Cnapter 7; PREPARING, ANALYZING, AND FORECASTING FINANCIAL STATEMENTS: QUANTIFYING THE Business PLAN Five hundred years ag tb eatord ‘all of eh ee the merchants of Venice invehted accounting. They wanted 7 cir busi Ss transact $ 2 ev Ii i: exported goods from siness transactions as they imported goods from Asia and organizations hav » Europe, Today, accounting has come a very long way. Professional Shave established generally accepted accounting principles. he intention of this reading is h out teaching entrepreneurs ‘adin i ng is not abe austenite itis simply about trying to understand, construct, and interpret ai nnericsieh nts. More specifically, it is meant to translate the Business Plan into ‘ormat composed of financial statements. These financial statements umm: i i = a me what is going to happen to the business if plans are carried out well. Let us gin by assuming that an entrepreneur has set up ABC Corporation. tt A ee 1 a separate legal personality created by law. It can sue and be sued. cana ual lly own assets. It can owe money and repay that money. At the beginning, ABC Corporation has nothing. However, stockholders will be giving cash to the corporation. In exchange for the cash, equity shares will be given to the stockholders or the owners. The agreement between the stockholders and ABC Corporation is this: all of the profits and losses of ABC Corporation will go to the stockholders in exchange for the cash they have given. So, the first transaction is giving of cash by and issuing of stocks to the stockholders. Second, ABC Corporation may need more money and goes ahead to borrow this from banks or other financial institutions. The banks provide loans, which the corporation would have to pay back in terms of principal payments and in terms of interest expenses. If we assume that ABC Corporation is a manufacturing concern, then there will be a third source of funds and these are the raw material suppliers. The suppliers would give raw materials and/or supplies to ABC Corporation and they would be paid later. From the cash of the corporation, it may want to invest in land, building, machinery, equipment, furniture, fixtures, and vehicles. Raw Materials and Suppliers’ Credit Tee Supplies Bank Loans Land, Building, Machinery, Equipment, Furniture, Fixtures, Vehicles Stockholders’ Equity Figure 7.1. (A)the raw materials into finishe Id need power and water, which power and water, which It will then try to activate the factory by converting goods. While in the factory, however, the corporation wou! they would pay from their cash, So, cash will be spent to buy would be used in the factory. i i hich again would be useq Cash will also be used to pay for labor and supervisors, w! : inside the factory. So what do we have in the factory? We have the raw materials, the power, the water, the labor, and the supervisors. The raw materials are then processed in the factory. They would be called work-in-process inventory. - When the goods are completed, they become finished goods inventory. d depreciation. They Meanwhile, the accountant will concoct an account calle T will assume that the building, machinery, equipment, furniture, fixtures, and vehicles would last a certain number of years. (For buildings perhaps, 20 years; machinery and equipment, 10 years; furniture and fixtures perhaps, 5 years; and so on and so forth.) Andas they depreciate, all of these fixed assets, the depreciation of the factory may go to the work-in-process inventory. However, the depreciation of the head office and all the machinery and equipment at the head office will go directly to the operating expenses. Jork-in-Process Inventory Operating Expenses Salaries, Supplies, Electricity, Depreciation, Others Land, Building, Machinery, Equipment, Furniture, Fixtures, Vehicles Stockholders’ Equity Figure 7.1. (B) There are other operating expenses that the corporation would have to pay for in cash. These are the salaries, the supplies, the electricity, and other expenses (e.g, travel and representation, rental, etc.). Notice that there are two types of costs. The cost of making the product becomes the product cost. The finished goods when sold become the cost of goods sold. Then, there are the period €6sts/which are the selling, general, and administrative expenses. Next, ABC Corporation pays, in cash, non-operating expenses, which are really the interest expenses and other financial charges owed to the banks. Next, ABC Corporation would have to pay cash to the government for taxes. ‘Once'the company sells the finished goods to the customers, they become cost of goods sold In exchange, sales or revenues are gotten from the customers.Suppliers’ Finished “ Cost of Credit : Process Goods Goods Sold Inventory Power and Labor and Depreciation) Bank Loans Land ig aN perating Expenses Fate, Vehicles ‘Stockholders’ Equity Figure 7.1. (C) Some customers will pay in cash, so the sales and revenues go back to the cash account. Some customers would want to avail of credit. Unpaid sales become accounts receivable. And when the customers finally pay, the amount of Accounts Receivables transforms back into cash. ABC Corporation might have investments in marketable securities, in which case they might have non-operating income. And this non-operating income comes back in the form of cash. What does ABC Corporation do with the cash? Most of it circulates back to the tion of the company. Round and round it goes. However, some cash will be used to pay the principal of the banks. ABC Corporation already paid for the interest payments in our previous transaction. Some of the cash will be used to pay the suppliers. And again some of the cash will be used to pay dividends to the stockholders. Remember, in the beginning, we said that the agreement between the owners and ABC Corporation is that all profits and losses belong to the stockholders. So a way of repaying the stockholders is to get a portion or all of the profits and pay dividends to the stockholders. opera Figure 7.1. (D) shows the completed flow of funds from the first business transaction to the last (and all the other subsequent transactions).Income Statement Cost of Goods Sold > 5 1.085 Expenses ween Equity Gtoctnotdes) Sheet Selence shee Funds Flow Figure 7.1. (D) © Discerning Four Financial Statements What we have in Figure 7.1. (D) is called funds flow. Funds going from one container or one circle to another container or another circle comprise the funds flow except for the account called depreciation, which is a figment of the imagination of the accountant. Depreciation is not really part of the funds flow. The funds flow is the first financial statement that we have encountered. The second financial statementis on the right side of Figure 7.1. (D). Ifyou will notice, there are sales and non-operating income, which actually enter back to the company. However, there are expenses and costs that permanently exit the company. This entry and exit of funds on the right side of the illustration will translate to the income statement. If the sales and non-operating income were greater than the cost of goods sold, operating expenses, non-operating expenses, and taxes, then profit for ABC Corporation would be generated. If, however, the sales or non-operating income were less than the cost of goods sold, operating expenses, non-operating expenses, and taxes, then losses would be incurred. So, the income statement is also called the profit and loss statement. Notice that a summary of the profit and loss statement is either a profit or a loss. This is the second financial statement that we have encountered. There is a third financial statement that we can see from Figure 7.1. (D) that is the cash flow. Just focus on the Cash container or circle. There are arrows pointing to the circle. These are the cash inflows. There are arrows emanating out of the cash circle. These are the cash outflows. The cash inflows and the cash outflows constitute the cash flow. If the cash inflows are greater than the cash outflows, we have a net cash inflow. However, if the cash outflows are greater than the cash inflows, then we will have a net cash outflow. So, the third financial statement we have encountered is the cash flow.All three financial statements are flows. There is the flow, which is all the flows of funds coming in and out of these circles. There is the auerannetoy which is the income statement. And the third is thegaaiia ‘There is a fourth financial statement. However, it is nota flow. It is a static picture of the company at one point in time. Let us say December 31 of X year, you may decide to take a picture of the company. At that very moment, you will find exactly so much cash in the bank or at hand, so much raw materials and supplie ‘0 much work-in-process inventory, so much finished goods, so much land, building, machinery, and equipment inside the company at that point in time. These are called the assets of the corporation at that point in time. You will also find at that point in time a certain amount of suppliers’ credit, a certain amount of bank loans, and a certain amount of stockholders’ equity. These constitute the liabilities of the corporation. Notice that on the right side of Figure 7.1. (D), we have the assets of the corporation which is everything owned by the corporation. And we have, on the left side, the liabilities of the corporation or everything that