external environment that impacts the firm and attempt to identify all possible outcomes. In short, it undertakes a SWOT (strengths, weaknesses, opportunities and threats) analysis. From there, appropriate actions can then be developed and considered for the benefit ofthe firm. Forecasting and planning is thinking in advance about the future, and be able to devise alternative actions that can be implemented should events of the future take unfortunate turns, or represent opportunities for the firm. In short, it represents the firm’s ability to respond to events that occur in the future. Finance managers, as part of the firm’s management, assis in the financial forecasting process in the firm. Businesses have to look to the future. Success in business by firms depends on correct predictions. For any firm commencing businesses forthe first time, or even to continue businesses in the future, managers have the responsibilty to attempt to forecast the future and to very large extent, the successor failure ofthe managers would also depend upon the ability ofthe managers to forecast successfully the future course of events. ‘As mentioned inthis chapter, history may not always repeat islf and it may foolhardy for ‘managers to expect economic conditions next year or over the next ten years to follow a dear cut prediction. Yet, frequently past patterns prevail suficiently to justify using the past asa basis for predicting the future. Managers cannot afford to base their decisions ‘on guesses. Forecasting helps businesses to reduce the areas of uncertainty that surround management decision making with respect to costs, sales, production, profits, capital investment, pricing, expansion of production, extension of crelt, development of markets, increase ofinventories and curtailment of loans. These decisions cannot be made offhand. Most ofthe time, such decisions are tobe based on present indications of future conditions. Nonetheless, while attempting to make forecasts (eaders should know that itis impossible to forecast the future precisely), some range of eror is allowed in the forecast. Statistical forecasts are those in which one can use the mathematical theory of probability to measure the risks of erors in predictions, Scanned with CamScanner ‘= Financial Forecasting 451, AAs teaders will note later in this chapter, forecasting methods and levels of sophistication vary greatly. Each portends to assess future events oF situations that will affect either positively oF negatively the business’ efforts, Managers prepare forecasts to determine the type and level of demand for products currently produced or that can be produced. Management analyses a broad spectrum of economic, demographic, political, and financial data for indications of growing and profitable markets. Forecasting involves the collection and analysis of hard data, and their interpretation by managers with proven business Judgment. Individual departments such as sales, and divisions such as manufacturing, aso engage in forecasting, Sales forecasting Is essential to setting production volume. Production forecasting determines the materials, labour, and machines needed. These are finally translated into activity budgets, recruitment and procurement budgets, and finally financial budgets. DEFINITION AND PURPOSE Financial forecasting is defined as the process of estimating a firm's future financial —Pyinancial forecasting isthe needs and requirements. In the main, every decision to be made by a firm incurs | process of estimating a costs. It is hence incumbent on the finance manager to ensure that at the end of the _ | frm’ future nancial needs day, the firm has adequate finances (cash flows) to meet the financing requirements — of the firm in the future. For instance, if the firm seeks to expand aggressively in the near future, through the opening of more outlets in the Klang Valley, this would inivolve: + Expectations of greater sales + Identification of choice locations + Planning for renovations to be conducted + Hiring and training of staff + Purchasing and ordering of raw materials + Logistics planning and many more steps Planning for growth hence means that the finanice manager must anticipate and prepare for the situation when the firm will require additional financing, Besides planning for situations when the firm requires cash, finance managers must anticipate when excess cash can possibly occur, plus an estimation of its quantum. Finance manager must decide what shall be done with the excess cash situation, and the appropriate investment vehicle to be decided on is also dependent on the time period of excess cash. Geer) Definition of Financial Forecasting Use the Intemet search engines to identify the definition of financial forecasting. Some of the suggested sites include: htpy//www.businessdictionary.com/defintion/financial-forecasthiml http//wwew.ask.com/questions-about/Definition-of-Financial-Forecasting hetp//wwwuthefreedictionarycomvfinancial forecast What is the common theme that you will note about the explanations and definitions as provided? Readers should note the uncertainty element when undertaking forecasting and this must bbe duly recognized by all partes. Scanned with CamScanner 152 Chapter6 m Financial Management GED STEPS IN FORECASTING ‘There are several basic steps that managers must undertake when undertake forecasts of the future. The following discussions relate to the scenario when one attempts to tse scientific approaches towards forecasting, though that may not always be the case, as will be discussed in paragraph 6.4 below. The steps concerned are: i. Understanding why changes in the past have occurred: One of the basic principles of statistical forecasting is that the forecaster should use the data on past performance (though this may not always be the case ~ especially when it is noted that past data does not reflect the future environment and conditions). The current rate and changes in the rate constitute the basis of forecasting. Once they