Financial Forecast a Shortcut to Financial Planning

Finance Financial Forecast: a Shortcut to Financial Planning In an ever changing business environment, business enterprises should make strategic decisions to be able to survive and grow. This requires setting and applying business strategic plans including operational activities, that cannot be implemented without taking care of their financial implications. Indeed, all strategic plans are associated with financial requirements that should be regarded and planned for ahead of each fiscal operational period. Preparing and controlling those strategic financial plans is a simpler issue for large business enterprises than it is for small and medium size companies. Financial forecasting techniques represent a simple strategic financial plan that helps business enterprise realizing and understanding all the financial implications and requirements associated with its overall strategic plan Ahmad Hamzeh* CPA, CMA, PhD. Candidacy, University lecturer and Coordinator of Accounting and Finance Sales and Assets: A Cause Effect Relationship ■ Profitability Profitability is briefly defined as: The result of business operations. Profits may be computed on daily, weekly, monthly, quarterly, semi-annually or annually. They are the effect of many business causes. Therefore, profits are usually considered from too many perspectives based on what their cause is considered to be. by the business owners to calculate the return on investment or return on equity. Return on Investment = Net Profits/Owners’ Equity * 100 Cause: Owners’ Equity  Sales  Effect: Profits Reading Profits from a Comprehensive Perspective Many are arguing about what is the main cause of business operations. The balance sheet states that business operations are based on the existence of assets, both fixed and current. Those assets are not only financed by owners’ equity, but also by liabilities. Therefore, business operations arise only when all necessary funds are provided to finance necessary assets required to activate them. Those necessary funds are not only created through owners’ equity. Thus, the cause of business operations also goes to the contribution made by business liabilities in financing business assets. So, the cause of any business operation is the existence of all business assets created through both liabilities and equity funds. Sequentially, operating and managing business assets, is the cause of all sales activities. In turn, sales activities act as the cause of achieving business profits. Under this perspective, profits are regarded as the result of operating business assets, and are compared to them to get business profitability. Return on Assets = Net Profits/Total Assets * 100 Cause: Assets  Sales  Effect: Profits Reading Profits from an Operational Perspective This perspective involves relating the profits to sales. Here the sale event is considered as the cause to an effect; that is the profit. Therefore, profits are compared to sales to calculate the net profit margin. Net Profit Margin = Net Profits/Sales * 100 Cause: Sales Effect: Profits Reading Profits from the Investors’ Perspective Business capital is its owners’ equity. This includes capital and any accumulated retained profits. In other words, the total investment made by the business owners. Business owners regard profits as the result achieved on their equity or investment. Here the story starts with the investment made by the business owners; which is the cause that creates sales activities; which in turn is the cause to the final effect; that is, the profits. Accordingly, profits are compared to the investment made * ahmad_ar_hamzeh@yahoo.com  THE CERTIFIED ACCOUNTANT 4th Quarter 2007 ‫ ـ ـ‬Issuse #32 Finance The Financial Implications of Being Strategic ■ Business Strategic Plans: Operations Require Finance Business enterprises usually develop strategic plans, that help them carry out business activities in an ever changing dynamic business environment. Those plans incorporate objectives that need to be accomplished through the implementation of different strategies, policies and simple tactics. Those include many operational activities to be undertaken to reach business goals and objectives. Operational plans have financial implications that should be fulfilled while considering them. For instance, an operational business plan might state the steps and details required for the acquisition and development of new business plant or equipment for expansion and increased market share purposes. However, such business decision, has a major financial implication that should be planned and properly dealt with to enable the business carry on with it. That is: where to bring the financing required for this operational plan from? Spontaneous Relationship Between Sales and Assets ■ Increasing Sales Increasing Fixed Assets One of the major investments made by companies is in the fixed assets. The capacity of utilizing those fixed assets affects the decision of whether sales may or may not be increased without the necessity to acquire more of them. In many instances, fixed assets already utilized are operated at below full capacity. The fixed assets utilization or the turnover ratio is one of the financial ratios calculated to answer questions such as: Are the fixed assets acquired required to enable business reach its actual level of sales? Are fixed assets operated at their full capacity? Is the business able to increase its sales with the existing fixed assets? Did the business carry an overload of useless fixed assets as compared to its attainable possible level of sales ant its market share? Once fixed assets are operated at their full capacity, any decision to increase sales is accompanied by a spontaneous decision to increase the business fixed assets. There are many calculations performed to assume a certain level of maximum sales, usually called “Full Capacity Sales”; where, businesses examine what is the maximum level of sales that can be attainable if the fixed assets are operated at their maximum level of productivity. Fixed Assets Turnover Ratio = Sales/Fixed Assets )Measurable in Times( Full Capacity Sales = Actual Sales Level/ Actual Percentage of Fixed Assets Utilization ■ Direct Relationship Between Sales and Assets According to the profit comprehensive perspective, sales can only be accomplished when business assets are