2. FINANCIAL PLANNING AND FORECASTING FINANCIAL STATEMENTS
CHAPTER 5
FINANCIAL PLANNING AND FORECASTING FINANCIAL STATEMENTS

3. Copyright © 2014 by Nelson Education Ltd.
CHAPTER 5 OUTLINE
Overview of Financial Planning
Sales Forecast
The AFN Formula
The Forecasted Financial Statement (FFS) Method
Forecasting Financial Requirements When the Balance Sheet Ratios Are Subject to Change
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5. Overview of Financial Planning
Three important components:
Strategic plans: Define its corporate purpose, scope, and objectives, and develop strategies for achieving its goals
Operating plans: Provide detailed implementation guidance to help meet the corporate objectives
Financial plans: Forecast the amount of external financing that will be required
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6. Financial Planning Process
Projects financial statements
Determines the funds needed
Forecasts the funds to be generated internally and identifying those to be obtained from outside sources
Sets up a performance-based management compensation system
Implements the plan and monitoring its operations
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7. Components of a Financial Plan
Sales forecast
Pro forma, or projected, financial statements
External financing plan
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8. Copyright © 2014 by Nelson Education Ltd.
Sales Forecast
An accurate sales forecast is critical to profitability.
Forecasting the future sales growth starts with a review of sales during the past years using a regression approach.
Adjust the estimate with the reality if necessary.
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9. 2013 Balance Sheet ($ Millions)
Cash $ $
Accts. pay.
$ 60
S-t invest
Accruals
$ 140
Accounts rec.
375
Notes payable
110
Inventories
615
Total CL
$ 310
Total CA
$1,000
L-t bonds
754
Pref. stk 40
Net fixed
Com. stk
130
assets
1,000
Ret. earnings
766
Total assets
$2,000
Total claims
$2,000
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10. 2013 Income Statement ($ Millions)
Sales
$3,000.00
Costs except Depr (60%)
2,616.20
Depreciation
100.00
EBIT $
Interest
88.00
EBT $
Taxes (40%)
78.30
NI before pref. div
117.50
preferred dividends
4.00
Net income for com. $
Dividends (50.7%)
$57.50
Add’n to RE
$56.00
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11. The AFN (Additional Funds Needed) Formula: Key Assumptions
Operating at full capacity in 2013
Each type of asset grows proportionally with sales.
Payables and accruals grow proportionally with sales.
2013 profit margin ($113.5/$3,000 = 3.78%), and payout (50.7%) will be maintained
Sales are expected to increase by $300 million.
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12. Definitions of Variables in AFN
A*/S0: Assets required to support sales; called capital intensity ratio
∆S: Change in sales
L*/S0: Spontaneous liabilities-to-sales ratio
M: Profit margin (net income/sales)
RR: Retention ratio; percentage of net income not paid as dividend
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Assets vs. Sales
Assets
Sales
2,000
3,000
2,200
3,300
A*/S0 = $2,000/$3,000 = 0.67 = $2,200/$3,300
 Assets =
(A*/S0)Sales
= 0.67($300)
= $200
Assets = 0.67 sales
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14. If Sales Increase by $300 Million, What is the AFN?
AFN = (A*/S0)∆S – (L*/S0)∆S – M(S1)(RR) AFN = Projected increase in assets – Spontaneous increase in liabilities – Increase in retained earnings AFN = ($2,000/$3,000)($300) – ($200/$3,000)($300) – ($3,300)(1 – 0.507) AFN = $ million
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15. 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
Higher capital intensity ratio, A*/S0:
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16. How Would Increases in These Items Affect the AFN? (cont’d)
Higher profit margin:
Increases funds available internally, decreases AFN
Pay suppliers sooner:
Decreases spontaneous liabilities, increases AFN
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17. Self-supporting Growth Rate
The maximum growth rate the firm could achieve if it had no access to external capital.
It can be found by setting AFN to zero and solving the resultant equation for g.
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18. Self-Supporting G for Microdrive
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19. The Forecasted Financial Statement (FFS) Method
Forecasts the complete set of pro forma statements, making the analysis reliable
Information also provides financial ratios to evaluate different business plans.
Uses the percentage of sales method
Begins with sales forecast, and estimates the assets required to support the growth
Allows different asset/liability classes to grow at different rates
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20. Projecting Pro Forma Statements with the Percent of Sales Method
Forecasts items as a percent of the forecasted sales (i.e., varying directly with sales)
Costs
Cash
Accounts receivable
Inventories
Net fixed assets
Accounts payable and accruals
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Projecting Pro Forma Statements with the Percent of Sales Method (cont’d)
Chooses other items that have no direct linear relationship with sales
Debt
Dividend policy (which determines retained earnings)
Common stock
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22. 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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24. 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 based on:
debt at end of year
debt at beginning of year
average of beginning and ending debt
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25. Basing Interest Expense on Debt at End of Year
Will overestimate 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.
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26. Basing Interest Expense on Debt at End of Year (cont’d)
Will underestimate interest expense if debt is added throughout the year instead of all on December 31
But doesn’t cause problem of circularity
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27. 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
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28. 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
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29. Percent of Sales: Inputs
2013 Actual
2014 Proj.
Costs ex Depr/Sales
87.2%
Cash/Sales
0.33%
Acct. rec./Sales
12.5%
Inv./Sales
20.5%
Net FA/Sales
33.3%
AP/Sales 2%
Accruals/sales
4.67%
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Other Inputs
Percent growth in sales
10%
Interest rate on debt
11%
Tax rate
40%
Dividend payout rate
50.7%
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31. 2014 Preliminary Forecasted Income Statement
Calculations
2014 Preliminary
Sales
1.10 Sales09 =
$3,300.0
Less: Costs ex. depreciation
87.2% Sales10 =
2,877.6
Depre. expenses
10% FA10 =
110.0
EBIT
$312.4
Interest
0.09(STD09) (LTD09) =
92.8
EBT
$219.6
Taxes (40%)
87.8
NI before pref. dividend
$131.8
Pref. dividend
4.0
Net income to com. (50,000,000 shares)
$127.8
Dividend
# of shares ×108%DPS09
$62.5
Add to RE
$65.3*
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32. 2014 Balance Sheet (Assets)
Calculations
2010
Cash
0.33% Sales14 =
$11.0
Accts rec.
