Financial Planning and Forecasting Financial Statements

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CHAPTER 19
Financial Planning and Forecasting Pro-Forma
Financial Statements
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Some Bad Forecasts

• "Everything that can be invented has been
  invented." --Commissioner, U.S. Office of
  Patents, 1899.
• "640K ought to be enough for anybody." -- Bill
  Gates, 1981

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Some Bad Forecasts

• "But what ... is it good for?" --Engineer at the
  Advanced Computing Systems Division of IBM, 1968,
  commenting on the microchip.
• "There is no reason anyone would want a computer
  in their home." --President, Chairman and
  founder of Digital Equipment Corp., 1977

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Some Bad Forecasts

• "I think there is a world market for maybe five
  computers." --Chairman of IBM, 1943
• "We don't like their sound, and guitar music is
  on the way out." --Decca Recording Co. rejecting
  the Beatles, 1962.

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Forecasting

• What is generally the first item to estimate when
  starting a business?
• What is the most difficult aspect of forecasting?

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Steps in Financial Forecasting

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

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The Sales Forecasting Process
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Forecasting sales

• 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.

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Sales Forecast

• Sales forecasts are usually based on the analysis
  of historic data.
• An accurate sales forecast is critical to the
  firms profitability

Sales Forecast
Under-optimistic

• Company will fail to meet demand
• Market share will be lost

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

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• Forecast future sales based on past sales growth

Sales Estimates for next 2 years
Sales
Growth Rate
Time
94 95 96 97 98 99 00 01 02 03
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• Forecast future sales based on past sales growth

• Also include the effects of any events which are
  expected to impact future sales (new products or
  economic conditions)

Sales
Time
94 95 96 97 98 99 00 01 02 03
12

• Forecast future sales based on past sales growth

• Also include the effects of any events which are
  expected to impact future sales (new products or
  economic conditions)

Sales
Time
94 95 96 97 98 99 00 01 02 03
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Sales Growth Imposes Costs on the Firm

• Current Assets Inventory, A/R, Cash
• Fixed Assets Plant and Equipment

• Will require additional resources

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What are the affects on the financials?

• Sold off stores
• Borrowed money
• Expanded to new markets
• Out-sourced labor to China
• Lowered retail prices
• Increased advertising
• Purchased inventory management system

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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.
• Many items on the balance sheet and income
  statement are assumed to change proportionally
  with sales.

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A Better Financial Planning Model
The Income Statement

• The pro forma income statement is generated by
  recognizing all variable costs that change
  directly with sales.

• Two key ratios are calculated dividend payout
  ratio and retention ratio.

• The first measures the percentage of net income
  paid out as dividends to shareholders, while the
  second measures the percentage of net income
  reinvested by the firm as retained earnings.

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A Better Financial Planning Model
The Balance Sheet

• Some balance sheet items vary directly with sales
  while others do not.

• To determine which accounts vary directly with
  sales, a trend analysis may be conducted on
  historic balance sheets of the firm.

• Typically, working capital accounts like
  inventory, accounts receivables and accounts
  payables vary directly with sales.

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A Better Financial Planning Model
The Balance Sheet

• Fixed assets do not always vary directly with
  sales. It will do so, only if the firm is
  operating at 100 percent capacity and fixed
  assets can be incrementally changed.

• The ratio of total assets to net sales is called
  the capital intensity ratio. This ratio tells us
  the amount of assets needed by the firm to
  generate 1 sales.

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A Better Financial Planning Model
The Balance Sheet

• The higher the ratio, the more capital the firm
  needs to generate salesthe more capital
  intensive the firm.

• Firms that are highly capital intensive are more
  risky than those that are not because a downturn
  can reduce sales sharply but fixed costs do not
  change rapidly.

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A Better Financial Planning Model
Liabilities and Equity

• Only current liabilities are likely to vary
  directly with sales. The exception here is notes
  payables (short-term borrowings) that changes as
  the firm pays it down or makes an additional
  borrowing.

• Long-term liabilities and equity accounts change
  as a direct result of managerial decisions like
  debt repayment, stock repurchase, issuing new
  debt or equity.

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A Better Financial Planning Model
Liabilities and Equity

• Retained earnings will vary as sales changes but
  not directly. It is affected by the firms
  dividend payout policy.

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A Better Financial Planning Model
The Preliminary Pro-forma Balance Sheet

• First, calculate the projected values for all the
  accounts that vary with sales.

