BAC F A158264-9781259... X 100% 96 (127 of 769) orecasting for the future has never been easy, but in recent years it has become incre Move page ingly difficult for those in the retail Industry. Let's consider Dollar General Corp. How does it intend to meet its goals in the future? While many retail stores have suffered in recent years, dollar stores such as Dollar General have been one of the few bright spots. In fact, between 2008 and 2014, Dollar General's store count grew by almost 6 percent per year. Now Dollar General operates more than 11,500 stores in 40 states, and it sells more than $18 billion annually. Of course, even at that size, Walmart is much larger, selling 25 times as much product each year. Dollar General differentiates itself from Walmart by locating in shopping plazas or strip malls of smaller communities. The company's motto of "Save Time. Save Money. Every Day!" emphasizes Its goal of offering consumers the lowest prices. For example, a 2014 study by Kantar Retall concluded that in Massachusetts, Dollar General had lower prices than any other retaller on a basket of commonly purchased goods. This pricing strategy could be risky because it results in very slim profit margins. When profit margins are tight, good financial forecasting becomes critical. If there is one skill that is essential for a financial manager to develop, it is the ability to plan ahead and to make necessary adjustments before actual events occur. We likely could construct the same set of external events for two corporations (Inflation, recession, severe new competition, and so on), and one firm would survive, while the other would not The outcome might be a function not only of their risk-taking desires, but also of their abil- ity to hedge against risk with careful planning. 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 recevable, Inventory, and plant and equipment that can- not 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 on sales. At the same time, assume assets represent 50 percent of sales and go from $50,000 to $100,000 as sales double. The $10,000 of profit (5 percent $200,000) will hardly be adequate to finance the $50,000 asset growth. The remaining $40,000 must come from suppliers, the 96 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 receiv- ables, inventory, payables, and other corporate accounts as well as its anticipated prof- its and borrowing requirements. The financial officer can then carefully track actual events against the plan and make necessary adjustments. Furthermore, these state- ments 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 4 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 Prior balance sheet Sales projection Production plan Pro forma income statement Pro forma balance sheet Cash budget Other supportive budgets Capital budget 102 Part 2 Financial Analysis and Planning D E Table 4-8 Income statement A B Pro Forma Income Statement 61 June 30, 2016 62 Sales revenue (Table 4-1) $100,000 63 Cost of goods sold (Table 4-6) 61,470 64 Gross profit $ 38,530 65 General and administrative expense 12,000 66 Operating profit (EBIT) $ 26,530 67 Interest expense 1,500 68 Earnings before taxes (EBT) $ 25,030 69 Taxes (20%) 5,006 70 Earnings after taxes (EAT) $ 20,024 71 Common stock dividends 1,500 72 Increase in retained earnings $18,524 *A 20 percent tax rate is used for simplicity. Cash Budget As previously indicated, the generation of sales and profits does not necessarily ensure there will be adequate cash on hand to meet financial obligations as they come due. This was especially true in the credit crisis period of 2007-2009 as many firms had to go into temporary bankruptcy. Macy's and Chrysler are two examples. A profitable sale may generate accounts receivable in the short run but no immedi- 102 (133 of 769) 100% go into temporary pankruptcy. Macy's and Chrysler are two examples. A profitable sale may generate accounts receivable in the short run but no immedi- ate cash to meet maturing obligations. For this reason, we must translate the pro forma income statement into cash flows. In this process, we divide the longer-term pro forma income statement into smaller and more precise time frames to anticipate the seasonal and monthly patterns of cash inflows and outflows. Some months may represent partic- ularly high or low sales volume or may require dividends, taxes, or capital expenditures. Cash Receipts In the case of the Goldman Corporation, we break down the pro forma income state- ment for the first half of the year 2016 into a series of monthly cash budgets. In Table 4-1, we showed anticipated sales of $100,000 over this time period; we shall now assume these sales can be divided into monthly projections, as indicated in Table 4-9. E F G H Table 4-9 Monthly sales pattern D 2 January February 3 $15,000 $10,000 March April $25,000 May $15,000 June $20,000 $15,000 A careful analysis of past sales and collection records indicates 20 percent of sales is collected in the month of sales and 80 percent in the following month. The cash receipt pattern related to monthly sales is shown in Table 4-10. It is assumed that sales for December 2015 were $12,000. 