CHAPTER 14
Financial Planning and Forecasting
Financial Statements
1
Topics



Financial Statements 101
Ratio Analysis
Financial Planning and Forecasting


AFN
Percent of Sales Method
2
Three Financial Statements



Balance Sheet
Income Statement
Cash Flow Statement
3
Balance Sheet of The firm Current
(Snap Assets
Shot ofhave
thea Firm)
life of less than 1 year
and include:
Shareholders’ Equity = Assets - Liabilities
•Cash
•Account receivable
•Inventory
Assets = Liabilities + Shareholders’ Equity
Current Liabilities have a
life of less than 1 year
and include:
•Short-term liability
•Bank loans
•Machine, Equipment
•Long-term
borrowings
•Patents
•Accounts Payable
CA - CL
4
Duke Corp.: Balance Sheet
(Assets)
Cash
S-T invest.
AR
Inventories
Total CA
Gross FA
Less: Depr.
Net FA
Total assets
2008
9,000
48,600
351,200
715,200
1,124,000
491,000
146,200
344,800
1,468,800
2009
7,282
20,000
632,160
1,287,360
1,946,802
1,202,950
263,160
939,790
2,886,592
5
Balance Sheet: Liabilities &
Equity
Accts. payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Ret. earnings
Total equity
Total L&E
2008
145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
1,468,800
2009
324,000
720,000
284,960
1,328,960
1,000,000
460,000
97,632
557,632
2,886,592
6
What effect did the expansion have on
the asset section of the balance sheet?



Net fixed assets almost tripled in size.
AR and inventory almost doubled.
Cash and short-term investments fell.
7
Liquidity of Assets





The order of assets on the balance sheet reflects their
liquidity. (decreasing order of liquidity)
Liquidity is the speed at which the asset can be
converted to cash with little or no loss in value
Liquid firms are less likely to experience financial
distress
But, liquid assets earn a lower return
Liquid Assets


Account receivable and possibly inventory
Non-liquid Assets

specialized fixed asset (e.g., equipment) and intangible assets (e.g.,
patents and trademarks)
8
Book Value vs. Market Value

Find the book value.


Historical cost
Recorded amount in financial statements


GAPP says “You record historical cost!”
Find the market value.





More important
True value of the firm
The amount of cash we would get if we
actually sell the firm now.
Is NOT on the financial statements
“Replacement” value
9
Income Statement (Example)
Sales
COGS
Other expenses
Deprec.
Tot. op. costs
EBIT
Int. expense
EBT
Taxes (40%)
Net income
2008
3,432,000
2,864,000
340,000
18,900
3,222,900
209,100
62,500
146,600
58,640
87,960
2009
5,834,400
4,980,000
720,000
116,960
5,816,960
17,440
176,000
(158,560)
(63,424)
(95,136)
10
What happened to sales and
net income?




Sales increased by over $2.4 million.
Costs shot up by more than sales.
Net income was negative.
However, the firm received a tax refund
since it paid taxes of more than
$63,424 during the past two years.
11
GAAP Allows Accrual Basis
Accounting!



Matching principle: GAAP says to show revenue when it
accrues and match the expenses required to generate
the revenue
Realization Principle: GAAP says to recognize revenue
when the earnings process is virtually complete and the
value of an exchange of goods or services is known or
can be reliably determined.
What does this mean?


Records revenue when it is earned, whether or not the revenue
has been received in cash.
Records expense when they are incurred, even if the money
has not actually been paid out.
12
Profits and cash flows are not
the same thing!

The potential problem with GAAP to
understand the firm’s financial condition



Mismatch between the time when the income
(cost) is realized and the time when the revenue
(cost) is collected
This is because GAAP requires that sales be
recorded on the income statement when made,
not when cash is received
GAAP also requires that we record cost of goods
sold when the corresponding sales are made,
regardless of whether we have actually paid our
suppliers yet
13
Noncash items

A typical noncash item is depreciation expense

Hypothetical number


Noncash items are irrelevant to firm valuation
in general because they do not represent true
cash inflow or outflow
However, noncash items are still important to
understand the firm’s financial condition
because they affect the firm's tax liability
(and, therefore, cash flow)
14
So, what can we conclude?


