1. Lecture 5 - Financial Planning and Forecasting

2. Strategy
A company’s strategy consists of the competitive moves, internal operating approaches, and action plans devised by management to produce successful performance.
Strategy is management’s “game plan” for running the business.
Managers need strategies to guide HOW the organization’s business will be conducted and HOW performance targets will be achieved. 2

3. Strategic Planning
Strategic planning is a systematic process through which an organization agrees on and builds commitment among key stakeholders to priorities that are essential to its mission and are responsive to the environment.
Strategic Planning guides the acquisition and allocation of resources to achieve these priorities. 3

4. Strategic Planning versus Operational Planning
implementation
how
means
plans
efficiency
control
Strategic Planning
formulation
What, where
ends
vision
effectiveness
risk 4

5. Financial Planning and Pro Forma Statements
Financial plans evaluate the economics behind the strategy and operations. They consist of six steps:
Project 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. 5

6. 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 6

7. Sales Forecast Sales Forecast
Sales forecasts are usually based on the analysis of historic data.
An accurate sale forecast is critical to the firm’s 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 7

8. Sales Forecast

9. 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. 9

10. Step 1 - Analyze the Historical Ratios* *
*Spontaneous generated funds - increase spontaneously with sales 10

11. Step 2 – Forecast the Income Statement11

12. 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… 12

13. 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.
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 doesn’t cause problem of circularity. 13

14. A Solution that Balances Accuracy and Complexity
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.
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 14

15. Step 3 – Forecast the Balance Sheet15

16. Step 4 – Raising the Additional Funds Needed

17. 2009 Balance Sheet(Millions of $)
Cash & sec. $
Accts. pay. &
accruals
$ 200
Accounts rec.
375
Notes payable
110
Inventories
615
Total CL
$ 310
Total CA
$ 1000
L-T debt
754
Common +pr stk
170
Net fixed
Retained
assets
1000
earnings
766
Total assets
$2,000
Total Liabilities
$2,000

18. 2009 Income Statement (Millions of $)
Sales
$3,000.00
Less: COGS (87.2%)
Dep costs
100.00
EBIT $
Interest
88.00
EBT $
Taxes (40%) +pr.div
82.30
Net income $
Dividends (Com+Pr
$57.50
Add’n to RE
$56.00

19. AFN (Additional Funds Needed): Key Assumptions
Operating at full capacity in 2009.
Each type of asset grows proportionally with sales.
Payables and accruals grow proportionally with sales.
2009 profit margin ($113.5/$3,000 = 3.80%) and retention ratio (56/114) = .49 will be maintained.
Sales are expected to increase by $300 million. 19

20. Assets vs. Sales Assets = 0..667sales Sales 2,000 3,000 2,200 3,300
2,000
3,000
2,200
3,300
A*/S0 = $2,000/$3,000 = = $2200/$3,300.
 Assets =
(A*/S0)Sales
= ($300)
= $200.
Assets = sales

21. 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
M: profit margin (Net income/sales)
RR: retention ratio; percent of net income not paid as dividend. 21

22. If assets increase by $200 million, what is the AFN?
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
AFN = ($2,000/$3,000)($300)
(0.667) x $300
- ($200/$3,000)($300)
(0.067) x ($300)
($3,300)(0.49) = $118 million
AFN = $118 million. 22

23. How Would Increases in Various Items Affect the AFN?
Higher sales:
Increases asset requirements, increases AFN.
Higher dividend payout ratio:
Reduces funds available internally, increases AFN.
Higher profit margin:
Increases funds available internally, decreases AFN.
Higher capital intensity ratio, A*/S0:
Pay suppliers sooner:
Decreases spontaneous liabilities, increases AFN. 23

24. 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. 24

25. What if Balance Sheet Ratios are Subject to Change
We have so far assumed that ratios of both assets and liabilities to sales are constant over time
Sometimes this assumption is incorrect. 25

26.  Economies of Scale Assets Sales 1,100 1,000 2,000 2,500
1,100
1,000
2,000
2,500
Declining A/S Ratio
$1,000/$2,000 = 0.5; $1,100/$2,500 = Declining ratio shows economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of assets. Next $500 of sales requires only $100 of assets.
Base
Stock 

27. Lumpy Assets – Buying Discrete Units
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

28. What if 2009 fixed assets had been operated at 96% of capacity:
Capacity sales =
Actual sales
% of capacity
= = $3,125.
$3,000
0.96
Thus, if sales increase to $3,300 fixed assets would only have to increase to 3,300 x .32 = $1,056
Target Fixed Assets/Sales = = = 32%
Actual Fixed Asset $1,000
Full Capacity Sales $3,125

29. 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. 29