DEPARTMENTOFBUSI

NESSANDPUBLI
C
MANAGEMENTCOURSE
CODE:
BFM 423
COURSETI
TLE:FI
NANCIALMODELLI
NGAND
FORECASTING

I
nst
ruct
ional
Mat
eri
alf
orBFM-Di
stance
Lear
ning
 .
.
.
.
BFM 423:FI
NANCI ALMODELLI
NGANDFORECASTI
NGPr
e-
requi
sit
es:BFM 312

Purpose:To i
ntr
oducethel earnermet
hodsandt
ool
sused i
n
fi
nancial
modeli
ngandforecasti
ng

Expect
edLear
ningOut
comesoft
he
Course

Bytheendofthecourseuni
tthel
ear
ner
sshouldbe
abl
eto:-i
) Ex pl
ai
nt het
ermsfi
nanci
almodeli
ng
andfor
ecast
ing

i
i
) Descr i
bemet
hodsandt
ool
susedi
nfi
nanci
al
f
orecast
ing

i
i
i) Appl ythemet
hodsandtool
sinfinanci
almodeli
ngand
f
orecast
ingiv) Appl
ycomputerpackagesi
nfinanci
al
f
orecast
ing

Cour
seCont
ent
:

2
 .
.
.
.
Buil
dingblocksoff i
nancialf
orecasti
ng;verti
calandhori
zontal
rel
ati
onshipsamongpar ametersoff i
nancialst
atements;Stat
isti
cal
andgr aphicalanal
ysi
sofpastbudgetpat terns;
Setti
ngpar ameter
sfor
fut
uregr owthand/orchangesoff inanci
albudgets;Prof
itandloss,
bal
ancesheetpr oj
ectedcashflow

Appli
cat
ionofcomput
erpack
agesi
nfi
nanci
al
for
ecast
ing

Teachi
ng/ Lear
ning Methodol
ogies:Lect
uresand tut
orials;gr
oup
di
scussi
on;
demonstr
ati
on;
Indivi
dualassi
gnment;Casestudies

Inst
ruct
ionalMat eri
als and Equi
pment:Project
or;testbook
s;
desi
gncatalogues;comput erl
abor
ator
y;desi
gnsoftware;si
mul
ator
s

3
 .
.
.
.
Cour
seAssessment

Examinat
ion-70%;
Conti
nuousAssessmentTest(
CATS)-
20%;Assi
gnments-10%;Tot
al-100%

RecommendedTextBooks:

i
) JaeK.Shi
m,Joel
G.Si
egel
(2005)
,Handbookoff
inanci
al
anal
ysi
s,f
orecast
ingandmodel
i
ng,

TextBooksf
orf
urt
herReadi
ng:

i
) Car
olAl
exander(
2008)
,Pr
act
icalFi
nanci
al
Economet
ri
cs(Ser
ies-Mar
ketRi
skAnal
ysi
s),
JohnWi
l
ey&
SonsI
nc

i
i
) Pei
j
iWang(
2003)
,Fi
nanci
alEconomet
ri
cs:Met
hodsAnd
Model
s,
Rout
ledge

i
i
i) Pet
erChr
ist
off
ersen,
(2003)
,El
ement
sofFi
nanci
alRi
skManagement
Academi
cPr
ess

4
 .
.
.
.
CHAPTERONE

I
NTRODUCTI
ON

Forecast
-ani
ndi
cati
onofwhatisgoi
ngtohappenatsome
fut
uretime.Ast
atementoff
utureev
ent
sbasedonsomekind
ofknowledgeor

j
udgment
s.

Fi
nancial
For
ecast
ing-Pl
anni
ngoff
utur
e
fi
nances

Model—arepr
esentati
onorcopyof
somethi
ng.
-ar
epresentati
veofthe
var
iabl
esandr
elati
onshipsbetweent
hem.

modelcanbedefi
nedasani
deal
izedr
epr
esentat
ionofar
ealll
i
fe
sy
stem.Thi
ssyst
em coul
dbeal
readyi
nexi
stenceorawai
ti
ng
ex
ecuti
on.

I
tisusefult
ool
in
pl
anning.

Fi
nancialplanni
nginvol
vesanaly
zingt
hefinanci
alf
lowsofthe
company ,f
orecasti
ngtheconsequencesofvari
ousinv
estments
fi
nancinganddivideddeci
si
onstowei ghi
ngtheeff
ectsofvar
ious
al
ternati
ves.

FORECASTI
NGMETHODS.

5
 .
.
.
.

Fi
nancialf
orecast
ingmethodsaretechni
quesofdet
ermini
ngin
advancetherequi
rementandut
il
izat
ionoffundsf
orafut
ureper
iod.

6
 .
.
.
Usesoff
i.
nanci
alf
orecast
ing

1.Helpst
oantici
pat
ef i
nanci
alneedsandef
fect
sonnew pol
i
cies
ther
ebyav
oidi
ngemergencydeci
sions.

2.Worksasacontr
oldevi
cei
naf i
rm asi
tpr
ovi
desast
andar
dof
fi
nanci
alper
for
mancefort
hef
utur
e.

3.Iti
sanaidi
nexpl
ai
ningther
equir
ement
soff
undsf
ort
hef
ir
m
toget
herwi
tht
hef
undsofsuppl
i
ers.

4.I
thel
pst oexpl
ai
nthepr
operr
equi
rement
soff
undsandt
hei
r
opt
imum ut
il
iz
ati
on.

5.I
tisusedt
opr
etestt
hef
inanci
alf
easi
bil
i
tyofv
ari
ouspr
ogr
ammes.

6.Itassi
ststhef i
rmf orthesuccessf
ulf
inanci
alpl
anni
ngby
pr
ovidi
ngsigni
fi
cantinf
ormati
on.

For
ecast
ingmet
hods

Qual
i
tat
iveappr
oachf
orecast
sbasedonj
udgmentandopi
nion:

7
 .
.
.

 Ex
ecut
iveopi
nions

 Del
phi
techni
que

 Sal
esf
orcepo11i
ng

8
 .
.
.
.
 Consumersur
vey
s

 Nomi
nal
GroupTechni
que

 Mar
ketResear
ch

Quant
it
ati
veappr
oach

For
ecast
sbasedonhi
stor
icaldat
a

 Nai
vemet
hods

 Mov
ingav
erage

 Ex
ponent
ial
smoot
hing
9
 .
.
.

 Tr
endanal
ysi
s

 Decomposi
ti
onoft
imeser
ies

Associ
ati
ve(
causal
)for
ecast
s

 Si
mpl
eregr
essi
on

 Mul
ti
pler
egr
essi
on

 Economet
ri
cmodel
i
ng

1
0
 .
.
.
Sel
ect
ionofFor
ecast
ingMet
hod

1
1
 .
.
.
Thechoi
c.
eofaf
orecast
ingt
echni
quei
sinf
luencedsi
gni
fi
cant
lyby
thest
agproductl
if
ecy
cleandsomet
imesbyi
ndust
ryf
orwhi
cha
deci
si
onisbeing

made.Int he begi
nni
ng of t
he product l
i
fe cycl
e,r el
ati
vel
y
smal
lexpendi
tur
esaremadef
orresear
chandmark eti
nvesti
gati
on.

Whatfor
ecast
ingt
echni
queort
echni
quest
osel
ectdependsonf
ive
cr
it
eri
a

Whati
st hecostassociat
edwit
hdevelopi
ngt
heforecast
ingmodel
,
comparedwithpotenti
algai
nsresul
ti
ngfr
om i
tsuse?Thechoi
ceis
oneofbenefi
t-
costtrade-
off
.

 Howcompl
i
cat
edar
ether
elat
ionshi
pst
hatar
ebei
ngf
orecast
ed?

I
sitf
orshor
t-
runorl
ong-
runpur
poses?

 Howmuchaccur
acyi
sdesi
red?

1
2
 .
.
I
st.
her
eami
nimum t
oler
ancel
evel
ofer
ror
s?

 Howmuchdataareavai
l
abl
e?Techni
quesv
aryi
ntheamount
ofdat
atheyr
equi
re.-

Qual
itat
iveFor
ecast
ing
Methods

1
3
 .
.
.
Thequal
i
t.
at
ive(
orj
udgment
al)appr
oachcanbeusef
uli
nfor
mul
ati
ng
shortt
ermfor
ecast
scanal
sosuppl
ementt
hepr
oject
ionsbasedon
theuseofanyof

t
hequant
it
ati
ve
met
hods.

Qual i
tat
ivef or
ecasti
ngtechniquesaregener all
ymor esubj
ecti
vethan
theirQuant ati
vecounterpart
s.Quali
tati
vetechniquesaremoreusef ul
i
nt heear l
ierstagesofthepr oductl
ifecycl
e, whenlesspastdata
existsforusei nquantit
ativ
emet hods.

Fourofthebet
ter-knownqual i
tat
ivefor
ecast
ingmethodsar e
execut
iveopi
nions,theDelphimethod,sal
es-
f or
cepoll
ing,
and
consumersurveys.Other
sar eNomi nalGr
oupTechniqueandMar
ket
Resear
ch.

Execut
ive
Opini
ons

The subj
ect
ivev
iews ofex
ecut
ives orex
per
tsf
rom sal
es,
1
4
 .
.
pr
oduct
i.
onf
inance,pur
chasi
ng.andadmi
nist
rat
ionar
eav
eraged-
to
generatea-f
orecastaboutfut
uresal
es.Usuall
ythi
smet hodisusedin
conjunct
ionwithsomequant i
tat
ivemethod,suchastrend
extr
apolati
on.Themanagementt eam modif
iestheresult
ingf
orecast
,
basedont hei
rexpectat
ions.

1
5
 .
.
.
.

Adv
ant
ages

a)Theforecasti
ngisdonequi
ckl
yandeasi
l
y,wi
thoutneedof
el
aboratestat
ist
ics.

b)Also,thejur
yofex ecut
iveopi
nionsmaybet heonl
ymeansof
forecasti
ngfeasi
bleint
heabsenceofadequatedat
a.

Di
sadv
ant
ages

Thedisadvant
ageshowever
,arethatof“
groupt
hink.
”Thisi
sa
setofprobl
emsinher
entt
othosewhomeetasagr
oup.For
emost
amongtheseare;

1
6
 .
.
.
.
a)Hi
ghcohesiveness:Withhighcohesiveness,t
hegr
oup
becomesincreasi
nglyconf
ormingthroughgrouppr
essur
ethat
hel
pssti
fl
edissensionandcrit
ical
thought

b)Str
ongl eader
shi
p:Strongl
eader
shi
pfost
ersgr
ouppr
essur
e
forunanimousopi
nion.

c)Insul
ati
onofthegroup:I
nsulat
ionofthegrouptendst
o
separat
ethegroupfr
om outsi
deopini
ons,i
fgiv
en.

1
7
 .
.
.
.

Del
phiTechni
que

Delphiforecasti
ngi sanon- quant i
tati
vet echniquef orfor
ecasti
ng.It
drawsi t
snamef rom theOr aclesofDel phi,whi chinGr eek
Antiquit
yadv i
sedpeopl ebasedoni ntuit
ionandcommonsense.
Unlikemanyot hermet hodst hatuseso- calledobj ect
ivepredi
cti
ons
i
nv olvi
ngquant it
ativeanalysis,theDel phimet hodi sbasedon
expertopinions.Ithasbeendemonst rat
edt hatpredi
cti
onsobtained
thi
swaycanbeatl eastasaccur at
easot herpr ocedur
es.The
essenceoft hepr ocedureist ouset heassessmentofopi ni
onand
predicti
onsbyanumberofex pertsoveranumberofr oundsin
carefull
ymanagedsequences.

OneofThemosti mpor t
antfactorsinDelphiforecast
ingisthe
sel
ectionofexpert
s.Theper sonsinvit
edt oparti
cipat
emustbe
knowledgeableabouttheissue,andrepresentav ari
etyof
backgrounds.Thenumbermustnotbet oosmal lt omak et he
assessmentt oonarrowlybased,nort ool arget obedi f
fi
cultt
o
coordi
nate.Iti
swidelyconsideredthat10t o15ex pertscanprovi
dea
goodbasef orthefor
ecast.

10
 .
.
Pr .
.
ocedur
e

Theprocedurebegi
nswi t
htheplanner/r
esear
cherprepari
nga
questi
onnair
eabouttheissueathand,it
scharacter
,causesand
fut
ureshape.Thesearedistr
ibut
edtotherespondentsseparat
elywho
areaskedtorat
eandr espond.Theresul
tsarethentabul
atedandthe
i
ssuesraisedarei
denti
fi
ed.

Ther esultsarethenr eturnedt ot heex pertsinasecondr ound.

Theyar easkedtorankorassesst hef actors,andjusti
fywhyt hey
madet heythei
rchoices.Duringat hirdorsubsequentr oundst heir
rati
ngsal ongwiththegroupav erages,andl i
stsofcomment sar e
provi
ded,andt heexper tsareask edt ore-evaluat
et hefactors.The
roundswoul dconti
nueunt i
lanagr eedl evelofconsensusi sreached.
Thel i
teratur
esuggest sthatbyt het hi
rdroundasuf fi
ci
entconsensus
i
susual l
yobtai
ned.

Theproceduremayt ak
eplaceinmanyway s.Thefi
rststepisusual l
y
undert
akenbymai l
.Aftertheini
ti
alresultsareobtainedt he
subsequentroundcouldbeundertakenatameet i
ngofex pert
s.
Assumingitwoul dbepossibl
etobringthem toget
herphy sical
ly.Or,
thesubsequentroundscouldbeconductedagainbymai l,
&Mai lhas
great
lyfaci
l
itat
edtheprocedur
e.Thebasicstepsareasf oll
ows:

11
 .
.
a)I
de.
.
nt
if
icat
ionoft
hepr
obl
em:-Resear
cheri
dent
if
iest
he
probl
em forwhi
chsomepr
edi
cti
onsar
erequi
red,
e.g.whati
s
thetr
aff
icofport

xli
kelytobei n10y earstime.Researcherpr epares
document ati
onr egardingpastandpr esentt r
afficactivi
ty.
Questionnair
eisf ormul at
edconcerningf uturet raf
fi
cest imat
es
andf actorsthatmi ghtinfl
uencesuchdev elopment s.Alevel
of
agreementbet weent heresponsesisselected,i.
e.if80%oft he
expertscanagr eeonapar ti
culart
raffi
cpr edicti
on.

b)Selectionofexper ts:-Int hecaseoapor tscenari

ot hi
s
mightinclude terminalmanager s,shipping li
ne
r
epr esent
at i
ves,landtr
ansportcompanyr epresent
ati
ves,
i
ntermediar i
essuchasf r
eightfor
warders,andacademics.Iti
s
i
mpor t
anttohav eabalance,sot hatnoonegr oupi
sov er
ly
r
epr esented.

c)Admini
str
ationofquesti
onnai
re:-Ex
pertsareprovi
dedwith
backgr
ounddocumentationandquesti
onnai
re.Responses
aresubmit
tedtor
esearcherwi
thi
nanarr
owt i
meframe.

12
 .
.
.
.
d)Resear
chersummar
izesr
esponses:-Act
ualt
raf
fi
c
pr
edicti
onsar e
tabulatedandmeansandst andar
ddevi
ati
onscal
culat
edf or
eachcat egoryofcar
goasi nt
hecaseofaportt
raf
fi
cpr edict
ion
exercise.Keyfact
orssuggest
edbyexper
tsar
ecompl i
edand
l
isted.

e)Feedback: -Thet abulati

onsar er eturnedt ot heexper t
seither
bymai lorinameet ingconv enedt odi scussf irstroundresults.
Theadv ant ageofameet ingisthatpar tici
pant scanconf ront
eachot hert odebat earear easofdi sagr eementov eractual
traf
ficpredictionsorofk eyfactorsident if
ied.Thedr awbackis
thatinf
luenceov erthedi scussionandt hereby. swayout comes,
at r
endt hatt her esearchermustbeal ertt oandseekt o
mi t
igat
e.Ex pert
sar einvitedtor ev
iewt heiroriginalesti
mat es
andchoi cesofk eyf actorsinlightoft her esultspresented,
andsubmi tanewr oundofpr edict
ions.

f
)Thesenewpr edi
cti
onsar etabul
atedandr eturnedt othe
expertsei t
herbymai lorimmediatelytot hemeet ing,i
fthelevel
ofagr eementdoesnotmeett hepr edeterminedl evelof
accept ance.Thespecificareasofdi sagreementar e
highli
ght ed,andtheexpertsareagainr equestedt oconsider
theirpredicti
onsinli
ghtofthepanel sov eral
lviews.

13
 .
.
.
.
g)Thepr
ocessi
scont
inuedunt
ilt
hel
evelofagr
eementhas
r
eached
thepr e-
determinedval
ue.Ifagr
eementisnotpossi
bleaft
er
severalrounds,ther
esear
chermustter
mi nat
etheprocessand
trytopinpoint

,
wher ethedi sagreement soccur,
andut il
izet her esult
sto
i
ndi catespeci fi
cpr oblemsinthetraf
ficpredi ctionprocessin
thiscase.Thi smet hodcouldbeappl i
edi nacl assroom setti
ng,
wi t
hst udentsser vingasex per
tsforapar ticularcasest udy.The
traffi
catt hel ocalair
portorportmightbeanappr opri
ate
exampl e.Ont hebasi sofcaref
ulexami nationoft r
affi
ctrends
andf act or
si nfl
uencingbusinessactivi
ty,thecl asscoul dbe
consul tedt ocomeupwi t
hpredicti
onst hatcoul dthenbe
compar edwi ththoseofsomeal t
ernatemet hodsuchast r
end
extrapol at
ion.

Adv
ant
ages&Di
sadvant
agesofDel
phiMet
hod:

Del
phi
met
hodhassomeex
clusi
veadv
ant
ages:

I
tfaci
li
tat
esanony mit
yoft
herespondentsi
denti
ty.Thi
s
enabl
esrespondent
stobef
rankandfort
hri
ghti
ngivingt
hei
r
vi
ews.

I
tfacil
itat
esposingtheproblem t
otheexpert
satoneti
me
andhast hei
rresponsenearl
yasgoodaspool i
ngt
he
paneli
ststoget
her.I
nonecase620ex pert
sfrom di
ff
erent
backgroundsuchaspol icy-

14
 .
.
.
.akers,technol
m ogi
sts,sci
ent
ist
s,economi
sts,
admini
str
atorsand
advi
ser
swer econsul
ted.

However,
Del
phi
met
hodpr
esumest
heset
wo
condi
ti
ons

a)Paneli
stsmustber ichinthei
rex
pert
isehavingwideknowledge
ofthesubjectandaresincer
eandearnesti
nt hei
rdi
sposi
ti
on
towardstheparti
ci
pants.

b)Theconduct or
sar eobjecti
veinthei
rjob,possessski
llt
o
conceptualizethepr oblemsf ordi
scussi
ontogenerate
considerablethinking,sti
mulatedial
ogueamongpanel i
stsand
makei nferenti
al analy
sisofthenumer ousviewsofthe
part
icipants

Sal
esFor
ce
Pol
li
ng

15
 .
.
.
.akers,technol
m ogi
sts,sci
ent
ist
s,economi
sts,
admi
nist
rat
orsand

Somecompani esuseasaf orecastsourcesalespeoplewhohav e

conti
nualcontactswit
hcustomer s.Theybeli
evethatthesalespeopl
e
whoar eclosesttot
heult
imat ecustomersmayhav esignif
icant
i
nsight
sr egardingt
hestateoft hefutur
emar ket
.Forecastsbasedon
salesf
orcepol l
ingmaybeav eragedtodev el
opaf ut
ureforecast.Or
theymaybeusedt omodifyot herquanti
tati
ve

16
 .
.
.
and/ .
orqual
i
tat
ivef
orecast
sthathav
e been gener
ated i
nter
nal
l
y
i
nt he
company
.

Adv
ant
age
s

I
tissi
mpl
etouseandunder
stand.

