# Financial Forecasting

## Forecasting Sales

### Learning Outcomes

By the end of this section, you will be able to:
1. Explain how sales are the main driver for a financial forecast.
2. Determine a past time period to formulate the basis for a financial forecast.
3. Explain the advantages and disadvantages of using past data to forecast future financial performance.
4. Calculate past sales growth averages.
5. Justify adjusting relationships when forecasting future financial performance.
In this section of the chapter, you will begin to explore the first step of creating a forecast: forecasting sales. We will discuss common time frames for sales forecasts and why we use historical data in our forecasts (but only with caution), and we will work through the process of forecasting future sales. We will be using the percent-of-sales method to forecast some expenses for Clear Lake Sporting Goods, the example used throughout the chapter. This method relies on sales data, further highlighting why accuracy in forecasting sales is crucial.

### Sales as the Driver

A significant portion of a business’s costs are driven by how much it sells. Thus, the sales forecast is the necessary first step in preparing a financial forecast. Common costs driven by sales include direct product costs, direct labor costs, and other key variable costs (i.e., costs that vary proportionately to sales), such as sales commissions.

### Looking to the Past

Forecasting sales is not always an easy task, as no one knows the future. We can, however, use the information we do have to forecast future sales with the greatest accuracy possible. Most firms start by looking at the past. A firm may look at past sales from a variety of prior periods. It’s common to look at the past 12 months to estimate the coming 12 months. Looking at 12 consecutive months helps identify seasonality of sales trends, what time of year sales tend to drop off and when they increase, possible sales spikes that might reoccur, and any other trends that tend to appear over a 12-month period. In , we see Clear Lake’s sales by month for the past 12 months.
Past data is often used in conjunction with probabilities and weighted average calculations derived from probabilities. Though used in several areas of forecasting, this approach is particularly common in drafting the sales forecast. Using multiple scenarios and the probability of each scenario occurring is a common approach to estimating future sales.
We can see at first glance that sales remain fairly steady from January to April. Sales then goes up significantly in April and May, seem to peak in June, taper off a bit in July, then decline steeply from August to the end of the year, with the lowest sales being in November and December. Though not exact, it’s easy to quickly see that sales follow a seasonal pattern. We will focus on just one year of data here to keep things simple. However, it’s important to note that when a firm has a seasonal sales pattern, it normally uses more than one year of data to detect and evaluate the pattern. It’s not uncommon for firms to have a seasonal sales pattern that fluctuates based on an external factor such as weather patterns, patterns in business or demand, or other factors such as holidays. Common examples might include farm-based businesses that function on a weather pattern for harvesting and selling crops or a toy company that fluctuates around gift-giving holidays.
This knowledge is helpful when assembling a first pass at the next year’s sales forecast. Using common-size and horizontal (trend) analyses on sales is also helpful, as shown in . We can see the exact percentages that sales went up or down each month:
1. In January, the company had sales of $9,000, which was  of the total annual sales.
2. In June, the company had $19,000 sales, which was  of the total annual sales and  of January sales.
Once a baseline in the 12-month period is assessed, it can also be helpful to look for trends in other ways. For example, the past several years might be assessed to see if there is a trend in total growth or decline for those years on a summary basis or by period. Clear Lake Sporting Goods had sales in the current year of $126,000, in the prior year of $105,000, and two years ago of $89,000. This reflects a 20% increase and an 18% increase, respectively. It might be reasonable to expect a roughly 18 to 20% increase in total sales in the future with only this information in mind. Keep in mind that we will learn about many other factors to consider in the forecast, so the 18 to 20% increase is a good general guideline to consider along with other factors.
Looking at , assume that Clear Lake Sporting Goods decides to take its first pass at a forecast using the more conservative estimate of 18% total sales growth. The company could consider last year’s sales of $126,000 and increase them by 18% to arrive at total forecasted sales for next year of . Next, to get the monthly sales, the company could use the same percent of the total for each month that it did for the previous year. For example, sales in January of last year were 7.1% of the full year’s sales. To find the forecast for the next year, the company would take the forecasted sales of $148,680 for the year and multiply that by 7.1% to get $10,620 for January. The process is repeated for each month to get the full year.
Keep in mind that this is only a starting point. These estimates will be reviewed, assessed, and updated as more information and other factors are taken into consideration.
It can also be helpful to look at a shorter period, perhaps just the last few months, on a more detailed basis (by department, by customer, etc.) to see if there are any possible new trends beginning to develop that might be an indicator of performance in the coming year. For example, Clear Lake Sporting Goods might look at detailed sales records for October, November, and December and see that it had an old product line that was discontinued in early October, which contributed to a 2% reduction in monthly sales. This reduction in monthly sales will likely continue into the new year until the new line the company has signed on begins arriving in stores. Thus, the management team feels they should reduce their first quarter monthly estimates by 2%, as reflected in . January is now , for example.

### Changes for the Future

It’s important to note that the past is not always a reliable predictor of the future. Circumstances can often change to make the future quite different from the past. The business itself may change, the economy can change, the customer base may undergo a shift in demographics or a change in buying habits, new competition may emerge, and so on. So while past performance is helpful, it is only one step in the process of forecasting sales.
Most firms first look to the past to target some form of baseline estimate for the coming year; then, managers begin making adjustments based on what they know about the future. Assume that Clear Lake Sporting Goods will be adding a new brand to its collection of fishing supplies in March. The manufacturer plans to begin running its commercials in late February, which managers anticipate will increase Clear Lake’s monthly sales by about $500 in March, $1,000 in April, $1,400 in May, and $2,000 per month in June, July, and August. We see the monthly adjustments to Clear Lake’s latest sales forecast in . March, for example, is now $10,908 ($10,408 prior estimate plus $500 increase from new brand).
What we have discussed here are only some brief examples of the myriad factors that might impact a sales budget for the coming year. It’s critical that all members of the team take the time and effort to research their customers and the factors that impact their business in order to effectively assess the impact of these factors on future sales. Though only two adjustments were made here, it’s likely that a large firm would have to consider many, many factors that would ultimately impact monthly sales figures before arriving at a conclusion.

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The sales forecast is the foundation on which much of the rest of the forecast is built. Thus, the sales forecast is completed first. Historical sales data and any other information on the firm, its products, the economy, its customers, and its competitors are all used to create the most accurate sales forecast possible.

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# Financial Forecasting

## Pro Forma Financials

### Learning Outcomes

By the end of this section, you will be able to:
1. Define pro forma in the context of a financial forecast.
2. Describe the factors that impact the length of a financial forecast.
3. Explain the risks associated with a financial forecast.
In this section of the chapter, we will move beyond the sales forecast and look at the general nature, length, and timeline of forecasts and the risks associated with using them. We’ll look at why we use them, how long they generally are, what the key variables in a forecast are, and how we pair those variables with common-size analysis to develop the forecast.

### Purpose of a Forecast

As mentioned earlier in the chapter, forecasts serve different purposes depending on who is using them. Our focus here, however, is the world of finance. In this realm, the key purpose of pro forma (future-looking) financial statements is to manage a firm’s cash flow and assess the overall value that the firm is generating through future sales growth. Growing just for the sake of growing doesn’t always yield favorable income for the firm. A larger top-line sales figure that results in lower net income doesn’t make sense in the grand scheme of things. The same is true of profitable sales that don’t generate enough cash flows at the right time. The firm may make a profit, but if it doesn’t manage the timing of its cash flows, it could be forced to shut down if it can’t cover the costs of payroll or keep the lights on. Forecasting helps assess both cash flow and the profitability of future growth. Managers can forecast cash flow using data from forecasted financial statements; this allows them to identify potential gaps in cash and plan ahead in order to either alter collection and payment policies or obtain funding to cover the gap in the timing of cash flows.

### Length of a Forecast

Forecasts can generally be for any length of time. The length generally depends on the user’s needs. A one-year forecast, broken down by month, is quite typical. A firm will often go through a formal budgeting process near the end of its calendar or fiscal year to project financial plans and goals for the coming year. Once that is done, a rolling financial forecast is then done monthly to adjust as time moves on, more information becomes available, and circumstances change.
To be useful, the future forecast for financial planning purposes is almost always calculated as monthly increments rather than one total figure for the next 12 months. Breaking the data down by month allows finance managers to more clearly see fluctuations in cash flows in and out, identify potential gaps in cash flow, and plan ahead for their cash needs.
Forecasts can also be done for several years into the future. In fact, they commonly are. However, once the firm is looking out beyond 12 months, it gets difficult to forecast items with a great degree of accuracy. Often, forecasts beyond a year will be completed only to quarterly or even annual figures rather than monthly. Forecasts that far into the future are often strategic in nature, made more to communicate future plans for the firm than for more detailed decision-making and cash flow planning.

