FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN EDITION BY:
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WONG
LAURENTIAN
UNIVERSITY
CHAPTER 5
FINANCIAL PLANNING AND
FORECASTING FINANCIAL
STATEMENTS
CHAPTER 5 OUTLINE
•
•
•
•
Overview of Financial Planning
Sales Forecast
The AFN Formula
The Forecasted Financial Statement (FFS)
Method
• Forecasting Financial Requirements When
the Balance Sheet Ratios Are Subject to
Change
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5-4
Overview of Financial Planning
• Three important components:
– Strategic plans: Define its corporate purpose, scope, and
objectives, and develop strategies for achieving its goals
– Operating plans: Provide detailed implementation
guidance to help meet the corporate objectives
– Financial plans: Forecast the amount of external
financing that will be required
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Financial Planning Process
• Projects financial statements
• Determines the funds needed
• Forecasts the funds to be generated internally
and identifying those to be obtained from
outside sources
• Sets up a performance-based management
compensation system
• Implements the plan and monitoring its
operations
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Components of a Financial Plan
• Sales forecast
• Pro forma, or projected, financial statements
• External financing plan
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Sales Forecast
• An accurate sales forecast is critical to
profitability.
• Forecasting the future sales growth starts with
a review of sales during the past years using a
regression approach.
• Adjust the estimate with the reality if
necessary.
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2013 Balance Sheet
($ Millions)
Cash
$ 10
S-t invest
0
375
Accounts rec.
615
Inventories
Total CA
$1,000
Net fixed
assets
1,000
Total assets $2,000
$ 60
Accts. pay.
Accruals
$ 140
Notes payable
110
Total CL
$ 310
L-t bonds
754
40
Pref. stk
130
Com. stk
Ret. earnings
766
Total claims $2,000
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2013 Income Statement
($ Millions)
Sales
Costs except Depr (60%)
Depreciation
EBIT
Interest
EBT
Taxes (40%)
NI before pref. div
preferred dividends
Net income for com.
Dividends (50.7%)
Add’n to RE
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$3,000.00
2,616.20
100.00
$ 283.80
88.00
$ 195.80
78.30
117.50
4.00
$ 113.50
$57.50
$56.00
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The AFN (Additional Funds Needed)
Formula: Key Assumptions
• Operating at full capacity in 2013
• Each type of asset grows proportionally with
sales.
• Payables and accruals grow proportionally with sales.
• 2013 profit margin ($113.5/$3,000 = 3.78%), and
payout (50.7%) will be maintained
• Sales are expected to increase by $300 million.
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Definitions of Variables in AFN
• A*/S0: Assets required to support sales; called
capital intensity ratio
• ∆S: Change in sales
• L*/S0: Spontaneous liabilities-to-sales ratio
• M: Profit margin (net income/sales)
• RR: Retention ratio; percentage of net income not
paid as dividend
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Assets vs. Sales
Assets
2,200
Assets = 0.67 sales
 Assets =
(A*/S0)Sales
= 0.67($300)
= $200
2,000
Sales
0
3,000 3,300
A*/S0 = $2,000/$3,000 = 0.67 = $2,200/$3,300
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If Sales Increase by
$300 Million, What is the AFN?
AFN = (A*/S0)∆S – (L*/S0)∆S – M(S1)(RR)
AFN = Projected increase in assets –
Spontaneous increase in liabilities – Increase
in retained earnings
AFN = ($2,000/$3,000)($300)
– ($200/$3,000)($300)
– 0.0378($3,300)(1 – 0.507)
AFN = $118.42 million
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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 capital intensity ratio, A*/S0:
– Increases asset requirements,
increases AFN
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How Would Increases in These Items
Affect the AFN? (cont’d)
• Higher profit margin:
– Increases funds available internally, decreases
AFN
• Pay suppliers sooner:
– Decreases spontaneous liabilities,
increases AFN
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Self-supporting Growth Rate
• The maximum growth rate the firm could
achieve if it had no access to external capital.
