Chapter 15 Financial Forecasting and Working Capital Policy

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Chapter 15Financial Forecasting and Working
Capital Policy
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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.

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Financial Forecasting

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

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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)

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Long Term Financial Planning

• Looking 1, 5, 10 years into the future
• Allows the firm to
• Analyze the future consequences of present
  decisions
• 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

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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

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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
Dividends
-


A portion of total financing needed can be
generated internally.
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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

External
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Assumptions of the Percent of Sales Forecasting
Method

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

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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 ...

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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
  due

key
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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
  need.
• CFs expected from operations
• CFs expected from investing activities
• CFs expected from financing activities
• Add cash and cash equivalents at the beginning of
  year
• expected cash and cash equivalents end of year

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Computerized Forecasting and Financial Planning

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

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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

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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
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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

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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
  company

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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
  collected
• Needed because of the asynchronous nature of cash
  receipts and disbursements

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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

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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
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Accounts Payable
Salaries, Benefits Payroll Taxes Payable
Payables Deferral Period


)
Cost of Sales
Selling, Gen, Admin Exp
/
(
365

Operating Cycle
Cash Conversion Cycle
Payables Deferral Period

-
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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.

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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

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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
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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
  debt
• 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

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Term Structure of Interest Rates and the Yield
Curve - June 14, 1999
Source http//www.Bloomberg.com/markets/C13.html
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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.

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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
  profitability
• 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.

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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
  policies.

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Conclusion

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