12.5%Sales14 =
412.5
Inventories
20.5%Sales14 =
676.5
Total CA
$1,100.0
Net FA
33.3% Sales14 =
1,100.0
Total assets
$2,200.0
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33. 2014 Preliminary Balance Sheet (Liabilities and Equity)
2009
Calculations
Forecast for 2010 AP 60
2% Sales14 =
$66.0
Accruals
140
4.67% Sales14 =
$154.0
Nt. pay.
110
Plug technique
224.7
Total CL
$444.7
L-t debt
754
Carried over
754.0
Pref. stk 40
40.0
Com. stk
130
130.0
Ret earn
766
+65.3*
831.3
T. L. & E.
$2,200.0
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34. What are the Additional Funds Needed (AFN)?
Required assets = $2,200.0
Specified sources of fin. = $2,085.3
Forecast AFN: $2,200 – $2,085.3 = $114.7
NWC must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $114.7 of financing.
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35. Assumptions About How AFN Will Be Raised
No new long-term bond, preferred stock, or stock will be issued.
Any external funds needed must be raised as notes payable.
Additional notes payable = $114.7, giving a forecasted notes payable for 2014 as $224.7 = $110 + $114.7.
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36. 2014 Balance Sheet (Liabilities and Equity)
w/o AFN
AFN
With AFN AP
$66.0
Accruals
154.0
Notes payable
110.0
+114.7
224.7
Total CL
$330.0
$444.7
L-t Debt
754.0
Preferred stk
40.0
Common stk
130.0
Ret earnings
831.3
Total claims
$2,085.3
$2,200.0
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37. Equation AFN = $118.42 vs. Pro Forma AFN = $114.7
Method using the AFN equation assumes a constant profit margin
The pro forma (FFS) method is more flexible. Importantly, the approach allows different items to grow at different rates. Use the plug technique to make sure the balance sheet is in order.
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38. Copyright © 2014 by Nelson Education Ltd.
Forecasted Ratios
Actual 2013
Forecast 2014
Industry
Current ratio
3.2x
2.5x
4.2x
Inv turnover
4.9x
9.0x
DSO (days)
45.6
36.0
TA turnover
1.5x
1.8x
Debt ratio
53.2%
40.98%
40.0%
Profit margin
3.8%
3.9%
5.0%
ROA
5.7%
5.8%
9.0%
ROE
12.7%
13.3%
15.0%
ROIC
9.5%
11.4%
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39. What are the Forecasted Free Cash Flow and ROIC?
2013
2014
Net operating WC
(CA – AP & accruals)
$800.0
$880.0
Total operating capital
(Net op. WC + net FA)
$1,800.0
$1,980.0
NOPAT (EBITx(1 – T))
Less Inv. in op. capital
$170.3
$187.4
$180.0
Free cash flow
–$174.7
$7.4
ROIC (NOPAT/Capital)
9.5%
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40. Proposed Improvements
Before
After
Tight up credit policy:
Accts. rec./Sales
12.5%
11.8%
Control inventory:
Inventory/Sales
20.5%
16.7%
Lay off workers:
Op. costs (excluding depreciation)/Sales
87.2%
86.0%
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41. Impact of Improvements
Before
After
DSO (days)
45.6
43.1
Inventory turnover
4.9x
6.0x
NOPAT
$187.4
$211.2
Net Op. WC
$880.0
$731.5
Tot. Op. capital
$1,980.0
$1,831.5
Free cash flows
$7.4
$179.7
AFN
$114.7
–$57.5
ROIC
9.5%
11.5%
ROE
13.3%
15.4%
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Forecasting Financial Requirements When the Balance Sheet Rations are Subject to Change: Economies of Scale
Assets
Sales
400
300
200
Declining A/S Ratio
$300/$200 = 1.5; $400/$400 = 1.0. Declining ratio shows economies of scale. Going from S = $0 to S = $200 requires $300 of assets. Next $200 of sales requires only $100 of assets.
Base
Stock 
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Lumpy Assets
Assets
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.
1,500
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44. If 2013 Fixed Assets Had Been Operated at 96% of Capacity:
With the existing fixed assets, sales could be $3,125 million.
Target fixed assets/Sales = Actual fixed assets/Full capital sales = $1,000/$3,125 = 0.32
New required fixed assets = (Target fixed assets/Sales)(Projected sales) = (0.32)($3,300) = $1,056 million
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45. How Would the Excess Capacity Situation Affect the 2014 AFN?
With full capacity, the previously projected increase in fixed assets is $100 million.
The excess capacity makes the actual required increase be $56 million only, with $44 million less than before.
Projected AFN will fall to $70.7 million = $114.7 million – $44 million.
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46. Summary: How Different Factors Affect the AFN Forecast
Excess capacity: Lowers AFN.
Economies of scale: Leads to less-than-proportional asset increases.
Lumpy assets: Leads to large periodic AFN requirements, recurring excess capacity.
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