Financial Planning and Forecasting

Financial Statements

1
Topics in Chapter

 Financial planning
 Additional Funds Needed (AFN) formula
 Forecasted financial statements
 Sales forecasts
 Percent of sales method

2
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

3
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

4
Our approach will be iterative
 Lets look at the process first without the
“heavy” assumptions
 Revisit the whole process with
assumptions
 Build actual models used in the
workplace

5
Financial Planning and
Forecasting process without
the “heavy” assumptions
 Remember we need to …
 Forecasting sales
 Projecting the assets and internally
generated funds
 Projecting outside funds needed
 Deciding how to raise funds
 Balance sheet (2002),
in millions of dollars

Accts. pay. &

Cash & sec. $ 20 accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stock 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000
Income statement (2002),
in millions of dollars
Sales $2,000.00
Less: Var. costs (60%) 1,200.00
Fixed costs 700.00
EBIT $ 100.00
Interest 16.00
EBT $ 84.00
Taxes (40%) 33.60
Net income $ 50.40
Dividends (30%) $15.12
Add’n to RE $35.28
Key assumptions
 Operating at full capacity in 2002.
 Each type of asset grows proportionally with
sales.
 Payables and accruals grow proportionally
with sales.
 2002 profit margin (2.52%) and payout
(30%) will be maintained.
 Sales are expected to increase by $500
million. (%S = 25%)
How shall AFN be raised?
 The payout ratio will remain at 30 percent
(d = 30%; RR = 70%).
 No new common stock will be issued.
 Any external funds needed will be raised as
debt, 50% notes payable and 50% L-T
debt.
 Forecasted Income Statement (2003)
Forecast 2003
2002 Basis Forecast
Sales $2,000 1.25 $2,500
Less: VC 1,200 0.60 1,500
FC 700 0.35 875
EBIT $ 100 $ 125
Interest 16 16
EBT $ 84 $ 109
Taxes (40%) 34 44
Net income $ 50 $ 65
Div. (30%) $15 $19
Add’n to RE $35 $46
 Forecasted Balance Sheet (2003)
Assets
Forecast 2003
2002 Basis 1st Pass
Cash $ 20 0.01 $ 25
Accts. rec. 240 0.12 300
Inventories 240 0.12 300
Total CA $ 500 $ 625
Net FA 500 0.25 625
Total assets $1,000 $1,250
 Forecasted Balance Sheet (2003)
Liabilities and Equity
Forecast 2003
2002 Basis 1st Pass
AP/accruals $ 100 0.05 $ 125
Notes payable 100 100
Total CL $ 200 $ 225
L-T debt 100 100
Common stk. 500 500
Ret.earnings 200 +46* 246
Total claims $1,000 $1,071
* From income statement.
What is the additional
financing needed (AFN)?
 Required increase in assets = $ 250
 Spontaneous increase in liab. = $ 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 (2003)
Assets – 2nd pass
2003 2003
1st Pass AFN 2nd Pass
Cash $ 25 - $ 25
Accts. rec. 300 - 300
Inventories 300 - 300
Total CA $ 625 $ 625
Net FA 625 - 625
Total assets $1,250 $1,250
 Forecasted Balance Sheet (2003)
Liabilities and Equity – 2nd pass
2003 2003
1st Pass AFN 2nd Pass
AP/accruals $ 125 - $ 125
Notes payable 100 +89.5 190
Total CL $ 225 $ 315
L-T debt 100 +89.5 189
Common stk. 500 - 500
Ret.earnings 246 - 246
Total claims $1,071 $1,250
* From income statement.
Now to our iterations
 Bringing in more assumptions…

18
Sales Forecast

Annual
Sales Growth Rate Ln(Sales)
2005 $2,058 7.63
2006 2,534 23.1% 7.84
2007 2,472 -2.4% 7.81
2008 2,850 15.3% 7.96
2009 3,000 5.3% 8.01
Average = 10.3%

19
Figure 9.1

20
Balance Sheets
BALANCE SHEET
(in millions of dollars)
2008 2009
Assets
Cash $15.0 $10.0
ST Investments $65.0 $0.0
Accounts receivable $315.0 $375.0
Inventories $415.0 $615.0
Total current assets $810.0 $1,000.0
Net plant and equipment $870.0 $1,000.0
Total assets $1,680.0 $2,000.0