are known, various mathematical techniques can develop projections from them. Ifan attempt is made to forecast business fluctuations without understanding why past changes have taken place, the forecast will be purely mechanical based solely upon the application of mathematical formulae and subject to series error. ii, Determining which phases of business activity must be measured: After itis known why business fluctuations have occurred, it is necessary to measure certain phase of business activity in order to predict what changes will probably follow the present level of activity. ili, Selecting and compiling data to be used as measuring devices: There may exist an independent relationship between the selection of statistical data and determination of why business fluctuations occur. Statistical data cannot be collected and analysed in an intelligent manner unless there is sufficient understanding of business fluctuations. It is important that reasons for business fluctuations be stated in such a manner that is possible to secure data that are related to the reasons. iv, Analysing the data: Lastly, the data are analysed in the light of understanding of the reason why change occurs. For example, if it is reasoned that a certain combination of forces will result in a given change, the statistical part of the problem is to measure these forces, from the data available, to draw conclusions on the future course of action. The methods of drawing conclusions may be called forecasting techniques. TYPES OF FORECASTS ‘Typically, forecasting models fall under three categories: + Time series models + Casual models + Qualitative models ‘These are summarised in Figure 6.1. Characteristics of Forecasting i. Based on past and present conditions: Forecasting may be based on past and present ‘economic condition of the business. To forecast the future, various data, information ‘and facts concerning to economic condition of business for past and present are analysed, Scanned with CamScanner 1 Financial Forecasting 453 I. Based on mathematical and statistical methods: The process of forecasting includes the use of statistical and mathematical methods. By using these methods the actual {wend which may take place in future can be forecasted, i. Period: The forecasting can be made for long teim, short term, medium term or any specific term. 1. Estimation of future: Here, businesses attempt to forecast the future regarding pprobable economic conditions. 1. Scope: The forecasting can be physical as well as financial, Figure 6.1 Types of forecast zu 1 dobée 6.4.1. Time Series Models = atten ae ‘Models under this category predict the future by using historical data. The typical fncsenesmoaele assumption made when using these models is ‘past represent (or is linked to) the | predict the future by using future! In other words, what will happen in the future is dependent on what happened {historical data. in the past. For example, if we seek to predict next week's sales ofa firm’s products, we look at ‘what sales were achieved in the previous weeks. Examples of time series models are: + Moving average “This is used when we assume that market demands stay fairly steady over time and because it smooths out variations. For example, a four-month moving average is found by summing up the demand during the past four months and dividing it by four. With each passing month, the most recent month's data is added to the sum. of the previous three months’ data, and the oldest month's data is dropped. This isargued to be able to smooth out short-term irregularities in the data series, The formula is: % AFAR Bat Aga Moving average, F,,, = "2 et Scanned with CamScanner 154 Chapter ™ Financial Management ime series models include moving average, [exponential smoothing ‘tend projections and decomposition, ‘Causal models identify and incorporate variables or factors that can influence the item that isto be forecast. ‘causal models include regression analysis and multiple regression analysis Qualitative models incorporate factors that ‘may be judgemental lorsubjective into the forecasting model. + Exponential smoothing, “This is given by the formula: New forecast t period’s forecast + a (last period’s actual value — last period’s forecast) ‘The concept behind this method is that the latest estimate is equal to the previous estimate, but adjusted by a fraction of the error. The smoothing constant is given by 4G, which can be increased to give more weight to recent data or decreased to give more weight to past data, + Trend projections Attempt to fit a trend line toa series of historical data points and then, projects the ine into the future for medium to long range forecasts. + Decomposition “This involves breaking down past data into components and then, projecting the data forward. Here, it typically comprises four components: a) Trend — gradual upward or downward movement of the data over time. 'b)_ Seasonality ~ pattern of demand fluctuation above or below the trend line that occurs every year. ©) Cycles ~ patterns in the data that occur every several years, which are usually tied into the business cycle. 4) Random variations ~ these are ‘blips’ in the data caused by chance and unusual circumstances. They do not follow any discernible patterns, 6.4.2 Causal Models ‘These models identify and incorporate variables or factors that might influence the quantity being forecasted, into the forecasting model. For example, the sales of ice- cream may be dependent on the temperature (hot or cold), the types of flavours available, the price, time of the day (day or night), season (rainy or dry) and so on. Hence, when using causal models, factors to be included in the model would be temperature, season, types of flavour, price, time, time of the day, season and so on. ‘The basic models under this category are: + Regression analysis — for single factor models.