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Copyright 2002 by Harcourt, Inc. All rights reserved.

CHAPTER 4

Financial Planning and ForecastingFinancial Statements

Plans: strategic, operating, andfinancial

Pro forma financial statementsSales forecastsPercent of sales method

Additional Funds Needed (AFN)formula

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Pro Forma Financial Statements

Three important uses:

Forecast the amount of external

financing that will be required

Evaluate the impact that changesin the operating plan have on the

value of the firm

Set appropriate targets forcompensation plans

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Steps in Financial Forecasting

Forecast salesProject the assets needed to support

salesProject internally generated fundsProject outside funds neededDecide how to raise fundsSee effects of plan on ratios and

stock price

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2001 Balance Sheet

(Millions of $)

$1000Total claims$1000Total assets

200Earnings500Assets

RetainedNet fixed

500Common stk

100L-T debt$500Total CA

$200Total CL240Inventories100Notes payable240Accounts rec.

$100accruals

Accts. pay. &$20Cash & sec.

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2001 Income Statement

(Millions of $)

35.28Addn to RE

$15.12Dividends (30%)

$50.40Net income33.60Taxes (40%)

$84.00EBT

16.00Interest

$100.00EBIT

700.00SGA costs

1,200.00Less: COGS (60%)

$2,000.00Sales

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Key Ratios

O.K.30.00%30.00%Payout ratio

Poor3.00x2.50xCurrent ratio

Poor9.40x6.25xTIEGood36.00%30.00%Debt/assets

Poor2.50x2.00xT.A. turnover

Poor5.00x4.00xF.A. turnover

Poor11.00x8.33xInv. turnover

Poor32.00 days43.20 daysDSO

Poor15.60%7.20%ROE

Poor4.00%2.52%Profit Margin

Poor20.00%10.00%BEP

ConditionIndustryNWC

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Key Ratios (Continued)

(NOPAT/Net oper. capital)

Poor14.00%6.67%Return on invested capital

(Net oper. capital/Sales)

Poor35.00%45.00%Oper. capital requirement

(NOPAT/Sales)

Poor5.00%3.00%Net oper. prof. margin after taxes

Cond.Ind.NWC

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AFN (Additional Funds Needed):

Key AssumptionsOperating at full capacity in 2001.Each type of asset grows proportionally

with sales.Payables and accruals grow proportionally

with sales.

2001 profit margin (2.52%) and payout(30%) will be maintained.Sales are expected to increase by $500

million. (%S = 25%)

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Assets

Sales0

1,000

2,000

1,250

2,500

A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.

Assets =(A*/S0)Sales= 0.5($500)= $250.

Assets = 0.5 sales

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Assets must increase by $250 million.

What is the AFN, based on the AFNequation?

AFN = (A*/S0

)S - (L*/S0

)S - M(S1

)(1 - d)

= ($1,000/$2,000)($500)

- ($100/$2,000)($500)

- 0.0252($2,500)(1 - 0.3)

= $180.9 million.

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Projecting Pro Forma Statements with

the Percent of Sales Method

Project sales based on forecastedgrowth rate in sales

Forecast some items as a percentof the forecasted sales

CostsCash

Accounts receivable (More...)

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Items as percent of sales (Continued...)

Inventories

Net fixed assets

Accounts payable and accrualsChoose other items

Debt (which determines interest)

Dividends (which determinesretained earnings)

Common stock

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Percent of Sales: Inputs

5%5%AP & accr./Sales

25%25%Net FA/Sales12%12%Inv./Sales

12%12%Acct. rec./Sales

1%1%Cash/Sales

35%35%SGA/Sales

60%60%COGS/Sales

Proj.Actual

20022001

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Other Inputs

30%Dividend payout rate

40%Tax rate

8%Interest rate on debt

1.25Growth factor in sales (g)

25%Percent growth in sales

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2002 1st Pass Income Statement

$46Add. to RE

$19Div. (30%)$65Net. Income

44Taxes (40%)$109EBT

1616Interest$125EBIT

875Pct=35%SGA1,500Pct=60%Less: COGS

$2,500g=1.25$2,000Sales1st PassFactor2001

2002

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2002 1st Pass Balance Sheet (Assets)

Forecasted assets are a percent of forecasted sales.