I
tusest
hespeci
ali
zedk
nowl
edgeoft
hosecl
osestt
otheact
ion

17
 .
.
.
and/ .
orqual
i
tat
ivef
orecast
sthathav
e been gener
ated i
nter
nal
l
y
i
nthe

 Itcanplaceresponsi
bil
i
tyf
orattai
ningthefor
ecasti
nthe
handsofthosewhomostaffectt
heactualr
esul
ts.

 Thei nf
ormat
ioncanbebr okendowneasi
l
ybyt
err
it
ory
,
product,
cust
omer,
orsal
esperson.

Di
sadv
ant
age
s

Salespersonsbei
ngov erl
yopti
mist
icorpessimist
icr
egar
dingt
hei
r
predict
ionsandinaccuraci
esduetobroadereconomicev
entst
hatar
e
l
argelybey ondt
heircontr
ol.

18
 .
.
.
.
ConsumerSur
vey

Somecompani esconducttheirownmar ketsurv

eysregardi
ng
specifi
cconsumerpur chases.Surveysmayconsistoftel
ephone
contacts,per
sonalint
ervi
ews, orquesti
onnai
resasameansof
obtaini
ngdata.Extensi
vestati
sticalanal
ysi
susuall
yisappli
edto
surveyresult
sinordertotesthy pot
hesesregar
dingconsumer
behav i
or.

NominalGr
oup
Techni
que

Nomi nalGr oupTechni queissi mil

art ot heDelphitechniquein
thatitutil
i
z esagr oupofpar t
ici
pant s,usuall
yex pert
s.Afterthe
parti
cipantsrespondt oforecast-rel
atedquest i
ons,theyranktheir
responsesi norderofper cei
vedr elat
iv ei
mpor t
ance.Thenthe
ranki
ngsar ecollect
edandaggr egated.Ev ent
uall
y,t
hegr oupshould
reachaconsensusr egardi
ngt hepr i
oriti
esoftherankedissues.

19
 .
.
.
.
ConsumerSur
vey

Mar
ketResear
ch

20
 .
.
I
n mar
ke.
.
tresear
ch,consumersur
vey
s ar
e used t
o est
abl
i
sh
potent
ial
demand. Such mar
ket
ing r
esear
ch usual
l
y i
nvol
ves
constr
ucti
ng a

questionnairethatsoli
citspersonal,demographi
c,economi cand
mar keti
ngi nfor
mat i
on.Onoccasion, mark
etresearcherscoll
ectsuch
i
nf or
mat i
oni npersonatr etai
lout
letsandmal l
s,wheretheconsumer
canex perience—taste,
feel,smell
,andsee—apar ti
cularproduct
.The
researchermustbecar efult
hatthesampleofpeopl esurv
eyedis
representativ
eoft hedesiredconsumertarget.

Quanti
tat
iveFor
ecast
ing
Methods

Quant i
tativeforecasti
ngt echniquesar egenerallymor eobject
ive
thant heirquali
tati
vecount erpart
s.Quantitat
iveforecastscanbet i
me-
seriesforecastsi.e.,
apr ojecti
onofthepasti ntothef utur
e)or
forecastsbasedonassoci ati
vemodel s(i
.e.,
basedononeormor e
explanator yvar
iables).Time-seri
esdatamayhav eunder l
yi
ng
behav i
orst hatneedt obei denti
fi
edbyt hef orecaster.I
naddit
ion,
thef orecastmayneedt oi denti
fythecausesoft hebehav i
or.
Someoft hesebehav i
orsmaybepat ternsorsimpl yrandom var
iati
ons.

21
 .
.
.

For
ecast
sbasedhi
stor
ical
dat
a

22
 .
.
.
.
 Nai
vemet
hods

 Mov
ingav
erage(
Cov
eredi
ncl
ass)

 Ex
ponent
ialsmoot
hing(
Cov
eredi
ncl
ass)

 Tendanal
ysi
s(cov
eredi
ncl
ass)

 Decomposi
ti
onoft
imeser
ies(cov
eredi
ncl
ass)

Associ
ati
ve(
causal
)
for
ecast

 Si
mpl
eregr
essi
on(
cov
eredi
ncl
ass)

 Mul
ti
pler
egr
essi
on

 Economet
ri
cmodel
i
ng

23
 .
.
.

Economet r
ic
Forecast
ing

Economet r
icmet hodssuchasaut oregr
essiveintegr atedmov ing-
averagemodel (
APJMA)usecompl exmat hemat ical equati
onst o
showpastr elati
onshipsbetweendemandandv ariablesthatinfluence
thedemand.Anequat i
onisderiv
edandt hentestedandf i
ne-t
unedt o
ensurethatitisasreliabl
ear epresentati
onoft hepastr el
ationship
aspossi bl
e.Oncet hisisdone,project
edv al
uesoft heinfl
uenci ng
vari
ables(i
ncome, prices,et
c.)areinser
tedintot heequat i
ontomake
aforecast.

24
 .
.
.
REGRES.
SI
ONANALYSI
S

Thi
sisast
ati
sti
caltechni
quethatidenti
fi
esther
elat
ionshi
pbetween
twoormor
evari
ableswhereonev ariabl
ecal
ledt
hedependent
var
iabl
ewi
l
lbepredictedbyanindependentorex
planator
yvar
iabl
e.

Inasi
mpl
eregr
essi
onanal
ysi
sthef
oll
owi
ngequat
ioni
s
used;

y=a+bx

Inamult
ipl
eregr
essi
onanal
ysi
sthef
oll
owi
ngequat
ionmaybe
used;

y=a+b1x
1+b2x
2 +………………………+bnx
n

I
ntheequat
ionYa+
bx

20
 .
.
.
visthedependent
vari
abl
e

xistheindependent
var
iableaandbar e
constant
s

Underl
yi
ng
assumpti
ons

Cl
assi
calassumpt
ionsf
orr
egr
essi
onanal
ysi
s
i
ncl
ude:

21
 .
.
.
.
 Thesampl
emustber
epr
esent
ati
veoft
hepopul
ati
onf
ort
he
i
nfer
encepr
edi
cti
on.

 Theerr
ori
sassumedtobear andom vari
abl
ewit
hamean
ofzer
ocondi
ti
onal
ont
heexpl
anatoryv
ariabl
es.

 Thevari
abl
esareerr
or-
fr
ee.I
fthi
sisnotso,model
i
ngmaybe
doneusi
ngerr
ors-
i
ntechni
ques.

 The predi
ctors mustbe l inear
lyindependent,i.e.i
tmust
notbepossi bl
et oex
pr essanypr edi
ctorasalinear
combinati
onoft heothers.SeeMu1t i
coll
ineai
rt
y .

 Theerr
orsareuncor
related,t
hatis,t
hevar
iance-
cov
ari
ance
matr
ixoftheer
rorsi
sdi agonalandeachnon-zer
oel
ementis
thev
ari
anceoftheerror.

 The v ar
iance of the error is constant across
observat
ions(homoscedast
ici
tv)
.Ifnot
,weight
edleastsquar
es
orothermethodsmightbeused.

Thel
eastsquar
emet
hodofr
egr
essi
on

Thismet
hoddetermi
nesmathemati
cal
lyt
heregressi
onli
neof
bestf
iti
nordert
oestabl
i
sht
herequi
redpr
edi
cti
veequati
on.

22
 .
.
Thenor.
ma.
lequat
ioncanbeusedasf
oll
ows;

y
=a+bx……………………………………………….
1

I
fyoumul
ti
plyequat
ion1byxy
ouobt
ain;

x
y +bx2………………………………………………2
ax

I
mposi
ngsummat
ionsi
gnweobt
ain

yanbx........................................3

xyaxbx2........
.
..
..
..
.
..
..
..
..
4
..

23
 .
.
.

Equat
ions3and4canthenbesol
vedsi
mul
taneousl
ytoobt
aint
he
val
uesofconst
ant
saandb.

Al
ter
nat
ivel
ythef
oll
owi
ngequat
ionsmaybeusedt
osol
vef
oraandb.

aybxand

n n

24
 .
.
.
bnxy.
xy

nx2
x
2

Exampl
e

Consi
dert
hef
oll
owi
ngi
nfor
mat
ionaboutcompanyABCl
i
mit
ed;

Mont
h. Sal
essh.000 Adver
ti
sement
sh.
000
1 20 5

2 25 7

3 30 8

4 40 10

5 50 12

25
 .
.
.
bnxy.
xy
6 60 15

Requi
red

1.Det
ermineanequat
ionoft
hef
ormy
=a+bxt
opr
edi
ctsal
es
f
rom adver
ti
sement
.

2.Pr
edi
ctsal
eswhenadv
ert
isementi
ssh20,
000,
25,
000and30,
000

26
 .
.
Sol
uti
.
on.

X2sh000

27
Mont
h Sal
es(
y)sh Adver
ti
seme x
ysh000
nt
.
.
Sol
uti
.
on.
1 0
200 5 25 100
(
x)sh000
2 25 7 49 175

3 30 8 64 240

-
4 40 10 100 400

5 50 12 144 600

6 60 15 225 900
2
y225 x57 x =607 xy2415

yanbx

xyaxbx2

28
 .
.
Sol
uti
.
on.

225=6a+57b

29
 .
.
.
241
.
5=57a+607b

Sol
vi
ng
si
mult
aneousl
ya=-
2.
7477

b=4.
2366

Thepr
edi
cti
veequat
ioni
s;

y
=-2.
7477+4.
2366x

i
fx=20t
hen,
y-2.
7477+4.
2366x20

Hencey81.
98

30
 .
.
.
241
.
5=57a+607b

I
fx=25t
hen,
y-2.
7477+4.
2366x25

Hencey
=103.
167

I
fx=30t
hen,
y-2.
7477+4.
2366X30

Hencey124.
35

CORRELATI
ONANALYSI
S

Theregressi
onanal
ysi
sident
if
iesaclearr
elati
onshi
pbetweentwo
var
iabl
es.Howeveri
tdoesnotexpl
ainthestrengt
hoftheassoci
ati
on.
Thi
sstrengthcan

31
 .
.
bedet
er.
m.
inedusi
ngast
ati
sti
cal
measur
eknownast
hecor
rel
ati
on

coef
fi
ci
entdenot
edbyρ.

ρ=cov
(x,
y)

δxδy
32
 .
.
.

cov(
x,y
)= (xx)(yy)=277.
5=55.
5

n-
1 6-
1

Wher
ecov
(x,
y)i
sthecov
ari
ancebet
weenxandy

δxandδyar
est
andar
ddev
iat
ionsofxandyr
espect
ivel
y

33
nist
.
he.sampl
e si
ze fr
om the previ
ous ex
ample ofXYZ
l
i
mit
ed t.
hecor
rel
ati
oncoeff
ici
entcanbecal
culat
edasfol
l
ows;

34
 .
.
.
Mont
h . x Y 
xx
yy

1 5 20 (5-
9.5)(
20-
37.5)=
78.75
2 7 25 (7-
9.5)(
25-
37.5)=3
3 8 30 1
(.
82
-
95.
5)(
30-37.
5)
4 10 40 =
(
11
01
-.
2
95
.
5)(
40—37.
5)=
5 12 50 1
(
1.
2
25
-9.
5)(50—37.5)=3

6 15 60 (
1
15
.
2-9.
5 5)(60—37.
5)

x57 y225 =123.

75

xxyy277.5

X=57/
6=9.
5

35
 .
.
.

y
=225/
6=37.
5

δx= (xx)2 =3.

619

36
 .
.
.
n-
1 .

δy= (yy)2=
15.
41

ρ=cov(
x,y
)= 55.
5 =
0.
995

δxδy 3.
61x

37
 .
15.
41 .

MULTI
PLEREGGRESI
ON

Thisinvol
vesthr
eeormorevar
iables.Ther eissti
lladependent
vari
ableybutnowther
earet
woormor ei ndependentvar
iabl
es.The
funct
ionforyi
nmulti
pler
egr
essionisgivenby ;

y
=a+b1x
1-1-
b2x
2

I
fyoumul
ti
plyt
hroughby
38
 .
x
1
.

39
 .
.
x
1y=ax
1+
.
.
b1x2
1+

b2x
1x2

I
fy oumul
ti
plyt
hroughby
X2

X2y+ax2+b1x
1x2+b2x
2
2

Thenthenor
mal
equat
ions
become;

1 2
yanb1 x =b x2……………………………………………….
1

40
 .
.
.
2
 x1y=a x1+b1 x1 +b2 x1x2………………………………….
2

2
 x2y=a x2+b1 x1x2+b2 x2 …………………………….
3

Exampl
e

Mr Orinathemark eti
ngmanagerofLainguli
mi tedisconcernedabout
thesal esbehavi
orofhi spr oduct
.Hereali
zest hattherearemany
factorst hatmayhel pex
plainthesal
esbehaviorbutbeli
evesthat
adv erti
si
ngandpr icesarethemajordet
erminants.Hehascol l
ect
ed
thef oll
owingdata;

41
 .
.
.
.

Sal
esi
n 33 61 70 82 17 24

Ad
unv
i
te
sr
ti
si 3 6 10 13 9 6
ng

(No
Prices 125 115 140 130 145 140
of
(sh)
adv er
ts)

Requi
red;

30
 .
.
Det
ermi
n.
ether
egr
essi
onequat
iont
opr
edi
ctsal
esf
rom
adv
ert
isi
ngandpr
ices

I
fadv
ert
isi
ngi
s15andpr
icei
s142howmanyuni
tswoul
dbesol
d?

Sol
uti
on;

31
 .
.
.
Thedepe.
ndentv
ari
abl
eissal
esi
nuni
ts(
y)andt
hei
ndependent
v
ari
abl
esar
eadv
ert
isi
ng(x
1)andpr
ices(
x2)
.

X1 x
2 Y x
1y x12 x1x x
2y x
22

3 125 33 99 9 375 4125 15625

6 115 61 366 36 690 7015 13225

10 140 70 700 100 1400 9800 19600

13 130 82 1066 169 1690 10660 16900

9 145 17 153 81 1305 2465 21025

6 140 24 144 36 840 3360 19600

287=6a+47bi
+795b2

2528=47a+43I
hl+6300b2

32
 .
.
.

37425=95a—63}
bl—1O5974b2Sol
vi
ngsi
mul
taneousl
y
a=219.
6bl=6.
366

b2=-
l.67

I
fv=a—bx+b2x
2then;

33
 .
.
.
v
=219. .
76+6.
366x
1-
1.
67x
2

I
fadv
ert
isi
ngi
s15andpr
icei
s142t
hen

Y=219.
76-
t-
6.366x15+-
1.67x142

Hencesal
es78.
11

Li
mit
ati
onsofr
egr
essi
onanal
ysi
s

1.Li
nearregressi
on i
mplements a statist
icalmodelthat
,
whenrelat
ionshi
psbetweentheindependentvar
iabl
esandthe
dependentvari
abl
earealmostl
inear,showsopti
mal r
esul
ts.

2.Li
nearregr
essionisof
teni
nappr
opr
iat
elyusedt
omodel
non-
li
nearr
elat
ionshi
ps.

34
 .
.
.
v
=219. .
76+6.
366x
1-
1.
67
3x2i
.Lnearr
egr
essi
oni
sli
mit
edt
opr
edi
cti
ngnumer
icout
put
.

4.Al
ackofex
planat
ionaboutwhathasbeenl
ear
nedcanbeapr
obl
em.

EXERCISE
Quest
ionOne

35
 .
.
Cal
cul
at.
e.
ther
egr
essi
onequat
ionofXandYandYonXf
rom t
he
f
oll
owi
ngdat
a:

X 1 2 3 4 5

Y 2 5 3 8 7

Quest
ionTwo

I
nthefol
l
owingtabl
ear
er ecordeddat
ashowingthetestscor
es
madebysal
esmenonanint
ell
igencet
estandt
hei
rweeklysal
es:
-

Sal
esmen 2 3 4 5 6 7 8 9 1
1 0

Testscor
es 70 50 6 80 5 90 4 6 6

36
 .
.
.
Sales 2.
5 4. 5. 4. 2. 5. 3. 4. 3
(sh000) 6.
0 0 0 0 5 5 0 5 .
0

Cal
cul
atet
heregr
essi
onli
neofsal
esontestscor
esandesti
matethe
pr
oabl
eweekl
ysalesv
olumei
fasalesmanmakesascoreof100.

37
 .
.
.
.

Quest
ionThr
ee

38
 .
.
.
Youhav
ebeenpr
esent
edwi
tht
hedat
abel
ow

Uni
ts 24 27 30 33 36

of
Cost 2,
000 2,
200 2,
400 2,
450 2,
500

out
put(
x)

Requi
red:

39
 .
.
i .
.
.comput
eal
i
nearcostf
unct
ion

i
i
.Comput
ethet
otal
costi
f80uni
tsar
epr
oduced.

Quest
ionFour

Thefoll
owi
ngdatarelat
estoMeldinCo.
Ltdinrel
ati
onst
osal
esand
costofadv
ert
isementfort
heyearended3jtMay2010.

Sal
es(
y 170 240 260 300 220 250
)

Cost 20 40 50 60 30 40
(
sx
)
h.000

40
 .
.
.

Requi
red:

i
.Computetherel
ati
onshi
pbetweensalesandcostof
adver
ti
sement.i
i
.Forecastf
orsal
esifsh.60,
000isspenton
adver
ti
sement.

i
i
i.whatwoul
dbet
hef
orecastsal
esi
fadv
ert
isementcosti
ssh.100,
000

Quest
ionFi
ve

41
 .
.
.
.
AbelMot
orsspeci
ali
zesi
nthei
mpor
tandsal
eofspor
tscar
sin
Kenya.The
marketi
ngmanagerhasbee;anal y
zingthedemandf orsport
scar
overthelastthr
eeyear
s.Thet
ablebelowshowsthequarter
ly
demandf orthespor
tscar
sandtheseasonalmul
tipl
i
cati
veindexf
or
eachquarter.

Numberofspor
tscar
demanded

Year Quar
ter Quar
ter Quar
ter Quar
ter
1 2 3 4
2007 8 17 12 6

2008 12 20 17 9

2009 16 28 25 14

Mul
ti
pli
cat
iv 0.
9093 1.
434 1.
1234 0.
5317
e

i
ndex

42
 .
.
.
.
AbelMot
orsspeci
ali
zesi
nthei
mpor
tandsal
eofspor
tscar
sin
Keq
R ny
ua
i
r.
eT
dhe

a)Al
i
nearr
egr
essi
onequat
ionf
ordemandf
orspor
tscar
s

b)Forecastthequar
ter
lydemandf
ort
hey
ear2010usi
ngt
he
l
inearregr
essi
oncars

43
 .
.
.
.
c)Deseasonaj
i
set
hedemanddat
aoft
hespor
tscarusi
ng
seasonal
mul
ti
pli
cat
ivei
ndi
cespr
ovi
ded.

d)Fi
tali
nearr
egr
essi
onequat
iont
othedeper
sonal
i
zed
demandi
n©

abov
e

e)Usethetr
endequat
ioni
n(d)abovetodet
ermi
nethe
seasonal
l
yadj
ustedfor
ecastf
ordemandofeachquar
teri
n
2010

f
)Gi vetheactualsal
esf ort
heyear2010tobe21, 32,
28and20
sport
scarsforquarters1,
2,3and4respect
ivel
y,det
ermi
ne
whichoftheforecastsin(
bOor(cOabov ewouldbepref
err
ed.

CHAPTERTWO

BUI
LDI
NGBLOCKSOFFI
NANCI
ALFORECASTI
NG.

Therei
snost andardf i
nancesystem f
ororgani
zati
ons.Butthere
aresomebasicbui l
dingblocks,whi
chmustbei nplacetoachieve
goodpract
iceinfinancialmanagement.Theyincl
ude:

Account
ingr
ecor
ds

Ev
eryor
gani
zat
ionmustkeepanaccur
ater
ecor
doff
inanci
al

44
 .
.
t
ransact
i.
onst
hatt
akepl
acet
oshowhowf
undshav
ebeenused.
Accountingrecor
dsal
soprovi
deval
uabl
einf
ormati
onabouthowt
he
organi
zationisbei
ngmanagedandwhet
heriti
sachi
evi
ngits
object
ives.