“The basic model is: yratbx hay ~ Bay where b = ————_— niSa2 — (Za)? + Multiple regression analysis — for multi-factor models. This is given by the equation: pat bx, + bx + by, ts 6.4.3 Qualitative Models The earlier two types of models, ie. time-series and causal models, make use of quantitative data. ; ‘Qualitative models, on the other hand, incorporate factors that are either judgemental or subjective into the forecasting model. In this case, subjective matters Scanned with CamScanner © Financia Forecasting 4 such as opinions, individuals’ post experience and judgements may be considered, Qualitative models are used when quantitative data may not be available or when subjective factors play important roles in the final outcome. Examples of qualitative models are: + Delphi method ~ this allows experts to make forecasts. It involves three different types of participants: decision makers, staff personnel and respondents, Decision makers consist of experts who would be making the actual forecasts. The staff personnel prepare, distribute, collect and summarise a series of questionnaires . and survey results, The respondents are the people whose judgements and ‘opinions are valued and sought - their inputs are used by the decision makers to. make decisions. + Jury of executive opinion - this method makes use of opinions of a small group of, high level managers. Then, using statistical models, a forecast figure is obtained. + Sales force composite — each salesperson is asked to provide estimates of what sales he or she is likely to achieve or what sales may be generated in a particular location or region under that particular sales person’ responsibility. Adjustments may be made by higher level management to make the forecasts more realistic or acceptable. These forecasts are then compiled and grouped together, at branch, istrict, regional and finally national level. If it is for a multinational corporation, might also be accumulated up to geographic regions and international levels. + Consumer market survey ~ inputs from customers or potential customers are solicited regarding their future purchasing plans. I s typically used when a firm ‘seeks to launch a new product, ie. market research as to a product’ desirability and the potential purchase pattern of individuals ‘Qualitative models include Delphi methods, jury of ‘executive opinions, sales force composite and ‘consumer market survey. @@GGB SALES FORECASTS AND SALES BUDGET ‘The following sections discuss the definition of and the reasons for preparing sales forecasts and budgets. Additionally, the different methods that may be used to undertake sales forecasting (for example, using moving averages, exponential smoothing and linear regression) will be covered. 6.5.1 Definition of Sales Forecasts . “The sales forecasts represent the firmis estimate of the quantity of the firm’s products that the firm expects to sellin the future. The forecasting methods to arrive at the Sales forecasts represent a fimis estimate ofthe suitable figures in terms of quantity of the firms products to be sold have been [Scanned aloe of sles discussed in brief in section 6:3 above. inthe etre Further Comments A sales forecast is usually 2 prediction based on a firm’s past sales performance and an analysisiof expected market conditions. The true value in making a forecast is that it forces. the firm to look at the future objectively. The firm that takes note of the past stays aware of the present and precisely analyses that information to see into the future. ‘ Conducting 2 sales forecast will provide a firm's business with an evaluation of past and Current sales levels and annual growth, and allow the frm to compare the frm performance to industry norms. It ill lo help the fim to establish policies so thatthe fu can easily monitor its prices and operating costs to guarantee (pt atleast achieve close to its targets) Profits, and make their be aware of minor problems before they become major problems. Scanned with CamScanner 156 Chapter 6 = Financial Management Sales budget shows the [quantity of ach product 10 be sold and the intended selling price, fier) 8 Steps Every Business Needs To Take When Forecasting 5: ByMelanie Hicken Vist the folowing webstink http//articles.businessinsider.com/2012-02-12/strategy/31051549_1_accurate- forecasting forecasting-methods important-forecasting Readers will come across an article provided by Melanie Hicken and should appreciate the eight (8) steps to take when forecasting sales. Inthe main, the steps ae listed as: a) Doyou have historical data available? 'b) How much time and money are you wiling to spend on your forecast? ©) Isyour product or service a new offering? 9) What kind of product or service do you sell? €) Is your company being affected by the current economic downtum? ) How many years of data do you have available? 9) How far out are you attempting to forecast? hh) How important is your forecast? What lessons have you learnt? Discuss and explain. 6.5.2 Lengths of Time for Sales Forecasting Although any forecast has a percentage of uncertainty, the farther into the future the firm projects, the greater will be the uncertainties. As a rule, there are three lengths of time for sales forecasting: i) Short-range forecasts are for fewer than three months. They are used to make continual decisions about planning, scheduling, inventory and staffing in production, procurement and logistics activities. ii) Intermediate forecasts have a span of three months to two years. For most firms, itis usual to prepare up to one year’s forecasts. They are used for budgetary planning, cost control, marketing new products, sales force compensation plans, facility planning, capacity planning and process selection and distribution planning. iii) Long-range forecasts cover more than two years. They are used to decide whether to enter new markets, develop new products or services, expand or create new facilities, or arrange long-term procurement contracts. Once the sales forecast has been made, the sales budget is prepared, which shows the quantity of each product that the firm plans to sell and the intended selling price. Hence, it provides predictions of the total revenue (usually by month) from. which cash receipts from customers may be estimated. It also provides the basic data for preparing budgets for production costs, and also for selling, distribution and administrative expenses, Hence, it is commonly argued that the sales budget represents the foundation of all other budgets, since all expenditure is ultimately dependent on the volume of sales. 