Financial Management: Financial Forecasting

Summary

In this financial management course segment, Thomas focuses on financial planning and forecasting, particularly the income statement and balance sheet. Key assumptions for forecasting include projected sales growth, cost of goods sold, operating expenses, interest based on debt balances, and taxes based on tax rates. The balance sheet considerations involve working capital, fixed assets, and company policies on capital issuance, debt, equity, and dividends. An example is provided, demonstrating how to forecast financials using historical data, assumptions, and company policies, with an emphasis on the importance of understanding relationships between financial statement items.

Takeaways

• 📈 Forecasting financials involves making assumptions about the relationships between income statement items and financial information.
• 💹 The foundational figure for forecasting is projected sales growth, which drives the income statement and balance sheet forecasts.
• 🔍 Relationships such as cost of goods sold, operating expenses, and interest to sales are crucial for income statement forecasting.
• 🏦 Interest expense is calculated based on debt balances and prevailing bank interest rates.
• 💼 Tax calculations are based on tax rates and the company's taxable income.
• 💼 Balance sheet forecasting involves assumptions about working capital, cash balances, accounts receivable, inventory, and payables as percentages of sales.
• 🏗️ Capital expenditures depend on the company's capacity level and the need for additional fixed assets to support sales growth.
• 💼 Company policies on capital issuance, debt, equity, and dividends affect balance sheet forecasting.
• 💼 Short-term debt adjustments are made based on cash needs, while long-term debt is influenced by company policy.
• 🔄 The balance sheet must balance, with adjustments to short-term notes payable to ensure equity.
• 🔢 Historical financials and assumptions are used to create a financial forecast, which is a critical tool for financial planning.

Q & A

What is the main topic of the lecture?

The main topic of the lecture is financial planning and forecasting, specifically focusing on forecasting the income statement and balance sheet for a company.

What foundational figure is essential for developing a financial forecast?

The foundational figure essential for developing a financial forecast is the projected growth and sales of the company.

How does the relationship of cost of goods sold to sales impact the financial forecast?

The relationship of cost of goods sold to sales, expressed as a percentage of sales, impacts the financial forecast by determining the cost structure as sales grow.

What factors influence interest expense in the financial forecast?

Interest expense in the financial forecast is influenced by debt balances and bank interest rates.

Why might a company experience a decrease in interest expense despite significant sales growth?

A company might experience a decrease in interest expense despite significant sales growth if the debt balance decreases, as interest expense is driven by the debt balance.

How does the balance sheet relate to the income statement in financial forecasting?

The balance sheet relates to the income statement in financial forecasting by showing how the company's assets, liabilities, and equity are expected to change in response to projected sales growth and other financial activities.

What is the role of working capital in the balance sheet forecast?

Working capital, which includes cash, accounts receivable, inventory, and payables, generally relates to sales and is forecasted as a percentage of sales in the balance sheet.

Why might a company need to increase its fixed assets?

A company might need to increase its fixed assets if it is at full capacity and plans to grow sales beyond the existing capacity, as additional fixed assets are required to support increased production or sales.

How does company policy affect the balance sheet forecast?

Company policy affects the balance sheet forecast by influencing decisions regarding new capital issuance, debt and equity structures, and dividend payments.

What is the significance of the dividend payout ratio in financial forecasting?

The dividend payout ratio, which is the relationship of dividends paid as a percentage of net income, is significant in financial forecasting as it indicates how much of the company's earnings are distributed to shareholders and how much is retained for growth or other purposes.

How is the interest rate for interest expense estimated in the absence of provided rates?

In the absence of provided interest rates, the interest rate for interest expense is estimated by dividing the interest expense from the income statement by the total of short-term and long-term notes payable.

What assumption is made regarding the timing of changes in short-term notes payable in the financial forecast?

The assumption made regarding the timing of changes in short-term notes payable in the financial forecast is that any increase occurs at the very last day of the year, simplifying the calculation of interest expense.

Outlines

00:00

📈 Financial Planning and Forecasting Overview

Thomas introduces the topic of financial planning and forecasting, focusing on the income statement and balance sheet. He emphasizes the importance of projected sales growth as the foundational figure for forecasting. Assumptions about the relationships between income statement items and other financial data are discussed, including cost of goods sold, operating expenses, interest based on debt balances and bank interest rates, and taxes based on tax rates. The potential for sales growth with a decrease in interest expense due to reduced debt is highlighted. Thomas also mentions the relationship between balance sheet items like working capital, cash balance, accounts receivable, inventory, and payables to sales. Capital expenditures are discussed in the context of company capacity and the need for additional fixed assets. Company policies on capital issuance, debt, equity, and dividends are also considered in the forecasting process.

