ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WONG LAURENTIAN UNIVERSITY...

ADAPTED FOR THE SECOND CANADIAN EDITION BY:

THEORY & PRACTICE

JIMMY WONGLAURENTIAN UNIVERSITY

FINANCIAL MANAGEMENT

ADAPTED FOR THE SECOND CANADIAN EDITION BY:

CHAPTER 5

FINANCIAL PLANNING AND FORECASTING FINANCIAL STATEMENTS

CHAPTER 5 OUTLINE

• Overview of Financial Planning• Sales Forecast• The AFN Formula• The Forecasted Financial Statement (FFS)

Method• Forecasting Financial Requirements When

the Balance Sheet Ratios Are Subject to Change

Copyright © 2014 by Nelson Education Ltd. 5-3


Overview of Financial Planning

• Three important components:– Strategic plans: Define its corporate purpose, scope, and

objectives, and develop strategies for achieving its goals– Operating plans: Provide detailed implementation

guidance to help meet the corporate objectives– Financial plans: Forecast the amount of external

financing that will be required


Financial Planning Process

• Projects financial statements• Determines the funds needed• Forecasts the funds to be generated internally

and identifying those to be obtained from outside sources

• Sets up a performance-based management compensation system

• Implements the plan and monitoring its operations


Components of a Financial Plan

• Sales forecast• Pro forma, or projected, financial statements• External financing plan


Sales Forecast• An accurate sales forecast is critical to

profitability.• Forecasting the future sales growth starts with

a review of sales during the past years using a regression approach.

• Adjust the estimate with the reality if necessary.


2013 Balance Sheet ($ Millions)

Cash $ 10 Accts. pay. Accruals $ 140

Accounts rec. 375 Notes payable 110Inventories 615 Total CL $ 310 Total CA $1,000 L-t bonds 754

Pref. stk130Net fixed

assetsCom. stkRet. earnings 766

Total assets $2,000 Total claims $2,000

1,000

$ 60S-t invest 0

$ 10

40


2013 Income Statement ($ Millions)

Sales $3,000.00Costs except Depr (60%) 2,616.20 Depreciation 100.00 EBIT $ 283.80Interest 88.00 EBT $ 195.80Taxes (40%) 78.30NI before pref. div

$ 113.50

Dividends (50.7%) $57.50Add’n to RE $56.00

4.00 117.50

preferred dividendsNet income for com.


The AFN (Additional Funds Needed) Formula: Key Assumptions

• Operating at full capacity in 2013• Each type of asset grows proportionally with

sales.• Payables and accruals grow proportionally with sales.• 2013 profit margin ($113.5/$3,000 = 3.78%), and

payout (50.7%) will be maintained• Sales are expected to increase by $300 million.


Definitions of Variables in AFN

• A*/S0: Assets required to support sales; called capital intensity ratio

• ∆S: Change in sales• L*/S0: Spontaneous liabilities-to-sales ratio• M: Profit margin (net income/sales)• RR: Retention ratio; percentage of net income not

paid as dividend


Assets vs. Sales

Assets

Sales0

2,000

3,000

2,200

3,300A*/S0 = $2,000/$3,000 = 0.67 = $2,200/$3,300

Assets =(A*/S0)Sales= 0.67($300)= $200

Assets = 0.67 sales


If Sales Increase by $300 Million, What is the AFN?

AFN = (A*/S0)∆S – (L*/S0)∆S – M(S1)(RR)

AFN = Projected increase in assets – Spontaneous increase in liabilities – Increase in retained earnings

AFN = ($2,000/$3,000)($300)– ($200/$3,000)($300)– 0.0378($3,300)(1 – 0.507)

AFN = $118.42 million


How Would Increases in These Items Affect the AFN?

• Higher sales:– Increases asset requirements,

increases AFN• Higher dividend payout ratio:

– Reduces funds available internally, increases AFN

• Higher capital intensity ratio, A*/S0:– Increases asset requirements,

increases AFN


How Would Increases in These Items Affect the AFN? (cont’d)

• Higher profit margin:– Increases funds available internally, decreases

AFN• Pay suppliers sooner:

– Decreases spontaneous liabilities, increases AFN


Self-supporting Growth Rate• The maximum growth rate the firm could

achieve if it had no access to external capital.• It can be found by setting AFN to zero and

solving the resultant equation for g.