2008 2009
Liabilities and equity
Accounts payable $30.0 $60.0
Accruals $130.0 $140.0
Notes payable $60.0 $110.0
Total current liabilities $220.0 $310.0
Long-term bonds $580.0 $754.0
Total liabilities $800.0 $1,064.0
Preferred stock $40.0 $40.0
Common stock $130.0 $130.0
Retained earnings $710.0 $766.0
Total common equity $840.0 $896.0
Total liabilities and equity $1,680.0 $2,000.0
21
Income Statement
INCOME STATEMENT
(in millions of dollars) 2008 2009

Sales $2,850.0 $3,000.0

Costs except depreciation $2,497.0 $2,616.2
Depreciation $90.0 $100.0
Total operating costs $2,587.0 $2,716.2
EBIT $263.0 $283.8
Less Interest $60.0 $88.0
Earnings before taxes (EBT) $203.0 $195.8
Taxes (40%) $81.2 $78.3
NI before preferred dividends $121.8 $117.5
Preferred dividends $4.0 $4.0
NI available to common $117.8 $113.5

Dividends to common $53.0 $57.5

Add. to retained earnings (DRE) $64.8 $56.0

Shares of common equity 50 50

Dividends per share $1.06 $1.15
Price per share $26.00 $23.00

22
AFN (Additional Funds Needed)
Formula: Key Assumptions
 Operating at full capacity in 2009.
 Each type of asset grows proportionally with
sales.
 Payables and accruals grow proportionally
with sales.
 2009 profit margin ($113.5/$3,000 = 3.78%)
and payout (49.3%) will be maintained.
 Sales are expected to increase by 10%.

23
The AFN Formula
If ratios are expected to remain constant:

AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)

Required  Assets  Retained

Earnings
Spontaneously 
Liabilities

24
Variables in the AFN Formula
 A* = Assets tied directly to sales
 S0 = Last year’s sales
 S1 = Next year’s projected sales
 ∆S = Increase in sales; (S1-S0)
 L* = Liabilities that spontaneously
increase with sales

25
Variables in the AFN Formula
 A*/S0: assets required to support sales;
“Capital Intensity Ratio”
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
 RR: retention ratio; percent of net
income not paid as dividend

26
Key Factors in AFN
 ∆S = Sales Growth
 A*/S0 = Capital Intensity Ratio
 L*/S0 = Spontaneous Liability Ratio
 M = Profit Margin
 RR = Retention Ratio

27
 Microdrive: Key AFN Factors
 ∆S = $3,300 – 3,000 = $300 m
 A*/S0 = $2,000/$3,000 = 0.6667
 L*/S0 = ($60+140)/$3,000 = 0.0667
 M = $113.5/$3,000 = 0.0378
 RR = $56/$113.5 = 0.493

28
 L*/S0 = ($60+140)/$3,000 = 0.0667
RR = $56/$113.5 = 0.493
BALANCE SHEET
(in millions of dollars)
INCOME STATEMENT 2009
(in millions of dollars) 2009 Assets
Cash $10.0
Sales $3,000.0 ST Investments $0.0
Costs except depreciation $2,616.2 Accounts receivable $375.0
Depreciation $100.0 Inventories $615.0
Total operating costs $2,716.2 Total current assets $1,000.0
EBIT $283.8 Net plant and equipment $1,000.0
Less Interest $88.0 Total assets $2,000.0
Earnings before taxes (EBT) $195.8
Taxes (40%) $78.3 2009
NI before preferred dividends $117.5 Liabilities and equity
Preferred dividends $4.0 Accounts payable $60.0
NI available to common $113.5 Accruals $140.0
Notes payable $110.0
Dividends to common $57.5 Total current liabilities $310.0
Add. to retained earnings (DRE) $56.0 Long-term bonds $754.0
Total liabilities $1,064.0
Preferred stock $40.0
Common stock $130.0
RR=Retention Ratio Retained earnings
Total common equity
$766.0
$896.0
Total liabilities and equity $2,000.0

L* = Spontaneous Liabilities29
 The AFN Formula
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)

AFN = 0.667($300)
- 0.067($300)
- 0.0378($3,300)(0.493)

