FINANCIAL PLANNING AND FORECASTING FINANCIAL STATEMENTS CHAPTER 5 FINANCIAL PLANNING AND FORECASTING FINANCIAL STATEMENTS

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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Components of a Financial Plan Sales forecast Pro forma, or projected, financial statements External financing plan Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

2013 Balance Sheet ($ Millions) Cash $ 10 $ 10 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 Copyright © 2014 by Nelson Education Ltd.

2013 Income Statement ($ Millions) Sales $3,000.00 Costs except Depr (60%) 2,616.20 Depreciation 100.00 EBIT $ 283.80 Interest 88.00 EBT $ 195.80 Taxes (40%) 78.30 NI before pref. div 117.50 preferred dividends 4.00 Net income for com. $ 113.50 Dividends (50.7%) $57.50 Add’n to RE $56.00 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd.

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) – 0.0378($3,300)(1 – 0.507) AFN = $118.42 million Copyright © 2014 by Nelson Education Ltd.

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: Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

Self-Supporting G for Microdrive Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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% Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Other Inputs Percent growth in sales 10% Interest rate on debt 11% Tax rate 40% Dividend payout rate 50.7% Copyright © 2014 by Nelson Education Ltd.

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) + 0.11(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* Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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% Copyright © 2014 by Nelson Education Ltd. Copyright © 2014 by Nelson Education Ltd.

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% Copyright © 2014 by Nelson Education Ltd.

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% Copyright © 2014 by Nelson Education Ltd.

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% Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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  Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. 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 Copyright © 2014 by Nelson Education Ltd.

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 Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.

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. Copyright © 2014 by Nelson Education Ltd.