Financial Planning and Forecasting

Chapter 4
Why the need To maximize stock price
for financial To reduce information asymmetry
To maximize gains and minimize losses

To provide useful information to

planning and investors regarding economic and
industry concerns.
forecasting?
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 Plans are Essential!
Strategic Plan
Corporate Purpose (Mission Statement/general philosophy)
Corporate Scope (Business and Geographic area)
Corporate Objectives (Specific goals; quantitative & qualitative)
Corporate Strategies (Broad approaches, not detailed plans, on how
to achieve goals)
Operating Plan
Provide detailed implementation guidance based on the corporate
strategy to meet corporate objectives.
Function responsibility, timeline, sales and profit targets
Usually good for 5 years
 Plans are Essential!
Financial Plan
The document that includes assumptions, projected financial
statements, and projected ratios and ties the entire planning
process together.
Steps in creating a financial plan:
Develop assumptions for use in the forecast
Project financial statements
Projected ratios are calculated and analyzed.
Determine funds needed to support the 5 year plan
Forecast fund availability over the next 5 years
Establish and maintain a system of control to govern the allocation and use
of funds within the firm
Reexamine the entire plan from start to end. Develop procedures for
adjusting the basic plan if economic forecasts upon which the plan was
based do not materialize (Feedback Loop)
Establish a performance-based management compensation system
 Sales Forecasts
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future period.
Generally based on recent sales trends + forecasts of the
economic prospects for the nation, region, industry, etc.
An objective decision. Many factors have to be
considered in doing sales forecast.
Extremely critical and important as it is a crucial
determinant of how much inventory and fixed assets to
invest in, which entail considerable amount of money.
 Percent of Sales Method
A method of forecasting future financial
statements that expresses each account as a
percentage of sales
The percentages can be constant, or can change
over time
Explicit Forecast Period

Year 2011 2012 2013 2014 2015 2016

Sales growth rate 20% 15% 10% 10% 8%
Sales 100,000 120,000 138,000 151,800 166,980 180,338

Forecast Horizon
 Percent of Sales Method
Total Sales = Sales Price per unit * # of units
In creating the Sales forecast, one has to consider population
growth (demand) and inflation.
Thus it is possible that even if unit selling price is forecasted to
increase due to inflation, the demand or # of units sold will
decrease.
If long term growth rate is 5%, _________ is what we call the
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Year 2011 2012 2013 2014 2015 2016
Unit Selling Price 10.00 10.50 10.92 11.25 11.59 11.93
Number of Units 10,000 11,000 11,880 12,474 12,225 12,347
Inflation rate 5% 4% 3% 3% 3%
Demand growth rate 10% 8% 5% -2% 1%
Sales 100,000 115,500 129,730 140,303 141,621 147,329
Growth rate (Total) 15.50% 12.32% 8.15% 0.94% 4.03%
 Forecasted Income Statement
(in thousands)
Actual (2011) Forecast Basis Forecast (2012)
Sales 1,500,000.00 1.2 1,800,000.00
Costs except depreciation 500,000.00 0.333 600,000.00
Depreciation 80,000.00 0.053 96,000.00
Total Operating Costs 580,000.00 696,000.00
EBIT 920,000.00 1,104,000.00
Interest 48,200.00 48,200.00
EBT 871,800.00 1,055,800.00
Taxes (40%) 348,720.00 422,320.00
NI before preferred dividends 523,080.00 633,480.00
Dividends to preferred 50.00 50.00
NI available to common 523,030.00 633,430.00
Dividends to common 500,000.00 550,000.00
Addition to retained earnings 23,030.00 83,430.00

Additional Information:
8% Bonds Payable, at par 565 million 2011 Net Plant and Equipment 800 million
5% Notes Payable 60 million 2012 Net Plant and Equipment 960 million
1% Preferred Stock 5 million Annual Depreciation Rate 10%
# of Common Stock Outstanding 50 million Dividend per share in 2011 is 10
Dividend per share is expected to increase by 10% Sales is expected to increase by 20%
Why BS items may be based on Sales
Companies exist and
operate to earn PROFITS

Assets are needed and

liabilities are incurred to Profits are attained
support company through SALES
operations

Sales are ultimately

turned into ASSETS
 Forecasted Balance Sheet
Actual (2011) Forecast Basis First Pass
Cash & MS 8,000.00 0.53% x 2009 Sales 9,600.00
Accounts Receivable 62,000.00 4.13% x 2009 Sales 74,400.00
Inventories 165,000.00 11% x 2009 Sales 198,000.00
TOTAL CA 235,000.00 282,000.00
Net Plant and Equipment 800,000.00 53.33% x 2009 Sales 960,000.00
TOTAL ASSETS 1,035,000.00 1,242,000.00

