Many companies fail to succeed due to poor planning, which is one reason why accountants are in big demand. Skilled at forecasting, accountants can plan a company's future by determining the maximum sustainable growth and predict its external fund requirements. This book provides you with the basic tools necessary to project the balance sheet and statements of income and cash flow, enabling you to add a unique value to your client(s) work. This book will prepare you to do the following: * Recall the basics of planning and forecasting financial statements * Recall considerations related to a basic forecasting model * Identify the evidence of growth mismanagement and develop the skills to determine maximum sustainable growth * Apply statistical procedures to forecasting * Analyze projected or forecasted financial statements
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Notice to Readers
Financial Forecasting and Decision Making is intended solely for use in continuing professional education and not as a reference. It does not represent an official position of the American Institute of Certified Public Accountants, and it is distributed with the understanding that the author and publisher are not rendering legal, accounting, or other professional services in the publication. This course is intended to be an overview of the topics discussed within, and the author has made every attempt to verify the completeness and accuracy of the information herein. However, neither the author nor publisher can guarantee the applicability of the information found herein. If legal advice or other expert assistance is required, the services of a competent professional should be sought.
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© 2017 American Institute of Certified Public Accountants, Inc. All rights reserved.
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Course Code: 733970FFMD GS-0417-0A Revised: December 2016
Chapter 1 Forecasting Prerequisites
An Overview of the Forecasting Process
More on the Forecasting Process
Budgets Versus Forecasted Financial Statements
Financial Planning Prerequisites
Value of a Company
Chapter 2 Using the Basic Forecasting Model
Percent of Sales and Sales Forecasts
The Basic Forecasting Model
Explanation of the Basic Model
Identification of Spontaneous and Quasi-spontaneous Accounts
The Basic Model: An Example
Using the Basic Model for Planning
The Basic Model: Sensitivity Analysis
The Zeta Company Case Study
The Balance Sheet: Percent of Sales Method
Forecasting the Balance Sheet: An Example
Using the Projected Balance Sheet for Decision Making: Capital Structure Decision
Methods of Financing EFN
Using the Projected Balance Sheet for Decision Making: Working Capital Decisions
Using the Projected Balance Sheet for Decision Making: Retention Decisions
Problems and Limitations Associated with the Basic Model
Chapter 3 Management Uses of the Forecasting Technique: A Case Analysis on Working Capital Planning
The Davidson Toy Company
Chapter 4 Using Forecasting to Plan the Company's Capital Structure
Value of the Firm
The Effect of Debt on the Cost of Capital
Other Factors: Bankruptcy Costs
Financing the Expected Funds Needed (EFN): Capital Structure Theory
Relation of Cost of Capital and Value to Debt Ratio
Optimal Capital Structure
Factors Influencing Debt Usage
Short Versus Long-Term Debt
Chapter 5 Forecasting the Balance Sheet: Statistical Procedures
Statistical Procedure Regression
Advantages of Regression Analysis
Finding a Trend Line with Two Data Points
Using Regression: An Example
Regression and Forecasting the Balance Sheet: An Example
Using Regression to Forecast the Income Statement
Chapter 6 Forecasting the Income Statement
How Expenses Vary with Sales Changes
The Income Statement Percent of Sales Method
Finding Fixed and Variable Expenses Graphically
Using Regression to Determine Fixed and Variable Expenses
Example of Using Regression to Determine Expense Components
Forecasting the Income Statement
Chapter 7 Reconciling the Income Statement and Balance Sheet
Why There Must Be a Reconciliation
Reconciliation of the Income Statement and the Balance Sheet
Reconciliation: A Complete Example
Forecasting and Reconciling the Income Statement: An Example
Reconciliation: An Example
Reconciliation: A Second Example
Chapter 8 Evidence of Growth Mismanagement
Evidence of Growth Mismanagement
Fixed Assets to Net Worth
Net Sales to Net Worth: The Trading Ratio
The Trading Ratio of Company A: An Example
Other Important Ratios to Monitor During Periods of Growth
Chapter 9 Maximum Sustainable Growth
The Basic Model: Maximum Sustainable Growth
The Sustainable Growth Model
Maximum Sustainable Growth: An Example
Maximum Sustainable Growth: A Second Example
Improving Sustainable Growth
Sustainable Growth: Available External Equity
Sustainable Growth with Regression
Chapter 10 Forecasting Sales
Forecasting Sales: Sales Goal
The Best Guess Forecast: Bottom-up
Compound Growth: An Example of Forecasting Sales
Fluctuating or Cyclical Sales
Using Regression to Predict Sales
Forecasting Sales: Regression Approach
Quick Mart Lumber Company
Chapter 11 Integrating the Percent of Sales with a Shorter-Term Forecast of Cash Needs
Shorter-Term Cash Needs
Appendix A The Basic Forecasting Model
Glossary of Controllership and Financial Management Terms
Table of Contents
Users of this course material are encouraged to visit the AICPA website at www.aicpa.org/CPESupplements to access supplemental learning material reflecting recent developments that may be applicable to this course. The AICPA anticipates that supplemental materials will be made available on a quarterly basis. Also available on this site are links to the various "Standards Trackers" on the AlCPA's Financial Reporting Center which include recent standard-setting activity in the areas of accounting and financial reporting, audit and attest, and compilation, review and preparation.
