© 2010 Institute of Business Management

Financial Management,
Prepared by: Amyn Wahid
 The Ingredients of a Financial Plan

 A financial plan consists of several

ingredients
• Expectations about the economic environment
• A sales forecast
• Cash Budget
• Pro forma (forecasted) financial statements
• Asset requirements
• Required new financing
 We will focus on developing the pro formas
financial statements
 Financial Statements Forecasting
 The Percent of Sales Method

• Once sales have been forecasted , we must forecast future

balance sheet and income statements.
• The most common method is the percent of sales method
• Many items on the income statement and the balance sheet
are assumed to increase proportionately with sales.
• Each item will grow at the same rate (%) as sales and this
approach is called the constant ratio method.
• Every case could vary so the assumptions pertaining to a
particular question need to be strictly followed.
 Types of Assets and Liabilities

 There are two types of assets:

• Current assets are the firm’s short-term assets and can
generally be expected to vary directly with sales
• Fixed assets are the firm’s long-term assets and generally do
not vary directly with sales
 There are two types of liabilities:
• Spontaneous liabilities are those that occur naturally
during the ordinary course of doing business. These sources
vary directly with sales
• Discretionary liabilities are those that require a special
effort for the firm to obtain. These sources do not vary
directly with sales
 Elvis Products International
Key Data

 Lets analyze this method in detail with the subsequent example

of Elvis Products International
 The company will be operating below capacity in 1998.
 Sales is expected to increase by 10%
 Spontaneous assets & liabilities grows proportionally with sales.
 Cash & equivalent levels are expected to be maintained at the same
as the previous year.
 The company expects to give $22,000 as dividends in 1998.
 We need to prepare here the forecasted financial statements of EPI
for 1998.
 Forecasting the Income Statement
Elvis Products International
Pro Forma Income Statement
For the Year Ended December 31, 1998 (figures in ‘000)
  1998* 1997 1996
Sales
Sales $4,235.00 $3,850.00 $3,432.00
Cost of Goods Sold $3,575.00 $3,250.00 $2,864.00
Gross Profit
forecasted $660.00 $600.00 $568.00

No change Selling and G&A Expenses to increase $363.33 $330.30 $280.00

Fixed Expenses by 10% $100.00 $100.00 $100.00
Depreciation Expense $20.00 $20.00 $18.90
EBIT $176.67 $149.70 $169.10
Interest Expense $76.00 $76.00 $62.50
Earnings Before Taxes $100.67 $73.70 $106.60
Taxes @ 40% $40.27 $29.48 $42.64
Net Income $60.40 $44.22 $63.96

  * Forecasted      

Other Data    
Cash Dividends $22.00 $15.00 $10.00
Increase in Retained Earnings $38.40 $29.22 $53.96
       
Note:- The company expects to give cash dividends of $22,000 in 1998      
 Forecasting the Balance Sheet
Elvis Products International Elvis Products International
Pro Forma Balance Sheet
As of December 31, 1998 (figures in
‘000)
Assets 1998* 1997 1996
Cash and Equivalents $52.00 $52.00 $57.60
Accounts Receivable $442.20 $402.00 $351.20
Inventory $919.60 $836.00 $715.20
Total Current Assets $1,413.80 $1,290.00 $1,124.00
Plant & Equipment $527.00 $527.00 $491.00
Accumulated Depreciation $186.20 $166.20 $146.20
Net Fixed Assets $340.80 $360.80 $344.80
Total Assets $1,754.60 $1,650.80 $1,468.80
Liabilities and Owner's Equity      
Accounts Payable $192.72 $175.20 $145.60
Short-term Notes Payable $225.00 $225.00 $200.00
Other Current Liabilities $154.00 $140.00 $136.00
Total Current Liabilities $571.72 $540.20 $481.60
Long-term Debt $424.61 $424.61 $323.43
Total Liabilities $996.33 $964.81 $805.03
Common Stock $460.00 $460.00 $460.00
Retained Earnings $264.39 $225.99 $203.77
Total Shareholder's Equity $724.39 $685.99 $663.77
Total Liabilities and Owner's Equity $1,720.72 $1,650.80 $1,468.80
Discretionary Financing Needed -$33.88 Deficit  
 Discretionary Financing Needed

 Ordinarily, the pro-forma balance sheet will not balance!

 This is intentional, and the amount needed to make it
balance is referred to as the Discretionary Financing
Needed, DFN (or External Financing Needed, EFN)
 This is a “plug figure” that represents the amount of
discretionary financing that the firm will need to obtain
in order to support its forecasted level of sales
 In the case of Elvis Products International , the
discretionary financing figure is $33.88 which has to be
provided in one of the following ways (shown in the
next slide)
 Discretionary Financing Needed

The four common methods of discretionary financing

are as follows:-

 Borrow more short-term (Notes Payable)

 Borrow more long-term (LT Debt)
 Sell more common stock (CS & APIC)
 Decrease dividend payout, which increase Add. To
RE
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 The AFN Formula

 Most Firms forecast their capital requirements by

constructing pro forma income statements and balance
sheets as explained before.
 However if the ratios are expected to remain constant, then
the following formula can be used to forecast financial
requirements

AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)

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 The AFN Formula
AFN = (A*/S0)S (L*/S0)S M(S1)(1 - d)

AFN =
Required Spontaneous Increase in
 A* = assets that are tied liability
directly to sales, hence must retained
increase if sales are to
increase. assets increase earnings
 S0 = Sales during the last year.
 L* = Liabilitiesincrease
that increase spontaneously.
 S1 = total sales projected for next year.
 S = change in sales.
 M = profit margin

 However if the ratios are expected to remain constant, then the following formula can be used to
forecast financial requirements

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 AFN (Additional Funds Needed):
Key Assumptions
 To illustrate the calculation of AFN, consider the
given data of Funky House for 2001.
 Operating 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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 2001 Balance Sheet
(Millions of $)

Cash & sec. $ 20 Accts. pay. &

accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000

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 2001 Income Statement
(Millions of $)
Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA 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
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 Assets
Assets = 0.5 sales

1,250  Assets =
(A*/S0)Sales
1,000
= 0.5($500)
= $250.

0 2,000 2,500
Sales
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.
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What is the AFN, based on the AFN
equation?

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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Assumptions about How AFN Will
Be Raised

 No new common stock will be issued.

 Any external funds needed will be raised 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 ($180.9) = $90.45  $90.

Additional L-T debt =

0.5 ($ 180.9) = $90.45 $90.

But this financing will add 0.08($180.9) =

$14.472 to interest expense, which will
lower NI and retained earnings.
(assuming the average interest rate of 8% on the debt)
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