Chapter 4

Financial Planning and

Forecasting
 Forecasting Sales
 Projecting the Assets and Internally
Generated Funds
 Projecting Outside Funds Needed
 Deciding How to Raise Funds
4-1
Strategic Planning:
Key Elements of Strategic Plan
 Mission Statement: A condensed version of a firm’s strategic plan
 Corporate Scope: Defines a firm’s lines of business and
geographic areas of operation
 Statement of Corporate Objectives: Sets forth specific goals to
guide management
 Corporate Strategies: Broad approaches developed for achieving
a firm’s goals
 Operating Plan: Provides management detailed implementation
guidance, based on the corporate strategy, to help meet the corporate
objectives
 Financial Plan: The document that includes assumptions ,
projected FS, and projected ratios and ties the entire planning process
together
4-2
Financial Planning:

 Is called value-based management.

This means that the effects of various
decisions on the firm’s financial position
and value are studied by simulating their
effects within the firm’s financial model.

4-3
Sales Forecast:
 Normally, it starts by reviewing the sales
performance during the past 5 years.
 Implications:
a.If the forecast is off:
1. Not able to meet customers’ demand and will
lose market share

b. If forecast is highly optimistic:

1. Too much cost of maintaining inventory
2. Low turnover ratio
3. High costs for depreciation, storage and
write-off
4. Low profit 4-4
5. Lower stock price
 Terminologies and Formula
 Spontaneously Generated Funds
Funds that arise out of normal business operations
from suppliers, employees and government

 Retention Ratio
It is the proportion of net income that is reinvested in
the firm, and is calculated as 1 minus the dividend payout
ratio

 Additional Funds Needed (AFN)

The amount of external capital (interest-bearing
debt and preferred and common stock) that will be
necessary to acquire the required assets.
4-5
Terminologies and Formula

 AFN Equation
An equation that shows the relationship of external funds
needed by a firm to its projected increase in the assets ,
the spontaneous increase in liabilities and its increase in
retained earnings

 Sustainable Growth Rate

The maximum achievable growth rate without the firm
having to raise external funds. It is the growth rate at
which the firm’s AFN equals zero.

4-6
Sources of Primary Capital

 Spontaneous Increases in Accounts

Payable and Accruals
 Addition to Retained Earnings
 Additional Funds Needed (AFN)
Spontaneo
AFN = Projected - us - Increase in
Increase in Retained
Increase in
Assets Earnings
Liabilities

4-7
Alternative AFN Formula

 (Asset0/Sales0) x Sales –
Liabilities0/Sales0) x Sales – MS1RR
Where:

Retention Rate (RR) = 1 – Dividend Payout Ratio or

= 1 – Dividends/Net Income

Profit Margin on Sales (M) = Net Income/Sales0

S1 (Projected Sales) = (1 + growth rate) x Sales0

S = S1 – S0
4-8
Illustration:
Data:

Assets = 2,000,000,000
Fixed Assets = 1,000,000,000
2015 Sales = 3,000,000,000
2015 Net Income = 117,500,000
2015 Dividend = 57,500,000
Liabilities = 200,000,000
Growth Rate = 10 %
Capacity rate for current assets = 100%
Capacity rate for fixed assets = 96 %

AFN = 114 million (can you worked it back?)

4-9
 AFN (Addnl. Funds Needed) Equation

Increase in Sales = change in sales

= rate of increase or decrease to
sales x sales amount

Ex. Allied had assets of 2,000,000,000 and sales of 3,000,000,000

Required assets to generate sales = 2,000,000,000/3,000,000,000

= .6667 per peso sales

The company plans to increase sales by 10 % = 10% x 3,000,000,000 =

300,000,000

Increase in assets to generate increase in sales = .6667 x 300,000,000

= 200,000,000

4-10
AFN (Addnl. Funds Needed) Equation

 Capital Intensity Ratio = (Asset/Sales)