• Second, calculate the projected value of any
  other balance sheet account for which an
  end-of-period value can be forecast or otherwise
  determined.

• Third, enter the current years number for all
  the accounts for which the next years figure
  cannot be calculated or forecast.

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A Better Financial Planning Model
The Preliminary Pro-forma Balance Sheet

• At this point the balance sheet will be
  unbalanced. A plug value is necessary to get the
  balance sheet to balance.

• First, determine the retained earnings based on
  the firms dividend policy.

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A Better Financial Planning Model
The Preliminary Pro-forma Balance Sheet

• Next, the plug figure will represent the external
  financing necessary to make the total assets
  equal total liabilities and equity. This calls
  for management to choose a financing option
  choosing debt, equity or a combination to raise
  the additional funds needed.

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A Better Financial Planning Model
The Management Decision

• The first decision relates to the firms dividend
  policy. Should the firm alter its dividend policy
  to increase the amount of retained earning?

• If external funding is still needed, should the
  firm issue new debt, or issue equity? Or, should
  it be a mix of both?

• It is important to recognize that while financial
  planning models can identify the amount of
  external financing needed, the financing option
  is a managerial decision.

Go to exhibit 19.6
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Beyond the Basic Planning Models
Improving Financial Planning Models

• There are several weaknesses in the previously
  described models.

• First, interest expense was not accounted for.
  This is difficult to do so until all the
  financing options are finalized.

• Second, all working capital accounts do not
  necessarily vary directly with sales, especially
  cash and inventory.

Go to exhibit 19.7
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Beyond the Basic Planning Models
Improving Financial Planning Models

• Third, how fixed assets are adjusted plays a
  significant role.

• When a firm is not operating at full capacity,
  sales may be increased without adding any new
  fixed assets.

• Fixed assets are added in large discrete amounts
  called lumpy assets. Since it requires time to
  get new assets operational, they are added as the
  firm nears full capacity.

Go to exhibit 19.8
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Beyond the Basic Planning Models
Managing and Financing Growth

• Managers prefer rapid growth as a goal to capture
  market share and establish a competitive position.

• Most firms experiencing rapid growth fund the
  growth with debt, increasing the firms leverage
  and putting it at risk.

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Beyond the Basic Planning Models
External Funding Needed

• External funding needed (EFN) is defined as the
  additional debt or equity a firm needs to issue
  so it can purchase additional assets to support
  an increase in sales.

• EFN is tied to new investments the management has
  deemed necessary to support the sales growth.

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Beyond the Basic Planning Models
External Funding Needed

• The new investments are the projected capital
  expenditure plus the increase in working capital
  necessary to sustain increases in sales.
  See equation 19.5.

• Companies first resort to internally generated
  funds in the form of addition to retained
  earnings.

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Beyond the Basic Planning Models
External Funding Needed

• Once internally generated funds are exhausted,
  the firm looks to raise funds externally.
  See equation 19.6 and 19.7.

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Beyond the Basic Planning Models
External Funding Needed

• First, holding dividend policy constant, the
  amount of EFN depends on the firms projected
  growth rate. Higher growth rate implies that the
  firm needs more new investments and therefore,
  more funds to have to be raised externally.

• Second, the firms dividend policy also affects
  EFN. Holding growth rate constant, the higher
  the firms payout ratio, the larger the amount of
  debt or equity financing needed.

Go to exhibit 19.9 -19.11
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How would increases in these items affect the EFN?

• Higher dividend payout ratio
• Reduces funds available internally, increases EFN.

(More)
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• Higher profit margin
• Increases funds available internally, decreases
  EFN.
• Higher capital intensity ratio, A/S0
• Increases asset requirements, increases EFN.

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Implications of EFN

• If EFN is positive, then you must secure
  additional financing.
• If EFN is negative, then you have more financing
  than is needed.
• Pay off debt.
• Buy back stock.
• Buy short-term investments.

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Summary How different factors affect the EFN
forecast.

• Excess capacity lowers EFN.
• Economies of scale leads to less-than-proportiona
  l asset increases.
• Lumpy assets leads to large periodic EFN
  requirements, recurring excess capacity.

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Lumpy Assets
Assets
1,500
1,000
500
Sales
1,000
2,000
500
A/S changes if assets are lumpy. Generally will
have excess capacity, but eventually a small ?S
leads to a large ?A.