SHORT-TERMFINANCIAL MANAGEMENT
Chapter 13 – Short-Term Financial Planning
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S/T FINANCIAL PLANNING
Chapter 13 Agenda
Differentiate between a long-term and short-term financial planning model, develop a financial planning model, and discuss and interpret the sustainable growth rate.
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S/T Financial Planning
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.
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S/T Financial Planning
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
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Types of Models
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%
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6 Steps in Modeling Process
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 – Ct = a1CSt + a2CSt-1 + a3CSt-2
Where: Ct = Cash flow from sales
CSt = Credit sales in month t
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6 Steps in Modeling Process – cont. Parameter estimation – a1, a2, and a3 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.
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Basics of Model Building
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
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Growth Ratios
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)
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Forecasting Models
% 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.
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Forecasting Models
% 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?”
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% of Sales Forecasting Model
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).
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% of Sales Forecasting Model
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
NEF = Total Assets / Sales × Change in Sales
- Current Liabilities / Sales × Change in Sales
- Sales × Net Profit Margin × [1 - (Dividends / Net Profit)]
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% of Sales Forecasting Model
1
2
3NEF = Total Assets / Sales × Change in Sales
- Current Liabilities / Sales × Change in Sales
- Sales × Net Profit Margin × [1 - (Dividends / Net Profit)]
Make sure you’re using the right inputs.
1. Previous year’s sales
2. Projected sales
3. Change in sales
1
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% of Sales Forecasting Model
NEF = Total Assets / Sales × Change in Sales
- Current Liabilities / Sales × Change in Sales
- Sales × Net Profit Margin × [1 - (Dividends / Net Profit)]
Using notation, the formula is:
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% of Sales Forecasting Model Example
This firm anticipates an increase in sales to $15 million (an increase of $2.75 million, or 22.4%) …will it require external financing?
Total Asssets 15,580,000$ Current Liabilities 4,261,000$
Long-Term Debt 3,638,000$
Net Worth 7,681,000$
Total Assets 15,580,000$ Total Liabilities & NW 15,580,000$
Net Sales 12,250,000$
Net Profit 692,000$
Dividends 429,000$
BALANCE SHEET
INCOME STATEMENT
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NEF = Total Assets / Sales × Change in Sales
- Current Liabilities / Sales × Change in Sales
- Sales × Net Profit Margin × [1 - (Dividends / Net Profit)]
NEF = $15,580,000 / $12,250,000 × $2,750,000
- $4,261,000 / $12,250,000 × $2,750,000
- $15,000,000 × ($692,000 / $12,250,000) × [1 - ($429,000 / $692,000)]
NEF = 1.2718 × $2,750,000 = $3,497,551
- 0.3478 × $2,750,000 = $956,551
- $847,347 × 0.3801 = $322,041
$2,218,959
Firm must pre-arrange this amount
of incremental
external financing to
support planned
sales growth.
% of Sales Forecasting Model Example
Total Asssets 15,580,000$ Current Liabilities 4,261,000$ Net Sales 12,250,000$
Long-Term Debt 3,638,000$ Net Profit 692,000$
Net Worth 7,681,000$ Dividends 429,000$
Total Assets 15,580,000$ Total Liabilities & NW 15,580,000$
BALANCE SHEET INCOME STATEMENT
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The sales growth will impact the financial statements.
Total Asssets 15,580,000$ Current Liabilities 4,261,000$ Net Sales 12,250,000$
Long-Term Debt 3,638,000$ Net Profit 692,000$
Net Worth 7,681,000$ Dividends 429,000$
Total Assets 15,580,000$ Total Liabilities & NW 15,580,000$
Total Asssets 19,077,551$ Current Liabilities 5,217,551$ Net Sales 15,000,000$
Long-Term Debt 3,638,000$ Net Profit 847,347$
Net Worth 8,003,041$ Dividends 525,306$
Total Assets 19,077,551$ Total Liabilities & NW 16,858,592$
SHORTFALL (NEF) 2,218,959$
BALANCE SHEET INCOME STATEMENT
LAST YEAR
PRO-FORMA FOR THIS YEAR
BALANCE SHEET INCOME STATEMENT
% of Sales Forecasting Model Example
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% of Sales Forecasting Model Example
= ($4,261,000 + $3,638,000) / $7,681,000
= 1.028
= ($5,217,551 + $5,856,959) / $8,003,041
= 1.384
Given the shortfall, the firm must have grown faster than the SGR, since the Debt/Equity ratio increased. Here, the shortfall was added to LTD; the firm could have
increased STD or equity instead.
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Sustainable Growth Rate (SGR) Sustainable growth can be estimated by equating
annual sources of capital to annual uses. If Uses = Sources
Then New Assets = New Equity + New Debt
And gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E)
Where, S = Prior year sales gS = Dollar change in sales during planning year A/S = Target ratio of total assets to total sales m = Projected after-tax profit margin d = Target dividend payout ratio (dividends/earnings) D/E = Target debt-to-equity ratio
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Sustainable Growth Rate
gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E)
gS(A/S) is the increase in assets required to support the expected increase in sales.
It is assumed the firm is operating efficiently.
Therefore, the uses of cash (the left-hand side of the equation) must be supported by new sources on the right-hand side).
A portion of the incremental assets
will come from additions to retained earnings (profits less
dividends paid).
As equity increases, liabilities can increase proportionately and
still maintain a constant value for D/E.
The growth in assets is limited to a constant proportion of D/E.
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Sustainable Growth Rate
The sales growth rate (g) that satisfies the previous equation is given by:
Where, S = Prior year sales gS = Dollar change in sales during planning year A/S = Target ratio of total assets to total sales m = Projected after-tax profit margin d = Target dividend payout ratio (dividends/earnings) D/E = Target debt-to-equity ratio
D/E1 d-1 m-A/S
)D/E1 d-1 mg*
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For this same firm, what is the SGR?
Total Asssets 15,580,000$ Current Liabilities 4,261,000$
Long-Term Debt 3,638,000$
Net Worth 7,681,000$
Total Assets 15,580,000$ Total Liabilities & NW 15,580,000$
Net Sales 12,250,000$
Net Profit 692,000$
Dividends 429,000$
BALANCE SHEET
INCOME STATEMENT
Sustainable Growth Rate
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Sustainable Growth Rate
Total Asssets 15,580,000$ Current Liabilities 4,261,000$ Net Sales 12,250,000$
Long-Term Debt 3,638,000$ Net Profit 692,000$
Net Worth 7,681,000$ Dividends 429,000$
Total Assets 15,580,000$ Total Liabilities & NW 15,580,000$
BALANCE SHEET INCOME STATEMENT
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
D/E1 d-1 m-A/S
)D/E1 d-1 mg*
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The firm can only grow sales to $12.7 million (3.545%) without changing its financial policies.
3.545%
Sustainable Growth Rate
3.545%
A/S = 1.272
A/S = 1.272
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NEF v. SGR
NEF SGR
D/E = 1.028
D/E = 1.384
Current Liabilities 4,261,000$
Long-Term Debt 3,638,000$
Net Worth 7,681,000$
Total Liabilities & NW 15,580,000$
Current Liabilities 4,412,071$
Long-Term Debt 3,766,983$
Net Worth 7,953,324$
Total Liabilities & NW 16,132,378$
LAST YEAR
PRO-FORMA FOR THIS YEAR
D/E = 1.028
D/E = 1.028
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SGR = ROE x (1 - dividend-payout ratio)= ($716,534 / $7,681,000) x ((1 – ($444,210 / $716,534))
3.545%
Alternative SGR Formula
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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