4-1
CHAPTER 4
Financial Planning and Forecasting
Financial Statements
Plans: strategic, operating, and
financial
Pro forma financial statements
Sales forecasts
Percent of sales method
Additional Funds Needed (AFN)
formula
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4-2
Pro Forma Financial Statements
Three important uses:
Forecast the amount of external
financing that will be required
Evaluate the impact that changes
in the operating plan have on the
value of the firm
Set appropriate targets for
compensation plans
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4-3
Steps in Financial Forecasting
Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and stock
price
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4-4
2001 Balance Sheet
(Millions of $)
Cash & sec.
Accounts rec.
Inventories
Total CA
Net fixed
Assets
Total assets
$20 Accts. pay. &
accruals
240 Notes payable
240 Total CL
$500 L-T debt
Common stk
Retained
500 Earnings
$1000 Total claims
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$100
100
$200
100
500
200
$1000
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4-5
2001 Income Statement
(Millions of $)
Sales
Less: COGS (60%)
SGA costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (30%)
Add’n to RE
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$2,000.00
1,200.00
700.00
$100.00
16.00
$84.00
33.60
$50.40
$15.12
35.28
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4-6
Key Ratios
BEP
Profit Margin
ROE
DSO
Inv. turnover
F.A. turnover
T.A. turnover
Debt/assets
TIE
Current ratio
Payout ratio
NWC
Industry
10.00%
20.00%
2.52%
4.00%
7.20%
15.60%
43.20 days 32.00 days
8.33x
11.00x
4.00x
5.00x
2.00x
2.50x
30.00%
36.00%
6.25x
9.40x
2.50x
3.00x
30.00%
30.00%
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Condition
Poor
Poor
Poor
Poor
Poor
Poor
Poor
Good
Poor
Poor
O.K.
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4-7
Key Ratios (Continued)
Net oper. prof. margin after taxes
NWC
Ind.
Cond.
3.00%
5.00% Poor
(NOPAT/Sales)
Oper. capital requirement
(Net oper. capital/Sales)
45.00% 35.00% Poor
Return on invested capital
6.67% 14.00% Poor
(NOPAT/Net oper. capital)
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4-8
AFN (Additional Funds Needed):
Key Assumptions
 Operating at full capacity in 2001.
 Each type of asset grows proportionally
with sales.
 Payables and accruals grow proportionally
with sales.
 2001 profit margin (2.52%) and payout
(30%) will be maintained.
 Sales are expected to increase by $500
million. (%S = 25%)
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4-9
Assets
Assets = 0.5 sales
1,250
 Assets =
(A*/S0)Sales
= 0.5($500)
= $250.
1,000
0
2,000
2,500
Sales
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.
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4 - 10
Assets must increase by $250 million.
What is the AFN, based on the AFN
equation?
AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0252($2,500)(1 - 0.3)
= $180.9 million.
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4 - 11
Projecting Pro Forma Statements with
the Percent of Sales Method
Project sales based on forecasted
growth rate in sales
Forecast some items as a percent
of the forecasted sales
Costs
Cash
Accounts receivable
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(More...)
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4 - 12
Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt (which determines interest)
Dividends (which determines
retained earnings)
Common stock
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4 - 13
Percent of Sales: Inputs
COGS/Sales
SGA/Sales
Cash/Sales
Acct. rec./Sales
Inv./Sales
Net FA/Sales
AP & accr./Sales
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2001
2002
Actual
60%
35%
1%
12%
12%
25%
5%
Proj.
60%
35%
1%
12%
12%
25%
5%
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4 - 14
Other Inputs
Percent growth in sales
25%
Growth factor in sales (g)
1.25
Interest rate on debt
8%
Tax rate
40%
Dividend payout rate
30%
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4 - 15
2002 1st Pass Income Statement
Sales
Less: COGS
SGA
EBIT
Interest
EBT
Taxes (40%)
Net. Income
Div. (30%)
Add. to RE
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2002
2001
Factor 1st Pass
$2,000
g=1.25
$2,500
Pct=60%
1,500
Pct=35%
875
$125
16
16
$109
44
$65
$19
$46
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4 - 16
2002 1st Pass Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.
2002 Sales = $2,500
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
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Factor
Pct= 1%
Pct=12%
Pct=12%
Pct=25%
2002
1st Pass
$25
300
300
$625
$625
$1250
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4 - 17
2002 1st Pass Balance Sheet (Claims)
2002 Sales = $2,500
2001
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret. earnings
Total claims
100
100
500
200
2002
Factor 1st Pass
Pct=5%
$125
100
$225
100
500
+46*
246
$1,071
*From 1st pass income statement.