05:04

🔍 Detailed Forecasting Process and Assumptions

This paragraph delves into the detailed process of forecasting financial statements. Thomas explains the need to estimate interest rates by analyzing historical financial statements and applying these rates to new debt balances. He discusses the calculation of taxes based on a percentage of earnings before taxes and the use of the same tax rate for projections. Dividends are also considered, with a focus on maintaining the dividend payout ratio. The centrality of annual sales growth to the forecasting process is reiterated, with a 20% growth rate used as an example. Thomas also discusses how balance sheet items like cash, accounts receivable, inventory, and fixed assets are driven by sales growth. The necessity to increase fixed assets when sales and fixed asset utilization are at 100% is highlighted. Liabilities and equity are also examined, with a focus on how accounts payable move with sales and the handling of short-term notes payable to balance the balance sheet. Company policy on issuing new debt and not issuing new equity is mentioned, with retained earnings calculated based on beginning balance, net income, and dividends.

10:05

🏫 In-Class Calculations and Final Thoughts

Thomas invites students to work through the calculations on their own as a preparation for the in-class activity, where they will work through the financial forecasting process together. He assures that they will cover the calculations in detail to ensure understanding. The paragraph concludes with a look forward to seeing the students in class, indicating an interactive and collaborative learning environment.

Keywords

💡Financial Planning and Forecasting

Financial planning and forecasting refer to the process of estimating a company's future financial performance based on its current financial situation and market conditions. In the video, this concept is central as the speaker discusses how to forecast a company's income statement and balance sheet, which are key financial planning tools. The speaker emphasizes the importance of understanding the relationships between different financial statement items and how they can change with sales growth and company policy.

💡Income Statement

The income statement, also known as the profit and loss statement, is a financial report that provides a summary of a company's revenues, expenses, and profits over a specific period. In the context of the video, forecasting the income statement involves making assumptions about sales growth, cost of goods sold, operating expenses, interest, and taxes. The script mentions that the income statement is foundational for financial forecasting, as it helps predict the company's profitability.

💡Balance Sheet

A balance sheet is a financial statement that presents a company's financial position by listing its assets, liabilities, and equity at a specific point in time. The video script discusses how to forecast the balance sheet, focusing on how working capital, fixed assets, and long-term debt relate to sales growth and company policy. The balance sheet is crucial for understanding a company's financial stability and its ability to meet its obligations.

💡Sales Growth

Sales growth is a measure of the increase in a company's sales over a specific period. It is a key driver in financial forecasting, as it directly impacts the company's revenues and, consequently, its profitability. The script highlights that the foundational figure for developing a financial forecast is the projected growth in sales, which influences the assumptions made for other income statement items.

💡Cost of Goods Sold (COGS)

Cost of goods sold represents the direct costs attributable to the production of the goods sold by a company. In the video, the relationship of COGS to sales is discussed as a percentage, which is used to forecast future COGS based on projected sales growth. Understanding this relationship is essential for accurately predicting a company's future cost structure and gross profit margin.

💡Operating Expenses

Operating expenses, also known as selling, general, and administrative (SGA) expenses, are the costs associated with running a business's core operations. The video script mentions that these expenses are forecasted based on their relationship to sales, implying that as sales increase, operating expenses may also rise, although the exact percentage relationship is used to make this forecast.

💡Interest Expense

Interest expense is the cost of borrowing money, typically associated with debt or loans. In the script, it is noted that interest expense is based on debt balances and bank interest rates. The video explains that even if sales increase, interest expense might decrease if the company's debt balance decreases, demonstrating the complex interplay between different financial elements.

💡Capital Expenditures

Capital expenditures, or capex, are funds used by a company to acquire or improve physical assets such as buildings, vehicles, equipment, or technology. The video script discusses that capital expenditures may be necessary if the company is at full capacity and needs to expand its fixed assets to support increased sales. This concept is integral to understanding a company's investment in its future growth.

💡Working Capital

Working capital is a measure of a company's short-term liquidity, calculated as current assets minus current liabilities. In the video, the speaker explains that working capital, including cash, accounts receivable, and inventory, generally relates to sales. Forecasting working capital is important for managing a company's day-to-day operations and short-term financial health.

💡Dividends

Dividends are payments made by a corporation to its shareholders, usually from the company's earnings. The script mentions that the company's dividend payout ratio remains unchanged, meaning the relationship between dividends paid and net income will be consistent. Forecasting dividends is important for investors as it indicates the company's profitability and its policy towards returning earnings to shareholders.

