Eugene F. Brigham & Joel F.

Houston

Fundamentals of Financial
Management Concise 8E

2-1
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Chapter 16

Financial Planning and Forecasting

Forecasted Financial Statements

AFN Equation
Reviewing Forecasted Statements
Excess Capacity
Factors Impacting AFN
16-2
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Preliminary Financial Forecast:

Balance Sheets (Assets)
2014 2015E
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

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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Preliminary Financial Forecast: Balance Sheets

(Liabilities and Equity)

2014 2015E
A/P & accrued liabilities $ 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

16-4
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Preliminary Financial Forecast:

Income Statements

2014 2015E
Sales $2,000.0 $2,500.0
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 $ 65.4
Dividends (30% of NI) $15.12 $19.62
Addition to retained earnings $35.28 $45.78
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Key Financial Ratios

2014 2015E Ind Avg Comment

Basic earning power Poor
10.00% 10.00% 20.00%
Profit margin Poor
2.52% 2.62% 4.00%
Return on equity Poor
7.20% 8.77% 15.60%
Days sales outstanding 43.8 days 43.8 days 32.0 days Poor
Inventory turnover 8.33x 8.33x Poor
11.00x
Fixed assets turnover 4.00x 4.00x 5.00x Poor
Total assets turnover 2.00x 2.00x 2.50x Poor
Liabilities/Assets OK
30.00% 40.40% 36.00%
Times interest earned 6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.99x 3.00x Poor
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Payout ratio OK
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30.00% 30.00% 30.00%
 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Key Assumptions in Preliminary Financial Forecast for

NWC

• Operating at full capacity in 2014.

• Each type of asset grows proportionally with sales.
• Payables and accruals grow proportionally with
sales.
• 2014 profit margin (2.52%) and payout (30%) will
be maintained.
• Sales are expected to increase by $500 million.
(%DS = 25%).

16-7
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Determining Additional Funds Needed Using the

AFN Equation

AFN = (A0*/S0)S – (L0*/S0)S – M(S1)(1 – Payout)

= ($1,000/$2,000)($500)
– ($100/$2,000)($500)
– 0.0252($2,500)(0.7)
= $180.9 million

16-8
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

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.

16-9
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

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.

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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Revised (Final) Financial Forecast:

Balance Sheets (Assets)

2014 2015F
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

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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Key Financial Ratios: Final Forecast

2014 2015F 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 OK
Liabilities/Assets 30.00% 40.40% 36.00% Poor
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

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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

What was the net investment in capital?

Capital 2015  NOWC  NetFA

 $625  ($315  $190)  $625
 $625  $125  $625
 $1,125

Capital2014  $900

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

 $225

16-13
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

How much free cash flow is expected to be generated

in 2015?

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

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

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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

Suppose Fixed Assets Had Been Operating at Only 85% of

Capacity in 2014

• The maximum amount of sales that can be

supported by the 2014 level of assets is:
Capacity sales  Actual sales/% of capacity
 $2,000/0.85  $2,353

• 2015 forecast sales exceed the capacity sales, so

new fixed assets are required to support 2015 sales.

16-15
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

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, liabilities-to-assets ratio, and TIE would
improve.

16-16
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 FORECASTED STMTS AFN EQUATION REVIEWING STMTS EXCESS CAPACITY IMPACTING AFN

How would 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 a given level of
sales.
• Pay suppliers in 60 days, rather than 30 days?
– Decrease AFN: Trade creditors supply more capital
(i.e., L0*/S0 increases).
16-17
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