100% D 105 (136 of 769) 105 Chapter 4 Financial Forecasting The primary purpose of the cash budget is to allow the firm to anticipate the need for outside funding at the end of each month. In the present case, we shall assume the Goldman Corporation wishes to have a minimum cash balance of $5,000 at all times. If it goes below this amount, the firm will borrow funds from the bank. If it goes above $5,000 and the firm has a loan outstanding, it will use the excess funds to reduce the loan. This pattern of financing is demonstrated in Table 4-15; this table illustrates a fully developed cash budget with borrowing and repayment provisions. Table 4-15 Cash budget with borrowing and repayment provisions A B D E F G 51 January February March April May June 52 Net cash flow $1,380 (56,452) (53,955) $4,548 $10,548 ($11.955) 53 Beginning cash balance 5,000 6,380 5,000 5,000 5,000 11,069 54 Cumulative cash balance 56,380 $ (72) $1,045 59,548 $15,548 5 (886) 55 Monthly loan (or repayment) 5,072 3,955 (4,548) (4,479) 5,886 56 Cumulative loan balance 5,072 9,027 4,479 5.886 57 Ending cash balance 56,380 $5,000 $5,000 $5,000 $11,069 $ 5.000 "We assume the Goldman Corporation has a beginning cash balance of $5,000 on January 1, 2016, and it desires a minimum monthly ending cash balance of $5,000 The first line in Table 4-15 shows net cash flow (from Table 4-14), which is added to the beginning cash balance to arrive at the cumulative cash balance. The fourth entry is the additional monthly loan or loan repayment, if any, required to maintain a minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry 105 (136 of 769) 100% minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry represents cumulative loans outstanding for all months. Finally, we show the cash bal- ance at the end of the month, which becomes the beginning cash balance for the next month. At the end of January the firm has $6,380 in cash, but by the end of February the cumulative cash position of the firm is negative, necessitating a loan of $5,072 to maintain a $5,000 cash balance. The firm has a loan on the books until May, at which time there is an ending cash balance of $11,069. During the months of April and May the cumulative cash balance is greater than the required minimum cash balance of $5,000, so loan repayments of $4,548 and $4,479 are made to retire the loans com- pletely in May. In June, the firm is once again required to borrow $5,886 to maintain a $5,000 cash balance. Pro Forma Balance Sheet Now that we have developed a pro forma income statement and a cash budget, it is relatively simple to integrate all of these items into a pro forma balance sheet. Because the balance sheet represents cumulative changes in the corporation over time, we first examine the prior period's balance sheet and then translate these items through time to represent June 30, 2016. The last balance sheet, dated December 31, 2015, is shown in Table 4-16. 109 (140 of 769) 75% Chapter 4 Financial Forecasting 109 Table 4-18 3 HOWARD CORPORATION Balance Sheet and Percent of Sales Table 4 Assets Liabilities and Stockholders' Equity 5 Cash $5,000 Accounts payable $40,000 6 Accounts receivables 40,000 Accrued expenses 10,000 7 Inventory 25,000 Notes payable 15,000 8 Total current assets $70,000 Common stock 10,000 9 Plant and equipment 50,000 Retained earnings 45.000 10 Total liabilities and Total assets $120,000 stockholders' equity $120,000 11 $200,000 Sales Percent of Sales 12 Cash 2.5% Accounts payable 20.05 13 Accounts receivable 20.0 Accrued expenses 5.0 14 Inventory 125 25.0% 15 Total current assets 35.0% 16 Plant and equipment 25.0 17 60.0% Once we know how much money we need to finance our growth, we will then decide whether to finance the sales growth with an increase in notes payable or the sale of common stock or long-term debt. There are two possible scenarios for our calculations. First, if the company is operating at full capacity, it will need to buy new plant and equipment to produce more goods