Md. Masud Chowdhury
masudjkkniu@gmail.com
CORPORATE FINANCE
Corporate Finance
Financial
Projection
• Sustainable Growth
Modeling
• Sales Forecast
• Income statement
Forecast
• Balance sheet forecast
• Common size income
statement.
Financial Projection:
• Financial projection refers to financial forecasting,
which is the pre-condition of financial planning.
• Sales forecast, Income statement forecast and
Balance sheet forecast.
• The proper preparation of this financial forecast is the
pre-requisite of a sound financial planning. If there is
any mistakes in any of these financial forecast, it would
lead to poor financial performance of a firm. Therefore
making proper financial projection is a must for the
successful achievement of the financial goal of the
firm.
Sustainable Growth Modeling
• Sustainable growth modeling situation is one
where the sustainable growth rate (SGR) is the
maximum annual percent increase in sales that
is possible given a set of target financial and
operating ratios. The management, responsible
for the growth of the firm, requires careful
balancing of the sales objectives of the firm with
its operating and financial resources. Here the
objective is to determine what sales growth is
consistent with the realities of the firm and of the
financial market place.
Steady State Model
• In steady-state model the future is treated exactly like the past with
respect to balance sheet and performance ratios. In this model it is also
assumed that the firm engages in no external equity financing. The equity
account is built only through earning retention.
SGR =
B
A
S
NP
S
− B
D
)
EQ
D
1+
EQ
(1+
NP
S
Where
A/S = Total assets to sales Ratio (total assets turnover)
NP/S= Net profit to sales Ratio (profit margin)
D/E= debt- Equity Ratio (Financial Policy)
So= Most recent annual sales (beginning sales)
▲ s = Absolute change in sales from the beginning sales.
B = Retention rate of earnings.
Changing model
In situations where the ratios and growth change from year to year, steadystate model cannot be used. In those situations year-by-year modeling is in
order. In effect the sales of the previous year and equity at the previous year
and serve as foundation on which to build year-by-year modeling. Also we
express dividend in terms of the absolute and as opposed to payout ratio.
Finally, we allow for the sale of common stock in a given year though this can
be specified as zero.
SGR =
D
EQo+New EQ−Dividend
NP
1− S
D
S
1+ EQ A
S
1+ EQ A
1
S0
[ ]−1
Where,
EQ0 = Beginning equity New; EQ = New equity Dividend = $5 million
D/EQ = Debt-equity ratio; S/A = Total sales to asset ratio
NP/S = Net profit margin; S0 = Sales
Exercise
Total Industries has $40 million in shareholders’ equity and
sales of $ 150 million last year.
Its target ratios are as follows:
• Assets to sales ratio 0.40, Net profit margin 0.07, Debtequity ratio 0.50 and Earnings retention 0.60 if these ratios
correspond to steady-state model what is its SGR?
• If instead of these ratios, what would be the SGR for next
year if the company moved from steady-state and had the
following ratios? Assets to sales ratio 0.42, Net profit
margin 0.06; Debt equity ratio 0.45; Dividend of 5 million
and no new equity financing.
Total Industries has $40 million in shareholders’ equity and sales of $ 150 million last year.
Its target ratios are as follows: Assets to sales ratio 0.40, Net profit margin 0.07, Debt-equity
ratio 0.50 and Earnings retention 0.60 if these ratios correspond to steady-state model what is
its SGR?
Data Given,
B = Earnings retention = 0.06; NP/S = Net profit margin = 0.07
D/EQ = Debt-equity ratio = 0.05; A/S = Total assets to sales ratio = 0.40
We Know that,
NP
SGR =
SGR =
SGR =
B S
A
S
− B
D
1+ EQ
NP
S
D
1+ EQ
0.60 ×0.07 (1+0.50)
0.40 − [ 0.60 × 0.07 (1+0.30)
0.063
0.40−0.063
=
0.063
0.337
= 0.1869 = 18.69% Ans.
Total Industries has $40 million in shareholders’ equity and sales of $ 150 million last year. If instead of these
ratios, what would be the SGR for next year if the company moved from steady-state and had the following
ratios? Assets to sales ratio 0.42, Net profit margin 0.06; Debt equity ratio 0.45; Dividend of 5 million and no
new equity financing.
Data Given,
EQ0 = Beginning equity = $40 million; New EQ = New equity = $0 million
Dividend = $5 million: D/EQ = Debt-equity ratio = 0.45; S0 = $150 million
1
S/A = Total sales to asset ratio = 0.42; NP/S = Net profit margin = 0.06
We know that SGR under Changing model.
SGR =
1−
NP
S
D
1+ EQ
1
SGR =
D
EQo+New EQ−Dividend
40+0−5 1+0.45 0.42
1
1− 0.06 1+0.45 0.42
SGR= 0.01596 = 1.60%
S
1+ EQ A
S
A
1
1
[S0] − 1
120.833333
) (0.00067)]
0.7929
[150] − 1 SGR = [(
−1
Financial Projection
The Methods of Financial Projection:
There are two methods of financial projection which are given below:
(a) Pro-forma Income statement: The pro-forma income statement is a projection of
income and expenses for a particular period of time in the future. There are two
methods of preparing pro-forma income statements namely:
1. Percentage of sales method
2. Past Ratios Method
(b) Pro-forma Balance sheet: The pro-forma balance sheet is a projection of all the
properties and assets and capital and liabilities for a particular period of time in the
future. The preparation of such a balance sheet gives an indication as to the probable
picture of financial condition of a firm.
