4-1

FINANCIAL PLANNING
AND CONTROL
 Sales forecasts
 Projected financial statements –
Additional Funds Needed
– Also called External Funds Needed (EFN)
 Financial control
 Hypothetical Data for Northwest
Chemical Company
 4-2

Financial Planning and Control

Financial Planning
The projection of sales, income, and assets
based on alternative production and marketing
strategies, as well as the determination of the
resources needed to achieve these projections.
Forecasting also is important for production
planning and human resource planning.

Financial Control
The phase in which financial plans are
implemented; control deals with the feedback and
adjustment process required to ensure adherence
to plans and modification of plans because of
unforeseen changes.
 4-3
Financial Planning:
• Growth is a key theme behind financial
forecasting. Remember that growth should not be
the underlying goal of a corporation – creating
shareholder value is the appropriate goal. In
many cases, however, shareholder value creation
is enabled through corporate growth.
• The sales forecast predicts a firm’s unit and dollar
sales for some future period; generally based on
recent sales trends plus forecasts of the
economic prospects for the nation, region,
industry, etc.
• We want to determine if we need external funds –
 4-4

Percentage of Sales Method

1. Projected Balance sheet forecasting of AFN
2. Increased sales requires increased assets that must be
financed. We will discuss the strategy for forecasting
assets.
3. Increased sales automatically increases spontaneous
liabilities.
4. Some financing will come from retained earnings.
Depending on the information, we formulate a strategy
for determining RE.
5. If additional funds are needed we have to choose to
finance with external funds -- debt or stock.
6. #5 affects #4 -- thus, we sometimes use an iterative
approach to refine the estimate.
 4-5

Projected balance sheet

 A = L + OE on a balance sheet
 If A = L + OE both at the beginning and end of an
accounting period
– Then A = L + OE
– Which is the fundamental basis for the sources and
uses of funds statements
– In other words the accounting works right
 The concern is about acquiring outside capital
– Debt and Equity
• Bond issue or loans
• Stock Issue
 External sources take a lead time and planning
 4-6
Steps to get AFN – simple one-pass
forecast balance sheet method
1. Calculate RE with the data given (method
varies)
2. Increase CA and spontaneous liabilities
proportionately with sales
3. Increase FA if needed based on capacity
information given
4. Carry over bonds/bank-loans and stock
5. Calculate TA - (TL+E) = AFN
 AFN = additional funds needed from
external sources
 4-7
Hand out simple example
 4-8
Two pass method example:
Northwest Chemical: next
year’s Sales Projection
(millions of dollars)
$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0
1996 1997 1998 1999 2000 2001
 4-9
Northwest Chemicals
Oregon producer of Ag Chemicals
 Prepare financial forecast, main
assumption is a 25% increase in sales
 Want to know how performance/ratios
changes.
 One of the main items is Additional Funds
Needed
 We will use the percentage of sales method
of forecasting financial statements. This
will give you a thorough feel for the
process of forecasting financial
statements.
 4-10

North West Chemical:

Key Ratios last year
NWC Industry Condition
Profit Margin 2.52% 4.00% Poor
ROE 7.20% 15.60% “
DSO 43.2 days 32.0 days “
Inv. turnover 5.00x 8.00x “
F.A. turnover 4.00x 5.00x “
T.A. turnover 2.00x 2.50x “
Debt/ assets 30.00% 36.00% Good
TIE 6.25x 9.40x Poor
Current ratio 2.50x 3.00x “
Payout ratio 30.00% 30.00% O.K.
 4-11

Projected Financial Statements

Step 1. Forecast next year’s
Income Statement to get Ret. Earn.
Key Assumptions
 Sales are expected to increase by $500 million.
(%S = 25%). Sales factor 1.25
 Operated at full capacity last year Use to increase
fixed assets and
 Capacity factor 1.25 also fixed cost.
 Payables and accruals grow proportionally with
sales.
 Dividend payout (30%) will be maintained.
 No new common stock will be issued. To finance
AFN half notes and half long term debt will be used
 Interest rate = 8% for any debt.
 4-12

NWC: Projected Income

Statement:

Last Yr. Factor Initial Forecast

Sales $2,000 x1.25 $2,500
Less: VC 1,200 x1.25 1,500
FC 700 x1.25 875
EBIT $ 100 $ 125
Interest 16 16
EBT $ 84 $ 109
Taxes (40%) 34 44
Net. income $ 50 $ 65
Div. (30%) $ 15 $ 19
Add. to RE $ 35 $ 46
 4-13

Projected Financial Statements

Step 2. Forecast the Balance Sheet

Last Yr Factor Initial Forecast

Cash/sec. $20 x1.25 $25
Accts. rec. 240 x1.25 300
Inventories 240 x1.25 300
Total CA $500 $625
Net FA 500 x1.25 625
Total assets $1,000 $1,250
At full capacity, so all assets must
increase in proportion to sales.
 4-14
Projected Financial Statements
Step 2. Forecast the 2001
Balance Sheet (Liability & Equity)
2000 Factor Initial Forecast
AP/accruals $100 x1.25 $125
Notes 100 100
payable
Total CL $200 $225
L-T debt 100 100
Common stk. 500 500
Ret. earnings 200 +46* 246
Total liab./eq. $1,000 $1,071
*From projected income statement.
 4-15