to sell. If the company is operating at less than full capacity, it can increase sales with its current plant and equipment, so it will only need to add more current assets to increase its sales. In the case of full capacity, any dollar increase in sales will necessitate a 35 percent increase in current assets, as well as a 25 percent increase in plant and equipment. These percentages are found in the bottom half of Table 4-18. or this 60 percent, 25 percent will be spontaneously or automatically financed through accounts pay- able and accrued expenses, leaving 35 percent to be financed by profit or additional outside sources of financing. We will assume the Howard Corporation has an after- 1. Page 96 example: Making this even trickier is that sales can be "lumpy," and not increase smoothly over time. If increasing sales cause the retailer to increase inventory (perhaps to not lose sales due to not having enough inventory on hand), then assets increase. What was the potential problem with that? 2. Page 97: Describe the impact of fads or sudden trends on this process. Actual examples include Timberland Boots and Beanie Babies. 3. Pro Forma statements in general: "Pro forma" means "made in advance," and consists of best (hopefully informed) guesses. Which is more dangerous to the company: overestimating sales or underestimating sales? (In your answer describe the downside to either mistake. Is there an upside to either mistake? If so, describe that/those as well.) 4. Page 102, Table 4-9: Where would these numbers have come from? 5. Page 105: Would the pro forma financial statements be meaningful information for investors? Describe 6. Sarbanes-Oxley separated consulting firms from auditing firms due to problems stemming from conflicts of interest. Do auditing firms review pro forma financial statements? 7. Page 109, Table 4-18: What would happen to these numbers if the company's stock price suddenly (and dramatically) increased? 8. Page 109: Why is the stock referred to as "common?" Is there another kind? If so, why is it ignored? 9. Chapter 4: This chapter seems to focus on a manufacturing company, other than its introduction focusing on a retail company. Describe whether a service company, e.g. a consulting firm, should use pro forma financial statements BAC F A158264-9781259... X 100% 96 (127 of 769) orecasting for the future has never been easy, but in recent years it has become incre Move page ingly difficult for those in the retail Industry. Let's consider Dollar General Corp. How does it intend to meet its goals in the future? While many retail stores have suffered in recent years, dollar stores such as Dollar General have been one of the few bright spots. In fact, between 2008 and 2014, Dollar General's store count grew by almost 6 percent per year. Now Dollar General operates more than 11,500 stores in 40 states, and it sells more than $18 billion annually. Of course, even at that size, Walmart is much larger, selling 25 times as much product each year. Dollar General differentiates itself from Walmart by locating in shopping plazas or strip malls of smaller communities. The company's motto of "Save Time. Save Money. Every Day!" emphasizes Its goal of offering consumers the lowest prices. For example, a 2014 study by Kantar Retall concluded that in Massachusetts, Dollar General had lower prices than any other retaller on a basket of commonly purchased goods. This pricing strategy could be risky because it results in very slim profit margins. When profit margins are tight, good financial forecasting becomes critical. If there is one skill that is essential for a financial manager to develop, it is the ability to plan ahead and to make necessary adjustments before actual events occur. We likely could construct the same set of external events for two corporations (Inflation, recession, severe new competition, and so on), and one firm would survive, while the other would not The outcome might be a function not only of their risk-taking desires, but also of their abil- ity to hedge against risk with careful planning. 