CHAPTER 19

Financial Planning and Forecasting Pro-Forma Financial Statements

Some Bad Forecasts

"Everything that can be invented has been invented." --Commissioner, U.S. Office of Patents, 1899. "640K ought to be enough for anybody." -- Bill Gates, 1981

Some Bad Forecasts

"But what ... is it good for?" --Engineer at the d!anced Com"#ting S$stems %i!ision of &B', 19(8, commenting on the microchi". "There is no reason anyone would want a com uter in their home." --President, Chairman and fo#nder of %igital E)#i"ment Cor"., 19**

Some Bad Forecasts

"! thin" there is a world mar"et for maybe five com uters." --Chairman of &B', 19+, "#e don$t li"e their sound% and guitar music is on the way out." --%ecca -ecording Co. re.ecting the Beatles, 19(/.

Forecasting

0hat is generall$ the first item to estimate 1hen starting a 2#siness3 0hat is the most diffic#lt as"ect of forecasting3

Ste"s in Financial Forecasting

Forecast sales Pro.ect the assets needed to s#""ort sales Pro.ect internall$ generated f#nds Pro.ect o#tside f#nds needed %ecide ho1 to raise f#nds See effects of "lan on ratios and stoc4 "rice

5he Sales Forecasting Process

Marketing (sales estimate) Top Management (policy, strategy) Production (capacity, schedules) Accounting (financial statements, depreciation, taxes) Finance Department

SA !S F"#!$AST

Forecasting sales

-e!ie1 "ast sales 6fi!e to ten $ears7. 8o# can #se a!erage gro1th rate 2#t it ma$ not gi!e $o# a correct estimate. Use regression slo"e to com"#te gro1th rate. Consider changes in econom$, mar4et conditions, etc. &m"ro"er sales forecast can lead to serio#s financial "lanning iss#es.

Sales Forecast

Sales forecasts are #s#all$ 2ased on the anal$sis of historic data. n acc#rate sales forecast is critical to the firm9s *a$es +orecast "rofita2ilit$:
Under-optimistic Company "i$$ fai$ to meet demand (ar&et share "i$$ )e $ost

'ver-optimistic

Too much inventory and/or fixed assets

o% turno&er ratio 'igh cost of depreciation and storage (rite)offs of o*solete in&entory

!o" profit !o" rate of return on e#uity !o" free cash f$o" %epressed stoc& price

Forecast f#t#re sales 2ased on "ast sales gro1th

*a$es *a$esEstimates Estimatesfor for next next2 2years years
*a$es

4ro"th Rate

9, 9-

9. 9/ 90

99 11 11 12

13

Time

 +orecast future sa$es )ased on past sa$es 5ro"th lso incl#de the effects of an$ e!ents 1hich are e;"ected to im"act f#t#re sales 6ne1 "rod#cts or economic conditions7 *a$es

6e" Product 7ntroduced

9, 9-

9. 9/ 90

99 11 11 12

13

Time

 +orecast future sa$es )ased on past sa$es 5ro"th lso incl#de the effects of an$ e!ents 1hich are e;"ected to im"act f#t#re sales 6ne1 "rod#cts or economic conditions7

*a$es

6e" Product 7ntroduced

9, 9-

9. 9/ 90

99 11 11 12

13

Time

Sales Gro1th &m"oses Costs on the Firm

8i$$ re#uire additiona$ resources

C#rrent ssets: &n!entor$, <-, Cash Fi;ed ssets: Plant and E)#i"ment

2119

2111

0hat are the affects on the financials3

Sold off stores Borro1ed mone$ E;"anded to ne1 mar4ets O#t-so#rced la2or to China =o1ered retail "rices &ncreased ad!ertising P#rchased in!entor$ management s$stem

5he Percent of Sales 'ethod

5his is the most common method, 1hich 2egins 1ith the sales forecast e;"ressed as an ann#al gro1th rate in dollar sale re!en#e. 'an$ items on the 2alance sheet and income statement are ass#med to change "ro"ortionall$ 1ith sales.

