15 - 1
Lecture Four
Financial Forecasting
Latest
Financial
Statements
Sales
Forecast
Cost Accounting
Forecasts
Financial
Market
Data
Preliminary Projections:
1. Financial Statements
2. Financing Plan
3. Resulting Ratios
Modify
and
Revise
Bad Plan
Evaluation:
Is the preliminary plan a
good one, or should it
be modified?
Good Plan
Final Projections:
1. Financial Statements
2. Financing Plan
3. Resulting Ratios
15 - 2
Steps
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
15 - 3
1997 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
15 - 4
1997 Income Statement
(Millions of $)
Sales
Less: Var. Costs (60%)
Fixed Costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (30%)
Add’n to RE
$2,000.00
1,200.00
700.00
$ 100.00
16.00
$ 84.00
33.60
$ 50.40
$15.12
$35.28
15 - 5
Key Ratios
BEP
Profit Margin
ROE
DSO
Inv. turnover
F.A. turnover
T.A. turnover
Debt/ assets
TIE
Current ratio
Payout ratio
NWC
10.00%
2.52%
7.20%
43.20 days
8.33x
4.00x
2.00x
30.00%
6.25x
2.50x
30.00%
Industry
Condition
20.00%
Poor
4.00%
“
15.60%
“
“
32.00 days
11.00x
“
5.00x
“
2.50x
“
36.00%
Good
9.40x
Poor
3.00x
“
30.00%
O.K.
Formula Method for Forecasting AFN
Additional
funds
needed
=
AFN =
(
Required
increase
in assets
A*
( )
S0
)(
-
DS -
)(
Spontaneous
increase in
liabilities
L*
( )D
S0
-
15 - 6
)
Increase
in retained
earnings
S - M S1 (1 - d)
Assumptions:
1. All assets, account payable, and accruals will grow proportionally with sales.
2. 1997 profit margin and dividend payout will be maintained.
DS
AFN =
= 0.25 x $2,000 = $500.
(
$1,000
$2,000
)
($500) -
= $250 - $25 - $44.10
= $180.90
(
$100
)
$2,000
($500) - 0.0252 ($2,500) (1 - 0.30)
15 - 7
Key Assumptions
 Operating at full capacity in 1997.
 Each type of asset grows proportionally
with sales.
 Payables and accruals grow proportionally
with sales.
 1997 profit margin (2.52%) and payout
(30%) will be maintained.
 Sales are expected to increase by $500
million. (%DS = 25%)
15 - 8
Assets
1,250
1,000
0
Assets = 0.5 sales
D Assets=
(A*/S0) D Sales
= 0.5(500)
=250.
2,000 2,500
Sales
A*/S0 = 1,000/2,000 = 0.5 = 1,250/2,500.
15 - 9
Assets must increase by $250 million.
What is the AFN, based on the AFN
equation?
AFN = (A*/S0)DS - (L*/S0)DS - M(S1)(1 - d)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0252($2,500)(1 - 0.3)
= $180.9 million.
15 - 10
Assumptions about How AFN Will
Be Raised
The payout ratio will remain at 30
percent (d = 30%).
No new common stock will be
issued.
Any external funds needed will be
raised as debt, 50% notes payable
and 50% L-T debt.
15 - 11
1998 Forecasted Income Statement
Sales
Less: VC
FC
EBIT
Interest
EBT
Taxes (40%)
Net. income
Div. (30%)
Add. to RE
1997
$2,000
1,200
700
$100
16
$84
34
$50
$15
$35
Factor
x1.25
x1.25
x1.25
1998
Forecast
$2,500
1,500
875
$125
16
$109
44
$65
$19
$46
15 - 12
1998 1st Pass Balance Sheet (Assets)
Cash
Accts. rec.
Inventories
Total CA
Net FA
Total assets
1997
$20
240
240
$500
500
$1,000
Factor
x1.25
x1.25
x1.25
x1.25
1st Pass
$25
300
300
$625
625
$1,250
At full capacity, so all assets must increase in
proportion to sales.
15 - 13
1998 1st Pass Balance Sheet (Claims)
1997
AP/accruals
$100
Notes payable
100
Total CL
$200
L-T debt
100
Common stk.
500
Ret. earnings
200
Total claims
$1,000
Factor
x1.25
+46*
*From income statement.
1st Pass
$125
100
$225
100
500
246
$1,071
15 - 14
What is the additional financing
needed (AFN)?
Forecasted total assets = $1,250
Forecasted total claims = $1,071
Forecast AFN
= $ 179
NWC must have the assets to make
forecasted sales. The balance sheet
must balance. So, we must raise $179
externally.
15 - 15
How will the AFN be financed?
Additional notes payable =
0.5($179) = $89.50
Additional L-T debt =
0.5($179) = $89.50
But this financing will add to interest
expense, which will lower NI and retained
earnings. We will generally ignore
financing feedbacks.
15 - 16
1998 2nd Pass Balance Sheet (Assets)
1st Pass
AFN
2nd Pass
Cash
$25
$25
Accts. rec.
300
300
Inventories
300
300
Total CA
$625
$625
625
625
$1,250
$1,250
Net FA
Total assets
No change in asset requirements.
15 - 17
1998 2nd Pass Balance Sheet (Claims)
1st Pass
AP/accruals
$125
Notes payable
100
Total CL
$225
L-T debt
100
Common stk.