The accrual accounting and noncash items
results in inequality between cash flows and
net income (or earnings).
Finance Emphasizes the Importance of
Timing




Timing of Cash Flow Matters
Accrual Accounting May Obscure Timing
“You Can’t Deposit Net Income, Only Cash”
Therefore, we must present cash flow
statement to understand the firm’s financial
condition better.
15
The Sources and Uses of
Corporate Cash
Sources





Decrease in any asset
Increase in any liability
Net profits after taxes
Depreciation and other
non-cash charges
Sale of stock
Uses





Increase in any asset
Decrease in any liability
Net loss
Dividends paid
Repurchase or retirement
of stock
16
Statement of Cash Flows: 2009
Operating Activities
Net Income
Adjustments:
Depreciation
Change in AR
Change in inventories
Change in AP
Change in accruals
Net cash provided by ops.
(95,136)
116,960
(280,960)
(572,160)
178,400
148,960
(503,936)
17
Long-Term Investing Activities
Cash used to acquire FA
(711,950)
Financing Activities
Change in S-T invest.
Change in notes payable
Change in long-term debt
Payment of cash dividends
Net cash provided by fin. act.
28,600
520,000
676,568
(11,000)
1,214,168
18
Summary of Statement of CF
Net cash provided by ops.
Net cash to acquire FA
Net cash provided by fin. act.
Net change in cash
Cash at beginning of year
Cash at end of year
(503,936)
(711,950)
1,214,168
(1,718)
9,000
7,282
19
What can you conclude from
the statement of cash flows?




Net CF from operations = -$503,936,
because of negative net income and
increases in working capital.
The firm spent $711,950 on FA.
The firm borrowed heavily and sold
some short-term investments to meet
its cash requirements.
Even after borrowing, the cash account
fell by $1,718.
20
EDGAR




EDGAR stands for Electronic Data
Gathering, Analysis and Retrieval system.
Since May 6, 1996, the SEC has required
all domestic public companies to post their
filings on EDGAR.
EDGAR includes the annual reports known
as 10-Ks and the quarterly reports known
as 10-Qs, as well as proxy.
Go to www.sec.gov
21
Why Evaluate Financial
Statements?

Internal uses



Performance evaluation – compensation
and comparison between divisions
Planning for the future – guide in estimating
future cash flows
External uses




Creditors
Suppliers
Customers
Stockholders
22
Why are ratios useful?


Standardize numbers; facilitate
comparisons
Used to highlight weaknesses and
strengths
23
24
Five Major Categories of
Ratios





Liquidity: Can we make required payments as
they fall due?
Asset management: Do we have the right
amount of assets for the level of sales?
Debt management: Do we have the right mix
of debt and equity?
Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
Market value: Do investors like what they see
as reflected in P/E and M/B ratios?
25
Calculate and appraise the
P/E.
Price = $12.17.
NI
$253.6
EPS = Shares out. = 250 = $1.01.
Price per share $12.17
P/E =
=
=
12x.
EPS
$1.01
26
Price-Earning Ratio



If PE ratio =10, then we would say the company's
stock sell for 10 times earnings.
PE ratio measures how much investors are willing to
pay per dollar of current earnings.
The higher the PE ratio is, the higher the firm’s
growth prospects would be in the future.