the corporation owes. The assets of the corporation always equal the liabilities of the corporation. And why is that? It is because the stockholders’ equity takes care of the residual. If the assets generate profits, they get added to the stockholders’ equity. If the company generates losses it gets deducted from stockholders’ equity. In the process, assets will always equal liabilities. So the fourth financial statement that we have encountered is the balance sheet, as shown in Table 7.1. The assets always balance the liabilities. Table 7.1. Balance Sheet Liabilities Assets Suppliers’ Credit (all suppliers’ credit availed of less | Cash (Cash inflows minus cash outflows) what has been paid for) Accounts Receivables (sales not yet collected) Debt (all debt incurred less all principal payments | Inventories (all merchandise coming in less all paid) merchandise sold) Equity (capital put in plus all net profits generated | Fixed Assets (or net losses incurred) minus all dividends paid Lands out) Buildings Machinery and Equipment Vehicles, ete. Less: Accumulated Depreciation Total Liabilities I Total Assets Constructing Financial Statements We have already noted from Figure 7.1. (D) that funds migrate from one container to another: For example, from the suppliers’ credit container, we get raw materials. From the raw materials, we will convert them into work-in-process. From the work-in-process, we can convert them into finished goods. From finished goods, they would become cost of goods sold. As the goods are sold, sales are registered. They come back in the form of cash. From the cash, ABC Corporation may decide to use it for paying suppliers and the banks. Notice that there is a sourcing of funds from one container and there is a usage or application of funds to the next container. The sourcing and usage or application of funds is the financial transaction. So in every accounting entry, there is a source of funds andthere is a use of funds. This is called double entry accounting, which is the basis for the entire construction of the financial statement. (See Appendix A: An Instructional Guide ty Bookkeeping Using an Illustrative Case.) Focusing on a few accounts of the funds flow statement, specifically loans, cash, ang inventory, as examples, we can follow how these containers of funds relate to one another, Let us begin with the loan. ABC Corporation borrows P1 million from a bank. So, there is an increase in loans of P1 million while at the same time, ABC Corporation increases its cash by P1 million. There is a source of funds from the loans of P1 million and a use of funds in cash for the same P1 million. From the P1 million in cash, ABC Corporation might take out P0.5 million from the cash container and this gets entered into the inventory container which is again a use of funds. Loans Cash . Inventory Figure 7.2. (A) If we put the infusion of funds into a container on the left side of that container (application or usage of funds) and we put the extraction of funds out of the same container on the right side of that container (sourcing of funds), we can construct the famous T account of the accountant. Assets Liabilities Use Source Use Source Use | Source +L Source Right 5 vA of funds Exit Credit Use of Left 1 mt — — en Funds Entry Debit Figure 7.2. (B)Note that we have constructed T accounts for each container. The T account divides the left side from the right side of the fund container. For consistency, the accountant sources funds from a container by make ite the righ i 7 € container. When funds are transformed to another container, funds enter on the left side of the container, as shown below. xit on these USE SOURCE Ra at ——_> of Funds of Funds Figure 7.2. (C) The accountant has made a rule. s. . we are able to increases in liabilities are sources of fun liabilities are uses of funds. All increases in assets are uses of funds, assets are sources of funds. ere is also a pattern that ds, and all decreases in and all decreases in To summarize, all increases in liabilities and all decreases in assets are sources of funds. They are recorded on the right side of the containers. The technical term given by the accountant for right side exits are ‘© all entries on the right side are credits. All decreases in liabilities and all increases in assets are uses of funds. Uses of funds are all recorded on the left side of the container. The technical term for recording on the left side is debits. Hence, the accountant always has two accounting entries: a credit followed by a debit or a debit followed by a credit. In Figure 7.2. (A) and Figure 7.2. (B), the containers into two sides: the right si accountant’s T accounts. On the right side are the sources of fund: left side are the uses of funds or the debits. Actually, the accountant prefers the format where the assets are recorded on the left side and the liabilities are recorded on the right side of the balance sheet contrary to what we have presented earlier. ‘The accountant will then create a chart of accounts. Each account represents a container of funds. In this case, the containers are the accounts for cash, accounts receivable, inventory, fixed assets, and other assets. In the liabilities side, we have the stockholders’ equity, short-term debt, long-term debt, suppliers’ credit, and accrued expenses. These accounts may number to more than ten. They may be twenty, thirty, or more depending on the sophistication of the accounting statement. With this realization, we can begin to make our financial statements. ABC Corporation will source cash from the stockholders’ equity. This is recorded as source of funds in the stockholders’ equity and enters cash as the use funds. oration may also get long-term loans and short terms from the banks. put into use in the form of cash. we see these three containers. We can divide de and the left side. This division creates the is or the credits. On the ABC Corp These loans are sources of funds andwithdraw some cash amount and it exits on the ay buy inventory, fixed assets, and other f funds while the purchased assets woulq From the cash, the company may right side as a source of funds. The company m: assets with the cash. Cash would be the source of be the uses of funds. y for suppliers’ credit, to pay for short-term ‘The company may also use the cash to pa} y debt and to ie for iongeterm debt. Again, cash is the source of funds while the payment for the liabilities are the uses of funds. In other words, each of the financial transaction will be recorded by the accountant one by one as a journal entry. Each journal entry is composed of source of funds and use of funds. (This is the double-entry accounting transaction.) See Table 7.2 for the proper format of the Balance Sheet. Table 7.2. Balance Sheet Assets Liabilities Cash ‘Accounts Receivable Supplier ‘Accrued Expenses Use | Soure Use | Source Use Source Use [Source Inventory Fixed Assets Short Term Debt Long Term Debt Use | Source Use | Source Use Source Use | Source Other Assets Stockholders’ Equity Use | Source Use Source Let us now put some numbers in this financial statement. First, let us source funds from the stockholders’ equity. Let us get 10,000 from the stockholders and this is transaction number one, a source of fund. This is put into the cash account also for the same P10,000 for the same transaction number one. This is the first journal entry. ‘The second journal entry is borrowing P20,000 from the bank, transaction number two. And this gets entered as cash, also as transaction number two for P20,000. Next we borrow short-term debt of P5,000 from the bank, transaction number three. And we also get cash for the same transaction of P5,000. If we add the total sources of funds from the past three transactions, they would amount to exactly the same amount of the uses of funds. Now let us move on to another transaction. The company decides to buy an inventory of merchandise or goods worth P10,000. So it reduces cash by 10,000 and puts this in inventory for P10,000 for transaction four. Again there is a use and there is a source of funds.For the next transaction, we again reduce cash by another P10,000 and we buy some machinery and equipment for the same price of P10,000. This is transaction number five. We may actually spend some money for organizing the company. These are called pre-operating expenses and they will be entered under other assets. So let us just Say we reduce cash by P5,000 (source of funds), transaction number six, for the purchase of other assets (use of funds) for the same amount. We can now be in business. We can now start selling goods. So we have an inventory of merchandise goods and we decide to sell half of it, meaning we will sell 5,000 worth of inventory. We reduce inventory, source of funds, by P5,000; transaction seven. Since here we have sold the inventory, it will permanently exit the company. Where is the exit point? Remember that the income statement is summarized in a profit or loss under stockholders’ equity. So, what we will do is to record it under stockholders’ equity rather than a separate income statement. (Technically, merchandise sold enters a separate account called Cost of Goods Sold.) So this P5,000 gets entered as a cost of goods sold as a reduction in stockholders’ equity (debit or use), transaction number seven, for P5,000. (Note: Sales will be recorded as sources of funds