M12 Brooks266675 01 FM C12

Chapter 12
Forecasting and
Short-Term
Financial
Planning
Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Learning Objectives
1. Understand the sources and uses of cash

that are used in building a cash budget.
2. Explain how sales forecasts are used to
predict cash inflow.
3. Understand how production costs vary in
terms of cash flow timing.
4. Explain possible ways to cover cash deficits
and invest cash surplus.
5. Prepare a pro forma income statement and a
pro forma balance sheet.

12-2
12.1 Sources and Uses of Cash
• Cash is considered to be the life-blood of a business.

Cash shortages can be problematic while cash excesses
can lead to poor returns.

• Since most businesses do not function on a purely cash
basis, it is critical for them to forecast their needs for
cash in advance.

• The cash budget is the analytical tool that estimates the
future timing of cash inflow and cash outflow and
projects potential shortfalls and surpluses.

12-3
(continued)
TABLE 12.1 Bridge Water Pumps and Filters, Cash Budget for First Six Months
of 2010 ($ in thousands)
Despite setting up a cash reserve, the firm is projected to have cash

shortfalls in 3 months and surpluses in 2 after all cash receipts and
disbursements have been forecasted for the first half of 2010.

12-4
(continued)
Identifying all possible

sources and uses of
cash is essential for
preparing a useful cash
budget. This list can
serve as a guide when
preparing a cash
budget.
FIGURE 12.1 Cash

inflows and cash
outflows for a company.

12-5
12.2 Cash Budgeting and the Sales
Forecast
Sales revenue base variable driving almost all

other items in the cash budget, Must forecast
sales as objectively as possible.
There is usually a time lag between when a sale
is made and when the cash receipts come
inMust keep track of collections time-line.
Need internal data (information that is
proprietary or unique to the firm) as well as
external data (publicly available information)
as sources for objective sales forecasts.

12-6
12.2 Cash Budgeting and the Sales
Forecast (continued)
FIGURE 12.2 Marketing data for Bridge Water Pumps and Filters.

12-7
12.2 (A) Cash Inflow from Sales
• Firms typically sell products and services

partially for cash and partially on credit.
• An analysis of a firm’s collection policy can
help project cash inflow from sales.
• It is quite common for firms to collect
some of their receivables in the 2 months
following the sale, i.e., November 2008’s
credit sales will be partially collected in
December 2008 and January 2009.

12-8
12.2 (A) Cash Inflow from Sales
(continued)
TABLE 12.2 Bridge Water Pumps and Filters Cash Flow from
Sales: January, February, and March 2009 Cash Flow Estimates
Managers often figure in a small percentage of the forecasted

sales as bad debts when preparing a cash budget.

12-9
12.2 (B) Other Cash Receipts
• Besides sales, which are the main

contributor to a firm’s cash inflow, need to
forecast the timing and magnitude of other
occasional sources of cash such as
– asset sales,
– funds raised through issuance and sale of
securities, and
– income earned on investments (dividends,
interest, etc.)

12-10
12.3 Cash Outflow from Production
• The magnitude and timing of the various cash

disbursements of a firm depend mainly on forecasted
sales.
– Payments for raw materials, labor costs, overheads such
as utilities and rent, shipping costs, etc.
• Like sales, there is often a time lag between when the firm
receives and records the benefit, and when it actually
makes the payment for it.
• The cash budget can be used as a handy planning
document to keep track of the projected disbursements.
• Depreciation is merely a tax write-off, not a cash
disbursement, so should not be included in a cash budget.

12-11
12.4 The Cash Forecast: Short-Term
Deficits and Short-term Surpluses
The main objective of developing a cash budget  Firm has

sufficient cash available from its revenues and other receipts to
cover its periodic cash disbursements such as:
1. Accounts payables for materials and supplies
2. Salaries, wages, taxes, and other operating expenses
3. Capital expenditures for plant, equipment, and machinery
4. Dividends, interest, and flotation cost payments related to the
raising and servicing of capital
Over a short planning cycle, the total periodic cash inflow rarely
matches the total periodic outflow, seasonal fluctuations and
time lags.
This results in forecasted cash deficits and cash surpluses in
certain periods.

