Financial Planning and Forecasting

Chapter 4

Why the need for financial planning and forecasting?

To maximize stock price

To maximize gains and minimize losses To reduce information asymmetry To provide useful information to investors regarding economic and industry concerns. Through value creation

Plans are Essential!

Strategic Plan
Corporate Purpose (Mission Statement/general philosophy) Corporate Scope (Business and Geographic area) Corporate Objectives (Specific goals; quantitative & qualitative) Corporate Strategies (Broad approaches, not detailed plans, on how to achieve goals)

Operating Plan
Provide detailed implementation guidance based on the corporate strategy to meet corporate objectives. Function responsibility, timeline, sales and profit targets Usually good for 5 years

Plans are Essential!

Financial Plan
The document that includes assumptions, projected financial statements, and projected ratios and ties the entire planning process together. Steps in creating a financial plan:
Develop assumptions for use in the forecast Project financial statements Projected ratios are calculated and analyzed. Determine funds needed to support the 5 year plan Forecast fund availability over the next 5 years Establish and maintain a system of control to govern the allocation and use of funds within the firm Reexamine the entire plan from start to end. Develop procedures for adjusting the basic plan if economic forecasts upon which the plan was based do not materialize (Feedback Loop) Establish a performance-based management compensation system

Sales Forecasts
A forecast of a firms unit and dollar sales for some future period. Generally based on recent sales trends + forecasts of the economic prospects for the nation, region, industry, etc. An objective decision. Many factors have to be considered in doing sales forecast. Extremely critical and important as it is a crucial determinant of how much inventory and fixed assets to invest in, which entail considerable amount of money.

Percent of Sales Method

A method of forecasting future financial statements that expresses each account as a percentage of sales The percentages can be constant, or can change over time
Explicit Forecast Period

Year Sales growth rate Sales

2011 100,000

2012 20% 120,000

2013 15% 138,000

2014 10% 151,800

2015 10% 166,980

2016 8% 180,338

Forecast Horizon

Percent of Sales Method

Total Sales = Sales Price per unit * # of units In creating the Sales forecast, one has to consider population growth (demand) and inflation. Thus it is possible that even if unit selling price is forecasted to increase due to inflation, the demand or # of units sold will decrease. If long term growth rate is 5%, _________ is what we call the competitive advantage period
Year Unit Selling Price Number of Units Inflation rate Demand growth rate Sales Growth rate (Total) 2011 10.00 10,000 2012 10.50 11,000 5% 10% 115,500 15.50% 2013 10.92 11,880 4% 8% 129,730 12.32% 2014 11.25 12,474 3% 5% 140,303 8.15% 2015 11.59 12,225 3% -2% 141,621 0.94% 2016 11.93 12,347 3% 1% 147,329 4.03%

100,000

Forecasted Income Statement

(in thousands) Sales Costs except depreciation Depreciation Total Operating Costs EBIT Interest EBT Taxes (40%) NI before preferred dividends Dividends to preferred NI available to common Dividends to common Addition to retained earnings Actual (2011) 1,500,000.00 500,000.00 80,000.00 580,000.00 920,000.00 48,200.00 871,800.00 348,720.00 523,080.00 50.00 523,030.00 500,000.00 23,030.00 Forecast Basis 1.2 0.333 0.053 Forecast (2012) 1,800,000.00 600,000.00 96,000.00 696,000.00 1,104,000.00 48,200.00 1,055,800.00 422,320.00 633,480.00 50.00 633,430.00 550,000.00 83,430.00

Additional Information: 8% Bonds Payable, at par 565 million 5% Notes Payable 60 million 1% Preferred Stock 5 million # of Common Stock Outstanding 50 million Dividend per share is expected to increase by 10%

2011 Net Plant and Equipment 800 million 2012 Net Plant and Equipment 960 million Annual Depreciation Rate 10% Dividend per share in 2011 is 10 Sales is expected to increase by 20%

Why BS items may be based on Sales

Companies exist and operate to earn PROFITS

Assets are needed and liabilities are incurred to support company operations

Profits are attained through SALES

Sales are ultimately turned into ASSETS

Forecasted Balance Sheet

Cash & MS Accounts Receivable Inventories TOTAL CA Net Plant and Equipment TOTAL ASSETS Accounts Payable Notes Payable Accrued Liabilities TOTAL CL Long-term Bonds TOTAL DEBT Preferred Stock Common Stock Retained Earnings TOTAL COMMON EQUITY Actual (2011) 8,000.00 62,000.00 165,000.00 235,000.00 800,000.00 1,035,000.00 20,000.00 60,000.00 75,000.00 155,000.00 565,000.00 720,000.00 5,000.00 10,000.00 300,000.00 310,000.00 Forecast Basis 0.53% x 2009 Sales 4.13% x 2009 Sales 11% x 2009 Sales 53.33% x 2009 Sales First Pass 9,600.00 74,400.00 198,000.00 282,000.00 960,000.00 1,242,000.00 24,000.00 60,000.00 90,000.00 174,000.00 565,000.00 739,000.00 5,000.00 10,000.00 383,430.00 393,430.00