The purpose of the first chapter is to acquaint you with some basic ideas about forecasting. After completing this chapter, you should be able to do the following:
• Identify the basic forecasting process.
• Distinguish the differences between budgets and forecasts.
• Identify how growth can affect a company
Forecasting involves looking into the future, but we base it in part on financial relationships from the past and upon expectations about the future. The model that we are using today is a sales-driven model. The most basic underlying assumption is that the firm, its size, and its financial condition are very closely tied to sales.
This model presumes some ability to forecast sales. For a company that cannot forecast where its sales are headed, this model may not be appropriate. This statement does not mean that you need a 100- percent-accurate sales forecast. In fact, all you need is a sales direction and a reasonable approximation of the magnitude of the sales change. A range of possible sales figures can be used in place of a single number. From the sales forecast the analyst then relates the various balance sheet accounts and expenses to the anticipated sales change. Finding these relationships allows the analyst to complete pro forma financial statements and to perform simulations for decision making.
1. In forecasting, the process usually starts with an estimate for ________________ and develops the forecast from this estimate.
a. Total assets.
b. Total sales.
c. Total cash.
d. Current Assets
The purpose of forecasting is to allow the company's managers to plan for the future. The purpose is not to predict next year's outcome. There is a subtle difference between these ideas. There are so many uncertainties that truly accurate predictions may not be possible. However, forecasting lets you decide in what direction to move your company. It helps you decide on particular strategies or between various strategies. It can show you the things that the company must do to improve.
The key word is planning. Making decisions affects the future of companies. Forecasting can help you understand the many ways that the decision can interrelate with the company's financial condition. By planning you attempt to reduce some of the uncertainty about the future. You can determine what some of the things are that you need to do to make the decision a success and what some of the potential pitfalls are that may undermine it.
The forecasting process starts out with a first-pass forecast. In this forecast you make the most basic assumptions—generally that you want to keep the company's future financial condition in line with its financial history. In other words, for the first pass you show what would happen if the company was to maintain the financial relationships on the current financial statements for things like receivable turnover, inventory turnover, liquidity, and so on. The first-pass forecast gives you a starting point for the planning process. It is what you will use to show what changes may need to occur. It is what you will use to compare to the changes you propose through various decisions.
Once the first-pass forecast is prepared, your real planning work begins. This often takes the form of simulation. You then can deviate, as appropriate, from the assumptions in your first pass. For example, you may want to see what the effects of a reduced collection period would do to your financial condition. You build this change into the model and compare it to the first pass. We can call this a second-pass. You then have information that you can use to help you make the decision.
Conducting simulations and preparing second-pass forecasts is where planning takes place. You can now answer the question, what if? What business opportunities is your company facing? If you embrace these opportunities how will this affect your company's balance sheet, its need for borrowed funds, its cash flow, and its income? What are the downsides of this opportunity?
Planning and forecasting do not replace common sense and business experience. What they do is allow you to use numbers to help you address the issues and opportunities facing your company. You still must use your common sense and business experience in compiling and analyzing the numbers.
