FINANCIAL MODELING

FINANCIAL MODELING

A financial model is the set of relationships that are behind the calcula- tions we perform in putting together the cash budget and the pro forma statements. In financial modeling, we generally focus on the essential features of the budget and statements, and try not to get bogged down in the details. In our Imagined Company example, we looked at the rela- tion between cash and marketable securities, but we avoided getting into detail of where the cash is held or which securities we buy or sell.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

EXHIBIT 29.11 Imagined Company Long-Term Planning, 2005 through 2010

Panel a: Cash Budget

Projected Sales $20,000 $22,000 $25,000 $26,000 $27,000 $28,000 Operating Cash Flows

Cash Inflows Cash sales

$2,600 $2,700 $2,800 Collections on account:

22,040 24,100 26,270 Operating cash inflows

$21,000 $22,020 $23,750 $24,640 $26,800 $29,070 Cash Outflows Payments of purchases on account:

$10,067 $10,917 $12,375 $12,958 $13,458 $13,958 Wages

1,300 1,350 1,400 Selling and administrative expenses

2,600 2,700 2,800 Operating cash outflows

$13,067 $14,217 $16,125 $16,858 $17,508 $18,158 Operating net cash flows

Nonoperating Cash Flows Cash inflows Retirement of plant and equipment

$0 $1,000 $2,000 Nonoperating cash inflows

$0 $1,000 $2,000 Cash outflows Maturing long-term debt

$1,000 $1,000 $1,000 Acquisitions of plant and equipment 10,000 7,500 7,500

5,000 1,000 5,000 Payment of cash dividends

400 400 400 Interest on long-term debt

1,520 1,773 1,901 Nonoperating cash outflows

$8,270 $4,473 $8,551 Nonoperating net cash flows

Analysis of cash Cash balance, beginning of year

$1,500 $1,500 $4,000 Net cash flows during year

–488 5,819 4,360 Cash balance without any financing

$1,012 $7,319 $8,360 Long-term debt issuance

244 0 0 Common stock issuance

244 0 0 Available to pay off long-term debt

0 3,319 4,360 Cash balance, end of year

Strategy and Financial Planning

EXHIBIT 29.11

(Continued) Imagined Company Long-Term Planning, Analysis of Accounts

Accounts receivable Year’s beginning balance

$2,000 $1,000 $980 $2,230 $3,590 $3,790 plus, credit sales during the year

$18,000 19,800 22,500 23,400 24,300 25,200 less, collections on accounts

$19,000 19,820 21,250 22,040 24,100 26,270 Year’s ending balance

$1,000 $980 $2,230 $3,590 $3,790 $2,720 Inventory Year’s beginning balance

$2,500 $2,500 $2,500 $2,500 $2,500 $2,500 plus, purchases

10,000 11,000 12,500 13,000 13,500 14,000 plus, wages and other production expenses 1,000 1,100 1,250 1,300 1,350 1,400 less, goods sold

11,000 12,100 13,750 14,300 14,850 15,400 Year’s ending balance

Accounts payable Year’s beginning balance

$2,000 $1,933 $2,017 $2,142 $2,183 $2,225 plus, purchases on account

10,000 11,000 12,500 13,000 13,500 14,000 less, payments on account

10,067 10,917 12,375 12,958 13,458 13,958 Year’s ending balance

$1,933 $2,017 $2,142 $2,183 $2,225 $2,267 Bank loans Year’s beginning and ending balance

$1,000 $1,000 $1,000 $1,000 $1,000 $1,000 Plant and equipment Year’s beginning balance

$10,000 $17,160 $21,701 $25,697 $27,013 $23,772 plus, acquisitions

9,500 7,500 7,500 5,000 3,000 less, depreciation

2,340 2,959 3,504 3,684 3,242 3,213 Year’s ending balance

$17,160 $21,701 $25,697 $27,013 $23,772 $23,559 Long-term debt Year’s beginning balance

$5,000 $6,287 $6,669 $7,234 $6,478 $2,159 plus, long-term debt issued

2,287 1,382 1,564 244 less, long-term debt retired or matured

1,000 1,000 1,000 1,000 4,319 5,360 Year’s ending balance

$6,287 $6,669 $7,234 $6,478 $2,159 –$3,202 Common equity Year’s beginning balance

$8,000 $12,939 $16,995 $21,551 $24,942 $28,678 plus, issuance of new shares of stock