AFN = $118.42 million*

30
Affect on AFN
 Higher sales:
 Increases asset requirements  AFN
 Higher dividend payout ratio:
 Reduces funds available internally  AFN
 Higher profit margin:
 Increases funds available internally  AFN
 Higher capital intensity ratio, A*/S0:
 Increases asset requirements  AFN
 Pay suppliers sooner:
 Decreases spontaneous liabilities  AFN
31
Forecasted Financial
Statements Method
 Project sales based on forecasted
growth rate in sales
 Forecast some items as a % of the
forecasted sales
 Costs
 Cash
 Accounts receivable
(More...)
32
Forecasted Financial
Statements Method
 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

33
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

34
Forecasting Interest Expense
 Interest expense is actually based on
the daily balance of debt during the
year.
 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

35
Basing Interest Expense on
End-of-Year Debt
 Over-estimates 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.
36
Basing Interest Expense on
Beginning-of-Year Debt
 Under-estimates interest expense if
debt is added throughout the year
instead of all on December 31.
 Doesn’t cause problem of circularity.

37
Basing Interest Expense on Average
of Beginning and Ending Debt
 Will accurately estimate the interest
payments if debt is added smoothly
throughout the year.
 Creates circularity problem

38
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

39
 Percent of Sales: Inputs
Pro Forma Ratios Actual Historical Industry
2008 2009 Average Composite

Costs / Sales 87.6% 87.2% 87.4% 87.1%

Depreciation / Net plant & equip. 10.3% 10.0% 10.2% 10.2%
Cash / Sales 0.5% 0.3% 0.4% 1.0%
Accounts Rec. / Sales 11.1% 12.5% 11.8% 10.0%
Inventory / Sales 14.6% 20.5% 17.5% 11.1%
Net plant & equip. / sales 30.5% 33.3% 31.9% 33.3%
Accounts Pay. / Sales 1.1% 2.0% 1.5% 1.0%
Accruals / Sales 4.6% 4.7% 4.6% 2.0%

Table 9.1

40
 Other Inputs
Other Inputs

Sales Growth Rate 10%

Tax rate 40%
Dividend growth rate 8%
Interest rate on notes payable and short-term investments 9%
Interest rate on long-term bonds 11%
Coupon rate on preferred stock 10%

41
 2010 First-Pass Forecasted
Income Statement (Table 9.2)
Table 9-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
1. Sales $ 3,000.0 110% x 2009 Sales = $ 3,300.0
2. Costs except depreciation 2,616.2 87.2% x 2010 Sales = $ 2,877.6
3. Depreciation 100.0 10% x 2010 Net plant = $ 110.0
4. Total operating costs $ 2,716.2 $ 2,987.6
5. EBIT $ 283.8 $ 312.4
6. Less Interest 88.0 Interest rate x 2009 debt = $ 92.8
7. Earnings before taxes (EBT) $ 195.8 $ 219.6
8. Taxes (40%) 78.3 $ 87.8
9. NI before preferred dividends $ 117.5 $ 131.8
10. Preferred dividends 4.0 Dividend rate x 2009 preferred = $ 4.0
11. NI available to common $ 113.5 $ 127.8

12. Shares of common equity 50.0 $ 50.0

13. Dividends per share $ 1.15 108% x 2009 DPS = $ 1.25
14. Dividends to common $ 57.5 2010 DPS x # shares = $ 62.5
15. Additions to retained earnings $ 56.0 $ 65.3

42
Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
Assets
1. Cash $ 10.0 0.33% x 2010 Sales = $ 11.0
2. ST investments 0.0 Previous plus "plug" if needed 0.0
3. Accounts receivable 375.0 12.50% x 2010 Sales = 412.5
4. Inventories 615.0 20.50% x 2010 Sales = 676.5
5. Total current assets $ 1,000.0 $ 1,100.0
6. Net plant and equipment 1,000.0 33.33% x 2010 Sales = 1,100.0
7. Total assets $ 2,000.0 $ 2,200.0

Liabilities and equity

8. Accounts payable $ 60.0 2.00% x 2010 Sales = $ 66.0
9. Accruals 140.0 4.67% x 2010 Sales = 154.0
10. Notes payable 110.0 Previous plus "plug" if needed 224.7
11. Total current liabilities $ 310.0 $ 444.7
12. Long-term bonds 754.0 Same: no new issue 754.0
13. Total liabilities $ 1,064.0 $ 1,198.7
14. Preferred stock 40.0 Same: no new issue 40.0
15. Common stock 130.0 Same: no new issue 130.0
16. Retained earnings 766.0 2009 RE + 2010 Add. to RE = 831.3
17. Total common equity $ 896.0 $ 961.3
18. Total liabilities and equity $ 2,000.0 $ 2,200.0

a
19. Required assets $ 2,200.0
b
20. Specified sources of financing $ 2,085.3
21. Additional funds needed (AFN) $ 114.7