Better Financial Planning 'odel

The 7ncome *tatement
The pro forma income statement is 5enerated )y

reco5ni9in5 a$$ varia)$e costs that chan5e direct$y "ith sa$es: T"o &ey ratios are ca$cu$ated ; dividend payout ratio and retention ratio:
The first measures the percenta5e of net income paid

out as dividends to shareho$ders< "hi$e the second measures the percenta5e of net income reinvested )y the firm as retained earnin5s:

Better Financial Planning 'odel

The =a$ance *heet
*ome )a$ance sheet items vary direct$y "ith sa$es

"hi$e others do not:

To determine "hich accounts vary direct$y "ith sa$es<

a trend ana$ysis may )e conducted on historic )a$ance sheets of the firm:

Typica$$y< "or&in5 capita$ accounts $i&e inventory<

accounts receiva)$es and accounts paya)$es vary direct$y "ith sa$es:

Better Financial Planning 'odel

The =a$ance *heet
+ixed assets do not a$"ays vary direct$y "ith sa$es:

7t "i$$ do so< on$y if the firm is operatin5 at 111 percent capacity and fixed assets can )e incrementa$$y chan5ed:
The ratio of tota$ assets to net sa$es is ca$$ed the

capita$ intensity ratio: This ratio te$$s us the amount of assets needed )y the firm to 5enerate >1 sa$es:

Better Financial Planning 'odel

The =a$ance *heet
The hi5her the ratio< the more capita$ the firm needs

to 5enerate sa$es?the more capita$ intensive the firm:

+irms that are hi5h$y capita$ intensive are more ris&y

than those that are not )ecause a do"nturn can reduce sa$es sharp$y )ut fixed costs do not chan5e rapid$y:

Better Financial Planning 'odel

!ia)i$ities and E#uity
'n$y current $ia)i$ities are $i&e$y to vary direct$y "ith

sa$es: The exception here is notes paya)$es @shortterm )orro"in5sA that chan5es as the firm pays it do"n or ma&es an additiona$ )orro"in5:
!on5-term $ia)i$ities and e#uity accounts chan5e as a

direct resu$t of mana5eria$ decisions $i&e de)t repayment< stoc& repurchase< issuin5 ne" de)t or e#uity:

Better Financial Planning 'odel

!ia)i$ities and E#uity
Retained earnin5s "i$$ vary as sa$es chan5es )ut

not direct$y: 7t is affected )y the firmBs dividend payout po$icy:

Better Financial Planning 'odel

The Pre$iminary Pro-forma =a$ance *heet
+irst< ca$cu$ate the proCected va$ues for a$$ the

accounts that vary "ith sa$es:

*econd< ca$cu$ate the proCected va$ue of any other

)a$ance sheet account for "hich an end-of-period va$ue can )e forecast or other"ise determined:
Third< enter the current yearBs num)er for a$$ the

accounts for "hich the next yearBs fi5ure cannot )e ca$cu$ated or forecast:

Better Financial Planning 'odel

The Pre$iminary Pro-forma =a$ance *heet
At this point the )a$ance sheet "i$$ )e un)a$anced: A

p$u5 va$ue is necessary to 5et the )a$ance sheet to )a$ance:

+irst< determine the retained earnin5s )ased on the

firmBs dividend po$icy:

Better Financial Planning 'odel

The Pre$iminary Pro-forma =a$ance *heet
6ext< the p$u5 fi5ure "i$$ represent the externa$

financin5 necessary to ma&e the tota$ assets e#ua$ tota$ $ia)i$ities and e#uity: This ca$$s for mana5ement to choose a financin5 option ; choosin5 de)t< e#uity or a com)ination ; to raise the additiona$ funds needed:

Better Financial Planning 'odel

The (ana5ement %ecision
The first decision re$ates to the firmBs dividend

po$icy: *hou$d the firm a$ter its dividend po$icy to increase the amount of retained earnin5D
7f externa$ fundin5 is sti$$ needed< shou$d the firm

issue ne" de)t< or issue e#uityD 'r< shou$d it )e a mix of )othD 7t is important to reco5ni9e that "hi$e financia$ p$annin5 mode$s can identify the amount of externa$ financin5 needed< the financin5 option is a mana5eria$ decision:
4o to exhi)it 19:.