💡Fixed Asset Utilization

Fixed asset utilization is a measure of how efficiently a company uses its fixed assets to generate sales. In the video, the speaker notes that the company's fixed asset utilization is at 100 percent, indicating that any increase in sales will require additional fixed assets. This concept is crucial for forecasting the need for capital expenditures and understanding the company's capacity to grow.

Highlights

Today's topic is financial planning and forecasting, focusing on forecasting the income statement and balance sheet for a company.

Forecasting the income statement involves making assumptions about the relationships of its items to other financial information.

Projected sales growth is a foundational figure for developing financial forecasts.

Understanding the relationship of cost of goods sold to sales is crucial for forecasting.

Operating expenses and interest are forecasted based on their respective relationships to sales and debt balances.

It's possible for a company to have sales growth and a decrease in interest expense if debt balance decreases.

Sales growth could lead to a decrease in taxes due to high expenses resulting in low taxable income.

Balance sheet forecasting involves assumptions about working capital, cash balance, and capital expenditures.

Fixed assets may need to increase if sales growth exceeds current capacity.

Company policies on capital issuance, debt, equity, and dividends payments influence balance sheet forecasting.

Short-term debt adjustments are made based on cash flow needs and operations.

The example provided includes a 2016 income statement, dividend payment, and projected sales growth for 2017.

Fixed asset utilization at 100% indicates a need for increased fixed assets to support sales growth.

Company policy includes issuing new debt and maintaining the dividend payout ratio in 2017.

Forecasting involves calculating cost of sales, SGA expenses, and depreciation based on historical percentages and assumptions.

Interest expense is estimated by dividing the interest expense by the total debt balances.

Historical tax rates are used to forecast taxes on the income statement.

Dividends are forecasted using the dividend payout ratio based on net income.

The central forecast figure is the annual sales growth of 20%.

Accounts receivable, inventory, and accounts payable are forecasted as percentages of sales.

Short-term notes payable is adjusted to balance the balance sheet, reflecting cash flow needs.

Long-term notes payable is influenced by company policy on new debt issuance.

Retained earnings are calculated based on beginning balance, net income, and dividends for the forecast year.

The lecture will work through the calculations in detail to ensure understanding of financial forecasting.