### Common-Size Financials

As we saw earlier in the chapter, common-size analysis involves using historical financial statements as a basis for future forecasts. Financial statements provide a great starting point for analysis, as we can see the relationships between sales and costs on the income statement and the relationships between total assets and line items on the balance sheet.
For example, in , we saw that for the past two years, cost of goods sold has been 50% of sales. Thus, in the first draft of a forecast for Clear Lake, it’s likely that managers would estimate cost of goods sold at 50% of their forecasted sales. We can begin to see why forecasting sales first is crucial and why doing so as accurately as possible is also important.

### Select Variables to Use

A simple way to begin a full financial statement forecast might be to simply use the common-size statements and forecast every item using historical percentages. It’s a logical way to begin a very rough draft of the forecast. However, several variables should be taken into consideration. First, managers must address the cost of an account and determine if it’s a variable or fixed item. Variable costs tend to vary directly and proportionally with production or sales volume. Common examples include direct labor and direct materials. Fixed costs, on the other hand, do not change when production or sales volume increases or decreases within the relevant range. Granted, if production were to increase or decrease by a large amount, fixed costs would indeed change. However, in normal month-to-month changes, fixed costs often remain the same. Common examples of fixed costs include rent and managerial salaries.
So, if we were to approach our common-size income statement, for example, we would likely use the percentage of sales as a starting point to forecast variable items such as cost of goods sold. However, fixed costs may not be accurately forecast as a percentage of sales because they won’t actually change with sales. Thus, we would likely look at the history of the dollar values of fixed costs in order to forecast them.

### Determine Potential Changes in Variables

So far, we have focused on using historical common-size statements to create a draft (not a final version) of the forecast. This is because the past isn’t always a perfect indicator of the future, and our finances don’t always follow a linear pattern. We use the past as a good starting point; then, we must assess what else we know to fine-tune and make adjustments to the forecast.
Many items impact the forecast, and they will vary from one organization to another. The key is to do research, gather data, and look around at the market, the economy, the competition, and any other factors that have the potential to impact the future sales, costs, and financial health of the company. Though certainly not an exhaustive list, here are a few examples of items that may impact Clear Lake Sporting Goods.
1. It has an old product line that was discontinued in early October, contributing to a 2% reduction in monthly sales that will likely continue into the new year until a new line begins arriving in stores.
2. It will be adding a new brand to its collection of fishing supplies in March. The manufacturer plans to begin running commercials in late February. Managers anticipate that this will increase Clear Lake’s monthly sales by about $500 in March, $1,000 in April, $1,400 in May, and $2,000 per month in June, July, and August.
3. The company has just finished updating its employee compensation package. It goes into effect in January of the new year and will result in an overall 4% increase in the cost of labor.
4. The landlord indicated that rent will increase by $50 per month starting July 1.
5. Some fixed assets will be fully depreciated by the end of March. Thus, depreciation expense will go down by $25 per month beginning in April.
6. There are rumors of new regulations that will impact the costs of importing some of the more difficult-to-obtain hunting supplies. Managers aren’t entirely sure of the full impact of the new legislation at this time, but they anticipate that it could increase cost of goods sold for the affected product line when the new legislation goes into effect in the last quarter. Their best estimate is that it could increase the overall cost of goods sold by up to 2%.
We will use all of this data later in the chapter when we are ready to compile a complete forecast for Clear Lake.

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Pro forma financial statements are forward looking in nature. They use the sales forecast, historical data, financial statement analyses, relationships between accounts and statements, and any other information known about the firm, the environment, and the future to create the most accurate financial statement forecast possible.

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### What Is a Pro Forma?


# Financial Forecasting

## Generating the Complete Forecast

### Learning Outcomes

By the end of this section, you will be able to:
1. Generate a forecasted income statement that incorporates pertinent sales, functional, and policy variables.
2. Generate a forecasted balance sheet.
3. Connect the balance sheet and income statement forecasts with appropriate feedback linkages.
In this section of the chapter, we will tie together what we have learned so far about forecasting sales, common-size analysis, and using what we know about the company and its environment to create a full set of pro forma (forward-looking or forecasted) financial statements.

### Forecast the Income Statement

To arrive at a fully forecasted income statement, we use historical income statements, common-size income statements, and any additional information we have about future sales and costs, such as the effects of the economy and competition. As we saw earlier in the chapter, we begin with forecasted sales because they are the basis for many of the forecasted costs.
Let’s begin with the sales forecast for Clear Lake Sporting Goods that we saw earlier in the chapter, in , and use it along with the prior year income statement by month shown in . We will consider other data we have about the business to begin creating a full income statement (see ).
The first two key points regarding product lines have already been built into the sales forecast. Notice that the cost of goods sold was 50% in the prior year. However, based on possible future legislation, to be conservative, we should increase the cost of goods sold by 2% in the last quarter of the year. Thus, we will forecast cost of goods sold at 50% of sales in the first nine months and increase it to 52% in the last three months of the year.
Rent is a fixed cost that historically amounts to $458 per month. However, we know that the landlord is increasing rent by $50 starting on July 1. Thus, we will forecast rent at the same fixed cost of $458 per month for the first six months and increase it to $508 per month for the second half of the year.
Depreciation, also a fixed cost, was historically $300 per month. However, we know that depreciation expense will go down by $25 beginning in April. Thus, we forecast depreciation at $300 for the first three months and at $275 for the last 9 months.
Salaries expense has historically been $450 per month. However, we know that the company is implementing a new compensation program on January 1 that will increase salaries expense by 4% ($18). Thus, we will forecast salaries for the whole year at $468.
Utilities expense seems to vary somewhat by sales from month to month, as shops are open longer hours during their busy season. However, the total utilities expense is not expected to change for the coming year. Thus, the forecast for utilities expense remains at $2,500, broken down by month as a percentage of sales.
Interest expense is a fixed cost and isn’t anticipated to change. Thus, the same $167 interest expense per month is forecast for the coming year.
Finally, income tax expense is forecasted as a percentage of operating income because tax liability is incurred as a direct result of operating income.  shows the next 12 months’ forecast for Clear Lake Sporting Goods using all of this data.

### Forecast the Balance Sheet

Now that we have a reasonable income statement forecast, we can move on to the balance sheet. The balance sheet, however, is entirely different from the income statement. It requires a bit more research and additional assumptions. Just like the income statement, it’s often a work in progress. A first draft is a good starting point, but adjustments must be made once it is created, and all the interrelationships between the statements, cash flow in particular, are taken into consideration.
The balance sheet is a bit more difficult to forecast because the statement reflects balances at just a given point in time. Account balances change daily, so forecasting just one snapshot in time for each month can be a challenge. A good starting point is to assess general company financial policies or rules of thumb. For example, assume that Clear Lake pays most of its vendors on net 30-day terms. A good way to forecast accounts payable on the balance sheet might be to add up the cost of goods sold from the forecasted income statement for the prior month. For example, in , we see that Clear Lake has forecasted its accounts payable for March as the cost of goods sold in March from its forecasted income statement.
For accounts receivable, Clear Lake generally receives payment from customers within net 90-day terms. Thus, it uses the sum of the current and prior two months’ forecasted sales to estimate its accounts receivable balance.
Inventory will vary throughout the year. For the first six months, the company tries to build inventory for four months of sales. Once the busy season hits, inventory goes down to three months’ worth of future sales, then finally drops to only two months of sales in December. Thus, managers use their sales forecast by month to estimate their inventory ending balance each month.
The equipment balance is forecasted by reducing the prior month’s balance by the forecasted depreciation expense on the forecasted income statement.
Unearned revenue is historically around 50% of the current month’s sales. Thus, Clear Lake estimates its unearned revenue balance each month by taking the current month’s net sales from the forecasted income statement and multiplying it by 50%.
Short-term investments, notes payable, and common stock are not anticipated to change, so the current balance is forecasted to remain the same for the next 12 months.
To forecast the ending balance for retained earnings for each month, managers add the monthly net income from the forecasted balance sheet to the prior balance and subtract a quarterly $10,000 dividend.
Once all of these accounts are completed, the balance sheet is out of balance. Given that all of these events are somewhat related but are not tied together dollar for dollar, it’s not surprising when the forecasted balance sheet is finished and does not balance. To complete the first draft (see ), the cash account is used as a variable and plugged in to make the balance sheet balance. Notice that by the end of the year, the company has $59,905 in cash. However, look at what happens midyear—the cash account falls to only $8,782. In the next section, we will generate a cash flow forecast, which will allow Clear Lake to update its balance sheet forecast once it estimates what it will do to cover the cash flow gaps.