while costs and expenses will be recorded as uses of funds under stockholders’ equity.) The customer actually buys our goods for P10,000 and these are recorded as sales. Let us add the sales to the sources of funds under the stockholders’ equity. So we will have sales of P10,000; transaction number eight under stockholders’ equity. (Again, technically the accountant records this separately under Sales.) If the customer does not pay in cash, then this gets recorded as accounts receivable or use of funds under the assets column. So we will now have transaction eight, P10,000 in accounts receivable. Next, we will be paying cash (source of funds) for operating expenses. Let us just say we will pay P5,000 for operating expenses on transaction nine. This gets recorded as operating expenses (use of funds) under stockholders’ equity for PS,000. Notice that we now have P5,000 worth of cost of goods sold and P5,000 worth of operating expenses under uses of funds in stockholders’ equity. Finally, we decide to pay P1,000, transaction number ten, in cash (source of funds), to reduce short-term debt by the same P1,000 (use of funds). Now let us stop there and begin to see if our balance sheet will still balance. But first, let us summarize. How does the accountant close these accounts? In terms of assets, the right side must be subtracted from the left side. The left side will always be greater than or equal to the right side because there is no such thing as a negative asset. So, on the left side of the assets, we have P35,000 cash entries (uses of funds) minus ?31,000 of cash exits (sources of funds) on the right side of the assets or a cash balance of P4,000 on the left side of the assets. That is the balance of the cash account. We will have a balance of P10,000 in accounts receivable. We will have a balance of P5,000 in inventory, a balance of ®10,000 in fixed assets, and a balance of P5,000 in other assets. In order to get the total assets, we have to add all of them. So let us add P4,000 in cash plus P10,000 plus P5,000 in inventory plus P 10,000 in fixed assets plus P5,000 in other assets equal 34,000 in total assets. So we have assets worth P34,000.Let us look at the liabilities column. Actually, we recorded sales of 10,000 plus we recorded cost of goods sold of 5,000 and operating expenses of P5,000. In effect, we have zero profit. Zero profit plus P10,000 in starting equity gives us P10,000 in stockholders’ equity. Add to this the P20,000 in long-term debt. Also add short-term debt which will have a balance of only P4,000 (that is P5,000 minus P1,000). So let us add all the liabilities to see if they are equal to the assets. Ten thousand pesos of stockholders’ equity plus 20,000 of long-term debt, plus P4,000 of short-term debt, equals P34,000. They still balance. Assets still equal Liabilities. From this presentation, we can also discern the four financial statements. Everything that was recorded in all of these containers is part of the funds flow. We see the income statement below the stockholders’ equity. There is sales of P10,000, cost of goods sold of P5,000, and operating expenses of P5,000 for a profit of zero. That is the income statement. We also have the third financial statement which is the cash flow composed of the cash inflows of P10,000, ®20,000, and ?5,000 for a total cash inflow of 35,000. We subtract the outflows of P10,000 plus P10,000 plus 5,000, plus P5,000 and #1,000 to get a net cash flow of ®4,000. This container called cash contains the cash flow statement. Thus far, we have these three financial statements: the funds flow or all of the transactions; the income statement or the operating flow under the stockholders’ equity; and, the cash flow under the cash account. The fourth financial statement is the balance sheet, which was shown earlier. In the balance sheet, we have an ending balance of ?4,000 in short- term debt, ?20,000 in long-term debt, and P10,000 in stockholders’ equity. This is ranged against the assets composed of P4,000 in cash, ?10,000 in accounts receivable, P5,000 in inventory, ?10,000 in fixed assets, and finally, 5,000 in other assets, for a total of P34,000 in assets. Thus, the four financial statements can be derived from following all these accounting transactions.Accounts and Four Financial Statements Assets Liabilities Cash Accounts Receivable ‘Suppliers’ Credit __ Accrued Expenses. Use Source Use Source Use | Source Use | Source (1)10,000 | (4)10,000 —_(8)10,000 (2)20,000 | (5)10,000 (3)5,000 | (6)5,000 (9)5,000 (10)1,000 Balance Balance 4,000 10,000 Inventory Fixed Assets Short Term Debt Long Term Debt Use Source Use Source Use Source Use Source (4)10,000 | (75,000 (5)10,000 (10)1,000 | (3)5,000 (2)20,000 Balance Balance Balance Balance 5,000 10,000 4,000 20,000 Other Assets Stockholders’ Equity Use Source Use Source (65,000 (210,000 Original (75,000 | (810,000 pital (995,000 Net profit, zero Balance Rance 3, tenine JPrene Income 5,000 10,000 State" ment | Total Assets 34,000 | 34,000 Note: Transaction numbers are in parentheses. Analyzing Financial Statements' Financial statements are nothing but abstractions of all the business transactions going on in an enterprise. Analyzing or interpreting financial statements can give very powerful insights into how an enterprise is conducting itself. 01 ne of the most easily understood financial statements is the income statement, also called the profit and loss statement.Income Statement Analysis i ne can compare the Sales figures of The top line of the income statement is se not. This comparative analysis an enterprise over the years to see whether itis growing OF i is (si pales eeral ¥ nths) is called a time series analysis or a horizontal analysis (since years (or mot per). The growth ii Jane in a piece of pa the Sales figures are usually put along a horizontal p! A rate from. fea to year can be computed on a percentage basis as shown in Table 7.4. Table 7.4. Time Series or Horizo! [~ [=] =| [mom | ra | or Below the Sales figure is the Cost of Goods Sold (also know! which reflects the cost of making the product itself or of delivering the services directly to the customers. If one subtracts Cost of Goods Sold from the Sales figure, one obtains the Gross Profit or Gross Margin. Entrepreneurs would be very interested to know the percentage or ratio of Cost of Goods Sold to Sales and Gross Profit to Sales because these percentages indicate whether the cost of producing the product or delivering the service is becoming higher or, perhaps, the selling price of the product is declining. In either case, the percentage or ratio of Cost of Goods Sold to Sales will go up. When this happens, the Gross Profit to Sales percentage ratio will necessarily decrease. The reverse will be true if costs go down and selling prices shoot up. ntal Analysis ‘annual Percentage Growth 2012- * 2013 Annual Percentage Growth 2011- 2012 m as Cost of Sales), Below the Gross Profit is the line-up of Operating Expenses, also known as i i . The various expense items that are not ctly part of the c involved in making the product or delivering the service are included here. The typical Operating Expense accounts are as follows: « — Salaries and Wages * Sales Commissions « — Rentals or Office Leases + Advertising and Promotions * Professional Fees ¢ Travel and Transportation ¢ — Training and Education + Employees’ Benefits ° Light, Water, and Power* Office Supplies Depreciation of Office Furniture, Equipment, and Leasehold Improvements . Representation Expenses « Miscellaneous or Other Expenses These expenses must be monitored carefully because if left unchecked, they can go out of control. Likewise, the entrepreneur would be very much interested to compute for the percentage or ratio of the total Operating Expenses to Sales, as well as each of the individual Operating Expense items in relation to Sales. However, many of these Operating Expense items do not necessarily have any correlation with Sales. By and large, many of them are budgeted for with some amount of discretion. Some expenses, though, go up and down directly and proportionately with Sales. An example is Sales Commissions. These are usually given to salesmen as a percentage of their Sales. The Advertising and Promotions budget are sometimes pegged as a percentage of Sales but that policy is arbitrarily set. Management can actually “fix” the amount budgeted for this expense item. After deducting Operating Expenses from Gross Profit, the accountant derives Operating Profit. Again, the percentage or ratio relationship between Operating Profit and Sales must be established. From Operating Profit, the accountant adds all Non-Operating Income (e.g., earnings from other investments, the sale of assets, interest from money market placements) and subtracts Non-Operating Expenses (eg. interest expenses, extraordinary losses, etc.) to derive Net Profit before Taxes. Taxes are deducted to get Net Profit after Taxes. Once more, the analyst gets the percentage or ratio relationship of each of these items to Sales. Sales, Cost of Goods Sold, Gross Profit, Operating Expenses, Operating Profit, Non- Operating Income, Non-Operating Expenses, Net Profit before Taxes, Taxes, and Net Profit after taxes are all lined up in a column and the percentage or ratio of all the items in relation to Sales are computed. Sales are made as the index for everything else and set at 100% or 