2002 Sales = $2,500

$1250Total assets$625Pct=25%Net FA$625Total CA

300Pct=12%Inventories300Pct=12%Accts. rec.$25Pct= 1%Cash

1st PassFactor

2002

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2002 1st Pass Balance Sheet (Claims)

*From 1st pass income statement.

2002 Sales = $2,500

$1,071Total claims246+46*200Ret. earnings500500Common stk.100100L-T debt

$225Total CL100100Notes payable

$125Pct=5%AP/accruals1st PassFactor2001

2002

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What are the additional funds

needed (AFN)?

Forecasted total assets = $1,250

Forecasted total claims = $1,071Forecast AFN = $ 179

NWC must have the assets to makeforecasted sales. The balance sheetsmust balance. So, we must raise $179externally.

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Assumptions about How AFN Will

Be Raised

No new common stock will beissued.

Any external funds needed will beraised as debt, 50% notes payable,and 50% L-T debt.

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How will the AFN be financed?

Additional notes payable =0.5 ($179) = $89.50 $90.

Additional L-T debt =0.5 ($179) = $89.50 $89.

But this financing will add 0.08($179) =$14.32 to interest expense, which willlower NI and retained earnings.

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$40$46Add. to RE

$17$19Div (30%)

$57$65Net income3844Taxes (40%)

$95$109EBT

30+1416Interest

$125$125EBIT 875875SGA

$1,500$1,500Less: COGS

$2,500$2,500Sales2nd PassFeedback1st Pass

2002 2nd Pass Income Statement

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2002 2nd Pass Balance Sheet (Assets)

No change in asset requirements.

$1,250$1,250Total assets

625625Net FA

$625$625Total CA

300300Inventories

300300Accts. rec.

$25$25Cash

2nd PassAFN1st Pass

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2002 2nd Pass Balance Sheet (Claims)

$1,244$1,071Total claims

240-6246Ret. earnings500500Common stk.

189+89100L-T debt

$315$225Total CL190+90100Notes payable

$125$125AP/accruals

2nd PassFeedback1st Pass

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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 the $6

reduction in retained earnings.Additional passes could be made untilassets exactly equal claims. $6(0.08) =$0.48 interest on 3rd pass.

Results After the Second Pass

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Equation method assumes aconstant profit margin.

Pro forma method is more flexible.More important, it allows differentitems to grow at different rates.

Equation AFN = $181

vs.Pro Forma AFN = $185.Why are they different?

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Ratios After 2nd Pass

30.00%

3.00x

9.40x

36.00%

2.50x

5.00x

11.00x

32.00

15.60%

4.00%

20.00%

Industry

OK30.00%30.00%Payout ratio

Poor1.99x2.50xCurrent ratio

Poor4.12x6.25xTIE

Good40.34%30.00%D/A ratio

Poor2.00x2.00xTA turnover

Poor4.00x4.00xFA turnover

Poor8.33x8.33xInv. turnover

Poor43.2043.20DSO (days)

Poor7.68%7.20%ROE

Poor2.27%2.52%Profit Margin

Poor10.00%10.00%BEP

Cond2002(E)2001

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Ratios after 2nd Pass (Continued)

NWC Ind. Cond.

Net oper. prof. margin after taxes 3.00% 5.00% Poor(NOPAT/Sales)

Oper. capital requirement 45.00% 35.00% Poor

(Net oper. capital/Sales)Return on invested capital 6.67% 14.00% Poor (NOPAT/Net oper. capital)

Note: These are the same as in 2001 (see slide 14-7),

because there have been no improvements in operations(i.e., all percent of sales items have same percentages in2001 and 2002). Also, there are no differences between 1stpass and 2nd pass because changes in financing do notaffect measures of operating performance.

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What is the forecasted free cash flow

for 2002?

-$150Free cash flow

$225Less Inv. in op. capital(EBITx(1-T))

$75$60NOPAT

(Net op. WC + net FA)

$1,125$900Total operating capital(CA - AP & accruals)

$500$400Net operating WC

2002(E)2001

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Suppose in 2001 fixed assets had been

operated at only 75% of capacity.

With the existing fixed assets, salescould be $2,667. Since sales areforecasted at only $2,500, no newfixed assets are needed.

Capacity sales =Actual sales

% of capacity

= = $2,667.$2,000

0.75

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How would the excess capacity

situation affect the 2002 AFN?

The projected increase in fixed assetswas $125, the AFN would decrease by$125.