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 recevable, Inventory, and plant and equipment that can- not 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 on sales. At the same time, assume assets represent 50 percent of sales and go from $50,000 to $100,000 as sales double. The $10,000 of profit (5 percent $200,000) will hardly be adequate to finance the $50,000 asset growth. The remaining $40,000 must come from suppliers, the 96 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 receiv- ables, inventory, payables, and other corporate accounts as well as its anticipated prof- its and borrowing requirements. The financial officer can then carefully track actual events against the plan and make necessary adjustments. Furthermore, these state- ments 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 4 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 Prior balance sheet Sales projection Production plan Pro forma income statement Pro forma balance sheet Cash budget Other supportive budgets Capital budget 102 Part 2 Financial Analysis and Planning D E Table 4-8 Income statement A B Pro Forma Income Statement 61 June 30, 2016 62 Sales revenue (Table 4-1) $100,000 63 Cost of goods sold (Table 4-6) 61,470 64 Gross profit $ 38,530 65 General and administrative expense 12,000 66 Operating profit (EBIT) $ 26,530 67 Interest expense 1,500 68 Earnings before taxes (EBT) $ 25,030 69 Taxes (20%) 5,006 70 Earnings after taxes (EAT) $ 20,024 71 Common stock dividends 1,500 72 Increase in retained earnings $18,524 *A 20 percent tax rate is used for simplicity. Cash Budget As previously indicated, the generation of sales and profits does not necessarily ensure there will be adequate cash on hand to meet financial obligations as they come due. This was especially true in the credit crisis period of 2007-2009 as many firms had to go into temporary bankruptcy. Macy's and Chrysler are two examples. A profitable sale may generate accounts receivable in the short run but no immedi- 102 (133 of 769) 100% go into temporary pankruptcy. Macy's and Chrysler are two examples. A profitable sale may generate accounts receivable in the short run but no immedi- ate cash to meet maturing obligations. For this reason, we must translate the pro forma income statement into cash flows. In this process, we divide the longer-term pro forma income statement into smaller and more precise time frames to anticipate the seasonal and monthly patterns of cash inflows and outflows. Some months may represent partic- ularly high or low sales volume or may require dividends, taxes, or capital expenditures. Cash Receipts In the case of the Goldman Corporation, we break down the pro forma income state- ment for the first half of the year 2016 into a series of monthly cash budgets. In Table 4-1, we showed anticipated sales of $100,000 over this time period; we shall now assume these sales can be divided into monthly projections, as indicated in Table 4-9. E F G H Table 4-9 Monthly sales pattern D 2 January February 3 $15,000 $10,000 March April $25,000 May $15,000 June $20,000 $15,000 A careful analysis of past sales and collection records indicates 20 percent of sales is collected in the month of sales and 80 percent in the following month. The cash receipt pattern related to monthly sales is shown in Table 4-10. It is assumed that sales for December 2015 were $12,000. 100% D 105 (136 of 769) 105 Chapter 4 Financial Forecasting The primary purpose of the cash budget is to allow the firm to anticipate the need for outside funding at the end of each month. In the present case, we shall assume the Goldman Corporation wishes to have a minimum cash balance of $5,000 at all times. If it goes below this amount, the firm will borrow funds from the bank. If it goes above $5,000 and the firm has a loan outstanding, it will use the excess funds to reduce the loan. This pattern of financing is demonstrated in Table 4-15; this table illustrates a fully developed cash budget with borrowing and repayment provisions. Table 4-15 Cash budget with borrowing and repayment provisions A B D E F G 51 January February March April May June 52 Net cash flow $1,380 (56,452) (53,955) $4,548 $10,548 ($11.955) 53 Beginning cash balance 5,000 6,380 5,000 5,000 5,000 11,069 54 Cumulative cash balance 56,380 $ (72) $1,045 59,548 $15,548 5 (886) 55 Monthly loan (or repayment) 5,072 3,955 (4,548) (4,479) 5,886 56 Cumulative loan balance 5,072 9,027 4,479 5.886 57 Ending cash balance 56,380 $5,000 $5,000 $5,000 $11,069 $ 5.000 "We assume the Goldman Corporation has a beginning cash balance of $5,000 on January 1, 2016, and it desires a minimum monthly ending cash balance of $5,000 The first line in Table 4-15 shows net cash flow (from Table 4-14), which is added to the beginning cash balance to arrive at the cumulative cash balance. The fourth entry is the additional monthly loan or loan repayment, if any, required to maintain a minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry 105 (136 of 769) 100% minimum cash balance of $5,000. To keep track of our loan balance, the fifth entry represents