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Chapter 15 Financial Forecasting and Working Capital Policy


About 60 % of a financial manager's time is devoted to short-term ... days, weeks, months, quarters. Major Concerns. Liquidity. Arranging short term borrowing ... – PowerPoint PPT presentation

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Title: Chapter 15 Financial Forecasting and Working Capital Policy

Chapter 15Financial Forecasting and Working
Capital Policy
Importance of Working Capital Management
  • About 60 of a financial managers time is
    devoted to short-term financial management.
  • In many manufacturing firms, current assets
    represent 35 of total assets.

Financial Forecasting
  • Major Role of the financial manager
  • Projecting cash flows and financial statements

Short Term Financial Planning
  • Looking up to one year into the future
  • days, weeks, months, quarters
  • Major Concerns
  • Liquidity
  • Arranging short term borrowing
  • Investing surplus cash
  • Cash management
  • Major Tool is the Cash Budget (Discussed later)

Long Term Financial Planning
  • Looking 1, 5, 10 years into the future
  • Allows the firm to
  • Analyze the future consequences of present
  • Analyze the financing and investment choices open
    to the firm
  • Measure expected future performance against the
    financial plan
  • Major tool is pro forma financial statements

Forecasting Methods
  • Forecasting Income Statement and Balance Sheet
  • Percent of sales
  • Cash budgets
  • Pro forma statement of cash flow
  • Computerized financial forecasting models
  • Forecasting with financial ratios

Percent of Sales Forecasting
  • Relies on a forecast of sales
  • Obtains estimates of variables as a of sales

Forecasted Asset Increases
Forecasted Current Liability Increases
Total Financing Needed

Tied to a sales increase
Increased Retained Earnings
Forecasted EAT

A portion of total financing needed can be
generated internally.
Additional financing needed
  • The difference between the total financing needed
    and the internal financing provided (Addition to
    Retained Earnings)

Additional Financing Needed
A/S ( S ) - CL/S ( S )
- EAT - D

Assumptions of the Percent of Sales Forecasting
  • Assumes no economies of scale with inventories
  • Assumes that fixed assets can be increased
    linearly - Actual additions are lumpy.

Cash Budgeting
  • A financial plan
  • Projects receipts and disbursements over future
    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 ...

Objectives of Cash Budgets
  • Monthly - Planning
  • Weekly and Daily - Control
  • Cash budgets are tied to projected sales.
  • Provide for liquidity - the ability of the
    company to meet its cash obligations as they come

Pro-Forma Statement of Cash Flows
  • Measures the increases and ( decreases ) in cash
    and cash equivalents and can be used to determine
    how much additional financing a company will
  • CFs expected from operations
  • CFs expected from investing activities
  • CFs expected from financing activities
  • Add cash and cash equivalents at the beginning of
  • expected cash and cash equivalents end of year

Computerized Forecasting and Financial Planning
  • Deterministic model
  • Uses single-value forecasts of each financial
  • Sensitivity Analysis
  • Scenario Analysis - Optimistic, Realistic,
  • Probabilistic models
  • Utilize probability distributions for input data
  • Optimization models
  • Choose the optimal levels of some variables

Forecasting With Financial Ratios
  • Forecasting bankruptcy with discriminant analysis
  • 5 ratios used in the Altman Model
  • Net working capital/ Total assets
  • Retained earnings/ Total assets
  • EBIT/ Total assets
  • Market value equity (Common and Preferred Stock)/
    Book value of total debt
  • Sales/ Total assets
  • Z .012X1 .014X2 .033X3 .006X4 .999X5

Working Capital Policy
  • Involves decisions about a companys current
    assets ( C/A ) and current liabilities (C/L )
  • What they consist of
  • How they are used
  • How their mix affects the risk-return
    characteristics of the company
  • Working capital
  • Total investment in C/A
  • Net working capital
  • C/A - C/L

Is a measure of the firms riskiness in terms of
its ability to pay bills on time
Zero Working Capital Concept
  • Working Capital Inventories Receivables -
    Payables 0 (desired)
  • Companies are able to start production after an
    order is received yet still meet customer
    delivery requirements. Campbell Soup, GE, Quaker
    Oats, Whirlpool
  • The system is known as demand-based management
    and builds on just-in-time inventory management
    and Electronic Data Interchange (EDI).
  • Reduces investment in Working Capital

Working Capital Management
  • Firms optimal level of C/A
  • Level of investment in each type of C/A
  • Optimal mix of S-T and L-T debt
  • The proportion of short-term versus long-term
    debt the firm uses to finance its assets
  • Affects the future risks and rewards of the

Working Capital
  • Represents assets that flow through the firm
  • Turned over at a rapid rate
  • Usually recovered during the operating cycle
  • When inventories are sold and receivables are
  • Needed because of the asynchronous nature of cash
    receipts and disbursements

Operating Cycle
  • Characterized by the time intervals between 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 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

Inventory Conversion Period
Operating Cycle
Receivables Conversion Period

Average Inventory
Inventory Conversion Period

Cost of Sales/ 365
Receivables Conversion Period
Accounts Receivable

Annual Credit Sales/ 365
Accounts Payable
Salaries, Benefits Payroll Taxes Payable
Payables Deferral Period

Cost of Sales
Selling, Gen, Admin Exp

Operating Cycle
Cash Conversion Cycle
Payables Deferral Period

Cash Conversion Cycle Concepts
  • The cash conversion cycle is the net time
    interval between the expenditures of cash in
    paying the liabilities and the receipt of cash
    from collection of receivables.
  • The longer the cash conversion cycle, the higher
    the financing requirements of the firm.
  • The Cash Conversion Cycle uses a going concern
    concept of liquidity rather than a stock or store
    of value.
  • It ignores reserves such as marketable securities
    or lines of credit.

Size and Nature of a Firms Investment 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 - Use of technology
    such as Electronic Data Interchange

Appropriate Level of Working Capital
More conservative policies have a lower risk of
insufficient cash to pay bills and insufficient
inventory to meet demand. 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
  • The cost of L-T debt is generally higher than S-T
  • Higher risk with S-T debt
  • Refunding or Roll Over
  • Fluctuating S-T interest rates
  • Permanent C/A
  • Are not affected by seasonal or cyclical demand
  • Fluctuating or Temporary C/A
  • Are affected by seasonal or cyclical demand

Term Structure of Interest Rates and the Yield
Curve - June 14, 1999
Source http//
Matching Approach to Financing Working Capital
  • Permanent working capital and fixed assets are
    financed from permanent sources, while temporary
    or fluctuating working capital is financed with
    temporary debt.

Other Approaches to Financing Working Capital
  • Matching maturity of debt and assets
  • Conservative Vs. Aggressive
  • Conservative Approach uses a higher proportion of
    long-term financing
  • Usually involves higher cost and lower
  • Aggressive Approach finances all of the fixed
    assets with long-term capital and part of the
    permanent current assets with temporary debt.
  • Higher proportion of short-term debt
  • More risk is involved.

Overall Working Capital Policy
  • Effective working capital policy requires the
    consideration of the joint impact of the working
    capital investment and the working capital
    financing decisions.
  • The optimal combination that will maximize
    shareholder wealth varies from firm to firm. The
    financial manager should consider the
    profitability - risk tradeoffs of alternative

  • Forecasting Methods
  • Percent of Sales
  • Cash Budget
  • Proforma Statements
  • Cash Conversion Cycle
  • Working Capital Mgt.
  • Investment
  • Financing
  • Matching Approach
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