6.5.3 Moving Average Ilustrat in to Sales Forecasting ‘The following example serves as an illustration towards the use of time series technique for sales forecasting. Scanned with CamScanner Example 6.1 Suppose you are given the sales data for Product X by Rohsun Sdn Bhd for the past six years: Use the simple moving average method over three years to estimate the sales units for 2010 to 2012. Solution: 50,000 + 65,000 + 52,000 3 2011; £5:000 + 52,000 + 56,000 _ 2010: = 55,667 units 57,667 units 3 nora, 22000 * S80 + See = 57,000 units 6.5.4 Exponential Smoothing Illustration to Sales Forecasting “The following serves as an illustration towards the use of exponential smoothing technique for sales forecasting. Example 6.2 ‘Suppose you are given the sales data for Product Y by Jimat Sdn Bhd for the past eight years: Use exponential smoothing method to forecast the number of units of Product Y for 2006 to 2012. The initial forecast for 2005 was 105,000 units; a = 0,2. 1 Financial Forecasting 4 Scanned with CamScanner 158 Chapter6:m Financial Nanagement Solution: ‘The formula for exponential smoothing is given by: New forecast = last period's forecast + a (last period's actual value ~ last period's forecast) ‘The result is as follows: ma 2005 2006 2007 2008 2009 100,000 92,000 110,000 115,000 108,000 110,000 130,000 135,000 105,000 + 0.2(100,000 ~ 105,000) 104,000 + 0.2(92,000 — 104,000) = 101,600 101,600 + 0,2(110,000 - 101,600) = 103,280 103,280 + 0.2(15,000 ~ 103280) = 105,624 105,624 + 0.2(108,000 - 105,624) = 106,099 106,099 + 0:2(110,000 ~ 106,099) = 106,879 + 0.2(130,000 - 106,879) = 11 6.5.5 Linear Regression Illustration to Sales Forecasting «The following serves as an illustration towards the use of linear regression technique for sales forecasting. Example 6.3 Suppose you are told that the sales.of Product Z by Bagus Sdn Bhd has been dependent on the amount spent on advertising by the firm. You are given the following data pertaining to sales quantity for Product Z and the amount spent on advertising by Bagus Sdn Bhd for the past six years: a a oe 2009 2010 it = 165,000 5000 + 13,000 "Use linear regression method to identify the linear equation suitable to represent the above relationship between sales units of Product Z and the __ | advertising expense by the firm. Based on the linear equation, also determine the forecast sales in unite if, inthe next year 2013, Bagus Sdn Bhd plans to spend RM30,000 on advertising and promotions. Scanned with CamScanner solution: The basic linear equation is, yaatbs where b = MEL= EAE yg ade? — (xP By _ ke Fe ” A 2007 264,000 25,000 625000000 6600000000 116,000 13,000 1169000000 1508000000 165,000 . 314,000 196000000. 2310000000" «101,000 10,000 100000000 1010000000 20,000 400000000 4180000000 26,000 676000000 5590000000 ie _ 108,000 2,166,000,000.._21,198,000,000__ = atime Etabives 2 21a Bycoa From the formula: n&xy — ZaZy _ 6 x 21,198,000,000 — 108,000 x 1,070,000 = 8.73 nxt — (Sx? ‘6 X 2,166,000,000 — 108,000 = 2 x oe Lorene Hence, the linear equation would be: Sales = 21,198 + 8.73 (advertising expense) If the firm plans to incur an advertising expense of RM30,000 in 2013, it is forecasted that sales would then be: Forecast sales = 21,198 + 8.73 x 30,000 = 283,098 units GD COMPONENTS IN PRO FORMA FINANCIAL STATEMENTS Pro forma financial statements show the effects and impact of the firm's decisions on its future financial statements. Firms make use of pro forma financial statements throughout the planning process to assess the effects of alternative decisions on various line items in the financial statements. This then allows financial managers to conduct ‘what-if’ tests. For example, what would the effect on profit before tax for the coming year, if sales were to increase by 5%? What would be the effect on profit before tax if interest expenses were to increase by 5% asa result of using more debt to finance the firms expansion plan? Besides assisting the management of the firm in the decision making process, pro forma financial statements also help the firm to make contingent plans to meet, unexpected situations. ‘Components of pro forma financial statements are + Pro forma income statement—projected revenues, expenses, net income, dividends to be paid and amounts retained for the year + Pro forma statement of financial position—projected assets, liabilities and equity + Pro forma cash flow statement—projected cash flows for operations, investing and financing activities Pro forma financial statements show the effects and impact of a firmis decisions on its future financial statements. Scanned with CamScanner CChapter6 1m Financial Management Besides the pro forma financial statements, firms also prepare many budgets that show in greater detail, the resources and responsibilities of each unit and division. The different types of budgets include the following: + Cash budget—cash inflows, outflows and cash balances + Sales budget—planned sales in units and sales price amount + Production budget—scheduled production (quantities and costs) + Stock budget—planned levels of stocks to maintain + Purchasing budget—planned purchases of raw materials that the firm uses in the production process + Labour budget—estimates of the labour hours required to meet the planned production schedule FORECASTING FINANCIAL VARIABLES ‘The following example shall attempt to illustrate the procedure for constructing the budgets, which in turn feed themselves into the pro forma financial statements. For ase of illustration, a manufacturing firm is taken as a case in point. Readers