12-12
12.4 The Cash Forecast: Short-Term
Deficits and Short-term Surpluses
(continued)
TABLE 12.3 Monthly Cash Budget for Bridge Water Pumps and
Filters

12-13
12.4 (A) Funding Cash Deficits
Cash shortfalls can be handled in 4 ways:

1. Cash from savings
2. Unsecured loans (letters of credit)
3. Secured loans (using accounts receivable or
inventories)
4. Other sources (commercial paper, trade
credit, or banker’s acceptance).

12-14
12.4 (B) Investing Cash Surpluses
When a company has excess funds, it has

4 options:
1. Put the surplus in a savings account or invest
it in marketable securities.
2. Repay lenders and owners (retire debt early
or pay extra dividends).
3. Replace aging assets.
4. Invest in the company, accepting positive net
present value projects

12-15
12.5 Planning with Pro Forma
Financial Statements
• Cash budgeting is only one aspect of short-term

financial planning. It is equally important for firms
to forecast their operating cash flow and net income
for the forthcoming period by developing pro forma
financial statements.
• There are a variety of ways to produce pro forma
statements, but the statements usually rely on two
primary inputs:
– The prior year’s financial statements and the relationship
of the account balances to each other
– The projected sales for the coming year

12-16
12.5 Planning with Pro Forma
Financial Statements (continued)
• We use the prior year’s financial statements to find the

relative percentage of each line either to sales (income
statement) or to total assets (balance sheet). We then
multiply the percentages of each item to forecast sales
or forecast total assets for the coming year to develop
pro forma financial statements.
– For example, let’s say that the cash balance for the prior
year is $2 million and the total assets are $100 million.
So cash is 2% of total assets.
– For the Pro Forma Balance Sheet, we would forecast
cash as 2% of the forecasted total assets as well, i.e., if
total assets are forecasted to increase by
20%$120mCash would be forecasted to be .
02*120m = $24m.
12-17
12.5 (A) Pro Forma Income
Statement (continued)
Figure 12.3

12-18
12.5 (A) Pro Forma Income
Figure 12.4
This approach, although a good

first step, is often too simplistic
in reality because many financial
statement items do not vary
proportionately with sales. In
particular, depreciation
decreases over time and cost of
goods sold often declines due to
economies of scale. The manager
would have to fine-tune the
forecasted values to make them
more in line with reality.

12-19
12.5 (B) Pro Forma Balance Sheet
Each prior year’s balance sheet item is expressed as a

percent of total assets, and then multiplied by the
forecasted total assets figure for the next period.

Items that are obviously constant each period or that
vary at a different rate (for whatever reason) are
accordingly adjusted for by the financial manager.

If total assets exceed total liabilities and owners’ equity,
external financing is allocated according to some
predetermined ratio to serve as the plug variable.

12-20
(continued)
Figure 12.5

12-21
(continued)
Based on the following assumptions, a pro forma balance

sheet is developed as shown in Figure 12.6.
• Net fixed assets will increase by $500,00 (capital

expenditure).
• Cash balance account will be at $150,000.
• Accounts receivables will be 6% of forecasted sales,
or $305,000.
• Total inventories will be 15% of prior year’s sales,
$4,800,000, with one-third in raw materials and
two-thirds in finished goods.
• All new financing will be long-term debt.
• Increase in retained earnings will be $380,000
(from the pro forma income statement).
12-22
(continued)
Key calculations include the following:
• Cash is $150,000.
• Accounts receivable is $305,280 ($5,088,000  0.06 = $305,280),
rounded to $305,000.
• Total inventory is $720,000 ($4,800,000  0.15 = $720,000).
• Raw materials are one-third of total inventory ($720,000  1/3 =
$240,000).
• Finished goods are two-thirds of total inventory ($720,000  2/3 =
$480,000).
Net fixed assets are $4,953,000 + $500,000 = $5,453,000.
The total assets will now be $6,628,000.
Fill in the liabilities based on the same percentages as those of last
year except for the common stock, which will not change (all new
financing is debt); a targeted reduction in accounts payable to 5%
of assets; and an increase in retained earnings ($380,000)
projected by the pro forma income statement:

12-23
(continued)
• Accounts payable will be reduced to 5.0% of $6,628,000, or

$331,400 (round to $331,000).
• Taxes payable will be 4.00% of $6,628,000, or $265,120
(round to $265,000).
• Retained earnings will be $380,000 + $2,688,000 =
$3,068,000.
• Common stock will remain at $62,000.
So, for the balance sheet to balance, long-term debt must

be $2,902,000 ($6,628 – $331 – $265 – $62 – $3,068 =
$2,902). Therefore, the long-term debt account needs to
increase by $200,000 ($2,902,000 – $2,702,000). To
complete the $500,000 funding for the project, outside
funding of $200,000 will be needed; the other funding will
come from internal funding sources.
12-24
(continued)
Figure 12.6

12-25
12.5 (C) Pro Forma Cash Flow
Statement
• Finally, the pro forma cash flow statement

(Figure 12.7) is prepared to tie together all
the changes in operating, investment, and
financing cash flows.

12-26
12.5 (C) Pro Forma Cash Flow
Figure 12.7

12-27
ADDITIONAL PROBLEMS WITH
ANSWERS
Problem 1

Sales Forecast: You have been asked to forecast sales for
the coming year. You are convinced that the compound
average growth rate is the best way to forecast growth, and
so you collect data for the prior three years, as listed below.
Using the data, compute the compound growth rate for
each of the years and then forecast next year’s sales by
using the two-year average growth rate.
Year Sales
2007 $1,200,000
2008 $1,750,000
2009 $2,100,000
2010 ?

12-28
ANSWERS
Problem 1 (Answer)
g = (ending value / beginning value)1 / number of years – 1

2008 growth rate =[ (2008 Sales/2007 sales)] -1 = (1.75m/1.2m) -1
2008 growth rate = 45.83%

2009 growth rate = =[ (2009 Sales/2008 sales)] -1 = (2.1m/1.75m) -1
2009 growth rate 20%

2-year average growth rate = (2009 Sales/2007 Sales) 1/2 =1=
(2.1m/1.2m)1/2 -1
2-year average growth rate =32.29%

2010 Sales Forecast =$ 2,100,000*(1.3229) = $2,778,090


12-29
ANSWERS
Problem 2
Sales Receipts: The financial manager of Hearty Cereals is in the
process of preparing a cash budget for the first quarter of 2010. The
firm typically sells 1/3 of its monthly sales on cash terms and the rest
on credit. An analysis of the accounts receivable shows that on
average, 40% of the sales are collected in the next month, 50% in 60
days, and 7% in 90 days, with the rest ending up as bad debts. As the
manager’s assistant it is your job to project the sales receipts for the
first quarter of 2010, using the monthly sales figures listed below.
2009 Sales 2010 Forecasted Sales
October $1,750,000 January $1,850,000

November $2,000,000 February $1,650,000
December $2,450,000 March $1,900,000

12-30
ANSWERS
Problem 2 (Answer)
Oct Nov Dec Jan Feb March
1,750,000 2,000,000 2,450,000 1,850,000 1,650,000 1,900,000
Cash 1/3 0.33 $583,333 $666,667 $816,667 $616,667 $550,000 $633,333
Credit 2/3 0.67 $388,889 $444,444 $544,444 $411,111 $366,667 $422,222
Bad debt
3% of
Credit sales 0.03 $11,666.67 $13,333 $16,333 $12,333 $11,000 $12,667
40% in 30
days =
.4*Prior
month's
credit sales 0.4 $155,556 $177,778 $217,778 $164,444 $146,667
50%in 60
days=.6* 2
month
earlier sales 0.5 $194,444 $222,222 $272,222 $205,556
7% in 90
days=.07 *
3 month
earlier sales 0.07 $27,222 $31,111 $38,111
1
Total
Receipts
from Sales $1,056,667 $986,667 $985,556