acquired, invested and operated. This perspective introduces the direct cause-effect relationship between sales and assets. Therefore, any increase in sales might require an increase in assets. And, since the relationship between sales and assets is said to be direct, then it is possible that any planned increase in sales might require a similar and proportional increase in assets. ■ Increasing Sales Increasing Cash Sources of Financing Increase in Assets Increasing business assets requires sources of financing. This can be brought either through getting different credit facilities from creditors in the form of debt, or through injection of owners’ capital and retained profits. One of the major direct responders among creditors to the urgent business need to funds, are the creditors also called suppliers that offer to the business credit facilities in the form of short-term regular accounts payable. However, all other creditors require written promises interest bearing notes to allow more credit financing to the business. Such as, bank loans, regular short and long-term notes payable, and corporate bonds payable. Similarly, it is a financially and legally a more complicated means of financing, when business decides to refer to owners new capital financing to increase business assets. Objective : Increase Business Sales : Operational : Increase business assets. Plan Financial : “How to raise funds?” Increase in Sales Increase in Assets  Financing?  Account Payable Companies usually decide on the amount of cash that should always be available in the safe and the bank account based on their anticipation to meet basic payments made to suppliers and other expenditures. When sales are expected to increase, a spontaneous increase in the amount and level of those payments is also expected. ■ Increasing Sales Increasing Inventory Businesses apply different policies just to keep the right amount of inventory required to meet their sales activities and accomplish the delivery of sold items at the right time and place. However, storing inventories is as complicated as accomplishing the sales. In fact, storage represents one of the major expenses incurred during the cash and production life cycle. Yet, it is considered as a non value adding cost element in this cycle. Companies tend to plan and apply different effective and strategic policies to import, inward, then store the right amount and level of inventory and for the optimal length of time before final delivery is made to clients upon sales; thus, minimize non value added cost elements on sales. The inventory turnover ratio is calculated by comparing the actual level of attainable sales to the amount and level of inventory actually stored. This ratio answers many analytical and financial 32 ‫الف�صل الرابع 7002 ـ ـ العدد‬  Finance questions; such as: Is the business storing the appropriate and necessary level of inventory to accomplish its actual level of sales? How fast is the company selling its inventory? How many times is the company able to sell its entire level of inventory stored during the course of completing its actual level of annual sales? New managerial trends introduced the concept of Just-In-time (JIT) inventories. This school of managerial thought suggests that inventories should only be ordered when business have in return available sales requests to fulfill. Consequently, storage cost is only paid and incurred for a minimum wait time. That is, the short interval of time, where goods are received; then, directly delivered to clients. JIT is a favorable storage policy that is faced with many implementation difficulties. Increasing sales requires a spontaneous increase in the level of inventories stored. For merchandise companies, this involves an increase in the level of inventory of inward goods that should be available for sales. For manufacturing companies, it involves a responding increase in the inventories of both raw materials available for production as well as finished manufactured goods available for sales. Inventory Turnover Ratio = Sales/Inventory )Measured in Times( Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory )Measured in Times( Cycle Time = Order Time + Production Time )If Manufactured( + Wait Time + Delivery Time Value Added Time = Production Time Non Value Added Time = Order time + Wait Time + Delivery Time Consequently, financial scientists have realized and established a spontaneous relationship between Sales and Assets based on the assumption of viewing profitability as the effect of sales which in turn is the effect of all the business assets’ operation. Therefore, the relationship of individual assets to sales is realized by calculating in percentages the amount of each asset compared to the company’s actual sales level. And, maintain those assets to sales ratios to forecast the required increase in the business assets required to enable attain the desired increase in sales. Required Increase in Fixed Assets = Fixed Assets/Sales * Increase in Sales Required Increase in Cash = Cash/Sales * Increase in Sales Required Increase in Inventories = Inventories/Sales * Increase in Sales Required Increase in Accounts Receivable = Receivables/Sales * Increase in Sales Total Required Increase in Assets = Required Increase in Fixed Assets + Required Increase in Cash + Required Increase in Inventories + Required Increase in Receivables Where to Finance the Required Increase in Total Assets? ■ Simple and Spontaneous Response from Business Suppliers Only simple debts and liabilities financing tools are expected to respond in financing the required increase in the total assets. For instance, the suppliers are expected to increase their credit facilities that are usually offered to the business. Negotiations between management and purchase department with the company’s suppliers can result in a spontaneous increase in the payment facilities those suppliers are actually providing. Therefore, suppliers’ payables are also compared to sales with the aim of establishing a spontaneous relationship between them. This relationship assumes the amount of financing expected to raise for the purpose of funding the required increase in total assets necessary to increase business sales. Spontaneous Increase in Liabilities = Suppliers Payables/Sales * Increase in Sales ■ Increasing Sales Allowed to Customers Increasing Credit Facilities The concept of credit