2. In a simulation, we examine the potential effects of a plan of action. In doing so, we answer the question “what if…” This is done
a. In the first-pass forecast.
b. In the second-pass forecast.
c. Prior to beginning the forecasting process.
d. After the forecasting process is finished.
Every forecasting technique requires the making of assumptions. Without assumptions we could not put a forecast together. When the analyst is troubled about an assumption, the analyst can use sensitivity analysis. This means rerunning the forecast under different assumptions or varying assumptions.
For example, suppose your company relies heavily on an input, say, gasoline. What would happen if gas prices increased by 50 percent over a two-month period? How could your company handle this?
Sensitivity analysis can help you understand which inputs are critical for your company's survival. If, for example, you discover that a change in gasoline prices could materially affect the future financial outcome, this understanding may lead you to engage in hedging activity such as the purchase of forward and future contracts on fuel.
You may recall that we said that the object of forecasting was not prediction. Its object is planning. We use the forecast to see what the various changes will do to a company and what direction the change will move the company. This forecasting is a planning tool, not a crystal ball.
• Short-term. One month or less to one year
– Concern for detail
– Ensures that the firm has necessary inputs
• Long-term. One year plus
– Concern for long-range strategy
– Determines if strategic action meets long-term goals
– Less concern for details
Budgets are generally prepared for a shorter time period and with a different purpose from a forecast. Budgets are generally short-term. For example, a company might prepare a cash budget for 90 days or for 6 months. The cash budget ensures that there will be sufficient cash on hand to pay bills and that the excess cash can be properly invested. Thus, budgets are concerned with details and controlling details. Budgets can also be used to control behavior and limit spending.
Forecasts are generally prepared for periods of one year up to five (or perhaps ten) years. As stated previously, a forecast is used for long-term planning. Forecasts are generally not used for control. With a forecast we want to determine if our plans will allow the company to meet its goals. Alternately, it can allow a company to determine what variables will affect the success of a decision. Simulation and sensitivity analysis indicate where we need to be diligent and what we need to monitor.
This manual focuses most heavily on forecasting and planning.
Before beginning the forecasting process, the financial analyst needs to take an introspective look at the company. It is important to know the company's current position and where it might be headed.
Following are a list of items that will be used to help in this process. These phrases will assist you in beginning the planning process.
• Corporate Purpose. Defines the overall goal of the firm (that is, increase value of the firm by 10 percent per year). Purpose is relatively static. It is also a long-term concept. Here, we decide the overall future direction of the business.
• Corporate Scope. Defines the firm's areas of business and strengths or weaknesses within these areas. It is important for a company to know its strengths and weaknesses. This will define its strategic actions. Companies that go beyond their scope often get into trouble.
• Corporate Objectives. Define the firm's specific goals. These are often quantitative such as target return on investment (ROI), earnings per share (EPS), and market share. Goals are not static; they must change as conditions change. Objectives tend to be very specific. They can be long- or short-term and can more carefully define the objectives.
• Corporate Strategies. Are broad approaches. Detail is less important than providing general direction. Strategies are used to fulfill the company's purpose and reach its objectives. We use the forecasting model to evaluate the various proposed strategies.
The overall reason to forecast is to help a company reach its objectives and to determine which strategies will accomplish this task. Defining the purpose, scope, and objectives gives you the target to aim your strategies.
3. Select the most correct statement:
a. Defining the corporate purpose is a prerequisite for forecasting.
b. Knowing the corporate purpose allows the forecaster to aim the company in the appropriate direction.
c. All of the above are true.
d. None of the above are true.
The faster a company grows, the greater its need for external funding. It seems ironic that companies that produce high rates of profit and growth are the companies that often run short of funds. However, upon second glance, it may not be as ironic as we first think.
Frequently growth requires large investments in new fixed assets, increased inventories, increased receivables, and even more cash. When the asset side of the balance sheet grows faster than the company's ability to generate funding internally, then external funding is required. Without proper planning growth can cause a non-optimal balance of liabilities and equities and inadequate working capital. Excessive debt and inadequate working capital can derail a company's plans. Planning and forecasting can help a company determine its funding needs, which helps to ensure the success of growth.