Accounts Payable 20,000.00 1.33% x 2009 Sales 24,000.00

Notes Payable 60,000.00 60,000.00
Accrued Liabilities 75,000.00 5% x 2009 Sales 90,000.00
TOTAL CL 155,000.00 174,000.00
Long-term Bonds 565,000.00 565,000.00
TOTAL DEBT 720,000.00 739,000.00

Preferred Stock 5,000.00 5,000.00

Common Stock 10,000.00 10,000.00
Retained Earnings 300,000.00 Plus 83,430 383,430.00
TOTAL COMMON EQUITY 310,000.00 393,430.00

TOTAL LIABS AND EQUITY 1,035,000.00 1,137,430.00

Addtl. Funds Needed 104,570.00

Financing Mix of New Capital

Notes Payable 10% 10,457.00

Long-term Bonds 40% 41,828.00

Common Stock 50% 52,285.00

TOTAL 100% 104,570.00

 nd
Forecasted Balance Sheet with 2 Pass
Actual (2011) Forecast Basis First Pass AFN Second Pass
Cash & MS 8,000.00 0.53% x 2009 Sales 9,600.00 9,600.00
Accounts Receivable 62,000.00 4.13% x 2009 Sales 74,400.00 74,400.00
Inventories 165,000.00 11% x 2009 Sales 198,000.00 198,000.00
TOTAL CA 235,000.00 282,000.00 282,000.00
Net Plant and Equipment 800,000.00 53.33% x 2009 Sales 960,000.00 960,000.00
TOTAL ASSETS 1,035,000.00 1,242,000.00 1,242,000.00

Accounts Payable 20,000.00 1.33% x 2009 Sales 24,000.00 24,000.00

Notes Payable 60,000.00 60,000.00 Plus 10,457 70,457.00
Accrued Liabilities 75,000.00 5% x 2009 Sales 90,000.00 90,000.00
TOTAL CL 155,000.00 174,000.00 184,457.00
Long-term Bonds 565,000.00 565,000.00 Plus 41,828 606,828.00
TOTAL DEBT 720,000.00 739,000.00 791,285.00
-
Preferred Stock 5,000.00 5,000.00 5,000.00
Common Stock 10,000.00 10,000.00 Plus 52,285 62,285.00
Retained Earnings 300,000.00 Plus 303,430 383,430.00 383,430.00
TOTAL COMMON EQUITY 310,000.00 393,430.00 445,715.00

TOTAL LIABS AND EQUITY 1,035,000.00 1,137,430.00 - 1,242,000.00

Addtl. Funds Needed 104,570.00

Determine the Additional Funds Needed using
the AFN Equation under normal circumstances:

AFN = Capital Intensity Ratio 4S t Spontaneous

Liabilities to Sales Ratio 4S t Profit Margin x Forecasted
Sales x Retention Ratio
= (A*/S0)4S t (L*/S )0 4S t M(S )(RR)
1
= ($1,035,000/$1,500,000)($300,000)
t ($95,000/$1,500,000)($300,000)
t ($523,030/$1,500,000)x($1,800,000)x(23,030/$523,030)
= $207,000 t $19,000 t $27,636
= $160,364
Financing Mix of New Capital

Notes Payable 10% 16,036.40

Long-term Bonds 40% 64,145.60

Common Stock 50% 80,182.00

TOTAL 100% 160,364.00

Other Techniques for forecasting FS
Simple Linear Regression (Inventories and
Receivables)
Excess Capacity Adjustments (Fixed Assets)

Used when Capital Intensity Ratio (A*/So) is

not constant
 Simple Linear Regression
If the estimated relationship between
inventories and sales is: Inventories = t
150,000 + 0.175 (Sales), and projected sales
for 2011 is 1,800,000; thus, the projected
inventories will be _______.
If the estimated relationship between
receivables and sales is: Receivables = 27,000
+ 0.045 (Sales), and projected sales for 2011 is
1,800,000; thus, the projected receivables will
be _______.
 Simple Linear Regression
Over the past four years, a well-managed company has had the
following link between its inventories and its sales:

Year Sales Inventories

2008 200 million 35 million
2009 250 million 38 million
2010 400 million 55 million
2011 500 million 70 million

