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    Chapter 9 PDF

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    Aristoteles Macaraig

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    of 16
    -——- — CHAPTER 9 FINANCIAL FORECASTING FOR STRATEGIC GROWTH INTRODUCTION A lack of effective long-range planning is a commonly cited reason for financial distress and failure. Long-range planning is a means of systematically thinking about the future and anticipating possible problems before they occur. Planning is said to be a process that at best helps the firm avoid stumbling into the future backward. Financial planning establishes guidelines for change and growth in a firm. It focuses on the big picture, which means that it is concerned with the major elements of a firm’s financial and investment policies without dealing with the lual components of those policies in detail WHAT IS FINANCIAL PLANNING? Financial planning formulates the way in which financial goals are to be achieved. ‘A financial plan is thus, a statement of what is to be done in the future. Many decisions have a long lead time which means they take a long time to implement. In an uncertain world, this req jons made far in advance of their implementation. For instance, if a firm wants to build a factory in 2018, it might have to begin lining up contractors and financing in 2016 or even earlier. GROWTH AS FINANCIAL MANAGEMENT GOAL [As discussed in the earlier chapters, the appropriate goal is for the financial manager is increasing the market value of the owners’ equity and not just growth by itself. If the firm is successful in doing this, then growth will usually result. Growth may thus be a desirable consequence of good decision making but it is not an end unto itself. However, while growth rate is used in the planning process, it is considered a convenient means of summarizing various aspects of a firm's financial and investment policies. Likewise, if we think of growth as growth in the market value of the equity in the firm, then goals of growth and increasing the market value of the equity in the firm are not all that different. Financial Forecasting for Strategic Growth _198 pERSPECTIVE OF FINANCIAL PLANNING For planning purposes, itis often useful to think of the future as having a short- ynand a long-run. The short-run planning, in practice, usually covers the coming 12 months while financial planning over the long-run is takes to be the coming two to ive years. This time period is referred to as the planning horizon and this is the fist dimension of the planning process that must be established. The second dimension of the planning process that needs to be determined is the level of aggregation. Ageregaion involves the determination of all of the individual projects together with the- investment required that the firm will undertake and adding up these investment proposals to determine the total needed investment which is treated as one big project. After the planning horizon and level of aggregation are established, a financial plan requires inputs in the form of altemative sets of assumptions about important variables. This type of planning is particularly important for cyclical businesses or business firms whose sales are strongly affected by the overall state of the economy or business cycles. WHAT ARE THE BENEFITS THAT CAN BE DERIVED FROM FINANCIAL PLANNING? Due to the amount spent in examining the different scenarios and variables that will eventually become the basis for a company's financial plan, it seems reasonable to ask what the planning process will accomplish. ‘Among the mote significant benefits of derived from financial planni following. are the 1. Provides a rational way of planning options or alternatives. The financial plan allows the firm to develop, analyze and compare many different business scenarios in an organized and consisted way. Various investrent and financing options can be explored, and their impact on the firm’s shareholders can be evaluated. Questions concerning the firm's future lines of business and optimal financing arrangements are addressed. Options such as introducing new products or closing plants might be evaluated 6 Chapin 9! id Ge 2. Interactions or Linkages between investment proposals are carefully examined, The financial plan enables the proponents to show ‘the between foresee proposals ae different operating activities of the firm and its available financing choices. For example. if the firm is planning on expanding or undertaking new investments and projects, all other relevant variables such as source, terms and timing of financing are thoroughly examined. explicitly the linkages 3. Possible problems related to the proposal projects are identified actions to address them are studied. pent the firm if diferent Financial pl i may hay il planning shoud identify what may happen il events take place. Specifically, it should address WI zs take if expectations do not materialize and more generally. if assumptions made today about the future are seriously in error. Thus, one objective of financial planning is to avoid surprises and develop contingency plans. 