must appreciate that the level of details provided here is much less than would be the case in practice. A truly realistic illustration would run into many pages. Example 6.4 ABC Sdn Bhd manufactures two products, known as Apa and Bawa. The standard ‘material usage and cost, labour hours and rates for the production of Apa and Bawa are: Material X MaterialY Labour 2.00 peru] ‘The Statement of Financial Position of ABC Sdn Bhd for the recent year 2010 was as follows: Non-current assets RM RM Property, plant and equipment Land 510,000 Buildings and equipment + cost 3.876000 + accumulated depreciation (765,000) sau 3,621,000 Current assets Stocks + raw materials LNs 567,600 + finished goods , 297,208 ‘Trade debtors 867,000 Cash in hand and at bank 102000 1,933,828 5,454,828 Equity Shares of RM1 each 3,600,000 Retained earnings 41,108,428 45708428 Current liabilities - creditors 746,400 ‘ 554,828, Scanned with CamScanner “ 1 Finareia Forecasting Other relevant data: Forecast sales (units) next year Selling price per unit(RM) Scanned with CamScanner 162 OE a CChapter6 Financial Management 6.7.1 Sales Budget Using the data found in Example 6.4 above, suppose the management of ABC Sdn Bhd sought to prepare the sales budget for the next financial year. The result would be: envene Cammn ed tobesold (oO) eta 28 . 6.7.2 Production Budget and Budgeted Stock Levels After the sales budget has been completed, the next step is to prepare the production budget. The objective for preparing the production budget is to ensure that there exist enough units of Apa and Bawa to meet the forecast sales demand. This has to also take into account the desired stock levels of finished goods to be maintained so that stock outs do not occur. The production budget for the new year would look as follows: Forecast sale units Required closing stocks Sub total a e ‘Opening stock levels Required units to be produced 6.7.3 Materials Usage and Purchase Budget Based on the production budget prepared in section 6.7.2 above, the materials usage budget can then be prepared as that would identify the quantity and cost of raw materials to be used in the production process. The materials usage budget for the new year will be: Required units to be produced (a) Material X: unit quantity to be used (6) Total units requited ¢ = bx a ‘Cost (RM) = ¢ x RM7.20 — Material ¥: unit quantity to be used (€)_ ‘The materials purchase budget will be prepared once the materials usage budget is completed. The quantum of materials to be purchased is dependent on the stock of raw materials in the firm itself as well. The annual materials purchase budget for the year will be: Scanned with CamScanner Dera SITY Quantity to be used for production (see above) 16,34 ‘Add: budgeted closing stock of aw materials Less: opening stock of raw materials ‘Quantity tobe purchased (a) pi Unit price (RM) (b) i Purchase cost (RM) (a x b) ‘Total purchase cost = RM5,356.224 6.7.4 Labour Budget “The labour budget represents estimates of the labour hours required to meet the planned production, and the corresponding labour cost to be incurred. The labour budget for the new year will be: ‘Unit tobe produced (Geton 662 above) a) Labour hours per unit (b) . ‘Total budgeted hours (c) = (a x 6) ‘Budgeted wage rate per hour (RM)(q)_——_ ‘Budgeted wages (RM) (¢) x (d) 6.7.5 Overheads Budget “The variable overhead rates are all given to be based on direct labour. Hence, based ‘on the budgeted labour hours (see Section 6.7.4), the overheads budget for the new year would be: fos Pa ni hours ‘Variable overheads Indirect materials — Indirect labour : Power (variable portion) _ “Maintenance (variable portion) Fixed overheads Depreciation ‘Supervision Power (fixed portion) ‘Maintenance (fixed portion) Total manufacturing overheads Based on total labour hours of 378,225, the total manufacturing overheads per labour hour would be: RM2,354,675 _ M6.26 per labour hour 378,225 Scanned with CamScanner 1 Financial Forecast 164 Chapter = Financial Management 6.7.6 Cash Budget Also, the cash budget for the new year would be: ‘Quarter Quarter? Quarters Qua ca nu na Receipts from debtors (a) 3,000,000 33 Payments Purchase of materials Payment of wages (Other costs and expenses Cy ‘Net receipts / (payments) Opening balance ‘Closing balance 6.7.7 Pro Forma Income Statement ‘When all the necessary budgets have been prepared, the budgets’ information can be consolidated and the pro forma financial statements prepared thereafter. The pro forma income statement for the new year would be: Sales (sales budget) ‘Opening stock of raw materials ‘X: 25500 x RM7.20 1 ¥: 24000 x RM16 567,600 ‘Add: purchase of raw materials 5356224 5,923,824 Less: closing stock of raw materials ‘X: 30600 x RM7.20 1 ¥:5100 x RMI6 Cost of raw materials used Z 6,225,744 Direct labour cost (labour budget) a. 4,538,700 ‘Manufacturing overheads (overheads budget) 2354675 Total manufacturing cost (Opening stock of finished goods Less: closing stock of finished goods ‘Apa: 5610 units x 384.60.and Bawa: 270 units x 475.50 (Note 1) Scanned with CamScanner Note 1: Cost per unit of Apa and Bawa 6.7.8 Pro Forma Statement of Financial Position ‘Also, the pro forma statement of fiiancial position at the end of the next year would be: Current liabilities - creditors (Note 3) bso st 1: oes aes anestaallS > Note 2: ‘Trade debtors = RM867,000 + 12,888,000 (sales) — 12,915,000 (receipts) = RM840,000 Note 3: Current liabilities = RM746,400 + 5,356,224 (purchases) + 378,225 (indirect materials) ~ 5,603,952 (payments) J = RM876,897 Scanned with CamScanner 6.7.9 Conflicting Roles of Budgets ‘This section serves to merely highlight and caution readers that budgets prepared are usually used to satisfy several purposes. There hence a probability that the budgets may conflict with each other. For example, the planning role of budgets may conflict with the motivational role of budgets. Demanding budgets that may not be achieved may be more appropriate to motivate maximum performance. However, such