From the course: Financial Modeling and Forecasting Financial Statements

Forecast financing cash flow

From the course: Financial Modeling and Forecasting Financial Statements

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Forecast financing cash flow

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The two sources of cash from financing activities are borrowing and owner investment. The most desirable sequence of decision making with respect to cash from financing activities is as follows. Forecast a level of activity, such as the level of sales. Evaluate the amount of cash that will be generated from operations or consumed by operations. After a careful capital budgeting process, determine the amount of cash that will be needed for investing activities. If financing cash inflows are needed, compare the relative costs of obtaining cash from borrowing and cash from owner investment. Now, as a general statement, the interest rate cost of borrowing money is lower than the cost of giving up ownership of part of the company in exchange for new partner investment or new shareholder investment. The exact decision this year of whether it is best to obtain financing from borrowing or from owner investment depends on market conditions this year. Detailed consideration of these decisions is part of the field of corporate finance. Now, to put some structure on the Home Depot forecasting exercise, let's assume that has been decided that the overall leverage of Home Depot should be such that the debt ratio, total liabilities divided by total assets is 80%. So forecasting the required balance in long-term debt each year means, one, determining total assets needed, two, determining the amount of internal, informal debt financing provided through suppliers, called accounts payable, and three, using the target debt ratio of 80% to compute the amount of additional financing that will need to come from long-term debt. Here are the forecasted levels of necessary long-term debt for Home Depot for each year from 1986 through 1990. These forecasts indicate that by 1990, Home Depot will need to get new long-term loans in 1990 of $310 million to increase the level of long-term debt from 780 million in 1989 to 1.090 billion in 1990. That's a lot of borrowing, especially considering that all of this long-term borrowing supporting the purchase of assets is only expected to generate net income of just $26 million in 1990. It doesn't seem worth the financial risk. Okay, let's see what would happen if Home Depot were to reduce its leverage target. Let's change the forecasted debt ratio to 60%. Okay, this looks better. For example, with the 60% forecasted debt ratio, the necessary new long-term borrowing in 1990 is just $195 million compared to 310 million with the original 80% debt ratio value. Better, but still not great. Even with this low level of leverage compared to what Home Depot historically has had, these annual long-term borrowing amounts are more than four times the amount of net income each year. Okay, now quick question. How is net income impacted by a change in debt ratio, which directly affects not the income statement, but the long-term debt amount in the balance sheet? Again, this illustrates the importance of careful financial modeling to capture all the interrelations within the financial statements. The decrease in the target debt ratio directly reduces the forecasted amount of long-term debt, needed each year, fine. But so far, I don't see any impact on net income. But less long-term debt in the balance sheet means a lower interest expense in the income statement. Forecasted net income goes up. So a reduction in target debt ratio leads indirectly to an increase in forecasted net income. Now, we have now been through a detailed examination of the impact of changing ratios on the forecasted amount of operating, investing, and financing cash flows, but we still haven't found a way to fix Home Depot. Let's keep going with some comprehensive dynamic modeling. And maybe I can get my brother Jim in here to help me.

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