### Linkages between the Forecasted Balance Sheet and the Income Statement

Notice that in the discussion in the prior section on the balance sheet forecast, a lot of the information in the forecasted income statement was used to generate the forecasted balance sheet. The balance sheet accounts generally depend on activity reported in the income statement. For example, for many firms, the balance in their accounts receivable account is tied to their sales. Looking at historical balances in the accounts receivable account and how those relate to historical sales will help determine how to use the forecasted future sales to estimate the future balance of accounts receivable.
The same is true of accounts payable. Looking at past balances, past expenses (normally cost of goods sold), and the firm’s payment terms for its vendors allows managers to use forecasted cost of goods sold or other expenses to estimate the balance in the accounts payable account.
We learned in Financial Statements that net income flows into retained earnings. Thus, the net income from the forecasted income statement can be used to help estimate the ending balance in retained earnings. If the firm intends to issue any dividends in the coming year, managers should also estimate that reduction in their forecast.
It’s also common to find other general policies or procedures that help drive performance and aid in forecasting balances. For example, if the company has a goal of maintaining a certain level of inventory or a minimum balance in its cash account, that information can be used to guide the estimate for those accounts.

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Interrelationships among historical data, the forecasted income statement, and the forecasted balance sheet are all used to estimate each line item in the financial statements.

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# Financial Forecasting

## Forecasting Cash Flow and Assessing the Value of Growth

### Learning Outcomes

By the end of this section, you will be able to:
1. Generate a cash flow forecast.
2. Assess a cash flow forecast to determine future cash funding needs.
3. Use pro forma financial statements and cash flow forecasts to assess the value of growth to the firm.
In this section of the chapter, we will use the forecasted income statement, forecasted balance sheet, and other information we know about the firm’s policies and goals for the coming year to generate and assess a cash flow forecast.

### Create a Cash Flow Forecast

A cash flow forecast isn’t overly complex, yet it is not easy to assemble because it requires making many assumptions about the future. A cash forecast begins with the beginning cash balance, adds anticipated cash inflows, and deducts anticipated cash outflows. This identifies cash surpluses and shortages.
For Clear Lake Sporting Goods, for example, we see in  that the company begins with cash of $42,581,000 in January of the new year. Next, it lists the cash inflows, or cash received from customers. Given the assumption that customers pay in 90-day terms, the cash flow is filled in by plugging in the sales forecast for the three prior months. For example, the cash flow from customers of $10,508 for June is the same as the net sales forecast for March (see ).
Next, Clear Lake identifies cash outflows, which include accounts payable, salaries, rent, utilities, dividends, and interest payments. Accounts payable are normally paid within 30 days, so the forecast for cost of goods sold for the prior month is used as an estimate of amount paid for payables. For example, in , we see that the accounts payable settled in June of $8,610 is the cost of goods sold for May from the forecasted income statement.
Salaries are paid monthly and thus represent the same recurring monthly cash outflow, as does rent. Utilities, like accounts payable, are assumed to be paid within 30 days. Thus, the cash outflow for utilities is the utilities expense for the prior month from the forecasted income statement.
Management intends to pay a quarterly dividend of $10,000. Thus, in , we see $10,000 cash outflows forecasted for March, June, September, and December. Interest on the long-term liability is paid quarterly. Thus, the $500 cash outflows in March, June, September, and December are simply the monthly interest expense of $167 from the income statement, summed for each quarter.

### Using a Cash Forecast to Determine Additional Funds Needed

Finally, at the end of the cash flow forecast, cash outflows are subtracted from the cash inflows. This identifies whether a cash surplus (extra) or cash deficit (not enough) exists for each month. For example, in , we see that in March, Clear Lake is forecasting $4,800 of cash inflows and $17,800 of total cash outflows, which results in a cash deficit of $13,000.
Clear Lake has a general policy to not let its cash balance fall below $35,000. Thus, managers need to assess their monthly balances and potential deficits and identify months when financing is necessary. For example, the deficit of $13,000 in March is enough to push the cash balance lower than $35,000. Thus, it’s estimated that the company will need $5,000 in short-term financing in March. It has an estimated surplus in April, so $3,000 of the borrowing is returned.

### Assessing the Value of Growth

It’s a fairly common assumption that most, if not all, businesses want to grow. While it certainly can be good as a firm to grow in size, growth just for the sake of growth isn’t necessarily a good goal. A firm can grow in size based on customers, employees, locations, or simply sales. However, that doesn’t mean that the growth will increase profits. Growth may increase profits, but this is not a safe assumption. Scaling up operations takes careful planning, which includes monitoring the profitability of the sales and, of course, the cash flow it would require. Growing a business can require more inventory, more locations, more equipment, and more manpower, all of which cost money. Even if the forecasted growth is profitable, it may pose problems from a cash flow perspective. It’s important that the firm review not only its forecasted income statement and balance sheet but also its cash forecast, as this can reveal some serious gaps in funding depending on the extent, timing, and nature of the planned growth.
For example, assume that Clear Lake Sporting Goods intends to run a large-scale ad campaign to boost sales in its busy season. Historically, the store relied primarily on its prime location for high volumes of retail foot traffic. Managers felt, however, that given the increase in competition, they could boost sales significantly by running the ad campaign in the first quarter. The campaign would cost $30,000. Forecasts already reflect a cash deficit at the end of the first quarter of $13,000, so the additional $30,000 ad campaign, which would require payment up front, would create a much larger need for funding. It’s also important that managers look at the increased cost of doing business along with the increased cost in advertising to ensure that the move would be profitable. Fortunately, Excel or other forecasting software can be used to create a forecast with formulas that tie together, making scenario analysis such as this a much easier process.

### Scenarios in Forecasting

Forecasting is almost never a linear process. In other words, we don’t do one forecast and call it good. The first draft is completed using historical data, and then changes are made a bit at a time as all potential variables are assessed for their impact on the forecast. It’s quite common to then use the work-in-progress forecast to complete scenario analysis. This is particularly true when the forecast is completed in Excel or other budgeting or forecasting software. Elements of the forecast can be changed to see what the overall impact would be to the firm. Assuming the forecast is set up using formulas in Excel or other software, a change to one figure or one variable would then “ripple” through the forecast to reflect the overall impact.
Often, a firm may complete an initial forecast (scenario) under the assumption that the economy is in a “normal state.” The firm can then alter the initial forecast for different scenarios, such as the economy in a recession or the economy in a state of expansion. This helps the firm understand different possible future states and highlights how changes in the economy such as inflation may cause revenue and expenses to increase.
Assume that Clear Lake’s initial forecast is created under the assumption that the economy will remain average. Management also wants to know the worst-case scenario. What will their financial results look like if the economy were in a recession, for example? If management assumes their sales would drop to only 60% of the prior year sales in a recessionary economy, they could alter the formula in Excel driving their sales and variable costs, resulting in a new pro forma income statement. In , we can see that net income would drop to $16,391 under this assumption, compared to the net income of $47,653 forecasted under average economy assumptions in .
Though creating a full forecast in Excel can be a bit complex, it is a powerful tool that is useful for analysis. Elements can be used to vary just about anything, from something small such as a 1% increase in the cost of a product to a company-wide increase in salaries, the introduction of an entire new product line, or the purchase of a new production machine, among other possibilities.
For example, assume that Clear Lake has completed a first pass at its forecast and is reviewing the forecasted profit for the next 12 months. Managers feel the profit is currently low, as they always want to target a certain percentage. They might tinker with variables in the forecast file to see the impact on profits of potential changes they are considering. They may reduce the new salaries package by a percentage point to see if it gets them closer to their goal. They may adjust cost of goods sold by a certain percentage if they feel they can negotiate with vendors to work down their costs. They may adjust rent and see if they can find a better retail location to either reduce costs or increase sales due to increased foot traffic in a new location. They may save an entirely new version of the forecast and change it drastically to see what investing in opening a second retail location would do.
As you can see, the list of possibilities is endless. Though the main goal of financial managers may be cash planning, the power of a well-developed forecast is tremendous. It can help assess potential growth, new opportunities, and even small changes in the business as well.