Fi
nanci
alpl
anni
ng

Fi
nanci
alpl
ans(budget
s)mustbel
inkedtot heor gani
zat
ionsstrat
egi
c
andoper
ati
onalpl
ans,t
hebudgeti
st hecornerstoneofanyfinanci
al
managementsy
stem andpaysani
mpor tantroleinmonitori
ngtheuse
oft
hefunds.

Fi
nanci
almoni
tor
ing

45
 .
.
Pr
ovi .
.
dedt
heor
gani
zat
ionhassetabudgetandhask
eptand
r
econci
l
editsaccount
ingr
ecor
dsi
nacl
earandt
imel
ymanner
,iti
s
t
henpossi
bleandeasy

toproducefi
nanci
alreport
swhichall
owthemanagert
oassesst
he
progressoft
heorganizat
ionagai
nstthepl
ans.

I
nter
nal
cont
rol
s

I
nter
nalcont
rolsaremechani
smstoenhancecont
rol
s,checksand
bal
ancesinorgani
zat
ioni
nordert
o:

-
Saf
eguar
dtheasset
s

-
Managei
nter
nal
risk

-
Det
eroppor
tuni
sti
cthef
torf
raud

-
Todet
ecter
ror
sandomi
ssi
onsi
naccount
ingr
ecor
ds.

(
a)Pr
ofor
maFi
nanci
alSt
atement
s.

Fi
nanci
alst
atement
swhicharemeanttodi
spl
aytheeffect
soffut
ure
ci
rcumst
ancesaredescr
ibedaspr
ofor
mastat
ements.Therear
eno
46
 .
.
r
igi .
dsetofr
ulesf
orconst
ruct
ingpr
o-f
ormast
atement
s.Thust
he
f
ormat
svar
ywi
tht
hei
ngenui
tyoft
hef
inanci
alexecut
ives.

Therear
et wotypesofpr
oformafi
nanci
al
st
atements.Theyarei
)Pr
ojectedi
ncomest
atement

i
i
)pr
oject
edbal
ancesheet
.

PROJECTEDI
NCOMESTATEMENTS.

Thi
sstatementisaproject
ionofi
ncomeforaperi
odofti
mein
fut
ure.
Inotherwords,proj
ectedi
ncomestat
ementisast
atement
whichfur
nishesa

f
airandr
easonabl
eestimateofexpect
ed
r
evenue,
cost
,pr
ofi
ts,
tax
es,di
vi
dendsandotherf
inanci
ali
tems.

47
 .
.
Thi
sst
at.
e.enti
m sbui
l
tar
oundt
heest
imat
eoft
heex
pect
ed
sal
esf
ort
hef
orecastper
iod.

Thesalesmaybeesti
matedonthebasi
softhedet
ail
edanal
ysi
s
ofcompeti
ti
vefi
rms,mar
k etr
esear
chandpr
ofessi
onal
economicsur
veys.

Producti
oncostcanbeesti
mat edonthebasisoftheformul
ated
producti
onschedul
e.Butt
hiscanbeaccuratelypr
edict
edthrough
thedetai
ledanal
ysi
sofpurchases,pr
oduct
ivewagesandov erhead
costs.

Thefinanceshoul
dalsoestimatetheadminist
rat
iveandsell
i
ng
expenses.Asbothofthem areusual
lybudgetedbefor
ehand,thei
r
esti
mat esar
eseldom cor
rect.

Theest i
matesshouldalsobemadef orot heri
ncomesand
expensesalongwithint
er estforcomput i
ngnetincomebefor
e
taxes.Forcal
culat
ingneti ncomeaftert axes,i
ncome-t
axesatthe
prescri
bedrateshouldalsobededuct ed.

Div
idendpaymentshouldbepredeter
minedattheappr
opri
ate
l
evel.
Suchpaymentsarerequi
redtobedeductedfr
om the
esti
matedneti
ncome/profi
taftert
ax.

Atypicalf
orm ofpr
oject
edi
ncomest
atementwi
thi
magi
nar
y
f
iguresisshownbelow:

Pr
oject
edI
ncomest
atement
48
 .
.
.
Fort earended31stDecember2002
hey

Rev
enue/
Sal
es 1600000

Ex
penses

Costofgoodssol
d

Rawmat
eri
als 400000

Di
rectwages 600000

49
 .
.
.
.
Fact
oryov
erheads 1000001100000

Gr
ossPr
ofi
t 500000

I
nter
est 20000
Admini
str
ati
veexpenses 80000
Sel
li
nganddist
ri
buti
onexpenses 60000

Depr
eci
ati
on 40000200000

Operat
ingPr
ofi
t/NetI
ncomeBef
ore 300000
Tax
LessTaxes50% 150000 Pr of
itaf
ter
t
ax/
Netincome 150000

Add:Ret
ainedEar
ningsb/
d 50000

200000

Less:
Div
idends 100000

Ret
ainedEar
ningsC/
D100000

40
 .
.
Al
t
.
houghpr
ofor
mai
ncomest
atementmayser
veasa
sat
isf
act
oryesti
mateofprofi
tsforthepr
oject
edper
iod,
itdoesnot
ser
veasadev i
cetocont
rolexpenses.

PROJECTEDBALANCESHEET

Theproject
edbal ancesheetisessent
ial
l
yaf orecastofexpected
fundf
lows.It
sconst ruct
ionisbasedontheinformati
onav ail
ablei
n
thepr
ojectedincomest atementtoget
herwithsupportingschedul
es
andbudgets.Thef oll
owingstepsarei
nvolv
edi nit
spr eparat
ion:

41
 .
.
a)
Cal
cul
a.
.
ti
onoft
heneti
nvest
menti
neachoft
heasset
soft
he
companyt
ocar
ryoutoper
ati
onsatt
hepl
annedl
evel
ont
het
arget
dat
e.

b)
Calcul
ati
onofthenetwor
thofthecompanyaft
eradjusti
ngthe
pr
oject
edincomeofthecompanyfrom t
heper
iodofforecast
ing.

c)Li
sti
ngoft heliabil
i
tiesthatcanberel
ieduponwithout
negotiat
ion.d)Compar isonofthepr
ojectedasset
swiththet
otal
sourcesoff unds,i
.e

l
i
abi
l
iti
esandnetwor
th.

I
nter
pret
ati
onofPr
oject
edBal
anceSheetI
tems

(a)Fi
xedAsset s-
Asout laysofplantandmachi neryaregenerall
y
plannedbef or
ehand, t
heamountoff i
xedasset scanbeest imated
withoutmuchdi ff
icult
y.Howev er
,adj
ustmentsar etobemadef or
additi
onsandsal esofol dassetsalongwiththeamountof
depreciati
on.Otherassetssuchaspr epai
dexpenses, patents,
goodwi
l
l
etcwillremainast heyareunlessitisspeci
fi
cal l
yment i
oned.

(
b)Cur
rentAsset
s.

(
i) Cash-Usuall
yaminimum amountofcashi stobe
maintai
nedinhandformeet i
ngv ari
ousneedsofthefi
rm.
I
tcanal sobeabalanci
ngorplugf igur
etoequal
izeasset
s
andli
abili
ti
es.Thi
sispart
icul
arlythecasewhen
borr
owingsf r
om banksaretakenasf i
xed.

(
ii
) Sundr
yDebt
ors(
Account
sRecei
vabl
e)-
Sal
esbudgetcanbe

42
 .
.
.
usedt
ofor
ecastt
hemagni
tudeofdebt
ors.Howev
eri
t
dependsont
henumberofdayscr
edi
tisal
l
owedto
customer
s.I
tcanbecomput
edwitht
hehelpofaf
ormul
a;

(
ii
i) I
nvent
ori
es—Thei
nvent
oryl
evel
inr
elat
iont
opr
oduct
ion

pr ogrammei sauniqueit
em i
ntheproj
ectedbalancesheet
.
Itsestimateismadeont hebasi
softur
nov err
atioor
thr oughcaref
ulest
imatesofpur
chase,pr
oductionand
sel li
ngschedul
es.I
tiscomputedasunder:

St
ockt
urnov
err
ati
o=

43
.
.
.
.Li
© abi
l
iti
es

1.Shar
ehol
der
sfunds/
net
wor
th:
Itconsi
stsoft
heamountof
share

capi
tal andreserv
esandsur pl
us(fi
x edasset spl uscur r
ent
assetsmi nuscurrentandl ongt erml iabil
it
ies).Shareholders
fundshoul dbecomput edbyt akingi ntoconsi derationthe
i
temssuchasf reshi ssueofshar es, redempt ionof
pref
erenceshar esandr etainedear ningsf rompr ofi
taswel l
.
Thepr ofi
tfigur
esar etak enf romt hepr oj
ectedi ncome
stat
ement .Incaset herei sal l
ocati
onofpr of i
ttor eserv
e, i
t
canbei ncorporat
edi nther espectiver eserves.

2.Cr
editor
s-Theycanbeest i
matedbyanal yzi
ngschedul
es
ofpurchases,paymentsfortheper
iodorbyascer t
aini
ng
therat
ioofaccountspayablewithpurchasesorcostof
goodssold.Credi
torscanbecomput edasf oll
ows:

44
.
.
.
3.
Out
standi
ngLi
abi
l
iti
es-
Out
standi
ngoraccr
uedl
i
abi
l
iti
es
canbeanalyzedbyexaminingthepatt
ernofwagepay ment,
taxpaymentsandint
erestobli
gati
ons.Pastandfut
uredata
rel
ati
ngtotheseit
emsshoul dalsobeconsider
edforthi
s
purpose.

4.Pr
ovisi
onf ort
axanddivi
dends:Thepr ojectedbalance
sheetshouldbeprepar
edonlyafterprovidingproper
provi
si
onf ortax
esanddivi
dends.Howev er,thesei
temsal so
dependonpastandf ut
uredata,t
her ateoft axanddividend
etc.

Hav i
ngesti
matedall
thecomponent softheproject
ed
balancesheet
,t
hefi
nanci
alananal y
stshouldcombi neand
presentt
hem inabal
ancesheet.Furt
her,
all
thebalancesheet
i
temscanbeest imat
edbyprojecti
ngf i
nancial
rati
osforthe
futur
e.

45
.
.
.
.
I
ll
ust
rat
ion1:

(
b)CashBudget
Cashbudgetisoneoft hemostimportanttool
sinthe
budget
arykitofthefi
nancial
execut
ive.I
tisprepar
edto
esti
matetheex pect
edcashrecei
ptsandpay mentsduri
nga
speci
fi
edper i
odinfut
ure.

46
 .
.
.
Thuscashbudgeti
saf
orecastofhowmuchcashwi
l
lbe
requi
reddur
ingapart
icul
arper
iodi
nfut
ure.Howeverthe
esti
matesaremadeonadayt oday,
weekt oweekor
monthtomont hbasi
sdependi
ngontherequi
rementof
cash.

Thefol
lowi
ngar ethemai nobj
ecti
vesofprepari
ngacash
budget:
(i)
Toensur etheavai
labi
li
tyofadequateamount
ofcashforthepurposeofvari
ouscapit
alandrevenue
expendi
tures.

Toarrangecashi
nadv
ancei
nthecaseofexpect
ed
shor
tageoffunds

Toemploysurpl
usamountofcashifanyi
nany
pr
ofi
tabl
einvest
mentout
sidethebusi
ness.

Benef
it
sofPr
epar
ingCashBudget

Thevari
ousadvant
ageswhi
chcanbeder
ivedf
rom t
hecash
budgetar
easfoll
ows:

47
 .
.
.
.
Cashr
equi
rement
s:Thecashbudgetpr
ovi
desacl
earpi
ctur
e
aboutt
hequant
um ofcashr
equi
rement
satapar
ti
cul
armoment
ofti
me.Thi
s

hel
psthefi
rmt
omakenecessar
yar
rangement
sforv
ari
ous
pur
pose.

Addi
tionalcashrequi
rements:Thecashbudgetalsoi
nfor
ms
thefi
rmt hequantum ofaddit
ional
cashrequi
rementduri
ngthe
peakperiod.Ital
sosuggeststhewayinwhichsuchfundsar
e
tobemobi li
zed.

Def
ici
torSurpl
us:Theresul
tofcashbudgeti
seit
hersur
plusor
def
ici
tcash.Thussur
pluscashifanycanbei
nvestedpr
operl
y.

Cashdiscountfi
rm canderi
vethebenef
itofcashdi
scountby
makingpaymentsbef or
ethedateasthesurpl
usamountof
cashcanbek nownbyt heprepar
ati
onofcashbudget.

Methodsofpr
epar
ingcash
budget

Acashbudgeti
spr
epar
edi
nanyoft
hef
oll
owi
ng
ways:

 Recei
ptsandpay
ment
smet
hod
48
 .
.
.Theadj
 ust
edpr
ofi
tandl
ossmet
hod

 Thebal
ancesheetmet
hod

Forshortter
mf orecast
ing,t
herecei
ptandpaymentmet hodisver
y
usefulastheinf
lowandout fl
owofcashcanbeest i
mat edbya
properanaly
sisunderthismethod.Howevert
headjustedprofi
tand
l
ossmet hodandt hebalancesheetmethodareuseful
forlongterm
forecast
ing.

Recei
ptsandpayment
smet
hod

Underthismethod, allt
healltheanti
cipatedcashr eceiptsand
paymentsdur i
ngt hebudgetper i
odareconsi dered.Inotherwords
theesti
matesofsal es,purchases,pr
oductionetcformt hebasisof
cashbudget.
Itconsi dersonlycashreceipts,regar
dlessoft heir
natureandperiod.Simil
arl
y,i
trecogni
zespay ment sirrespect
iveoft
he
parti
cul
arpointoft i
meatwhi chtheli
abil
ityforexpendi t
ureari
ses.
Mor eov
erthenat ureofcashpay mentisal so

49
 .
.
i
rr
elev .
.
ant
.Buti
sneedl
esst
opoi
ntoutt
hatt
heaccr
ued
expensesandi
ncomesar
enott
obeconsi
der
edatal
li
nthi
s
budget.

Underthi
smethod,
thebudgeti
sdi
vi
dedi
ntot
wopar
ts;
r
ecei
ptsandpayment
s.

Therecei
ptspartofthebudgetisconstructedinaccor
dancewiththe
sal
esbudget,asthechiefsourcesoffundsar efr
om sal
es.Butthe
paymentspartofthebudgetisconstr
uct edasperotherf
uncti
onal
budgets.

Thecashbudgetpr
eparedundert
hismet
hodpr
ovi
dest
he
fol
l
owingi
nformati
on:

I
nfor
mat
ionastothequant
um ofsal
estobemadeandal
soabout
t
heti
me-lagi
nthecaseofcredi
tsal
es.

I
nfor
mationabouttherawmater
ial
stobebought
.Thi
sis
f
urni
shedfrom pur
chasebudget
.

I
nfor
mati
onaboutt
hetot
alamountofwagest
obepai
dand
t
helagi
npaymentofwages.

I
nfor
mati
onaboutt
heamounttobepai
dforv
ari
ousov
erheadsand
t
helagi
npaymentofov
erheads.

I
nfor
mat
ionaboutt
hecostt
obeconsi
der
edf
oracqui
ri
ngf
ixed
50
 .
.
asset
s. .
Thi
sisr
equi
redf
orpr
epar
ingcapi
tal
expendi
tur
ebudget
.

Allotheri
nf or
mationrel
atingtorecei
ptssuchasissueofshares,
overdraft
s,etcandpayment ssuchasdivi
dend,
taxati
on,
repayment
ofloansetcar ealsoavai
lablefr
om cashbudget.

I
ll
ust
rat
ion1

51
 .
.
.
.

Adj
ust
edpr
ofi
tandl
ossmet
hod

Adjustedprofi
tandlossmethodispracti
cal
lyuseful
forlongterm
forecast
ingwhichattempt
stoindicat
etheeffectofproposedlong
rangeplanssuchasacquisati
ons,
newpr oductdevel
opmentandl ong
rangechargesont hecompanysbalancesheetthr
ee,f
ive,
oreventen
yearsinthefutur
e.

Themethodi
sbasedontheassumpti
onthatpr
ofi
tisequi
val
entt
o
cashandbot
hcashandnoncashtr
ansacti
onsareconsi
der
ed.

I
ll
ust
rat
ion:

Bal
ancesheetmet
hod

Inthi
smet hodabudget
edbalancesheeti
spreparedbyrecor
dingal
l
expectedasset
sandexpect
edliabi
l
iti
esexceptcash.I
ncasethe
52
 .
.
l
i
abi
l
ites.
i si
dei
smor
ethant
heasset
ssi
de,
thedi
ff
erencewi
l
lbe
cashbalance.Onthecontr
ary
,ift
heasset ssi
deishi
ghert
hant
he
l
iabi
li
ti
esside,thebal
ancewil
lrepresentbankov
erdr
aft
.

Thi
smet hodi
shighl
yuseful
forl
ongt
erm
for
ecast
ing.I
ll
ust
rat
ion1.

OTHERMETHODSOFFINANCI
ALFORECASTI
NG
Per
cent
ageofsal
esmet
hod

I
tist
hesimplestf
orecast
ingt
echni
queandi
ssui
tabl
efor
l
ongter
mf or
ecasti
ng.

53
 .
.
Thi .
smet
h.
odi
scommonl
yusedi
nest
imat
ingt
hef
inanci
al
r
equi
rement
soft
hef
ir
m basedonf
orecastofsal
es.

Underthismethod,
eachcomponentofbalancesheeti
tem i
s
expr
essedi nt
ermsofpercent
ageofsales.Fi
nanci
aldatacannow
bedevelopedforpr
oject
edsal
esatdif
ferentl
evel
s.

BUDGETI
NG

Cour
seobj
ect
ives

Themai nfocusforbudgeti
ngisinpl
anning.Thisrepr
esentssteps
takenbyabusinesst oachi
evethei
rdesir
edlevelsofprofi
ts.
Thisisin
partbyprepari
nganumberofbudget swhichwhenputt oget
herforms
anintegr
atedbusinessplanof
tenrefer
redtoasmast erbudget.

Themasterbudgetisavit
almanagementtool
that
communicatesmanagementplanthr
oughoutt
heorgani
zat
ion,
al
locat
eresourcesandcoordi
nat
eacti
vi
ti
es.

I
nbudgeti
ng,weoftenident
ifyali
mit
ingfact
or;
thisbei
ngaf
act
orat
anygi
venti
meeffecti
velyconst
rai
ntstheact
ivi
ti
esofthe
54
 .
.
or
gani .
zat
ionoft
hecust
omer
sdemandorpr
oduct
ioncapaci
ty,
l
abourshor
tagesorshor
tagesofmat
eri
alsspaceorf
inance.

Profi
tcentr
eisasecti
onorpartoftheorgani
zat
iont
hati
s
accountabl
eforbot
hcostsandrevenues.

Budgetcent
rei
sasectionofanent
it
yforwhi
chcont
rol
maybe
exer
cisedandbudget
sprepar
ed.

Costcentr
eisanident
if
iabl
esecti
onorpar
tofor
gani
zat
ionf
or
whichcostsmaybeaccumulated.

Budgetdef
ini
ti
on:

55
 .
.
Aquant
i.
f
i.
abl
eex
pressi
onofapl
anofact
ionpr
epar
edi
nadv
ance
oft
heper
iodt
owhi
chi
trel
ates.

-Aquanti
tat
ivestat
ementforadef
inedwhi
chi
ncl
udesr
evenue
expensesassetsli
abi
l
iti
es.

Iti
ncludesbot
hfi
nanci
alandnonfi
nanci
alaspect
soft
heplanandi
t
servesasabluepr
intf
ortheor
gani
zati
ontofoll
owint
heupcoming
peri
odahead

Abudgetmaybepreparedf
ortheorgani
zat
ionasawhol
eorfora
depart
mentorasfi
nanci
alr
esourcesi
temsofcash,
capi
tal
expendi
tur
eetc.