The company is in the process of generating its forecasted financial

statements for 2012. The company first generates a forecast for sales
and then, given its sales forecast, uses a regression model to forecast its
inventories for 2012. Assuming that the forecasted sales for 2012 are
P650 million, what are its forecasted inventories for 2012?
 Excess Capacity Adjustments
Occurs when excess capacity exists in fixed
assets.
Full Capacity Sales = Actual Sales / % of
capacity
Target Fixed Assets/Full Capacity Sales= Actual
fixed assets/full capacity sales
Required Level of Fixed Assets = (Target
FA/Sales) x (Projected Sales)
 Excess Capacity Adjustments
Assuming that fixed assets of P800,000 in
2010 were being utilized to only 80% of
capacity.
Full Capacity Sales = 1,500,000 / 80% =
1,875,000
Target Fixed Assets / Full Capacity Sales =
800,000 / 1,875,000 = 42.6667%
Required Level of Fixed Assets = 42.6667% x
(1,500,000 x 1.2) = 768,000.60
 Computation of AFN under
abnormal circumstances:
The EFN has to be computed using two steps. The first step
illustrated by the equation for EFN(1) finds the EFN needed to
get full capacity sales. The second step, illustrated by the
equation for EFN(2) finds the additional EFN to get from full
capacity sales to the forecasted sales. Total EFN = EFN(1) +
EFN(2).
 Illustrative Problem: AFN under different circumstances

2011 2011 2011

Requirement 1: Using the EFN equation, compute the EFN assuming that fixed
assets are operating at full capacity and the forecasted growth rate in sales is 25%.
Requirement 2: Using the EFN equation, compute the EFN and required level of
fixed assets assuming that fixed assets are currently being utilized at 60% of
capacity and the forecasted growth rate in sales is 25%.
Requirement 3: Using the EFN equation, compute the EFN and required level of
fixed assets assuming that fixed assets are currently being utilized at 90% of
capacity and the forecasted growth rate in sales is 25%.
Key Assumption of the AFN Equation:
Ratios are all expected to remain constant

Why do the AFN equation and financial statement

method have different results?
Equation method assumes a constant profit margin, a
constant dividend payout, and a constant capital
structure.
Financial statement method is more flexible. More
important, it allows different items to grow at
different rates.
SUPPLEMENTARY INFORMATION:
 Computing for FCF
NOWC 2010 = 1,242,000 t 114,000 = 1,128,000
NOWC 2009 = 1,035,000 t 95,000 = 940,000
Net Investment in OC = 188,000
FCF in 2010 = EBIT (1-T) t Net Investment in OC
= 1,104,000 (1-40%) t 188,000
= 474,400
 Effects of Changing Ratios
MODIFYING RECEIVABLES:
If your projected DSO is 40.15 days, and you want it
reduced to the industry average DSO of 36 days, how much
free cash flow (reduction of receivables) would you have
freed up?
MODIFYING INVENTORIES:
If your forecasted inventory turnover is 5.26x and that of
the industry is 10.9 times, how much free cash flow
(reduction of inventory) would you have freed up?
 Various Ratio Analysis
Industry 2010 (1st 2010 (2nd
KEY RATIOS Formula 2009 (Actual) Average Condition Pass) Condition Pass) Condition
BEP EBIT/Total Assets 88.89% 40% Good 88.89% Good 88.89% Good
Profit Margin NI to common/Sales 34.87% 35% Poor 35.19% Good 35.19% Good
NI to common/Common
ROE Equity 168.72% 35% Good 161.00% Good 142.12% Good
DSO (Receivables/Sales) x 365 15.09 10 Days Poor 15.09 Poor 15.09 Poor
Inventory TO Sales/Inventory 9.09 12 x Poor 9.09 Poor 9.09 Poor
Fixed Assets TO Sales/Fixed Assets 1.88 3x Poor 1.88 Poor 1.88 Poor
Total Assets TO Sales/Total Assets 1.45 2.5 x Poor 1.45 Poor 1.45 Poor
Debt/Assets Total Debt/Total Assets 70% 50% Poor 59.50% Poor 63.71% Poor
Times Interest (NI to common +
Earned Interest)/Interest 11.85 x 12 x Poor 14.14 x Good 14.14 x Good
Current Ratio CA/CL 1.52 2.8 Poor 1.62 Poor 1.53 Poor
Div to common/NI to
Payout Ratio common 95.60% 95.60% OK 86.83% Poor 86.83% Poor
Return on Assets NI to common/Total Assets 50.53% 40% Good 51.00% Good 51.00% Good
Return on EBIT(1-T)/Total Operating
invested capital Capital 58.72% 30% Good 58.72% Good 58.72% Good
 How would excess capacity affect
the forecasted ratios?
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lower, so turnovers would be better.
Less new debt, hence lower interest, so higher
profits, EPS, ROE (when financing feedbacks
were considered).
Debt ratio, TIE would improve.

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How would the following items affect the
AFN?
Higher dividend payout ratio?
Increase AFN: Less retained earnings.
Higher profit margin?
Decrease AFN: Higher profits, more retained earnings.
Higher capital intensity ratio?
Increase AFN: Need more assets for given sales.
Pay suppliers in 60 days, rather than 30 days?
Decrease AFN: Trade creditors supply more capital (i.e.,
L*/S0increases).

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 Problems in the Book
4-1 to 4-3: AFN Equation
4-5: Excess Capacity
4-7: Pro Forma Income Statement
4-8: Long-term Financing Needed
4-9: Sales Increase