1.33% x 2009 Sales 5% x 2009 Sales

Plus 83,430

TOTAL LIABS AND EQUITY

Addtl. Funds Needed

1,035,000.00

1,137,430.00
104,570.00

Financing Mix of New Capital

Notes Payable
Long-term Bonds Common Stock

10%
40% 50%

10,457.00
41,828.00 52,285.00

TOTAL

100%

104,570.00

Forecasted Balance Sheet with 2nd Pass

Cash & MS Accounts Receivable Inventories TOTAL CA Net Plant and Equipment TOTAL ASSETS Accounts Payable Notes Payable Accrued Liabilities TOTAL CL Long-term Bonds TOTAL DEBT Preferred Stock Common Stock Retained Earnings TOTAL COMMON EQUITY TOTAL LIABS AND EQUITY Addtl. Funds Needed Actual (2011) 8,000.00 62,000.00 165,000.00 235,000.00 800,000.00 1,035,000.00 20,000.00 60,000.00 75,000.00 155,000.00 565,000.00 720,000.00 5,000.00 10,000.00 300,000.00 310,000.00 1,035,000.00 Forecast Basis 0.53% x 2009 Sales 4.13% x 2009 Sales 11% x 2009 Sales 53.33% x 2009 Sales First Pass 9,600.00 74,400.00 198,000.00 282,000.00 960,000.00 1,242,000.00 24,000.00 60,000.00 90,000.00 174,000.00 565,000.00 739,000.00 5,000.00 10,000.00 383,430.00 393,430.00 1,137,430.00 104,570.00 AFN Second Pass 9,600.00 74,400.00 198,000.00 282,000.00 960,000.00 1,242,000.00 24,000.00 70,457.00 90,000.00 184,457.00 606,828.00 791,285.00 5,000.00 62,285.00 383,430.00 445,715.00 1,242,000.00

1.33% x 2009 Sales 5% x 2009 Sales

Plus 10,457

Plus 41,828

Plus 52,285

Plus 303,430

Determine the Additional Funds Needed using the AFN Equation under normal circumstances:
AFN = Capital Intensity Ratio S Spontaneous Liabilities to Sales Ratio S Profit Margin x Forecasted Sales x Retention Ratio = (A*/S0)S (L*/S0) S M(S1)(RR) = ($1,035,000/$1,500,000)($300,000) ($95,000/$1,500,000)($300,000) ($523,030/$1,500,000)x($1,800,000)x(23,030/$523,030) = $207,000 $19,000 $27,636 = $160,364

Financing Mix of New Capital

Notes Payable
Long-term Bonds Common Stock

10%
40% 50%

16,036.40
64,145.60 80,182.00

TOTAL

100%

160,364.00

Other Techniques for forecasting FS

Simple Linear Regression (Inventories and Receivables) Excess Capacity Adjustments (Fixed Assets)
Used when Capital Intensity Ratio (A*/So) is not constant

Simple Linear Regression

If the estimated relationship between inventories and sales is: Inventories = 150,000 + 0.175 (Sales), and projected sales for 2011 is 1,800,000; thus, the projected inventories will be _______. If the estimated relationship between receivables and sales is: Receivables = 27,000 + 0.045 (Sales), and projected sales for 2011 is 1,800,000; thus, the projected receivables will be _______.

Simple Linear Regression

Over the past four years, a well-managed company has had the following link between its inventories and its sales: Year 2008 2009 2010 2011 Sales 200 million 250 million 400 million 500 million Inventories 35 million 38 million 55 million 70 million

The company is in the process of generating its forecasted financial statements for 2012. The company first generates a forecast for sales and then, given its sales forecast, uses a regression model to forecast its inventories for 2012. Assuming that the forecasted sales for 2012 are P650 million, what are its forecasted inventories for 2012?