• It can be found by setting AFN to zero and
solving the resultant equation for g.
M  RR  S0
Self - supporting g  * *
A  L  M  RR  S0
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Self-Supporting G for Microdrive
M  RR  S0
Self - supporting g  *
*
A  L  M  RR  S0
0.0378  0.493  $3,000

$2,000  $200  0.0378  0.493  3,000
 3.21%
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The Forecasted Financial Statement
(FFS) Method
• Forecasts the complete set of pro forma statements,
making the analysis reliable
• Information also provides financial ratios to evaluate
different business plans.
• Uses the percentage of sales method
• Begins with sales forecast, and estimates the assets
required to support the growth
• Allows different asset/liability classes to grow at
different rates
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Projecting Pro Forma Statements with
the Percent of Sales Method
• Forecasts items as a percent of the forecasted
sales (i.e., varying directly with sales)
– Costs
– Cash
– Accounts receivable
– Inventories
– Net fixed assets
– Accounts payable and accruals
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Projecting Pro Forma Statements with
the Percent of Sales Method (cont’d)
• Chooses other items that have no direct linear
relationship with sales
– Debt
– Dividend policy (which determines retained
earnings)
– Common stock
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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
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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.
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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 based on:
– debt at end of year
– debt at beginning of year
– average of beginning and ending debt
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Basing Interest Expense on Debt
at End of Year
• Will overestimate 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.
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Basing Interest Expense on Debt
at End of Year (cont’d)
• Will underestimate interest expense if debt is added
throughout the year instead of all on December 31
• But doesn’t cause problem of circularity
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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
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A Solution That Balances Accuracy
and Complexity
• Base interest expense on beginning debt, but use a
slightly higher interest rate
– Easy to implement
– Reasonably accurate
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Percent of Sales: Inputs
Costs ex Depr/Sales
Cash/Sales
Acct. rec./Sales
Inv./Sales
Net FA/Sales
AP/Sales
Accruals/sales
2013 Actual 2014 Proj.
87.2%
87.2%
0.33%
0.33%
12.5%
12.5%
20.5%
20.5%
33.3%
33.3%
2%
2%
4.67%
4.67%
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Other Inputs
Percent growth in sales
10%
Interest rate on debt
11%
Tax rate
40%
Dividend payout rate
50.7%
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2014 Preliminary Forecasted Income
Statement
Calculations
Sales
1.10 Sales09 =
Less: Costs ex. depreciation
87.2% Sales10 =
Depre. expenses
10% FA10 =
EBIT
$3,300.0
2,877.6
110.0
$312.4
Interest
0.09(STD09) +
0.11(LTD09) =
EBT
92.8
$219.6
Taxes (40%)
87.8
NI before pref. dividend
$131.8
Pref. dividend
4.0
Net income to com. (50,000,000 shares)
Dividend
2014 Preliminary
$127.8
# of shares
×108%DPS09
Add to RE
$62.5
$65.3*
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2014 Balance Sheet (Assets)
Cash
Calculations
0.33% Sales14 =
2010
$11.0
Accts rec.
12.5%Sales14 =
412.5
Inventories
Total CA
Net FA
Total assets
20.5%Sales14 =
676.5
$1,100.0
1,100.0
$2,200.0
33.3% Sales14 =
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2014 Preliminary Balance Sheet
(Liabilities and Equity)
2009
Calculations
AP
60
2% Sales14 =
Accruals
140
4.67% Sales14 =
$154.0
Nt. pay.
110
Plug technique
224.7
Total CL
Forecast for
2010
$66.0
$444.7
L-t debt
754
Carried over
754.0
Pref. stk
40
Carried over
40.0
Com. stk
130
Carried over
130.0
Ret earn
766
+65.3*
831.3
T. L. & E.
$2,200.0
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What are the Additional Funds
Needed (AFN)?
•
•
•
•
Required assets = $2,200.0
Specified sources of fin. = $2,085.3
Forecast AFN: $2,200 – $2,085.3 = $114.7
NWC must have the assets to make forecasted
sales, and so it needs an equal amount of
financing. So, we must secure another $114.7
of financing.