Budgetprovi
desforaplanorthef
orecastf
ortheorganizat
ion,
ai
dincoor di
nat
ioninacti
vi
ti
esandfaci
li
tat
escontr
ol and
pl
anning.

Planni
ngismaki ngofobj
ectiv
esandprepar
ingbudget
st oachi
eve
thoseobj
ecti
v es.Thi
sisaccompl
ishedbyuseofamast erbudget
(fi
xedorstat
ic)

Controlrepresentst
hest epstakenbymanagementtochangethe
l
ikeli
hoodt hatthepl
anssetatt heplanni
ngst
ageareatt
ainedand
thatall
par t
soft heorganizat
ionareworki
ngt
ogethert
owardsthat
goal.

Cont
roli
sexer
cisedbycompari
ngact
ivi
ti
escostr
evenueswi
th
amounti
nthefl
exibl
ebudget
.
56
 .
.
.
Avari
anceisthedif
ferencebetweenbudgetedresult
sandt he
act
ualoutcome.Afavorabl
evari
ancear i
seswhenact ual
costare
l
essthanthebudgetedcostswhileunfavor
ablevar
ianceari
ses
whenactualcost
sex ceedthebudgetedcosts.

Companiespr epar
elongter
mst rategicplansspari
ngaperiodoffi
ve
totenyear
st hatprov
idearoadmapf orthefut
ureregar
dingpotent
ial
opport
unit
iesasnewpr oducts,
mat erial
sorinvestment
s.Theyare
thenfi
netunedandbr okendowni ntomedi um andandshortter
m
plans.

Shortterm pl
ansaremoreoperati
onal
innatureandtransl
ate
str
ategicplansint
oacti
onsthatar
efai
rlyconcret
e.Theyalsocont
ain
specif
icobjecti
vesandgoal
s.

57
 .
.
BudgetA.
.
dmi
nist
rat
ion.

Itr
eferstotheappropri
ateadmini
strat
iveproceduresputinplaceto
ensurethatthebudgetworksappropri
ately.I
tshouldbetail
oredto
aparti
cularorgani
zati
onanditsci
rcumst ances.

Ther
earethreeel
ementsinbudget
admini
str
ati
on:Budgetcommit
tee

BudgetRepor
ti
ng

Budgett
imi
ng

Abudgetcommi tt
eeoverseasthepreparat
ionofabudget.Budget
s
shouldnotjustbehandeddownast opmanagementf i
nalwor
d.
Budgetf i
guresandesti
matesar eusual
lymor ehelpf
ulwhen
developedthroughabottom-upapproachinwhi chever
ydepart
ment
preparethei
rownbudgetwhi chisthenhandedov ertobudget
commi tteef
orscruti
ny,moderati
onandappr oval.

Thecommi t
teei
smadeupofdepar t
mental
headsandother
executi
veswhoarer
esponsi
bleseei
ngt
hatbudget
aryamountsar
e
real
ist
ic.

Thereisneedforcont
inuedcommunicationfr
om theorigi
nat
ing
depart
ment sandthebudgetcommit
teet oensur
et hatbot
hparti
es
acceptthebudgetandesti
matesar
er easonabl
e,attai
nabl
eand
desi
rable.

58
 .
.
Budgetr
e.
por
tscont
ainr
elev
anti
nfor
mat
iont
hatcompani
esact
ual
resultst
oplannedobj
ectiv
es.Theymaybepr eparedatanyt
imeand
foranyperi
od.Theyhighl
ightvar
iancesbet
weenact ual
andbudget
ed
targetswhi
chmaycall f
orinvest
igat
ionandifneedberemedi
al
action.

St
epsi
nbudgetpr
ocess.

1).
Communi
cat
ingdet
ail
soft
hebudget
ingpol
i
cy.

2)Det
ermi
net
hef
act
orst
hatr
est
ri
ctper
for
mance.

3)Pr
epar
ethesal
ebudget
.

4)Pr
epar
ethei
nit
ial
budgetf
rom t
hesub-
uni
tsoft
heor
gani
zat
ion.

59
 .
.
.
.
5)Negot
iat
ethebudgetwi
thsuper
visor
s.

6)Coor
dinat
ionofr
evi
ewofbudget
s.

7)Summar
isi
ngt
hesect
ionbudget
sint
oamast
erbudget
.

8)Budgetr
evi
ewdoneper
iodi
cal
l
y.

Ty
pesofBudget
s.

1.St
rat
egicpl
an-
set
stheov
eral
lgoal
sandobj
ect
ivesoft
he
or
gani
zati
on.

2.Longr angeplans-Resul
tfr
om str
ategi
cplanandproduces
forecastfi
nancialst
atementsspari
ngfiv
etotenyears.Such
plansinvolv
emaki ngdecisi
onsofdesignandall
ocationofnew
plant,acqui
sit
ionofitemsandbuil
dings,l
ongter
m
commi t
mentset c

3.Capi
tal
Budget
s—Detai
l
stheexpendi
tur
ef orf
aci
li
ty
r
equi
rement
,newpr
oductandotherl
ongterminv
estment
s.

4.Mast
erBudget-Oneyearort welv
emonths,
summar i
zeal
l
t
heacti
vi
ti
esofallsub-unit
sofanorgani
zat
ionacr
ossall
the
f
unct
ionse.
g.f
inance,producti
on

5.Conti
nuousorRol
li
ngbudget—Commonf
orm ofamast
er
budgett
hataddsamonthoraquar
ter

6.Fixedbudget—onedesignedtor emai
nunchangedir
respect
ive
ofthevolumeofoutputachievedtheperi
oditr
elat
esto.I
tis
theref
orebasedonasinglepredeter
minedamountofsalesor
output.Thepur
poseofast ati
cbudgeti
stohelpmanagersin
50
 .
.
pl.
anni
ngf
utur
eact
ivi
ti
est
heor
gani
zat
ion.

7.7.Flexiblebudget s-
Desi gnedt oadjusttot heper mittedcost
l
ev el
ssoast osui tthelevel ofactivi
tythatisattained.
Designedt or ecogni zev ari
ousbehav i
orpat ter
nschangeand
changeofv olumeofact ivi
ty.It
sar eportbasedonpr edicted
amount sofr evenuesandex pensescor respondingt ot he
actuallevelofout put.Unlikefixedbudgetf lexi
blebudgeti s
preparedaf tert heper i
odsact ivit
iesarearecompl ete.Inor der
toprepar ei
t, onemustanal yzecostasf i
xedorv ar i
able
element ssot hatthebudgetmaybef lexedorchanged
accordingtot helevel ofactivi
ty.Thepur poseofaf lexible
budgeti s

51
 .
.
t
oh.
.
el
pmanager
sev
aluat
epastper
for
mancewhi
char
e
usedi
nthecont
rol
process.

Component
sofamast
erbudget
.

i
. Operat
ingbudget—focusesontheincome
stat
ement.
comprisesofsal
es,pur
chases,
andproducti
onbudget
,
costofsal
esbudget,oper
ati
ngexpensesandbudgetedincome
stat
ement.

i
i
. Financialbudget—repr
esentt
hatpar
tofthemast
erbudget
focusingont heeff
ectofoper
ati
ngbudgetandot
herpl
ans
whichi nv
olvecost.

Appr
oachest
oover
comi
ngPr
obl
emsi
nbudget
ing

1.1.
Zer
obasedbudget
ing

2.2.
Act
ivi
tybasedbudget
ing

3.3.
Rol
l
ingorcont
inuousbudget
ing

Zer
obasedbudget
ing

Allact
ivi
ti
esarere-
eval
uat
edever
ytimeabusi
nessisf
ormulat
ed.
Eachtri
albudgetbegi
nswit
htheassumpt
iont
hatthef
unct
iondoesnt

52
 .
.
exi .nychangei
standa ncashmustbej
ust
if
iedbyi
ncr
ement
albenef
it
.

Usef
ulf
ordi
scr
eti
onal
l
yspendi
ngegadv
ert
isi
ngcost
s.

Adv
ant
ages

1)Itr
esul
tsinmoreeffi
ci
entresour
ceall
ocat
iont
oact
ivi
ti
es
especi
all
ywhenproperl
ycarri
edout
.

2)Itf
ocusesatt
entiononval
ueformoneyandmak es
expli
ci
tther
elat
ionshi
pbetweenresour
cesusedand
output.

3)I
thel
psi
nfur
ther
ingaquest
ioni
ngat
ti
tudeandel
i
minat
esnon

pr
oduct
iveoper
ati
ons.

4)Ital
soprovidesasystemati
cwayofchal
l
engi
ngthestat
us
quo—itobli
gest heor
ganizat
iont
oexami
neal
ter
nati
ve
acti
vi
ti
es,exist
ing

53
 .
.
.
.
behav
iorpat
ter
ns.Pr
ovi
desat
ool
thatr
esponds
t
ochangesi
ntheenv
ironment
.

Demer
it
s

Notalwaysacceptabl
etostaffandtradeunionswhomayprefer
cozybutexpensi
vestatusquo.Theymayv i
ewadet ai
l
ed
examinat
ionofalt
ernati
vesasat hr
eatinst
eadofchall
enge.

ZBBi
sdi
ff
icul
ttosel
ltomanager
sfort
wor
easons:

1.I
ncrement
alcost
sandbenef
it
sov
eral
ter
nat
ivemet
hodscan
l
eadtoquant
if
yaccur
acy.

2.Tradeuni
onswillr
est
rictmanagementi
deast
hatchange
waysinwhichbudget
ingisdone.

3.Theapproachi
sti
meconsumi
ngandf
eat
uresal
otof
paper
work.

54
 .
.
.
CHAPTE.HREE
RT

VERTI
CALANDHORI
ZONTALRELATI
ONSHI
PSAMONG
PARAMETERSOFFI
NANCI
ALSTATEMENTS

Obj
ect
ives:
att
heendoft
hel
ect
uret
hest
udentshoul
dbe
abl
eto

I
denti
fythemaj
orchanges(
tur
ningpoi
ntsi
ntr
endsamount
s
r
elat
ionshi
p)

Commonsi
ze
anal
ysi
s

Commonsizeanalysi
sinv
olvesexpressi
ngcompari
sonsin
per
cent
agesforexamplei
fcashisksh.40,000andt
otal
asset
sisksh.
1,
000,
000,t
hencashis

4%oftot
al
asset
s.

55
 .
.
.

Theuseofper
cent
agei
susual
l
ypr
efer
abl
etot
heuseofabsol
ute
fi
gur
es.

e.gifafi
rm Aear nsshs.10,
000andf ir
m Bear nsks.
1,000whichis
moreprofi
table?Fir
m A probabl
yy ourresponse.Howev er
,the
tot
alowner sequi
tyofAi sksh.1000,000andBsi sksh.10,000the
ret
urnonowner sequit
yisasfoll
ows

Fi
rm A f
ir
mB

Ear
nings sh.
10,000=1% sh.
1,000=10%
Ownersequi
ty sh.
1,000,
000 sh.
10,
000

56
 .
.
.
.

Theuseofcommonsi zeanalysi
scanmak ecompar
isonsof
fi
rmsofdi f
fer
entsi
zesmuchmor emeani
ngsi
ncet
henumbersar
e
broughtt
oacommonbase; per
fect.

Vert
ical
anal
ysis

Inver
ti
calanal
ysi
s,af
igur
ef r
om ay
eari
scompar
edwi
thabase
sel
ect
edfrom t
hesameyear.

Eg.
Ifadver
ti
si
ngex
penseswer
eksh.1,
000i
n1992andsal
es
wereksh.

100,
000t
headv
ert
isi
ngwoul
dbe1%of
sal
es.

57
 .
.
Hor
iz .
ont
al
anal
ysi
s

Inhorizont
al anal
ysisadol l
ar/
shi
l
li
ngfigur
ef oranaccounti
s
expressedint er
msoft hatsameaccountfigur
eforaselect
ed base
year
.Forexampl e,ifsaleswereksh.400,000i n1991andksh.
600,
000i n1992t hensal esi
ncr
easedt150% ofthe1991leveli
n
1992ani ncreaseof50%.

RATI
OANALYSI
S

58
 .
.
Fi
nanci
al.
.
r
ati
osar
eusual
l
yex
pressedi
nper
cent
agesorar
ati
oni
s
def
inedasi
ndi
cat
edquot
ientoft
womat
hemat
ical
timesex
pressi
ons.

Ty
pesofr
ati
os

1.Li
quidi
tyrat
ios—measur esaf i
rmsabili
tytomeetit
scur
rent
obli
gati
ons.Theymayincludetherat
iosthatmeasur
ethe
eff
ici
encyoftheuseofcur r
entasset
s

2.Leverager at
ios—t heyarecapi
talstr
uctur
erati
os.They
measur ethefinanci
alri
sk.Thedegreeofprot
ecti
onofsuppl
i
es
oflong-t
ermf unds

3.Act
ivi
tyr
ati
ons(t
urnov err
ati
os)ev
aluat
etheef
fi
ci
encywi
th
whi
chasset
sareuti
l
ized.

4.Profi
tabil
i
tyrati
os-measuretheearni
ngabi
l
ityofaf
ir
m
i
ncludingtheuseofasset
singener
al

-
Infinanci
alanalysi
s,ar at
ioisusedasabenchmar
kfor
eval
uati
ngt hef
inancial
product
ion.

59
 .
.
.
St
andar
dsofcompar
ison

Pastr
ati
os—cal
cul
atedf
ort
hesamef
ir
m

60
 .
.
Compet
i.
.
t
ionval
ues—sel
ect
edf
ir
msatsel
ect
edpoi
nti
n
t
imes

Industr
y—i
ndust
ryt
owhi
cht
hef
ir
m
belongs

Pr
oject
edrat
io—rati
osf
rom pr
oject
edorpr
ofor
maf
inanci
al
st
atement
softhesamef
irm.

Rat
ioanal
ysi
sisaveryuseful
tooltorai
ser elevantquesti
onsona
numberofmanager
iali
ssues.Itprov
idescl uest oinvest
igat
ethose
i
ssues.I
tprovi
descl
uestoinvesti
gat
et hosei ssuesindetai
l.

Howev er
,caut i
onneedst obeappl i
edwhileint
erpreti
ngr at
iosas
theyarecalculat
edf rom theaccount
ingnumbers.Account i
ng
number ssufferfrom account
ingpoli
cychangesarbit
raryall
ocat
ion
proceduresandinflat
ion.

Li
qui
dit
yrat
ios

61
 .
.
.
Curr
entr
ati
o=cur
rent
Asset
s

Cur
rent
l
i
abi
li
ti
es

Qui
ckrat
io=cur
rentasset
s—
i
nvent
ory

Curr
ent
l
iabi
li
ti
es

I
nter
nalmeasur
e= cur
rentasset
s—
i
nvent
ory

62
 .
.
.
. Av
eragedai
l
ycashoper
ati
ngexpenses

Lever
ager
ati
os

Tot
aldebtr
ati
o=
TotalDebt
Capit
al
employed

Debtequi
tyr
ati
o= Net
wor
th
Tot
aldebt

Capi
tal
equi
tyr
ati
o= capi
tal
empl
oyedornetasset
s

63
 .
.
.

Networ
th

I
nter
estcov
erage= EBI
DTA
I
nter
est

Act
ivi
tyr
ati
os

64
 .
.
I
nvent
or.
y.
tur
nov
er= costofgoodssol
d/sal
es

I
nvent
ory

Noofday
sinv
ent
ory= 360

I
nvent
ory
tur
nover

Debt
orst
urnov
er= cr
edi
tsal
esonsal
es

65
 .
.
.
Debt
ors

Col
l
ect
ionper
iod= 360

Debtor
s
t
urnover

Asset
stur
nov
er= sal
es

Networki
ng
capi
tal

66
 .
.
.

Pr
ofi
tabi
li
tyRat
ios

67
 .
.
.
Gr .
ossmar
gin=gr
osspr
ofi
t EBI
T
or

Sal
es sal
es

Netmar
gin=Pr
ofi
taf
tert
ax

Sal
es

Or EBI
T (I
-T)
Sal
es

PAT t
oEBI
Trat
io= PAT
EBIT

Ret
urnonI
nvest
ment(
ROI
)bef
oret
ax= EBI
T/ netasset
sorcapi
tal
68
 .
.
.
Gr .
ossmar
gin=gr
osspr
ofi
t EBI
T
e
omp
r l
oyed

Ret
urnoni
nvest
ment=EBI
DTA

S(
ROI
)bef
oret
ax Tot
alasset
sornetasset
s

69
 .
.
.
Ret
urnon.
equi
ty(
ROE)= pr
ofi
taf
tert
ax

Networ
th

Ther
eexist
sar el
ati
onshipbet
weenv
ari
ousr
ati
os,
forex
ampl
e,ROE
canbeexpressedasfol
lows

ROE=sal
es xEBI
T x PAT x Netasset
s

Netsal
es sal
es EBI
T networ
th

I
npracti
ce,companiescal
cul
atemanyotherrat
ios.Mosti
mpor
tant
r
ati
osincl
udeotherr
ati
os.Mosti
mport
antrat
iosi
nclude

60
 .
EDS= PAT
Numberof
shar
es

DPS= pr
ofi
tdi
str
ibut
ed

Numberof
shar
es

Pay
out= Dps

Eps

Pr
ice—ear
ningr
ati
o=mar
ketv
alueofshar
e

61
 .
E
xce
ll
enc
ei.
n
F
ina
nci
al
Man
age
men
t

.
.
EPS

Mar
ketv
aluebookv al
uerat
io= mar ketval
ueof
sharebookval
ueofshares

CHAPTE
RFOUR

F
INANCI
ALPL
ANNI
NGANDF
ORE
CAS
TING

62
 .
.
.
.
.
1
I
ntr
oduc
ti
on

Financialplanningisacontinuousprocessofdi r
ecti
ngandallocati
ngfinancial
resourcest omeetst r
ategi
cgoalsandobj ecti
ves.Theoutputfr
om f i
nancial
planningtak est heform ofbudgets.Themostwi del
yusedf orm ofbudget s
i
sPr oFor maorBudget edFinanci
alStatements.Thefoundati
onforBudget ed
FinancialStatementsi sDet
ailBudgets.Detai
lBudgetsincl
udesalesforecasts,
productionf orecast
s,andotheresti
mat esinsuppor toftheFi nanci
alPl an.
Collecti
vel
y ,alloft hesebudgetsar ereferr
edtoastheMast erBudget.

Wecanal sobreakfi
nancialplanningdowni ntoplanningforoperationsand
pl
anningforfi
nanci
ng.Oper ati
ngpeopl efocusonsal esandpr oductionwhile
fi
nancial
planner
sareinterestedinhowt of i
nancetheoper ati
ons.Ther efor
e,
wecanhav eanOper at
ingPl anandaFi nancialPl
an.Howev er
, t
ok eept hi
ngs
si
mpleandt omak esurewei ntegr
atethepr ocessf ull
y,wewillconsi der
fi
nancial
planni
ngasonesi ngleprocesst hatencompassesbot hoper ati
ons
andfi
nancing.

St
artwi
thSt
rat
egi
cPl
anni
ng

Fi
nanci
alPl
anni
ngst
art
satt
het
opoft
heor
gani
zat
ionwi
thst
rat
egi
cpl
anni
ng.
62
 .
Si
ncestrategicdeci
si
onshavefi
nanciali
mpli
cati
ons,youmustst ar
tyour
budgeti
ngpr ocesswit
hint
hestrat
egicpl
anni
ngpr ocess.Fai
l
uretoli
nkand
connectbudgetingwit
hstr
ategi
cplanni
ngcanresulti
nbudgetsthatar
e"dead
onarri
val
."

Strategi
cpl anningisaf or mal processf orestabli
shi
nggoal sandobj ecti
v es
overt helongr un.Strategicpl anninginv ol
vesdev el
opi
ngami ssi
onst atement
thatcapt ur
eswhyt heor ganiz at
ionex istsandpl ansf orhow theor ganizati
on
willthri
veint hef uture.St rategi
cobj ect i
vesandcor r
espondinggoal sare
dev el
opedbasedonav eryt horoughasses smentoft heorganizati
onandt he
externalenv i
ronment .Final ly
, st
rategi
cpl ansar eimplementedbydev eloping
anOper ati
ngorAct ionPl an.Wi thi
nt hisOper ati
ngPlan,wewi l
l i
ncl
udea
compl etesetoff i
nanci al plansorbudget s.