0**

0

SRRMLA

SRRMg supporting-Self


Self-Supporting G for Microdrive

Self - supporting g M RR S0

A* L* M RR S0

0.0378 0.493 $3,000

$2,000 $200 0.0378 0.493 3,0003.21%


The Forecasted Financial Statement (FFS) Method

• Forecasts the complete set of pro forma statements, making the analysis reliable

• Information also provides financial ratios to evaluate different business plans.

• Uses the percentage of sales method• Begins with sales forecast, and estimates the assets

required to support the growth• Allows different asset/liability classes to grow at

different rates


Projecting Pro Forma Statements with the Percent of Sales Method

• Forecasts items as a percent of the forecasted sales (i.e., varying directly with sales)– Costs– Cash– Accounts receivable– Inventories– Net fixed assets– Accounts payable and accruals


Projecting Pro Forma Statements with the Percent of Sales Method (cont’d)

• Chooses other items that have no direct linear relationship with sales– Debt– Dividend policy (which determines retained

earnings)– Common stock


Sources of Financing Needed to Support Asset Requirements

• Given the previous assumptions and choices, we can estimate:– required assets to support sales– specified sources of financing

• Additional funds needed (AFN) is:– required assets minus specified sources of

financing


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.


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 based on: – debt at end of year– debt at beginning of year– average of beginning and ending debt


Basing Interest Expense on Debt at End of Year

• Will overestimate 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 End of Year (cont’d)

• Will underestimate interest expense if debt is added throughout the year instead of all on December 31

• But doesn’t cause problem of circularity


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


Percent of Sales: Inputs

2013 Actual 2014 Proj.Costs ex Depr/Sales 87.2% 87.2%Cash/Sales 0.33% 0.33%Acct. rec./Sales 12.5% 12.5%Inv./Sales 20.5% 20.5%Net FA/Sales 33.3% 33.3%AP/Sales 2% 2%Accruals/sales 4.67% 4.67%


Other Inputs

Percent growth in sales 10%

Interest rate on debt 11%

Tax rate 40%

Dividend payout rate 50.7%


2014 Preliminary Forecasted Income Statement

Calculations 2014 PreliminarySales 1.10 Sales09 = $3,300.0

Less: Costs ex. depreciation 87.2% Sales10 = 2,877.6

Depre. expenses 10% FA10 = 110.0

EBIT $312.4

Interest 0.09(STD09) + 0.11(LTD09) =

92.8

EBT $219.6

Taxes (40%) 87.8

NI before pref. dividend $131.8

Pref. dividend 4.0

Net income to com. (50,000,000 shares) $127.8

Dividend # of shares ×108%DPS09

$62.5

Add to RE $65.3*


2014 Balance Sheet (Assets)

Calculations 2010Cash 0.33% Sales14 = $11.0

Accts rec. 12.5%Sales14 = 412.5

Inventories 20.5%Sales14 = 676.5

Total CA $1,100.0Net FA 33.3% Sales14 = 1,100.0

Total assets $2,200.0


2014 Preliminary Balance Sheet (Liabilities and Equity)

2009 Calculations Forecast for 2010

AP 60 2% Sales14 = $66.0

Accruals 140 4.67% Sales14 = $154.0

Nt. pay. 110 Plug technique 224.7

Total CL $444.7

L-t debt 754 Carried over 754.0

Pref. stk 40 Carried over 40.0

Com. stk 130 Carried over 130.0

Ret earn 766 +65.3* 831.3

T. L. & E. $2,200.0


What are the Additional Funds Needed (AFN)?

• Required assets = $2,200.0• Specified sources of fin. = $2,085.3• Forecast AFN: $2,200 – $2,085.3 = $114.7• NWC must have the assets to make forecasted

sales, and so it needs an equal amount of financing. So, we must secure another $114.7 of financing.