sales introduced the policy of selling now and collecting later. The increased competition between similar and different commodities imposed increased pressure over the limited resources consumers possess. Therefore, most of the businesses implement credit policies to face intensive market competition. Increasing sales can be attained through increasing the credit facilities on payments expected to be collected from business customers after sales take place. The Average collection period is a ratio that measures the average number of days required by a company to cash back one of its credit sales invoices. A major financial problem arises when the average collection period is greater than the length of time required to make reciprocal payments on goods and raw materials to business suppliers. If this problem exists, businesses tend to borrow in order to meet their due payments on time. Borrowing creates a financial burden and reduces business profitability when interest expenses are imposed on debts. It is essential to create an additional base to attract clients by allowing them more credit sales facilities when company plans to increase its actual level of sales. Average Collection Period = Accounts Receivable/Average daily sales )Measured in number of days( ■ Indirect Response from Business Expected Profits Business net profit margin on sales is expected to be maintained during next year’s operational exercise. Net profits are projected and a portion is appropriated for distribution to owners. The residual profits are retained for both legal and provisionary purposes. Those provisionary retained profits can also be used to raise funds for the upcoming required increase in total assets. Increase in provisionary retained profits = )Net Profit Margin * Projected Sales( – Appropriated profits for distribution The Problem: Where to get the additional financing required to complete funding the necessary increase in the total assets? The decision of increasing sales is usually obstructed; when the  THE CERTIFIED ACCOUNTANT 4th Quarter 2007 ‫ ـ ـ‬Issuse #32 Finance funds rose through suppliers credit facilities and provisionary retained earnings are expected not to be sufficient to cover the necessary increase in total assets. Both management and finance department must work closely to arrange for other sources of financing. For instance, financing through both shortterm and long-term note and interest bearing debts, and through the injection of new capital by the owners. The decision of where and how to raise the residual finance required is based upon business target capital structure. That is, the target portion of debt versus capital financing. Additional Financing Required = Required Increase in Total Assets – Spontaneous Increase in Simple Debts – Expected Increase in provisionary profits distribution, the increase in the retained profits is calculated and projected. ■ The Projected Balance Sheet The Assets: Individual assets relationship with sales is maintained, and a projection of next year’s assets is accomplished by multiplying those assets ratios to sales by next year’s projected sales. The Liabilities: A similar calculation to that of the assets is performed regarding the suppliers payables. The Owners’ Equity: The projected retained Profits are added to the owners’ equity. The Difference: The Projected Balance Sheet shows unequal totals. Usually projected assets are greater then projected liabilities and equity. The resulting difference is exactly in the same amount of the additional financing required. Once the management and financial department of the company decide upon where to get the remaining finance from, the appropriate projection of those amounts is then made to the other liabilities and capital accounts. Preparing a Shortcut Projection to Next Year’s Financial Statements ■ The Projected Income Statement Target attainable sales are forecasted and projected to the next operational year. Both cost and variable expenses relationship with last year’s sales is projected to next year. However, fixed expenses are either projected with the same amount of last year, or estimated with a new fixed amount. Consequently, a projection of next year’s net income is projected. This exercise may be re-taken using a direct shortcut to calculate the projected net income by simply applying the net profit margin assumed to be maintained, to the projected sales of next year. Method 1 Projected Net Income = Projected Sales – Projected Variable Cost and Expenses – Projected Fixed Expenses )Variable Cost and Expenses have a maintainable ratio to sales(. Method 2 Projected Net Income = Projected Sales * Net Profit Margin )Maintained( Projected Financial Forecast…. a Shortcut to Strategic Financial Planning Being Strategic can be accomplished with a financial expense. Designated business operations required to be strategic, increase sales and market share, compete and enrich business reputation, require a well structured financial plan that takes care of all its financial implications. Large businesses usually develop short term master budgets that can be examined and revised during the year to check for operational and financial variances from the budget plan and correct and control any deviations. Those master budgets are expensive to develop and time consuming. Which make them very difficult to prepare for small and medium size business enterprises. Preparing a projected financial forecast can be simpler and less costing to prepare; yet, not replacing the master budget. The projected financial forecast may be considered as an elegant simple shortcut of financial strategic plans  ■ The Projected Retained Profits After the deduction of the expected profits appropriated for How to Give Orders Many people believe that to be a good manager you have to give orders to the people below you. They are wrong. You do not have to give orders. In fact, you should not give orders. person to figure out the best way to do the task. Second, you do not let them learn. Ø Give instructions instead Ø Don't give orders When you give orders, you tell someone to do something. When you give an order, you do not allow the other person any latitude to think about what to do or how to do it. All they can do to satisfy your order is exactly what you ordered. There are two reasons why this is bad. 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