cumulative loans outstanding for all months. Finally, we show the cash bal- ance at the end of the month, which becomes the beginning cash balance for the next month. At the end of January the firm has $6,380 in cash, but by the end of February the cumulative cash position of the firm is negative, necessitating a loan of $5,072 to maintain a $5,000 cash balance. The firm has a loan on the books until May, at which time there is an ending cash balance of $11,069. During the months of April and May the cumulative cash balance is greater than the required minimum cash balance of $5,000, so loan repayments of $4,548 and $4,479 are made to retire the loans com- pletely in May. In June, the firm is once again required to borrow $5,886 to maintain a $5,000 cash balance. Pro Forma Balance Sheet Now that we have developed a pro forma income statement and a cash budget, it is relatively simple to integrate all of these items into a pro forma balance sheet. Because the balance sheet represents cumulative changes in the corporation over time, we first examine the prior period's balance sheet and then translate these items through time to represent June 30, 2016. The last balance sheet, dated December 31, 2015, is shown in Table 4-16. 109 (140 of 769) 75% Chapter 4 Financial Forecasting 109 Table 4-18 3 HOWARD CORPORATION Balance Sheet and Percent of Sales Table 4 Assets Liabilities and Stockholders' Equity 5 Cash $5,000 Accounts payable $40,000 6 Accounts receivables 40,000 Accrued expenses 10,000 7 Inventory 25,000 Notes payable 15,000 8 Total current assets $70,000 Common stock 10,000 9 Plant and equipment 50,000 Retained earnings 45.000 10 Total liabilities and Total assets $120,000 stockholders' equity $120,000 11 $200,000 Sales Percent of Sales 12 Cash 2.5% Accounts payable 20.05 13 Accounts receivable 20.0 Accrued expenses 5.0 14 Inventory 125 25.0% 15 Total current assets 35.0% 16 Plant and equipment 25.0 17 60.0% Once we know how much money we need to finance our growth, we will then decide whether to finance the sales growth with an increase in notes payable or the sale of common stock or long-term debt. There are two possible scenarios for our calculations. First, if the company is operating at full capacity, it will need to buy new plant and equipment to produce more goods to sell. If the company is operating at less than full capacity, it can increase sales with its current plant and equipment, so it will only need to add more current assets to increase its sales. In the case of full capacity, any dollar increase in sales will necessitate a 35 percent increase in current assets, as well as a 25 percent increase in plant and equipment. These percentages are found in the bottom half of Table 4-18. or this 60 percent, 25 percent will be spontaneously or automatically financed through accounts pay- able and accrued expenses, leaving 35 percent to be financed by profit or additional outside sources of financing. We will assume the Howard Corporation has an after- 1. Page 96 example: Making this even trickier is that sales can be "lumpy," and not increase smoothly over time. If increasing sales cause the retailer to increase inventory (perhaps to not lose sales due to not having enough inventory on hand), then assets increase. What was the potential problem with that? 2. Page 97: Describe the impact of fads or sudden trends on this process. Actual examples include Timberland Boots and Beanie Babies. 3. Pro Forma statements in general: "Pro forma" means "made in advance," and consists of best (hopefully informed) guesses. Which is more dangerous to the company: overestimating sales or underestimating sales? (In your answer describe the downside to either mistake. Is there an upside to either mistake? If so, describe that/those as well.) 4. Page 102, Table 4-9: Where would these numbers have come from? 5. Page 105: Would the pro forma financial statements be meaningful information for investors? Describe 6. Sarbanes-Oxley separated consulting firms from auditing firms due to problems stemming from conflicts of interest. Do auditing firms review pro forma financial statements? 7. Page 109, Table 4-18: What would happen to these numbers if the company's stock price suddenly (and dramatically) increased? 8. Page 109: Why is the stock referred to as "common?" Is there another kind? If so, why is it ignored? 9. Chapter 4: This chapter seems to focus on a manufacturing company, other than its introduction focusing on a retail company. Describe whether a service company, e.g. a consulting firm, should use pro forma financial statements