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Assumptions About How AFN
Will Be Raised
• No new long-term bond, preferred stock, or stock
will be issued.
• Any external funds needed must be raised as
notes payable.
• Additional notes payable = $114.7, giving a
forecasted notes payable for 2014 as
$224.7 = $110 + $114.7.
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2014 Balance Sheet
(Liabilities and Equity)
w/o AFN
AP
Accruals
Notes payable
$66.0
154.0
110.0
AFN
With AFN
+114.7
$66.0
154.0
224.7
Total CL
L-t Debt
Preferred stk
Common stk
$330.0
754.0
40.0
130.0
$444.7
754.0
40.0
130.0
Ret earnings
Total claims
831.3
$2,085.3
831.3
$2,200.0
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Equation AFN = $118.42
vs. Pro Forma AFN = $114.7
• Method using the AFN equation assumes a constant
profit margin
• The pro forma (FFS) method is more flexible.
Importantly, the approach allows different items to
grow at different rates. Use the plug technique to
make sure the balance sheet
is in order.
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Forecasted Ratios
Actual 2013 Forecast 2014
Industry
Current ratio
Inv turnover
DSO (days)
3.2x
4.9x
45.6
2.5x
4.9x
45.6
4.2x
9.0x
36.0
TA turnover
Debt ratio
Profit margin
ROA
ROE
ROIC
1.5x
53.2%
3.8%
5.7%
12.7%
9.5%
1.5x
40.98%
3.9%
5.8%
13.3%
9.5%
1.8x
40.0%
5.0%
9.0%
15.0%
11.4%
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What are the Forecasted Free Cash
Flow and ROIC?
Net operating WC
(CA – AP & accruals)
Total operating capital
(Net op. WC + net FA)
2013
$800.0
2014
$880.0
$1,800.0 $1,980.0
NOPAT (EBITx(1 – T))
Less Inv. in op. capital
$170.3
Free cash flow
ROIC (NOPAT/Capital)
–$174.7
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$187.4
$180.0
$7.4
9.5%
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Proposed Improvements
Tight up credit policy:
Accts. rec./Sales
Control inventory:
Inventory/Sales
Lay off workers:
Op. costs (excluding
depreciation)/Sales
Before
After
12.5%
11.8%
20.5%
16.7%
87.2%
86.0%
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Impact of Improvements
Before
After
45.6
43.1
4.9x
$187.4
6.0x
$211.2
$880.0
$1,980.0
$731.5
$1,831.5
$7.4
$179.7
$114.7
–$57.5
ROIC
9.5%
11.5%
ROE
13.3%
15.4%
DSO (days)
Inventory turnover
NOPAT
Net Op. WC
Tot. Op. capital
Free cash flows
AFN
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Forecasting Financial Requirements When the Balance Sheet
Rations are Subject to Change: Economies of Scale
400
300
Assets

Declining A/S
Ratio
Base
Stock
0
200
400
Sales
$300/$200 = 1.5; $400/$400 = 1.0. Declining ratio shows
economies of scale. Going from S = $0 to S = $200 requires $300
of assets. Next $200 of sales requires only $100 of assets.
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Assets
Lumpy 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.
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If 2013 Fixed Assets Had Been
Operated at 96% of Capacity:
• With the existing fixed assets, sales could be
$3,125 million.
• Target fixed assets/Sales =
Actual fixed assets/Full capital sales =
$1,000/$3,125 = 0.32
• New required fixed assets =
(Target fixed assets/Sales)(Projected sales) =
(0.32)($3,300) = $1,056 million
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How Would the Excess Capacity
Situation Affect the 2014 AFN?
• With full capacity, the previously projected
increase in fixed assets is $100 million.
• The excess capacity makes the actual required
increase be $56 million only, with $44 million
less than before.
• Projected AFN will fall to $70.7 million =
$114.7 million – $44 million.
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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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