### Sensitivity Analysis in Forecasting

Sensitivity analysis will often look at the change in just one variable rather than the entire scenario. It examines how sensitive a particular output (commonly net income) will be to a change in a particular underlying input (sales or costs, for example). What if sales are 10% more or less than forecasted? What if the prices the firm can charge its customers are 10% more or less? What if the cost of goods sold increases by 10%? The purpose is to see which variables are crucial to “get right.” It isn’t worth spending a lot of research dollars to make sure you are accurately predicting a variable if that variable won’t notably change the outcome. However, a slight change in other variables may have significant impact.
Using pro forma financial statements created in Excel allows management to quickly generate new pro forma financials and see the impact that each possible variable might have on the overall financial results.

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Once the income statement and balance sheet forecasts are complete, data from those statements, information on company policies, and account relationships are used to generate a cash forecast. The cash forecast is important for identifying any gaps in cash flow so that financial managers can plan for cash needs. It’s also important to review not only the cash forecast but all forecasted financial statements to assess the overall impact and value of proposed firm growth.

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### Cash Flow Forecasting Explained: How to Complete a Cash Flow Forecast Example


# Financial Forecasting

## Using Excel to Create the Long-Term Forecast

### Learning Outcomes

By the end of this section, you will be able to:
1. Generate a financial statement forecast using spreadsheet tools.
2. Connect the balance sheet and income statement using appropriate formula referencing.
3. Use spreadsheet functions to generate appropriate iterations that balance financial forecasts.
Throughout this chapter, we have seen forecasted financial statements for Clear Lake Sporting Goods along with its forecasted cash flow. These statements could all have been generated by hand, of course, but that wouldn’t be an effective use of time. As mentioned in prior sections, several different types of software can be quite effective in making the forecasting process faster and more flexible. In this section, we will review just one common option, Microsoft Excel.

### Using the “Sheet”

Creating a budget in Excel can be very simple or extremely complex, depending on the size and complexity of the business and the number of formulas and dependencies that are written into the Excel workbook.
Creating the forecast in Excel follows the same steps and flow we just explored in this chapter but with the power of a software program to do the math for you. We begin with the sales forecast, which uses several key formulas in Excel.
1. First, sales are projected to be 18% higher than the prior year. Thus, a total projection for the year is calculated using a simple link and multiplication function tied to last year’s total sales. In , you can see the formula in cell O4 is “='Figure 18.12'!N4*1.18”. This formula simply does the math to increase the prior year’s sales by 18%.
2. Next, the sales are distributed by month. In , we see in cell B5 that the forecasted income statement sheet is linked to the percent of annual sales from the Prior Year Income Statement () sheet. Then, in cell B4, January sales are estimated with a formula that multiplies the total forecasted sales in O4 by the percent of annual sales for January of the prior year. Notice that the formula then multiplies that product by 0.98. This is because Clear Lake discontinued a product line in the last quarter of the prior year, and management feels that this will reduce sales in the first quarter of the new year by roughly 2%.

3. As Clear Lake continues to fill out its forecasted income statement, the next formula we see is a simple sum formula to calculate net sales in B8 (see ). It’s a simple formula that subtracts sales returns and allowances in B7 from gross sales in B4. Similar formulas are also found in B10 for gross margin and B18 for net income.
4. In cell B9, we see a multiplication formula that multiplies sales from B4 by 0.5, or 50%. This is because management feels that cost of goods sold will remain the same as last year, in most quarters at least, and last year’s percentage was 50%.
5. Rent, depreciation, and salaries are all simply typed in, as they are fixed expenses that remain the same as last year.
6. The utilities calculation, found in cell B14, is somewhat similar to the sales calculation. The total utilities expense from O14 is multiplied by the current month’s sales in B4 divided by the total annual sales in O4. This spreads out the utility cost by month based on the percentage of annual sales.
Clear Lake’s forecasted balance sheet ties very closely to both the forecasted income statement and the prior year’s income statement. In , we see in C7 an addition formula using the sum of the current month and three months of prior sales as an estimate of the ending accounts receivable balance. The formula for inventory is similar but forward looking. In C8, inventory is estimated by adding the cost of goods sold for the current month and next three months from the forecasted income statement.
Total current assets in C10 is calculated with a SUM formula that adds together the values in all the selected cells. Amounts such as short-term investments and common stock that are not anticipated to change are simply typed as a number in the cell. Much like in the income statement, subtotals are found in C13 for total assets, C17 for current liabilities, C24 for total equity, and C25 for total liabilities and equity. Retained earnings in C23 pulls the ending retained earnings balance from the end of last year (hidden in column B) and adds the net income for January in the forecasted income statement to get the current month’s ending balance.
Much like the balance sheet, the cash forecast also relies heavily on data from the forecasted income statement as well as the forecasted balance sheet. To begin the year, in , we see that the formula in B4 pulls the cash balance from the forecasted balance sheet. In B6, the formula pulls the sales for the three months prior from the previous year’s income statement. This is because it’s assumed that cash is collected from customers 90 days after the sale. The same approach is used for accounts payable, rent, salaries, and utilities. The formulas pull the expenses from a prior month depending on the assumed timing for payment. Utilities, for example, are assumed to be paid within 30 days, so the cash outflow in February is assumed to be the utilities expense for January from the forecasted income statement. Note that interest payments are assumed to be zero in January and February, but in March, the formula in D14 sums the interest expenses on the forecasted income statement for January, February, and March. This is because interest is paid quarterly.
Finally, note the formula in C4. The beginning cash balance for a given month is the same as the ending cash balance from the prior month; thus, the figure in B18 is linked to C4 to start the new month.

### Using Excel Functions to Balance

Once we get a draft of the forecasts outlined, then the tinkering starts. Additional information can be used to adjust the formulas, as we saw with the 2% reduction in January sales for the forecasted income statement. Because we have linked most (though not all) of our expenses, subtotals, and statements together using formulas, management can also use the forecast workbook to perform scenario and sensitivity analyses, essentially asking “what if?” and looking at the results. When completed, however, before finalizing the forecast, it’s important that the financial statements are in balance (particularly the balance sheet, just as the name implies).
Notice that throughout, we used formulas to calculate subtotals to ensure they are correct and change as needed. We also linked figures, such as the ending and beginning cash balances, to ensure they are in balance. Perhaps the easiest but most important thing to do is to ensure that the balance sheet balances. We can do this with a simple formula that compares total assets to total liabilities and equity. We can see in  that subtracting one from the other in cell C27 should result in $0. If there is a difference, the formula will highlight it, forcing us to investigate and correct the sheet so that it balances.

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Excel can be a powerful tool for creating financial forecasts. Formulas that complete mathematical functions and tie accounts and financial statements together are used to create the statements, ensure that they balance, and facilitate scenario and sensitivity analyses.

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# The Importance of Trade Credit and Working Capital in Planning

## Why It Matters

During the COVID-19 pandemic, many families and small businesses realized the importance of financial resiliency. In personal finance, financial resiliency is the ability to overcome financial difficulties such as sudden job loss or significant unexpected expenses—to spring back quickly.
To help promote resiliency, personal financial planners advise clients to maintain liquid assets equal to three to six months of living expenses, keep debt levels low, manage the household budget, keep insurance in force (health, property, and life), establish a solid credit history, and make wise use of credit cards and home equity lines of credit.
In business finance, financial resiliency is not important only during pandemics but is important through the ups and downs of seasonal cycles and economic downturns. Managing cash, accounts receivable, and inventory while making optimal use of trade credit (accounts payable) makes for a business that meets its operating needs and pays its debts when due.
Working capital management is also critical during good times. Even though profits might be rising, a business with growing demand for its products and services still needs to have working capital management tools to pay its bills. Growth in sales and profits do not immediately mean sufficient cash flow, so planning ahead with tools such as a cash budget is key.