Fi
nanci
alPl
ans(
Budget
s) Oper
ati
ngPl
an St
rat
egi
c
Pl
an

NOTE:Shor
tCour
se10descr
ibeshowt
opr
epar
eaSt
rat
egi
c
Pl
an.

63
 .
.
.
.
TheSal
esFor
ecas
t

Inor dertodev elopbudget s,

wewi llstartwithaf or
ecastofwhatdr i
vesmuch
ofourf i
nanci alact i
vi
ty;
namel ysales. Theref
ore,thefi
rstf orecastwewi ll
prepar eistheSal esForecast.Inor dert oestimatesales,wewi lll
ookatpast
saleshi storiesandv ar
iousfactorst hatinfl
uencesales.Forex ample,
mar k et
ingr esear chmayr ev
ealt hatf uturesalesareex pectedt ost abil
i
ze.
May bewecannotmeetgr owingsal esbecauseofl imitedpr oducti
on
capaci ti
esormay betherewil
lbeagener aleconomicsl owdownr esult
ingin
fal
lingsal es. Therefore,weneedt ol ookatsev eralf
actorsi narri
vingatour
salesf orecast .

Aft
erwehavecoll
ect
edandanal yzedalloftherel
evantinfor
mation,wecan
esti
matesal
esvol
umesf orthepl anni
ngper i
od.I
tisv eryimportantthatwe
arr
iveatagoodesti
mat esincethisesti
mat ewil
lbeusedf orseveralot
her
esti
matesi
nourbudgets.TheSalesFor ecasthastotakeintoaccountwhatwe
expectt
osel
latwhatsalesprice.

EXHI
BIT1—SALESFORECAST

Pr
oduct Vol
ume Pr
ice Tot
alSal
es

LaceShoes16,
000 $45.
00 $720,
000

64
 .
Pe
rce
ntofSal
es

Wenowneedt oestimateaccountchangesbecauseofest imat

edsal es.
Onewayt oesti
mateandf or
ecastcert
ainaccountbal
ancesi swit
ht he
PercentofSal
esMe thod.Bylooki
ngatpastaccountbal ancesandpast
changesinsales,wecanestabli
shaper cent
agerelat
ionship.Forex ample,al
l
vari
ablecostsandmostcur rentassetsandcurrentl
iabil
i
ti
eswi l
lvaryas
sal
eschange.

EXAMPLE1—ESTI
MATEDACCOUNTSRECEI
VABLE

Pasthist
oryshowst hataccount
sreceiv
ablerunsar
ound30%of
sal
es.Wehav eestimatedthatnextyear
ssaleswil
lbe$160,
000.
Theref
ore,ourest
imatedaccountsrecei
vabl
eis$48,000
($160,
000x. 30).

65
 .

2
.
.

De
tai
l
Bud
get
s

Weal soneedt opr

eparesev eraldet ai
lbudgetsf ordevel
opingaBudget
ed
I
ncomeSt at
ement.Forexampl e,productionmustbepl annedforour
esti
matedsal
esof16,000unitsf rom Ex hibi
t1.ThePr oduct
ionDepart
ment
wil
lneedtobudgetformat eri
als,labor,andoverheadbasedonwhatwe
expectt
osellandwhatweex pecti ninventor
y.

EXHI
BIT2—PRODUCTI
ONBUDGET

PlannedSales(Exhibi
t1) 16,
000
DesiredEndingInv
entory 1,
500
TotalUnit
s 17,
500
LessBeginningInvent
ory (3,
000)
66
 .
Pl
annedPr
oduct
ion 14,
500

Oncewehav eestabli
shedourl
evelofproducti
on(Exhi
bit2),wecanpr epar
ea
Materi
alsBudget.TheMateri
alsBudgetattemptstof orecastthelevelof
pur
chasesrequir
ed,taki
ngint
oaccountmat er
ial
srequir
edf orproducti
on
andinvent
orylevel
s.Wecansummar izemat er
ial
stobepur chasedas:

Mater
ial
sPur
chased=Mat
eri
al
sRequi
red+Endi
ngI
nvent
ory-
Begi
nni
ng
I
nvent
ory

EXHI
BIT3—MATERI
ALSBUDGET

LaceShoesrequi
re.
25squareyardsofl
eat
herandleat
heri
s
esti
matedtocost
s$5.00peryar
dnextyear
.Mater
ial
sRequi
red
=14,500(Ex
hibi
t

2)x.
25=3,
625y
ards.

67
 .
.
.
.
.
Ma
D t
ese
i
rr
i
eal
dsn
ERde
iqg
nui
redforProduct
io3
n753,
625
Tot
alMa t
eri
a sI
l nvent
ory 4,
000
LessBegi
nni
ngI
nventor
y
(500)Total
Mat
eri
alsRequi
red
3,
500
Uni
tCostf
orMat
eri
al
s x$5.
00

Thesecondcomponentofpr oducti
onislabor.Weneedtoforecastour
l
aborneedsbasedonex pectedproducti
on.TheLaborBudgetarri
vesat
expect
edlaborcostbyapply
inganex pect
edlaborr
atet
orequi
redlaborhour
s.

EXHI
BIT4—LABORBUDGET

LaceShoesr
equi
re.
50hour
stopr
oduceoneuni
t.

14,
500uni
tsx.
50=7,
250hour
s.

Theex
pect
edhour
lyl
aborr
atenex
tyeari
s$12.
00.

68
 .
.
Est
imat
edPr
oduct
ionHour
s 7,
250

Hour
lyL
aborRat
e x12.
00

Tot
alLaborCost
s $87,
000

Aspr oducti
onmov esupordown, supportservi
cesandot hercostsrel
atedto
producti
onwi ll
alsochange.Theseov er
headcost srepresentt
het hi
rdmajor
costsofpr oducti
on.Eachitem thatcompr i
sesov erheadmaywar rant
i
ndependentanal ysissothatwecandet erminewhatdr i
vesthespecifi
ccost.
Forex ample,producti
onrental
equi pmentmaybedr i
venbyproductionorder
s
whil
edepr eciat
ionisdriv
enbyl evelsofcapitali
nvestmentspending.

EXHI
BIT5—OVERHEADBUDGET(
BasedonUni
queDr
iver
s)

Est
imat
edf
oreachl
i
nei
temasf
oll
ows:

I
ndi
rectLaborCost
s* $12,
000

69
 .
.
.
.
.
Ue
Dt
il
i
pt
i
r
ee
cs
iat
ion 3,
0005,
000
Maint
enance 1,
000
I
nsur
anceandTax
es 4,
000

Tot
alOv
erheadCost
s $25,
000

Oncepr oductioncost
s(directmat eri
als,di
rectlabor
,andov erhead)hav ebeen
budgeted, wecanwor kthesenumber sintoourbeginninginventorylevelsfor
DirectMateri
als,WorkInPr ogress,andFinishedInventory
.Beginninginventory
l
ev el
sareact ualamountsf r
om t helastreporti
ngperiod.Weneedt oappl your
costsbasedonwhatwewantendi nginventorytobe.Theend- r
esultisa
Budgetf orCostofGoodsSol d,whichwewi l
luseforourForecastedIncome
Statement.

70
.
.

EXHI
BIT6—COSTOFGOODSSOLDBUDGET

Di
rect Wor
kIn Fi
ni
shed

Mat
eri
al
s Pr
ogr
ess I
nvent
ory

Begi
nni
ngI
nvent
ory $ 2,
500 $16,
000 $46,
000

Pur
chases(
Exhi
bi
t3) 17,
500

LessEndi
ngInv
entor
y (1,875)
Mater
ial
sRequi
red 18,
125

Di
rectL
abor(
Exhi
bi
t4) 87,
000

Ov
erhead(
Exhi
bi
t5) 25,
000

Tot
alManuf
act
uri
ngCost
s$130,
125 130,
125

Tot
alWor
kInPr
ogr
ess 146,
125

LessEndi
ngI
nvent
ory (12,
000)

CostofGoodsManuf
act
ured $134,
125 134,
125

CostofGoodsAv
ail
abl
eforSal
e 180,
125

71
 .
.

.
.
LessEndi
ngI
nvent
ory (36,
000)

CostofGoodsSol
d $144,
125

Wecannowf i
nishourestimateofex pensesbylooki
ngatallremaini
ng
operat
ingexpenses.Thefi
rstmajorty
peofoperati
ngexpenseismarketi
ng.
Marketi
ngandSal esManagerswillpr
epareandsubmitaMarketi
ngBudgetto
upperl
evelmanagementf orapproval
.

EXHI
BIT7—MARKETI
NGBUDGET

Est
imat
edf
oreachl
i
nei
tempert
heMar
ket
ingDepar
tment
:

Mark eti
ngPersonnel $75,
000
Adver t
isi
ng&Pr omoti
on 42,
000
Mark eti
ngResearch 12,
000
Travel&Personal 6,
500
To
Expenses t
tal MarkeingExpenses $135,
500

Thefi
nalareaofoper at i
ngex pensesistheadmi ni
strati
vecostsofrunni
ng
theover
allbusiness.Theset ypesofex penseswi llbeestimatedbasedon
pastt
rendsandwhatweex pecttohappeni nt hefuture.Forexample,i
fthe
companyhaspl ansforanewcomput ersystem, thenweshoul dbudgetfor
addi
ti
onaltechnologyr el
atedex penses.Severaldepar t
mentmanager swillbe
i
nvolv
edinpr eparingtheGener alandAdmi nistrati
veEx penseBudget.
72
.
.

EXHI
BIT8—GENERAL&ADMI
NISTRATI
VEBUDGET

Est
imat
edf
oreachl
i
nei
temperDepar
tmentManager
s:

73
 .
.
.
.
.
Man
Acca
og
ue
nme
t
i n
ngPt
eP
re
sr
s
oo
nn
nn
eel
l $110,
000
55,
000
Legal
Per
sonnel 40,
000

Technol
ogyPer
sonnel 45,
000

Rent&Ut
il
i
ti
es 25,
000

Suppl
i
es 15,
000

Bu
dge
tedF
ina
nci
al
Sta
teme
n
t
s

Basedont hedet ai
lbudgetswehav eprepared( Exhibi
ts1t hru8), wecan
fi
nali
zeourbudget sinthefor
m ofaBudget edI ncomeSt atement.Af ewnew
l
ineitemsareaddedt oaccountfornon-operati
ngi tems, suchasi ncome
receiv
edoni nv
est mentsandfi
nancingcosts.TheFi nanceandTax
Departmentswillassi
stinesti
mati
ngi t
emsl ikef i
nancingex pensesand
i
ncomet axex penses.TheBudget edIncomeSt at
ementwi l
lpulltoget
herall
revenueandex penseestimat
esfrom ourprev i
ouslypr epareddet ail
budget
s.

74
.
.

EXHI
BIT9—BUDGETEDI
NCOMESTATEMENT

Revenues( Exhibit1) $720,000

LessCostofGoodsSol d (144,
125)
G
(Er
o
xss
h Pr
6) ofi
t 575,875
LessMar k
eting(Exhibit7) (135,
500)
LessG&A( Exhibit8) (297,
500)
Oper ati
ngIncome 142,875
LessI nt
erestonDebt (8,000)
IncomeBef oreTax es 134,
875
Tax es@ 37.5% (50,578)
NetI ncome $ 84,
297

EXAMPLE2—BUDGETEDI
NCOMESTATEMENT

75
.
.
.
.
.
Ha
Pl
al
t
no
nnCo
ed mp
salan
esay
r
eha
5s
0c
,
0o
0mp
0 i
l
une
i
tda
sth
te
af
po
rl
l
o
i
cewo
i
ng
f$i
n
1f
1o
0r
ma
00t
. i
po
en
r:
uni
t.
Beginni
ngInventor
yconsist
sof5,000uni
tsatacostof$60.00
perunit
.Plannedproduct
ionis55,
000uni
tswit
hthefoll
owing
product
ioncost:
Di
rectMat
eri
al
sar
e$18.
50peruni
t
Di
rectLaborr
equi
redi
s4hour
speruni
t@ $12.
00perhour

Ov
erheadi
sest
imat
edat20%ofDi
rectL
aborCost

Desi
redEndi
ngI
nvent
oryi
s6,000uni
tsundert
heLI
FO
Method.Mar
ket
ingEx
pensesarebudget
edat$350,
000
Gener
al&Admi
ni
str
ati
veEx
pensesar
ebudget
edat$400,
000

<-
---
---
----
---
-Budget
edI
ncomeSt
atement-
----
---
-----
-

>

Sal
es(
50,
000x$110)

$5,
500,
000

LessCostofGoodsSol
d:

Begi
nni
ngI
nvent
ory(
5,000x$60.
00) $ 300,
000

Di
rectMat
eri
al
s(55,
000x$18.
50) 1,
017,
500

Di
rectL
abor(
55,
000x4hour
sx$12.
00) 2,
640,
000

Ov
erhead(
$2,
640,
000x.
20) 528,
000

76
 .
.
Nowt .
hatwe.
hav
eaBudget
edI
ncomeSt
atement
,wecanpr
epar
eaBudge
ted
Bal
ance

Sheet
.TheBudget
edBal
anceSheetwi
l
lpr
ovi
deuswi
thanest
imat
eofhow
much

ext
ernal
fi
nanci
ngi
srequi
redt
osuppor
tourest
imat
ed
sal
es.

Themai nlinkbetweent heI ncomeSt atementandt heBalanceSheetis

Retai
nedEar ni
ngs.Ther efore,pr
eparati
onoft heBudgetedBalanceSheet
star
tswithanest i
mat eoft heendingbal anceforRetai
nedEarnings.I
norder
toesti
mateendi ngRet ainedEarnings,weneedt opr oj
ectfut
uredivi
dends
basedoncur rentdiv
idendpol ici
esandwhatmanagementex pectstopayin
thenextplanningperi
od.

EXHI
BIT10—ESTI
MATEDRETAI
NEDEARNI
NGS

Beginni
ngBalance $ 270,
000
BudgetedNetIncome 84,
297
L
(e
Es
xs
hi
bE
is
tt
i
9ma
)tedDi v
idends (55,
000)
EndingRetai
nedEar ni
ngs $299,
297

Next
,weneedt oaccountfort
heacqui
sit
ionoff
ixedasset
s.Asabusi
ness
depl
etesi
tsassetbase,i
tmustre-
i
nvesttosust
ainasset
swhichar
ethebasi
s

70
 .
.
f
orgener
at.
i
ngr
evenues.Forex
ampl
e,doweneedt
opur
chasenew
machi neryorcomput erequipment?Dowepl antoexpandourpr
oduct
ion
facil
i
ties?Operati
ngper sonnelandupper-
lev
elmanagementwil
ldeci
deon
futur
ecapi t
alspending.Futurecapi
talex
pendit
uresar
esummar i
zedonthe
CapitalExpendi
turesBudget .

EXHI
BIT11—CAPI
TALEXPENDI
TURESBUDGET

Pur
chaseNewOf
fi
ceEqui
pment $ 16,
000

Repl
aceL
eat
herCut
ti
ngMachi
ne 8,
500

Tot
alCapi
tal
Expendi
tur
es $24,
500

Basedonthebegi
nni
ngbal
ancei
nasset
sandthebudgetf
orcapi
tal
asset
s
(Ex
hibi
t11),
wecanesti
mat
eanendi
ngassetbal
ancefort
heBudget
ed
Bal
anceSheet.

EXHI
BIT12—CHANGEI
NFI
XEDASSETS

71
 .
.
.
.
.

B
Ne
egi
nn
wA i
n
cg
q B
ui
sa
i
tl
a
i
on
nc
se
(Ex
hibi $886,
t11) 00
20
4,
500

LessDepr
eci
ati
onf
ort
heYear (
33,
500)

Wewi l Emet
lassu ndi
ng
haF
ti
x
le
i
adA
bi
li
ts
i
es
set
as
ndinter $
este8
x7
p7
e,
0
n0
s0i
ew llr
emainthesame.
However,afterwehavedeterminedourl evelofexter
nalfi
nanci
ng,wewi l
l
needtorevisetheseamount s.Addit
ionall
y,weneedt oanaly
zetrendsand
rat
iosi
nor dertoascert
ainaccountst hatdonotfluct
uatewithsal
es.For
example,
pr epai
dexpenseisacur rentassetthathasli
ttl
etodowithsal
es.

SincetheBalanceSheetisay ear-endestimate,i
tassumest hatal
lother
estimateshavebeenmet .Inawor l
dofr api
dchange, annualfor
ecastsare
rarel
yclose.Ther
efore,wewi l
lsimplif
yourpr eparat
ionoftheBudgeted
BalanceSheetbyrelyingonr elati
onships.Stablerel
ati
onshipsoverthel
ast
fi
vey earsarepar
ti
cularl
yhel pful.TheBudget edBalanceSheetwillshow
eit
herasur pl
us(excessf inancingoverasset s)oradefici
t(addi
ti
onal
fi
nancingneededt ocov erasset s).Thisdif
ferenceisderivedfr
om the
Account i
ngEquati
on:Asset s=Li abil
i
ti
es+Equi t
y.

EXHI
BIT13—BUDGETEDBALANCESHEET

Cash $36,
000 5%ofSal
es

Account
sRecei
vabl
e 86,
400 12%ofSal
es

I
nvent
ory 50,
400 7%ofSal
es
72
.
.
.
Pr
epai
dEx
penses 11,
000 5y
eart
rendanal
ysi
s

Fi
xedAsset
s 877,
000 Ex
hibi
t12

Tot
alAsset
s $1,
060,
800

Account
sPay
abl
e 79,
200 11%ofSal
es

Cur
rentPor
ti
onofL
TDebt 6,
000 Pr
inci
pal
Pai
d

LongTer
mDebt 60,
000 Subj
ectt
oRev
isi
on

Tot
alLi
abi
l
it
ies 145,
200

CommonSt
ock 450,
000 unchanged

Ret
ainedEar
nings 299,
297 Ex
hibi
t10

Tot
alEqui
ty 749,
297

Tot
alLi
ab&Equi
ty 894,
497

73
 .
.
.
.
.
Ext
ernal
Financi
ngRequi
red$166,
303

Weal socancal
cul
ateExt
ernalFi
nanci
ngRequired(EFR)basedonthe
rel
ati
onshi
psbet
weenassets,l
i
abi
li
ti
es,andsal
es.Thefol
lowingf
ormul
acan
beused:

EFR=(
A/SxSal
es)-
(L/SxSal
es)-
(PMxFSx(
1-d)
)

A/S:
Asset
sthatchangegi
venachangei
nsal
es,
expr
essedasaper
cent
ageofsal
es.

Sal
es:
Changei
nsal
esbet
weent
hel
astr
epor
ti
ngper
iodandt
hef
orecast
edsal
es.

L/S:Liabi
l
it
iesthatchangegi
venachangeinsal
es,
expr
essedasaper
cent
age
ofsal
es.PM: Pr
ofitMargi
nonSales;
i.
e.neti
ncome/sal
es.

FS:
For
ecast
edSal
es

(1-d):Per
centofearni
ngsr
etai
nedaf
terpay
ingoutdi
vi
dends;di
sthe
di
vi
dendpayoutr
ati
o.

EXAMPLE3—CALCULATEEXTERNALFI
NANCI
NGNEEDED

Fal
conCompanyhascompi
l
edt
hef
oll
owi
ngi
nfor
mat
ion:

74
.
.
Assetsof$900( most
lycur
rentasset
s)fromthelastperi
od
changewithsales.Li
abil
i
ti
esof$300f rom thelastper
iod
changewithsales.Sal
eswer e$3,000f orthelastper
iod.
Forecast
edsalesar e$3,900.Profi
tmar gi
nsonsalesare6%
and40%ofear ningsarepai
d-outasdi
vidends.

