Copyright ©2003 South-Western/Thomson Learning
Chapter
15
Financial Forecasting andWorking Capital Policy
Introduction
•This chapter discusses techniques forforecasting a company’s future cashflows and need for funds.
•It also deals with the management ofworking capital, which involvesdecisions about the optimal overalllevel of current assets and the optimalmix of short-term funds used tofinance the company’s assets.
Forecasting Methods
•Percent of sales
•Cash budgets
•Pro forma statement of cash flow
•Computerized financial forecastingmodels
•Forecasting with financial ratios
Percent of Sales Forecasting
•Relies on a forecast of sales
•Obtains estimates of variables as a percent ofsales
Forecasted Current
Liability Increases
–
ForecastedAssetIncreases
=
TotalFinancingNeeded
Tied to a sales increase
Dividends
–
ForecastedEAT
=
IncreasedRetainedEarnings
Portion of financing needed generated internally
Additional financing needed
•The difference between the totalfinancing needed and the internalfinancing provided:
Additional
Financing
Needed
=
External
[ A/S(ΔS) – CL/S(ΔS) ] – [EAT – D]
Cash Budgeting
•A financial plan
•Projects receipts and disbursements overfuture periods of time.
–Receipts on credit sales lag projected sales.
–Payments for purchases depend on
•How much the purchase precedes the sale
•Credit terms
–Other scheduled receipts and disbursements
•Long-term loans
•Capital expenditures
•Dividend payments
•Wages
•Salaries
•Rent…
Cash Budgeting Tools
•Check out the interactive tools for cashbudgeting at this Web site:
•Check out business planning with acash flow forecast at this Web site:
Pro Forma Statement of Cash Flows
•Measures the increases (and decreases)in cash and cash equivalents
–CFs expected from operations
–CFs expected from investing activities
–CFs expected from financing activities
•Add cash and cash equivalents at thebeginning of year
•Sums up to expected cash and cashequivalents at the end of year
Computerized Forecasting andFinancial Planning
•Deterministic model
–Uses single-value forecasts of eachfinancial variable
•Probabilistic models
–Utilize probability distributions for inputdata
•Optimization models
–Choose the optimal levels of somevariables
Forecasting With Financial Ratios
•Forecasting bankruptcy with discriminantanalysis
•5 ratios
–Net working capital/Total assets
–Retained earnings/Total assets
–EBIT/Total assets
–Market value equity/Book value total debt
–Sales/Total assets
Working Capital Policy
•Involves decisions about a company’scurrent assets (C/A) and currentliabilities (C/L)
–What they consist of
–How they are used
–How their mix affects the risk-returncharacteristics of the company
•Working capital
–Total investment in C/A
•Net working capital
–C/A – C/L
Working Capital Management
•Firm’s optimal level of C/A
•Optimal mix of S-T and L-T debt
•Level of investment in each type of C/A
•Specific sources and mix of S-T credit the firmshould employ
•This Web site offers extensive information onbusiness financing including working capital:
Working Capital
•Represents assets that flow throughthe firm
–Turned over at a rapid rate
–Usually recovered during the operatingcycle when inventories are sold andreceivables are collected
•Needed because of the asynchronousnature of cash receipts anddisbursements
Financing Working Capital
•This Web site helps small businessobtain working capital to produce andmarket U.S. products and services forexport:
Operating Cycle
•Operating cycle
= 1 to 4
•Inventory conversion period= 1 to 3
•Receivables conversion period= 3 to 4
•Payables deferral period
= 1 to 2
•Cash conversion cycle
= 2 to 4
•Characterized by the time intervalsbetween the following dates:
•Date 1 Purchase of resources
•Date 2 Pay for resource
purchases
•Date 3 Sell product on credit
•Date 4 Collect receivables
Operating
Cycle
=
Inventory
Conversion
Period
+
Receivables
Conversion
Period
Inventory
Conversion
Period
=
Average Inventory
Cost of Sales/ 365
Receivables
Conversion
Period
=
Accounts Receivable
Annual Credit Sales/ 365
Operating Cycle Analysis
Cash
Conversion
Cycle
=
Operating
Cycle
+
Payables
Deferral
Period
Operating Cycle AnalysisContinued
Payables
Deferral
Period
=
Accounts
Payable
+
Salaries, Benefits
& Payroll Taxes
Payable
Cost of
Sales
–
Selling, Gen,
Admin Exp
(
/
365
)
Size and Nature of a Firm’sInvestment in C/A
•Type of product
•Length of operating cycle
•Inventory size
•Safety stock
•Probability of running out
•Credit policies
•Efficiency of C/A management
Appropriate Level of WorkingCapital
More conservative policies often result in lost sales due
to restrictive credit policies.
Optimal level of working capital investment is the level
which is expected to maximize shareholder wealth.
Optimal Level of S-T and L-T Debt
•Term structure of interest rates
•Higher risk with S-T debt
–Refund
–Fluctuating S-T interest rates
•Permanent C/A
–Are not affected by seasonal or cyclical demand
•Fluctuating C/A
–Are affected by seasonal or cyclical demand
•Matching maturity of debt and assets
Conservative Moderate Aggressive