1. SHORT-TERM FINANCIAL MANAGEMENT Chapter 13 – Short-Term Financial Planning

2. S/T F INANCIAL P LANNING Chapter 13 Agenda 2 Differentiate between a long-term and short-term financial planning model, develop a financial planning model, and discuss and interpret the sustainable growth rate.

3. S/T Financial Planning 3  Short-term financial planning differs from long-term financial decisions in two important ways:  Decisions are easily reversed in most cases.  There is far less uncertainty about the decision variables since the planning horizons are shorter.  Short-term financial decisions ensure the firm's liquidity and are critical to the short-term survival of the business.  Rapidly growing companies focused on sales often run out of cash given the need to have additional cash tied up in assets.

4. S/T Financial Planning 4  We assume it requires additional assets to support incremental sales.  This includes new, permanent current assets as well as new fixed assets (unless the firm is not operating at capacity).  The additional assets must have a financing source. Some might be supported by financial slack (excess cash or ready access to debt).  Short-term financial planning allows a firm to model different assumptions about sales growth rates and plan for the impact on:  Cash flow  The Balance Sheet  The Income Statement

5. Types of Models 5  Deterministic  Data inputs are single point estimates Example – Sales growth is expected to be 5%  Stochastic  Data inputs include probability distributions Example – Sales growth is normally distributed with an expected value of 5% and a standard deviation of 3%

6. 6 Steps in Modeling Process 6  Determine question asked – What is the dependent variable?  Variable specification – What are the independent variables? Generally, the longer the time period, the less detail needed.  Determine relationship between variables  Example – C t = a 1 CS t + a 2 CS t-1 + a 3 CS t-2  Where: C t = Cash flow from sales CS t = Credit sales in month t

7. 6 Steps in Modeling Process – cont. 7  Parameter estimation – a 1, a 2, and a 3 in previous slide. Estimates may be simple historical average or may be found by using fancy statistics.  Model validation – Run the model using some real data and check the results.  Model documentation – Write down the logic behind the model.

8. Basics of Model Building 8  Decide on driving variable (Usually sales)  Avoid the temptation to make model too detailed  Build model into electronic worksheet  Use cell references to minimize model changes

9. Growth Ratios 9  It is important to understand the impact on the balance sheet based on different assumptions around growth rates.  Assets should grow (or shrink) in relationship to sales.  We’ll look at two forecasting models:  % of Sales (Needed External Financing – NEF)  Sustainable Growth Rate (SGR)

10. Forecasting Models 10  % of Sales (Needed External Financing – NEF)  The amount of external financing needed for a desired level of sales growth. Firms that grow faster than the SGR must support growth with incremental external capital. Conversely, firms growing slower than the SGR have excess cash to retire debt, increase dividends, etc.  Sustainable Growth Rate (SGR)  Maximum sales growth rate using both internal and external sources of financing, but without increasing leverage ratio or changing existing financial policies: D/E, A/S, capital structure, profit margin, and dividend payout ratio.

11. Forecasting Models 11  % of Sales (Needed External Financing-NEF)  Answers the question: “What amount of new capital do I need if I plan to grow X% or by $Y?”  Sustainable Growth Rate (SGR)  Answers the question: “How much can I grow without changing existing financing policies?”

12. % of Sales Forecasting Model 12  We assume it requires additional assets to support incremental sales and that balance sheet relationships stay consistent and proportional (+/-) to sales volume.  e.g.: If Total Assets are 45% of sales this year and we are at 100% capacity, we assume the same relationship next year based on next year’s projected sales.  The additional assets must have a financing source. Current liabilities (primarily A/P and accruals) are a spontaneous source of financing. Another source of financing is new retained earnings. Any gap is needed external financing (NEF) and must be supplied by external financing (probably short-term debt (N/P), but could include long-term debt and/or new equity).

13. % of Sales Forecasting Model 13 1.Additional Total Assets are required to support incremental sales. 2.Some of these additional Assets (e.g.: Inventory) will be supported by ‘spontaneous financing’ through increased Current Liabilities. 3.Some of these assets are supported by earnings retained by the firm (profits not paid out as dividends). The NEF can be acquired through either new debt or new equity, but must be acquired externally from somewhere to support sales growth. 1 2 3

14. % of Sales Forecasting Model 14 1 2 3  Make sure you’re using the right inputs. 1. Previous year’s sales 2. Projected sales 3. Change in sales 1

15. % of Sales Forecasting Model 15  Using notation, the formula is:

16. % of Sales Forecasting Model Example 16  This firm anticipates an increase in sales to $15 million (an increase of $2.75 million, or 22.4%) …will it require external financing?

17. 17 Firm must pre- arrange this amount of incremental external financing to support planned sales growth. % of Sales Forecasting Model Example

18. The sales growth will impact the financial statements. 18 % of Sales Forecasting Model Example

19. 19 % of Sales Forecasting Model Example = ($4,261,000 + $3,638,000) / $7,681,000 = 1.028 = ($5,217,551 + $5,856,959) / $8,003,041 = 1.384  Given the shortfall, the firm must have grown faster than the SGR, since the Debt/Equity ratio increased.  Here, the shortfall was added to LTD; the firm could have increased STD or equity instead.

20. Sustainable Growth Rate (SGR) 20  Sustainable growth can be estimated by equating annual sources of capital to annual uses.  If  Uses = Sources  Then  New Assets = New Equity + New Debt  And  gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E) Where, S = Prior year sales gS = Dollar change in sales during planning year A/S = Target ratio of total assets to total sales m = Projected after-tax profit margin d = Target dividend payout ratio (dividends/earnings) D/E = Target debt-to-equity ratio

21. Sustainable Growth Rate 21 gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E) gS(A/S) is the increase in assets required to support the expected increase in sales. It is assumed the firm is operating efficiently. Therefore, the uses of cash (the left-hand side of the equation) must be supported by new sources on the right-hand side). A portion of the incremental assets will come from additions to retained earnings (profits less dividends paid). As equity increases, liabilities can increase proportionately and still maintain a constant value for D/E. The growth in assets is limited to a constant proportion of D/E.

22. Sustainable Growth Rate 22  The sales growth rate (g) that satisfies the previous equation is given by: Where, S = Prior year sales gS = Dollar change in sales during planning year A/S = Target ratio of total assets to total sales m = Projected after-tax profit margin d = Target dividend payout ratio (dividends/earnings) D/E = Target debt-to-equity ratio

23. 23  For this same firm, what is the SGR? Sustainable Growth Rate

24. 24 Sustainable Growth Rate m = $692,000 / $12,250,000 = 5.65% 1 - d = 1 - ($429,000 / $692,000) = (1-62%) = 38% 1 + D/E = 1 + (($4,261,000 + $3,638,000) / $7,681,000) A/S = $15,580,000 / $12,250,000 = 0.043548114 3.545% 1.228288621

25. 25 The firm can only grow sales to $12.7 million (3.545%) without changing its financial policies. 3.545% Sustainable Growth Rate 3.545% A/S = 1.272

26. NEF v. SGR 26 NEFSGR D/E = 1.028 D/E = 1.384 D/E = 1.028

27. 27 SGR = ROE x (1 - dividend-payout ratio) = ($716,534 / $7,681,000) x ((1 – ($444,210 / $716,534)) 3.545% Alternative SGR Formula

28. 28 SGR = (ROE x b)/(1 – ROE x b) = ($692,000/7,681,000) x (.38)/(1 – $692,000/7,681,000) 3.545% Alternative SGR Formula b = (692,000 – 429,000)/692,000 = 0.38