budgets are unsuitable for planning purposes. In the case of planning purposes (which has been the emphasis and concentration of this chapter), budgets should be based on easier targets that are expected to be met. Once again, the cautionary explanation serves to highlight that in businesses budgets may also be prepared at high standards or expectations. How this impacts on the motivational level and the actual performance of the firm and its employees becomes a separate issue. ‘There may also be a conflict between planning and performance evaluation roles. For planning purposes, budgets are usually set in advance of the budget period, based on a set of assumptions and anticipated set of circumstance or environment. Such assumptions and anticipations may be based on the forecast figures that were derived based on the forecasting techniques that were earlier discussed. Performance evaluation should be based on a comparison between actual performance and adjusted budgets (ie. budgets that have been adjusted to reflect changed circumstances and situations). The reality is that in practice, firms tend to compare actual performance figures with the original unadjusted figures. However, readers should note that if the circumstance and situations have changed so as to render the previously held assumptions and expectations out-dated or no longer applicable, then there will naturally be a conflict between the planning and evaluation activities. (GG PERCENT OF SALES FORECASTING METHOD Section 6.7 had covered the more detailed approach towards forecasting financial statements. However, it should be noted that in reality, this represents a complex and time consuming approach. Hence, managers tend to use a shorter approach ~ the percent of sales forecasting method. This method is somewhat crude but would represent a simpler method to estimate the funds required to finance growth. A firm would be successful in achieving sales growth, provided that it is willing to make additional investments in stock, trade debtors, and possibly fixed assets as ‘well. Some short-term financing may come from the additional sales generated, it may entail additional purchases, hence the increase in creditors. Other forms of financing may also come from retained earnings. Whatever remaining necessary financing will have to be obtained from other sources, for example short-term borrowings. ‘The per cent of sales forecasting formula is given as follows: Additional required increase in increase in retained financing needed = increasein — liabilities — earnings assets AEN (AlS)gS-—(L/S)gS_ - = (PL + g)S-DI Where: AFN = additional financing needed A/S = typical ratio of quantity of assets to sales achieved (This indicates the increase in assets required per Ringait of increased sales) Scanned with CamScanner 1 Financial Forecast L/S = typical ratio of liabilities to sales achieved (This indicates the increase in liabilities per Ringgit of increased sales) S= curient year sales g = forecast growth in sales P= net profit margin on sales D= cash dividends to be paid Example 6.5 ‘The management of Lucky Sdn Bhd is seeking to estimate the additional financing that it may require in the coming new financial year. ‘They have been furnished by their finance manager the following information: a) Current year sales: RMS million b) Sales are expected to grow by 30% in the next year ©) Total assets in the firm currently stands at RM4 million 4) Total liabilities in the firm currently stands at RM2 million e) Net profit margin on sales is 10% f) Itis forecast that Lucky Sdn Bhd will pay dividends of RM120,000 next year ) There is a possibility that the banks might be willing to provide additional facility in the form of bank overdraft of RMS0,000 Determine the additional financing needed by Lucky Sdn Bhd for the next year and whether the additional bank overdraft facility of RM50,000 would be sufficient for Lucky Sdn Bhd to meet its additional financing need, Solution: Summary of information required: A= RM4million L= RM2million RMS million = 30% P= 10% D= RM120,000 ‘Hence, AFN required = 4,000,000 x 0.3 X 5,000,000) (zeman 5,000,000 )- ~ [0.1 x (1 + 0.3) x 5,000,000 ~,120,000) = 1,200,000.— 600,000 — 530,000 = RM70,000. 0.3 X 5,000,000] However, it is noted that the bank has only agreed to provide additional bank overdraft facility of RM50,000. This is evidently insufficient, and that the management of Lucky Sdn Bhd can see that there would be a shortfall of RM20,000 (ie, RM70,000 - RM50,000). ‘This means that the finance manager of Lucky Sdn Bhd would have to identify additional sources of short term funding to meet that expected shortfall. Readers should now note that had such a forecast of ‘additional financing needed’ not been made, the shortfall would not have been noted in advance and hence, action would not be taken to overcome the shortfall until it is too late. Scanned with CamScanner 168 Chapter. Financial Management Firs must forecast ifthere may ensta shortfall of Funds inthe future and take appropriate steps to cover the shortfall (GD STEPS THAT MAY BE TAKEN WHEN THERE IS A FORECAST SHORTFALL OF FUNDS Example 6. in section 6.8 illustrated a case of predicted or forecast shortfall in funds in the next year, Developing further from that example, the finance manager of Lucky Sdn Bhd has several options in hand that the finance manager may consid + Obtaining new financing ~ the finance manager may approach the bank and apply for a bigger increase in bank overdraft facility than the current existing RMS0,000 that the bank has approved to provide + Reducing assets balance — this may be achieved through better collections from debtors and reduction in stock levels. This approach was discussed in Chapter 5 Working Capital Management. The finance manager would have to evaluate the impact of shortening the credit period offered to its customers. Additionally, better stock management systems should be considered. + Increasing liabilities balance — in this case, Lucky Sdn Bhd might