There are two methods of preparing pro-forma income statements namely:
1. Percentage of sales method
2. Past Ratios Method
Methods of preparing Pro-forma Income Statement
and Pro-forma balance sheet
Percentage of sales method:
This would involve using the prior year income
statement and calculate what each item is as a
percentage of total sales.
Past ratio method:
Under the method every item of income and
expenses of the future year are based on the
ratios of these items prior to that year.
The following income statement and balance sheet relate to Bata Ltd. During 2004
Bata Ltd.
Income statement
For the year ended 2004
Particulars
Taka
Net sales
15000
Less: costs of goods sold
12300
Gross profit
2700
Less: Fixed operating costs except Depreciation
900
EBITD
1800
Less: Depreciation
500
EBIT
1300
Less Interest
400
EBT
900
Less: Taxes 40%
360
Net Income
540
Less: Dividends
270
Addition to Retained Earnings
270
Bata Ltd.
Balance Sheet
As at 31st Dec-2004
Liabilities
Taka
Assets
Taka
Accounts payable
300
Cash
150
Accounts
600
Accounts Receivable
1800
Notes payable
400
Inventories
2700
Long term Bond
3000
Net plant and equipment
3800
Common stock
1300
Retained earnings
2850
Total
8450
Total
8450
Additional information:Assume that the sales and operating cost will be 10% higher in 2005 than in 2004.
Further assume that the company currently operates at full capacity so it will need to expand its plant capacity
in 2005 to handle the additional operations.
Required:Prepare a pro forma income statement for 2005
Prepare a pro forma balance sheet for 2005
Pro forma income statement
Bata Ltd. Company
Pro forma Income statement
For the year ended 2005
Particulars
2004
Results
2005 forecast
2005
forecasts
Net sales
15000
X1.10
16500
Less: costs of goods sold
12300
X1.10
13530
Gross profit
2700
Less: Fixed operating cost except depreciation
900
EBITD
1800
Less: Depreciation
500
EBIT
1300
1430
Less Interest
400
400
EBT
900
1030
Less: Taxes 40%
360
412
Net Income
540
618
Less: Dividends @50%
270
309*
Addition to retained earnings
270
309
2970
X1.10
990
1980
X1.10
550
Bata Ltd. Company
Pro-forma Balance Sheet
As on 31st Dec-2005
Particulars
2004
Results
2005 forecast
2005
forecasts
Cash
150
X1.10
165
Accounts Receivable
1800
X1.10
1980
Inventories
2700
X1.10
2970
Total current assets
4650
Net plant and Equipment
3800
Total Assets
8450
Accounts payable
300
X1.10
330
Accruals
600
X1.10
660
Notes payable
400
400*
Total current Liabilities
1300
1390
Long term Bond
3000
3000**
Common stock
1300
1300***
Retained earnings
2850
Additional Funds needed
-
828.5*****
Total Liabilities and Equity
4850
9295
5115
X1.10
4180
9295
+309****
3159
Common Size Analysis
• Common size analysis, also referred as vertical
analysis, is a tool that financial managers use
to analyze financial statements. It evaluates
financial statements by expressing each line
item as a percentage of the base amount for
that period. The analysis helps to understand
the impact of each item in the financial
statement and its contribution to the resulting
figure.
Importance of Common size Analysis
• One of the benefits of using common size analysis is
that it allows investors to identify drastic changes in a
company’s financial statement. This mainly applies
when the financials are compared over a period of two
or three years. Any significant movements in the
financials across several years can help investors decide
whether to invest in the company. For example, large
drops in the company’s profits in two or more
consecutive years may indicate that the company is
going through financial distress. Similarly, considerable
increases in the value of assets may mean that the
company is implementing an expansion or acquisition
strategy, making the company attractive to investors.
Importance of Common size Analysis
2. Common size analysis is also an excellent tool to
compare companies of different sizes but in the
same industry. Looking at their financial data can
reveal their strategy and their largest expenses that
give them a competitive edge over other
comparable companies. For example, some
companies may sacrifice margins to gain a large
market share, which increases revenues at the
expense of profit margins. Such a strategy allows
the company to grow faster than comparable
companies because they are more preferred by
investors.
Common Size Balance Sheet
A common size balance sheet is a balance sheet
that displays both the numeric value and
relative percentage for total assets, total
liabilities, and equity accounts. Common size
balance sheets are used by internal and external
analysts and are not a reporting requirement of
generally accepted accounting principles
(GAAP).
Methods
• The balance sheet common size analysis
mostly uses the total assets value as the base
value. On the balance sheet, the total assets
value equals the value of total liabilities and
shareholders’ equity.
Common Size Income Statement
• A common size income statement is an
income statement in which each line item is
expressed as a percentage of the value of
revenue or sales. It is used for vertical
analysis, in which each line item in a financial
statement is represented as a percentage of a
base figure within the statement.
Common Size Income Statement
• The base item in the income statement is usually
the total sales or total revenues. Common size
analysis is used to calculate net profit margin, as
well as gross and operating margins. The ratios
tell investors and finance managers how the
company is doing in terms of revenues, and they
can make predictions of future revenues.
Companies can also use this tool to analyze
competitors to know the proportion of revenues
that goes to advertising, research and
development, and other essential expenses.
Common size Balance sheet
Common Size Income Statement