CHAPTER 8 Financial Planning and Forecasting Financial Statements

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CHAPTER 8Financial Planning and Forecasting
Financial Statements
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Financial Planning

• Strategic Plans
• Mission
• Corporate Scope, Objectives, Strategies
• Operating Plans
• Detailed implementation Guidance
• Time horizon

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Financial Planning

• The Financial Plan
• Project financial statements
• Analyze the effects of the operating plan
• Project profits and financial ratios
• Determine the funds needed
• Determine the funds available in the future
• Internal and external funds
• Incorporate restriction
• Establish performance-based management
  compensation system

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Steps in Financial Forecasting

• Prepare pro forma financial statements
• Forecast sales
• Project 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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Why Pro Forma Statements?

• Is the firms anticipated performance in line with
  the firms own general goal?
• To estimate the effect of proposed operating
  changes. What if analysis
• To anticipate the firms future financing needs.
  AFN (Additional Funds Needed)
• To anticipate the firms future free cash flows
  under different operating plans.

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Sales Forecasting

• Use historical data
• The arithmetic average approach
• (see Toolkit)

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Sales Forecasting

• Calculating the growth rate
• Use financial calculator
• N4, PV-2058, PMT0, FV3000
• Problem Outliers

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Sales Analyze the Historical Ratios

• Graph the data and use equation (see Toolkit)
• Sales in 2007 220 x 2007 437637 3,903
• Growth rate is very sensitive to starting and
  ending dates.
• One way to smooth this out is to regress the
  natural log (LN) of sales versus the years.

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Income Statement (Millions of )
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Balance Sheet (Millions of )
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Balance Sheet (Millions of )
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Analyzing the Historical Ratios

• Percent of Sales Method
• Ratio of costs to sales for past years
• Historical Average
• Industry Average
• Depreciation
• proportional to net plant equipment

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Analyzing the Historical Ratios

• Proportional to sales
• Accounts receivable
• Inventory
• Net plant and equipment
• Accounts payable
• Accruals to sales

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Sources of Financing Needed to Support Asset
Requirements

• Given previous assumptions and choices, 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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Analyzing the Historical Ratios
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Analyzing the Historical Ratios

• Other Inputs

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Forecast the Income Statement
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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 forecasted year
• Debt at beginning of year
• Average of beginning and ending debt

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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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A Solution that Balances Accuracy and Complexity

• Base interest expense on beginning debt, but use
  a slightly higher interest rate.
• Easy to implement
• Reasonably accurate
• See Ch 8 Mini Case Feedback.xls for an example
  basing interest expense on average debt.

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Calculating Interest Expense

• Total Interest Expense
• Net Interest on Short-term Financing
• Interest on Notes Payable -
• Interest on Short-term Investments
• plus
• Interest on Long-term Bonds

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Forecast the Income Statement
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Forecast the Balance Sheet (Assets)
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Forecast the Balance Sheet

• Liability side is trickier
• Companies rarely issue new stocks
• Use common stock from last year
• Use preferred stock from last year
• Issuing more long-term bonds needs often requires
  approval by the board of directors.
• Use long-term debt from last year
• Change in retained earnings
• forecasted net income dividend payout
• Notes payable (financial shock absorber)
• For extra funds needed
• Depends on line of credit

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Forecast the Balance Sheet
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Forecast the Balance Sheet

• Calculate Additional Funds Needed

• If positive
• Add to Liabilities/Equity
• (e.g Notes Payable)
• If negative
• Add to Assets
• (e.g Short-term Investments)

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Forecast the Balance Sheet
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Analysis of the Forecast

• Does the forecast meet the financial targets?
• Compare
• Actual ratios
• Projected ratios
• Industry average ratios
• Make adjustments

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Analysis of the Forecast
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Analysis of the Forecast
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Analysis of the Forecast

• Cost-to-sales O.K.
• Investments in inventories and receivables
• too high.
• Asset turnover ratio poor
• Drags down the return on investments
• Debt ratio higher than average
• More debt is needed to finance excessive assets.
• Higher interest expenses reduce profit margin.
• Low current ratio because of high amount to
  short-term debt.

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Analysis of the Forecast

• Steps to improve financial statements
• Lowering costs
• Lay off workers
• Close operations
• Collecting past-due accounts more aggressive.
• Improves accounts receivable
• Reducing inventory

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Analysis of the Forecast
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Analysis of the Forecast
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Analysis of the Forecast
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Analysis of the Forecast

• Other changes
• Change range of sales forecast
• Change range of dividend payout ratio
• See how the numbers change
• Reduce inventory

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AFN (Additional Funds Needed)Key Assumptions

• Operating at full capacity in 2003.
• Each type of asset grows proportionally with
  sales.
• Payables and accruals grow proportionally with
  sales.
• 2003 profit margin (113.5/3.000 3.80) and
  dividend growth rate (8) will be maintained.
• Sales are expected to increase by 300 million.

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Definitions of Variables in AFN

• A/S0 assets required to support sales called
  capital intensity ratio.
• ?S increase in sales.
• L/S0 spontaneous liabilities ratio
• L accounts payable accruals
• M profit margin (Net income/sales)
• RR retention ratio percent of net income not
  paid as dividend.

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Assets
Assets 0.67 sales
2,200
? Assets (A/S0)?Sales 0.667(300) 200.
2,000
Sales
0
3,000
3,300
2,200/3,300.
A/S0 2,000/3,000 0.67
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Assets must increase by 200 million. What is
the AFN, based on the AFN equation?
AFN (A/S0)?S - (L/S0)?S - M(S1)(RR)
(2,000/3,000)(300) - ((60140)/3,000)(
300)) - 0.038(3,300)(1 - 0.486)
115.55 million. Recall that dividends grew by
8 so Div.PO 62.1/127.8
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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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• 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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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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Equation AFN 115.6 vs. Pro Forma AFN
114.7Why are they different?

• 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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Assumptions about How AFN Will Be Raised

• No new common stock will be issued.
• Any external funds needed will be raised as debt,
  50 notes payable, and 50 L-T debt.

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How will the AFN be financed?
Additional notes payable
0.5 (115.6) 57.8 Additional L-T
debt 0.5 (115.6)
57.8
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2004 Balance Sheet (Claims)
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Economies of Scale

• So far we assumed constant and identical growth
  ratios.
• Due to Economies of Scale this may not hold.
• Due to base stock inventory might grow less than
  sales and the inventory to sales ratio declines.

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Economies of Scale
Inventory
400
300
?
Declining A/S Ratio
Base Stock
Sales
0
200
400
300/200 1.5 400/400 1.0. Declining
ratio shows economies of scale. Going from S
0 to S 200 requires 300 of inventory. Next
200 of sales requires only 100 of inventory.
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Lumpy Assets
Assets
225
150
A
75
B
Sales
100
200
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A/S changes if assets are lumpy. Generally will
have excess capacity, but eventually a small ?S
leads to a large ?A.
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Suppose in 2003 fixed assets had been operated at
only 96 of capacity.
With the existing fixed assets, sales could be
3,125. Since sales are forecasted at only
3,000, no new fixed assets are needed.
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How would the excess capacity situation affect
the 2004 AFN?

• The previously projected increase in fixed assets
  was 100
• (1,000 to 1,100)
• Now the required level of fixed assets is
• 0.32 (3,300) 1,056
• This is 44 million less
• AFN would decrease by 44 million
  (114.7-4470.7)

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Summary How different factors affect
the AFN
forecast.

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