Growth Stock= stocks with relatively higher PE ratio (e.g.,
Tech stocks)
Value stock= stocks with relatively lower PE ratio (e.g.,
Utility stocks)
Watch out: If the firm generates almost no earnings,
then PE ratio could be very large. (Why?) So, care is
needed in interpreting this ratio
27
Industry P/E Ratios
Industry
Banking
Software
Drug
Electric Utilities
Semiconductors
Steel
Tobacco
S&P 500
Ticker*
STI
MSFT
PFE
DUK
INTC
NUE
MO
P/E
16.43
31.59
22.56
20.04
28.38
13.03
13.25
21.52
*Ticker is for typical firm in industry, but P/E ratio is for the industry,
not the individual firm; www.investor.reuters.com, May 2006
28
Benchmarking


Ratios are not very helpful by themselves; they
need to be compared to something
Time-Trend Analysis




Peer Group Analysis



one-year ratios do NOT provide a full picture
Used to see how the firm’s performance is changing
through time
Do multi-year analysis
Compare to similar companies or within industries
SIC and NAICS codes (http://www.naics.com/)
Should be used in conjunction with other qualitative
measurements. For example, heterogeneity in
accounting practice, market structures, customer
29
bases, capital structures, etc.
Peer Group Analysis:
Advanced Micro Device (AMD)
30
Financial Forecasting



Financial planning
Additional Funds Needed (AFN) formula
Pro forma financial statements


Sales forecasts
Percent of sales method
31
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
32
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
33
2007 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
34
2007 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
35
AFN (Additional Funds Needed):
Key Assumptions





Operating at full capacity in 2007.
Each type of asset grows proportionally with
sales.
Payables and accruals grow proportionally
with sales.
2007 profit margin ($54/$2,000 = 2.70%)
and payout (40%) will be maintained.
Sales are expected to increase by $500
million.
36
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.
37
Assets vs. Sales
Assets
1,250
1,000
Assets = 0.5 sales
 Assets =
(A*/S0)Sales
= 0.5($500)
= $250.
0
2,000
2,500
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.
Sales
38
AFN=
 Required
Assets
 Required
Assets
=
=
=
 Spontaneous =
Liabilities
=
=
 Retained
Earnings
AFN=
=
AFN=
 Required
Assets
$250.00
$184.50
 Spontaneous
Liabilities
Asset to Sales
Ratio
0.500
$250.00
Spontaneous
Liab. to Sales
Ratio
0.050
$25.00
=
Profit Margin
=
=
0.027
$40.50
-
 Spontaneous
Liabilities
$25.00
-
 Retained
Earnings
x
 Sales
x
$500.00
x
 Sales
x
$500.00
x
Sales
x $
2,500.0
-
Retention
Ratio
x
0.600
x
 Retained
Earnings
$40.50
39
If assets increase by $250
million, what is the AFN?
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
AFN = ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0270($2,500)(1 - 0.4)
AFN = $184.5 million.
40
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.
(More…)
41

Higher profit margin:


Higher capital intensity ratio, A*/S0:


Increases funds available internally, decreases
AFN.
Increases asset requirements, increases AFN.
Pay suppliers sooner:

Decreases spontaneous liabilities, increases AFN.
42
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
(More...)
43

Items as percent of sales (Continued...)




Inventories
Net fixed assets
Accounts payable and accruals
Choose other items



Debt
Dividend policy (which determines retained
earnings)
Common stock
44
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
45
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.
46
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…
47
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.
More…
48
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.
More…
49
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.
More…
50
A Solution that Balances
Accuracy and Complexity

Base interest expense on beginning
debt, but use a slightly higher interest
rate (say, 0.5% higher).