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4 - 18
What are the additional funds
needed (AFN)?
Forecasted total assets = $1,250
Forecasted total claims = $1,071
Forecast AFN
= $ 179
NWC must have the assets to make
forecasted sales. The balance sheets
must balance. So, we must raise $179
externally.
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4 - 19
Assumptions about How AFN Will
Be Raised
No new common stock will be
issued.
Any external funds needed will be
raised as debt, 50% notes payable,
and 50% L-T debt.
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4 - 20
How will the AFN be financed?
Additional notes payable =
0.5 ($179) = $89.50  $90.
Additional L-T debt =
0.5 ($179) = $89.50  $89.
But this financing will add 0.08($179) =
$14.32 to interest expense, which will
lower NI and retained earnings.
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4 - 21
2002 2nd Pass Income Statement
Sales
1st Pass Feedback
$2,500
Less: COGS
SGA
EBIT
Interest
EBT
Taxes (40%)
Net income
Div (30%)
Add. to RE
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$1,500
875
$125
16
$109
44
$65
$19
$46
2nd Pass
$2,500
$1,500
875
$125
+14
30
$95
38
$57
$17
$40
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4 - 22
2002 2nd Pass Balance Sheet (Assets)
1st Pass
$25
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
300
300
$625
625
$1,250
AFN
2nd Pass
$25
300
300
$625
625
$1,250
No change in asset requirements.
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4 - 23
2002 2nd Pass Balance Sheet (Claims)
AP/accruals
1st Pass Feedback
$125
Notes payable
Total CL
L-T debt
Common stk.
Ret. earnings
Total claims
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100
$225
100
500
246
$1,071
2nd Pass
$125
190
+90
$315
189
+89
500
240
-6
$1,244
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4 - 24
Results After the Second Pass
Forecasted assets = $1,250 (no change)
Forecasted claims = $1,244 (higher)
2nd pass AFN
=$
6 (short)
Cumulative AFN = $179 + $6 = $185.
The $6 shortfall came from the $6
reduction in retained earnings.
Additional passes could be made until
assets exactly equal claims. $6(0.08) =
$0.48 interest on 3rd pass.
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4 - 25
Equation AFN = $181
vs.
Pro Forma AFN = $185.
Why are they different?
Equation method assumes a
constant profit margin.
Pro forma method is more flexible.
More important, it allows different
items to grow at different rates.
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4 - 26
Ratios After 2nd Pass
BEP
Profit Margin
ROE
DSO (days)
Inv. turnover
FA turnover
TA turnover
D/A ratio
TIE
Current ratio
Payout ratio
2001
10.00%
2.52%
7.20%
43.20
8.33x
4.00x
2.00x
30.00%
6.25x
2.50x
30.00%
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2002(E)
10.00%
2.27%
7.68%
43.20
8.33x
4.00x
2.00x
40.34%
4.12x
1.99x
30.00%
Industry
20.00%
4.00%
15.60%
32.00
11.00x
5.00x
2.50x
36.00%
9.40x
3.00x
30.00%
Cond
Poor
Poor
Poor
Poor
Poor
Poor
Poor
Good
Poor
Poor
OK
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4 - 27
Ratios after 2nd Pass (Continued)
NWC
Ind. Cond.
Net oper. prof. margin after taxes 3.00% 5.00% Poor
(NOPAT/Sales)
Oper. capital requirement
45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital
6.67% 14.00% Poor
(NOPAT/Net oper. capital)
Note: These are the same as in 2001 (see slide 14-7),
because there have been no improvements in operations
(i.e., all percent of sales items have same percentages in
2001 and 2002). Also, there are no differences between 1st
pass and 2nd pass because changes in financing do not
affect measures of operating performance.
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4 - 28
What is the forecasted free cash flow
for 2002?
Net operating WC
(CA - AP & accruals)
Total operating capital
(Net op. WC + net FA)
NOPAT
(EBITx(1-T))
Less Inv. in op. capital
Free cash flow
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2001 2002(E)
$400
$500
$900
$1,125
$60
$75
$225
-$150
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4 - 29
Suppose in 2001 fixed assets had been
operated at only 75% of capacity.
Actual sales
Capacity sales =
% of capacity
$2,000
=
= $2,667.
0.75
With the existing fixed assets, sales
could be $2,667. Since sales are
forecasted at only $2,500, no new
fixed assets are needed.
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4 - 30
How would the excess capacity
situation affect the 2002 AFN?
The projected increase in fixed assets
was $125, the AFN would decrease by
$125.
