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Financial Planning and Forecasting Financial Statements

Chapter 9

“In preparing for battle I have always found that plans are useless, but planning is indispensable.” - Dwight D. Eisenhower

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The Financial Plan• Steps

– Project statements and use to analyze effects of operating plan on profits & ratios

– Determine funds needed to support plan– Forecast available funds (internal AND external)– Establish performance-based compensation system

• Methods– Formula approach– Pro forma financial statements (% of sales method)

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Example: Mini Case

• Betty Simmons, the new financial manager of Southeast Chemicals (SEC), a Georgia producer of specialized chemicals for use in fruit orchards, must prepare a financial forecast for 2004. SEC’s 2003 sales were $2 billion, and the marketing department is forecasting a 25% increase for 2004. Simmons thinks the company was operating at full capacity in 2003, but she is not sure about this.

• Assume that you were recently hired as Simmon’s assistant. Your first major task is to help her develop the financial forecast.

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SEC:2003 Balance Sheet (millions)

Cash 20 AP & accruals 100 Accounts receivable 240 Notes payable 100 Inventory 240 Total CL 200 Total CA 500 Long-term debt 100 Common stock 500 Net fixed assets 500 Retained earnings 200 Total assets 1000 Total liabilities & Equity 1000

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SEC: 2003 Income Statement (millions)

Sales 2000 COGS (60% of sales) 1200 SGA 700 EBIT 100 Interest 10 EBT 90 Taxes (40%) 36 Net income 54 Dividends (40% of NI) 21.60 Addition to RE 32.40

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SEC

• Key assumptions– Operating at full capacity in 2003– All assets are proportional to sales– Accounts payable and accruals are also

proportional to sales– 2003 profit margin (54/2000 = 2.70%) will be

maintained– Sales are expected to increase by $500 million

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SEC: Additional Funds Needed

• Goal: Find AFN– In general, higher sales must be supported by

additional assets. Some of the asset increases can be financed by payables, accruals, and retained earnings. Any shortfall (AFN) must be financed from external sources, using debt, preferred, and/or common.

AFN

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AFN

• Variables in equation– A*/S0: assets required to support sales; called capital

intensity ratio S: increase in sales (S1 – S0)

- L*/S0: spontaneous liabilities ratio

- M: profit margin (Net income/sales)

- RR: retention ratio; percent of net income not paid as dividend (equal to 1 – dividend payout ratio)

- NOTE: * means those that increase “spontaneously”

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SEC AssetsAssets

Sales0

1,000

2,000

1,250

2,500

A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.

Assets =(A*/S0)Sales= 0.5($500)= $250.

Assets = 0.5 sales

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AFN Formula

• Assets must increase by $250. What is AFN?– Formula

• AFN = Required increase in assets - Spontaneous increases in liabilities - Increase in retained earnings

• AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)

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How Do the Following Affect AFN?

• Higher sales?• Lower dividend payout ratio?• Higher profit margin?

• Higher capital intensity (A*/S0) ratio?

• Pay suppliers in 60 days rather than 30 days?

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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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Pro Forma Approach

• Project sales based on forecasted growth rate in sales• Forecast some items as a percent of the forecasted sales

– Cash, accounts receivable, costs, inventory, net fixed assets, accounts payable, and accruals

• Spontaneous!

• Choose other items– Debt, dividends (determines RE), and common stock

• Financing choices!

• Process– Estimate required assets to support sales– Estimate sources of funding– AFN is required assets minus specified sources of funding

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Forecasting Interest Expense

• Interest expense is actually based on the daily balance of debt during the year

• Three approaches . . . base 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 circular issue called financing feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.

– Debt at beginning of year• Will under-estimate interest expense if debt is added throughout the

year instead of all on December 31– Average of beginning and ending debt

• Will accurately estimate the interest payments if debt is added smoothly throughout the year

• Still have circular issue

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Forecasting Interest Expense

• Solution based on balancing accuracy and complexity– Base interest expense on beginning debt, but

use a slightly higher interest rate• Easy & reasonably accurate

“Planning is a process that at best helps the firm avoid stumbling into the future backwards.” - GM board member

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SEC: Percentage of Sales Inputs

2003 Actual

2004 Forecast

COGS/Sales 60% 60% SGA/Sales 35% 35% Cash/Sales 1% 1% AR/Sales 12% 12% Inv/Sales 12% 12% NFA/Sales 25% 25% AP & Accruals/Sales 5% 5%