12-31
ANSWERS
Problem 3
Production cash outflow: The Creative Products Corporation
produces its products two months in advance of anticipated sales
and ships to warehouse centers the month before sale.
The inventory safety stock is 15% of the anticipated month’s
sale.
Beginning inventory in October 2009 was 120,000 units. Each
unit costs $1.50 to make. The average selling price is $2.50 per
unit. The cost is made up of 60% labor, 30% materials, and
10% shipping (to warehouse).
Labor is paid the month of production, shipping the month after
production, and raw materials the month prior to production.
What is the production cash outflow for the month of October
2009 production, and in what months does it occur?
Assume that the sales forecast for December 2009 is
$2,500,000.
12-32
ANSWERS
Problem 3 (Answer)
Unit Sales Forecast for December 2009 = $2,500,000/$2.5
1 million units
Safety stock required = 15% of December sales = 150,000 units
Beginning Inventory (October 2009) = 120,000 units
Production needed in October = Dec. ‘09 Sales + Safety Stock –
Beg. Inventory
Production needed in October = 1,000,000 + 150,000 –
120,000=970,000 units
Cost of Production (Oct. 2009) = 970,000*$1.50= $1,455,000
Labor cost = .60*$1,455,000 = $873,000 paid in October 2009

Shipping cost = .10*$1,455,000 = $145,500 paid in November
2009
Material cost = .30*$1,455,000 = $436,500 paid in September
2009
12-33
ANSWERS
Problem 4
Imperial Products Corp.
Pro forma income statement. Income Statement for 2009
Given the income statement Sales Revenue $28,8000,000
below for Imperial Products
Corporation for 2009 and a COGS 11,4000,000
20% growth in sales for SG&A Expenses 6,800,000
2010, prepare a pro forma
income statement. Depreciation Expenses 2,3000,000
EBIT $8,300,000
Interest Expense 1,200,000
Taxable Income $7,100,000
Taxes $2,414,000,000.00
Net Income $4,686,000.00

12-34
ANSWERS
Problem 4 (Answer)
First divide each item by sales
Then multiply each proportion by forecast sales for 2010
Forecast sales = 28,800,000*(1.2) = $34,560,000
2009 % of sales 2010 Forecast
Sales Revenue $28,8000,000 100.00% $34,560,000
COGS 11,4000,000 39.58% $13,680,000
SG&A Expenses 6,800,000 23.61% $8,160,000
Depreciation Expenses 2,3000,000 7.99% $2,760,000
EBIT $8,300,000 28.82% $9,960,000
Interest Expense 1,200,000 4.17% $1,440,000
Taxable Income $7,100,000 24.65% $8,520,000
Taxes $2,414,000,000.00 8.38% $2,896,000
Net Income $4,686,000.00 16.27% $5,623,200

12-35
ANSWERS
Problem 5
The Global Growth Corporation is planning for next year and wants you to help them
prepare a Pro Forma Balance Sheet for 2011. Their current Balance Sheet is shown
below, along with some predetermined changes in key balance sheet accounts. How
will you proceed?
Current Assets 2010
Cash $1,500,000
Marketable Securities 830,000

Accounts Receivable 3,450,000
Inventories 2,500,000
Total Current Assets $8,280,000
Long-term Assets
Plant, Property & Equip. $8,500,000
Goodwill 3,500,000
Intangible Assets 1,350,000
Total Long-term Assets $13,350,000

TOTAL ASSETS $21,630,000 12-36
ANSWERS
Problem 5 (continued)
Current Liabilities
Accounts Payable $5,125,000
Other Current Liabilities $1,350,000
Total Current Liabilities $6,475,000
Long-Term Liabilities
Long-Term Debt $3,200,000
Other Long-Term Liabilities $1,650,000
Total Long-Term Liabilities $4,850,000
TOTAL LIABILITIES $11,325,000
Owner Equity
Common Stock $2,500,000
Retained Earnings $7,805,000
TOTAL OWNER’S EQUITY $10,305,000
TOTAL LIABILITIES AND
OWNER’S EQUITY $21,630,000