# The Importance of Trade Credit and Working Capital in Planning

## What Is Working Capital?

By the end of this section, you will be able to:
1. Define working capital.
2. Calculate a firm’s operating cycle and cash cycle.
3. Compute inventory days, accounts receivable days, and accounts payable days.
The concept of business capital is often associated with the cash and assets (such as land and equipment) that the owners contributed to the business. Early political economists like Adam Smith and Karl Marx identified this concept of capital, along with labor and entrepreneurship, to be the factors of production.
That general idea of capital is important and critical to a company’s productive capacity. This chapter is about a specific type of capital— working capital—that is just as important as long-term capital. Working capital describes the resources that are needed to meet the daily, weekly, and monthly operating cash flow needs. Employees are paid out of working capital as well as cash from operations, the fulfillment of merchandise orders is possible because of working capital, and the liquidity of a company hinges upon how well management plans and controls working capital.
Understanding working capital begins with the concept of current assets—those resources of a business that are cash, near cash, or expected to be turned into cash within a year through the normal operations of the business. Current assets are necessary for the everyday operation of the firm, and they are synonymous with term gross working capital.
Cash is needed to pay the bills and meet the payroll. Excess cash is invested in cash alternatives such as marketable securities, creating liquidity that can be tapped when operating cash flow needs exceed the amount of cash on hand (checking account balances). Investment in inventory is necessary to meet the demand for products (sales), and if the firm extends credit to its customers so that a sale can be made, the balance sheet will also show accounts receivable—a very common current asset that derives its value from the probability that customers will pay their bills.
Working capital is often spoken about in two versions: gross working capital and net working capital. As was previously stated, gross working capital is equivalent to current assets, particularly those that are cash, cash-like, or will be converted to cash within a short period of time (i.e., in less than one year).
Net working capital (NWC) is a more refined concept of working capital. It is best understood by examining its formula:

### Goal of Working Capital Management

The goal of working capital management is to maintain adequate working capital to
1. meet the operational needs of the company;
2. satisfy obligations (current liabilities) as they come due; and
3. maintain an optimal level of current assets such as cash (provides no return), accounts receivable, and inventory.
Working capital management encompasses all decisions involving a company’s current assets and current liabilities. One very important aspect of working capital management is to provide enough cash to satisfy both maturing short-term obligations and operational expenditures—keeping the company sufficiently liquid.
In summary, working capital management helps a company run smoothly and mitigates the risk of illiquidity. Well-run companies make effective use of current liabilities to finance an optimal level of current assets and maintain sufficient cash balances to meet short-term operating goals and to satisfy short-term obligations. Working capital management is accomplished through
1. cash management;
2. credit and receivables management;
3. inventory management; and
4. accounts payable management.

### Components of Working Capital Management

In contrast to net working capital, gross working capital is synonymous with current assets, particularly those current assets that are either cash or cash equivalents or that will be converted to cash within a short period of time (i.e., in less than one year).
Below is a list of the components of gross working capital.
1. Cash and cash equivalents
2. Marketable securities
3. Accounts receivable
4. Inventory
Here is an example. On December 31, a company has the following balances and gross working capital:
Think of the $1,105,000 of gross working capital as a source of funds for the most pressing obligations (i.e., current liabilities) of the company. Gross working capital is available to pay the bills. However, some of the current assets would need to be converted to cash first. Accounts receivable need to be collected, and inventory would need to be sold before it too can become cash. What if the company had $600,000 of current liabilities? That amount of current obligations could not be paid out of cash until the marketable securities were sold and a significant portion of accounts receivable were collected.
The second, more refined and useful concept of working capital is net working capital:
For example, if a company has $1,000,000 of current assets and $750,000 of current liabilities, its net working capital would be $250,000 ($1,000,000 less $750,000).
NWC provides a better picture because it takes into account the liability “coverage” provided by the current assets. As the above example shows, the current assets would “cover” the current liabilities with an excess of $250,000. Think of it this way: if the current assets could be converted to cash, they could be used to meet the current obligations with another $250,000 of cash leftover.
Current liabilities include
1. accounts payable;
2. dividends payable;
3. notes payable (due within a year);
4. current portion of deferred revenue;
5. current maturities of long-term debt;
6. interest payable;
7. income taxes payable; and
8. accrued expenses such as compensation owed to employees.
Net working capital possibilities can be thought of as a spectrum from negative working capital to positive, as explained in .
Measures of Financial Health provides information on a variety of financial ratios to help users of financial statements understand the strengths and weakness of companies’ financial statements. Three of the financial ratios covered in that chapter are brought back into this chapter’s discussion to demonstrate how financial managers examine working capital and liquidity. Liquidity is the ease with which an asset can be converted into cash. Those ratios are the current ratio, the quick ratio, and the cash ratio. A higher ratio indicates a greater level of liquidity.
The formulas for the three liquidity ratios are:
Notice how the current ratio includes the two elements of net working capital—current assets and current liabilities. It makes for a quick comparison of relative size or proportion.
There are two drawbacks to the current ratio: (1) it is a working capital analytic as of a point in time but is not indicative of future liquidity or future cash flows and (2) as an indicator of liquidity, it can be deceptive if a significant proportion of the current assets are inventory, supplies, or prepaid expenses. Inventory is not very liquid as it can take an extended time period to convert to cash, and assets such as supplies and prepaid expenses never become cash and therefore are not a source of funds to pay bills.
The quick ratio is considered a more conservative indication of liquidity since it does not include a firm’s inventory: .
Working capital ratios, like any financial ratio, are most valuable when examined in light of trends and in comparison to industry/peer averages. For example, a deteriorating current ratio over several quarters (a decline in the company’s current ratio) could indicate a reduced ability to pay bills.
Working capital ratios are also compared to industry averages, which are available in databases produced by such financial publishers as Dun & Bradstreet, Dow Jones Company, and the Risk Management Association (RMA). These information services are available via subscriptions and through many libraries. For example, if a company’s current ratio is 0.9 while the industry average is 2.0, then the company is less liquid than the average company in its industry and strategies, and techniques need to be considered to change things and to better compete with peer groups. Industry averages can be aspirational, motivating management to set liquidity goals and best practices for working capital management.
It is common to think about working capital with a simple assumption: current assets are being “financed” by current liabilities. However, such an assumption may be an oversimplification. Some level of current assets is often necessary to meet longer-term obligations, and in that way, you could think of some amount of current assets as a permanent based of working capital that may need to be financed with longer-term sources of capital.
Think of a company with seasonal business. During busy times, more working capital will be needed than during certain other portions of the year, such as less busy times. But there will always be some level—a permanent base—of working capital needed. Think of it this way: the total working capital of many companies will ebb and flow depending on many variables such as the operating cycle, production needs, and the growth of revenue. Therefore, working capital can be thought of as having a permanent base that is always needed and a total working capital amount that increases when activity levels (i.e., production and sales volume) are higher (see ).

### The Cash Cycle

The cash cycle, also called the cash conversion cycle, is the time period between when a business begins production and acquires resources from its suppliers (for example, acquisition of materials and other forms of inventory) and when it receives cash from its customers. This is offset by the time it takes to pay suppliers (called the payables deferral period).
The cash cycle is measured in days, and it is best understood by examining its formula:
The inventory conversion period is also called the days of inventory. It is the time (days) it takes to convert inventory to sales and is calculated by following these steps:
1. First, calculate the Inventory Turnover Ratio using this formula:

      The Average Inventory is arrived at as follows:

2. Then, use the Inventory Turnover Ratio to calculate the Inventory Conversion Period:

The receivables collection period, also called the days sales outstanding (DSO) or the average collection period, is the number of days it typically takes to collect cash from a credit sale. It is calculated by following these steps:
1. First, calculate the Accounts Receivable Turnover using this formula:

      The Average Accounts Receivable is arrived at as follows:

2. Then, use the Accounts Receivable Turnover to calculate the Receivables Collection Period:

The payables deferral period, also known as days in payables, is the average number of days its takes for a company to pay its suppliers. It is calculated by following these steps:
1. First, calculate the Accounts Payable Turnover using this formula:

      The Average Accounts Payable is arrived at as follows:

2. Then, use the Accounts Payable Turnover to calculate the Payables Deferral Period:

Shortening the inventory conversion period and the receivables collection period or lengthening the payables deferral period shortens the cash conversion cycle. Financial managers monitor and analyze each component of the cash conversion cycle. Ideally, a company’s management should minimize the number of days it takes to convert inventory to cash while maximizing the amount of time it takes to pay suppliers.
Quickly converting inventory to sales speeds up cash inflows and shortens the cash cycle, but it also could help reduce inventory losses as a result of obsolescence. Inventory becomes obsolete because of a variety of factors including time—inventory that has not been sold for a long period of time and is not expected to be sold in the future has to be written down or written off according to accounting rules. Write-offs of inventory can result in significant losses for a company. In the food business, inventory conversion periods take on great importance because of spoilage of perishable goods; in retailing, seasonal items lose value the longer they stay on the shelves.
Various inventory management techniques are used to shorten production time in manufacturing, and in retailing, strategies are used to reduce the amount of time a product sits on the shelf or is stored in the warehouse. Production techniques such as just-in-time inventory systems and marketing and pricing strategies can have an impact on the number of days in the inventory conversion cycle.
For the receivables collection period, a relatively long receivables collection period means that the company is having trouble collecting cash from its customers and so whatever can be done to speed up collections while still offering competitive credit terms should be pursued by financial managers. For example, companies that converted paper invoicing to e-invoicing most likely reduce the average collection period by some number of days, as it makes sense that if a bill is transmitted electronically, lag time is cut (no delays because of “snail mail”) and collections (payments back to the company from customers) may happen sooner. Other credit management techniques, some of which are explained in subsequent sections, can help minimize and control the receivables collection period.
The payables deferral period is the one element that probably cannot be optimized without violating credit terms. Certainly, cash balances can be conserved by delaying payments to vendors for as long as possible; however, payments on trade credit need to be made on time or the company’s relationship with the supplier can suffer. In a worst-case scenario, the company’s credit rating could also deteriorate.
A credit rating, also called a credit score, is a measure produced by an independent agency indicating the likelihood that a company will meet its financial obligations as they come due; it is an indication of the company’s ability to pay its creditors. Three business credit rating services are Equifax Small Business, Experian Business, and Dun & Bradstreet.

