Financial Planning and Forecasting

Financial Plans
y

Financial plans evaluate the economics behind the strategy and operations. They consist of six steps:
1. Projected financial statements: to analyze the effects of the operating plan on projected profits and financial ratios. 2. Determine the funds needed to support the plan. 3. Forecast funds availability. 4. Establish and maintain a system of controls to govern the allocation and use of funds within the firm. 5. Develop procedures for adjusting the basic plan if the economic forecasts upon which the plan was based do not materialize 6. Establish a performance-based management compensation system.

Sales Forecast
y y

Sales forecasts are usually based on the analysis of historic data. An accurate sale forecast is critical to the firms profitability:
Sales Forecast
Company will fail to meet demand Market share will be lost

Under-optimistic

Over-optimistic

Too much inventory and/or fixed assets

Low turnover ratio High cost of depreciation and storage Write-offs of obsolete inventory

Low profit Low rate of return on equity Low free cash flow Depressed stock price

The Percent of Sales Method

This is the most common method, which begins with the sales forecast expressed as an annual growth rate in dollar sale revenue. y Many items on the balance sheet and income statement are assumed to change proportionally with sales.
y

The Percent of Sales Method: An Example

Balance Sheet
*Cash *Receivables *Inventory *TCA *Fixed Assets 1,080 6,480 9,000 16,560 12,600 *Accounts Payable *Accruals Notes Payable TCL Bonds Common Stock Retained Earnings Total (L+E) 4,320 2,880 2,100 9,300 3,500 3,500 12,860 29,160

*Total Assets

29,160 X 1.15 =

33,534

4,374

We need increase on the asset side.

All assets are spontaneous. On the liability and equity side, Accounts Payable and Accruals are the only spontaneous funds. During the next year, sales increase by 15% resulting in a 15% increase in Total Assets (4,374). Hence, the asset side on next years balance sheet must go up by 15%. Also, the spontaneous funds on the liability side must also increase by 15%.

*Denotes spontaneous, which means increase spontaneously with sales.

Example (contd):
Balance Sheet
*Cash *Receivables *Inventory *TCA *Fixed Assets 1,080 6,480 9,000 16,560 12,600 *Accounts Payable *Accruals Notes Payable TCL Bonds Common Stock Retained Earnings Total (L+E) 4,320 X 1.15 = 4,968 648 2,880 X 1.15 = 3,312 432 2,100 9,300 3,500 3,500 12,860 29,160

*Total Assets

29,160 X 1.15 = 33,534 4,374

The spontaneous items on the liabilities side of the projected balance sheet must also increase by 15%.

Example (contd):
Income Statement *Sales *Operating Costs *EBIT Interest EBT Keep Net Income Keep (45% dividends) Retained Earnings 2001 36,000 X 1.15 = 32,440 X 1.15 = 3,560 X 1.15 = 560 3,000 0.6 1800 0.55 990 2002 41,400 37,306 4,094 560 3,534 0.6 2,120 0.55 1,166

*Keep is the after tax result (1-tax)

Example (contd):
Balance Sheet
*Cash *Receivables *Inventory *TCA *Fixed Assets 2001 1,080 6,480 9,000 16,560 12,600 2002 *Accounts Payable *Accruals Notes Payable TCL Bonds Common Stock Retained Earnings Total (L+E) 2001 4,320 X 1.15 = 2,880 X 1.15 = 2,100 9,300 3,500 3,500 12,860 +1,166 29,160 Total Assets AFN 2002 4,968 648 3,312 432 2,100 10,380 3,500 3,500 14,026 31,406 33,534 2,128 (short)

*Total Assets

29,160 X 1.15 =

33,534

4,374

Retained earnings will also increase but not at the same rate as sales. The 2002 amount of RE is the old amount plus the addition to retained earnings, which we calculated in the projected income statement. Since the TA = TL and the TA have increased to 33,534, while TL have increased to 31,406, there are additional funds needed (AFN) of 2,128 on the liabilities side.

Example (contd):
y

There are two categories of sources for the AFN:

Issuance of new stocks (equity) Use some combination of debt In this example, there are internally generated funds from:
x Retained Earnings x Accounts Payable and Accruals

Example (contd):
Balance Sheet
*Cash *Receivables *Inventory *TCA *Fixed Assets 2001 1,080 6,480 9,000 16,560 12,600 2002 *Accounts Payable *Accruals Notes Payable TCL Bonds Common Stock Retained Earnings Total (L+E) 2001 4,320 X 1.15 = 2,880 X 1.15 = 2,100 9,300 3,500 3,500 12,860 +1,166 29,160 Total Assets AFN 2002 4,968 648 3,312 432 2,100 10,380 3,500 3,500 14,026 31,406 33,534 2,128 (short)

*Total Assets

29,160 X 1.15 =

33,534

4,374

Internally available Change in TA Less: RE Change in A/P Change in Accruals 4,374 (1,166) 3,208 (648) (432) 2,128

Have to go to the capital markets

Financing Feedbacks
y y

If the business issues new debt and common stock, the total amount of interest and dividends paid will change. Because interest and dividends must be paid with cash, any increase in these costs will decrease the funds the firm has to investthat is, the amount of income added to retained earnings will be less than originally forecasted. When we consider the effects of the increased interest and dividend payments, we find that the AFN is actually greater than originally expected. Financing feedbacksthat is, the effects on the financial statements of actions taken to finance forecasted increases in assetsmust be considered to determine the exact amount of AFN.