The ratio of assets required per dollar of sales
 Excess Capacity Adjustments
Changes made to the existing asset forecast because the firm is not
operating at full capacity.
 Full capacity sales = Actual sales
% of capacity at which FA were operated
Example = 3,000,000,000/.96 ; = 3,125,000,000
 Target Fixed Assets/Sales = Actual fixed assets = 1,000,000,000
Ratio (full capacity) Full capacity sales 3,125,000,000
= 32 %
 Fixed Assets/Sales = Actual fixed assets = 1,000,000,000
Ratio (actual capacity) Actual sales 3,000,000,000
= 33.3 % 4-11
 AFN (Addnl. Funds Needed) Equation

 Required Level of Fixed Asset = Target Fixed Assets/Sales Ratio

(for the projected sales @ full capacity) x Projected Sales
= .32 (3,300,000,000) = 1,056,000,000

***Additional Fixed Asset Needed = Original – Required

(for the increase in sales) = 1,000,000,000 – 1,056,000,000
= 56,000,000

 Earlier estimate of fixed asset = .333* (3,300) = 1,100,000,000

(for the projected sales @ actual capacity )

Difference in fixed asset needed = 44,000,000

(due to excess capacity in fixed asset)

Note: The excess capacity in fixed asset would lower AFN by

44 million, thus from 114 million to 70 million
4-12
How will 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 given sales.
 Higher trade credit period?
 Decrease AFN: Trade creditors supply more
capital (i.e., L0*/S0 increases).

4-13
Exercise:
Carter Corporation’s sales are expected to increase from 5,000,000 in
2015 to 6,000,000 in 2016. Its assets totaled 3,000,000 million of
which 1,000,000 is fixed at the end of 2015. Carter is at full capacity
for current assets but only utilizes 85 percent of fixed assets. Its
liabilities totaled to 1,000,000. Its profit margin is forecasted to be 5%
of sales and the forecasted retention ratio is 30%.
Compute:
1.Growth Rate
2.Increase in Sales
3.Capital Intensity Ratio
4.AFN
5.Increase in total asset to generate increase in sales
6.Full capacity sales
7.Fixed Assets/Sales Ratio
8.Target Fixed Assets/Sales Ratio
9.Increase in fixed assets to generate increase in sales
10.Reduction in the AFN due to excess capacity in FA
4-14
Assignment:
Edney Manufacturing Company has 2,000,000 in sales and 600,000
in fixed assets. Currently the company’s fixed assets are operating at
80% of capacity.

a.What level of sales could Edney have obtained if it had been

operating at full capacity?
b.What is Edney’s Target fixed assets/Sales ratio?
c.If Edney’s sales increase 30%, how large of an increase in fixed
assets will the company need to meet its Target fixed assets/Sales
ratio?

4-15
Forecasted Financial Statements
Financial statements that project the company’s financial
position and performance over a period of years.
Example:
At the end of last year, Roberts Inc. reported the following
income statement and balance sheet
Sales 3,000,000
Operating cost (excluding depreciation) (2,450,000)
EBITDA 550,000
Depreciation (250,000)
EBIT 300,000
Interest (125,000)
Taxes (40%) (70,000)
Net Income 105,000
4-16
Forecasted Financial Statements
Example:
Cash 180,000
Receivables 360,000
Inventories 720,000
TCA 1,260,000
Fixed asset 1,440,000
Total Asset 2,700,000

Accounts Payable 360,000

Accrued Liabilities 236,000
TCL 596,000
Common stock 1,900,000
Retained earnings 204,000
Total Liabilities and Equity 2,700,000
4-17
Forecasted Financial Statements

The company has assembled the following information for

the forecasted FS
Year-end sales are expected to be 20 % higher than the
3,000,000 sales generated last year
Year-end operating costs, excluding depreciation, are
expected to equal 80% of year-end sales
Depreciation is expected to increase at the same rate as sales
Interest costs are expected to remain unchanged
The tax rate is expected to remain at 40%
Declared and paid 20 percent cash dividend on the forecasted
income

Prepare forecasted IS and BS.