1.0. The rest become lesser percentages or ratios of Sales. This process is called vertical analysis as shown in Table 7.5.Table 7.5. Vertical Analysis 2,000,000 1,200,000 Sales Cost of Goods Sold Gross Profit Operating Expenses Salaries and Wages Employees’ Benefits Sales Commissions Rental Expenses Advertising Professional Fees Travel and Transportation Representation Allowance Training and Education Light, Water, and Power 100,000 20,000 50,000 50,000 50,000 30,000 20,000 20,000 50,000 50,000 30,000 30,000 20,000 520,000 280,000 Office Supplies Depreciation Miscellaneous Total Operating Expenses Operating Profit ‘Add: Non-Operating Income Less: Non-Operating Expenses Net Profit before Taxes 200,000 Taxes Net Profit after Taxes By doing the horizontal and vertical analysis over several years, the analyst can come up with what is termed the “common size” analytical format. The common size format involves translating all the financial figures over two or more years in “common” or percentage/ratio terms. This is done to detect trends and patterns in the movement of all sales, cost, and expense items over time easily. What the analyst does is to set all the Sales figures over several years at 100% (or 1.0 if using the ratio approach). What this methodology fails to capture ig the year-to-year percentage growth. Table 7.6 shows a common size format.Table 7.6. Common Size Income Statement sales Cost of Goods Sold Gross Profit Operating Expenses ‘Operating Profit Non-Operating Income Non-Operating Expenses From the Common Size Income Statement in Table 7.6, we can easily spot the culprits responsible for bringing the Net Profit percentage down from 4.5% of sales in 2011 to only 1.5% of sales in 2013, These culprits are: the increasing percentage of Cost of Goods Sold; the absence of Non-Operating Income in 2013; and, the 1% increase in Non-Operating Expenses in 2013. However, Operating Expenses actually decreased by 2.0% during the same period, thereby cushioning the effect of the three culprits. Balance Sheet Analysis The balance sheet items are logically arranged by the accountant for convenient analysis. Looking at the Assets side, the different accounts are presented according to their relative liquidity or convertibility to Cash. Of course, the number one item is Cash itself. This is followed by Marketable Securities, if there’s any, like bonds, money market placements, and corporate shares that can be easily sold in the stock market. Next comes Accounts Receivables, which are normally collectible within the month or within a couple of months. Inventories follow. These still need to be sold and be transformed into Accounts Receivables and later, into Cash. Other Current Assets bring up the rear of the Current Asset accounts. Current Assets are those convertible to Cash within a relatively short period of time. The next group of accounts is Fixed Assets led by land, which is the most saleable among them. Next comes buildings, which take a bit longer to liquidate. This is followed by machinery and equipment, which may be too specialized for the product being produced, and thus turn out to be harder to dispose. The last group is composed of Other Assets, usually intangible, such as Organizational Development Expenses which are Enterprise creation expenses (eg, feasibility studies, pre-operating expenses, etc.). They are “capitalized” or regarded as assets to be amortized (ie, depreciated) over a few years. Goodwill also comes under Other Assets. It represents the premium price paid by the enterprise on assets or corporate shares bought over their stated book values. Both Organizational Development Expenses and Goodwill are intangible assets that are very difficult to sell, if they are saleable at all.The Liabilities side is also presented by the accountant in a similar manner, The Liabilities that must be paid in cash first are placed on top, while those to be paid last are at the bottom, Leading Liabilities are Suppliers’ Credit or Accounts Payable which are obligations to suppliers who usually expect to be paid in a matter of days or ina couple of months, Other short-term payables, such as Accrued Wages and Taxes follow. Next come the short-term Notes Payable or all debt obligations due within one year. The first group of Liabilities, therefore, is composed of Current Liabilities. These are financial obligations that must be paid within one year. The second group of Liabilities is Long-Term Debts or Notes Payables. They are payable after one year. The third group of Liabilities is composeq of Owners’ or Stockholders’ Equity. Owners do not intend to get paid back by the enterprise but definitely expect to receive dividends over the course of the enterprise’s economic life. The owners can sell their stocks in the enterprise but this has nothing to do with receiving payments from the enterprise as such because the enterprise is not the entity buying or selling the stocks. It is the stockholder. The logical arrangement of the Assets and Liabilities in the Balance Sheet allows the analyst to match Current Assets with Current Liabilities, which are both presented on the top portion. Since Current Assets will be used to pay for the Current Liabilities due to their highly liquid nature (easy convertibility to cash), the matching enables the analyst to compute for what are called the Liquidity Ratios. The first Liquidity Ratio is the Current Ratio. It is simply the ratio between Current Assets and Current Liabilities. The second Liquidity Ratio is the Quick Ratio (otherwise known as the Acid Test Ratio). The Quick Ratio takes only the very liquid Current Assets (or Quick Assets) composed of Cash, Marketable Securities, and Accounts Receivables because the Inventories have not yet been sold (and may not get sold for some time). The analyst obtains the ratio of the Quick Assets and the Current Liabilities to derive the Quick Ratio. Current Ratio = . Cash, Marketable Securities, and Accounts Receivables Quick Ratio Current Liabilities oF altShne The Liabilities column is divided into Current Liabilities, Long-Term Debt, and Owners’ Equity. This makes it convenient for the analyst to compare the Total Debt (Current Liabilities and Long-Term Debt) with the Owners’ Equity to gauge the financial risk level of the enterprise. Presumably, the bigger the Total Debt-to-Owners’ Equity Ratio, the more financial exposure and risk the enterprise has. However, the analyst may only be interested in the Long-Term Debt-to-Owners’ Equity Ratio, particularly if he or she is comfortable that Current Assets can meet the payment schedule for Current Liabilities. The Total Debt-to-Equity and the Long-Term Debt-to-Equity Ratio are called Solvency Ratios because they try to approximate the relative financial risk being taken by the enterprise.Total Liabilities Total Debt - to - Owner's Equity Ratio ‘Owners’ Equity Long - Term Debt Long - Term Debt - to - Owners’ Equity Ratio = “Owners Equity ~ p The third ios i e third group of ratios is the Profitability Ratios. The Net Profit after Taxes of the enterprise are related to the Sales, Assets, and Owners’ Equity of the enterprise. The ratio of Net Profit after Taxes to Sales provides the Return on Sales (ROS). The ratio of Net Profit after Taxes to Assets gives the Return on Assets (ROA). The ratio of Net Profit after Taxes to Owners’ Equity yields Return on Equity (ROE). Net Profit after Taxes Sales Net Profit after Taxes Assets Net Profit after Taxes - Owners’ Equity i In computing the ROA or the ROE, the analyst sometimes uses the Assets or Owners’ Equity as of the ending Balance Sheet. The more correct approach is to average the beginning and the ending Balance Sheets of the income period (usually one year but it could be a month, a quarter, or a semester). Of the three Profitability Ratios, the ROE is the most relevant ratio as far as stockholders or owners are concerned. ROE relates to Net Profit to Owners’ Equity. The ROE is actually the joint effect of the Return on Asset Ratio (ROA) and the Total Assets over Owners’ Equity Ratio. ROA relates Net Profit to Total Assets. ROA is actually the equivalent of Return on Investment (ROI) since the enterprise invests in assets. Total Assets over Owners’ Equity is a measure of how much financial leverage the enterprise has. (Note that the greater the Assets over Owners’ Equity Ratio, the larger the Debt level is, thus, increasing financial leverage.) Finally, there are the Activity Ratios. These ratios allow the analyst to gauge the efficiency, effectiveness, and economy levels of enterprise operations in financial terms. The first Activity Ratio is the Asset Turnover Ratio. It measures how much Sales are generated by the Assets of the enterprise. The Assets are actually the Investments made by the enterprise in the form of Working Capital (Current Assets), Fixed, and Other Assets. If the enterprise can squeeze a Jot of Sales from the Assets or Investments made, then it is efficient, effective, and economical in the use of resources. The analyst may also wish to make variants of this ratio such as the Sales over Current Assets Ratio or Sales over Fixed Assets Ratio, which relate Sales to specific forms of Assets.Sales Asset Turnover Ratio = Total Assets = Sales Current Assets Turnover Ratio Current Assets Fixed Asset Turnover Ratio = Sales Fixed Assets he Inventory Turnover Ratio. It focuses on the Inventories