Transcripts

hi I'm Thomas welcome back to the course

financial management

today's topic is financial planning and

forecasting

we'll look at forecasting the income

statement and balance sheet for a

company and with those two financial

statements it's also possible to

forecast the cash flow statement

although we will focus on the income

statement and balance sheet for this

lecture in forecasting the income

statement we have certain assumptions

that we're making regarding the

relationships of income statement items

to other financial information of the

company first we need to know what is

the projected growth and sales that

that's really the foundational figure to

develop our forecast we also need to

know relationships to sale we need to

know the relationship of cost of goods

sold to sales or as a percentage of

sales same for operating expenses

interest will be based on debt balances

and whatever the bank interest rates are

and taxes will be based on tax rates so

it is possible a company could have

significant sales growth but a decrease

in interest expense because interest

expense is driven by debt balance and

it's possible that while sales goes up

the debt balance goes down it's also

possible that sales could go up and

taxes could go down because of high

expenses resulting in a low taxable

income number assumptions relating to

the balance sheet working capital or

cash balance along with our working

capital accounts receivables inventory

and payables generally relate to sales

and we will look at those as a

percentage of sales and capital

expenditures may or may not need to be

incurred depending on the company's

capacity level if we are at full

capacity we can't produce any more or

sell any more without additional fixed

assets then the sales go up our fixed

assets also need to increase but if we

have capacity and we're not growing our

sales beyond the

existing capacity then we don't need any

new buildings or machines etc and

company policy relating to the balance

sheet companies generally have policies

regarding new capital issuance debt and

equity as well as dividends payments now

in calculating our forecast we will

ultimately see that from the short-term

debt standpoint we're either going to

need extra cash and we will borrow we

will increase short-term debt or we'll

have excess cash beyond what we need for

our operations and we will pay down

short-term debt but from the standpoint

of what we'll consider more of a

permanent kind of debt I don't mean

forever

it could even be short term short term

or long term but it's more of a notes

payable as opposed to let's say a short

term line of credit from a bank notes

payable would be based on company policy

at the end of our calculations we'll see

we have excess or a shortage of cash and

we will even that out with a line of

credit from the bank now here's an

example we have our 2016 income

statement with some additional

information what the dividend payment

was for the 2016 or the dividend payment

during 2016

and now our annual sales growth that

were projecting for the following year

for 2017 and going forward we have our

2016 balance sheet with some additional

information our fixed asset utilization

is currently 100 percent so if we grow

sales which our projection was to grow

sales by 20% then we're going to need it

to increased increase fixed assets as

well in order to increase sales company

policy we plan on issuing new debt of a

hundred and ten dollars in 2017 there

will be no new equity issued and the

dividend payout ratio is no change that

doesn't mean the dividend payout in

dollars does not change that means the

dividend payout ratio the relationship

of dividends paid as a percentage of net

income will

change so looking back let's talk about

some of the relationships you'll want to

understand cost of sales as a percentage

of sales $520 is what percentage of $800

and next year we'll use the same

percentage to calculate costs of sales

on a bigger grown sales number we'll do

the same thing with SGA expense we could

also call that operating expense

depreciation expense we are going to let

the assumptions drive that number if we

increase our fixed assets then we will

increase the annual depreciation expense

by the same number and if we don't

increase our fixed assets then we will

leave depreciation expenses the same

number

interest expense what we need to do is

we need to look at one slide forward our

debt notice that we have short term

notes payable and long term notes

payable now we're not provided with an

interest rate we can estimate the

interest rate by dividing the interest

expense again going back to the income

statement dividing interest expense by

the total of short-term notes payable in

a long term notes payable that will give

us an estimate of interest rate and

that's the interest rate that we will

use for our interest expense in 2017 and

our taxes on the income statement these

taxes were based on some percentage of

earnings before taxes the line directly

above so you calculate the historic tax

rate and use the same tax rate in your

projection dividends were seventy

dollars that is some percentage of the

ninety-five dollars in net income you

want to use the same percentage the same

dividend payout ratio in 2017 and again

our sales growth the central number to

this forecast both the income statement

and the balance sheet is annual sales

growth of 20% and now again to the

balance sheet and maybe still going back

and forth cash accounts receivable

inventory all three of those will be

driven by sales growth as sales goes up

these three should go

fixed assets needs to increase not

always but again looking to the right we

see our fixed asset utilization is

currently 100 percent and we're growing

sales we can only do that with more

fixed assets so we need to increase our

fixed assets balance moving to

liabilities and equity accounts payable

will also move with sales that's a

working capital account as sales

increases accounts payable increases our

short-term notes payable this is a

number that we will finalize at the end

of our forecast we're going to change

this number either an increase or a

decrease to make the balance sheet

balance an increase would mean we had a

cash shortfall and we need to borrow a

decrease would mean excess cash and we

were able to pay down some short-term

debt looking to the bottom section long

term notes payable notice on the right

our company policy this coming year 2017

we will issue new debt let's put that

into the long term category of $110 we

will not issue any new equity so common

stock won't change and retained earnings

you will need to calculate based on the

beginning balance here of 220 plus 2017

net income minus 2017

dividends so once you've factored all

those numbers into your forecast you

will have a new income statement and a

new balance sheet will see the solution

on the following slides but in our

lecture we're going to work through this

activity together you can certainly take

a look now and you can even try and work

through the calculations on your own

that will give you great preparation for

our activity in class but we will work

through these calculations in detail

together during our lecture now looking

at the solution income statement and

balance sheet notice a couple of

particular items number one the two

numbers in yellow interest expense 37

dollars

remember interest expenses based on debt

balance so I must be calculating that

number based

some interest rate and I had to estimate

that interest rate for my historical

financial statements and I apply that

interest rate to my new debt balance now

when I say the new debt balance what I

mean there is looking at what the

short-term notes payable was plus the

long-term notes payable factoring in the

increase in 2017 immediately before

completing the model and what I mean by

that is if we look to the right in the

balance sheet we have another number

highlighted and also in red to really

emphasize this is a key number in our

model short-term notes payable has

increased it's now one hundred fifty six

dollars

we're making the assumption that that

increase was at the very last day of the

year and that the short-term notes

payable before that was the same balance

as it was at the end of 2016 in other

words in calculating our interest

expense we've got several moving parts

so we're making some simplifying

assumptions by assuming that short-term

notes payable doesn't increase until the

very last day of the year and so we

calculate and the other assumption we're

making is that the increase in long term

notes payable happened on the first day

of the year so again you can work

through the calculations to see if you

get the same numbers and we will do

these calculations together in class to

make sure you understand how to take a

set of historical financials some

assumptions and create your financial

forecast we'll do that together

I look forward to seeing you in class