Since no new fixed assets will be
needed, AFN will fall by $125, to
$179 - $125 = $54.
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4 - 31
Q.
If sales went up to $3,000,
not $2,500, what would the
F.A. requirement be?
A.
Target ratio = FA/Capacity sales
= $500/$2,667 = 18.75%.
Have enough F.A. for sales up to
$2,667, but need F.A. for another
$333 of sales:
FA = 0.1875($333) = $62.4.
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4 - 32
How would excess capacity affect the
forecasted ratios?
1. Sales wouldn’t change but assets
would be lower, so turnovers would
be better.
2. Less new debt, hence lower interest,
so higher profits, EPS, ROE (when
financing feedbacks considered).
3. Debt ratio, TIE would improve.
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4 - 33
2002 Forecasted Ratios: S02 = $2,500
BEP
Profit Margin
ROE
DSO
Inv. Turnover
F.A. turnover
T.A. turnover
D/A ratio
TIE
Current ratio
% of 2001 Capacity
100%
75%
10.00%
11.11%
2.27%
2.51%
7.68%
8.44%
43.20
43.20
8.33x
8.33x
4.00x
5.00x
2.00x
2.22x
40.34%
33.71%
4.12x
6.15x
1.99x
2.48x
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Industry
20.00%
4.00%
15.60%
32.00
11.00x
5.00x
2.50x
36.00%
9.40x
3.00x
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4 - 34
How is NWC performing with regard to
its receivables and inventories?
DSO is higher than the industry
average, and inventory turnover is
lower than the industry average.
Improvements here would lower
current assets, reduce capital
requirements, and further improve
profitability and other ratios.
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4 - 35
Improvements in Working Capital
Management
Before
After
DSO (days)
43.20
32.00
Accts. rec./Sales
12.00%
Inventory turnover
Inventory/Sales
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8.33x
12.00%
8.89%
11.00x
9.09%
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4 - 36
Impact of Improvements in Working
Capital Management
Before
After
Free cash flow (1999)
-$150.0
$0.5
ROIC (NOPAT/Capital)
6.7%
7.7%
ROE
7.7%
8.59%
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4 - 37
Declining A/S Ratio
Assets
1,100
1,000

Base
Stock
0
Sales
2,000
2,500
$1,000/$2,000 = 0.5; $1,000/$2,500 = 0.44. Declining
ratio shows economies of scale. Going from S = $0
to S = $2,000 requires $1,000 of assets. Next $500 of
sales requires only $100 of assets.
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4 - 38
Assets
1,500
1,000
500
500
1,000
2,000
Sales
A/S changes if assets are lumpy. Generally will have
excess capacity, but eventually a small S leads to a
large A.
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4 - 39
Summary: How different factors affect
the AFN forecast.
 Excess capacity:
Existence lowers AFN.
 Base stocks of assets:
Leads to less-than-proportional asset
increases.
 Economies of scale:
Also leads to less-than-proportional asset
increases.
 Lumpy assets:
Leads to large periodic AFN requirements,
recurring excess capacity.
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4 - 40
Regression Analysis for Asset
Forecasting
Get historical data on a good
company, then fit a regression line
to see how much a given sales
increase will require in way of asset
increase.
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4 - 41
Example of Regression
Inventory
For a Well-Managed Co.
Year
Sales
Inv.
$1,280
$118
1999
1,600
138
2000
2,000
162
2001
192E
2002E
2,500E
Regression
line
1.28 1.6
Constant
ratio forecast
2.0
2.5
Sales
(000)
Constant ratio overestimates inventory required
to go from S1 = $2,000 to S2 = $2,500.
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4 - 42
Regression with 10B for Our Example
 Same as finding beta coefficients.
 Clear all
1280 Input 118
1600 Input 138
2000 Input 162
^ m 40.0 = Inventory at sales = 0.
0
y,
SWAP 0.0611 = Slope coefficient.
Inventory = 40.0 + 0.0611 Sales.
LEAVE CALCULATOR ALONE!
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4 - 43
Equation is now in the calculator. Let’s
use it by inputting new sales of $2,500
and getting forecasted inventory:
2500
^
y, m
192.66.
The constant ratio forecast was inventory
= $300, so the regression forecast is
lower by $107. This would free up $107
for use elsewhere, which would improve
profitability and raise P0.
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4 - 44
How would increases in these items
affect the AFN?
Higher dividend payout ratio?
Increase AFN: Less retained
earnings.
Higher profit margin?
Decrease AFN: Higher profits, more
retained earnings.
(More…)
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4 - 45
Higher capital intensity ratio, A*/S0?
Increase AFN: Need more assets for
given sales increase.
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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