A/S=$900/$3,
000=.
30

L/S=$300/$3,
000=.
10

Changei
nSal
es=$3,
900-
$3,
000=$900

EFR=.
30(
$900)-.
10(
$900)-.
06(
$3,
900)
(1-
.
40)= $270-$90-

$140.
4=$39.
6

EXAMPLE4—PREPAREBUDGETEDBALANCESHEET

Gi
l
merCompanyhascompi
l
edt
hef
oll
owi
ngi
nfor
mat
ion:

 Sal
esf
ort
hel
astr
epor
ti
ngper
iodwer
e$600,
000

 Pr
oject
edsal
esar
e$800,
000

75
.
.
.
.
.
 Pi
 r
ofi
tRdat
iois5%o fsal
es
D v
Cui
d
r
re
en
ntBP
aa
ly
ao
nu
ct
eR
i
nat
Ri
o
et
ai
s
i4
n0
e%
dEar
ningsi
s$200,
000
 Cashasa%ofsal
esi
s4%

 Account
sRecei
vabl
easa%ofsal
es10%

I
nvent
oryasa%ofsal
esi
s30%

 NetFi
xedAsset
sar
ebudget
edat$300,
000

 Account
sPay
abl
easa%ofsal
esi
s7%

 Accr
uedLi
abi
l
iti
esasa%ofsal
esi
s15%

 CommonSt
ockwi
l
lremai
nat$220,
000

Budget
edBal
anceSheet

Cash(
$800,
000x.
04) $ 32,
000

Account
sRecei
vabl
e($800,
000x.
10) 80,
000

I
nvent
ory(
$800,
000x.
30) 240,
000

NetFi
xedAsset
s 300,
000

Tot
alAsset
s
$ 652,
000

76
 .
.

Aft
erwehav epr
eparedbudget
edfi
nanci
alst
atement
s,i
tisver
yimport
antt
o
caref
ull
yrevi
ewthesest
atementswi
thmanagement.Forex
ample,canwe
tr
ulyexpectt
oraise
77
 .
$166,
303i.api
nc tal
asi
ndi
cat
edi
nEx
hibi
t13?Wi
l
lthebudget
edf
inanci
al
st
atement
smeettheexpectat
ionsofsharehol
ders?Sever
alcr
it
icalquest
ions
mustbeaskedbef
orewefinal
izeourbudgetedfi
nanci
alst
atements.

78
 .
.
.
Addi
ti
onal
l
y,.
ourbudget
swer
epr
epar
edonanannualbasi
s.Manyunpl
anned
ev
entscantakeplacedur
ingt
hey
ear
,maki
ngourannualbudget
s
ex
tremel
yinaccur
ate.

Ther
efor
e,f
inancialpl
anningi
softeni
mprov
edbysimpl
yfor
ecast
ingona
monthl
yorquarterl
ybasisasopposedt
oanannual
basi
s.

TheCashBudget

Agoodex ampl
eofshort-
ter
mf i
nanci
alplanningistheCashBudget .TheCash
Budgetisanestimateoffut
urecashinf
lowsandout fl
ows.CashBudget sare
ofteni
ncludedwitht
heBudgetedBalanceSheet .Howev er,i
tshouldbenoted
thatCashBudgetsarenotwidel
yusedasagener alfor
ecasti
ngtoolsince
theyarespecif
ictooneaccount,
namelycash.I nstead,CashBudgetsare
oftenusedbyCashManager sandTreasur ypersonnelformanagingcash.

Wecanuseourpr evi
ousf orecastst ohelpuspr epareaCashBudget .For
example,wecangetani deaofpay abledisbur sementsformanuf act
uri
ngby
l
ookingattheMat erialsBudget( Exhibit3),LaborBudget(Exhi bi
t4),
andt he
OverheadBudget( Ex hi
bit5).Wecanst ar
tprepar i
ngaCashBudgetbysi mply
l
ookingatourst ablecashf lowpat terns,suchasaccount sr ecei
vabl
e,
accountspayable,pay r
oll,
etc.Weal sohav esev eral
predi
ctabletr
ansacti
ons,
suchasinsurancepay ments,l
oanpay ment s,etc.

EXHI
BIT14—CASHBUDGETFORJANUARY

79
.
.
.
Begi
nni
ngCashBal
ance $28,
000

CashCol
l
ect
ionsonSal
es(
60dayl
ag) $47,
000

Sol
dol
dmachi
nei
nJanuar
y 3,
000

I
nvest
mentRev
enues 2,
000

Tot
alCashI
nfl
ows 52,
000

Di
sbur
sement
sforManuf
act
uri
ng(
30dayl
ag)12,
400

Mar
ket
ingEx
penses 10,
000

Gener
al&Admi
ni
str
ati
veEx
penses 26,
000

Capi
talEx
pendit
ures -
0-
RepaymentsonDebt 750

DebtI
nter
estPay
ment
s 450

Div
idendPay
ment
s -
0-
TaxesPai
d -
0-

Tot
alCashOut
fl
ows 49,
600

80
 .
.
.
.
.
2 NetCashInf
low(
Out
fl
ow) 2,
400
E,
4
n0
d0
i
ngCashBalance 30,
400
Mi
ni
mumDesi
redCashBal
ance 10,
000

CashSur
plusor(
Def
ici
t) $20,
400

Summar
yoft
heBudge
ti
ngPr
oce
ss

Westart
edourbudget
ingprocessbylookingatstr
ategi
cpl anni
ng.Strategic
Pl
anni
ngshoul
dalwaysbet hestar
ti
ngpoi ntf
orfi
nancialplanni
ng.From t he
St
rat
egicPl
an,wedevelopaPlanofActionsowecani mpl ementtheSt rategi
c
Pl
an.Thisi
soft
encall
edanOper ati
ngPl an.Wit
hintheOper at
ingPlan,we
wi
lli
ncl
udeasetofbudget sforsuccessfuli
mplement at
ionoft heStrategic
81
 .
.
Pl .
an.Theent
ir
esetofbudget
scanbecat
egor
izedasf
oll
ows:

<-
---
---
---
---
---
----
---
---Mast
erBudget--
---
----
----
---
---
----

-
->

<-
----
---
---Oper
ati
ngPl
an-
------
-><-
---
----
-Fi
nanci
alPl
an-
----
---

-
>

Sal
esFor ecast(Ex hi
bi
t1) BudgetedRetai
nedEarnings(Ex
hibit
10)
BudgetedPr oduction(Exhi
bi
t2) Budget edCapit
alExpendit
ures(Exhi
bit
11)BudgetedPr oduct
ionCost
s(Exhi
bit
s3- 5) Changei nFixedAssets
(Exhi
bi
t12)Budget edCostofGoodsSold(Exhibi
t6) Budget edBalance
Sheet(Exhibi
t13)Budget edOper
ati
ngEx penses(Exhi
bi
ts7-8) Cash
Budget(Exhibit14)

Budget
edI
ncomeSt
atement(
Exhi
bi
t9)

Ad
dit
i
ona
lCo
nce
ptsi
nBu
dge
ti
ng

Sofar,
wehaveemphasizedsi
mpleappr
oachest
oprepar
ingbudget
s,such
aslooki
ngatr
elati
onshi
psbet
weenaccountbal
ancesandsales.Weal so
shoul
dhaveacl ear

82
 .
.
under
st .
andi
ng.
ofpastfinanci
alper
for
mance t
o hel
p us pr
edi
ctf
utur
e
fi
nanci
al

per
for
mance.Ex
tendi
ngpastt
rendsandadj
ust
ingf
orwhati
sex
pect
edi
sa
common

appr
oacht oprepari
ngaf or
ecast
.However
,wecani mproveforecast
ing
byusingsever
al t
echni
ques.
Thefi
rstst
epi
srecogni
zecer
tai
nfundamental
s
aboutfor
ecast
ing:

1.Forecast
ingreli
esonpastrel
ati
onshipsandexi
sti
nghistori
cal
infor
mation.
I
ftheserelat
ionshi
pschange,f
orecasti
ngbecomesincreasi
ngl
yinaccur
ate.

2.Si
nceforecast
ingcanbeinaccur
ateduetouncertai
nty,weshoul
dconsi
der
devel
opingseveral
for
ecastunderdi
ff
erentscenari
os.Wecanassign
probabi
l
iti
estoeachscenar
ioandarr
iveatourexpectedfor
ecast
.

3.Thelongert heplanningperiod,themor einaccur

atetheforecast.I
fwe
needtoincreaser el
iabil
i
tyinforecasting,weshouldconsiderashor ter
pl
anni
ngper iod.Thepl anni
ngper i
oddependsuponhowof t
enex isti
ng
pl
ansneedt obeev aluat
ed.Thiswi l
ldependuponst abi
l
it
yinsales,
busi
nessrisk,f
inancialcondi
ti
ons, et
c.

4.Forecastingoflar
gei nt
er-
rel
atedi
temsi smor eaccurat
ethanf orecast
inga
specifi
citemizedamount .Whenal ar
gegroupofi t
emsar ef or
ecast
together,er
ror
swi t
hinthegrouptendt ocancelout.Forexample, an
overalleconomicforecastwil
lbemor eaccuratet
hanani ndustryspeci
fic
forecast.

Quant
i
tat
iv
eandQual
i
tat
iv
eTec
hni
que
s

83
 .
Youshouldf .
orecastforaspecifi
cr eason- t
ohelpmak ebett
erdecisi
ons.
For
ecast ng.
i i
sex t
remelydif
fi
cultandy oumustpul lfr
om allr
elevantsources.
Weprev i
ousl ydiscussedthePer centofSalesMethodandTr endAnal ysi
sasa
wayoff orecasti
ng.Thesef orecastingtechni
quesarequantit
ati
ve.
Quanti
tati
v etechniquesofforecast i
ngarebestusedwhenchangesar e
i
nfr
equent .Intoday sworl
dofr apidchange, quant
it
ati
vetechni
quest endtobe
ofl
it
tl
euse.

Weneedt oaddmor equalit

ati
vet echniquesintothebudgeti
ngpr ocess.
Quali
tati
vetechniquesincludesurveys,intervi
ewswithpeoplewhoar e"i
nthe
know",marketreports,ar
ticl
es,andot herinformati
onsourcesthatall
owust o
mak eabetterjudgement .Quali
tati
veorJudgment alFor
ecasti
ngcanhel p
i
mpr ovethebudget i
ngpr ocess,especiall
yifweareoperati
nginarapidl
y
changingenvir
onment .

TheDel phiMethodisanex ampleofaqual i

tati
vetechniquewher eagroupof
expertsgetstoget
herandr eachesaconsensusonwhatwi l
lhappeninthe
futur
e.Aquest i
onnai
reissomet i
mesusedt ofaci
li
tatethepr ocess.Two
disadvantagesoftheDelphiMet hodarelow reli
abil
it
ywi t
ht heconsensus
andi nabi
lit
ytoreachacl earconsensus.

84
 .
.
.

.
.
Smoot
hingoutt
heNumbe
rs

Onesimpleapproacht of orecast
ingistosetupamodel t
hatrel
i
eson
aver
agesfrom pasthistoricaldat
a.Forex ample,wecantakeanav erageof
thel
astfiv
ey ear
s.Aswemov eforwardtothenex tpl
anni
ngperiod,anew
movingaverageiscalculatedandusedast heforecastf
orthenextplanni
ng
peri
od.Exponent
ialsmoot hi
ngcanbeusedwher ebyweplacemor eweighton
themostrecentsetofact ualnumbers.Thiscanbei mport
antwherechanges
haveoccurr
ed,mak i
ngol derdatalessrel
iabl
e.

Regr
essi
onAnal
ysi
s

Ast ati
stical approachcanbeusedf orfor ecasti
ng.Wecanr elyont heaverage
rel
ationshi psbet weenadependentv ar
iableandani ndependentv ari
able.
Simpl eregr essionsl ookatoneindependentv ariabl
e( suchassal esprici
ngor
advertisi
ngex penses)wher easmul t
ipl
eregr essionsconsi dertwoormor e
vari
abl es( suchassal espri
ci
ngandadv er t
isi
ngexpensest ogether).
Regressi onanal ysisisverypopularforf orecasti
ngsal essinceithelpsus
fi
ndt her ightfitov erarangeofobser v
ations.Forex ampl e,ifwepl otoutthe
fol
lowi ngobser vati
ons,wecanpr epareascat tergraphandf indther i
ghtfi
t:

Adv
ert
isi
ngEx
pense Sal
esDol
l
ars

$100 $1,
5
150 1,
005
180 1
6,
6
0

85
 .
.
220. 1,6
270 1,
6
58
55

86
 .
.
.
.
.
Scat
terGr
aphf
or

Fi
veObser
vat
ions

$1,
700
s
ar

$1,
650
l
esDol

$1,
600
Sal

$1,
550

$1,
500

$1,
450

$0 $100 $200 $300

Adv
ert
isi
ngDol
lar
s

Sensi
ti
vi
tyAnal
ysi
s

Wecanmeasur ehowsensiti
veourf orecasti
stochangesincer
tai
nvari
abl
es.
Wecandev el
opar angeofpossibi
liti
esunderdi f
fer
entassumpti
onsand
prepar
eal t
ernati
vepl
ans.I
fPlanAf ail
s,wecanqui ck
lymovetoPlanB.
Sensit
ivi
tyanaly
sisal
sotel
l
suswhi chassumpt i
onshavethebi
ggesti
mpact

87
 .
ont hefor .
eca
st.Manager
scanconcent
rat
emostoft hei
rresourcesont he
biggestimpactareasfori
mprovi
ngtheforecast
.Themainbenef i
tof
sensiti
vi
tyanaly
sisi
stomeasuret
hepossi
bili
tyofer
ror
sintheforecast
.

Fi
nanc
ial
Model
s

Budget scanbepr eparedwi tht heuseoff or malmodel swhichtak eadvantage

oft echniquesl ikeregressionsandsensi t
ivityanalysi
s.Modelsar ebuil
taround
thecol lectionofequat ions, l
ogi c,anddat at hatflowsaccordingtot he
relati
onshi psbet weenoper atingv ariablesandf i
nancialout
puts.Financi
al
variables( costs,sales,invest ment s,taxes, etc.
)canbemani pul
atedbyt he
usersot hattheusercanseet heout comeofadeci si
onbeforeitismade.
Thi scanhel pfacil
it
atest r
at egict hinkingwi thinthebudgeti
ngpr ocess.Two
typesoff i
nancialmodel sar esi mul ationandopt imi z
ati
on.Simulati
on
attempt stodupl i
catet heef fect sofadeci sionandshowi t
si mpact.
Opt imizat i
onseek st ooptimi ze( max i
mi z
eormi nimize)aforecastobjecti
ve
(revenues, pr
oductioncost s, etc.).

Fi
nanci
al model
spr
ovi
dedeci
sionsupportser
vi
cesf
orimprov
ement
swi
thi
n
budget
ing.Someoft
hebenef
it
soffinanci
almodel
sincl
ude:

88
 .
.
.
 Showst
he.
resul
tsofpl
anni
ngunderav
ari
etyofassumpt
ions,
all
owi
ngt
he
usert
o

asses
sthei
mpact
sofest
imat
est
hathav
ebeenus
ed.

 Gener
atest
heBudget
edI ncomeStatementandBudget
edBalanceSheet
aswellasf
orec
ast
edfinancial
sbybusi
nessuni
tordepar
tment.

Inordertobuil
daf i
nanci
almodel,weneedtoestabl
ishvari
abl
es,
parameter
s,andrel
ati
onshi
ps.Addi
ti
onal
l
y,wecandivi
devari
abl
esint
othr
ee
types:

1.Cont
rolVar
iables:Theinput
sthatthecompanycancont
rol
,suchast
he
l
evel
ofdebtfinancingorthel
evelofcapi
tal
spendi
ng.

2.Exter
nalVar
iabl
es:I
nput
sthatt
hecompanycannotcont
rol
,suchas
economic

condi
ti
ons,
consumerspendi
ng,
int
erestr
ates,
etc.

3.Poli
cyVariables
:Goalsandobj
ecti
vesofthecompanycanimpactthe
expect
edout comes.Forex
ample,managementmaysettar
get
sf orsal
es,
pr
ofit
abil
i
ty,andcosts.

Parameter
sarethebasel
inesorboundari
esfort
hefi
nanci
almodel
.For
example,t
helev
elofdebtmayhav eami ni
mum andmax i
mum val
ue.Weal
so
wil
lsetourbegi
nni
ngaccountbalanceswit
hint
hefi
nanci
almodel
.

Rel
ati
onshi
psar
ethel
ogi
candspeci
fi
cat
ionsr
equi
redf
ormak
ingt
hings

89
 .
wor
k .
.Forex
ampl
e,t
heBudget
edBal
anceSheetwi
l
lrequi
ret
hatAsset
s=
Liabil
i
ties+Equi ty.Sever
alequati
onswi l
lbeusedwi thinthefinancialmodel .
Manyoft heseequat i
onswil
lberelat
ional
;i.
e.i
fwechangesal espr i
ces,total
revenueswi l
l change.Equati
onsaretestedandaddedt othef inanci
almodel
tomak eitcompl ete.Equati
onscanbeex pandedi ntobusinessanddeci si
on
rulessot hatusersdonothav etowor ryaboutcalculati
ngthingslikereturnon
equity.Thefinancialmodeltakescareofcri
ti
calrulesf orr
unningt hebusiness
ormak i
ngdeci si
ons.

EXHI
BIT15—FI
NANCI
ALMODELFORCASH

Rel
ati
onshi
ps(
Equat
ions)
:

Cash(
t)=Cash(
t-
1)+CashRecei
pts(
t)+CashDi
sbur
sement
s(t
)

CashRecei
pts(
t)=(
a)xSal
es(
t)+(
b)xSal
es(
t-
1)+(
c)xSal
es(
t
-
2)+Loan(t
)

CashDi
sbur
sement
s(t
)=Account
sPay
abl
e(t
+1)+I
nter
est
(t
)+
Loan

Pay
ment
(t
)

I
nputVar
iabl
esi
nDol
l
ars
:

90
 .
.
.
.
.
.

Sal
es(
t-
1),
Sal
es(
t-
2),
Sal
es(
t-
3)
Loan(
t)
,LoanPay
ment
(t
)

(a)
:AccountsReceiv
abl
eCol l
ect
ionPatt
ernincurrent
peri
od(b):Account
sReceivabl
eColl
ecti
onPattern
oneperi
odago( c):
AccountsReceiv
abl
eCollecti
on
Patt
erntwoper i
odsago(a)+(b)+(c)<1.0

Par
amet
ers(
Ini
ti
alVal
uesi
nDol
l
ars)
:

Cash(t
-1)
,Sal
es(
t-
1),
Sal
es(
t-
2),
BankLoan(
t-
1),
Account
s
Payabl
e(t
-1)

Mak
ingt
heBu
dge
ti
ngPr
oce
ssWo
r
k

Nowthatweunder
standwhatgoesi
ntof
inanci
alpl
anni
ng,i
tist
imetofocus
onhowtomaketheprocessi
ntoaval
ue-
addedacti
vi
ty.Manyor
gani
zat
ions

80
 .
ar
eat
tempt
i.
ngt
ore-
engi
neerbudget
ingpr
act
icessi
ncebudget
ingi
susual
l
ya
non-val
ueaddedactivi
ty
; i
.
e.itdoesnotaddv aluet
othedeci si
onmaking
process.Thegoali
stomak etheenti
refi
nancialpl
anningprocessi
ntoa
decisi
onsupportserv
icewithintheorgani
zati
onwher ebythebenef
it
softhe
processexceedthecosts.

I
nordert
ofull
ycomprehendthepr
oblemsassociat
edwithbudget
ing,l
ets
qui
ckl
yli
stt
hetoptenprobl
emswithbudget
ingaccordi
ngtoContr
oll
er
Magazi
ne:

1.Tak
estool
ongt
o
pr
epar
e.

2.Doesnthel
pusr
unour
busi
ness.

3.Budget
sar
eout
-of
-dat
ebyt
het
imeweget
them.

