Forecasting Financial
Statements.
Part I: Financing Needs
173A
• Financial planning
• Additional Funds Needed (AFN)
formula
• Pro forma financial statements
– Sales forecasts
– Percent of sales method
Financial Planning and Pro Forma 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
Financial Forecasting
• 1) Project sales revenues and
expenses.
• 2) Estimate current assets and
fixed assets necessary to support
projected sales.
– Percent of sales forecast
– Assumptions driven forecast
Steps in Financial Forecasting
• First and Most important: Forecast sales
a) Historical growth?
b) Will future growth be different?
c) Sources of assumptions
• Project the assets needed to support sales
a) Spontaneous assets grow with sales, IF management not different
b) Discretionary assets grow as “management decision”
• Project internally generated funds
a) Spontaneous liabilities grow with sales
b) Retention of all or part of Net Income
• Project outside funds needed
a) Do forecasted assets > Forecasted Funding?
• Decide how to raise funds
• See effects of plan on ratios and stock price
2006 Balance Sheet (Millions of $)
Cash & sec.
$
20
Accounts rec.
Inventories
Total CA
240
240
$ 500
Net fixed
assets
Total assets
500
$1,000
Accts. pay. &
accruals
Notes payable
Total CL
L-T debt
Common stk
Retained
earnings
Total claims
$ 100
100
$ 200
100
500
200
$1,000
2006 Income Statement (Millions of $)
Sales
Less: COGS (60%)
SGA costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (40%)
Add’n to RE
$2,000.00
1,200.00
700.00
$ 100.00
10.00
$ 90.00
36.00
$ 54.00
$21.60
$32.40
AFN (Additional Funds Needed):
Key Assumptions
• Operating at full capacity in 2006.
• Each type of asset grows proportionally with
sales as no changes in management are made
• Payables and accruals grow proportionally with
sales.
• 2006 profit margin ($54/$2,000 = 2.70%) and
payout (40%) will be maintained.
• Sales are expected to increase by $500 million.
Definitions of Variables in AFN
• A*/S0: assets required to support sales;
called capital intensity ratio.
 S: increase in sales.
• L*/S0: spontaneous liabilities ratio
• M: profit margin (Net income/sales)
• RR: retention ratio; percent of net
income not paid as dividend.
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.
Assets must increase by $250 million. What
is the AFN, based on the AFN equation?
AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0270($2,500)(1 - 0.4)
= $184.5 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 profit margin:
– Increases funds available internally, decreases
AFN.
• Higher capital intensity ratio, A*/S0:
– Increases asset requirements, increases AFN.
• Pay suppliers sooner:
– Decreases spontaneous liabilities, increases
AFN.
Projecting Pro Forma Statements with the
Percent of Sales Method
• Project sales based on forecasted growth
rate in sales
• Forecast “spontaneous” items as a percent
of the forecasted sales
– Costs
– Cash
– Accounts receivable
– Inventories
– Net fixed assets
– Accounts payable and accruals
• Determine “discretionary” items
– Debt (issue/obtain more, pay back)
a) Short term Notes Payable
b) Long Term Debt (Bank or Bonds)
– Dividend policy (which determines retained
earnings)
– Common stock (issue more, purchase
back shares)
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. Especially, IF
cash will be needed sometime soon
How to Forecast Interest Expense
• Interest expense is actually based on
the daily balance of debt during the
year. Thus, it will not grow with sales!
• 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
– Assume that rates stay the same?
Basing Interest Expense on Debt at End of Year
• Will over-estimate 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.
• Thus, to be accurate, must recalculate until no
more changes are required…
Basing Interest Expense on Debt at Beginning of Year
• Will under-estimate 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.
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
COGS/Sales
SGA/Sales
Cash/Sales
Acct. rec./Sales
Inv./Sales
Net FA/Sales
AP & accr./Sales
2006
2007
Actual
Proj.
60%
35%
1%
12%
12%
25%
5%
60%
35%
1%
12%
12%
25%
5%
Other Inputs
Percent growth in sales
Growth factor in sales (g)
25%
1.25
What is this? IF sales grow 25%, next year’s sales are 125% or this
year’s or 1.25 * this year’s
Interest rate on debt
Tax rate
Dividend payout rate
10%
40%
40%
2007 Forecasted Income Statement
Sales
Less: COGS
SGA
EBIT
Interest
EBT
Taxes (40%)
Net. income
Div. (40%)
Add. to RE
2004
Factor 1st Pass
2003
g=1.25 $2,500.0
$2,000
Pct=60%
1,500.0
Pct=35%
875.0
$125.0
0.1(Debt03)
20.0
$105.0
42.0
$63.0
$25.2
$37.8
2007 Balance Sheet
Forecasted assets are a percent of forecasted sales.
Because they stay same % of sales, they grow at g!
2007 Sales = $2,500
Factor!
Cas
h
Accts.
rec.
Inventories
Total CA
Net FA
Total assets
1.25
1.25
1.25
1.25
2007
$25.0
300.0
300.0
$625.0
625.0
$1,250.0
2004 Sales = $2,500
2003
AP/accruals
Notes payable
Total CL
L-T debt
Common stk.
Ret. earnings
Total claims
Factor
1.25
100
100
500
200
+37.8*
2007
Without AFN
$125.0
100.0
$225.0
100.0
500.0
237.8
$1,062.8
*From forecasted income statement.
What are the additional funds needed (AFN)?
• Required assets
• Specified sources of fin.
• Forecast AFN
= $1,250.0
= $1,062.8
= $ 187.2
The company must have the assets to
make forecasted sales, and so it needs an
equal amount of financing. So, we must
secure another $187.2 of financing.
