ACS310ab: Finance - PowerPoint PPT Presentation

Title: ACS310ab: Finance


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ACS310a/b Finance

• Financial Planning and Forecasting
• (Lecture 3)

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Financial Planning Process

• There are three key aspects to the financial
  planning process.
• Cash Planning
• forecasting the need for cash.
• Forecasting future profitability.
• Forecasting the need for financing.
• These are prepared as Pro Forma income
  statements and balance sheets.

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Long-Term Strategic Plans

• Long-term financial plans are the planned
  financial actions and the anticipated financial
  impact of those actions over periods ranging from
  2 to 10 years.
• Such planning projections may be carried out as a
  regular function of the firms operations, or in
  conjunction with corporate strategic planning
  efforts.

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LT Strategic Planning Contd

• LT plans are often revamped and revised
• Why?
• Market constantly changing
• Demographics
• Technological improvements (RD breakthroughs)
• Change in management
• Etc.
• Strategic planning also includes discussion about
  what your competition is doing and what theyll
  do if you implement plan x.
• Application of Game theory

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Strategic Planning Game Theory

• Very basic and brief introduction
• Excellent for use in business and everyday life
• Taught at all of the best business school
• Founder John Nash
• Beautiful Mind guy
• Nash equilibrium
• Defn
• Given the actions of my opponent, the strategy
  that Ive chosen is a best response.
• Question to ask yourself
• Given that my opponent is implementing strategy
  x, what is my best alternative?

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Prisoners Dilemma
Prisoner 2
Dont Confess
Confess
Dont Confess
Prisoner 1
Confess
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Game Theory Contd

• Beauty of game theory is that it is a simple
  technique to analyze problems, which arise in
  business.
• Risk/reward decisions
• Takes businesses out of their own little bubble
  and exposes their decisions to implications of
  real world
• Just as effective in analyzing long-term, as it
  is short-term issues
• Can build in risk/uncertainty, multi-period games
  (timing issues), etc.

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Game Theory Contd

• Examples
• Cuba Missile Crisis
• Iraq situation
• Microsoft case
• Elections

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Short-Term Operating Plans

• Short-term financial plans are those planned
  financial actions and the anticipated impact of
  those actions over periods ranging from one to
  two years.
• Because of their relevance to immediate
  operations, such plans form a regular and needed
  function to the firm.

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Figure 4.1 Short-Term Financial Planning
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Cash Planning Cash Budget

• The Cash Budget or cash forecast is a statement
  of the firms planned inflows and outflows of
  cash that is used to estimate its short-term cash
  requirements.

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Cash Budget (contd)

• Seasonality or uncertainty will necessitate a
  cash budget that is examined at more frequent
  intervals
• It is not uncommon to have cash budgets broken
  down into weekly or daily units
• Market conditions may also necessitate a cash
  budget that contains more intervals
• Examples
• Service industry and Retail industry will have
  very short cash budgets
• Manufacturing will likely have longer cash
  budgets

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Sales Forecast

• The prediction of the firms sales over a given
  period, based on external and internal data
• used as the key input to the financial planning
  process.
• External forecasts
• involve the use of general economic data such as
  GDP, interest rates, disposable personal income,
  and other similar data.
• Internal forecasts
• utilize data internal to the firm, such as sales
  force surveys, order buildups, and other sales
  channel information.

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Sales Forecast (contd)

• Accuracy of forecast is of paramount importance
• Can be affected by a number of things
• Quality of data being used to assess firms
  financial or market position
• Optimistic or pessimistic attitudes
• Future market conditions
• Knowing or thinking you know what customers want
  what are the trends going to be? (Retail
  Industry)
• Etc.

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Sales Forecast (contd)

• Techniques for formulating/calculating forecasts
• Regression
• Moving averages
• Exponential smoothing
• Etc.
• NOTE this kind of thing can get quite
  complicated rather quickly
• Good news We dont cover this stuff in this
  class!!

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Preparing Cash Budgets

• Two basic categories of data are required to
  develop the Cash Budget
• Cash Receipts, including cash sales, collections
  of accounts receivable, and other cash receipts.
• Cash Disbursements, including cash dividends,
  principal repayment, purchases, payment of
  accounts payable, wages, salaries, and taxes.

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Cash Receipts Coulson Industries (Table 4.2)
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Cash Disbursements Coulson Ind
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Preparing Cash Budgets (contd)

• Given the Cash Receipts and Cash Disbursements
  the Cash Budget produces
• Net Cash Flows,
• Ending period cash, and
• Any required total financing needs or excess cash
  balances.