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SEC: Percentage of Sales Inputs

• Other inputsPercent growth in sales 25%Growth factor in sales (g) 1.25 Interest rate on debt 10%Tax rate 40%Dividend payout ratio 40%

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2004 Forecasted Income Statement

2003

Factor

2004 Forecast

Sales 2000 g=1.25 2500 COGS Pct=60% 1500 SGA Pct=35% 875 EBIT 125 Interest .1(Debt03) 20 EBT 105 Taxes (40%) 42 Net income 63 Dividend (40%) 25.2 Add to RE 37.8

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2004 Forecasted Balance Sheet: Assets

2003 Factor 2004 Forecast

Cash Pct=1% 25 Accts Rec Pct=12% 300 Inv Pct=12% 300 Total CA 625 NFA Pct=25% 625 Total Assets 1250

Forecasted assets are a percent of forecasted sales.2004 Sales = $2,500

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2004 Forecasted Balance Sheet: Claims

2003 Factor 2004 Forecast

AP & Accruals Pct=5% 125 Notes Payable 100 financing 100 Total CL 225 LT Debt 100 financing 100 Common st. 500 financing 500 RE 200 +37.8* 237.8 Total claims 1062.8 * From forecasted income statement

2004 Sales = $2,500

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SEC: Pro Forma Statements

• Now, can calculate AFN– Forecasted total assets 1250.0

Forecasted total claims 1062.8

AFN 187.2• NOTE: Just remember that B/S must balance. AFN is the

“plug”.

• Financial mix considerations– target capital structure, effect of s-t borrowing on

current ratio, conditions in debt and equity markets, restrictions from current debt, etc.

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SEC: Raising AFN

• Financing staff decided on that any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt

Amount of New Capital Rate(%) ($) (%)

Notes Payable 50% $93.6 10%LT debt 50 93.6 10%

100% $187.2

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2004 Forecasted Balance Sheet: Claims

w/o AFN AFN w/ AFN AP & Accruals 125 125 Notes Payable 100 +93.6 193.6 Total CL 225 318.6 LT Debt 100 +93.6 193.6 Common st. 500 +0 500 RE 237.8 237.8 Total claims 1250.0

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Formula vs. Pro Forma

– Assumes profit margin remains constant– Pro forma method is more flexible. More

important, it allows different items to grow at different rates

“You’ve got to be careful if you don’t know where you’re going,

because you might not get there.”

- Yogi Berra

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Forecasted Ratios 2003 2004(E) IndustryProfit Margin 2.70% 2.52% 4.00%ROE 7.71% 8.54% 15.60%DSO (days) 43.80 43.80 32.00Inv. turnover 8.33x 8.33x 11.00xFA turnover 4.00x 4.00x 5.00xDebt ratio 30.00% 40.98% 36.00%TIE 10.00x 6.25x 9.40xCurrent ratio 2.50x 1.96x 3.00x

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FCF 2003 2004(E)Net operating WC $400 $500 (CA - AP & accruals)Total operating capital $900 $1,125 (Net op. WC + net FA)NOPAT (EBITx(1-T)) $60 $75 Less Inv. in op. capital $225

Free cash flow -$150

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Proposed Improvements

DSO (days) 43.80 32.00Accts. rec./Sales 12.00% 8.77%Inventory turnover 8.33x 11.00xInventory/Sales 12.00% 9.09%SGA/Sales 35.00% 33.00%

Before After

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Effect of Improvements

AFN $187.2 $15.7

Free cash flow -$150.0 $33.5

ROE 7.7% 12.3%

Before After

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SEC: Excess Capacity• Suppose they were operating at 75% capacity

– FormulaCapacity Sales = Actual Sales/% of Capacity = 2,000/.75 = 2,667

• So, with NO new FA, SEC can support sales of 2,667• Since forecasted sales are 2,500, they would not need any new

FA• Previously projected increase in FA was $125• AFN will fall by 125

AFN = 187.2 – 125 = 62.2

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HOMEWORK PROBLEM

• Example– Pierce Furnishings generated $2.0 m in sales in 2003

and its year-end total assets were $1.5 m. Also, cl were $500,000 consisting of $200,000 notes payable, $200,000 of accounts payable and $100,000 accruals. Looking ahead to 2004, the company estimates that its assets must increase by 75 cents for every $1 increase in sales. Pierce’s profit margin is 5% and its payout ratio is 60%. How large a sales increase can the company achieve without having to raise funds externally?