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.
How will the AFN be financed? How Will
that impact the L&E (claims) side of BS?
Additional notes payable =
0.5 ($187.2) = $93.6.
Additional L-T debt =
0.5 ($187.2) = $93.6.
w/o AFN AFN With AFN
AP/accruals
$ 125.0
$ 125.0
Notes payable
100.0 +93.6
193.6
Total CL
$ 225.0
$ 318.6
L-T debt
100.0 +93.6
193.6
Common stk.
500.0
500.0
Ret. earnings
237.8
237.8
Total claims
$1,071.0
$1,250.0
Equation AFN = $184.5
vs.
Pro Forma AFN = $187.2.
Why are they different?
 Equation method assumes a constant profit
margin, which does not take into account:
a) Expenses don’t always grow as fast as sales
b) Interest is not a function of sales
 Pro forma method is more flexible. More
important, it allows different items to grow at
different rates. And it allows forecasting
improved asset management…
Forecasted Ratios
2006
Profit Margin
ROE
DSO (days)
Inv. turnover
FA turnover
Debt ratio
TIE
Current ratio
2007(E) Industry
2.70% 2.52%
7.71% 8.54%
43.80
43.80
8.33x
8.33x
4.00x
4.00x
30.00% 40.98%
10.00x
6.25x
2.50x
1.96x
4.00%
15.60%
32.00
11.00x
5.00x
36.00%
9.40x
3.00x
So what do the forecasted ratios
tell us????
What are the forecasted
free cash flow and ROIC?
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
ROIC (NOPAT/Capital)
2006 2007(E)
$400
$500
$900
$1,125
$60
$75
$225
-$150
6.7%
Proposed Improvements
DSO (days)
Accts. rec./Sales
Inventory turnover
Inventory/Sales
SGA/Sales
Before
After
43.80
32.00
12.00%
8.77%
8.33x 11.00x
12.00%
9.09%
35.00% 33.00%
How do we calculate the new
balances now?
• We solve for the “x” in the formula
DSO = AR/(Sales/365) => 32=x/(2,500/365)
• OR, we can use the % already calculated for us!
Impact of Improvements
Before
AFN
Free cash flow
ROIC (NOPAT/Capital)
ROE
$187.2
-$150.0
6.7%
7.7%
After
$15.7
$33.5
10.8%
12.3%
What if in 2006 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. Fixed asset increase is a
discretionary management decision
How would the excess capacity situation
affect the 2007 AFN?
• The previously projected increase in
fixed assets was $125.
• Since no new fixed assets will be
needed, AFN will fall by $125, to
$187.2 - $125 = $62.2.
Economies of Scale
Assets
1,100
1,000

Base
Stock
0
Declining A/S Ratio
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.
Lumpy Assets
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. This is typical pattern for fixed assets!
Summary: How different capacity 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.
• It is hard to add fixed asset capacity linearly
with sales!
One more iteration
Percent of Sales Method
Home Depot
• This year’s sales _________
• Next year, we forecast sales of
$_____ million. What assumption?
• Net income should be ___% of sales.
Keep constant!
• Dividends should be ___% of
earnings. Keep constant!
This year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
% of
m
%
n/a *
%
%
n/a
n/a
n/a
Next year
Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Accrued Expenses
Notes Payable
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
% of
m
%
n/a
%
%
n/a
n/a
n/a
Predicting Retained
Earnings
• Next year’s projected retained earnings =
last year’s $___ million, plus
• This year’s Net Income of $___ million,
minus
-Net Income= Last Year’s Margin %*This
Year’s Sales
• This year’s Dividends of $___ million
-Dividends=Last Year’s Dividend Payout
Ratio*This Year’s Net Income
Predicting Discretionary
(Additional) Financing (Funding)
Needs
Discretionary Financing Needed =
projected
total
assets
projected
total
liabilities
OR
Total Assets – Total L&E
projected
owners’
equity
Predicting Discretionary
Financing Needs
Discretionary Financing Needed =
projected
total
assets
projected
total
liabilities
projected
owners’
equity
$___ million- ___ $ million$___million
The DFN (AFN)=________
Sustainable Rate of Growth
g* = ROE (1 - b)
where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
Sustainable Rate of Growth
g* = ROE (1 - b)
where
b = dividend payout ratio
(dividends / net income)
ROE = return on equity
(net income / common equity) or
net income
sales
ROE =
sales
assets
common equity
assets
x
x
Assumptions Driven ForecastIncome Statement
• Same first step: What will sales growth be
• Then need to determine line by line if
* COGS will stay same % of sales - why,
why not
* OPEX will stay same % of sales - why,
why not
* Interest expense and taxes assumptions
same? - why, why not
• Calculate Net Income under assumptions
Assumptions Driven ForecastIncome Statement
• When would the assumptions change?
• Company/product life cycles
• Economies of scale (COGS), Reengineering Production
• Investment in/hedging future
(leading/lagging with R&D hiring etc,)
• Restructuring (cost cutting, re-engineering)
• New debt financing, etc.
Assumptions Driven ForecastBalance Sheet
• When would the assumptions change?
• Assume improvement in management
practices (or deterioration due to external
factors)
* Accounts receivable
* Inventory
* Fixed Assets (Investment/Divestment)
• Change financial or capital structure (more
ST or LT debt/more equity)
• IS/BS Iterations may be necessary
Assumptions Driven ForecastBalance Sheet
•
•
•
•
What does not change?
Assets = Liabilities+Equity
DFN= Assets-Liabilities-Equity
New Equity=Old Equity+Net IncomeDividends
Let’s Forecast HP!