4, Feasibility and internal consistency are ensured. Financial planning is a way of verifying that the goals and plans made for specific areas ofa firm's operations are feasible and internally consistent. The financial plan makes explicit the linkages between different aspects of a firm's business such as the market share, return on equity, financial leverages, and so on. It also imposes a unified structure for reconciling goals and objectives 5. Managers are forced to think about goals and establish priorities. ‘Through financial planning, directions that the firm would take are established, risks are calculated and educated alternative courses of action are considered thoroughly. ——_—_—_____ Financial Forecas cial Forecasting for Strategic Growth 197 FINANCIAL PLANNING MODELS Financial planing process will differ from firm to firm, just as companies differ i sae ad procs, However, a basic financial planning model will have the following common elements; (a) economic environment assumptions, (b) sales forecast, (¢) pro forma statements, (d) asst i 7 . et requirements, (e) financial requirement, and (f) additional funds needed. winereay A |. Economic Environment Assumption. The plan will have to state exnlicitly the economic environment in which the fim expects to reside ‘over the life of the plan. Among the more important economic assumption that will have to be made are the inflation rates, level of interest rates and the firm’s tax rate. Sales Forecast. An extemally supplied sales forecast considered the driver” shall be the “heart” of all financial plans. The user of the planning model will supply this value and most other values will be calculated based on it. Planning will focus on projected future sales and the assets and financing needed to support those sales. Oftentimes, the sales forecast will be given as the growth rate in sales rather than as an explicit sales figure. Perfect sales forecast are not possible, of course, because sales depend on the uncertain future state of the economy. To come up with its projections, firms could consult with some businesses which specialize in macroeconomic and industry projections. Also, evaluating alternative scenarios does not require sales forecast to be very accurate because the financial planner's goal is to examine the interplay between investment and financing needs at different possible sales level, not to pinpoint what we expect to happen, Determinants of Growth Rates A firm’s ability to sustain growth depends explicitly on the following factors: © Profit Margin. An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth. 10 Chapnes 9 ge of net income paid tio. This increases tainable growth. © Dividend Policy. A decrease in the percentas ‘out as dividends will increase the retention Ta! internally generated equity and thus increases $4 © Financial Policy, An increase in the debt-equity a eres sos fien's Franchi verge anaes wa TOE ASO financing available, it increases the sustainable grow! 4 onal Asvet Furnover An increas the fits coal asset rumover increases the. sales generated for each peso Sh ie irre the Firms need fr ew assets as sles BFP ST) ereby increases the sustainable growth rate. Notice that total asset is the same thing as decreasing capital intensity. tumove useful planning number. list relationship between the firm’s (a) its operating efficiency as se efficiency as measured olicy as measured by the icy as measured by the The sustainable growth rate is a very What it illustrates is the exp! four major areas of concern: measured by profit margin, (b) its asset us by total asset tumover, (c) its dividend p retention ratio, and (d) its financial pol debt-equity ratio. 3. Pro forma Statements. A financial plan will have a forecast sigiement of statement of cash flows and income statement, | These are called pro forma or projected the different events projected for the statements which future. 4. Asset Requirements. The financial plan will describe projected capital Spending, Ata minimum, the projected statement of financial position will Contain changes in total fixed assets and net working capital. These changes are effectively the firm’s total capital budget. Proposed capital spending in different areas must thus be reconciled with the overall increases contained in the long-range plan. Financial Requirements. The financial plan will include a section about the necessary financing arrangements. This part of the plan should discuss dividend policy and debt policy. Sometimes firms will expect to raise cash by selling new shares of stock or by borrowing. In this case, the plan will have to consider what kinds of securities have to be sold and what methods of issuance are most appropriate. r= a Ba Flat rors Strategic Growth _199 6, Additional Funds Needed (AFN). Aficr the firm has a sales forecast and fan estimate of the required spending on assets, some amount of new financing will often be necessary becauise projected total assets will exceed projected total liabilities and equity. In other words, the statement of financial position will no longer balance. Because new financing may be necessary to cover all of the projected capital spending, a financial “plug” variable must be selected. The plug is the designated source(s) of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the statement of financial position into balance. For example, a firm with a great number of investment opportunitits and limited cash flow may have to raise new equity. Other firms with few growth opportunities and ample cash flow will have « surplus and thus might pay an extra dividend. Inthe first case, external equity isthe plug variable; and the second, the dividend is used. FINANCIAL PLANNING PROCESS Well rin companies generally base their operating plans on a