### Working Capital Needs by Industry

When comparing working capital needs by industry, you can see some variation. For example, some companies in the grocery business can have very low cash conversion cycles, while construction companies can have very high cash conversion cycles. And some companies, like those in the restaurant business, can have very low numbers and even have negative cash conversion cycles.
Working capital can also differ from one industry to another. An often cited general rule is that a current ratio of 2 is considered optimal. However, general rules of thumb must be treated with caution. A better benchmarking approach is to compare a firm’s ratios—current ratio and quick ratios—to the average of the industry in which the subject company operates.
Take, for example, a home construction company. Such as firm has a long operating cycle because of the production process (building homes), and the “storage of finished goods” can result in very high current ratios—such as 11 or 12 times current liabilities—whereas a retailer like Walmart or Target would have much lower current ratios.
In recent years, Walmart Stores Inc. (NYSE: WMT) has had a current ratio of around 0.9 and has been able to manage its working capital needs by efficient management of its supply chain, quick turnover of inventory, and a very small investment in accounts receivables.Walmart Inc. “2020 Annual Report.” 2020. https://corporate.walmart.com/media-library/document/2020-walmart-annual-report/_proxyDocument?id=00000171-a3ea-dfc0-af71-b3fea8490000 Big retailers like Walmart are effective at negotiating favorable payment terms with their vendors. The ability to generate consistent positive cash flow from operations allows a retailer like Walmart to operate with relatively low amounts of working capital.
The credit policies of a company also affect working capital. A company with a liberal credit policy will require a greater amount of working capital, as collection periods of accounts receivable are longer and therefore tie up more dollars in receivables.
Almost all businesses will have times when additional working capital is needed to pay bills, meet the payroll (salaries and wages), and plan for accrued expenses. The wait for the cash to flow into the company’s treasury from the collection of receivables and cash sales can be longer during tough times.
During the COVID-19 pandemic, the US government made paycheck protection program (PPP) loans available to help alleviate working capital problems for small and large business when the economy slowed because of shutdowns and social distancing. And although 60 percent of the PPP loan proceeds were to go to cover payroll-related costs, 40 percent could be used to bolster working capital to meet rent, utilities costs, and some interest expense while companies were “treading water”—waiting for positive cash flow to pick up under a recovery.US Small Business Administration. “PPP Loan Forgiveness.” n.d. https://www.sba.gov/funding-programs/loans/covid-19-relief-options/paycheck-protection-program/ppp-loan-forgiveness
It isn’t just during downturns that working capital is strained. Growing companies, even if they are extremely profitable, need additional working capital as they ramp up operations by acquiring raw materials, component parts, supplies, or other forms of inventory; hiring temporary or additional employees; and taking on new projects. Whenever additional resources are needed, working capital is also needed.
Some of the current assets and expenditures needed in a growing company may need to be financed from sources that are not spontaneous financing—trade credit (accounts payable). Such forms of external financing such as lines of credit, short-term bank loans, inventory-based loans (also called floor planning), and the factoring of accounts receivables might have to be relied upon.

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Working capital is not only necessary to run a business; it is a resource that will expand and contract with business cycles and must be carefully managed and monitored. The daily, weekly, and monthly needs of business operations are met by cash. Financial managers understand the significance of net working capital (current assets – current liabilities) and various liquidity ratios as they attempt to ensure that bills can be paid. The cash conversion cycle and the cash budget provide additional working capital management tools.

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### How Companies Report Cash Flow

### Trade Credit and Interest Rates on Short-Term Borrowing


# The Importance of Trade Credit and Working Capital in Planning

## What Is Trade Credit?

By the end of this section, you will be able to:
1. Compute the cost of trade credit.
2. Define cash discount.
3. Define discount period.
4. Define credit period.
Trade credit, also known as accounts payable, is a critical part of a business’s working capital management strategy. Trade credit is granted by vendors to creditworthy companies when those companies purchase materials, inventory, and services.
A company’s purchasing system is usually integrated with other functions such production planning and sales forecasting. Purchasing managers search for and evaluate vendors, negotiate order quantities, and prepare purchase orders. In carrying out the purchasing process, credit terms are granted by the company’s vendors and purchases of inventory and services can be made on trade credit accounts—allowing the purchaser time to pay. The purchaser carries an accounts payable balance until the account is paid.
Trade credit is referred to as spontaneous financing, as it occurs spontaneously with the gearing up of operations and the additional investment in current assets. Think of it this way: If sales are increasing, so too is production. Increased sales mean more current assets (accounts receivable and inventory), and increased sales mean increases in accounts payable (financing happening spontaneously with increased sales and inventory purchases). Compared to other financing arrangements, such as lines of credit and bank loans, trade credit is convenient, simple, and easy to use.
Once a company is approved for trade credit, there is no paperwork or contracts to sign, as is the case with various forms of bank financing. Invoices specify the credit terms, and there is usually no interest expense associated with trade credit. Accounts payable is a type of obligation that is interest-free and is distinguished from debt obligations, such as notes payable, that require the creditor to pay back principal and interest.

### How Trade Credit Works

Trade credit is common in B2B (business to business) transactions and is analogous to consumer spending using a credit card. With a credit card, a consumer opens an account with a credit limit. Most trade credit is offered to a company with an open account that has a credit limit up to which the company can purchase goods or services without having to pay the cash up front. As long as the payments are made in accordance with the terms of the agreement (also called credit terms), no interest or additional fees are charged on the credit balance except possibly for a fee for late payment.
Initially, the vendor’s credit department approves both a trade credit limit and credit payment terms (i.e., number of days after the invoice date that payment is due). Timely payments on accounts payable (trade credit) helps create a credit history for the purchasing firm.

### Trade Credit Terms

Trade credit arrangements often carry credit terms that offer an incentive, called a discount, for a company (the buyer) to pay its bill within a relatively short period of time. Net terms, also referred to as the full credit period, are the number of days that a business (purchaser) has before they must pay their invoice. A common net term is Net 30, with payment due in full within 30 days of the invoice.
Many vendors also offer cash discounts to customers that pay their bill early. A company’s invoice that specifies payment terms of “2/10 n/30” (stated as: “two ten net 30”) would allow a 2 percent discount if the buyer’s account balance is paid within 10 days of the invoice date; otherwise, the net amount owed would be due in 30 days. The “10 days” in the example is the discount period—the number of days the buyer has to take advantage of the cash discount for an early payment, also known as quick payment.
For example, Jackson’s Premium Jams Inc. received a $10,500 invoice for the purchase of jelly jars. The invoice has payment terms of 2/10 n/30. Jackson’s pays the bill within 10 days of the invoice date. Jackson’s payment would be . The effect of taking a discount because of a quick payment is a lowering of the cost of inventory in the case of purchases of materials (for a manufacturer), merchandise (for a retailer or wholesaler), and operating expenses (for any company that “buys” services using trade credit). In Cost of Trade Credit, there is an example that shows the high annualize opportunity cost (36.73 percent) of not taking advantage of cash discounts.

### Cost of Trade Credit

Trade credit is often referred to as a no-cost type of financing. Unlike with other credit arrangements (e.g., bank loans, lines of credit, and commercial paper), there is usually no interest expense associated with trade credit, and as long as your account does not become delinquent, there are no special fees. Some accounts payable arrangements specify an interest penalty or a late fee when the account goes delinquent, but as long as payments are made on time, trade credit is thought of as a low-cost source of working capital.
However, there is one possible cost associated with trade credit for companies that don’t take advantage of cash discounts when offered by sellers. Using accounts payable to purchase goods and services can involve an opportunity cost—a cost of the forgone opportunity of making a quick payment and benefiting from a cash discount. A business that does not take advantage of a cash discount for early payment of trade credit will pay more for goods and services than a business that routinely takes advantage of discounts.
The annual percentage rate of forgoing quick payment discounts can be estimated with the following formula:
Example: Novelty Accessories Inc. (NAI) purchases products from a vendor that offers credit payment terms of 2/10, net 30. The annual cost to NAI of not taking advantage of the discount for quick payment is 36.73 percent.