Example (contd):
y

Borrow at 10% (Notes Payable).

It means that next year the interest will be 560 + (10% * 2,128)
Income Statement *Sales *Operating Costs *EBIT Interest EBT Keep Net Income Keep (45% dividends) Retained Earnings First Pass 2001 2002 36,000 X 1.15 = 41,400 37,306 32,440 X 1.15 = 4,094 3,560 X 1.15 = 560 560 3,000 3,534 0.6 0.6 1800 2,120 0.55 0.55 1,166 990 Second Pass 2002 2002 41,400 37,306 4,094 + 213 773 3,321 0.6 1,993 0.55 1,096 = 70 (AFN)

*Keep is the after tax result (1-tax)

Instead of retaining 1,166, the company retains 1,096 because of the interest. The end results is that the company has to raise 2,128 + 70 = 2198

The AFN Formula

*A *L ( (S )  ( (S )  (RE ! AFN S S
In the formula, we can use either year (2001 or 2002) numbers to arrive at the final result. y *A refers to the Total Assets. y *L refers to the sum of all spontaneous liabilities (Accounts Payable and Accruals).
y
33,534 8,280 * 5,400  * 5,400  1,166 ! 2,128 ( First Pass) 41,400 41,400 33,534 8,280 * 5,400  * 5,400  1,096 ! 2,198 ( Second Pass) 41,400 41,400

70 AFN

Steps in Financial Forecasting

Forecast sales y Project the assets needed to support sales y Project internally generated funds y Project outside funds needed y Decide how to raise funds y See effects of plan on ratios and stock price
y

Forecasting sales
y y y y y

Review past sales (five to ten years). You can use average growth rate but it may not give you a correct estimate. Use regression slope to compute growth rate. Consider changes in economy, market conditions, etc. Improper sales forecast can lead to serious financial planning issues.

After sales forecasting, what is next?

Forecast the COGS (a certain % of sales). y Inventory numbers will change with sales. y A/R (consider credit policy changes) will change and so will A/R. y Accordingly, cash and cash equivalents will change.
y

Sales forecasting and longer term assets and liabilities

y

Do they need to be changed as well along with sales?

Depends. Existing production capacity relative to the new sales projections.

Ready to prepare the income statement

Start with forecasted sales y Project the COGS y Assuming changes in longer term assets and liabilities, forecast depreciation and interest expenses (assumptions required for interest rates / COC, etc.) y Compute EBIT.
y

Ready to prepare the Balance Sheet

y y y y

Determine the new level of assets (both shortterm and longer term). Separate them as operating assets and long term assets. Forecast liabilities (current as well as longer term). Is any common stock or preferred stock to be issued? If so, take into account the changes in these numbers.

Additional funds needed

Forecasted assets and liabilities may not perfectly match. y The difference is because of AFN or additional funds needed. y AFN is the required assets minus the specified sources of financing.
y

How would increases in these items affect the AFN?

y y

Higher sales:
Increases asset requirements, increases AFN.

Higher dividend payout ratio:

Reduces funds available internally, increases AFN.

How would increases in these items affect the AFN?

y y y

Higher profit margin:

Increases funds available internally, decreases AFN.

Higher capital intensity ratio, A*/S0:

Increases asset requirements, increases AFN.

Pay suppliers sooner:

Decreases spontaneous liabilities, increases AFN.

Projecting Pro Forma Statements with the Percent of Sales Method

Project sales based on forecasted growth rate in sales y Forecast some items as a percent of the forecasted sales
y

Costs Cash Accounts receivable

Items as percent of sales

Inventories Net fixed assets Accounts payable and accruals

Choose other items

Debt Dividend policy (which determines retained earnings) Common stock

Sources of Financing Needed to Support Asset Requirements

y

Given the previous assumptions and choices, we can estimate:

Required assets to support sales Specified sources of financing

Additional funds needed (AFN) is:

Required assets minus specified sources of financing

Implications of AFN
If AFN is positive, then you must secure additional financing. y If AFN is negative, then you have more financing than is needed.
y

Pay off debt. Buy back stock. Buy short-term investments.

How to Forecast Interest Expense

Interest expense is actually based on the daily balance of debt during the year. y There are three ways to approximate interest expense. Base it on:
y

Debt at end of year Debt at beginning of year Average of beginning and ending debt

Basing Interest Expense on Debt at End of Year

Will over-estimate interest expense if debt is added throughout the year instead of all on January 1. y Causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.
y

Basing Interest Expense on Debt at Beginning of Year

Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. y But doesnt cause problem of circularity.
y

Basing Interest Expense on Average of Beginning and Ending Debt

Will accurately estimate the interest payments if debt is added smoothly throughout the year. y But has problem of circularity.
y

Equation AFN versus Pro Forma AFN

Equation method assumes a constant profit margin. y Pro forma method is more flexible. More important, it allows different items to grow at different rates.
y

Summary: How different factors affect the AFN forecast.

Excess capacity: lowers AFN. y Economies of scale: leads to less-thanproportional asset increases. y Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.
y

Economic Value Added (EVA)

EVA = (Operating Income) x (1-T) - WACC x (Capital Employed) Changes in y Ratios
Performance Debt
y

Risk o will lead to changes in EVA.