500
Ret. earnings
246
Total claims
$1,071
AFN
+89.5
+89.5
2nd Pass
$125
190
$315
189
500
246
$1,250
15 - 18
Equation AFN = $181 vs. $179.
Why different?
Equation method assumes a
constant profit margin.
Financial statement method is more
flexible. More important, it allows
different items to grow at different
rates.
15 - 19
Ratios
BEP
Profit Margin
ROE
DSO (days)
Inv. turnover
F.A. turnover
T.A. turnover
D/A ratio
TIE
Current ratio
Payout ratio
1997 1998(E) Industry
10.00% 10.00% 20.00% Poor
2.52%
2.60% 4.00%
“
7.20%
8.71% 15.60%
“
43.20
43.20
32.00
“
8.33x
8.33x 11.00x
“
4.00x
4.00x
5.00x
“
2.00x
2.00x
2.50x
“
30.00% 40.32% 36.00%
“
6.25x
7.81% 9.40x
“
2.50x
1.98x
3.00x
“
30.00% 30.00% 30.00% O.K.
15 - 20
Suppose in 1997 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.
15 - 21
How would the excess capacity
situation affect the 1998 AFN?
The projected increase in fixed asets
was $125, the AFN would decrease by
$125.
Since no new fixed assets will be
needed, AFN will fall by $125, to
$179 - $125 = $54.
15 - 22
Q.
If sales went up to $3,000,
not $2,500, what would the
F.A. requirement be?
A.
Target ratio = FA/Capacity sales
= 500/2,667 = 18.75%.
Have enough F.A. for sales up to
$2,667, but need F.A. for another
$333 of sales:
DFA = 0.1875(333) = $62.4.
15 - 23
How would excess capacity affect the
forecasted ratios?
1. Sales wouldn’t change but assets
would be lower, so turnovers would
be better.
2. Less new debt, hence lower interest,
so higher profits, EPS, ROE (when
financing feedbacks considered).
3. Debt ratio, TIE would improve.
15 - 24
1998 Forecasted Ratios: S98 = $2,500
BEP
Profit Margin
ROE
DSO (days)
Inv. turnover
F.A. turnover
T.A. turnover
D/A ratio
TIE
Current ratio
% of 1997 Capacity
100%
75%
10.00%
11.11%
2.60%
2.60%
8.71%
8.71%
43.20
43.20
8.33x
8.33x
4.00x
5.00x
2.00x
2.22x
40.32%
33.69%
7.81%
7.81x
1.98x
2.48x
Industry
20.00%
4.00%
15.60%
32.00
11.00x
5.00x
2.50x
36.00%
9.40x
3.00x
15 - 25
How is NWC performing with regard to
its receivables and inventories?
DSO is higher than the industry
average, and inventory turnover is
lower than the industry average.
Improvements here would lower
current assets, reduce capital
requirements, and further improve
profitability and other ratios.
15 - 26
Declining A/S Ratio
Assets
1,100
1,000
}
0
Base
Stock
Sales
2,000
2,500
1,000/2,000 = 0.5; 1,000/2,500 = 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.
15 - 27
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 DS leads to a
large DA.
15 - 28
Summary: How different factors affect
the AFN forecast.
 Excess capacity:
Existence lowers AFN.
 Base stocks of assets:
Leads to less-than-proportional asset
increases.
 Economies of scale:
Also leads to less-than-proportional asset
increases.
 Lumpy assets:
Leads to large periodic AFN requirements,
recurring excess capacity.
15 - 29
Regression Analysis for Asset
Forecasting
Get historical data on a good
company, then fit a regression line
to see how much a given sales
increase will require in way of asset
increase.
15 - 30
Example of Regression
Inventory
For a Well-Managed Co.
Year
Sales
Inv.
$1,280
$118
1995
1,600
138
1996
2,000
162
1997
192E
1998E
2,500E
Regression
line
1.28 1.6
Constant
ratio forecast
2.0
2.5
Sales
(000)
Constant ratio overestimates inventory required
to go from S1 = 2,000 to S2 = 2,500.
15 - 31
Regression with 10B for Our Example
 Same as finding beta coefficients.
 Clear all
1280 Input 118S+
1600 Input 138S+
2000 Input 162S+
^
0
y, m 40.0 = Inventory at sales = 0.
SWAP 0.0611 = Slope coefficient.
Inventory = 40.0 + 0.0611 Sales.
LEAVE CALCULATOR ALONE!
15 - 32
Equation is now in the calculator. Let’s
use it by inputting new sales of $2,500
and getting forecasted inventory:
2500
^
y, m
192.66.
The constant ratio forecast was inventory
= 300, so the regression forecast is lower
by $107. This would free up $107 for use
elsewhere, which would improve
profitability and raise P0.
15 - 33
How would increases in these items affect
the AFN?
 Higher dividend payout ratio?
Increase AFN : Less retained earnings.
 Higher profit margin?
Decrease AFN: Higher profits, more retained
earnings.
 Higher capital intensity ratio, A*/S0?
Increase AFN: Need more assets for given
sales increase.
 Pay suppliers in 60 days rather than 30 days?
Decrease AFN: Trade creditors supply more
capital, i.e., L*/S0 increases.