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Trade credit is very prevalent in the business world, especially in B2B (business-to-business) transactions. Many business exchanges (sales) could not take place without trade credit and the credit terms that are offered. Like any component of working capital, trade credit must be planned and managed. The creditor (the company granting the credit) does so based on an analysis of creditworthiness and must monitor payments and manage slow-paying accounts. The debtor (accounts payable) needs to make payments on time to keep a clean credit history and to take advantage of discounts.

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# The Importance of Trade Credit and Working Capital in Planning

## Cash Management

By the end of this section, you will be able to:
1. Explain why firms hold cash.
2. List instruments available to a financial manager for investing cash balances.
Cash management means efficiently collecting cash from customers and managing cash outflows. To manage cash, the cash budget—a forward-looking document—is an important planning tool. To understand cash management, you must first understand what is meant by cash holdings and the motivations (reasons) for holding cash. A cash budget example is covered in Using Excel to Create the Short-Term Plan.

### Cash Holdings

The cash holdings of a company are more than the currency and coins in the cash registers or the treasury vault. Cash includes currency and coins, but usually those amounts are insignificant compared to the cash holdings of checks to be deposited in the company’s bank account and the balances in the company’s checking accounts.

### Motivations for Holding Cash

The initial answer to the question of why companies hold cash is pretty obvious: because cash is how we pay the bills—it is the medium of exchange. The transactional motive of holding cash means that checks and electronic funds transfers are necessary to meet the payroll (pay the employees), pay the vendors, satisfy creditors (principal and interest payments on loans), and reward stockholders with dividend payments. Cash for transaction is one reason to hold cash, but there is another reason—one that stems from uncertainty and the precautions you might take to be ready for the unexpected.
Just as you keep cash balances in your checking and savings accounts and even a few dollars in your wallet or purse for unexpected expenditures, cash balances are also necessary for a business to provide for unexpected events. Emergencies might require a company to write a check for repairs, for an unexpected breakdown of equipment, or for hiring temporary workers. This motive of holding cash is called the precautionary motive.
Some companies maintain a certain amount of cash instead of investing it in marketable securities or in upgrades or expansion of operations. This is called the speculative motive. Companies that want to quickly take advantage of unexpected opportunities want to be quick to purchase assets or to acquire a business, and a certain amount of cash or quick access to cash is necessary to jump on an opportunity.
Sometimes cash balances may be required by a bank with which a company conducts significant business. These balances are called compensating balances and are typically a minimum amount to be maintained in the company’s checking account.
For example, Jack’s Outback Restaurant Group borrowed $500,000 from First National Bank and Trust. As part of the loan agreement, First National Bank required Jack’s to keep at least $50,000 in its company checking account as a way of compensating the bank for other corporate services it provides to Jack’s Outback Restaurant Group.

### Cash Alternatives

Cash that a company has that is in excess of projected financial needs is often invested in short-term investments, also known as cash equivalents (cash alternatives). The reason for this is that cash does not earn a rate of return; therefore, too much idle cash can affect the profitability of a business.
 shows a list of typical investment vehicles used by corporations to earn interest on excess cash. Financial managers search for opportunities that are safe and highly liquid and that will provide a positive rate of return. Cash alternatives, because of their short-term maturities, have low interest rate risk (the risk that an investment’s value will decrease because of changes in market interest rates). In that way, prudent investment of excess cash follows the risk/return trade-off; in order to achieve safe returns, the returns will be lower than the possible returns achieved with risky investments. Cash alternative investments are not committed to the stock market.
 shows a note within the 2021 Annual Report (Form 10-K) of Target Corporation. The note discloses the amount of Target’s cash and cash equivalent balances of $8,511,000,000 for January 30, 2021, and $2,577,000,000 for February 1, 2020.
In that note, which is a supplement to the company’s balance sheet, receivables from third-party financial institutions is also considered a cash equivalent. That is because purchases by Target’s customers who use their credit cards (e.g., VISA or MasterCard) create very short-term receivables—amounts that Target is waiting to collect but are very close to a cash sale. So instead of being reported as accounts receivable—a line item on the Target balance sheet that is separate from cash and cash equivalents—these amounts receivable from third-party financial institutions are considered part of the cash and cash equivalents and are a very liquid asst. For example, the amount of $560,000,000 for January 30, 2021, is considered a cash equivalent since the settlement of these accounts will happen in a day or two with cash deposited in Target’s bank accounts. When a retailer sells product and accepts a credit card such as VISA, MasterCard, or American Express, the cash collection happens very soon after the credit card sale—typically within 24 to 72 hours.Creditcardprocessing.com. “How Long Does it Take for a Merchant to Receive Funds?” n.d. https://www.creditcardprocessing.com/resource/article/long-take-merchant-receive-funds/#:~:text=The%20time%20that%20it%20takes,days%20to%20process%20the%20payment
Companies also invest excess funds in marketable securities. These are debt and equity investments such as corporate and government bonds, preferred stock, and common stock of other entities that can be readily sold on a stock or bond exchange. Ford Motor Company has this definition of marketable securities in its 2019 Annual Report (Form 10-K):
“Investments in securities with a maturity date greater than three months at the date of purchase and other securities for which there is more than an insignificant risk of change in value due to interest rate, quoted price, or penalty on withdrawal are classified as Marketable securities.”Ford Motor Company. “2019 Annual Report.” n.d. https://s23.q4cdn.com/725981074/files/doc_downloads/Ford-2019-Printed-Annual-Report.pdf

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Cash management is simply making sure you have enough cash to meet expected obligations and for contingencies (unexpected or emergency cash needs). Excess cash should be invested low-risk and highly liquid marketable securities. The cash budget is a critical tool of cash management.

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# The Importance of Trade Credit and Working Capital in Planning

## Receivables Management

By the end of this section, you will be able to:
1. Discuss how decisions on extending credit are made.
2. Explain how to monitor accounts receivables.
For any business that sells goods or services on credit, effective accounts receivable management is critical for cash flow and profitability planning and for the long-term viability of the company. Receivables management begins before the sale is made when a number of factors must be considered.
1. Can the customer be approved for a credit sale?
2. If the credit is approved, what will be the credit terms (i.e., how long do we give customers to pay their bills)?
3. Will there be a cash discount for quick payment?
4. How much credit should be extended to each customer (credit limit)?
Accounts receivable is not about accepting credit cards. Credit card sales are not technically accounts receivable. When a credit card is accepted, it means that the credit card company (e.g., VISA, MasterCard, or American Express) will guarantee the payment. The cash will be deposited in the merchant’s bank account in a very short period of time.
When a business makes a sale on account, management (e.g., a credit manager or analyst) does its best to distinguish between customers who have a high likelihood of paying and customers who have a low likelihood. Customers with low credit risk are approved; the decision is based on an effective analysis of creditworthiness.
Creditworthiness is judged by looking at a number of factors including an evaluation of the customer’s financial statements, financial ratios, and credit reports (credit scores) based on a customer’s payment history on credits owed to other firms. If a company has a prior relationship with a customer seeking trade credit, the customer’s payment history with the firm is also carefully evaluated before additional credit is granted.

### Determining the Credit Policy

A company’s credit policy encompasses rules of credit granting and procedures for the collections of accounts. It’s how a company will process credit applications, utilize credit scoring and credit bureaus, analyze financial statements, make credit limit decisions, and conduct collection efforts when accounts become delinquent (still outstanding after their due date).

### Establishing Credit Terms

Trade credit terms were discussed earlier. Recall that part of the terms and conditions of a sale are the credit terms—elements of a sales agreement (contract) that indicate when payment is due, possible discounts (for quick payments), and any late fee charges.
If open credit is for a sales transaction, an agreement is made as to the length of time for which credit is to be granted (payment period) and a discount for early payment. Although companies are free to establish credit terms as they see fit, most companies look to the practice of the particular industry in which they operate. The credit terms offered by the competition are a factor. Net terms usually range between 30 days and 90 days, depending on the industry. Discounts for early payments also differ and are typically from 1 to 3 percent.
Establishing credit terms offered can be thought of as a decision process similar to setting a price for products and services. Just as a price is the result of a market forces, so too are credit terms. If credit terms are not competitive within the industry, sales can suffer. Typically, companies follow standard industry credit terms. If most companies in an industry offer a discount for early payments, then most companies will follow suit and also offer an equal discount.
Once credit terms are established, they can be changed based on both marketing strategies and financial management goals. For example, discounts for early payments can be more generous, or the full credit period can be extended to stimulate additional sales. Both discount periods and full credit periods can be tightened to try to speed up collections. The establishment of and changes to credit terms are usually made in consultation with the sales and financial management departments.