generated or the Cost of Goods Sold. What the the enterprise can turn its inventories around 50 pieces of furniture at any one time in its The second Activity Ratio ist of the enterprise in relation to the Sales ratio does is measure how many times ina year: If a furniture enterprise displays ure at showroom and it sells 500 furniture pieces in a year, the furniture inventory, therefore, turns around ten times (500 + 50 = 10). Expressed in monetary terms, the analyst obtains the Cost of Goods Sold for the year and divides this by the average Inventory (i.e., the average of the beginning and ending inventories of the income period). The account Cost of Goods Sold is chosen because it has the same cos' per unit of furniture as the Finished Goods Inventory. Hence, there is no cost difference that would otherwise misrepresent the actual volume or quantity turnover: However, some analysts use Sales over Average Inventories if Cost of Goods Sold figures are not available. Tu Sch eo Cost of Goods Sold Inventory Turnover Ratio. = (Beginning + Ending Inventory) + 2 or Sales es Inventory Turnover Ratio (Beginning + Ending Inventory) +2 The third Activity Ratio is the Average Accounts Receivables Collection Period, that is, the ratio of Accounts Receivables to Credit Sales (i.e., excluding Cash Sales). This ratio approximates the average age of Accounts Receivables or how long it usually takes to collect from customers who bought goods using credit. The ratio is derived by dividing ‘Accounts Receivables by the annual Credit Sales. The Average Accounts Receivables Collection Period is thus obtained. Accounts Receivables ‘Average Accounts Receivables Collection Period = ‘Annual Credit Sales For example: Accounts Receivables _ _? 100,000 Annual Credit Sales P 1,200,000 = 0.0833 yearsIn terms , a year or, ane Average Collection Period is 0.0833 multiplied by 365 days in Credit Sales by the nu os (one month). One can also derive this by dividing the annual cree nts Recelveb leet Of days ina year to get Sales per day. Then, the outstanding les are divided by the Sales per Day. An example is given below. Current Credit Sales of P1, 200,000 rumen 7 a ati 365 days = 3,287.67 sales/day Accounts Receivables of P100,000 83,287.67 =, Sadays : ana es nee Sheets as of the ending dates from several years can be put in Common and Liabilities objective is to detect patterns and trends, which indicate whether Assets tiebilities? les accounts are rising or falling as a percentage of Total Assets or Total Table 7.7. Common Size Balance Sheets Balance Sheets as of December 31 2011 2012 2013 ASSETS Current Assets Cash 5.0 5.0 70 Accounts Receivables 20.0 22.0 220 Inventories 25.0 27.0 29.0 Total Current Assets 50.0 54.0 58.0 Fixed Assets 40.0 39.0 37.0 Other Assets 10.0 5.0 Total Assets 100.0 LIABILITIES AND OWNERS’ EQUITY Current Liabilities 30.0 340 38.0 Long Term Liabilities 30.0 24.0 18.0 Owners’ Equity 40.0 42.0 44.0 Total Liabilities & Owners’ Equity. 100.0 100.0 100.0 Forecasting Financial Statements The art of financial forecasting is popular among entrepreneurs who know their businesses inside out. It enables them to ask the following questions, among many, prior toa financial forecasting exercise: + What will happen to the market conditions tomorrow? © What will competition do?* What products and services will come out? * What technology is in store for us? + What will interest rates be like? * How will the economy grow? * What regulations might the government impose? * What changes are happening in the environment? * Howis our organization responding to these changes? * Whatare we capable of doing or not doing tomorrow? Simply, financial forecasting is just rendering into numbers of the assumptions that entrepreneurs make about how their sales will move, how costs will behave, what kind of profit they will attain, what assets they will require, and how they will finance those assets. In forecasting, it is important to examine the critical variables that affect the industry and business that one is in and assess how these variables will behave. Instead of going through the complex analysis of financial forecasting, the entrepreneur will have a better appreciation of a simpler approach, which is, using past trends, cycles, and patterns to predict the future. The basic assumption we are making is that the critical variables that have affected our business in the past and the present will not change significantly in the future. We are also assuming that the environment or market we operate in will, more or less, move along the trends, cycles, and patterns we saw in the past and continue to see at present. If the critical variables and the environmental or market conditions are expected to change, then we must input these things into our forecast. In deciphering the past financial condition of an enterprise, we have to quantify the relationships of the many items found in the different financial statements. The most important item is the Sales/Revenues of the enterprise. This item almost dictates how most of the other items will move. Income Statement Forecasting There is usually a very close relationship between Sales and Cost of Sales (or Cost of Goods Sold). Many companies, in determining their selling prices, conveniently add a specific percentage mark-up or margin to the Cost of Sales, thus establishing a predictable ratio between the two items. If an enterprise decides to slap a hundred percent mark- up on its Cost of Sales, the Sales figure will double the Cost of Sales. As a percentage, Cost of Sales will, therefore, be fifty percent of Sales. Not all, however, has the luxury of determining their own prices. Market prices tend to be relatively low ina very competitive business. Enterprises are forced to slap lower mark-ups or margins on their Cost of Sales. In determining the most likely ratio of Cost of Sales to Sales in the future, one can use past patterns or ratios. Let’s take a hypothetical company XYZ. Sales for the last three years (2011, 2012, and 2013) have been growing as shown in Table 7.8.Table 7. . © 7-8. Forecasting Sales and Cost of Sales for XYZ (P in Thousands) [sales Forecast = Sales (P00) ooo} 1000 ~ fissio] [anon 69.0 | 70.0 + 70.0 waa] _fnoesol —_] Sales Forecast (P000) [Past Costot Sales (P000) (Cost of Sales Forecast [in Percentage Terms in Peso Value (000) _____The Sales figures are converted to 100.0% over those three years to get a common size picture. Next, the Cost of Sales is divided by the Sales figure to get a percentage or a of Cost of Sales to Sales. After deriving the percentages or ratios, one can make a fearless forecast of what the Cost of Sales percentage will be in the coming years. The Sales forecast for the next two years can be set to approximate the growth trend of the last three years. Since Sales grew by 10% from 2011 to 2012 and by 10% from 2012 to 2013, the financial forecaster can reasonably assume a sales growth of 10% per annum in the next two years. The Sales forecast for the year 2014 is, thus, P1,331,000 and for the year 2015, the forecast can be set at P1,464,000. The forecast for the Cost of Sales percentage is 70.0% of sales for the years 2014 and 2015 as given in Table 7.8. This percentage is merely an average of the percentages for the last three years (2011 to 2013). One can conceivably use the latest Cost of Sales percentage (2013) to reflect the most current scenario. The next step is to apply the 70.0% percentage to the Sales forecast for the years 2014 and 2015 to get the Cost of Sales peso value forecast for those two years. The computations are given in Table 7.8. (Note: The more rigorous way of forecasting Cost of Sales is to estimate item by item, what is most likely to happen to cost of materials, cost of labor, and cost of overhead in a manufacturing enterprise. These costs will be a factor of operating efficiency, volume produced, inflation, and other variables.) Itis important to realize that if one expects inflation to affect major items in the Cost of Sales and in the selling prices of the company, then there is a need to adjust the forecast based on the inflation rate. After forecasting Sales and Cost of Sales, the Gross Profit figures can be derived by subtracting the Cost of Sales from Sales. The next step will be to forecast Operating Expenses. These are expenses that are not directly related to manufacturing the product (or delivering the service) of the enterprise. The salaries, rental, representation, and other expenses incurred by the headquarters, marketing, administration, finance, legal, and operations departments are part of Operating Expenses. Again, one can classify them into variable and fixed costs. Those that vary with Sales will increase proportionally to Sales. Those that are fixed will not vary with Sales. However, these fixed costs may also rise because the enterprise may want to add head office personnel, increase salary rates, and adjust for contract escalationclauses (e.g,, rentals, professional fees, etc.). The financial forecaster can go through each, Operating Expense item and determine how it will behave in the future as Sales rise. The forecaster may not have all the information available to make a good guess. In such a case, the forecaster can then make reasonable assumptions that are defensible under existing or expected conditions. The fixed Operating Expenses have to be determined