Assumptions About How AFN Will Be Raised

• No new long-term bond, preferred stock, or stock will be issued.

• Any external funds needed must be raised as notes payable.

• Additional notes payable = $114.7, giving a forecasted notes payable for 2014 as $224.7 = $110 + $114.7.


2014 Balance Sheet (Liabilities and Equity)

w/o AFN AFN With AFNAP $66.0 $66.0

Accruals 154.0 154.0

Notes payable 110.0 +114.7 224.7

Total CL $330.0 $444.7

L-t Debt 754.0 754.0

Preferred stk 40.0 40.0

Common stk 130.0 130.0

Ret earnings 831.3 831.3

Total claims $2,085.3 $2,200.0


Equation AFN = $118.42 vs. Pro Forma AFN = $114.7

• Method using the AFN equation assumes a constant profit margin

• The pro forma (FFS) method is more flexible. Importantly, the approach allows different items to grow at different rates. Use the plug technique to make sure the balance sheet is in order.


Forecasted Ratios

Actual 2013 Forecast 2014 Industry

Current ratio 3.2x 2.5x 4.2x

Inv turnover 4.9x 4.9x 9.0x

DSO (days) 45.6 45.6 36.0

TA turnover 1.5x 1.5x 1.8x

Debt ratio 53.2% 40.98% 40.0%

Profit margin 3.8% 3.9% 5.0%

ROA 5.7% 5.8% 9.0%

ROE 12.7% 13.3% 15.0%

ROIC 9.5% 9.5% 11.4%


What are the Forecasted Free Cash Flow and ROIC?

2013 2014Net operating WC(CA – AP & accruals)

$800.0 $880.0

Total operating capital(Net op. WC + net FA)

$1,800.0 $1,980.0

NOPAT (EBITx(1 – T))Less Inv. in op. capital

$170.3 $187.4$180.0

Free cash flow –$174.7 $7.4ROIC (NOPAT/Capital) 9.5%


Proposed Improvements

Before After

Tight up credit policy:Accts. rec./Sales 12.5% 11.8%Control inventory:Inventory/Sales 20.5% 16.7%Lay off workers:Op. costs (excluding depreciation)/Sales

87.2% 86.0%


Impact of Improvements

Before AfterDSO (days) 45.6 43.1

Inventory turnover 4.9x 6.0x

NOPAT $187.4 $211.2

Net Op. WC $880.0 $731.5

Tot. Op. capital $1,980.0 $1,831.5

Free cash flows $7.4 $179.7

AFN $114.7 –$57.5

ROIC 9.5% 11.5%

ROE 13.3% 15.4%


Forecasting Financial Requirements When the Balance Sheet Rations are Subject to Change: Economies of Scale

Ass

ets

Sales0

400300

200 400

Declining A/S Ratio

$300/$200 = 1.5; $400/$400 = 1.0. Declining ratio shows economies of scale. Going from S = $0 to S = $200 requires $300 of assets. Next $200 of sales requires only $100 of assets.

BaseStock


Lumpy AssetsA

sset

s

Sales1,000 2,000500

A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.

500

1,000

1,500


If 2013 Fixed Assets Had Been Operated at 96% of Capacity:

• With the existing fixed assets, sales could be $3,125 million.

• Target fixed assets/Sales = Actual fixed assets/Full capital sales = $1,000/$3,125 = 0.32

• New required fixed assets = (Target fixed assets/Sales)(Projected sales) = (0.32)($3,300) = $1,056 million


How Would the Excess Capacity Situation Affect the 2014 AFN?

• With full capacity, the previously projected increase in fixed assets is $100 million.

• The excess capacity makes the actual required increase be $56 million only, with $44 million less than before.

• Projected AFN will fall to $70.7 million = $114.7 million – $44 million.


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.


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ADAPTED FOR THE SECOND CANADIAN EDITION BY: THEORY & PRACTICE JIMMY WONG LAURENTIAN UNIVERSITY...

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