From the course: Financial Modeling and Forecasting Financial Statements

Revise financial forecasts based on financing options

From the course: Financial Modeling and Forecasting Financial Statements

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Revise financial forecasts based on financing options

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Now that we know that Darrell Company expects to need $1,090 in assets in year two, we need to determine where Darrell will get the money to support those assets. Now, one easy source of financing to forecast is the amount of accounts payable. Accounts payable represents the operational financing provided by the suppliers. As with the other financial statement items that naturally increase, accounts payable will also increase naturally as sales increase. So if sales are expected to increase by 50 percent, then inventory purchases are also expected to increase by 50 percent, and supplier financing will also increase by about 50 percent as well. In year two, accounts payable will increase to $150 from the $100 in year one. Now the level of long-term debt and of stockholders equity is determined by management decisions on how to best obtain financing. In fact, management often uses forecasted financial statements prepared under a variety of different financing scenarios to help determine what financing choices to make. For now, we will make the simple assumption that Derald is planning to partially finance its operations in year two by increasing its bank loans payable from $300 to $400. The year two forecasted liabilities and equity section of the balance sheet looks like this so far. Now, how about retained earnings and paid-in capital? And how do we know that the total is $1,090? Well, let's address the last question first. Total liabilities and equities have to equal $1,090 because that is the amount of financing needed to buy the $1,090 in assets that are forecasted to be needed in year two. To forecast retained earnings, we need to first complete the forecasted income statement, and here is where we are so far. Interest expense depends on how much interest-bearing debt a company has. In year one, Darrold Company reported interest expense of $30 with a bank loan payable of $300. These numbers imply that the interest rate on Darrold's loan is 10%. Because the bank loan payable is expected to increase to $400 in year two, Darrold can expect interest expense to be about $40. Now the assumptions made so far imply that Darrold's income before income taxes in year year 2 will total $98. That's $138 in operating profit, less $40 in forecasted interest expense. Now income tax expense is determined by how much pre-tax income a company has, and the most reasonable assumption to make is that a company's income tax rate, equal to income tax expense divided by pre-tax income, will stay constant from year to year. Daryl's tax rate in year one was 43%, that's $30 divided by $70, which when applied to the forecasted pre-tax income for year two of $98, implies that income tax expense in year two will be $42. The computation of the forecasted amount of retained earnings for year two now looks like this. Part of this forecast is the management decision to increase dividends from $15 in year one to $20 in year two. Depending on how the forecasted financial statements look, management might decide to change this preliminary dividend decision. Now we have everything, except for the forecasted paid-in capital amount for year two. But we know what the number is. It has to be the number that causes total liabilities and equity to be the same as forecasted total assets of $1,090. Here I call this number the plug figure. The number is $444. This implies that $344 in new equity needs to be solicited from shareholders during year two. Now note, the paid-in capital balance doesn't have to serve as the plug figure. There are other possibilities. We'll talk about this in a later module. What if now is not the right time to solicit new funds from shareholders? Well, the good news is that we haven't done it yet. This is just a forecasting exercise. If we don't like the implications, we can change the plan before the year ever begins. Don't increase property plan equipment so much. Increase the planned amount of borrowing. Financial modeling and the preparation of forecasted financial statements allows us, in advance, to evaluate whether Derald Company's operating, investing, and financing plans are feasible and internally consistent.

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