Lecture 5– Financial Planning and Forecasting
Lecture 5 - Financial
Planning and
Forecasting
Strategy
A company’s strategy consists of the competitive
moves, internal operating approaches, and action
plans devised by management to produce
successful performance.
Strategy is management’s “game plan” for running
the business.
Managers need strategies to guide HOW the
organization’s business will be conducted and HOW
performance targets will be achieved.
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Strategic Planning versus
Operational Planning
Strategic Planning
Strategic planning is a systematic process
through which an organization agrees on and
builds commitment among key stakeholders
to priorities that are essential to its mission
and are responsive to the environment.
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Strategic Planning
– formulation
– What, where
– ends
– vision
– effectiveness
– risk
Strategic Planning guides the acquisition and
allocation of resources to achieve these
priorities.
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Operational Planning
– implementation
– how
– means
– plans
– efficiency
– control
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Lecture 5– Financial Planning and Forecasting
Steps in Financial Forecasting
Financial Planning and Pro Forma
Statements
Financial plans evaluate the economics behind the strategy and
operations. They consist of six steps:
Forecast sales
1. Project financial statements to analyze the effects of the
operating plan on projected profits and financial ratios.
Project the assets needed to support sales
2. Determine the funds needed to support the plan.
Project internally generated funds
3. Forecast funds availability.
Project outside funds needed
4. Establish and maintain a system of controls to govern the
allocation and use of funds within the firm.
Decide how to raise funds
5. Develop procedures for adjusting the basic plan if the
economic forecasts upon which the plan was based do not
materialize
See effects of plan on ratios and stock price
6. Establish a performance-based management compensation
system.
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Sales Forecast
Sales Forecast
Sales forecasts are usually based on the analysis of historic data.
An accurate sale forecast is critical to the firm’s profitability:
Sales Forecast
•Company will fail to meet demand
•Market share will be lost
Under-optimistic
Over-optimistic
Too much inventory
and/or fixed assets
•Low turnover ratio
•High cost of depreciation and storage
•Write-offs of obsolete inventory
•Low profit
•Low rate of return on equity
•Low free cash flow
•Depressed stock price
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Lecture 5– Financial Planning and Forecasting
The Percent of Sales Method
Step 1 - Analyze the Historical Ratios
This is the most common method, which
begins with the sales forecast expressed as
an annual growth rate in dollar sale revenue.
Many items on the balance sheet and income
statement are assumed to change
proportionally with sales.
*
*
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Step 2 – Forecast the Income Statement
*Spontaneous generated funds -
increase spontaneously with sales
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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. Base it on:
Debt at end of year
Debt at beginning of year
Average of beginning and ending debt
More…
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Lecture 5– Financial Planning and Forecasting
Basing Interest Expense on Debt at End of Year
Basing Interest Expense on Average of Beginning and
Ending Debt
Will over-estimate interest expense if debt is added
throughout the year instead of all on January 1.
Will accurately estimate the interest payments if debt
is added smoothly throughout the year.
Causes circularity called financial feedback: more
debt causes more interest, which reduces net
income, which reduces retained earnings, which
causes more debt, etc.
But has problem of circularity.
Basing Interest Expense on Debt at Beginning of Year
A Solution that Balances Accuracy and
Complexity
Will under-estimate interest expense if debt is added
throughout the year instead of all on December 31.
Base interest expense on beginning debt, but use a
slightly higher interest rate.
But doesn’t cause problem of circularity.
Easy to implement
Reasonably accurate
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Step 3 – Forecast the Balance Sheet
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Step 4 – Raising the Additional Funds Needed
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Lecture 5– Financial Planning and Forecasting
2009 Income Statement (Millions of $)
2009 Balance Sheet(Millions of $)
Cash & sec.
Accounts rec.
Inventories
Total CA
Net fixed
assets
Total assets
$
Sales
Less: COGS (87.2%)
Dep costs
EBIT
Interest
EBT
Taxes (40%) +pr.div
Net income
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Accts. pay. &
accruals
$ 200
375 Notes payable
110
615
Total CL
$ 310
$ 1000 L-T debt
754
Common +pr stk 170
Retained
1000 earnings
766
$2,000
Total Liabilities $2,000
Dividends (Com+Pr
Add’n to RE
$3,000.00
2616.00
100.00
$ 283.80
88.00
$ 195.80
82.30
$ 113.50
$57.50
$56.00
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AFN (Additional Funds Needed):
Key Assumptions
Assets vs. Sales
Operating at full capacity in 2009.
Assets
Each type of asset grows proportionally with
sales.
2,200
Payables and accruals grow proportionally
with sales.
2,000
Assets = 0..667sales
∆ Assets =
(A*/S0)∆
∆Sales
= 0..667($300)
= $200.
2009 profit margin ($113.5/$3,000 = 3.80%)
and retention ratio (56/114) = .49 will be
maintained.
Sales are expected to increase by $300
million.
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Sales
0
3,000
3,300
A*/S0 = $2,000/$3,000 = 0.667 = $2200/$3,300.
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Lecture 5– Financial Planning and Forecasting
If assets increase by $200 million,
what is the AFN?
Definitions of Variables in AFN
A*/S0: assets required to support
sales; called capital intensity ratio.
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
AFN = ($2,000/$3,000)($300)
(0.667)
∆S: increase in sales.
x
$300
L*/S0: spontaneous liabilities ratio
- ($200/$3,000)($300)
M: profit margin (Net income/sales)
- 0.0380($3,300)(0.49) = $118 million
(0.067)
RR: retention ratio; percent of net
income not paid as dividend.
x
($300)
AFN = $118 million.
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How Would Increases in Various Items
Affect the AFN?
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Implications of AFN
Higher sales:
If AFN is positive, then you must
secure additional financing.
Increases asset requirements, increases AFN.
Higher dividend payout ratio:
If AFN is negative, then you have more
financing than is needed.
Reduces funds available internally, increases AFN.
Higher profit margin:
Pay off debt.
Increases funds available internally, decreases
AFN.
Buy back stock.
Higher capital intensity ratio, A*/S0:
Buy short-term investments.
Increases asset requirements, increases AFN.
Pay suppliers sooner:
Decreases spontaneous liabilities, increases AFN.
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Lecture 5– Financial Planning and Forecasting
Economies of Scale
What if Balance Sheet Ratios are
Subject to Change
We have so far assumed that ratios
of both assets and liabilities to sales
are constant over time
1,100
1,000
}
Assets
Sometimes this assumption is
incorrect.
Declining A/S Ratio
Base
Stock
0
Sales
2,000
2,500
$1,000/$2,000 = 0.5; $1,100/$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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What if 2009 fixed assets had been
operated at 96% of capacity:
Lumpy Assets – Buying Discrete Units
Actual sales
% of capacity
Capacity sales =
Assets
1,500
=
1,000
500
$3,000
= $3,125.
0.96
Target Fixed Assets/Sales = Actual Fixed Asset
Full Capacity Sales
= $1,000
$3,125
= 32%
Sales
500
1,000
Thus, if sales increase to $3,300 fixed assets would
only have to increase to 3,300 x .32 = $1,056
2,000
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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Lecture 5– Financial Planning and Forecasting
Summary: How different factors affect
the AFN forecast.
Excess capacity: lowers AFN.
Economies of scale: leads to less-thanproportional asset increases.
Lumpy assets: leads to large periodic
AFN requirements, recurring excess
capacity.
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