Easy to implement
Reasonably accurate
See Ch 14E Toolkit.xls for an example
basing interest expense on average
debt.
51
Percent of Sales: Inputs
COGS/Sales
SGA/Sales
Cash/Sales
Acct. rec./Sales
Inv./Sales
Net FA/Sales
AP & accr./Sales
2007
Actual
60%
35%
1%
12%
12%
25%
5%
2008 Proj.
60%
35%
1%
12%
12%
25%
5%
52
Other Inputs
Percent growth in sales
25%
Growth factor in sales (g)
1.25
Interest rate on debt
10%
Tax rate
40%
Dividend payout rate
40%
53
2008 First-Pass Forecasted
Income Statement
Calculations
2008 1st Pass
Sales
1.25 Sales07 =
$2,500.0
Less: COGS
60% Sales08 =
1,500.0
35% Sales08 =
875.0
SGA
EBIT
Interest
EBT
$125.0
0.1(Debt07) =
20.0
$105.0
Taxes (40%)
42.0
Net Income
$63.0
Div. (40%)
$25.2
Add to RE
$37.8
54
2008 Balance Sheet (Assets)
Cash
Accts Rec.
Inventories
Total CA
Net FA
Total Assets
Calcuations
1% Sales08 =
12%Sales08 =
2008
$25.0
300.0
12%Sales08 =
300.0
$625.0
625.0
$1,250.0
25% Sales08 =
55
2008 Preliminary Balance
Sheet (Claims)
5
AP/accruals
Calculations
5% Sales08 =
2008 Without
AFN
$125.0
Notes payable
Total CL
100
Carried over
100.0
$225.0
L-T debt
100
Carried over
100.0
Common stk
500
Carried over
500.0
Ret earnings
200
+37.8*
237.8
Total claims
$1,062.8
56
What are the additional funds
needed (AFN)?




Required assets = $1,250.0
Specified sources of fin. = $1,062.8
Forecast AFN: $1,250 - $1,062.8 =
$187.2
NWC 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.
57
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.
58
How will the AFN be financed?


Additional notes payable
=0.5 ($187.2) = $93.6.
Additional L-T debt
= 0.5 ($187.2) = $93.6.
59
2008 Balance Sheet (Claims)
AP accruals
Notes payable
Total CL
L-T Debt
Common stk
Ret earnings
Total claims
w/o AFN
$125.0
100.0
$225.0
100.0
500.0
237.8
$1,062.8
AFN
+93.6
+93.6
With AFN
$125.0
193.6
$318.6
193.6
500.0
237.8
$1250.0
60
Equation AFN = $184.5 vs.
Pro Forma AFN = $187.2.


Equation method assumes a constant
profit margin.
Pro forma method is more flexible.
More important, it allows different items
to grow at different rates.
61
Forecasted Ratios
Profit Margin
ROE
DSO (days)
Inv turnover
FA turnover
Debt ratio
TIE
Current ratio
2007
2.70%
7.71%
43.80
8.33x
4.00x
30.00%
10.00x
2.50x
2008(E) Industry
2.52%
4.00%
8.54% 15.60%
43.80
32.00
8.33x
11.00x
4.00x
5.00x
40.98% 36.00%
6.25x
9.40x
1.96x
3.00x
62
What are the forecasted free
cash flow and ROIC?
2007
$400
2008(E)
$500
Total operating capital
(Net op. WC + net FA)
$900
$1,125
NOPAT (EBITx(1-T))
Less Inv. in op. capital
$60
$75
$225
-$150
6.7%
Net operating WC
(CA - AP & accruals)
Free cash flow
ROIC (NOPAT/Capital)
63
Proposed Improvements
Before
After
43.80
32.00
12.00%
8.77%
8.33x
11.00x
Inventory/Sales
12.00%
9.09%
SGA/Sales
35.00%
33.00%
DSO (days)
Accts. rec./Sales
Inventory turnover
64
Impact of Improvements (see
Ch 14 Mini Case.xls for details)
Before
After
$187.2
$15.7
-$150.0
$33.5
ROIC (NOPAT/Capital)
6.7%
10.8%
ROE
7.7%
12.3%
AF
Free cash flow
65
If 2007 fixed assets had been
operated at 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.
66
How would the excess capacity
situation affect the 2008 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.
67
Economies of Scale
Assets
1,100
1,000

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.
68
Lumpy Assets
Assets
1,500
1,000
500
Sales
500
1,000
2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A.
69
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.
70