Since no new fixed assets will beneeded, AFN will fall by $125, to

$179 - $125 = $54.

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Q. If sales went up to $3,000,

not $2,500, what would theF.A. requirement be?

A. Target ratio = FA/Capacity sales= $500/$2,667 = 18.75%.

Have enough F.A. for sales up to

$2,667, but need F.A. for another$333 of sales:

FA = 0.1875($333) = $62.4.

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How would excess capacity affect the

forecasted ratios?

1. Sales wouldnt change but assets

would be lower, so turnovers wouldbe better.

2. Less new debt, hence lower interest,

so higher profits, EPS, ROE (whenfinancing feedbacks considered).

3. Debt ratio, TIE would improve.

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2002 Forecasted Ratios: S02 = $2,500

% of 2001 Capacity

3.00x2.48x1.99xCurrent ratio

9.40x6.15x4.12xTIE

36.00%33.71%40.34%D/A ratio2.50x2.22x2.00xT.A. turnover

5.00x5.00x4.00xF.A. turnover

11.00x8.33x8.33xInv. Turnover

32.0043.2043.20DSO15.60%8.44%7.68%ROE

4.00%2.51%2.27%Profit Margin

20.00%11.11%10.00%BEP

Industry75%100%

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How is NWC performing with regard to

its receivables and inventories?

DSO is higherthan the industryaverage, and inventory turnover islowerthan the industry average.

Improvements here would lowercurrent assets, reduce capitalrequirements, and further improveprofitability and other ratios.

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Improvements in Working Capital

Management

9.09%12.00%Inventory/Sales

11.00x8.33xInventory turnover

8.89%12.00%Accts. rec./Sales

32.0043.20DSO (days)

AfterBefore

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Impact of Improvements in Working

Capital Management

8.59%7.7%ROE

7.7%6.7%ROIC (NOPAT/Capital)

$0.5-$150.0Free cash flow (1999)

AfterBefore

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Assets

Sales0

1,1001,000

2,000 2,500

Declining A/S Ratio

$1,000/$2,000 = 0.5; $1,000/$2,500 = 0.44. Decliningratio shows economies of scale. Going from S = $0to S = $2,000 requires $1,000 of assets. Next $500 ofsales requires only $100 of assets.

BaseStock

}

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Assets

Sales

1,000 2,000500A/S changes if assets are lumpy. Generally will haveexcess capacity, but eventually a small S leads to alarge A.

500

1,000

1,500

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Summary: How different factors affectthe AFN

forecast.Excess capacity:Existence lowers AFN.

Base stocks of assets:Leads to less-than-proportional asset

increases.Economies of scale:Also leads to less-than-proportional asset

increases. Lumpy assets:Leads to large periodic AFN requirements,

recurring excess capacity.

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Regression Analysis for Asset

Forecasting

Get historical data on a goodcompany, then fit a regression lineto see how much a given salesincrease will require in way of

asset increase.

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Example of Regression

Constant ratio overestimates inventory requiredto go from S1 = $2,000 to S2 = $2,500.

For a Well-Managed Co.Year Sales Inv.

1999 $1,280 $1182000 1,600 1382001 2,000 162

2002E 2,500E 192E

Inventory

Sales

(000)1.28 1.6 2.0 2.5

Regressionline

Constantratio forecast

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Regression with 10B for Our Example

Same as finding beta coefficients.Clear all

1280 Input 118+1600 Input 138+2000 Input 162+0 y, m 40.0 = Inventory at sales = 0.

SWAP 0.0611 = Slope coefficient.

Inventory = 40.0 + 0.0611 Sales.

LEAVE CALCULATOR ALONE!

^

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Equation is now in the calculator. Letsuse it by inputting new sales of $2,500and getting forecasted inventory:

2500 y, m 192.66.

The constant ratio forecast wasinventory = $300, so the regressionforecast is lower by $107. This wouldfree up $107 for use elsewhere, whichwould improve profitability and raise P0.

^

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How would increases in these items

affect the AFN?

Higher dividend payout ratio?

Increase AFN: Less retainedearnings.

Higher profit margin?Decrease AFN: Higher profits, moreretained earnings.

(More)

4 45

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Higher capital intensity ratio, A*/S0?

Increase AFN: Need more assets forgiven sales increase.

Pay suppliers in 60 days rather than30 days?

Decrease AFN: Trade creditorssupply more capital, i.e., L*/S0

increases.

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