12-37
ANSWERS
Problem 5 (continued)

Next year, the firm will increase its Plant, Property, and
Equipment (PPE) by $7,000,000 with a plant expansion.
The inventories will grow by 70%, but accounts payables will
grow by 60%, and marketable securities will be reduced by
50% to help finance the expansion.
If all other asset accounts remain the same and long-term debt
will be used to finance the remaining costs of the expansion
(no change in common stock or retained earnings), prepare a
pro forma balance sheet for 2011. How much additional debt
will be estimated using this pro forma balance sheet?

12-38
ANSWERS
Problem 5 (Answer)
Start by changing the known asset accounts and then
total up assets. Then use the total assets for total
liabilities and owners’ equity balance. Finally, make
the required change in long-term debt to balance the
balance sheet.
i.e., PPE will be $8,500,000+$7,000,000 =
$15,500,000
Inventories = 70% higher
(1.7)*2500000=4,250,000
Accounts payables = 60% higher
5,125,000*1.6=8,200,000
Marketable Securities = 50% lower = 830,000*.5
415,000

12-39
ANSWERS
Problem 5 (Answer continued)
2010 2011 pro forma
Cash $1,500,000 $1,500,000
Marketable Securities 830,000 415000
Accounts Receivable 3,450,000 3,450,000
Inventories 2,500,000 4250000
Total Current Assets $8,280,000 $9,615,000

Plant, Property & Equip. $8,500,000 $15,500,000
Goodwill 3,500,000 3,500,000
Intangible Assets 1,350,000 1,350,000
Total Long-term Assets $13,350,000 $20,350,000
Total Assets $21,630,000 $29,965,000

12-40
ANSWERS
Problem 5 (Answer continued)
Accounts Payable $5,125,000 $8,200,000.0

Other Current Liabilities $1,350,000 $1,350,000
Total Current Liabilities $6,475,000 $9,550,000
Long -Term Debt $3,200,000 $8,460,000

Other Long -term Liab. $1,650,000 $1,650,000
Total Long -Term
Liabilities $4,850,000 $10,110,000
$11,325,000 $16,585,000
Common Stock $2,500,000 $2,500,000

Retained Earnings $7,805,000 $7,805,000
Shareholders’ Equity $10,305,000 $10,305,000
Total Liab. And Sh.
Equity $21,630,000 $29,965,000
12-41

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Chapter 12

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

1. Understand the sources and uses of cash

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Cash is considered to be the life-blood of a business.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Despite setting up a cash reserve, the firm is projected to have cash

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Identifying all possible

FIGURE 12.1 Cash

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Sales revenue base variable driving almost all

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Firms typically sell products and services

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Managers often figure in a small percentage of the forecasted

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Besides sales, which are the main

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• The magnitude and timing of the various cash

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

The main objective of developing a cash budget  Firm has

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Cash shortfalls can be handled in 4 ways:

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

When a company has excess funds, it has

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Cash budgeting is only one aspect of short-term

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• We use the prior year’s financial statements to find the

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

This approach, although a good

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Each prior year’s balance sheet item is expressed as a

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Based on the following assumptions, a pro forma balance

• Net fixed assets will increase by $500,00 (capital

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Accounts payable will be reduced to 5.0% of $6,628,000, or

So, for the balance sheet to balance, long-term debt must

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

• Finally, the pro forma cash flow statement

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

October $1,750,000 January $1,850,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Labor cost = .60*$1,455,000 = $873,000 paid in October 2009

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Marketable Securities 830,000

Total Long-term Assets $13,350,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Marketable Securities 830,000 415000

Accounts Receivable 3,450,000 3,450,000

Inventories 2,500,000 4250000