Foundations of Financial Management: An Analysis (part 9)

Your net worth to the world is usually determined by what remains after your bad habits are subtracted from your good ones.

Benjamin Franklin

Financial Forecasting

 by

Charles Lamson

While we may assume that no growth or a decline in volume is the primary cause for a shortage of funds; this is not necessarily the case. A rapidly growing firm may witness a significant increase in accounts receivable, inventory, and plant and equipment that cannot be financed in the normal course of business. Assume sales go from $100,000 to $200,000 in one year for a firm that has a 5 percent profit margin (see last post about calculating profit margin) on sales. At the same time, assume assets represent 50% of sales and go up from $50,000 to $100,000 as sales double. The $10,000 of profit (5 percent X $200,000) will hardly be adequate to finance the $50,000 asset growth. The remaining $40,000 must come from suppliers, the bank, and perhaps stockholders. You should recognize that profit alone is generally inadequate to finance some significant growth and a comprehensive financing plan must be developed. Too often, the small business person (and sometimes the big one as well) is mystified by an increase in sales and profits but less cash in the till.

Constructing Pro Forma Statements

The most comprehensive means of financial forecasting is to develop a series of pro forma, or projected, financial statements. We will give particular attention to the pro forma income statement, the cash budget, and the pro forma balance sheet. Based on the projected statements, the firm is able to estimate its future level of receivables, inventory, payables, and other corporate accounts as well as its anticipated profits and borrowing requirements. The financial officer can then carefully track actual events against the plan and make necessary adjustments. Furthermore, the statements are often required by bankers and other lenders as a guide for the future.

A systems approach is necessary to develop pro forma statements. We first construct a pro forma income statement based on sales projections and the production plan, then translate this material into a cash budget, and finally assimilate all previously developed material into a pro forma balance sheet. the process of developing pro forma financial statements is depicted in Figure 1. We will use a six-month time frame to facilitate the analysis, though the same procedures could be extended to one year or longer.

Figure 1 Development of pro forma statements

Pro Forma Income Statement

Assume the Lamson Corporation has been asked by its bank to provide pro forma financial statements for midyear 2021. The pro forma income statement will provide a projection of how much profit the firm anticipates making over the ensuing time period. In developing the pro forma income statement, we will follow four important steps.

1. Establish a sales projection. 

2. Determine a production schedule and the associated use of new material, direct labor, and overhead to arrive at gross profit. 

3. Compute other expenses. 

4. Determine profit by completing the actual pro forma statement.

Establish a Sales Projection

For purposes of analysis, we shall assume the Lamson Corporation has two primary products: wheels and casters. Our sales projection calls for the sale of 1000 wheels and 2,000 casters at a price of $30 and $35, respectively. As indicated in Table 1, we anticipate total sales of $100,000.

 

Table 1 Projected wheel and caster sales (first six months, 2021)

Determine a Production Schedule and the Gross Profit

Based on anticipated sales, we determine the necessary production plan for the six-month period. The number of units produced will depend on the beginning inventory of wheels and casters, our sales projection, and the desired level of ending inventory. Assume that on January 1st, 2021, the Lamson Corporation has in stock the items shown in Table 2.

Table 2 Stock of beginning inventory

We will add the projected quantity of unit sales for the next 6 months to our desired ending inventory and subtract our stock of beginning inventory and units to determine our production requirements. This process is Illustrated below.

Following this process, in Table 3 we see a required production level of 1,015 wheels and 2,020 casters.

Table 3 Production requirements for six months

We must now determine the cost to produce these units. In previously mentioned table 2 we see that the cost of units in stock was $16 for wheels and $20 for casters. However, we shall assume the price of materials, labor, and overhead going into the new products is now $18 for wheels and $22 for casters, as indicated in Table 4.

Table 4 Unit costs

The total cost to produce the required new items for the next six months is shown in Table 5.

Table 5 Total production costs

Cost of Goods Sold The main consideration in constructing a pro forma income statement is the costs specifically associated with units sold during the time (the cost of goods sold). Note that in the case of wheels we anticipate sales of 1,000 units, as indicated in Table 1, but are producing 1,015, as indicated in Table 3, to increase our inventory level by 15 units. For profit measurement purposes, we will not charge these extra 15 units against current sales. Furthermore, in determining the cost of the 1,000 units sold during the current time period, we will not assume that all of the items sold represent inventory manufactured in this period. We shall assume the Lamson Corporation uses FIFO (first-in, first-out) accounting and it will first allocate the cost of current sales to beginning inventory and then to goods manufactured during the period. 

In Table 6 we look at the revenue, associated cost of goods sold, and gross profit for both products. For example, 1,000 units of wheels are to be sold at a total revenue of $30,000. Of the 1,000 units, 85 units are from beginning inventory at a $16 cost, and the balance of 915 units is from current production at an $18 cost. The total cost of goods sold for wheels is $17,830, yielding a gross profit of $12,170. The pattern is the same for casters, with sales of $70,000, cost of goods sold of $43,640, and gross profit of $26,360. The combined sales for the two products are $100,000 with cost of goods sold of $61,470 and gross profit of $38,530.

Table 6 Allocation of manufacturing cost and determination of gross profits

At this point, we also compute the value of ending inventory for later use in constructing financial statements. As indicated in Table 7, the value of ending inventory will be $6,200. 

Table 7 Value of ending inventory

Other Expense Items

Having computed total revenue, cost of goods sold, and gross profit, we must now subtract other expense items to arrive at a net profit figure. We deduct general and administrative expenses as well as interest expenses from gross profit to arrive at earnings before taxes, then subtract taxes to determine after-tax income, and finally deduct dividends to ascertain the contribution to retained earnings. For the Lamson Corporation, we shall assume general and administrative expenses are $12,000, interest expense is $1,500, and dividends are $1,500.

Actual Pro Forma Income Statement

Combining the gross profit in Table 6 with our assumptions on other expense items, we arrive at the pro forma income statement presented in Table 8. as shown toward the bottom of the table, we anticipate earnings after taxes of $20,024. Dividends of $1,500, and an increase in retained earnings of $18,524.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 87-92*

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