22. Required additional notes payable $ 114.7

23. Additional short-term investments 0.0

43
Sources of Financing
Specified Sources of Financing

Accounts payable $ 66.0

Accruals $ 154.0
Notes payable (carryover) $ 110.0
Long-term bonds $ 754.0
Preferred stock $ 40.0
Common stock $ 130.0
Retained earnngs $ 831.3
$ 2,085.3

44
Implications of AFN
 If AFN is positive, additional financing
required
 If AFN is negative, surplus funds
available
 Pay off debt
 Buy back stock
 Buy short-term investments

45
Additional Funds Needed
 AFN = Required – Available
 If AFN >0, then  Notes Payable
 Acquire needed funds through short term
borrowing
 If AFN <0, then  Short term
investments
 Park excess funds in short term investments

46
What are the additional funds
needed (AFN)?
 Required assets = $2,200.0
 Specified sources of fin. = $2,085.3
 Forecast AFN: $114.7
 MicroDrive 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.

47
 Financial Policy Decisions
1. Mature firms rarely issue common stock.
2. Dividends tend to increase at a fairly steady
rate
3. Preferred stock rarely used
4. Issuing long-term debt (bonds) is a major
event
5. Most firms use short-term bank loans as
financial “shock absorbers.”

48
Assumptions about how
MicroDrive will raise AFN
 No new common stock will be
issued.
 Any external funds needed will be
raised as short-term debt (notes
payable).

49
Table 9-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Doll
Actual Forecast
2009 2010
(1) (3)
Assets
1. Cash $ 10.0 $ 11.0
2. ST investments 0.0 0.0
3. Accounts receivable 375.0 412.5
4. Inventories 615.0 676.5
5. Total current assets $ 1,000.0 $ 1,100.0
6. Net plant and equipment 1,000.0 1,100.0
7. Total assets $ 2,000.0 $ 2,200.0

Liabilities and equity

8. Accounts payable $ 60.0 $ 66.0
9. Accruals 140.0 154.0
10. Notes payable 110.0 224.7
11. Total current liabilities $ 310.0 $ 444.7
12. Long-term bonds 754.0 754.0
13. Total liabilities $ 1,064.0 $ 1,198.7
14. Preferred stock 40.0 40.0
15. Common stock 130.0 130.0
16. Retained earnings 766.0 831.3
17. Total common equity $ 896.0 $ 961.3
18. Total liabilities and equity $ 2,000.0 $ 2,200.0 50
Equation AFN = $118.42 vs.
Pro Forma AFN = $114.7
 Equation method assumes a constant
profit margin.
 Pro forma method is more flexible.
More important, it allows different
items to grow at different rates.

51
 Forecasted Ratios
Actual Forecast
2009 2010
(1) (2)
Ratio Analysis
Current ratio 3.2 2.5
Inventory turnover 4.9 4.9
Days sales outstanding 45.6 45.6
Total assets turnover 1.5 1.5
Debt ratio 53.2% 54.5%
Profit margin PM 3.8% 3.9%
Return on assets ROA 5.7% 5.8%
Return on equity ROE 12.7% 13.3%
Return on invested capital ROIC 9.5% 9.5%

52
Planned Changes
1. Lower operating costs to 86% of sales
• Layoff workers and close operations
2. Reduce accounts receivables to sales
to 11.8%
• Screen credit more closely
• More aggressive collections
3. Reduce inventory to sales to 16.7%
• Tighter inventory control

53
 Revised 2010 Income
Statement Forecast
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
1. Sales $ 3,000.0 110% x 2009 Sales = $ 3,300.0
2. Costs except depreciation 2,616.2 86.0% x 2010 Sales = $ 2,838.0
3. Depreciation 100.0 10% x 2010 Net plant =$ 110.0
4. Total operating costs $ 2,716.2 $ 2,948.0
5. EBIT $ 283.8 $ 352.0
6. Less Interest 88.0 Interest rate x 2009 debt = $ 92.8
7. Earnings before taxes (EBT) $ 195.8 $ 259.2
8. Taxes (40%) 78.3 $ 103.7
9. NI before preferred dividends $ 117.5 $ 155.5
10. Preferred dividends 4.0 Dividend rate x 2009 preferred = $ 4.0
11. NI available to common $ 113.5 $ 151.5