individually. Where the salaries and wages of head office personnel are concerned, will there be increases in the number of people? Will there be increases in their rates? For rental expenses, will there be additional space needed? At what rate per square meter? For depreciation of office furniture, equipment, and vehicles, one has to lookat the depreciation schedules of existing furniture, equipment, and vehicles. After this is done, one has to add the depreciation expenses of additional furniture, equipment, and vehicles needed for incoming hirees or to replace old furniture, equipment, and vehicles, Other fixed Operating Expenses have to undergo the same detailed analysis. Once all the Operating Expenses are computed, they should be summed up. The total is then subtracted from the Gross Profit forecasted in order to derive Operating Profit. The next step is to calculate the Non-Operating Income and Non-Operating Expenses, Non-Operating Income comes from transactions not connected with the main business of the enterprise. This includes dividends from stock investments, interest income from money market placements, profit derived from the sale of enterprise assets, and other such activities. Non-Operating Expenses include interest expenses on short and long-term loans, losses incurred in the sale of assets or marketable securities, etc. The financial forecaster must estimate these non-operating income and expenses based on the investments made or about to be made by the enterprise and based on loans incurred or about to be incurred by the enterprise. A detailed schedule of investments and loans should be done for this purpose. After the Non-Operating Income is added and the Non-Operating Expenses are subtracted from Operating Profit, we are able to derive the Net Profit before Taxes. The taxes applicable are then computed following government rules and regulations, and then subtracted from Net Profit before Taxes to arrive at Net Profit after Taxes. Balance Sheet Forecasting Forecasting what the Balance Sheet of an enterprise will look like in the future depends a lot on the future Sales. Let us start with the Current Assets, of the Balance Sheet, which include Cash, Marketable Securities, Accounts Receivables, Inventories (Raw Materials, Work-in-Process, and Finished Goods), and other Current Assets. Beginning with Cash, one can assume that the enterprise will set a minimum Cash balance (Cash on hand or in the banks) in order to pay for the company’s day-to-day expenses and purchases of inventories, taking into consideration the expected cash inflows and outflows from the operations of the enterprise. This minimum Cash balance can be discernibly set to be equivalent to ten, twenty, or thirty days of cash purchases and cash operating expenses, The choice will depend on the cash requirement and assurance level needed by the finance manager or entrepreneur, His worst nightmare is running out of cash to meet payroll expenses and critical purchases for the factory. Cash beyond theoperating EXPENSES) will tend topo up ar gee eae especially es with Sales. As stated earlier, M: drawn down or redusedinn Securities can be the repository of excess cash. It can ue © Cash balance falls below the minimum required. counts Receir ere has an avant be projected since these cmb and fall with Sales the enterP! *verage Accounts Receivables collection period of one month, then the forecaster SRE Accounts Receivables to be one-twelfth of projected Sales for the next 12 months: More accurately, the projected Accounts Receivables at the end of the fiscal year ofan. enterprise will be the expected Sales of the last month of that fiscal year. ifthe collection period is two months, then the projected Accounts Receivables as of the ending date of the Balance Sheet will be the Sales for the last two months of the fiscal year. The enterprise can decide to be stricter or more lax with its collection policies. This will change the forecast accordingly, In forecasting Accounts Receivables, a straightforward approach would be to multiply the average ratio or percentage of Accounts Receivable to Sales experienced in the past years, and then apply this ratio or percentage to the Sales forecast of the future years. Inventories can be projected in the same way as Accounts Receivables. The enterprise’s experience in its past inventory turnover can be used to forecast future inventories. Inveritory turnover can be computed using past Sales or Cost of Sales as the numerator and past inventories as the denominator. The resulting ratio or multiple (the numerator over the denominator) can then be the divisor used to forecast future inventories. For example, if past Sales were P1,210 and past inventories were P201, then the inventory turnover would be six. If Sales are expected to increase to P1,331 the following year, then the forecaster can just divide P1,331 by six to get the peso forecast for inventories of P221. Another way of doing this is to use the ratio or percentage approach by dividing the Inventories by the Sales or Cost of Sales. The resulting ratio or percentage can then be multiplied to the expected Sales to derive the projected inventories. Using the same example, divide P201 (past Inventories) by #4,210 (past Sales) to get 0.166 or 16.6%, Multiply 0.166 by the Sales forecast of P1,331 to obtain P21, which is next year’s forecast. Other Current Assets must be individually looked at. Prepaid insurance, for example, can be determined by examining how much premium will be required to insure the company’s properties for the coming year Advances to Employees is another item found in Other Current Assets. It can be projected according to the experience of the enterprise. The enterprise may also decide to collect all of the Advances and not give any more of such Advances to employees, in which case the Advances to Employees becomes zero for the next year.t of the enterprise's future fixtures, and other long, d still-to-be purchaseg sets, or Simply, Fixeg Forecasting Fixed Assets requires an assessmen requirements for land, building, machinery, equipment, furniture, lasting assets, The acquisition costs of previously purchased a Fixed Assets are added to comprise the forecasted Gross Fixed As! Assets, Next, the forecaster must subtract Accumulated Depreciation Scien Assets, The Depreciation Expenses ofall the Gross Fixed Assets for the foreraziet Sit are added to the Accumulated Depreciation of the previous year to obtain ti? {Pi ted Depreciation for the forecasted year. By subtracting the forecaste ice ulated Depreciation from the forecasted Gross Fixed Assets, one is able to compute t . forecasted Net Fixed Assets. The Gross Fixed Assets include both the assets used in ae ane floor and the head office building. The Depreciation Expenses imbedded in the Cost of Goods Sold and in the Operating Expenses are cumulatively added over the years to arriveat the Accumulated Depreciation. To determine the Depreciation Expenses, the forecastel depreciation schedules calculated by the enterprise’s accountants for each fixed asset, Some Fixed Assets are depreciated over three years, some over five years, others over ten years, and still others, over twenty or so years. This would depend on accepted accounting practices, the auditors’ prudent estimates, and government taxation policies. In making rough estimates of Gross Fixed Assets, the forecaster can make simplifying assumptions. If the enterprise is thinking of increasing total production capacity by 50%, then the forecaster can roughly assume a 50% increase in Gross Fixed Assets. If the enterprise is still operating below capacity, then the forecaster may assume that Gross Fixed Assets will not change much, except for the replacement of some very old fixed assets. Other Assets include Organizational Expenses, Goodwill, Patents, etc. Organizational Expenses comprise feasibility studies, enterprise promotion activities, pre-operating expenses, and other set-up costs. These are capitalized and amortized. Goodwill is the premium paid by the enterprise for an asset or share of stock whose book value is lower than the purchase or acquisition price. For example, if a company acquires an asset at a book value of a million pesos but pays two million pesos for it, the incremental million is recorded as goodwill. Patents are payments to holders of an invention or technology. Shifting to the Liabilities column of the Balance Sheet, we start with items in Current Liabilities. The first item is Accounts Payable or Suppliers’ Credit. This can be estimated by relating it to the Purchase of Raw Materials or Semi-Processed Goods. When an enterprise is expecting a Sales increase, it prepares for this by increasing the production of goods, which means increasing Inventories. Increasing Inventories, in turn, means availing of more Suppliers’ Credit or Accounts Payable. One way of forecasting Accounts Payable is to, again, get the past ratio or percentage of Accounts Payable to Sales and then apply this ratio or percentage to the forecasted Sales, in order to derive forecasted Accounts Payable. The forecaster can also use the ratio or percentage of Accounts Payable to Cost of Goods Sold. More accurately, the forecaster can pinpoint the exact amount of Purchases needed just before the forecasted ending date of the Balance Sheet. For example, if the forecaster is trying to estimate