Introduction• This chapter demonstrates a number of techniques for forecasting the company’s financial requirements. As the last of te three consecutive “tools” chapters, the discussions here will find later applications, particularly on the issues involving determination of asset levels and financing sources and in the assessment of the degree of risk in investment and financial decisions.
Funds Flow Analysis• The previous chapter examined some methods of evaluating the company’s financial condition and performance using financial relationships or ratios.
Uses and Types of Funds FlowAnalysis• The funds flow statement addresses this deficiency of the financial ratio technique.• It also uses two sets of financial statements, along with an accounting classification technique. Essentially, a funds flow statement uses two sets of financial statements, along with an accounting classification technique, in order to asses how the company has moved from a previous financial status to the present.• Since the fund flow statement is lifted directly from the basic financial statements, it has become a standard supplementary statement are offered to the public for sale.
There are two conceptually separate types of funds being utilized and sourced by a company.• The first involves the long-term funds cycle which includes fixed assets, other long term assets, and permanent fund sources like long-term debt and equity.• The second involves the short term, or operating funds cycle which consists of movements in current assets and current liabilities.
Long Term Funds CycleThe long term funds cycle describes the company’s pattern of productive capacity or investment expansion (or divestment/liquidation) and the balance of sources of permanent capital (long-term debt or equity).
Operating Funds Cycle• Indicates the flow of funds and its composition in relation to the current or day to day conduct of the business .• The operating cycle is actually the “funds” description of the company’s basic revenue and expense transactions and it’s access to trade and bank creditors.
The Funds Flow Statement• Requires as basis, the balance sheets at two points in time and an income statement covering the two balance sheet dates. The preparation of the funds flow statement proceeds by:2. Comparing balance sheet accounts and determining whether there have been increases o decreases over time. Other off- balance sheet information like dividends and sale of fixed asset are also gathered.3. Classifying the changes as either sources or uses of working capital o cash;
3. Classifying, from the income statement, the factors which increase or decrease working capital or cash.Sources of funds which increase working capital are:3. A decrease in fixed assets (e.g.; asset sale o disposition);4. An increase in long-term debt (new borrowing);5. Proceeds from sale of common or preferred stock; and6. Funds provided by operations (cash income)
Uses of funds which decreaseworking capital are:• An increase in fixed assets (e.g., acquisition);• Repayment of long term debt;• Purchase of own stock (treasury stock);• Cash dividends; and• Funds used in operations (excess of net loss over depreciation and other non-cash charges).
The change in net working capitalcan be verified as follows: Sources of Funds-Uses of Funds=Changes in Net Working CapitalChange in Net Working Capital= Current Assets (1983)- Current Liabilities (1983) LESS Current Assets (1982)- Current Liabilities ( 1982)
Sources of funds which increasecash are:• Changes which were previously classified as sources of funds which increase working capital (all items in Table 5.1);• A net increase in any current liability (new borrowings);• A net decrease in any current asset other than cash (liquidation of assets)
Uses of funds which decease cashare:• Changes which were previously classified as funds which decrease working capital (all items in Table 5.1);• A net increase in any current asset (working capital build-up );• A net decrease in any current liability (repayment of debt).
Limitations and Implications ofFunds Flow StatementsIn describing the scope of analysis possible using the funds flow statement, we should first note that the funds statement depicts net rather than gross changes of financial statement accounts over two points in time. We could determine the net asset increases or decreases from one year-end to another but we could not describe how assets changed during the year.
• A second major limitation of the funds flow statement is its inability to trace very specific financing sources to particular fund uses.
Some limited interpretations based on the Bacnotan Consolidated figures in the tables are advanced by way of example:3. Internal cash generationThe first item in the sources of funds is the internal cash generation of the company, consisting of net income and depreciation.
2. Balance in asset growthAssets are usually expected to change in relation to certain external or discretionary factors.3. Determination of financing requirementsA funds statement can reveal the nature and amount of future funding needs.
4. Balance in financing sourcesEven after the nature of financing needs has been determined, the analyst might want to review whether the company has achieved a balance among its financing sources.
COMMON SIZE STATEMENTANALYSISWhen analyzing the flow of funds for a company, we deal with monetary values and can sometimes miss out the significance of funds changes relative to the company’s picture.The common size financial statement is an expression of the balance sheet and the income statement in percentages, with total assets and net sales as reference points, respectively.
The importance of common size analysis lies in its insights regarding the company’s changing patterns, over time, in asset expansion, financing sources and operating perfomance.
FINANCIAL FORECASTINGThe preceding discussions about funds flow and common size statement analysis and the financial ratio technique of the previous chapter share a common limitation up to this time: all are based on past or historical financial statements.In this section, we cover financial forecasting tools as they apply to the prediction of future company financial performance and condition.It will be noted that past financial reports remain important component of forecasting, but we will demonstrate that certain techniques involved in incorporating past data into forecasts can be useful to the analyst and that other bases for prediction (other than historical data) are available as well.
Types and Uses of FinancialForecastThe three major categories of financial forecast are:2. The Cash Forecast3. The Balance Sheet Forecast4. The Income Statement Forecast
Forecasting TechniquesWhile it may be difficult to disagree with the claim of forecasts are useful, it is often equally difficult to make managers and other decision-makers rely on forecasts. The reason lies in (a.) the inherent uncertainty of future events and (b.) the subjective nature of the assumptions used in forecasts.
The subjective nature of the assumptions used in forecasts has also led some to doubt the inherent validity of the exercise. In particular, the core of the forecast lies on the choice of set of assumptions used by the analyst. We should emphasize that process of forecasting consists of two steps, namely:2. The application of “objective” forecasting techniques to analyze data; and
2. The use of “subjective” judgment to choose the specific forecast technique and to interpret the results.
The “objective” forecasting techniques can be either of two types: one based on analysis of trends over time, o one based on derived relationships among variables. We now describe these approaches in some detail.• Trend Analysis simplest relationship is that between a financial variable and time periods.
The most common technique is to extrapolate future values using “past experience”. There are several interpretations which might be used in incorporating the past into predictions about the future, in particular,(a.) the use of immediately preceding value, adjusted for subjective factors,(b.) the use of average growth rates, and(c.) the use of entire set of historical data to derive a prediction model relative to time.
Forecasts Based on RelationshipsAmong VariablesMany financial variables appear to behave in the same direction as certain determining factors other than the lapse of time.There are two alternative methods of forecasting using relationships among financial variables, namely, (a.) the ratio technique and (b.) regression analysis.
Financial Statement ForecastsWhile the different financial variables can be forecasted using any of the techniques discussed in the preceding section, we should recognize that these forecasts should tie into a “total financial picture”- the cash budget, the forecasted income statement and the balance sheet. These comprehensive financial forecasts have one common starting point: the forecast of sales or activity level of the company.
The financial statement forecast simply ties in all the individual financial variable forecasts into the indicated form.2. Forecasted Income Statement2. Forecasted Balance Sheet3. Cash Flow Forecast
A monthly cash forecast would need the following estimates:b) Monthly accounts receivable collectionc) Payments of accounts payabled) Cash purchases of inventorye) Loan amortization and other payables (e.g., income taxes)f) Anticipated drawings on existing credit linesg) Capital expenditures and other payables (e.g)., income taxes)
g) Proceeds from new equity issuesh) Dividend paymentsi) Proceeds from sale of fixed assets or investments.
Improving the Accuracy of Forecasts: Sensitivity Analysis1. Use of several variables to “explain” movements in the financial variable being forecasted.2. Use of two-stage analysis in forecasting: quantitative techniques followed by qualitative analysis3. Use of consensus approaches