4.Toomuchpl
ayi
ngwi
tht
he
number
s.

81
 .
.
.
.
5.Toomanyi
ter
ati
ons/r
epet
it
iv
etask
swi
thi
nthepr
ocess.

6.Budget
sar
ecasti
nst
onei
naconst
ant
lychangi
ngbusi
nessenv
ironment
.

7.Toomanypeopl
ear
einv
olv
edi
nthebudget
ingpr
ocess.

8.Unabl
etocont
rol
budgetal
l
ocat
ions.

9.Byt
het
imebudget
sar
ecompl
ete,
Idontr
ecogni
zet
henumber
s.

10.
Budget
sdonotmat
cht
hest
rat
egi
cgoal
sandobj
ect
iv
esoft
heor
gani
zat
ion.

Wewi l
lnowdiscusssever
alwaysofmaki
ngbudget
ingi
ntoav
alue-
added
act
ivi
tywi
thi
ntheorgani
zat
ion.

Aut
omat
ethePr
oce
ss

Inorderf orbudget
ingtobev al
ue-
added,itmustacceptrevi
si
onsquickl
yand
easil
y.Ahi ghlyaut
omat edbudgeti
ngprocesscanhelpst r
eamli
netheprocess
forquickandeasyupdat i
ng.As a mi nimum,budget s should be
maintained on spr eadsheet
s.Aspr eadsheet(suchasEx cel
,Lotus1-2-
3,
etc.
)canhav eani nputpanelforenteri
ngv ari
abl
esandaut omati
c
generationofbudget swithi
nafull
yint
egratedsetofspreadsheet
s.For
exampl e,wecanuseaf ormulat
ocalcul
ateinter
estexpenseas:

82
 .
.
I
nter
estRat.(Begi
ex nni
ngLongTer
m Debt+Cur
rentPor
ti
onofLongTer
m
Debt+Ext
ernalFi
nanci
ngUsi
ngLongTer
mDebt
)

Spr
eadsheetsalsoal
lowust
oper f
orm sensi
ti
vi
tyanal
ysi
s.Wecansimply
ent
ernewv ari
ablesi
ntot
hei
nputpanel
andr ev
iewthei
mpactonourbudgets.

Wecanal sousemor eformalsof t

wareprogramsf orbudget ing.Thebest
soft
wareprogramswi llgi
veust heopti
onofcont rol
l
ingthelevel ofdet ai
l.For
example,
dowewantacashbudgetbycust omerordowewantcashbudget s
byaccountorcanwesi mplyenterthecashf l
owdat aoursel
ves?I tisv ery
i
mpor t
antthatwehav econt r
oloverthedetail
sincecommer cial pr
ogr ams
someti
mesov er
-anal
yzetransacti
onsandpr ovi
dewayt oomuchdet ail
.Thi si
s
whymanyf inancial
plannersprefe
rspreadsheetsovercommer cialprograms.

83
 .
.
.

.
.
Te
nBe
stPr
act
i
cesi
nBudge
ting

Finall
y,her
earesomebestpr
act
icest
hatcant
ransf
orm budget
ingi
ntoa
value-
addedacti
vi
ty
:

1.Budgeti
ngmustbelink
edtost r
ategi
cpl
anni
ngsi
ncest
rat
egi
cdeci
si
ons
usual
lyhav
efi
nanci
ali
mpli
cat
ions.

2.Makebudget ingprocedurespar
tofstrategicplanni
ng.Forexample,
str
ategicassessment sshoul
dincludehistori
caltr
ends,competi
ti
ve
analysi
s,andot herpr
oceduresthatmightotherwisetak
eplacewithi
nthe
budgeti
ngpr ocess.

3.TheBudget i
ngProcessshoul
dmi ni
mizetheti
mespentcoll
ect
ingand
gather
ingdataandspendmoreti
megenerati
ngi
nfor
mati
onforst
rategi
c
decisi
onmak i
ng.

4.Getagr
eementonsummar
ybudget
sbef
orey
ouspendt
imepr
epar
ingdet
ail
budget
s.

5.Aut
omat et
hecol
l
ect
ionandconsol
i
dat
ionofbudget
swi
thi
ntheent
ir
e
or
gani
zat
ion.

User
sshoul
dhav
eaccesst
obudget
ingsy
stemsf
oreasyupdat
ing.

6.Budget
sneedtoacceptchangesquick
lyandeasi
ly
.Budget
ingshoul
dbea
conti
nuouspr
ocessthatencour
agesalt
ernat
iv
ethi
nki
ng.
84
 .
.
.
7.Lineit
em det
ail
inbudget
sshouldbebasedonmat
eri
alt
hreshol
dsandnot
relyonasyst
emofgenerall
edgeraccount
s.

8.Budgetsshoul
dgivel
owerl
evel
manager
ssomef
orm off
iscal
cont
rol
over
whatisgoingon.

9.Lev
erageyourf
inancial
systemsbyestabl
i
shingadat
awar
ehouset
hatcan
beusedforbot
hfinanci
alrepor
ti
ngandbudgeti
ng.

10.
Multi
-
Nati
onalCompaniesshouldhaveabudget
ingsyst
em thatcan
handl
eint
er-companyeli
minat
ionsandf
orei
gncurr
encyconv
ersions.

S
umma
r
y

FinancialPlanni
ngisacont inuouspr ocesst hatfl
owswi t
hstr
ategicdeci
si
on
mak i
ng.TheOper at
ingPlanandt heFinancialPlanwil
lbothsupportthe
Strategi
cPl an.Thebestplacetost artinpr
epar i
ngabudgetiswithsalessi
nce
thisisadr i
vingfor
cebehindmuchofourf inancialact
ivi
ty
.Howev er,
wehav e
tot akeintoaccountnumer ousf actorsbef
or ewecanf i
nali
zeourbudgets.

85
 .
.
.
Budget
i .
ngshoul
dbef
lex
ibl
e,al
l
owi
ngmodi
fi
cat
ionwhensomet
hing
changes.Forex
ampl
e,t
hef
oll
owi
ngwi
l
limpactbudget
ing:

 Li
fecycl
eoft
he
busi
ness

 Fi
nancial
condi
ti
onsoft
he
busi
ness

 General
economi
c
condi
ti
ons

 Competi
ti
ve
si
tuat
ion

 Technol
ogy
t
rends

 Avail
abi
li
tyof
r
esources

Budgetingshoul
dbebot htopdownandbot tom up;i.
e.upperlevel
managementandmi ddl
elevelmanagementwillbothworkt ofinal
i
zea
budget.Wecanst r
eamlinethebudgeti
ngprocessbydev elopingaf i
nancial
model.Financi
almodelscanf aci
li
tat
e"whatif
"analysi
ssowecanassess
decisi
onsbeforet
heyaremade.Thi scandramatical
l
yimprov ethebudget
ing
process.

Oneoft hebiggestchallengeswithi
nfinanci
alplanningandbudgeti
ngishow
dowemak eitvalue-
added.Budgeti
ngr equi
resclearchannel
sof
communi cati
on, suppor
tf r
om upper-
levelmanagement ,parti
ci
pati
onfrom
vari
ousper sonnel,andpr edi
cti
vecharacter
ist
ics.Budgeti
ngshouldnotst
ri
ve
foraccuracy,butshouldstri
vetosuppor tt
hedecisionmak i
ngprocess.
Ifwe
86
 .
.
f
ocust .
oomuchonaccur
acy
,wewi
l
lend-
upwi
thabudget
ingpr
ocesst
hat
i
ncurstimeandcostsinexcessofthebenefi
tsderi
ved.Thechal
lengei
sto
makefinanci
alpl
anni
ngavalue-
addedacti
vi
tyt
hathel
pstheorgani
zati
on
achi
eveitsst
rat
egi
cgoal
sandobjecti
ves.

EXERCI
SE

Sel
ectthebestanswerf
oreach
quest
ion.

1. I
nor
derf
orbudget
ingt
oreal
l
ywor
k,wemustl
i
nkt
hebudget
ing
pr
ocesswi
th:

a.Fi
nanci
al

87
 .
.
St
at.
ement
s

88
 .
.
.
b.Accou.
nt
ing
Tr
ansact
ionsc.St
rat
egi
c
Pl
anni
ng

d.Oper
ati
ngRepor
ts

2. Thef
ir
stf
orecastwewi
l
lpr
epar
eforbudget
ingwi
l
lbet
he:

a.Budget
edIncome
St
atementb.SalesFor
ecast

c.CashBudget

d.Budget
edBal
anceSheet

3. Tay
lorManuf
act
uri
nghascompi
l
edt
hef
oll
owi
ngpr
oduct
ion
i
nfor
mat
ionf
ormanuf
act
uri
ngj
ugsofbev
erages:

Pl
annedpr
oduct
ioni
s6,
000j
ugs

Materi
al
srequir
edperjug:10poundsofpowder
Desi
redEndingInv
entoryforMat
eri
als:4,000
poundsBeginni
ngInv
ent or
yforMateri
als:3,
000
poundsPurchaseCostforMater
ial
s:$2. 00per
pound

Basedont heabov einf

ormat
ion,whati
sthet
otalcostf
orpl
anned
mater
ial
spurchased?

89
 .
.
.
a $110,
0
. 00
b $120,
0
. 00
c $122,
0
. 00
d $128,
0
. 00

4. Whi
choft
hef
oll
owi
ngdet
ailbudget
swi
l
lhel
puspr
epar
etheBudget
ed
I
ncome

St
atement
?

a.Di
rectL
aborBudget

90
 .
.
b.Cash.
B.
udget

c.BudgetedBalance
Sheetd.YearEnd
Bal
anceSheet

5. I
faccount
spay
abl
ehav
ehi
stor
ical
l
ybeen20% ofsal
esandwehav
e
est
imat
edsal
esof$200,
000,
thanest
imat
edaccount
spay
abl
emustbe:

a.
$10,
000b.
$20,
000c.
$30,
000d.
$40,
000

6. Whi
chbudgeti
spr
epar
edf
ordet
ermi
ni
nghowmuchex
ter
nalf
inanci
ng
wewi
l
lneedt
osuppor
test
imat
edsal
es?

a.Cash
Budget

b.BudgetedIncome
Statementc.Budget
ed
BalanceSheet

d.Sal
es
For
ecast

7. Agoodpl
acet
ost
arti
npr
epar
ingt
heBudget
edBal
anceSheeti
swi
tht
he
mai
nli
nkbet
weent
heI
ncomeSt
atementandt
heBal
anceSheet
.Thi
sli
nki
s:

91
 .
.
a. .
Cash

b.Retained
Earni
ngsc.Cur
rent
Assets

d.LongTer
m
Li
abi
li
ti
es

8. Onewayt
oimpr
ovet
hebudget
ingpr
ocessi
stoi
ncl
udequal
i
tat
iv
e
techniquesint
oforec
ast
ing.Whi
choft
hef
oll
owi
ngi
sanex
ampl
eofa
quali
tati
vetechni
que?

a.5YearTr
end
Anal
ysi
sb.Rat
io
Anal
ysi
s

92
 .
.
c.Per .
cen.
tofSal
esMet
hod

d.I
nter
vi
ewi
ngt
hePr
esi
dentoft
heCompany

9.St
ati
sti
cal
met
hodscanbeusedt
oimpr
ovet
heaccur
acyoff
orecast
ing.
Thisapproachi spar
ticul
arlyusef
ulf orforecast
ingsal
essinceweare
searchi
ngf ortheri
ghtf i
tbasedonsev eralobserv
ati
ons.Onepopul
ar
approachtof i
ndingtherightstat
ist
icalfi
tistouse:

a.Exponent
ial
Smoothi
ngb.
Regr
essi
onAnalysi
s

c.Ex ecut
ive
Poll
i
ngd.Mov i
ng
Average

10.Whi
choft
hef
oll
owi
ngwi
l
lcont
ri
but
etomak
ingbudget
inganon-
val
ue
addedact
iv
it
y;i
.
e.t
hecostofbudget
ingex
ceedst
hebenef
it
?

a.Thebudget
ingpr
ocessi
sincl
udedwi
thi
nthest
rat
egi
cpl
anni
ngpr
ocess.

b.Det
ailandSummaryBudget
sareprepar
edatt
hesamet
imeandar
e
di
str
ibut
edtomanagementf
orappr
oval.

c.Budgetsthr
oughouttheor
gani
zat
ionar
e aut
omat
edf
orent
erpr
ise
-
wideconsol
idat
ion.

d.Li
nei
temdet
ail
inbudget
sisbasedonmat
eri
alt
hreshol
ds.

93
 .
.
.

CHAPTERFI
VE
Cashfl
ow
for
ecast
ing

Def
ini
ti
on

Acashf
lowforecastai
mstopredi
ctacompanysfut
urefi
nanci
all
i
quidit
y
ov
eraspeci
fi
cper i
odofti
me,usi
ngtr
iedandtest
edfi
nanci
almodels.

94
 .
.
.
(
i) I
n.acor
por
atef
inancesense,
cashf
lowf
orecasti
shemodel
i
ng
ofacompanyorasset
sfut
uref
inanci
all
i
qui
dit
yov
eraspeci
fi
c
ti
mefr
ame

whil
ecashnor mall
yrefer
st otheliqui
dassetsinacompany s
bankaccount,t
heforecastusuall
yest i
matesitst r
easur y
posit
ion,whi
chiscashplusshor t
-terminvestment smi nusshort-
ter
m debt.Thecashf l
owitselfr
eferstothechangei nthecash
ortr
easuryposit
ionfrom oneperiodtothenex t.Thecashf l
ow
for
ecastisanimportantwayt ovalueassets,wor koutbudget s,
anddet er
mineappropri
atecapit
al str
uctur
es.Itwillprovidea
goodindicat
orofacompany sfi
nancialhealt
hf orpotential
i
nvestors.

(
ii
) I
ncont extoftheentr
epreneurormanager,for
ecasti
ngwhatcash
will
comei ntothebusinessorbusinessuni
tinordert
oensur
e
thatoutgoi
ngcashcanbemanagedsoast oav oi
dthem
exceedingcashf l
owcomi ngin.I
ftherei
sonething
entrepr
eneurslearnf
ast,iti
stobecomev er
y

goodatcashf
low

For
ecast
ing.

Cashf
lowpr
oject
ionmet
hods

Sever
almethodsaregenerall
yusedtoforecastcashfl
owonedirect.The
di
rectmethodismostsuitabl
eforshor
t-t
ermf orecast
sofanywherefrom
30daysupt oayear,
sinceiti
sbasedonact ualdatafr
om whi
chthe
proj
ecti
onsareext
rapolat
ed.Thedatausedar ethecompanyscash

95
 .
.
r
ecei
pt .i
sanddsbur
sement
s(R&D)
.Recei
ptspr
imar
il
yincl
udeaccount
s
fr
om recentsal
esofot herasset
s,pr
oceedsoffi
nanci
ng,et
c.
Disbursement
sincludesalari
es,
paymentsforr
ecentpur
chases,
div
idends,
anddebtservi
cing.Manyoft heR&Dentri
esarebasedonproj
ect
edfuture
sales.

Theot hermethodsal luseacompany sprojectedincomest atement sand

balancesheetast heirbasi
s.Thefi
rstmethodi sadj ust
edneti ncome
(ANI),
whichfir
stexami nestheoperat
ingincomeorear ningsbef or
e
i
nterestsandt ax(EBIT)orearni
ngsbeforeinterests,t
ax,depreciat
ionand
amor t
izati
on(EBITDA) ,t
henlooksatchangesont hebalancesheetsuchas
receiv
ables,payables,andi
nventor
ytof or
ecastcashf l
ow.

96
 .
.
Thepr
ofor
m..
abal
ancesheet(
PBS)met
hodl
ook
satt
hepr
oject
edbook
cashaccounti
fthepr
oject
ionsf
oral
lot
herbal
ancesheetaccount
sar
e
corr
ect
,thenthe

cashflowwillal
sobecor rect.Boththesemet hodscanbeusedt omak e
short
-t
erm( upto12mont hs)andlong- term(mul ti
pleyear)for
ecasts.Si
nce
theyusethemont hl
yorquar terl
yinter
v alsofacompany sf i
nanci
alplan,
theymustbeadj ust
edt oaccountf orthedifferencesbetweent hebook
cashandt heactualbankbalance,andt hismaybesi gnif
icantl
ydif
ferent
.

Thet hir
dmet hodusest heaccr ual r
ev ersalmethod( ARM) ,which
reverseslar
geaccr ual
s( revenueandexpencest hatarer ecognizedwhen
theyar eearnedori ncur
red, di
sr egardingt heact
ual receiptordispersalof
cash)andcal culat
esthecashef f
ectsbasedonst at
isti
caldistr
ibuti
ons
andal ogari
thms.Thi sallowst hef orecastingperi
odt obeweekl yorev en
daily.I
tcanal sobeusedt oex tendtheR&Dmet hodbey ondt he30day
horizonbecausei tel
iminat esthei nher entcumulat i
veerrors.Thisist he
mostcompl icatedofallmet hodsandi sbestsuitedformedi um- ter
m
forecasts.

Adv
ant
ages

 Cashfl
owpr oj
ect
ionsof
ferausef
uli
ndi
cat
orofacompany
s
fi
nanci
alhealt
h.

 Cashf
lowf
orecast
senabl
eonet
opr
edi
ctt
hepeak
sandt
roughsi
n

97
 .
.
t
he.
cashbal
ance,
andhel
pst
opl
anbor
rowi
ngs,
andt
heyt
ell
how
muchsurpluscashthecompanymayhaveatagiv
enti
me.Most
bank
sinsistonforecast
sbef
oreconsi
der
ingal
oan.

Di
sadv
ant
ages

Acashflowforecastnev
ert
ell
sthewholest
oryaboutacompanys
f
inanci
alsi
tuat
ionandshoul
dnotbereli
edonasthesoleindi
cat
or.

Fact
orsAf
fect
ingPr
oFor
maSt
atement
s

98
 .
.
.
.

Prepar
ati
onofforecast(pr
of or
mastatements)r
equi
resassembli
nga
widearr
ayofperti
nent,v
eri
fiabl
efact
saffect
ingt
hebusinessandit
spast
perf
ormance.Theseincl
ude:

Dat
afr
om pr
iorf
inanci
alst
atement
s,par
ti
cul
arl
y:

1.Pr
evi
oussal
esl
evel
sandt
rends

2.Pastgr
ossper
cent
ages

3.Averagepastgener
al,
admi ni
str
ati
ve,
andsell
i
ngexpenses
necessar
ytogenerat
ey ourfor
mersalesv
olumes

4.Trendsinthecompany sneedtoborrow( suppl

i
er,t
rade
credi
t,andbankcredi
t)tosupportv
ariouslevel
sofinvent
ory
andtrendsinaccount
sr ecei
vabl
erequiredtoachi
eve
previ
oussalesvolumes

Uni
quecompanydat
a,par
ti
cul
arl
y:

99
 .
.
.

1.Pl
antcapaci
ty

2.Compet
it
ion

3.Fi
nanci
alconst
rai
nts

4.Per
sonnel
avai
l
abi
l
ity

I
ndust
ry-
widef
act
ors,
incl
udi
ng:

1.Ov
eral
lst
ateoft
heeconomy

2.Economyst
atusofy
ouri
ndust
rywi
thi
ntheeconomy

3.Popul
ati
ongr
owt
h

4.Elasti
cit
yofdemandforthepr oductofserv
icey our
businessprovi
des(
demandi ssaidtobe“el
asti
c”ifi
tis
decreasedasthepr
icesincrease,ademonstrat
ionthat
consumer scandowithoutor

10
0
 .
.
.
.wi
thl
essoft
hegoodsorser
vice.I
fdemandf
or
somethi
ngisr
elat
ivel
yst
eadyaspr
icesi
ncr
ease,
iti
s
“i
nel
asti
c”)

5.Av
ail
abi
l
ityofr
awmat
eri
al
s

Oncethisf
actorsarei
dent
if
ied,theymaybeusedi
nProFor mas,which
est
imatesthelevel
ofsal
es,expense,
andpr
ofi
tabi
l
ityt
hatseem possibl
ein
afut
ureperiodofoper
ati
ons.

