T3.1 Chapter Outline
T3.2 Financial Planning Model Ingredients
Chapter 3
„ Sales Forecast
‹ Drives the model
Long-Term Financial Planning and
Corporate Growth
„ Pro Forma Statements
‹ The output summarizing different projections
Chapter Organization
„ Asset Requirements
‹ Investment needed to support sales growth
„ 3.1 What is Financial Planning?
„ 3.2 Financial Planning Models: A First Look
„ Financial Requirements
‹ Debt and dividend policies
„ 3.3 The Percentage of Sales Approach
„ The “Plug”
‹ Designated source(s) of external financing
„ 3.4 External Financing and Growth
„ 3.5 Some Caveats Regarding Financial
„ Economic Assumptions
‹ State of the economy, interest rates, inflation
Planning Models
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T3.3 Example: A Simple Financial Planning Model
T3.3 Example: A Simple Financial Planning Model (concluded)
Pro Forma Financial Statements
Recent Financial Statements
Income statement
Sales
$100
Costs
90
Net Income
$ 10
Income statement
Balance sheet
Assets
Total
$50
Debt
$20
Equity
30
Total
$50
$50
Balance sheet
Sales
$______
Assets $______
Debt
______
Costs
______
______
Equity
______
$ ______
Total $______
Net
Total $______
„ Assume that:
‹
‹
‹
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1. sales are projected to rise by 25%
2. the debt/equity ratio stays at 2/3
3. costs and assets grow at the same rate as sales
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T3.3 Example: A Simple Financial Planning Model (concluded)
T3.4 The Percentage of Sales Approach
Income Statement
(projected growth = 30%)
Pro Forma Financial Statements
Income statement
Sales
$ 125
Costs
112.5
Net
Balance sheet
Assets
$ 12.5
Total
$ 62.5
Debt
______
Equity
$ 62.5
Total
$
Original
25
37.5
$ 62.5
Sales
$2000
Costs
1700
Pro forma
$_____ (+30%)
2210 (= 85% of sales)
EBT
300
_____
What’s the plug?
Taxes (34%)
102
132.6
Notice that projected net income is $12.50, but equity
only increases by $7.50. The difference, $5.00 paid out
in cash dividends, is the plug.
Net income
198
257.4
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T3.4 The Percentage of Sales Approach
Dividends
Add. to ret. Earnings____
Sales
Costs
$2000
1700
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Preliminary Balance Sheet
Pro forma
Cash
$2600 (+30%)
2210 (= 85% of sales)
300
390
Taxes (34%)
102
132.6
Net income
198
257.4
66
85.8 (= 1/3 of net)
Add. to ret. Earnings132
171.6 (= 2/3 of net)
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____ (= 2/3 of net)
T3.4 The Percentage of Sales Approach (concluded)
EBT
Dividends
85.8 (= 1/3 of net)
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Income Statement
(projected growth = 30%)
Original
66
Orig.
% of sales
% of sales
$100
___%
A/P
$60
___%
A/R
120
6%
N/P
140
n/a
Inv
140
7%
Total
200
n/a
Total
$360
__%
LTD
$200
n/a
NFA
640
32%
C/S
10
n/a
590
n/a
R/E
Total
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Orig.
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$1000
50%
Total
$600
n/a
$1000
n/a
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T3.5 Pro Forma Statements
T3.4 The Percentage of Sales Approach (concluded)
The Percentage of Sales Approach, Continued
Preliminary Balance Sheet
Cash
A/R
Inv
Total
NFA
Total
Proj.
Orig.
% of sales
Orig.
% of sales
$100
5%
A/P
$60
3%
Cash
120
6%
N/P
140
n/a
140
7%
Total
200
n/a
$360
18%
LTD
$200
n/a
640
32%
$1000
50%
C/S
10
n/a
R/E
590
n/a
$600
n/a
$1000
n/a
Total
Note that the ratio of total assets to sales is $1000/$2000 = 0.50. This
is the capital intensity ratio. It equals 1/(total asset turnover).
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T3.5 Pro Forma Statements
(+/-)
Proj.
$____
A/P
A/R
____
____
N/P
____
____
Inv
182
42
Total
$____
$____
Total
$____
$108
LTD
NFA
832
192
C/S
10
R/E
761.6
____
$771.6
$____
$1189.6
$____
Total
$____
$____
Total
EFN = $300 - 189.60 = $________
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Proj.
„ Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
(+/-)
$130
$ 30
A/P
A/R
156
36
N/P
Inv
182
42
Total
Total
$468
$108
LTD
200
0
PM = profit margin
NFA
832
192
C/S
10
0
b = earnings retention (“plowback”) ratio
R/E
$1300
$300
200
Financing needs are $300, but internally generated sources are only
$189.60. The difference is external financing needed:
Proj.
Total
$____
T3.6 The Percentage of Sales Approach: General Formulas
The Percentage of Sales Approach, Continued
Cash
$____
(+/-)
$____
Total
$
78
(+/-)
$
140
$ 218
Let:
18
S = previous period’s sales
0
$
g = projected increase in sales
18
761.6
171.6
$771.6
$171.6
$1189.6
$189.6
„ The expected addition to retained earnings is:
S(1 + g)
PM
b
This represents the level of internal financing the firm is
expected to generate over the coming period.
Financing needs are $300, but internally generated sources are only
$189.60. The difference is external financing needed:
EFN = $300 - 189.60 = $110.40
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T3.7 Growth and External Financing
T3.6 The Percentage of Sales Approach: General Formulas (concluded)
„ What level of asset investment is needed to support a given
level of sales growth? For simplicity, assume we are at full
capacity. Then the indicated increase in assets required
equals
A
„ Key issue:
‹ What is the relationship between sales growth and
financing needs?
g
where A = ending total assets from the previous period.
‹
Suppose the firm does not issue new equity
Change in assets = change in debt + change in equity
‹
Given the profit margin, the payout ratio, the debt-equity
ratio, and the asset-requirement ratio (the ratio of total
assets to sales), the growth rate can be determined. This
is referred to as the firm’s “sustainable growth rate”.
„ If the required increase in assets exceeds the internal funding
available (i.e., the increase in retained earnings), then the
difference is the
External Financing Needed (EFN).
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T3.14 Questions the Financial Planner Should Consider
„ Mark Twain once said “forecasting is very difficult, particularly if it
concerns the future”. The process of financial planning involves the use
of mathematical models which provide the illusion of great accuracy. In
assessing a financial forecast, the planner should ask the following
questions:
‹
‹
‹
‹
‹
‹
Are the results generated by the model reasonable?
Have I considered all possible outcomes?
How reasonable were the economic assumptions which were used to
generate the forecast?
Which assumptions have the greatest impact on the outcome?
Which variables are of the greatest importance in determining the
outcome?
Have I forgotten anything important?
„ The final question may be the most crucial. It is worthwhile to
remember that, if you think your forecasting model is too good to be
true, you’re undoubtedly right.
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