Financial Forecasting and Decision Making

By Wallace Davidson, III

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

• Language: English
• Publisher: Wiley
• Release date: Mar 28, 2018
• ISBN: 9781119514251

Book preview

Title Page

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.

You can qualify to earn free CPE through our pilot testing program. If interested, please visit aicpa.org at http://apps.aicpa.org/secure/CPESurvey.aspx.

© 2017 American Institute of Certified Public Accountants, Inc. All rights reserved.

For information about the procedure for requesting permission to make copies of any part of this work, please email [e-mail] with your request. Otherwise, requests should be written and mailed to Permissions Department, 220 Leigh Farm Road, Durham, NC 27707-8110 USA.

Course Code: 733970

FFMD GS-0417-0A

Revised: December 2016

TABLE OF CONTENTS

Chapter 1

Forecasting Prerequisites

An Overview of the Forecasting Process

More on the Forecasting Process

Budgets Versus Forecasted Financial Statements

Financial Planning Prerequisites

Corporate Growth

Value of a Company

Chapter 2

Using the Basic Forecasting Model

Making Assumptions

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

Case Study

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

Case Studies

Chapter 5

Forecasting the Balance Sheet: Statistical Procedures

Statistical Procedure Regression

Advantages of Regression Analysis

Finding a Trend Line with Two Data Points

Regression Analysis

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

Case Study

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

Case Study

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

Case Study

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

Case Study

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

Case Study

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

Solutions

Chapter 1

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Chapter 6

Chapter 7

Chapter 8

Chapter 9

Chapter 10

Chapter 11

EULA

Recent Developments

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.

Chapter 1

FORECASTING PREREQUISITES

LEARNING OBJECTIVES

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

An Overview of the Forecasting Process

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.

KNOWLEDGE CHECK

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

More on the Forecasting Process

PURPOSE OF FORECASTING

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.

FIRST-PASS FORECAST

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.

SIMULATION

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.

KNOWLEDGE CHECK

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.

ASSUMPTIONS AND SENSITIVITY ANALYSIS

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.

PLANNING AND FORECASTING

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.

Budgets Versus Forecasted Financial Statements

BUDGETS

•

Short-term. One month or less to one year

–

Concern for detail

–

Ensures that the firm has necessary inputs

FORECASTED FINANCIAL STATEMENTS

•

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