Accounts Payable outstanding as of December 31, 2013 and assumes that the enterprise gets only 30 days or one month of Suppliers’ Credit, then the forecaster should determine the Purchases needed for December which will not yet be paid on that month but on January 2014. This will be the Accounts Payable outstanding as of December 31, 2013. + has to refer to theAccrued Expenses come next, These are expenses incurred during the accounting period concerned but not yet paid during that period. These expenses include Accrued Salaries and Wages, Taxes Payable, Interest Payable, and so on. The forecaster can do a detailed analysis of how each item behaves. The forecaster may discover that Accrued Salaries and Wages are roughly equivalent to one week's pay. He may discover that ‘Taxes Payable is a function of government regulations. If the taxes for income realized during the accounting period are allowed to be paid in the next fiscal year, then they will all appear as Taxes Payable as of the ending date of that accounting period. Interest Payable can be computed by estimating the short and long-term loans needed for the period being forecasted. The Balance Sheet forecast will, in fact, reveal the loan status of the enterprise. The forecaster can assume that any financing shortfall will be covered by additional loans. This will increase the total loans of the enterprise, thereby, increasing interest expenses. The interest expenses incurred during the accounting period, but not yet paid during wale will appear as Interest Payable as of the ending date of the same accounting As discussed previously, the forecaster can use either short or long-term loans to fund any shortfall in the financing of assets required for the forecasted period. What the forecaster needs to do beforehand is to forecast the Stockholders’ Equity. If there are no expected increases in Paid-in ‘Capital, then the only change in Stockholders’ Equity will be in Retained Earnings. One can estimate this by adding the Net Income after Taxes for the forecasted year (less dividends expected to be paid) to the previous year’s Retained Earnings. This will give the new Retained Earnings as of the ending date of the forecasted accounting period. Once the forecaster has estimated the Stockholders’ Equity, he or she can now go back to the loans. If the shortfall in financing is largely due to the acquisition of Fixed Assets, then the forecaster should increase the long-term loans accordingly, to finance the shortfall. If the shortfall, however, is largely due to increases in Current Assets, then the forecaster can increase the short-term loans. If the increase in Current Assets is permanent in nature, meaning it is not a seasonal increase in Current Assets or Working Capital, then the forecaster may decide to obtain long-term loans instead. Here, prudent financial judgment is required. But for financial projection purposes, the forecaster can use a simplification technique as a first iteration in his effort to come up with a Pro Forma (or Projected) Balance Sheet. He or she can conveniently assume that any financing shortfall will be financed by loans for the purpose of Balance Sheet “balancing” and then adjusted later for a more refined financial strategy. Whenever we talk about the Balance Sheet, assets must always equal liabilities and owners’ equity. However, in financial forecasting, most probably, the respective totals of Assets and Liabilities plus Owners’ Equity will not be the same in the initial attempt to construct a forecasted or Pro Forma Balance Sheet. This is because each forecasted item is obtained independently based on the assumptions, policies, or regulatory requirements followed. Thus, there is a need to have a “balancing” account. One can use the Cash account, Instead of stipulating a minimum Cash balance, Cash can be allowed to go above the minimum balance or to go below that, even to the point of showing a negative Cash balance. If the Cash goes above the minimum balance, the forecaster can subsequently adjust the Balance Sheet by using the excess cash to pay for outstanding loans or to increase placements in Marketable Securities. If the Cash goes below the minimum balance, the forecaster can cover the cash shortfall by obtaining more loans or by liquidating Marketable Securities into cash.Table 7.9 provides an example of a Pro-Forma Balance Sheet with explanatory Notes on the side to indicate the assumptions used by the forecaster. Table 7.9. Pro-Forma Balance Sheet As of Year Ending December 31, 2012 and December 31, 2013 (in Thousand Pesos) [ Audited Forecasted Balance Sheet | Balance Sheet as Assumption Used sein | ofDec-31,2013 ASSETS Current Assets Cash 10,000 10,000 | Minimum cash balance. Accounts Receivables 30,000 45,000 | 30 days of Sales (atest month) Inventories 15,000 22,500 | 15 days of Sales (latest month) Total Current Assets 55,000| 77,500 | Gross Fixed Assets 100,000 119,000 Additional depreciation computed p at 19,000 Accumulated Depreciation 40,000 50,000 | Additional depreciation computed | ‘| at P10,000. Net fixed Assets 60,000 69,000 Other Assets 5,000 | 5,000 | Assume same level as last year Total Assets _| 120,000 151,500 | |ABILITIES I Current Liabilities Accounts Payable 15,000 22,500 | Enterprise experience where the level of Accounts Payable is roughly the same as the inventories level. Accrued Expenses 5000 7,000 | same but additional Taxes Payable included. Siioretered Deak 7,000 | Balancing figure to make 10,000 Liabilities equal to Assets. Total Current Liabilities 30,000 36,500 Long-term Loans 50,000 69,000 | increased by P19,000 due to additional Fixed Asset acquisition of P19,000. Stockholders’ Equity Paid-in Capital 30,000 30,000 | Same level as last year. Retained Hatniigs 10,000 16,000 | Additional Net profit after Taxes. Total Stockholders’ Equity 40,000 | +— Total Liabilities and 120,000 Stockholders’ Equity Since there would be additional long-term loan to finance the additional Fixed Assets, interest expenses would go up. This means that the forecaster would have to adjust the Pro-Forma Income Statement previously made as shown in Table 7.10. Since the Net Income After Taxes would go down from P6,000 to P5,400, there would be a need to increase loans by P600 in order to balance the Balance Sheet.Table 7.10. Pro-Forma Income Statement and Adjusted Pro-Forma Income Statement for Year 2013 Pro Forma Income Statement 540,000 340,000 200,000 200,000 186,000 186,000 Less Interest Expenses 6,000 | ‘Adjusted Pro Forma Income Statement Sales Cost of Good Sold Gross Profit Operating Expenses ‘Additional expenses of P800 Equals Net Profit before Taxes 8,000 | 7,200 Less Taxes 2,000" | 7,800 | Taxes decreased by ®200 Equals Net Profit after Taxes P6,000 | 5,400 | Net effect of P600 125% of Net Profit before Taxes Funds Flow Forecasting To forecast the Funds Flow, the financial forecaster should compute for the increase or decrease in the different items found in the Assets and Liabilities columns, when comparing the actual or previous year’s Balance Sheet and the Pro Forma Balance Sheet. Decreases in Assets and increases in Liabilities are sources of funds, while increases in Assets and decreases in Liabilities are uses of funds. The Funds Flow Forecast is also called the Cash Position Forecast as can be seen in Table 7.11. Starting from the beginning cash balance, the forecaster adds the Sources of Funds to obtain Cash Available. From there, the Uses of Funds are subtracted in order to obtain the Net Cash Position (Ending Cash Position). Table 7.11. Cash Position Forecast Using Sources and Uses of Funds Beginning Cash Balance (as of last Balance Sheet) 1,000 ‘Add Source of Funds: Increases in Liabilities Accounts Decreases in Assets Accounts Equals Cash Available Subtract Uses of Funds: Decreases in Liabilities Accounts Increases in Assets Accounts Equals Net Cash Positiont the reduction in the Net Fixed Assets account caused by the increase in additional ‘Accumulated Depreciation from the previous year to the forecasted year. This will, in effect, increase the Use of Funds by the exact amount of the additional Accumulated Depreciation. The contra entry on the Sources of ands would be an adjustment in the Retained Earnings account brought about by adding . the Depreciation Expenses taken out of the Net Profit after Taxes. If one assumes that the additional Accumulated Depreciation is P200, then this means that the Depreciation- Expenses for the year is also P200. Table 7.12 reflects these adjustments. Other adjustments have to be made because of the accrual method used. Table 7.12, Adjusted Cash Position Forecast The forecaster should adjus Beginning Cash Balance (as of last Balance Sheet) 1,000 ‘Add Source of Funds: ato Increases in Liabilities Accounts 4 + Decreases in Assets Accounts 2,100 Equals Cash Available Subtract Uses of Funds: Decreases in Liabilities Accounts 500 Increases in Assets Accounts 200 + 200 P1200 Equals Net Cash Position Cash Flow Forecasting The entrepreneur or finance manager is concerned about the enterprise's survival ona day-to-day basis as well as its long-term sustainabiis agS a precious commodity that will make the enterprise live on and on. It is crucial, therefore, to monitor and budget the enterprise’s cash position on a daily, weekly, monthly, and yearly basis. The entrepreneur or finance manager should determine the Cash Receipts