2,287 1,382 1,564 244 0 0 plus, earnings retained during the year

2,652 2,674 2,992 3,146 3,736 4,036 Year’s ending balance

SELECTED TOPICS IN FINANCIAL MANAGEMENT

EXHIBIT 29.11

(Continued) Panel b: Imagined Company Pro Forma Financial Statements, 2005 through 2010 Pro Forma Balance Sheet

Assets Cash and marketable securities

$1,500 $4,000 $4,000 Accounts receivable

2,500 2,500 2,500 Plant and Equipment

27,013 23,772 23,559 Total Assets

$31,927 $34,603 $34,062 $32,779 Liabilities and Equity Accounts payable

$2,183 $2,225 $2,269 Bank loans

1,000 1,000 1,000 Long-term debt

6,478 2,159 (3,202) Stockholders’ equity

24,942 28,678 32,714 Total Liabilities and Equity

Pro Forma Income Statement

Sales $20,000 $22,000 $25,000 $26,000 $27,000 $28,000 less, Cost of goods sold

13,750 14,300 14,850 15,400 less, Depreciation

3,504 3,684 3,242 3,213 Gross profit

$7,746 $8,016 $8,908 $9,387 less, Selling and administrative expenses

2,500 2,600 2,700 2,800 Earnings before interest and taxes

$5,246 $5,416 $6,208 $6,587 less, Interest

400 350 300 250 Earnings before taxes

$4,846 $5,066 $5,908 $6,337 less, Taxes

1,454 1,520 1,773 1,901 Net income

$3,392 $3,546 $4,136 $4,436 less, Cash dividends

400 400 400 400 Retained earnings

In the case of Imagined Company, the following relations between cash inflows and sales are “modeled”:

 Second  Cash inflows = 10%  month’s  + 60%  month’s  + 30%  preceding

 month’s sales  Cash outflows are similar, but instead of collecting on sales and receiv-

 sales

ables, we are paying expenses and paying on our accounts payable:

Strategy and Financial Planning

Cash outflows  This

  This  = 20%  month’s  + 80%  month’s  +

 Last

 This

 + month’s  10%  month’s   purchases 

 sales   sales  

 purchases 

  Payments on purchases

Wages Other expenses Purchases are determined by projected sales, so we can rewrite this

as:

 Sales

 Next   This  Cash outflows = 20%  forecasted 

 + 80% month’s  + two months 15%   month’s 

 sales   sales 

 out

The cash inflows and outflows from operations are therefore dependent on the forecast of sales in future periods. By changing forecasted sales, the cash inflows and outflows change as well.

We could continue modeling the relations expressed in the cash budget and pro forma financial statements until we have represented all the rela- tionships. Once we have done this, we have our financial model. By play- ing “what if” with the model—changing one item and observing what happens to the rest—managers can see the consequences of their decisions.

Building the financial model forces the manager to think through the relationships and consequences of investment and financing deci- sions. Much of the computation in financial modeling can be accom- plished using computers and spreadsheet programs.

The task of modeling financial relationships is made easier by com- puter programs. Many software packages are available, including:

Excel (Microsoft Corporation) Lotus 1-2-3 (Lotus Development Corporation) VisiCalc (Lotus Development Corporation) Multiplan (Microsoft Corporation)

These programs reduce the modeling effort because they enable the user to program a financial model using understandable phrases instead of programming code.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

BUDGETING AND FINANCIAL PLANNING PRACTICES Based on numerous surveys of budgeting practices in U.S. companies,

we can make some general statements regarding budgeting and financial planning practices: 5

■ Most firms start with sales forecasts. ■ Most use historical data analysis to forecast sales and expenses, though

some use opinions of management and economic models. ■ Most firms have budget manuals, detailing budget procedures and forms to be completed.

The survey indicates the following recent changes in firms’ financial planning:

■ An increasing number of firms have established formal budget pro- grams. ■ There is a decreasing role of Board of Directors in approving budgets. ■ Strategy is becoming more centralized within the companies. ■ There is more frequent updating of long-run plans. ■ There is an increasing use of flexible budgets that separate controllable

and uncontrollable revenues and expenses. Over time, the level of sophistication of capital budgeting in the

United States has increased. This is due to two factors. First, there is an increased awareness of the need to plan a firm’s finances to meet its objective of maximizing owners’ wealth. Second, technological advances in computer software and hardware make financial planning less time consuming and less costly.