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Chapter 04 IM 10th Edxp - CHAPTER 4 Financial Forecasting...

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CHAPTER 4 Financial Forecasting, Planning, and Budgeting CHAPTER ORIENTATION This chapter is divided into two sections. The first section includes an overview of the role played by forecasting in the firm's planning process. The second section focuses on the construction of detailed financial plans, including developing a cash budget for future periods of the firm's operations. A budget is a forecast of future events and provides the basis for taking corrective action and can also be used for performance evaluation. The cash budget also provides the necessary information to estimate future financing requirements of the firm. These estimates are the key elements in our discussion of financial planning and budgeting. CHAPTER OUTLINE I. Financial forecasting and planning A. The need for forecasting in financial management arises whenever the future financing needs of the firm are being estimated. There are three basic steps involved in predicting financing requirements. 1. Project the firm's sales revenues and expenses over the planning period. 2. Estimate the levels of investment in current and fixed assets, which are necessary to support the projected sales level. 3. Determine the financing needs of the firm throughout the planning period. B. The key ingredient in the firm's planning process is the sales forecast. This forecast should reflect (l) any past trend in sales that is expected to continue and (2) the effects of any events, which are expected to have a material effect on the firm's sales during the forecast period. 61
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C. The traditional problem faced in financial forecasting begins with the sales forecast and involves making forecasts of the impact of predicted sales on the firm's various expenses, assets, and liabilities. One technique that can be used to make these forecasts is the percent of sales method. 1. The percent of sales method involves projecting the financial variable as a percent of projected sales. 2. As sales volume changes, the level of assets required to support the firm changes. Assets are financed by liabilities and equity, so changes in assets lead to changes in liabilities and equity. Current liabilities, such as accounts payable and accrued expenses, vary spontaneously as sales change. Retained earnings are impacted by changes in net income and dividends. 3. The difference between the projected level of assets and the projected change in liabilities and equity is the discretionary financing needed. 4 Percent of sales forecasting can give erroneous results for assets that have scale economies or assets that must be purchased in discrete quantities. II. Sustainable rate of growth A. Sustainable rate of growth indicates how fast a firm can grow without having to increase the firm’s debt ratio and without having to sell more stock.
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