Financial Planning and Forecasting Financial Statements

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Financial Planning and Forecasting
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Financial Plans

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

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Sales Forecast

• Sales forecasts are usually based on the analysis
  of historic data.
• An accurate sale 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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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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The Percent of Sales Method An Example

• 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.
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Example (contd)
The spontaneous items on the liabilities side of
the projected balance sheet must also increase
by 15.
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Example (contd)
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Example (contd)

• 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.

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Example (contd)

• 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
• Retained Earnings
• Accounts Payable and Accruals

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Example (contd)
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Financing Feedbacks

• 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.

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Example (contd)

• Borrow at 10 (Notes Payable).
• It means that next year the interest will be
• 560 (10 2,128)

• 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

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The AFN Formula

• In the formula, we can use either year (2001 or
  2002) numbers to arrive at the final result.
• A refers to the Total Assets.
• L refers to the sum of all spontaneous
  liabilities (Accounts Payable and Accruals).

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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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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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After sales forecasting, what is next?

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

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Sales forecasting and longer term assets and
liabilities

• Do they need to be changed as well along with
  sales?
• Depends.
• Existing production capacity relative to the new
  sales projections.

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Ready to prepare the income statement

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

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Ready to prepare the Balance Sheet

• Determine the new level of assets (both
  short-term 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.

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Additional funds needed

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

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How would increases in these items affect the AFN?

• Higher sales
• Increases asset requirements, increases AFN.
• Higher dividend payout ratio
• Reduces funds available internally, increases AFN.

(More)
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How would increases in these items affect the AFN?

• 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.

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Projecting Pro Forma Statements with the Percent
of Sales Method

• Project sales based on forecasted growth rate in
  sales
• Forecast some items as a percent of the
  forecasted sales
• Costs
• Cash
• Accounts receivable

(More...)
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• Items as percent of sales (Continued...)
• Inventories
• Net fixed assets
• Accounts payable and accruals
• Choose other items
• Debt
• Dividend policy (which determines retained
  earnings)
• Common stock

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Sources of Financing Needed to Support Asset
Requirements

• 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

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Implications of AFN

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

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How to Forecast Interest Expense

• Interest expense is actually based on the daily
  balance of debt during the year.
• There are three ways to approximate interest
  expense. Base it on
• Debt at end of year
• Debt at beginning of year
• Average of beginning and ending debt

More
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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.
• Causes circularity called financial feedback
  more debt causes more interest, which reduces net
  income, which reduces retained earnings, which
  causes more debt, etc.

More
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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.
• But doesnt cause problem of circularity.

More
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Basing Interest Expense on Average of Beginning
and Ending Debt

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

More
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Equation AFN versus Pro Forma AFN

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

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Summary How different factors affect the AFN
forecast.

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

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Economic Value Added (EVA)

• EVA (Operating Income) x (1-T)
• - WACC x (Capital Employed)
• Changes in
• Ratios
• Performance
• Debt
• Risk
• will lead to changes in EVA.