UsesofPr
oFor
maSt
atement
s

BusinessPlanning:Acompanyusespr of ormastatementsintheprocess
ofbusinessplanningandcont rol.Becausepr oformast at
ementsare
presentedi
nast andardi
zed,columnarf ormat ,
managementempl oys
them tocompar eandcont rastalter
nat i
v ebusinessplans.Byarr
anging
thedatafortheoper ati
ngandf inancialst atementside-
by-si
de,
managementanal yzestheprojectedr esultsofcompet i
ngplansinordert
o
decidewhichbestser vestheinterestsoft hebusiness.

I
nconst
ruct
ingpr
ofor
mast
atement
s,acompanyr
ecogni
zest
he

90
 .
.
queness.
uni anddi
sti
nctf
inanci
alchar
act
eri
sti
csofeachpr
oposedpl
an
orpr
oject
.Pr
ofor
mast
atement
sal
l
owsmanagementt
o:

I
denti
fyt
heassumptionsaboutthefi
nanci
aland
oper
ati
ngchar
acter
isti
csthatgener
atethescenar
ios.

 Developt
hev
ari
oussal
esandbudget(
rev
enueand
expense)

pr
oject
ions.

 Tr
ansl
atet
hisdat
aint
ocash-
fl
owpr
oject
ions.

 Assembl
ether
esul
tsi
npr
ofi
tandl
osspr
oject
ions.

 Compar
ether
esul
ti
ngbal
ancesheet
.

 Perf
ormrat
ioanal
ysi
stocomparepr
ojecti
onsagainst
eachot
herandagai
nstt
hoseofsimi
larcompanies.

 Reviewpr
oposeddeci
sioni
nmar keti
ng,
product
ion,
resear
chanddevel
opment,et
c.,
andassessthei
r
i
mpactonprobabil
i
tyandli
quidi
ty.

91
 .
.
Si
mul
ati .
ngc.
ompet
ingpl
anscanbequi
teusef
uli
nev
aluat
ingt
hef
inanci
al
ef
fect
soft hedi
ff
erental
ter
nat
ivesunderconsi
der
ati
on.Basedon
di
ff
erentsetson

assumpti
ons,
thesepl
ans
propose.

Vari
ousscenar i
osofsal es,product
ioncosts,profi
tabil
it
y,andviabi
li
ty.Pro-
Formast atementsf oreachpl anprovideimportantinf
ormationaboutf ut
ure
expectati
ons,includi
ngsal esandear ningsf
orecasts,cashflows,bal
ance
sheets,proposedcapi t
alizat
ion,andincomest atements.

Managementalsousest
hisprocedur
einchoosingamongbudget
al
ter
nati
ves.Pl
anner
spresentsalesr
evenues,product
ionexpenses,
bal
ancesheetandcashfl
ow

stat
ementsforcompet i
ngplanswitht
heunderl
yi
ngassumpti
onsexpl
ained.
Basedonananal ysi
softhesefigur
es,
managementselect
sanannual
budget.Af
terchoosi
ngacour seofact
ion,
iti
scommonf ormanagementto
examinevari
ati
onswi t
hint
heplan.

Ifmanagementconsi der saflexibl

ebudgetmostappr opri
ateforits
company ,i
twoul dest abli
shr angeofpossi bl
eout comesgener all
y
categori
zedasnor mal( expectedresult
s),abovenor mal( bestcase) ,and
belownor mal(wor stcase) .Managementex aminescont ingencypl ansfor
thepossibleoutcomesati nput /
outputl
ev els specif
ied wi t
hint he
operati
ng range.Si nce these t hr
ee budget s arepr oject
ionsappear i
ng
i
nast andardized,columnarf or matandf oraspeci f
iedt i
meper iod,theyare
proforma.

Duri
ngthecour
seofthefi
scalper
iod,managementeval
uatesi
ts
perf
ormancebycompari
ngactualresul
tst
ot heexpect
ati
onsofthe
accept
edplanusi
ngasi mi
lar

profor
maf or
mat.Managementsappraisalt
estsandre-
test
sthe
assumpti
onsuponwhichitbasedit
splans.Inthi
swayproforma
stat
ementsarei
ndi
spensabletothecontrol
process.

92
 .
.
.

Fi
nancialModeli
ng:Profor
mast atement
spr ov
idedat aforcalculat
ing
fi
nanci
alrat
iosandforperf
ormi
ngot hermathematicalcalculat
ions.
Fi
nancialmodel
sbuiltonpr
oformpr oj
ect
ionscontr
ibutetot he
achi
evementofcorporat
egoal
sifthey:

i
) Testt
hegoal
soft
hepl
ans;

i
i
) Fur
nishf
indi
ngst
hatar
ereadi
l
yunder
standabl
e;and

i
i
i) Pr
ovi
det
ime,
qual
i
ty,
andoostadv
ant
agesov
erot
hermet
hods.

Financi
almodel i
ngt est
stheassumptionsandrelat
ionshi
psofpr oposed
plansbyst udy
ingt heimpactofvari
ablesi
nthepr i
cesofl abor,mater
ial
s,
andov erhead;costofgoodssol d;costofborrowing money ;sal
es
volume;and inv ent
oryval
uat
iononthecompanyinquest i
on.

Comput
er-
assi
stedmodel
i
nghasmadeassumpt
iont
est
ingmor
eef
fi
ci
ent
.
Theuse

of power
fulpr
ocessor
s per
mit
s onl
i
ne,r
eal
-t
ime deci
si
on maki
ng
thr
ough

93
 .
.
.
.
i
mmedi
at
.cul
ecal at
ionsofal
ter
nat
ivecashf
low st
atement
s,bal
ance
sheet
s,andi
ncomest
atement
s.

Assessi ngtheI mpactofChanges:Acompanypr eparespr oformaf i

nanci
al
statementswheni texpectstoex per i
enceorhasj ustexper ienced
signif
icantfi
nancialchanges.Thepr o-f
ormaf i
nanci
alst atementspr esent
theimpactoft hesechangesont hecompany '
sfi
nancial posi
ti
onas
depictedinthei ncomestatement ,
balancesheet,andt hecash- f
low
statement.Forexampl e,managementmi ghtprepareprof ormast atements
togauget heef fect
sofapot enti
almer gerorjoi
ntventure.Ital
somi ght
preparepr oformast at
ementstoev aluatetheconsequencesofr efi
nancing
debtthroughi ssuanceofprefer
redst ock,commonst ock, orotherdebt .

EternalReporti
ng;Businessesalsousepr oformast at
ementinext er
nal
reportsprepar
edforowner s(st
ockholders)-cr
editor
s,andpotent
ial
i
nv estor
s.Forcompanieslist
edont hestockex changes,t
heregulat
ory
authorit
ies(e.
g.CMA)requireproformast atementswithanyfi
li
ng,

regi
str
ati
onstatements,orproxyst
atements(Documenti
ntendedto
provi
deshareholder
swithinformat
ionnecessar
ytovoteinaninf
ormed
manneronmat terstobebr oughtupata-st ockhol
der
smeet i
ng).The
author
it
iesandor gani
zati
ons

governi
ngaccounti
ngpracti
cesrequi
recompaniestoprepar
eprof or
ma
stat
ement swhenessent
ialchangesi
nt hecharact
erofabusinesss
fi
nancialstat
ement
shav eoccurr
edorwi l
loccur
.Fi
nanci
alst
atementsmay
changebecauseof:

 Changesi
naccount
ingpr
inci
plesduet
oadopt
ionofagener
all
y

94
 .
.
.
accept
edaccount
ingpr
inci
pledi
ff
erentf
rom oneusedpr
evi
ousl
yfor
f
inanci
alaccount
ing.

 Achangeinaccount
ingesti
mat
esdeali
ngwiththeest
imat
ed
economi
cli
feandnetresi
dualv
alueofasset
s.

 Achangei
nthebusi
nessent
it
yresul
ti
ngf
rom t
heacqui
si
ti
onor
di
sposi
ti
on

ofanassetor

i
nvest
ment ,
and/
ort
hepool
i
ngofi
nter
est
soft
woormor
eexi
sti
ng
busi
nesses.

 Acor
rect
ionofaner
rormadei
nrepor
torf
il
ingofapr
evi
ousper
iod

Management sdeci siontochangeaccount i

ngprincipl
esmaybebasedon
thei
ssuanceofanewaccount ingpri
nciplebytheIASBorKASB;i nternal
considerat
ions t aking advantage ofr evi
sed valuati
ons ortax codes;
ort heaccount ingneedsofanewbusi nesscombi nati
on.Bychangingit
s
accountingpract i
ces, abusi
nessmi ghtsigni
fi
cantlyaffectt
hepresentat
ion
ofit
sf i
nancial positi
onand t heresultsofi t
soper at
ions.Thechange
also mightdi stortt he

95
 .
.
.
.
.
earni
ngstrendr
epor
tedi
nthei
ncomest
atement
sforear
li
ery
ear
s.Some
examples

ofchangesi naccounti
ngpr i
nci
plesmighti
ncludev al
uat
ionofi nvent
ory
viaaf i
rst
-i
n,f
ir
st-
our(FIFO)methodoralast
-i
n,fi
rst
-outmethod(LIFO),or
recordi
ngofdepreci
ati
onv i
aastrai
ght
-l
inemethodoranacceler
ated
met hod.

Whenacompanychangesanaccount i
ngmet hod,itusespr ofor
ma
fi
nancialstatement st orepor
tthecumul ati
veef f
ectoft hechangef or
theper i
oddur i
ngwhi chthechangeoccurred.Toenabl ecompar i
sonofthe
proforma,financialstat
ementswithprevi
ousfinancialstat
ements,the
companywoul dpr esentthefi
nanci
alstat
ement sforpriorperi
odsas
ori
ginall
yrepor t
ed, showthecumulati
veeffectofthechangeonneti ncome
andr et
ainedear nings,andshownetincomeonapr of ormabasisasi ft
he
newlyadopt edaccount i
ngpri
ncipl
ehadbeenusedi npr i
orperi
ods.

Achangei naccount i
ngesti
mat emayber equiredasnewev entsoccurand
asbetterinformati
onbecomesav ail
abl
eaboutt hepr obabl
eoutcomeof
fut
ureev ents.Forexample,ani ncreaseintheper centageusedtoestimate
doubtf
ul accounts,amajorwr i
te-downofi nventories,achangeint he
economicl i
v esofplantassets,andar evi
sionint heesti
mat edl
iabi
li
tyfor
outst
andingpr oductwarr
antieswoul drequireprof ormastatements.

TheFor
maI ncome
Stat
ement

I
npr epar
ingt
hePr
oFor
maI
ncomeSt
atement
,theest
imat
eoft
otalsal
es
dur
inga

sel
ect
edper
iodi
sthemostcr
it
ical
“guesst
imat
e”Amanager
shoul
d;

96
 .
i
) .
Empl
oybusi
nessexper
iencesf
rom pastf
inanci
alst
atement
s.

i
i
) Gethelpfrom managementand sal
espeopl
ein dev
elopi
ng
thi
s al
l
-import
antnumber
.

Thenassume, f
orex ampl e, thata10per centincr
easeinsal esv olumei sa
real
isti
candat t
ainablegoal .Multiplylasty earsnetsal
esby1. 10t ogeet hi
s
yearsestimateoftot alnetsal es.Next ,br eakdownt hi
st otal ,
mont hby
mont h,bylooki
ngatt hehi stori
calmont hlysalesvol
ume.Fr om thisonecan
determinewhatper cent ageoft ot alannualsal esfel
lont heav eragein
eachoft hosemont hsov erami nimum oft hepastthreey ear s.Onemay
fi
ndt hat75percentoft ot alannual Salesv ol
umewasr ealizeddur i
ngt hesi
x
mont hsfrom JulythroughDecemberi neachoft hosey ear sandt hatthe
remaining25per centofsal es;wasspr eadf ai
rl
yevenlyov ertheFi rstsi
x
mont hsofthey ear
.

97
 .
.
.
.
.
Compari
sonwi
thAct
ualMont
hly
Per
for
mance

Putt
ingt
oget
hert
hisi
nfor
mat
ionmont
hbymont
hforay
eari
ntot
he
fut
urewi
ll

r
esul
tinthebusinesssProFormaStatementofIncome.Useitt
ocompar
e
wi
ththeactualmonthl
yresul
tsfrom oper
ati
ons.Prepar
ati
onofthe
i
nfor
mati
oni ssummar i
zedbelow:

Revenue
(Sal
es)
 Listt
hedepartmentswithi
nthebusiness.Forex
ample,
ifthebusiness
isappli
ancesalesandservi
ce,thedepart
mentswouldi
ncludenew
appli
ances,used,appl
i
ances,part
s.,
in-
shopservi
ce,
on-si
teser
vice.

Inthe"Est
imate"col
umns, ent
erar easonabl
epr oj
ecti
onofmonthl
y
sal
esforeachdepartmentoft hebusiness.I
ncludecashandon-
accountsales.I
nthe"Act
ual"columns, ent
ertheactualsal
esf
orthe
monthast heybecomeav ail
able.

 Excl
udefrom t
heRev
enuesect
ionanyr
evenuenotst
ri
ctl
yrel
atedt
o
thebusi
ness.

Costof
sal
es
 Ci
tecost
sbydepar
tmentoft
hebusi
ness,
asabov
e.

I
nthe" Esti
mat
e"columns,entert
hecostofsal esest i
mat edforeach
monthforeachdepartment
.Forproductinventory,calculat
ethecost
ofthegoodssoldforeachdepart
ment(beginninginv entorypl
us
pur
chasesandt r
ansport
ati
oncostsduringt hemont hmi nusthe
i
nventory)
.Ent
er"Actual
"cost
seachmont hast heyaccr ue.

98
 .
.
Gr
osspr
ofi
t
Subtr
actt
het
otal
costofsal
esf
romt
het
otal
rev
enue

Expense
s

 Sal
aryExpenses:
Basepaypl
usov
ert
ime.

 PayrollExpenses;Incl
udepai
dv acati
ons,si
ckl eave,heal
th
insurance,unemployment,
i
nsurance.Soci
alSecurit
ytaxes.

 Outsi
deServi
ces;Incl
udecostsofsubcont
ract
s,ov
erf
lowwor
k
far
med-out
,specialorone-
ti
meservi
ces.

 Suppl
ies:Servi
cesandi
temspur
chasedf
orusei
nthebusi
ness,
notforresal
e.

 Repai
rsandMaintenance:Regul
armaint
enance-andrepai
r,
incl
udi
ng,
per
iodi
clargeexpendi
tur
es,
suchaspaint
ingordecor
ati
ng.

 Advert
isi
ng:Include desi
red sal
es v
olume,cl
assi
fi
ed di
rect
ory
l
ist
ingexpense,etc.

99
 .
.
.
.
.
 Car
,Del
i
ver
yandTr
avel
:Incl
udechar
gesi
fper
sonalcari
susedi
n
t
he

busi
ness.I
ncl
udepar
king,
toi
l
s,mi
l
eageonbuy
ingt
ri
ps,
repai
rs,
etc.

 Account
ingandLegal
:Out
sidepr
ofessi
onal
ser
vices.

 Rent
:Li
stonl
yreal
est
ateusedi
nthebusi
ness.

 Tel
ephone.

 Ut
il
it
ies;
Wat
er,
heal
,l
ight
,et
c.

I nsur
ance:Fi
reorl
i
abi
l
ityonpr
oper
tyorpr
oduct
s,wor
ker
s
compensati
on.

 Taxes:
Inv
ent
ory
,sal
es.
,ex
cise,
real
est
ate,
other
s,

I
nter
est
.

 Depr
eci
ati
on:
Amor
ti
zat
ionofcapi
tal
asset
s.

 Ot
herEx
penses(
speci
fyeach)
:Tool
s,l
easedequi
pment
,et
c.

 Miscel
laneous(
unspeci
fi
ed}
:Smal
lex
pendi
tur
eswi
thoutsepar
ate
account
s.

Netpr
ofi
t
Tofi
ndnetpr
ofi
t,subt
ractt
otal
expensesf
rom gr
oss
pr
ofi
t.

ThePr
oFor
maSt
atementofI
ncome,
prepar
edonamont
hlybasi
sand
10
0
 .
cul
minat
i .
ngi
nanannual
proj
ect
ionf
ort
henex
tbusi
nessf
iscal
year
,shoul
d
berevisednotl
essthanquart
erl
y.Itmustref
lectt
heactualperf
ormance
achi
evedi nt
heimmediatel
yprecedingt
hreemonths;oensureits
conti
nuingusef
ulnessasoneofshet womostv al
uabl
eplanningtool
s
avai
labletomanagement.̀

Shouldtheproformar evealt
hatthebusi
nesswil
lnicel
ynotgeneratea
prof
itfr
om operati
ons,plansmustimmediatel
ybedev el
opedloIdenti
fy
whattodot oatleastbreakeven-incr
easevol
ume, decr
easeexpenses,or
putmoreownercapi tali
nt opaysomedebtsandreduceint
erestexpenses.

Br
eak-
EvenAnal
ysi
s

Br
eak— Ev enmeanl evelofoper ati
onsatwhichabusi nessneither
makesapr ofitnorsustainsaloss.Atthi
spoi
nt,revenueisjustenought o
covetexpenses.Br
eak-
EvenAnal ysisenabl
esyout ostudyther el
ationshi
p
ofvolume,costs,andr
ev enue.

Break-
Evenrequi
resthebusinessowner/managertodef
ineasal
eslevel-
eit
herinter
msofr evenueshil
l
ingstobeearnedorinuni
tstobesol
dwi t
hin
agivenaccounti
ngper i
od-atwhi chthebusinesswoul
dearn,abefore
raxnetprofi
tof!zer
o.Thi smaybedonebyempl oyi
ngoneofv ar
ious
formul
acalculat
ionstot he

10
1
 .
.
.
.
.
busi
nessest
imat
edsal
esv
olume,est
imat
edf
ixedcost
:,andest
imat
ed
vari
abl
e

cost
s.

 Achangei
nsal
esv
olumewi
l
lnotaf
fectt
hesel
l
ingpr
iceperuni
t;

 Fix
ed ex penses(rent
,salari
es,administ
rat
iveand of
fi
ce
expensesinterest anddepreci
ati
on)wil
lremai
nthesameatal
l
vol
umel evels;
and

 Var
iabl
e ex
penses(
costofgoods sol
d,v
ari
abl
elaborcost
s,
i
ncl
udi
ng,

over
timewagesand sal
escommissi
ons)(wil
lincr
easeordecr
ease
i
ndirectpr
opor
ti
ontoanyincr
easeordecr
easeinsalesv
olume.

Twomethodsaregener
all
yempl oyedinBr
eak—Ev enAnal
ysi
s,dependi
ng
onwheat
herthebreak—ev enpointiscal
cul
atedi
nitemsofsalesshi
ll
i
ngs
vol
umeorinnumberofunit
st hatmustbesol
d.

 Obt
ainal
i
stofex
pensesi
ncur
redbydi
ecompanydur
ingi
tspastf
iscal
y
ear.

 Separ
atetheexpensesl
i
stedi
nSt
ep1i
ntoei
therav
ari
abl
eora
fi
xedtxper
.se

cl
assi
fi
cat
ion.

 Ex
presst
hev
ari
abl
eexpensesasaper
cent
ageofsal
es.

 Subst
it
utethei
nfor
mationgat
her
edm t
hepr
ecedi
ngst
epsi
nthe
basi
cbreak-ev
enformula

10
2
 .
t .
ocal
cul
atet
hebr
eak-
evenpoi
nt.

Note:Increasedsal
esdonotnecessarymeani ncreasedprof
it
s.Ifone
needstoknowt hecompanysbreak—ev en,
thenshe/ hewil
lknowhowt o
pri
cetheproducttomakeaprofi
t.I
fanacceptabl
ei snotmade,alt
erorsel
l
thebusi
nessbeforether
etai
nedearni
ngsarelost
.

10
3