Growth requires continual monitoring and planning. Without proper planning a firm can grow right out of business.
4. Future external funding requirements can be caused by which of these?
a. The expected growth in assets is equal to the expected sources of internal funding.
b. The expected growth in assets is greater than the expected sources of internal funding.
c. The expected growth in assets is less than the expected sources of internal funding.
d. There is no expected growth in assets.
We base this program on the assumption that maximizing the value of the company is an important objective and therefore the basis for decision making. The value of a company is generally considered to be the present value of the expected future free cash flows.
To increase the value of a company you can
1. Improve the ability of the company to generate cash flow
a. By increasing revenues, or
b. By reducing expenses.
2. Reduce the company's risk. The reduction of risk lowers the company's cost of capital and increases value.
Financial planning and forecasting can help us understand whether or not our plans are consistent with value maximization. If a proposed activity does not increase expected cash flows or reduce risk, it probably does not enhance value.
The purpose of this chapter is to introduce you to the basic forecasting model. After completing this chapter, you should be able to do the following:
• Recognize the importance of assumptions.
• Recall the EFN requirements for a company using the percent of sales method to prepare a sources and uses of cash equation.
• Identify when an asset or liability is spontaneous.
Assumptions are a necessary part of the forecasting process. Through them, we make the forecast workable, and through them, we begin to develop an understanding of how things interrelate in our company.
When we prepare our first-pass forecast, we generally make very basic assumptions. The most common basic assumption is that we want the current or existing financial relationships to be maintained. (Remember, this is just our starting point. We can and should reevaluate these assumptions in later forecasting passes during our planning process.)
The most common way to operationalize these basic assumptions is to link various values to sales. This should make some sense to you because the company's sales level is probably one of the biggest, if not the biggest, determinant of its future.
The basic model we use is called the percent of sales method. To prepare our first-pass forecast, we determine how each asset, liability, and expense should behave as sales change. Sometimes the changes in the assets, liabilities, and expenses occur on their own. For others, we must make the changes occur if the company is to be successful. Whether the changes occur on their own or whether we must force the change, before forecasting we must determine these relations. Generally, as a starting point in our first-pass forecast, we assume that we want the past relationships between sales and the other accounts to remain as they are now.
As stated before, we can later change the assumptions. If, for example, we have been mismanaging our inventory, the basic assumption builds this mismanagement into the forecast. As we plan for the future, correcting this mismanagement would be a good idea. We build the correction into a second-pass forecast. By observing the first pass and the second pass, we can see the impact of continued mismanagement and the impact of the correction.
1. Once we make an assumption in our forecasting model,
a. The model requires that we use this assumption for all of our planning.
b. The assumption is generally irrelevant to decision making with a forecasting model.
c. We can change and update the assumption as part of our planning process and test the importance of the assumption through sensitivity analysis.
d. None of the above.
To use the percent of sales model requires a sales forecast. This is the one area where a prediction is important. If your company has “no idea” where its sales are headed in the future, then this model should not be used. If you have no idea where your company's sales are headed, there probably is not a planning model that will work for you.
The sales forecast can be a simple number or it can be a range. In the model, we prepare a forecast with one sales prediction at a time. We can then re-compute the model with other alternate sales predictions. We can then see the likely impact of the possible range of sales increases.
The answer to this question varies. The accountants and financial analysts (us) are generally not in the best position to forecast sales. After all, we tend to have less of a relationship with our customers and markets than others in the company. We therefore often must rely on sales forecasts generated by others.
Sometimes we must become involved in sales forecasting. This could occur if there is no one else in the company willing or able to generate the forecast. Or, it could occur if we believe the forecast we have been given is, in some way, flawed or unrealistic.
For much of the seminar, we will assume that the sales forecast is provided to us from others in the company. In a later chapter, we will return to the idea of sales forecasting for those instances where we need to become involved in it.
The basic forecasting model uses the percent of sales method as the starting point. We first prepare a pro forma sources and uses of cash equation. This equation is a good starting point for developing an understanding of the model. It will also lead us into the preparation of the pro forma balance.
Required increase in assets – Spontaneous increase in liabilities – Increase in retained earnings ± Miscellaneous items
External Funds Needed.
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