Projected Financial Statements

Step 3. Raising the
Additional Funds Needed

 Forecasted total assets = $1,250

 Forecasted financing = $1,071
 Forecast AFN1 = $ 179

NWC must have the assets to make

forecasted sales. The balance sheet must
balance. So, we must raise $179 externally.
 4-16

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 0.08 ($179) = $14.32

to interest expense, which will reduce NI and
retained earnings.
 4-17

Projected Financial Statements

Step 4. Financing Feedbacks

The effects on the income statement and

balance sheet of actions taken to finance
forecasted increases in assets.
 4-18

NWC: Revised Forecast

of Income Statement

1st Pass Feedback 2nd Pass

Sales $2,500 $2,500
Less: VC 1,500 1,500
FC 875 875
EBIT $125 $125
Interest 16 +14 30
EBT $109 $95
Taxes (40%) 44 38
Net. income $65 $57
Div. (30%) $19 $17
Add. to RE $46 $40
 4-19

NWC: Revised Forecast

of Balance Sheet (Assets)

1st Pass Feedback 2nd Pass

Cash/sec. $25 $25
Accts. rec. 300 300
Inventories 300 300
Total CA $625 $625
Net FA 625 625
Total assets $1,250 $1,250

No change in asset requirements.

 4-20
NWC: Feedback on the Forecast

of the Balance Sheet

(Liabilities & Equity)
1st Pass Feedback 2nd Pass
AP/accruals $125 $125
Notes 100 +89.5 190
payable
Total CL $225 $315
L-T debt 100 +89.5 189
Common stk. 500 500
Ret. earnings 246 -6 240
Total liab./eq. $1,071 $1,244

Look at a spreadsheet with all of this on one page.

 4-21

Results of the
Adjusted Forecast:

 Forecasted assets = $1,250 (no change)

 Forecasted claims = $1,244 (higher)
 2nd pass AFN = $ 6 (short)
 Cumulative AFN= $179 + $6 = $185.
 The $6 shortfall came from reduced net
earnings. Additional passes could be
made until assets exactly equal
liabilities/equity. ex: $6 (0.08) = $0.48
interest 3rd pass.
 4-22

North West Chemical:

Adjusted Key Ratios
NWC
Last Yr. Est. Next Industry
Profit Margin 2.52% 2.27% 4.00% Poor
ROE 7.20% 7.68% 15.60% “
DSO (days) 43.2 43.2 32.0 “
Inv. turnover 5.00x 5.00x 11.00x “
F.A. turnover 4.00x 4.00x 5.00x “
T.A. turnover 2.00x 2.00x 2.50x “
D/A ratio 30.00% 40.34% 36.00% “
TIE 6.25x 4.12% 9.40x “
Current ratio 2.50x 1.99x 3.00x “
Payout ratio 30.00% 30.00% 30.00% O.K.
 4-23

Analysis of the Forecast:

How does North West
Chemical Compare?

 Not very profitable relative to other

companies in the industry.
 Carrying excess inventory and receivables.
 Debt ratio projected to move ahead of
average.
 Overall, not in good shape and doesn’t
appear to be improving.
 4-24

Other Considerations in
Forecasting: Excess Capacity
Suppose last year fixed assets had been
operated at 90% of capacity:
1.25 x .90 = 1.125; will be at 112.5% of capacity
Increase fixed assets and fixed cost by 12.5% (example in
spreadsheet)

Suppose last year fixed assets had

been operated at only 75% of capacity:
1.25 x .75 = .9375; will be at 93.75% of capacity
Would keep fixed assets and fixed cost the same as
last year.
 4-25

How would excess capacity

affect the forecasted ratios?

Sales wouldn’t change but assets

would be lower, so turnovers would be
better.

Less new debt, hence lower interest,

so higher profits, EPS,ROE.

Debt ratio, TIE would improve.

 4-26

Forecasted Ratios:

% of Capacity last year

100% 90% Industry
Profit Margin 2.28% 4.56% 4.00%
ROE 7.70% 14.6% 15.60%
DSO (days) 43.2 43.2 32.0
Inv. turnover 5.00x 5.00x 8.00x
F.A. turnover 4.00x 4.44x 5.00x
T.A. turnover 2.00x 2.10x 2.50x
D/A ratio 40.8% 34% 36.00%
TIE 4.17% 9.48x 9.40x
Current ratio 1.96x 2.35x 3.00x
Payout ratio 30.00% 30.00% 30.00%
 4-27

Summary: How different factors

affect the AFN forecast.

 Dividend payout ratio changes.

If reduced, more RE, reduce AFN.
 Profit margin changes.
If increases, total and retained earnings increase,
reduce AFN.
 Plant capacity changes.
Less capacity used, less need for AFN.
 AP Payment terms increased to 60 days from 30.
Accts. payable would double, increasing
liabilities, reduce AFN.