set of forecasted Tiancial statements, The planning process begins with a sales forecast for the Ney five or so years. Then the assets required to meet the sales targets are determined, IN decision is made conceming how to finance the required assets, At that point income statements and statements of financial position ean be projected, and tamings per share, as well as the key ratios ean be forecasted. Once the “base-case” forecasted statements and ratios have been prepared, top managers will ask questions such as: ‘we can realistically expect, and if not, 1 plans to produce better earnings and ‘¢ Are the forecasted results as good how might we change our oper a higher stock price? «How sure are we that we will be able to achieve the projected results? For example, if our base-case forecast assumes a reasonably strone Scone fat @ recession occurs, would we be better off under an altemative operating plan? 200 Cinyter # LN THe PROJECTED FINANCIAL STATEMENT METHOD any ferevont fant equines involves (#) determining how much mon ny forint 1 ang given prio. () determining how much mong SE ned a ving te ane period, and () subtracting the aa ane i _ ‘the funds required 10 determine the external financial requirements wvorated fr iat statement method is straightforward, one simply projects re mning poriod. then projects the liabilities and equity normal operations, and subtracts the projected vrasets to estimate the additional funds needed The projected finan the avwet requirements for the that will bo genernted under Fiabilities/eapital from the required (AEN) The steps in the procedures are as follows Foreeust the Income Statement, stablish a sales projection. Prepare the production schedule and project the corresponding Nuction costs; direct materials, direct labor and overhead. ing and administrative expenses. ‘any. Step 1. e a prod c. Estimate sel Consider financial expenses, ¢. Determine the net profit. Forecast the Statement of Financial Position. Step 2. a. Project the assets that will be needed to support projected sales. bb Project funds that will be spontaneously generated (through accounts payable and accruals) and by retained earnings. i c. Project liability and stockholders’ equity accounts that will not ey rise spontaneously with sales (¢.g., notes payable, long-term = bonds, preferred stock and common stock) but may change due to financing decisions that will be made later. 4d, Determine if additional funds will be needed by using the following formula. ‘Additional Required Spontaneous _ Increase in Funds Needed = Increase - Increasein — Retained in Assets Liabilities Earnings ‘The additional financing needed will be raised by borrowing from the bank as notes payable, by issuing long-term bonds, by selling, new common stock or by some combination of these actions. a Financial Forecasting for Strategic Growth 201 Step 3. Raising the additional funds needed. ‘The financing decision will consider the following factors: a, Target capital structure; b. Effect of short-term borrowing on its current ratio; c. Conditions in the debt and equity markets; or 4d. Restrictions imposed by existing debt agreements. Step 4. Consider financing feedbacks. Depending on whether additional funds will be borrowed or will be raised through common stocks. consideration should be given on additional interest expense in the income statement or dividends, thus decreasing the retained earnings. Apply the iteration process using the available financing mix until the ‘AFN would become so small that the forecast can be considered complete Illustrative Case 9-1. Fina Forecasting (Percent of Sales Method) ‘The Millennium Company has the following statements which are representative of the company’s historical average. Income Statement Sales 2,000,000 Cost of sales 4,200,000 Gross profit 800,000 Operating expenses 380,000 Earnings before interest and taxes 420,000 Interest expense 79,000 Eamings before taxes 360,000 Taxes (35%) 122,500 Eamings after taxes 2.227.500 Dividends 196.500 — 2Bryur alee ie — Statement of Financial Postion Assets P 50,000 Cash ca Accounts recehvable i Inventory Pian Current assets 600,000 Fed assets (net 7000.00 Total assets. Uabiities and Equily p 250,000 heen ints payable 10,000 red wages 20,000 Accrued taxes 280,000 Current fiabiliies 70,000 Noles payable —bank 450,000 ‘Long-term debt 4,200,000 Ordinary shares "300,000 Retained earings 000.000 Total abitties and equity ear, and management is ‘The increase in sales is sets, but rather through liabilities, only current The firm is expecting a 20 percent increase in sales neXt Y concerned about the company’s need for external funds. expected to be carried out without any expansion of fixed as more efficient asset utilization in the existing store. Among liabilities vary directly with sales. Using the percent-of-sales method, determine whether the company has external financing needs ora surplus of funds. Solution: Step 1. Forecast the Income Statement. ‘The projected income statement will show the following: ‘Sales 2,400,000 Cost of sales 1,440,000 Gross prot 960,000 Operating expenses 456,000 Earnings before interest and taxes 504,000 Interest expense — 10.000 | Earnings before taxes 434,000 Taxes (35%) x 151,900 Earnings afer taxes 202.100 Dividends (36% payment) P_101,600 Financial Forecasting for Strategic Growth 203 Step 2. Forecast the Statement of Financial Position The projected statement of financial position will show the following: Assets Cash () P 60,000 ‘Accounts receivable Q 480,000 tnventory @) 900,000 Total current assets ,000 Fixed assets (net) O) 800,000 Total assets 2,240,000 Liabilities and Equity ‘Accounts payable 6) 300,000 Accrued wages 6) 42,000 Accrued taxes a 24,000 Current liabiities ® 336,000 Notes payable - bank 4) 70,000 Long-term debt (4) 160,000 Ordinary shares (4) 1,200,000 Retained eamings (8) 480,500 Total 2,236,500 ‘Additional financing required 3.500 * Total _— P2280,000 Supporting computations: (1) Cash = 2.5% x 2.4M sales (2) Accounts receivable = 20% of P2.4M (3) Inventory = 37.5% x P2.4M (A) No percentages are computed for fixed assets, notes payable, long- term debt, ordinary shares and retained earnings because they are not assumed to maintain a direct relationship with sales volume. For simplicity, depreciation is not explicitly considered (5) Accounts payable = 12.5% of P2.4M (6) Accrued expenses = 0.5% of P2.4M (7) Accrued taxes = 1% of P2.4M (8) Retained earnings = P300,000 + P282,100 - P101,600 —" 8. 4a” eo 200k: pt Sg gk pe ee Formula Method puted as follows: * Additional financing needed (AFN) may alse be comt Increase in us Additional Required Spontaneei® __ retained funds = increase - NE earnings needed inassets — in lial where: it) Required Current Assets (present increase = Change x Sales (present) in assets a Spontaneous Current Liabilities (present) increase = . Change x Sales (present) in liabilities, ae Increase Dividend Eamings inretained = a it canker after taxes pay" Applied to Millennium Co., AFN is computed as follows: 4,200,000 280,000 _} _ 282,100 - 101,600 AFN { 400,000 x = 5004 | 2 (sco. x 900,000 = 240,000 66,000 -180,500 = P3500 Financial Forecasting for Strategic Growth _ 205 Illustrative Case 9-2, Projected Financial Statements with Financing, Feedback For Tamarind Company, the following data have been made available: Tamarind Company Income Statement ‘Year 20x4 (Thousands of Pesos) Sales ‘Operating coss (inclusive of 200 depreciation) Eamings before interest and taxes Less intrest expense Ezmings before taxes Taxes (40%) Netincome before preference dividend Dividends to preference Net income avaliable to ordinary Dividends to ordinary ‘Addon to retained earings ‘Tamasind Company ‘Statement of Financia Poston December 31, 20%4 (Thousands of Pesos) Assets Cesh Accounts receivable Inventories Total curent assets Net pant and equipment Total Assets Liabites and Equity ‘Accounts payable Notes payable Aootuals Total curent iabities Long-term bonds Tota ibis Preference shares Ordinary shares (50,000 shares) Retained earings Total Equity Total Lables end Equity 5,000 176 392 46r 235 ER. 7 8 bea EGke: Eeebss BE aa Nia Ohypoter Ashliiional information follows: 1. HHistorival sates for the last five years (In Thousand Pesos). Yoar Sales 20x0 4,116 20X1 5,066 20K2 4,94 20x3 5,700 20xA 6,000 20X5 6,600 (projected") 2. Assets and spontaneous liabilities will increase by 10%. 3. Ordinary shares outstanding, 50,000, 4, Ordinary share dividends are projected at 2.50 per share. 5 ct value per share at the end of 20X2 is P46.67. REOUIRED: 1. Construct the pro forma financial statements using the projected financial ‘statement method. How much additional capital will be required? Assume the firm operated at full eapacity in year 20X4. Do not include financing feedback. Solution: Based on the data and assumptions given, the following projections are made and the additional financing needed determined. Figure 9-1. Projected Income Statement (First Pass) (Thousands of Pesos) ae z0xsFercest Cs Acid Bast Fis Pass ; ‘6,000 peratng costs (ncusve of F200 nd roa eecatn) 5k Eamings before interest and taxes pte S95 568 x 110% 65 Lessinerest pense before aes a i Taxes (0%) i 49 Net income before preference Pree 1 Ont een BF m= Neinome aval oray aw =f Peed okies 116 Pal Addition to reiined earings ' 28 t Financial Forecasting for Strategic Growth 207 f Figere 2. | Projected Statement of Financial Poston (Fst Pass) (Thousands of Pesos) 20x4 20X5 Forest ‘Actual a Fist Pass Cosh | Pa x 110% PB } et receivable 780 x 10% 5 rectet Zo x 110% 1353 carent assets 200 Po20 Net pant and equipment 2000 x 110% 2.200 Ta Asses som aa abies and Equity j ‘Accounts payable P 120 x 110% Pw | Notes payable 2m 2 : poral 230 4 Toll rent bites Pea og Fe0 i Longs bonds 1508 ne “ota lites Pais . Pete : Prelerence Shares Pp 8 fo j ‘Ordinary shares (0,000 shares) 280 ses i Retined earings 152 +1% ae Total Equity Pisa PATE | ‘Total Lisblitves and Equity ‘pa.00 ; ‘Additional funds needed (AFN) baz | Cumulative AFN, Bae Discussion: Figure 15-1 shows Tamarind’s actual 20X4 and forecasted 20X5_ income ‘Statement. For year 20XS earnings before interest and taxes are projected at £P625,000 and earnings after taxes of P269,000. Dividends to preference shares and ordinary shares are projected at P8,000 and P125,000, respectively Figure 15-2 contains Tamarind’s 20X4 actual and its projected 20X5 statements of financial position. Total assets are projected at P4,400,000 while the forecasted liability and equity accounts total to only P4,176,000. Since the resources or assets required to support the higher sales level exceed the vailable sources, it means that additional funds wil have to be obtained. The ‘APN of 224,000 will be raised by borrowing from the bank as notes payable or by issuing long-term bonds or by selling new ordinary shares, oF by some combination of these actions. ~

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