and Cash Disbursements that the enterprise is most likely to experience. If there are projected surpluses or shortages, these should be added to the Beginning Cash Balance to determine the Ending Cash Balance, If the ending cash balance turns out to be positive and stays above the minimum cash required, there is no need to raise funds. Excess cash can then be placed in marketable securities or other forms of investments. If the ending cash balance is negative, then there is a need to borrow short-term funds for seasonal requirements or to borrow longer-term funds for long-term requirements. The nature of the cash needs can be established by forecasting the cash situation over a longer timeframe. The Cash Budget or Cash Flow Forecast should indicate whether excess cash is likely to accumulate. In this instance, the surplus cash can be placed in longer-term investments. If the excess cash will be needed in future operating periods, then the enterprise is well advised to place it in very short-term investments. For cash shortages, the enterprise must obtain additional loans. The cash forecasting period must, therefore, be extended to ascertain whether the loans can be repaid or not. If the cash forecast shows repayment difficulties, then additional equity must be sourced. However, if the future forebodes continuing cash shortages leading to bankruptcy, there may be reason to pre-empt that bankruptcy by liquidating the company before mounting cash shortages eat up all of its assets. The Cash Budget emanates from the forecasts made on the Income Statement and Balance Sheet except that these financial statements follow the accrual methodof accounting. On the one hand, the Income Statement recognizes Sales when they are transacted, not when they are collected. The Cash Budget, on the other hand, only recognizes cash collections from Sales made. Also, the Income Statement recognizes Cost of Sales, Operating Expenses, and Non-Operating Expenses that can be matched to the Sales transacted during a period. However, the Cash Budget only recognizes cash payments on purchases made and expenses incurred regardless of the time when those purchases or expenses were transacted, The cash payments may occur before, during, or after the Income Statement period. The Cash Budget should take into account the credit terms given to customers and provided by suppliers, Doing so implies a delay in the collection of cash (Accounts Receivables) and a delay in the payment of purchases (Accounts Payable). The Cash Budget must distinguish between actual cash receipts and disbursements and the accountant’s accrual method of recording Sales, Cost of Sales, and Operating Expenses. Take the following example of ACME Enterprises in Table 7.13. (A). It has a policy and actually experiences a 30-day sales collection period. It purchases the raw materials and pays for the labor costs and outlays for overhead expenses in cash one month before they are recognized as Cost of Sales. In other words, ACME’s products must be produced one month before they get sold. Most (80%) of the Selling, General, and Administrative (SGA) Expenses are paid in cash during the operating month. However, 20% is paid one month later. Interest expenses on long-term debt are paid on June 30 and December 31. The amortization of principal payments is also paid on the same dates. Half of the taxes for the previous year’s income is paid on’April 30 while the other half is paid on July 31. Income taxes are pegged at 25% of Net Income before Taxes. Beginning Cash Balance as of January 1, 2012 is P25,000. Table 7.13. (A) ACME Enterprises Actual and Projected Income Statements (in Pesos) Actual Projected for 2013 January to December 2012 Jan_| Feb | Mar | apr | May | jun | jul Sales* 450,000 | 50,000] 55,000] 60,000} 60,000} 55,000] 55,000] 50,000 Cost of Sales Materials 130,000 | 15,000] 16,500] 18,000} 18,000] 16,500] 16,500] ‘15,000 Labor 68,000} 6,000} 6,000} 6,000} 6,000} 6,000] 6,000] 6,000 Manufacturing Overhead 36,000] 3,000] 3,000] 3,000] 3,000] 3,000} 3,000] 3,000 Depreciation 36,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Total Cost of Sales 270,000} 27,000} 28,500] 30,000] 30,000} 28,500] 28,500] 27,000 Gross Profit 180,000 | 23,000} 26,500] 30,000] 30,000 26500} 26,500 23,000 Selling, General and Administrative 100,000] 12,000] 12,000} 12,000] 12,000 12,000] 12,000] 12,000 Expenses** : Operating Profit 80,000 | 11,000} 14,500] 18,000] 18,000] 14,500} 14,500] 11,000 Interest Expenses*** 72,000] 6,000] 6,000} 6,000] 6000} 6,000] 6,000] 6,000 Net Profit Before Taxes 8,000} 5,000] 8500] 12,000] 12,000] 8soo| 8500} 5,000 Taxes*** 2,000] 1,250] 2,125] 3,000] 3,000] 2125) 2125] 1375 Net Profit After Taxes 6,000} 3,750,] 6375] 9,000] 9,000] 6375] 6375] 3,625, ‘Sates in December 2000 of P40,000. Therefore, oustanding accounts receivables as of December 31, 2013 1s P40,000 PEt 3 oath or yar 2012 ‘ of Pet 00 incurred on December 31,2011 payable six years with grace period af one year or inthe year 2012, Principal payments of P50,000{n une 13 adn December 31, 2013. Interest expenses of 12% f on oan oustanding interest expense of 1a month am Jenuary enone payable une $0. faxes are computed at 25% on Net Profit belore Taxes,h Budget for ACME Enterprises. This ginning Cash Balance, which is d Cash Receipts. These include 30-day credit policy. For h payments for sales of There is enough information to project a Cas! is shown in Table 7.13. (B). We must start with the Be; given at P25,000. To this figure, we must add all expectes cash collections from the previous month’s sales because of the ACME, there are no other cash receipts like loan proceeds, cast eee THe ofthe assets, and cash advances from customers as other enterprises mig! z Beginning Cash Balance and the Cash Receipts (or cash collections) equals the Sa Cash of the enterprise. From this Available Cash we must then deduct al on se as : Disbursements. These include materials, labor, and manufacturing overhead for . le nex! months’ Cost of Sales or Cost of Goods Sold since the products must be produced one month before. This means that Cash is also disbursed one month before. Deprec i is a non-cash item and never enters the Cash Budget. Next, 80% of the month's Selling, General, and Administrative (SGA) Expenses is paid for in cash on the month incurred, The remaining 20% is paid one month later. Taxes for last year’s Net Income are paid this year. The taxes for the year 2012 are computed at P2,000. Fifty percent (50%) of this, or P1,000 is due on April 2013. Next, principal payment on the loan is to be paid on June 30, 2013, It amounts to P50,000 per semester (or P100,000 per year). Finally, the interest expense of P36,000 for the months of January to June is paid on June 30 of the same year. The Total Cash Disbursements are tallied. From the available Cash, we subtract the Total Cash Disbursements to derive the Ending Cash Balance, which becomes the Beginning Cash Balance for the next month. Note in Table 7.13. (B) that the Ending Cash Balance of ACME Enterprises remains positive from January to June 2013. If the Cash Budget showed a negative cash balance, the enterprise must raise some cash to fill the cash shortfall. The enterprise may elect to do any of the following: 1) borrow money; 2) ask shareholders to infuse more cash into the enterprise; 3) sell some assets; 4) postpone or restructure the loan payments; 5) postpone the payment of raw materials by asking for longer-term suppliers’ credit; 6) delay the payment of certain Selling, General, and Administrative Expenses; and 7) other means. Table 7.13. (B) gives us the Cash Budget of ACME Enterprises for January to June 2013.Table 7.13. (B) ACME Enterprises Cash Budget (in Pesos) January to June 2012 —— [seer February] March | April | May | June Beginning Cash Balance 25,000 =| 39200] 55200] 76.700] 99,200 ‘Add: a Cash Collection for Previous Month’s Sales 40,000] so,000] 55,000] 60,000 60,000} 55,000 Equals: ‘Available Cash ie oe agar r 65,000} 78,200] 94,200] 115,200] 136,700] 154,200 Less Cash Disbursements, {+ 1) Materials for Next Month 16500] 18,000] 18,000] 16500] 16500] 15,000 + 2) Labor for Next Month 6000| 6000] 6000] 6.000] 6,000] 6,000 3) Manufacturing Overhead for Next Month | 3000] 3,000] 3.000] 3.000] 3.000] _ 3,000 4) 80% of Month's Selling, General, and 9600] 9,600] 9,600] 9,600] 9,600] 9,600 ‘Administrative (SGA) Expenses 5) 20% of Previous Month's SGA Expenses 1700] 2400] 2400] 2,400] 2,400) — 2,400 6) Taxes from Last Year's Income - - ‘oro - - 7) _ Principal Payrhent a : - - -| 50,000 8) Interest Payment = a 5 -| 36,000 Total Cash Disbursements 36800| 39,000] 39,000] 38500] 37S00| 122,000 Equals: Ending Cash Balance 28,200] 39,200 55,200] 76,700] 99,200 00 Using Financial Forecasts to Evaluate Business Investment Decisions In Part 1 of the book, the income and cash payback period was introduced as a method to evaluate business investments. Other methods are shown in Appendix B. These include the Break-even Sales Volume Analysis, the Go or No-Go Business Investment Decision, and Investment Analysis Using the Time Value of Money. The construction and forecasting of Financial Statements would help the entrepreneur get a firmer grip on the viability of his or her enterprise. Appendix C discusses Enterprise Budgeting to help the entrepreneur allocate and monitor crucial resources invested in the enterprise.