### Monitoring Accounts Receivables

Financial managers monitor accounts receivables using some basic tools. One of those tools is the accounts receivable aging schedule (report). To prepare the aging schedule, a classifying of customer account balances is performed with age as the sorting attribute.
An account receivable begins its life as a credit sale. The age of a receivable is the number of days that have transpired since the credit sale was made (the date of the invoice). For example, if a credit sale was made on June 1 and is still unpaid on July 15, that receivable is 45 days old. Aging of accounts is thought to be a useful tool because of the idea that the longer the time owed, the greater the possibility that individual accounts receivable will prove to be uncollectible.
An aging schedule is a report that organizes the outstanding (unpaid) receivable balances into age categories. The receivables are grouped by the length of time they have been outstanding, and an uncollectible percentage is assigned to each category. The length of uncollectible time increases the percentage assigned. For example, a category might consist of accounts receivable that are 0–30 days past due and is assigned an uncollectible percentage of 6 percent. Another category might be 31–60 days past due and is assigned an uncollectible percentage of 15 percent. All categories of estimated uncollectible amounts are summed to get a total estimated uncollectible balance.
The aging of accounts is useful to the credit and collection managers, both from a global view—estimating how much of the accounts receivable asset might be bad debts—and on a micro basis—being able to drill down to see which specific customers are slow paying or delinquent so as to implement collection tactics.
Accountants and auditors also find the aging of accounts to determine a reasonable amount to be reported as bad debt expense and to establish a sufficient balance in the allowance for doubtful accounts. Bad debt expense is the cost of doing business because some customers will not pay the amounts they owe (accounts receivable), while the allowance for doubtful accounts is a contra-asset (it will be deducted from accounts receivable on the balance sheet) that contains management’s best guess (management’s estimate) as to how much of its accounts receivable will never be collected.
In , Foodinia Inc.’s accounts receivable aging report shows that the total receivables balance is $189,000. The company splits its accounts into four age categories: not due, 30 to 60 days past due, 61 to 90 days past due, and more than 90 days past due. Of the $189,000 owed to Foodinia by its customers, $75,500 ($189,000 less $113,500) of invoices have been outstanding (not paid yet) beyond their due dates.
In addition to preparing aging schedules, financial managers also use financial ratios to monitor receivables. The accounts receivable turnover ratio determines how many times (i.e., how often) accounts receivable are collected during an operating period and converted to cash. A higher number of times indicates that receivables are collected quickly. In contrast, a lower accounts receivable turnover indicates that receivables are collected at a slower rate, taking more days to collect from a customer.
Another receivables ratio is the number of days’ sales in receivables ratio, also called the receivables collection period—the expected days it will take to convert accounts receivable into cash. A comparison of a company’s receivables collection period to the credit terms granted to customers can alert management to collection problems. Both the accounts receivable turnover ratio and receivables collection period are covered, including the formulas for calculating the ratios, in the previous section of this chapter.

### Accounts Receivables and Notes Receivable

An accounts receivable is an informal arrangement between a seller (a company) and customer. Accounts receivable are usually paid within a month or two. Accounts receivable don’t require any complex paperwork, are evidenced by an invoice, and do not involve interest payments. In contrast, a note receivable is a more formal arrangement that is evidence by a legal contract called a promissory note specifying the payment amount and date and interest.
The length of a note receivable can be for any time period including a term longer than the typical account receivable. Some notes receivable have a term greater than a year. The assets of a bank include many notes receivable (a loan made by a bank is an asset for the bank).
A note receivable can be used in exchange for products and services or in exchange for cash (usually in the case of a financial lender). Sometimes a company might request that a slow-paying customer sign a note promissory note to further secure the receivable, charge interest, or add some type of collateral to the arrangement, in which case the receivable would be called a secured promissory note. Several characteristics of notes receivable further define the contract elements and scope of use (see ).

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Accounts receivables are monitored by management with tools such as the ratios accounts receivable turnover and average collection period and the aging of receivables. The credit managers’ mantra rings true: “The older the receivable, the greater the likelihood that the account will not be collected.”

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# The Importance of Trade Credit and Working Capital in Planning

## Inventory Management

By the end of this section, you will be able to:
1. Outline the costs of holding inventory.
2. Outline the benefits of holding inventory.
Financial managers must consider the impact of inventory management on working capital. Earlier in the chapter, the concept of the inventory conversion cycle was covered. The number of days that goods are held by a business is one of the focal points of inventory management.
Managers look to minimize inventory balances and raise inventory turnover ratios while trying to balance the needs of operations and sales. Purchasing personnel need to order enough inventory to “feed” production or to stock the shelves. The sales force wants to meet or surpass their sales budgets, and the operations people need inventory for the factories, warehouses, and e-commerce sites.
The days in inventory ratio measures the average number of days between acquiring inventory (i.e., purchasing merchandise) and its sale. This ratio is a metric to be watched and monitored by inventory managers and, if possible, minimized. A high days in inventory ratio could mean “aging” inventory. Old inventory could mean obsolesce or, in the case of perishable goods, spoilage. In either case, old inventory means losses.
Imagine a company selling high-tech products such as consumer electronics. A high days in inventory ratio could mean that technologically obsolete products will be sold at a discount. There are similar issues with older inventory in the fashion industry. Last year’s styles are not as appealing to the fashion-conscious consumer and are usually sold at significant discounts. In the accounting world, lower of cost or market value is a test of inventory value to determine if inventory needs to be “written down,” meaning that the company takes an expense for inventory that has lost significant value. Lower of cost or market is required by Generally Accepted Accounting Principles (GAAP) to state inventory valuations at realistic and conservative values.
Inventory is a very significant working capital component for many companies, such as manufacturers, wholesalers, and retailers. For those companies, inventory management involves management of the entire supply chain: sourcing, storing, and selling inventory. At its very basic level, inventory management means having the right amount of stock at the right place and at the right time while also minimizing the cost of inventory. This concept is explained in the next section.

### Inventory Cost

Controlling inventory costs minimizes working capital needs and, ultimately, the cost of goods sold. Inventory management impacts profitability; minimizing cost of goods sold means maximizing gross profit (Gross Profit = Net Sales Less Cost of Goods Sold).
There are four components to inventory cost:
1. Purchasing costs: the invoice amount (after discounts) for inventory; the initial investment in inventory
2. Carrying costs: all costs of having inventory in stock, which includes storage costs (i.e., the cost of the space to store the inventory, such as a warehouse), insurance, inventory obsolescence and spoilage, and even the opportunity cost of the investment in inventory
3. Ordering costs: the costs of placing an order with a vendor; the cost of a purchase and managing the payment process
4. Stockout costs: an opportunity cost incurred when a customer order cannot be filled and the customer goes elsewhere for the product; lost revenue
Minimizing total inventory costs is a combination of many strategies, the scope and complexity of which are beyond the scope of this text. Concepts such as just-in-time (JIT) inventory practices and economic order quantity (EOQ) are tools used by inventory managers, both of which help keep a company lean (minimizing inventory) while making sure the inventory resources are in place in time to complete the sale.

### Benefit of Holding Inventory

Brick-and-mortar stores need goods in stock so that the customer can see and touch the product and be able to acquire it when they need it. Customers are disappointed if they cannot see and touch the item or if they find out upon arrival at the store that it is out of stock.
Customers of all kinds don’t want to wait for the delivery of a purchase. We have become accustomed to Amazon orders being delivered to the door the next day. Product fulfillment and availability is important. Inventory must be in stock, or sales will be lost.
In manufacturing, the inventory of materials and component parts must be in place at the start of the value chain (the conversion process), and finished goods need to be ready to meet scheduled shipments. Holding sufficient inventory meets customer demand, whether it is products on the shelves or in the warehouse that are ready to move through the supply chain and into the hands of the customer.

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Inventory, usually the least liquid of the current assets, presents its own set of management challenges. Finding the optimal level of inventory is probably more of an art than a science. JIT helps to reduce the investment in inventory and lower the costs of storage, but stockout costs can be very damaging to profitability.

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