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Cash Budgets (contd)
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Evaluating Cash Budget

• The Cash budget provides the firm with figures
  indicating whether a cash shortage or surplus is
  expected to result in each month covered by the
  forecast.

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Coulson Ind. example (contd)
End of Month Balance
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Coping with Budget Uncertainty

• There are two basic ways of coping with
  uncertainty for the cash budget
• Prepare several cash budgets based on
  pessimistic, most likely, and optimistic
  forecasts of cash receipts and disbursements.
• Develop a cash budget simulation with detailed
  assumptions of possible outcomes and their
  underlying probability distributions.

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Coping with Budget Uncertainty (contd)

• Simulations are common and useful in all types of
  situations
• Steps
• Begin by examining a variety of outcome for the
  exogenous variables
• Exogenous variables sales and any other
  uncertain events you want to control for
• Endogenous variables Cash Flows
• Using one estimate at a time, simulate the model
• Develop probability distribution based on the
  outcome of the endogenous variables
• Use the probability distribution to determine
  amount of financing needed to protect against
  cash shortages

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Cash Flows within the Month

• While the cash budget generally shows cash flows
  on a monthly basis, this may not ensure that the
  firm is able to meet daily cash requirements.
• Effective cash planning requires a look beyond
  the cash budget.

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Fundamentals of Pro Forma Statements

• Pro Forma statements are vital for
• Management to evaluate the future expected
  financial position, and
• Investors and Creditors to evaluate the firms
  ability to provide a return on funds invested.
• Three key outputs of forecasting
• Pro forma income statement,
• Pro forma balance sheet, and
• Statement of external financing requirements.

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Items Required for Forecasting

• Preparing Pro Forma statements require
• Financial statements from the previous year,
• Sales forecast for the forecast year, and
• Forecasts for all other financial statement
  accounts.

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Pro Forma Income Statement

• Like the Cash Budget, Pro Forma Income Statements
  are based on the sales forecast.
• One approach to forecasting expenses is to
  project them as their historical percentage of
  sales.

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Table 4.9 of Sales Approah
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Weaknesses of Percent-of-Sales

• There are three weaknesses of the
  percent-of-sales approach
• It is unrealistic to assume all expenses will
  remain exactly the same percentage from year to
  year.
• It essentially locks in a fixed profit margin.
• It assumes all costs are variable.
• Basing forecasts solely on past data tends to
  understate profits when sales increase, and
  overstate profits when sales decline.

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Alternative Method Judgmental Approach

• Steps
• Analyze the current situation
• Internal
• External
• Make estimates of individual accounts based on
  this analysis
• Builds in what we previously studied namely,
  ratio analysis.
• Use industry standards and averages as guidelines
  in preparing pro forma income statement

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Table 4.10 Actual vs. Judgmental
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Fixed and Variable Costs

• Break expenses and costs into fixed and variable
  components
• NOTE
• Widespread technique for estimating the
  relationship between fixed/variable costs and
  sales is regression analysis

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Table 4.11 Fixed and Variable Costs
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Methodology Comparison
Which technique is used will depend upon a number
of Factors - Industry - Market Conditions -
Frequency of estimates - etc.
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Pro Forma Balance Sheet

• The Judgmental Approach is a method for
  developing the Pro Forma Balance Sheet where
  values of certain balance sheet accounts are
  estimated, and others are calculated, based on a
  ratio analysis.
• Projected changes in assets from the latest
  fiscal year to the forecast year determines the
  Total Financing Required (TFR).

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Pro forma B/S Ratios revisited

• Using the judgmental approach requires a firm
  understanding of ratios
• Industry averages and firm ratios only mean
  something if you can understand and interpret how
  to achieve the firms goals from them
• Composition of assets
• Rules of thumb
• Composition of ratios

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Pro Forma Balance Sheet (contd)

• Increases in accounts payable and accruals
  generate the internal spontaneous sources of
  financing.
• When internal financing is less than the Total
  Financing Required, the Pro Forma Balance Sheet
  will determine the External Financing Required
  (EFR).

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Using Pro Forma Statements

• Both financial managers and lenders can analyze
  the firms expected financial performance.
• After analyzing pro forma statements, managers
  can take steps to adjust planned operations to
  better achieve short-term financial goals.