Excess Capacity Adjustments

Occurs when excess capacity exists in fixed assets. Full Capacity Sales = Actual Sales / % of capacity Target Fixed Assets/Full Capacity Sales= Actual fixed assets/full capacity sales Required Level of Fixed Assets = (Target FA/Sales) x (Projected Sales)

Excess Capacity Adjustments

Assuming that fixed assets of P800,000 in 2010 were being utilized to only 80% of capacity. Full Capacity Sales = 1,500,000 / 80% = 1,875,000 Target Fixed Assets / Full Capacity Sales = 800,000 / 1,875,000 = 42.6667% Required Level of Fixed Assets = 42.6667% x (1,500,000 x 1.2) = 768,000.60

Computation of AFN under abnormal circumstances:

The EFN has to be computed using two steps. The first step illustrated by the equation for EFN(1) finds the EFN needed to get full capacity sales. The second step, illustrated by the equation for EFN(2) finds the additional EFN to get from full capacity sales to the forecasted sales. Total EFN = EFN(1) + EFN(2).

Illustrative Problem: AFN under different circumstances

2011

2011

2011

Requirement 1: Using the EFN equation, compute the EFN assuming that fixed assets are operating at full capacity and the forecasted growth rate in sales is 25%. Requirement 2: Using the EFN equation, compute the EFN and required level of fixed assets assuming that fixed assets are currently being utilized at 60% of capacity and the forecasted growth rate in sales is 25%. Requirement 3: Using the EFN equation, compute the EFN and required level of fixed assets assuming that fixed assets are currently being utilized at 90% of capacity and the forecasted growth rate in sales is 25%.

Key Assumption of the AFN Equation:

Ratios are all expected to remain constant
Why do the AFN equation and financial statement method have different results?
Equation method assumes a constant profit margin, a constant dividend payout, and a constant capital structure. Financial statement method is more flexible. More important, it allows different items to grow at different rates.

SUPPLEMENTARY INFORMATION:

Computing for FCF

NOWC 2010 = 1,242,000 114,000 = 1,128,000 NOWC 2009 = 1,035,000 95,000 = 940,000 Net Investment in OC = 188,000 FCF in 2010 = EBIT (1-T) Net Investment in OC = 1,104,000 (1-40%) 188,000 = 474,400

Effects of Changing Ratios

MODIFYING RECEIVABLES:
If your projected DSO is 40.15 days, and you want it reduced to the industry average DSO of 36 days, how much free cash flow (reduction of receivables) would you have freed up?

MODIFYING INVENTORIES:
If your forecasted inventory turnover is 5.26x and that of the industry is 10.9 times, how much free cash flow (reduction of inventory) would you have freed up?

Various Ratio Analysis

KEY RATIOS BEP Profit Margin Formula EBIT/Total Assets NI to common/Sales NI to common/Common Equity (Receivables/Sales) x 365 Sales/Inventory Sales/Fixed Assets Sales/Total Assets Total Debt/Total Assets (NI to common + Interest)/Interest CA/CL Div to common/NI to common 2009 (Actual) 88.89% 34.87% Industry Average 40% 35% Condition Good Poor 2010 (1st Pass) 88.89% 35.19% Condition Good Good 2010 (2nd Pass) 88.89% 35.19% Condition Good Good

ROE
DSO Inventory TO Fixed Assets TO Total Assets TO Debt/Assets Times Interest Earned Current Ratio Payout Ratio

168.72%
15.09 9.09 1.88 1.45 70%

35%
10 Days 12 x 3x 2.5 x 50%

Good
Poor Poor Poor Poor Poor

161.00%
15.09 9.09 1.88 1.45 59.50%

Good
Poor Poor Poor Poor Poor

142.12%
15.09 9.09 1.88 1.45 63.71%

Good
Poor Poor Poor Poor Poor

11.85 x
1.52 95.60% 50.53% 58.72%

12 x
2.8 95.60% 40% 30%

Poor
Poor OK Good Good

14.14 x
1.62 86.83% 51.00% 58.72%

Good
Poor Poor Good Good

14.14 x
1.53 86.83% 51.00% 58.72%

Good
Poor Poor Good Good

Return on Assets NI to common/Total Assets Return on EBIT(1-T)/Total Operating invested capital Capital

How would excess capacity affect the forecasted ratios?

Sales wouldnt change but assets would be lower, so turnovers would be better. Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks were considered). Debt ratio, TIE would improve.

Source: Brigham s Official PPT

How would the following items affect the AFN?

Higher dividend payout ratio?
Increase AFN: Less retained earnings.

Higher profit margin?

Decrease AFN: Higher profits, more retained earnings.

Higher capital intensity ratio?

Increase AFN: Need more assets for given sales.

Pay suppliers in 60 days, rather than 30 days? Decrease AFN: Trade creditors supply more capital (i.e., L*/S0 increases).
Source: Brigham s Official PPT

Problems in the Book

4-1 to 4-3: AFN Equation 4-5: Excess Capacity 4-7: Pro Forma Income Statement 4-8: Long-term Financing Needed 4-9: Sales Increase