CHAPTER 4

Financial Planning and Forecasting

Forecasting sales Projecting the assets and internally generated funds Projecting outside funds needed Deciding how to raise funds
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Strategic Planning

Mission Statement

- A condensed version of a firms strategic plan.

Corporate Scope

- defines a firms lines of business and geographic areas of operation.

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Strategic Planning

Statement of Corporate Objectives

- sets forth specific goals to guide management. broad approaches developed for achieving firms goals

Corporate Strategies

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Strategic Planning

Operating Plan Provides management with detailed implementation guidance based on the corporate strategy to help meet corporate objectives. Financial Plan The document that includes assumptions, projected financial statements, and projected ratios and ties the entire planning process together.
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Sales Forecast

Starting Point of a financial plan. Increase in sales = increase in cost

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Primary Capital Sources

1. Spontaneously Generated Funds Funds that arise out of normal business operations that reduce the firms need for external financing. 2. Addition to Retained Earnings Portion of earnings that is not given out as dividends 3. AFN = Additional Funds Needed The amount of external capital needed to acquire the needed assets.

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The AFN equation

AFN = (A*/S0)S (L*/S0) S M(S1)(RR)
AFN = Projected increase in assets-Spontaneous increase
in liabilities increase in retained earnings
The equation that shows the relationship of external funds needed by a firm to its projected increase in assets, the spontaneous increase in liabilities, and its increase in retained earnings.
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The AFN equation

AFN = (A*/S0)S (L*/S0) S M(S1)(RR)
A* = Assets tied directly to sales L* = Spontaneous Liab that will be affected by sales S0 = Sales during the last year S1 = Total Sales projected next year S = change in sales between S0 and S1 M = Profit Margin or profit per unit of sales M(S1)= Projected Net Income RR = Retention Ratio from NI and is calculated as (1-payout ratio)
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The AFN equation

AFN = (A*/S0)S (L*/S0) S M(S1)(RR)
(A*/S0) = Capital Intensity Ratio
The ratio of assets required per dollar of sales.

(L*/S0) = Spontaneous Liability Ratio

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Sustainable Growth Rate

The maximum achievable growth rate without the firm having to raise external funds. It is the growth rate at which the firms AFN equals zero.
EXTERNAL CAPACITY ADJUSTMENTS

Changes made to the existing asset forecast because the firm is not operating at full capacity

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Preliminary financial forecast: Balance sheets (Assets)

2005 Cash and equivalents Accounts receivable Inventories Total current assets Net fixed assets Total assets $ 20 240 240 2006E $ 25 300 300

$ 500 500 $1,000

$ 625 625 $1,250

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Preliminary financial forecast: Balance sheets (Liabilities and equity)

Accts payable & accrued liab. Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities & equity 2005 $ 100 100 200 100 500 200 $1,000 2006E $ 125 190 315 190 500 245 $1,250
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Preliminary financial forecast: Income statements

2005 Sales Less: Variable costs Fixed costs EBIT Interest EBT Taxes (40%) $2,000.0 1,200.0 700.0 $100.0 16.0 $84.0 33.6 2006E $2,500.0 1,500.0 875.0 $125.0 16.0 $109.0 43.6

Net income
Dividends (30% of NI) Addition to retained earnings

$50.4
$15.12 $35.28

$65.40
$19.62 $45.78
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Key financial ratios

Basic earning power Profit margin Return on equity Days sales outstanding Inventory turnover Fixed assets turnover Total assets turnover Debt/assets Times interest earned Current ratio Payout ratio 2005 10.00% 2.52% 7.20% 2006E 10.00% 2.62% 8.77% Ind Avg 20.00% 4.00% 15.60% Comment Poor Poor Poor Poor Poor Poor Poor OK Poor Poor OK
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43.8 days 43.8 days 32.0 days 8.33x 8.33x 11.00x 4.00x 4.00x 5.00x 2.00x 2.00x 2.50x 30.00% 40.34% 36.00% 6.25x 7.81x 9.40x 2.50x 1.99x 3.00x 30.00% 30.00% 30.00%

Key assumptions in preliminary financial forecast

Operating at full capacity in 2005. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2005 profit margin (2.52%) and payout (30%) will be maintained. Sales are expected to increase by $500 million. (%DS = 25%)
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Determining additional funds needed, using the AFN equation

AFN = (A*/S0)S (L*/S0) S M(S1)(RR) = ($1,000/$2,000)($500) ($100/$2,000)($500) 0.0252($2,500)(0.7) = $180.9 million.

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Managements review of the financial forecast

Consultation with some key managers has yielded the following revisions: Firm expects customers to pay quicker next year, thus reducing DSO to 34 days without affecting sales. A new facility will boost the firms net fixed assets to $700 million. New inventory system to increase the firms inventory turnover to 10x, without affecting sales. These changes will lead to adjustments in the firms assets and will have no effect on the firms liabilities on equity section of the balance sheet or its income statement. 17-17

Revised (final) financial forecast: Balance sheets (Assets)

2005 Cash and equivalents Accounts receivable Inventories Total current assets Net fixed assets Total assets $ 20 240 240 2006E $ 67 233 250

$ 500 500 $1,000

$ 550 700 $1,250

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Key financial ratios final forecast

Basic earning power Profit margin Return on equity Days sales outstanding Inventory turnover Fixed assets turnover Total assets turnover Debt/assets Times interest earned Current ratio Payout ratio 2005 10.00% 2.52% 7.20% 2006F 10.00% 2.62% 8.77% Ind Avg 20.00% 4.00% 15.60% Comment Poor Poor Poor OK OK Poor Poor OK Poor Poor OK
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43.8 days 34.0 days 32.0 days 8.33x 10.00x 11.00x 4.00x 3.57x 5.00x 2.00x 2.00x 2.50x 30.00% 40.34% 36.00% 6.25x 7.81x 9.40x 2.50x 1.75x 3.00x 30.00% 30.00% 30.00%

What was the net investment in operating capital?

OC2006 = NOWC + Net FA = $625 - $125 + $625 = $1,125

OC2005 = $900

Net investment in OC = $1,125 - $900 = $225

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How much free cash flow is expected to be generated in 2006?

FCF = = = = = NOPAT Net inv. in OC EBIT (1 T) Net inv. in OC $125 (0.6) $225 $75 $225 -$150.

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Suppose fixed assets had only been operating at 85% of capacity in 2005

The maximum amount of sales that can be supported by the 2005 level of assets is:

Capacity sales = Actual sales / % of capacity = $2,000 / 0.85 = $2,353

2006 forecast sales exceed the capacity sales, so new fixed assets are required to support 2006 sales.

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How can excess capacity affect the forecasted ratios?

Sales wouldnt change but assets would be lower, so turnovers would improve. Less new debt, hence lower interest and higher profits

EPS, ROE, debt ratio, and TIE would improve.

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How would the following items affect the AFN?

Higher dividend payout ratio?

Higher profit margin?

Increase AFN: Less retained earnings.

Decrease AFN: Higher profits, more retained earnings. Increase AFN: Need more assets for given sales.

Higher capital intensity ratio?

Pay suppliers in 60 days, rather than 30 days? Decrease AFN: Trade creditors supply more capital (i.e., L*/S0 increases).
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