Financial Planning and Forecasting

Warren Buffet, a great investor of all times, once said,

“If you don’t know where you’re going, you probably won’t get there.”

That’s certainly true for a company—it needs a plan, one that starts with the firm’s
general goals and details the steps that will be taken to get there.

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 Content
 The importance of strategic planning and financial forecasting
 Forecasting sales
 Use the Additional Funds Needed (or AFN) equation and
discuss the relationship between asset growth and the need for
funds
 Use spreadsheet to forecast starting with historical statements,
ending with projected statements, and including a set of
financial ratios based on those projected statements.

 Discuss how planning is an iterative process.

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 Strategic planning
 Mission statement and objectives
 Chairman’s letter in the annual report: We expect our

businesses to achieve 10%+ earnings growth most years,

with long-term returns on equity of 20%. We expect our
businesses to be industry leaders in market share, value,
and profitability.
 Corporate Scope:
 The lines of business the firm plans to pursue and the

geographic areas in which it will operate

 Operating plan: 5-year horizon, those people responsible for
each particular function, deadlines for specific tasks, sales and
profit targets, and the like.
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Financial planning
(Value-based management)
 First, assumptions are made about the future levels of
sales, costs, interest rates, and so forth, for use in the
forecast.

 Second, a set of projected financial statements is

developed

 Third, projected ratios are calculated and analyzed.

 Fourth, the entire plan is reexamined, the assumptions

are reviewed, and the management team considers how
additional changes in operations might improve results
from the mission statement to the operating plan 17-4
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 Sales forecast
 Financial plans generally begin with a sales forecast, which assume that
most of the assets increase at the same rate as sales.
 Sales growth must be balanced against the cost of achieving that growth
 A review of sales during the past 5 years.

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 The AFN equation

 It is possible that spontaneous funds and additional retained

earnings will offset the forecasted increase in assets. Normally,
though, that situation does not occur—normally, there is a
shortfall, called Additional Funds Needed (AFN), which has
to be made up by additional borrowing and/or the sale of new
stock. 17-7
 Key assumptions
 Operating at full capacity in 2009.
 Each type of asset grows proportionally with sales.
 Payables and accruals grow proportionally with sales.
 2008 profit margin (2.52%) and payout (30%) will be
maintained.
 Sales are expected to increase by $300 million. (%DS
= 10%)

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 Determining additional funds
needed, using the AFN equation

AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

= $200 - $20 - $66
= $114 million.

 How much new capital the firm will need to

support the targeted 10% growth rate, assuming
the various operating ratios remain constant.

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Analyse the historical ratios

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Projected income statement

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Projected balance sheet

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Raising the additional funds
needed

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 Other changes affect AFN ?
 Lower AFN
 Change in fixed assets, inventories, cash, any
other assets.
 Increase the L0*/S0 ratio due to longer credit
term for firm purchase
 Increase profit margin, lower dividend payout
ratio

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Analysis of the forecast

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Using regression to improve
forecasts
 Allied’s sales, inventories, and receivables during
the last 5 years and scatter diagrams of inventories
and receivables versus sales.

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The effects of changing ratios
 Modifying accounts receivable

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The effects of changing ratios
 Modifying inventories

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Other “special” studies
 Change of dividend policy: increase the retained
ratios

 Now suppose Allied anticipated problems raising $114

million to carry out its business plan. The CFO might
then suggest to the directors a reduction of the
payout ratio to 20%. That would result in an AFN of
about $77 million.
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 Excess capacity adjustments
 Allied had $1,000 million of current assets and $1,000
million of fixed assets; so he broke A0*/S0 into two parts,
one for fixed assets and one for current assets:

 Current assets: Ao*/S0 = $1,000/$3,000 = 0.333 = 33.3%

 Fixed assets: A0*F/S0 = $1,000/$3,000 = 0.333 = 33.3%

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 Excess capacity adjustments
 However, the CFO thought that in 2008, fixed assets had
been used at only 96% of capacity in 2008.

 If fixed assets had been used to full capacity, sales

could have reached $3,125 million with no increase
in fixed assets

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 Excess capacity adjustments
 A sales increase to $3,300 million would require
only $1,056 million of fixed assets

 We previously assumed that fixed asset grow

proportionally as sales, 10%

The existence of excess capacity would lower

Allied’s required AFN from $114 million to $114
million - $ $44 million = $70 million 17-22
 Using forecast to improve
operations
 Change the growth rate and the five key input variables in Part I
 Change the financing assumptions, perhaps using more bank debt
and fewer bonds , or only with debt or only with stock.

 Allied’s ratio analysis pointed out the firm’s weaknesses.

 The model demonstrates how improvements in the driver variables

will affect the firm’s ROE, its EPS, and (of course) its stock price.

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