Financial MANAGEMENT

CH.17: Financial Planning & Forecasting

Part (6)
 1

Financial Management
(Part 6)
Example
Income Statement
Sales $2,000
- Variable costs (60%) 1,200
- Fixed costs 700
= EBIT (operating profit) 100
- Interest 16
= EBT 84
- Taxes (40%) 33.60
= Net Income 50.40
Dividends (30%) 15.12
Add’n to RE (retained earnings) 35.28

Balance Sheet (2002), in millions of dollars

Assets Liabilities & Equity
Cash & Sec. $20 Accts. Payable & Accruals $100
Accounts rec. 240 Notes Payable 100
Inventories 240 = Total CL $200
Long-term Debt 100
Total CA $500
= Total Liabilities 300

Common Stock 500

Retained Earnings 200
Net FA 500
Total Equity 700
Total Assets $1,000 Total L & E $1,000

Key Ratios
NWC Industry Condition
BEP 10% 20% Poor
Profit Margin 2.52% 4% Poor
ROE 7.20% 15.60% Poor
DSO 43.80 days 32 days Poor
Inv. Turnover 8.33x 11.00x Poor
F.A. turnover 4.00x 5.00x Poor
T.A. turnover 2.00x 2.50x Poor
Debt/assets 30% 36% Good
TIE 6.25x 9.40x Poor
Current Ratio 2.50x 3.00x Poor
Payout Ratio 30% 30% O.K

MR. KH. A. DREAM BOOKSHOP

 2

♣ What we are going to discuss in this part is:

1. Key Assumptions.
2. Determining Additional Funds Needed (AFN)- Using AFN Equation.

1. KEY ASSUMPTIONS.

1. Operating at full capacity in 2002.

2. Each type of assets grows proportionally with sales.

3. Payables and accruals grows proportionally with sales.

4. 2002 profit margin (2.52%) and payout ratio (30%) will be maintained

5. Sales are expected to increase by $500 million (%∆𝑆 = 25%)

2. DETERMINING ADDITIONAL FUNDS NEEDED (AFN)-

USING AFN EQUATION.

MR. KH. A. DREAM BOOKSHOP

 3

AFN = (1,000/2,000) (500) – (100/2000) (500) – 0.0252 (2,500) (0.7)

= 250 – 25 – 44.1 = 180.9 million.

How shall AFN be raised?

● The payout ratio will remain at 30% (d=30% ; RR = 70%)

● No new common stock will be issued.
● Any external funds needed will be raised as debt, 50% from notes payable and
50% from L-T debt.

MR. KH. A. DREAM BOOKSHOP

 4

Forecasted Income Statement

2002 Forecast Basis 2003 (Forecasted)
Sales $2,000 1.25 2,500
- Variable costs 0.60 1,500
1,200
(60%)
- Fixed costs 700 0.35 878
= EBIT (operating profit) 100 125
- Interest 16 16
= EBT 84 109
- Taxes (40%) 33.60 44
= Net Income 50.40 65
Dividends (30%) 15.12 19
Add’n to RE (retained 46
35.28
earnings)

Forecasted Balance Sheet (Assets)

Forecast
2002 2003 (Forecasted
Basis
Cash & Sec. $20 0.01 $25
Accounts rec. 240 0.12 300
Inventories 240 0.12 300

Total CA $500 $625

0.25
Net FA 500 625
Total Assets $1,000 $1,250

Forecasted Balance Sheet (Liabilities and Equity) – 1st pass

2003
Forecast
2002 (Forecasted)
Basis
1st pass
Accts. Payable & Accruals $100 0.05 $125
Notes Payable 100 100
= Total CL $200 225
Long-term Debt 100 100
Common stock 500 500
Retained Earnings 200 +46* 246
Total L & E $1,000 $1,071
* From income statement.

MR. KH. A. DREAM BOOKSHOP

 5

What is the AFN?

→ Required Increase in Assets = 250

→ Spontaneous increase in liabilities = 25
→ Increase in retained earnings = 46
Total AFN = $179

► NWC must have the assets to generate forecasted sales.

► The balance sheet must balance, so we must raise $179 million externally.

How will the AFN be financed?

Additional N/P
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.

Forecasted Balance Sheet (Liabilities and Equity) – 2nd pass

Forecast
2003 1st pass 2003 2nd pass
Basis
Accts. Payable & Accruals $125 - $125
Notes Payable 100 +89.5 190
= Total CL 225 315
Long-term Debt 100 +89.5 189
Common stock 500 500
Retained Earnings 246 246
Total L & E $1,071 $1,250

MR. KH. A. DREAM BOOKSHOP

 6

Why do the AFN equation and financial statement method

have different results?
1. Equation method assumes a constant profit margin, a constant dividend payout,
and a constant capital structure.
2. Financial statement method is more flexible. More important, it allows
different items to grow at different rates.

Forecasted Ratios (2003)

2002 2003 Industry Condition
BEP 10% 10% 20% Poor
Profit Margin 2.52% 2.62% 4% Poor
ROE 7.20% 8.77% 15.60% Poor
DSO 43.80 days 43.80 days 32 days Poor
Inv. Turnover 8.33x 8.33x 11.00x Poor
F.A. turnover 4.00x 4.00x 5.00x Poor
T.A. turnover 2.00x 2.00x 2.50x Poor
Debt/assets 30% 40.34% 36% Good
TIE 6.25x 7.81x 9.40x Poor
Current Ratio 2.50x 1.99x 3.00x Poor
Payout Ratio 30% 30% 30% O.K

How would the following 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?
► Increase AFN: Need more assets for given sales.

Pay suppliers in 60 days, rather than 30 days?

► Decrease AFN: Trade creditors supply more capital (i.e., L*/S0
increases).

MR. KH. A. DREAM BOOKSHOP