4-18
Forecasted Income Statement
Current Projected
Sales 3,000,000 3,600,000
Operating cost (excluding depreciation) (2,450,000) 2,880,000
EBITDA 550,000 720,000
Depreciation (250,000) 300,000
EBIT 300,000 420,000
Interest (125,000) 125,000
Taxes (40%) (70,000) 118,000
Net Income 105,000 177,000

4-19
Forecasted Balance Sheet
Current Projected
Cash 180,000 144,600
Receivables 360,000 360,000
Inventories 720,000 720,000
TCA 1,260,000 1,260,000
Fixed asset 1,440,000 1,440,000
Total Asset 2,700,000 2,664,600

Accounts Payable 360,000 360,000

Accrued Liabilities 236,000 236,000
TCL 596,000 596,000
Common stock 1,900,000 1,900,000
Retained earnings 204,000 168,600
Total Liabilities and Equity 2,700,000 2,664,600

4-20
Regression Analysis

A statistical technique that fits a line to observed data points

so that the resulting equation can be used to forecast other
data points
Year Sales (x) Inventories (y) AR (y)
2008 2058 387 268
2009 2534 398 297
2010 2472 409 304
2011 2850 415 315
2012 3000 615 375
TOTAL 12,914 2,224 1,559

b = n ∑xy - ∑x ∑y a = ∑y - b ∑x
n ∑x2 - (∑ x)2 n
4-21
Regression Analysis

What would be the regression equation for inventory? for

accounts receivable?

What would be the forecasted inventory and accounts

receivable if sales become 3,300?

4-22
Modifying Accounts Receivable

Problem:

A company’s projected DSO is 40.15 days while the industry’s

average is 36 days. If the projected annual sales is 3,300,000:

How much will be the reduction in the receivable if the company

operates at the industry average?

Receivable at 40.15 = 40.15 x 9.041 = 363.0 million

Receivable at 36 = 36 x 9.041 = 325.5 million
Reduction in receivable = 37.5 million

4-23
Modifying Inventory

Problem:

A company’s projected inventory turnover is 5.26 times versus

10.9 times for the industry. The forecasted inventory and sales
are 627 million and 3,300 million, respectively.

How much will be the reduction in the inventory if the company

achieves the industry average?

Inventory turnover at 5.26 = 3,300/5.26 = 627.0 million

Inventory turnover at 10.9 = 3,300/10.9 = 303.0 million
Reduction in inventory = 324.0 million

4-24
Exercises/Seatwork

Answer the following:

Page # 592 = Problem 17-5 (Walter)

Page # 593 = Problem 17-10 (Edward) and 17- 11 (Charly)

4-25
End of Presentation

17-26
Preliminary Financial Forecast:
Balance Sheets (Assets)
2008 2009E
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

4-27
Preliminary Financial Forecast: Balance
Sheets (Liabilities and Equity)
2008 2009E
Accts payable & accrued liab. $ 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

4-28
Preliminary Financial Forecast:
Income Statements
2008 2009E
Sales $2,000.0 $2,500.0
Less: 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 $ 65.40
Dividends (30% of NI) $15.12 $19.62
Addition to retained earnings $35.28 $45.78
4-29
 Key Financial Ratios

2008 2009E 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 43.8 days 32.0 days Poor
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
Debt/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

4-30
Key Assumptions in Preliminary
Financial Forecast for NWC
 Operating at full capacity in 2008.
 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 $500 million.
(%S = 25%)

4-31
Determining Additional Funds
Needed Using the AFN Equation
AFN = (A0*/S0)S – (L0*/S0)S – M(S1)(RR)
= ($1,000/$2,000)($500)
– ($100/$2,000)($500)
– 0.0252($2,500)(0.7)
= $180.9 million

4-32
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.

4-33
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.

4-34
Revised (Final) Financial Forecast:
Balance Sheets (Assets)
2008 2009F
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

4-35
Key Financial Ratios – Final Forecast

2008 2009F 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 days OK
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 Poor
Debt/assets 30.00% 40.40% 36.00% OK
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

4-36
What was the net investment in
capital?
Capital2009  NWC  Net FA
 $625  $125  $625
 $1,125

Capital2008  $900

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

 $225

4-37
How much free cash flow is expected to
be generated in 2009?

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

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

4-38
Suppose Fixed Assets Had Been Operating at
Only 85% of Capacity in 2008

 The maximum amount of sales that can be supported by the 2008 level of assets is:

Capacity sales  Actual sales/ % of capacity

 $2,000/0.85  $2,353

 2009 forecast sales exceed the capacity sales,

so new fixed assets are required to support
2009 sales.

4-39
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, debt ratio, and TIE would improve.

4-40