Financial Planning and Forecasting Financial Statements
ANSWERS TO END-OF-CHAPTER QUESTIONS
The operating plan provides detailed implementation guidance designed to accomplish corporate objectives. It details who is responsible for what particular function, and when specific tasks are to be accomplished. The financial plan details the financial aspects of the corporation’s operating plan. In addition to an analysis of the firm’s current financial condition, the financial plan normally includes a sales forecast, the capital budget, the cash budget, pro forma financial statements, and the external financing plan. A sales forecast is merely the forecast of unit and dollar sales for some future period. Of course, a lot of work is required to produce a good sales forecast. Generally, sales forecasts are based on the recent trend in sales plus forecasts of the economic prospects for the nation, industry, region, and so forth. The sales forecast is critical to good financial planning.
A pro forma financial statement shows how an actual statement would look if certain assumptions are realized. With the percent of sales forecasting method, many items on the income statement and balance sheets are assumed to increase proportionally with sales. As sales increase, these items that are tied to sales also increase, and the values of these items for a particular year are estimated as percentages of the forecasted sales for that year.
Funds are spontaneously generated if a liability account increases spontaneously (automatically) as sales increase. An increase in a liability account is a source of funds, thus funds have been generated. Two examples of spontaneous liability accounts are accounts payable and accrued wages. Note that notes payable, although a current liability account, is not a spontaneous source of funds since an increase in notes payable requires a specific action between the firm and a creditor.
Additional funds needed (AFN) are those funds required from external sources to increase the firm’s assets to support a sales increase. A sales increase will normally require an increase in assets. However, some of this increase is usually offset by a spontaneous increase in liabilities as well as by earnings retained in the firm. Those funds that are required but not generated internally must be obtained from external sources. Although most firms’ forecasts of capital requirements are made by constructing pro forma income statements and balance sheets, the AFN formula is sometimes used to forecast financial requirements. It is written as follows:
Capital intensity is the dollar amount of assets required to produce a dollar of sales. The capital intensity ratio is the reciprocal of the total assets turnover ratio.
“Lumpy” assets are those assets that cannot be acquired smoothly, but require large, discrete additions. For example, an electric utility that is operating at full capacity cannot add a small amount of generating capacity, at least not economically.
Accounts payable, accrued wages, and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately.
The equation gives good forecasts of financial requirements if the ratios A*/S and L*/S, as well as M and d, are stable. Otherwise, another forecasting technique should be used.
+. It reduces spontaneous funds; however, it may eventually increase retained earnings.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
AFN = (A*/S0)∆S - (L*/S0)∆S - MS1(1 - d)...
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