FINANCIAL

PLANNING AND
FORECASTING
Strategic Planning
• Elements of strategic planning: mission statement,
corporate scope, statement of corporate objectives,
corporate strategies, operating plan and financial
plan.
• Financial planning is a multistep process:
1. Assumptions made on e.g. future levels of sales, costs
and interest rates for use in the financial forecast.
2. A set of projected financial statements is developed.
3. Projected ratios are calculated and analyzed.
4. The entire strategic planning is reexamined.
• The financial planning ties the entire strategic
planning process together.
The Sales Forecast
• Financial planning generally begins with a sales
forecast, which starts with a review of sales during the
past 5 years.
• Management likes higher sales growth, but not at any
cost.
• Sales growth must be balances against the cost of
achieving the growth.
• Sales forecast is the most important input in the firm’s
forecast of financial statements.
 4

Preliminary Financial Forecast:

Balance Sheets (Assets)
2012 2013E
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
 5

Preliminary Financial Forecast:

Balance Sheets (Liabilities and Equity)
2012 2013E
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
 6

Preliminary Financial Forecast:

Income Statements
2012 2013E
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
 7

Key Financial Ratios

2012 2013E 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
Debt/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
Payout ratio OK
30.00% 30.00% 30.00%
 8

Key Assumptions in Preliminary

Financial Forecast for NWC Inc.
• Operating at full capacity in 2012.
• Each type of asset grows proportionally with
sales.
• Payables and accruals grow proportionally with
sales.
• 2012 profit margin (2.52%) and payout (30%)
will be maintained.
• Sales are expected to increase by $500 million.
(%DS = 25%)
The AFN Equation
• The primary capital sources:
• Spontaneously generated fund
Funds that arise out of normal business operation from
its suppliers, employees, and the government that
reduce the firm’s need for external financing
• Addition to retained earning
The proportion of net income that is reinvested in the
firm and is calculated as 1 minus the dividend payout
ratio
• AFN: additional fun needed
The amount of external capital (interest-bearing debt,
and preferred and common stock) needed to acquire
the needed assets
The AFN Equation
• The AFN equation shows the relationship of external
funds needed by a firm to its projected increase in
assets, the spontaneous increase in liabilities, and its
increase in retained earnings

• When the AFN is zero, sustainable growth rate show

the maximum achievable growth rate without the
firm having to raise external funds
The AFN Equation
• The capital Intensity Ratio (A0*/S0)
• The ratio of assets required per dollar of sales
• Excess capacity adjustment
• Changes made to the existing asset forecast
because the firm is not operating at full capacity
The AFN Equation
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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
 14

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.
• 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.
 15

Revised (Final) Financial Forecast:

Balance Sheets (Assets)
2012 2013F
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
 16

Key Financial Ratios: Final

Forecast
2012 2013F 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% 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
 17

What was the net investment in

capital?
Capital2013  NOWC  NetFA
 $625  ($315  $190)  $625
 $625  $125  $625
 $1,125

Capital2012  $900

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

 $225
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How much free cash flow is expected

to be generated in 2013?

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

= $125(0.6) – $225
= $75 – $225
= -$150
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Suppose Fixed Assets Had Been Operating

at Only 85% of Capacity in 2012

• The maximum amount of sales that can be

supported by the 2012 level of assets is:
•

Capacity sales  Actual sales/% of capacity

 $2,000/0.85  $2,353

• 2013 forecast sales exceed the capacity sales, so

new fixed assets are required to support 2013
sales.
 20

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.
 21

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).
Using regression to improve forecasts