consider delaying its payment to its creditors. However, the efficacy of the approach has to be weighed against the adverse consequence that the firm might suffer, in the form of loss of goodwill for instance, + Reducing the sales growth rate — perhaps the main contributing factor for the additional financing needed is none other than the forecast sales growth. The easiest decision that the firm may take is just to decide that it seeks to achieve less sales than originally planned for and this will automatically reduce the pressure for more financing. + Reducing the amount of dividends to be paid ~ by reducing the amount of dividends that the firm may pay in the next year, the cash flow saved may be ploughed back into the firm and used to meet its operating requirements. ‘The management of Lucky Sdn Bhd must weigh the advantages and disadvantages of each action before deciding on the final action to be taken. For example, if the firm currently has excess production capacity for its factory, then in the interest of ‘maximizing the wealth of its shareholders, it should increase its production quantity and hence, the firm would then have more units of products to sell. Of course, it is expected that the management would have performed market analysis to identify if the market can absorb the increase in supply of finished goods in the said market. (GSD LIMITATIONS OF THE PER CENT OF SALES FORECASTING METHOD ‘The percent of sales method is merely a quick estimation approach ofa firm's financing, requirements. Readers should be aware of its limitations. Its main limitation is that it provides reasonable estimation only when asset requirements and financing sources can be assumed to be a constant percentage of sales, Whilst the forecast of future stocks was not discussed earlier using this approach, readers should be able to foresee that the use of ‘percent of sales’ method to forecast future stock level would be given by the formula: ‘The assumption surrounding such a method isa ‘straight line’ or ‘direct proportion’ relationship between stack levels and sales. Scanned with CamScanner 1 Financial Forecasting ‘This however ignores stock management principles that are discussed in Chapter 5: Working Capital Management, whereby firms might have to hold ‘safety stock’ levels to provide for possible situations of stockouts should deliveries from suppliers become delayed. Also, firms may also seek to use just-in-time’ stock management whereby firms liaise closely with the suppliers. Suppliers then time their deliveries of stock (raw materials) to a firm ‘justin time’ for use by a firm in the manufacturing process. This then reduces the quantity of stocks (raw materials) that the firm may have to hold. Instead, sufficient stocks will have to be held by the suppliers. This in turn reduces the quantity and hence, the cost of stocks in the firm. ‘The limitation of ‘per cent of sales’ forecasting method is further amplified when applied to estimation of required fixed assets. Once again, the formula to estimate desired level of fixed assets would be similarly given by: fixed assets, * x forecast sales,,, Fixed assets,,, jai, An example of fixed assets would be ‘property, plant and equipment: In this case, finance managers will never be able to purchase ‘portions’ of a property, plant and equipment, These are whole, discrete numbers. For machinery, it will be a case of having to consider its production capacity. By purchasing one additional unit of machinery, the firm may perhaps be able to increase its production by 60%. However, what happens if the forecast increase in sales is 20%. Can the firm decide to purchase 1/3 (ie. 20% / 60%) of a machinery? This situation is known as a case of the existence of lumpy assets! Summary ‘+ Financial forecasting isthe process of estimating a firm’ future financial needs and requirements. The main objective is to ensure that the firm has adequate finances (cash lows) to meet the financial requirements of the firm in the future, ‘Forecasting models fall three categories: a) Time series models b) Causal models ©) Qualitative models © Time series models forecast the future by using historical data. Examples of such models include: a) Moving average b) Exponential smoothing ©) Trend projections 4) Decomposition + Causal models identify and incorporate variables or factors that might influence the quantity being forecasted, into the forecasting model. The models. under this category include: a) Regression analysis b) Multiple regression analysis. Scanned with CamScanner * Qualitative models incorporate factors that are judgemental or subjective into the forecasting model. These models are used when data may not be available or when subjective factors significant influence the forecast outcome. Examples of such ‘models include: a) Delphi method b) Jury of executive opinion ©) Sales force composite 4) Consumer market survey + Afirm’s sales forecast represents the firm’ estimate of the expected future sales. It incorporates an analysis of expected market conditions. The discipline of conducting a sales forecast will benefit the firm as it forces the firm to evaluate the past, current and future situations facing the firm. It also presents the firm with a way of monitoring its performance. + There is no fixed length of time into the future for sales forecasting. The further into the future the firm projects, the greater will be the uncertainties surrounding the forecast. 