FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Chapter 6

Financial Planning and

Forecasting
Forecasted Financial Statements
AFN Equation
Reviewing Forecasted Statements
Excess Capacity
Factors Impacting AFN
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Preliminary Financial Forecast:

Balance Sheets (Assets)

2016E
2015
Cash and equivalents $ 20 $ 25
Accounts receivable 240 300
Inventories 240 300
Total current assets $ 500 $ 625
Net fixed assets 500 625
Total assets $1,000 $1,250

6-2
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Preliminary Financial Forecast: Balance Sheets

(Liabilities and Equity)

2015 2016E
A/P & accrued liabilities $ 100 $ 125
Notes payable 100 190
Total current liabilities $ 200 $ 315
Long-term debt 100 190
Common stock 500 500
Retained earnings 200 245
Total liabilities & equity $1,000 $1,250

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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Preliminary Financial Forecast:

Income Statements

2015 2016E
Sales $2,000.0 $2,500.0
Variable costs 1,200.0 1,500.0
Fixed costs 700.0 875.0
EBIT $ 100.0 $ 125.0
Interest 16.0 16.0
EBT $ 84.0 $ 109.0
Taxes (40%) 33.6 43.6
Net income $ 50.4 $ 65.4
Dividends (30% of NI) $15.12 $19.62
Addition to retained earnings $35.28 $45.78
6-4
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Key Financial Ratios

2015 2016E Ind Avg Comment

Basic earning power 10.00% 10.00% 20.00% Poor
Profit margin 2.52% 2.62% 4.00% Poor
Return on equity 7.20% 8.77% 15.60% Poor
Days sales outstanding 43.8 43.8 days 32.0 days Poor
days
Inventory turnover 8.33x 8.33x 11.00x Poor
Fixed assets turnover 4.00x 4.00x 5.00x Poor
Total assets turnover 2.00x 2.00x 2.50x Poor
Liabilities/Assets 30.00% 40.40% 36.00% OK
Times interest earned 6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.99x 3.00x Poor
Payout ratio 30.00% 30.00% 30.00% OK
6-5
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Key Assumptions in Preliminary Financial

Forecast for NWC

• Operating at full capacity in 2016.

• Each type of asset grows proportionally with
sales.
• Payables and accruals grow proportionally with
sales.
• 2016 profit margin (2.52%) and payout (30%)
will be maintained.
• Sales are expected to increase by $500 million.
(%S = 25%).

6-6
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 Additional Financing Needed

• Financing Capital Needed (FCN):

financial funds needed to acquire assets
necessary to support a firm’s sales growth
• Spontaneously Generated Funds:
increases in accounts payables and accruals
(wages and taxes) that occur with a sales
increase

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 Additional Funds Needed

• Additional Funds Needed (AFN):

gap remaining between the financial capital
needed and that funded by spontaneously
generated funds and retained earnings, or,

AFN =
Required Increase in Assets – Spontaneously
Generated Funds – Increase in Retained
Earnings

8
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 AFN Equation

TA o APo  ALo NIo

AFN  (NS) - (NS) - (NS1) (RRo)
NSo NSo NSo
where : TA  Total assets
NS  Net sales
NS  Change in net sales between next year and current year
AP  Accounts payable
AL  Accrued liabilitie s
NI  Net Income
RR  Retention Rate

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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Determining Additional Funds Needed Using

the AFN Equation

AFN = (A0*/S0)S – (L0*/S0)S – M(S1)(1 – Payout)

= ($1,000/$2,000)($500) – ($100/$2,000)($500)
– 0.0252($2,500)(0.7)
= $180.9 million

6-10
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 AFN Equation

TA o APo  ALo NIo

AFN  (NS) - (NS) - (NS1) (RRo)
NSo NSo NSo
where : TA  Total assets
NS  Net sales
NS  Change in net sales between next year and current year
AP  Accounts payable
AL  Accrued liabilitie s
NI  Net Income
RR  Retention Rate

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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Management’s Review of the Financial Forecast

• Consultation with some key managers has

yielded the following revisions:
– Firm expects customers to pay quicker next year,
thus reducing DSO to 34 days without affecting
sales.
– A new facility will boost the firm’s net fixed assets
to $700 million.
– New inventory system to increase the firm’s
inventory turnover to 10x, without affecting sales.

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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Management’s Review of the Financial Forecast

• These changes will lead to adjustments in the

firm’s assets and will have no effect on the
firm’s liabilities and equity section of the
balance sheet or its income statement.

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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Revised (Final) Financial Forecast:

Balance Sheets (Assets)

2015 2016F
Cash and equivalents $ 20 $ 67
Accounts receivable 240 233
Inventories 240 250
Total current assets $ 500 $ 550
Net fixed assets 500 700
Total assets $1,000 $1,250

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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Key Financial Ratios: Final Forecast

2015 2016F Ind Avg Comment

Basic earning power 10.00% 10.00% 20.00% Poor
Profit margin 2.52% 2.62% 4.00% Poor
Return on equity 7.20% 8.77% 15.60% Poor
Days sales outstanding 43.8 days 34.0 days 32.0 OK
days
Inventory turnover 8.33x 10.00x 11.00x OK
Fixed assets turnover 4.00x 3.57x 5.00x Poor
Total assets turnover 2.00x 2.00x 2.50x OK
Liabilities/Assets 30.00% 40.40% 36.00% Poor
Times interest earned 6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.98x 3.00x Poor
Payout ratio 30.00% 30.00% 30.00% OK
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

What was the net investment in capital?

Capital 2016  NOWC  NetFA

 $625  ($315  $190)  $625
 $625  $125  $625
 $1,125

Capital 2015  $900

Net investment in capital  $1,125  $900

 $225

6-16
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

How much free cash flow is expected to be

generated in 2016?

FCF = EBIT(1 – T) – Net investment in capital

= $125(0.6) – $225
= $75 – $225
= -$150

6-17
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Suppose Fixed Assets Had Been Operating at Only

85% of Capacity in 2015

• The maximum amount of sales that can be supported by the 2015 level of
assets is:

Capacity sales  Actual sales/% of capacity

 $2,000/0.8 5  $2,353

• 2016 forecast sales exceed the capacity sales,

so new fixed assets are required to support
2016 sales.

6-18
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

How can excess capacity affect the

forecasted ratios?

• Sales wouldn’t change but assets would be

lower, so turnovers would improve.
• Less new debt, hence lower interest and higher
profits
• EPS, ROE, liabilities-to-assets ratio, and TIE
would improve.

6-19
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FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

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 a given
level of sales.
• Pay suppliers in 60 days, rather than 30 days?
– Decrease AFN: Trade creditors supply more
capital (i.e., L0*/S0 increases).
6-20
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