Be$ond the Basic Planning 'odels

7mprovin5 +inancia$ P$annin5 (ode$s
There are severa$ "ea&nesses in the previous$y

descri)ed mode$s:
+irst< interest expense "as not accounted for: This

is difficu$t to do so unti$ a$$ the financin5 options are fina$i9ed:

*econd< a$$ "or&in5 capita$ accounts do not

necessari$y vary direct$y "ith sa$es< especia$$y cash and inventory:

4o to exhi)it 19:/

Be$ond the Basic Planning 'odels

7mprovin5 +inancia$ P$annin5 (ode$s
Third< ho" fixed assets are adCusted p$ays a si5nificant

ro$e:
8hen a firm is not operatin5 at fu$$ capacity< sa$es may

)e increased "ithout addin5 any ne" fixed assets:

+ixed assets are added in $ar5e discrete amounts

ca$$ed $umpy assets: *ince it re#uires time to 5et ne" assets operationa$< they are added as the firm nears fu$$ capacity:
4o to exhi)it 19:0

Be$ond the Basic Planning 'odels

(ana5in5 and +inancin5 4ro"th
(ana5ers prefer rapid 5ro"th as a 5oa$ to capture

mar&et share and esta)$ish a competitive position:

(ost firms experiencin5 rapid 5ro"th fund the 5ro"th

"ith de)t< increasin5 the firmBs $evera5e and puttin5 it at ris&:

Be$ond the Basic Planning 'odels

Externa$ +undin5 6eeded
Externa$ fundin5 needed @E+6A is defined as the

additiona$ de)t or e#uity a firm needs to issue so it can purchase additiona$ assets to support an increase in sa$es:
E+6 is tied to ne" investments the mana5ement has

deemed necessary to support the sa$es 5ro"th:

Be$ond the Basic Planning 'odels

Externa$ +undin5 6eeded
The ne" investments are the proCected capita$

expenditure p$us the increase in "or&in5 capita$ necessary to sustain increases in sa$es: *ee e#uation 19:-:
Companies first resort to interna$$y 5enerated

funds in the form of addition to retained earnin5s:

Be$ond the Basic Planning 'odels

Externa$ +undin5 6eeded
'nce interna$$y 5enerated funds are exhausted<

the firm $oo&s to raise funds externa$$y: *ee e#uation 19:. and 19:/:

Be$ond the Basic Planning 'odels

Externa$ +undin5 6eeded
+irst< ho$din5 dividend po$icy constant< the amount

of E+6 depends on the firmBs proCected 5ro"th rate: Hi5her 5ro"th rate imp$ies that the firm needs more ne" investments and therefore< more funds to have to )e raised externa$$y:
*econd< the firmBs dividend po$icy a$so affects E+6:

Ho$din5 5ro"th rate constant< the hi5her the firmBs payout ratio< the $ar5er the amount of de)t or e#uity financin5 needed:
4o to exhi)it 19:9 -19:11

>o1 1o#ld increases in these items affect the EF?3 >igher di!idend "a$o#t ratio:

-ed#ces f#nds a!aila2le internall$, increases EF?.

(More+)

>igher "rofit margin:

&ncreases f#nds a!aila2le internall$, decreases EF?.

>igher ca"ital intensit$ ratio,

<S@:

&ncreases asset re)#irements, increases EF?.

&m"lications of EF?

&f EF? is "ositi!e, then $o# m#st sec#re additional financing. &f EF? is negati!e, then $o# ha!e more financing than is needed.

Pa$ off de2t. B#$ 2ac4 stoc4. B#$ short-term in!estments.

S#mmar$: >o1 different factors affect the EF? forecast.

E;cess ca"acit$: lo1ers EF?. Economies of scale: leads to lessthan-"ro"ortional asset increases. =#m"$ assets: leads to large "eriodic EF? re)#irements, rec#rring e;cess ca"acit$.

Assets

umpy Assets

,,/-,,--/-Sales

/--

,,---

.,---

A0S changes if assets are lumpy1 2enerally %ill ha&e excess capacity, *ut e&entually a small S leads to a large A1