12. Shares of common equity 50.0 $ 50.0

13. Dividends per share $ 1.15 108% x 2009 DPS = $ 1.25
14. Dividends to common $ 57.5 2010 DPS x # shares = $ 62.5
15. Additions to retained earnings $ 56.0 $ 89.0

54
Revised 2010 Balance Sheet Forecast
Actual Forecast
2009 Forecast basis 2010
(1) (2) (3)
Assets
1. Cash $ 10.0 0.33% x 2010 Sales = $ 11.0
2. ST investments 0.0 Previous plus "plug" if needed 57.5
3. Accounts receivable 375.0 11.80% x 2010 Sales = 389.4
4. Inventories 615.0 16.70% x 2010 Sales = 551.1
5. Total current assets $ 1,000.0 $ 1,009.0
6. Net plant and equipment 1,000.0 33.33% x 2010 Sales = 1,100.0
7. Total assets $ 2,000.0 $ 2,109.0

Liabilities and equity

8. Accounts payable $ 60.0 2.00% x 2010 Sales = $ 66.0
9. Accruals 140.0 4.67% x 2010 Sales = 154.0
10. Notes payable 110.0 Previous plus "plug" if needed 110.0
11. Total current liabilities $ 310.0 $ 330.0
12. Long-term bonds 754.0 Same: no new issue 754.0
13. Total liabilities $ 1,064.0 $ 1,084.0
14. Preferred stock 40.0 Same: no new issue 40.0
15. Common stock 130.0 Same: no new issue 130.0
16. Retained earnings 766.0 2009 RE + 2010 Add. to RE = 855.0
17. Total common equity $ 896.0 $ 985.0
18. Total liabilities and equity $ 2,000.0 $ 2,109.0

a
19. Required assets $ 2,051.5
b
20. Specified sources of financing $ 2,109.0
21. Additional funds needed (AFN) $ (57.5)

22. Required additional notes payable $ -

23. Additional short-term investments 57.5
55
 Impact of Improvements
Preliminary Revised Industry
Actual Forecast Forecast Average
2009 2010 2010 2009
(1) (2) (3) (4)
Ratio Analysis
Current ratio 3.2 2.5 3.1 4.2
Inventory turnover 4.9 4.9 6.0 9.0
Days sales outstanding 45.6 45.6 43.1 36.0
Total assets turnover 1.5 1.5 1.6 1.8
Debt ratio 53.2% 54.5% 51.4% 40.0%
Profit margin PM 3.8% 3.9% 4.6% 5.0%
Return on assets ROA 5.7% 5.8% 7.2% 9.0%
Return on equity ROE 12.7% 13.3% 15.4% 15.0%
Return on invested capital ROIC 9.5% 9.5% 11.5% 11.4%

56
 Economies of Scale

1,100
1,000


Declining A/S Ratio
Assets

Base
Stock

Sales
0 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. 57
 Lumpy Assets

1,500
Assets

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. 58
If 2009 fixed assets had been
operated at 96% of capacity:
Actual sales
Capacity sales =
% of capacity
$3,000
= = $3,125
0.96

With the existing fixed assets, sales

could be $3,125. Since sales are
forecasted at $3,300 less new fixed
assets are needed.
59
Excess Capacity Adjustment
 Full capacity sales = $3,125 million
 Target FA/Sales:
 Actual FA/Full Capacity Sales
 $1,000/$3,125 = 32%
 Required FA:
 Target FA% x Projected Sales
 32% * $3,300 = $1,056 million

60
How would the excess capacity
situation affect the 2010 AFN?
 The previously projected increase in fixed
assets was $100 million.
 From $1,000 to $1,100 million
 With excess capacity, only $56 million is
required, $44 million less.
 Since less fixed assets will be needed, AFN
will fall by $44 million, to:

$118 - $44 = $74 million

61
Summary: How different factors
affect the AFN forecast.
 Economies of scale: leads to less-than-
proportional asset increases.
 Lumpy assets: leads to large periodic
AFN requirements, recurring excess
capacity.
 Excess capacity: lowers AFN

62