170 CChapter6 Financial Management ‘# Lengths of time for sales forecasting: a) Short range forecasts—shorter than 3 months ») Intermediate forecasts—3 months to 2 years ) Long range forecasts—more than 2 years + Components of pro forma financial statements include: a) Pro forma income statement b) Pro forma statement of financial position ©). Pro forma cash flow statement + Different types of budgets that may be prepared include: a) Cash budget—cash inflows, outflows and cash balances b) Sales budget—planned sales in units and sales price amount ©) Production budget—scheduled production (quantities and costs) 4) Stock budget—planned levels of stocks to maintai ©) Purchasing budget—planned purchases of raw materials that the firm uses in the production process f) Labour budget—estimates of the labour hours required to meet the planned production schedule (ert Study + Ashorter and simpler approach to forecasting isto use the ‘per cent of sales’ forecasting method. + ‘Theper cent of sales forecasting formula is given as follows: Additional Required increase increase in financing = increase ~ = retained needed inassets liabilities earnings AFN = (A/S)gS - (LiS\gS = (P( + g)S-D} ¢ When a firm forecasts that it is likely to face potential shortfall in funds in the future, it has several options in hand it may consider: a). Obtain new financing b) Reduce assets balance ) Increase liabilities balance ) Reduce the sales growth rate ©) Reduce the amount of dividends to be paid + The main limitation of ‘per cent of sales’ forecast is the assumption that there exists a straight relationship between the asset and financing ‘requirement to be forecast and the forecast level of sales. This assumption may not hold in reality. Lei! Assume that you own a business, ABC Sdn Bhd. You plan to acquire a manufacturing business, DEF Sdn Bhd, in the near future for RM630,000, this price to include ‘goodwill (RM300,000), plant and equipment (RM120,000), and stock of raw materials and finished goods (RM90,000). To facilitate the conduct of business, a delivery van will be purchased for RM30,000 as soon as the business purchase is completed. The delivery van will be paid for in the second month of operations. ‘The following forecasts have been made for the business following purchase: (i) Sales (before discounts) of the business's single product, at a mark-up of 60% on, production cost, will be as follows: 25% of sales will befor cash; the remainder will be on credit for settlement in the |» month following that of sale. A discount of 10% will be given to selected credit customers. Such customers represent 25% of gross sales. (i) Production cost will be RM10.00 per unit. The produetion cost will be made up oft Raw materials RMS.00 Direct labour RM3.00 Fixed overhead RM2.00 Scanned with CamScanner m 1 Financial Fore (ii) Production will be arranged such that closing stock at the end of any month is sufficient to meet sales requirements in the following month. It is estimated that there exists RM60,000 worth of finished goods at the beginning of business which was acquired on purchase of the business, (iv) The single raw material will be purchased so that stock at the end of a month is, sufficient to meet half of the following month's production requirements. Raw material stock acquired on purchase of the business (RM30,000) is valued at the cost per unit which is forecast as given in (li) above. Raw materials will be purchased on one month’s credit. (v) Costs of direct labour are to be paid as they are incurred in production. (vi) The fixed production overhead rate of RM2.00 per unit is based upon a forecast of the first year's production of 150 000 units, This rate includes depreciation of equipment and fittings on a straight-line basis over the next five years. (vit) Selling and administration overheads are all fixed. It is estimated that such costs will be RM416,000 in the first year. These overheads include depreciation of the delivery van at 30% per annum on a reducing balance basis. All fixed overheads will be incurred on a regular basis, with the exception of rent and rates. RM50,000 is payable for the year ahead in month one for rent and rates. (a) Prepare a monthly cash budget. You should include the business purchase and the first four months of operations following purchase. (b) Calculate the stock, debtor, and creditor balances at the end of the four month period. Comment briefly upon the liquidity situation. n and Assignment Questions; » 1. Define the purpose for a firm to undertake financial planning and forecasting. 2. List the types of financial forecasting models that are available, 3. What isa time series forecasting model? 4. What is the difference between a causal and a time-series forecasting model? 5. Whatis a qualitative forecasting model, and when is it appropriate? 6. For each of the scenario below, indicate whether it would increase or decrease a firms need for additional financing: a) Increase in net profit margin b) Decrease in credit period offered by the firms creditors ©) Decrease in credit period offered by the firm to its customers 4) Increase in corporate tax rates ) Increase in cash dividends paid 7. What alternatives do profitable firms with strong growth potentials have when internal funds are insufficient to finance expansion in the short run? Scanned with CamScanner m Chapter ® Financial Management 8. The following data summarises information on the yearly demand for 25kg bags of fertiliser at Kwong Heng Nursery: peairken nek Develop a three-year moving average to forecast sales for years 4to 10. ‘Compare your results with actual demand, and comment on the differences. 9. Banyak Udara Sdn Bhd has seen its sales of air-conditioners grow steadily over the ppast few years and has provided you with the following sales data: enntaeneern: Use exponential smoothing with a = 0.4to develop forecast of sales from Year 2to Year 6. ‘Gugus Sdn Bhd has the following Statement of Financial Position: Statement of Financial Position Next year, Gugus Sdn Bhd is planning for a major sales increase of 40%. Sales are currently RM30,000,000 and it is forecast that next year’s sales will be RM@42,000,000. Stocks, trade debtors and cash balances are expected to increase in direct proportion with increase in sales. Similarly, trade creditors and other creditors are also expected proportionately as per the increase in sales. Fixed assets on the other hand will increase by RM1,000,000; short and long term borrowings expected to remain constant.

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