Financial

Forecasting,
Working Capital &
Financing
Decisions
Robert Z. San Juan
Management Consultancy
Chapter 14-15
May 1, 2020
Chapter 14 - Financial Forecasting
Financial Management is concerned with the maintenance and creation of
economic value or wealth. It focuses on financial decisions such as to introduce a
new product, when to invest in new assets, when to borrow from banks, when to
issue stocks or bonds, when to extend credit to a customer and how much cash
to maintain.
In order to attain this objectives, it is necessary to plan, implement and control the
activities of he firm. A management consultant (preferably a CPA) may provide
advisory services relative to financial management in the following areas:
1. Financial Analysis
2. Financial Forecasting
3. Working Capital Management and Financing Decisions
4. Capital Budgeting
5. Dividend Policy and External Growth through M&A activities
Nature of Financial Forecasting
It involves the process of anticipating events before they occur, particularly the
need for raising funds externally. Companies base their operating plans on a set
of projected financial statements. Normally, the process begins with a sales
forecast for the next 2 years or so, then assets required to meet the sales targets
are determined and a decision is made as to how to finance the required assets.
Henceforth, projected income statement and statement of financial position can
be projected.
Steps in Financial Forecasting
It involves the determination of
a. How much money will the firm need during a given period?
b. How much money will the firm generate internally or through operations?
c. How much additional funds or external financing will be required?
It should be noted that financial forecasting is the basis for budgeting activities.
Projected Financial Statement Method
a. Establish a sales projection
b. Prepare the production schedule such direct materials, direct labor and
overhead
c. Estimate selling and administrative expenses
d. Consider financial expenses
e. Determine the net profit
Then, forecast the Statement of Financial Position, raising of additional funds
needed, and consider financing feedbacks
• In like manner, major steps in preparation of a budget consists of:
1. Prepare a sales forecast
2. Determine expected production volume
3. Estimate manufacturing costs and operating expenses
4. Determine cash flow and other financial effects
5. Formulate projected financial statement

FORECASTING CASH INFLOWS AND OUTFLOWS

Forecasting cash inflows and outflows is one of the most difficult task a company
faces in managing its cash. It involves coordinating the cash movements from the
providers and users of cash throughout the company. Without an accurate cash
forecasting system, the company is liable to experience problems involving
overdrafts, deficiencies, late payments, and reduced levels of earnings from idle
cash.
What is Budgetary Slack
Budgetary slack is a cushion created in a budget by management to increase the
chances of actual performance beating the budget. Budgetary slack can take one of
two forms: an underestimate of the amount of income or revenue that will come in
over a given amount of time, or an overestimate of the expenses that are to be paid
out over the same time period.
BREAKING DOWN Budgetary Slack
Budgetary slack is generally frowned upon because the perception is that managers
care more about making their numbers to keep their seats and gaming the executive
compensation system rather than pushing company performance to its potential.
Managers putting a budget together could low-ball revenue projections, pump up
estimated expense items, or both to produce numbers that will not be hard to beat
for the year. The best way to avoid budgetary slack is to install a management team
with integrity.
Chapter 15 – Working Capital and The Financing Decision
The ability to manage working capital will enhance the return and lower the risk
of running short of cash. There are a number of ways to manage working capital
and cash to result in optimal balances including quantitative techniques. Net working capital equals
current assets less current liabilities. A consideration must be given to how assets should be
financed (e.g., short-term debt, long-term debt, or equity). There is a trade-off between return and
risk that has to be taken into account. If funds move from fixed assets to current assets, there is a
reduction in liquidity risk, greater ability to obtain short-term financing, and more flexibility,
because a company can better adjust current assets of changes in sales volume. However, less of a
return is typically earned on current assets than fixed assets.
Factors Affecting Level of Current Assets
1. General nature of business and product – trading and manufacturing usually require higher
proportions of current assets than service and utility companies
2. Effect of sales pattern – working capital needs depends on the nature of the change in sales or
business activity. If the change in sales if brought about by cyclical or seasonal changes, the
periodic build-up of receivables and inventory is temporary and financing need is considered
short-term. Conversion of investments into cash will come in the normal course of operation.
3. Length of the manufacturing process – the longer the period of time required to manufacture
the products, the higher the level of working capital requirement
4. Industry practices – if line of business requires greater proportion of assets readily convertible
to cash, the lower working capital investments and a higher level of current liabilities
5. Terms of purchases and sales – it depends on the length of credit period granted. The longer
period granted by the supplier of merchandise, the lower the working capital but the longer
the credit period given to customers, the higher the requirement for working capital
Advantages of Adequate Working Capital –
a. Ease in settling debts
b. Credit extended to customers thereby increasing sales volume
c. Inventories can be readily replenished
d. Operating expenses paid promptly
e. Management and employee morale is enhanced
f. Profitable opportunities can be taken advantage of
Disadvantages of Excessive Working Capital
g. Management may become inefficient and complacent
h. Tendency to speculate
i. Unnecessary expenses and extravagance
j. Resources not optimally employed
Current Assets Investment Policies
1. Conservative or Relaxed Investment Policy – large amount of cash, marketable securities and
inventories are carried and under which sales are stimulated by liberal credit policy, resulting in a
high level of receivables. This policy provides the lowest expected return since capital tied up in
current assets does not earn any substantial income but entails lowest risks
2. Aggressive or Restricted – the firm has fewer liquid assets with which to prevent a possible
financial failure. Holdings in current assets are minimized. While risk of financial failure is high
because of small amount of total capital commitment, the profitability rate measured by the rate
of return as total assets however is high.
3. Moderate – this is a policy that is between the relaxed and restricted policies.
Alternative Current Asset Financing Policies –
1. Maturity Matching or “Self-liquidating approach
2. Aggressive Approach
3. Conservative Approach

Risk – Return Tradeoff

Working capital financing decision involves a risk/return tradeoff. Since the short-term financing
generally cost less than long-term capital, the aggressive approach has the highest expected return,
but short term financing brings with it the greatest risk. Conversely, the conservative approach
offers the lowest expected return but also the lowest risk.