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CHAPTER 4
Financial Planning and Forecasting
Financial Statements
Plans: strategic, operating, and
financial
Pro forma financial statements
Sales forecasts
Percent of sales method
Additional Funds Needed (AFN)
formula
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4-2
Pro Forma Financial Statements
Three important uses:
Forecast the amount of external
financing that will be required
Evaluate the impact that changes
in the operating plan have on the
value of the firm
Set appropriate targets for
compensation plans
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Steps in Financial Forecasting
Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and
stock price
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4-4
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 $1000 Total claims $1000
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4-5
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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Key Ratios
NWC Industry Condition
BEP 10.00% 20.00% Poor
Profit Margin 2.52% 4.00% Poor
ROE 7.20% 15.60% Poor
DSO 43.20 days 32.00 days Poor
Inv. turnover 8.33x 11.00x Poor
F.A. turnover 4.00x 5.00x Poor
T.A. turnover 2.00x 2.50x Poor
Debt/assets 30.00% 36.00% Good
TIE 6.25x 9.40x Poor
Current ratio 2.50x 3.00x Poor
Payout ratio 30.00% 30.00% O.K.
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4-7
Key Ratios (Continued)
NWC Ind. Cond.
Net oper. prof. margin after taxes 3.00% 5.00% Poor
(NOPAT/Sales)
Oper. capital requirement 45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital 6.67% 14.00% Poor
(NOPAT/Net oper. capital)
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4-8
AFN (Additional Funds Needed):
Key Assumptions
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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4-9
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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Assets must increase by $250 million.
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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Projecting Pro Forma Statements with
the Percent of Sales Method
Project sales based on forecasted
growth rate in sales
Forecast some items as a percent
of the forecasted sales
Costs
Cash
Accounts receivable (More...)
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Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt (which determines interest)
Dividends (which determines
retained earnings)
Common stock
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Percent of Sales: Inputs
2001 2002
Actual Proj.
COGS/Sales 60% 60%
SGA/Sales 35% 35%
Cash/Sales 1% 1%
Acct. rec./Sales 12% 12%
Inv./Sales 12% 12%
Net FA/Sales 25% 25%
AP & accr./Sales 5% 5%
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Other Inputs
Percent growth in sales 25%
Growth factor in sales (g) 1.25
Interest rate on debt 8%
Tax rate 40%
Dividend payout rate 30%
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2002 1st Pass Income Statement
2002
2001 Factor 1st Pass
Sales $2,000 g=1.25 $2,500
Less: COGS Pct=60% 1,500
SGA Pct=35% 875
EBIT $125
Interest 16 16
EBT $109
Taxes (40%) 44
Net. Income $65
Div. (30%) $19
Add. to RE $46
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2002 1st Pass Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.
2002 Sales = $2,500
2002
Factor 1st Pass
Cash Pct= 1% $25
Accts. rec. Pct=12% 300
Inventories Pct=12% 300
Total CA $625
Net FA Pct=25% $625
Total assets $1250
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2002 1st Pass Balance Sheet (Claims)
2002 Sales = $2,500
2002
2001 Factor 1st Pass
AP/accruals Pct=5% $125
Notes payable 100 100
Total CL $225
L-T debt 100 100
Common stk. 500 500
Ret. earnings 200 +46* 246
Total claims $1,071
*From 1st pass income statement.
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What are the additional funds
needed (AFN)?
Forecasted total assets = $1,250
Forecasted total claims = $1,071
Forecast AFN = $ 179
NWC must have the assets to make
forecasted sales. The balance sheets
must balance. So, we must raise $179
externally.
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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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4 - 20
How will the AFN be financed?
Additional notes payable =
0.5 ($179) = $89.50 ≈ $90.
Additional L-T debt =
0.5 ($179) = $89.50 ≈ $89.
But this financing will add 0.08($179) =
$14.32 to interest expense, which will
lower NI and retained earnings.
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2002 2nd Pass Income Statement
1st Pass Feedback 2nd Pass
Sales $2,500 $2,500
Less: COGS $1,500 $1,500
SGA 875 875
EBIT $125 $125
Interest 16 +14 30
EBT $109 $95
Taxes (40%) 44 38
Net income $65 $57
Div (30%) $19 $17
Add. to RE $46 $40
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2002 2nd Pass Balance Sheet (Assets)
1st Pass AFN 2nd Pass
Cash $25 $25
Accts. rec. 300 300
Inventories 300 300
Total CA $625 $625
Net FA 625 625
Total assets $1,250 $1,250
No change in asset requirements.
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2002 2nd Pass Balance Sheet (Claims)
1st Pass Feedback 2nd Pass
AP/accruals $125 $125
Notes payable 100 +90 190
Total CL $225 $315
L-T debt 100 +89 189
Common stk. 500 500
Ret. earnings 246 -6 240
Total claims $1,071 $1,244
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Results After the Second Pass
Forecasted assets = $1,250 (no change)
Forecasted claims = $1,244 (higher)
2nd pass AFN =$ 6 (short)
Cumulative AFN = $179 + $6 = $185.
The $6 shortfall came from the $6
reduction in retained earnings.
Additional passes could be made until
assets exactly equal claims. $6(0.08) =
$0.48 interest on 3rd pass.
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Equation AFN = $181
vs.
Pro Forma AFN = $185.
Why are they different?
Equation method assumes a
constant profit margin.
Pro forma method is more flexible.
More important, it allows different
items to grow at different rates.
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Ratios After 2nd Pass
2001 2002(E) Industry Cond
BEP 10.00% 10.00% 20.00% Poor
Profit Margin 2.52% 2.27% 4.00% Poor
ROE 7.20% 7.68% 15.60% Poor
DSO (days) 43.20 43.20 32.00 Poor
Inv. turnover 8.33x 8.33x 11.00x Poor
FA turnover 4.00x 4.00x 5.00x Poor
TA turnover 2.00x 2.00x 2.50x Poor
D/A ratio 30.00% 40.34% 36.00% Good
TIE 6.25x 4.12x 9.40x Poor
Current ratio 2.50x 1.99x 3.00x Poor
Payout ratio 30.00% 30.00% 30.00% OK
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Ratios after 2nd Pass (Continued)
NWC Ind. Cond.
Net oper. prof. margin after taxes 3.00% 5.00% Poor
(NOPAT/Sales)
Oper. capital requirement 45.00% 35.00% Poor
(Net oper. capital/Sales)
Return on invested capital 6.67% 14.00% Poor
(NOPAT/Net oper. capital)
Note: These are the same as in 2001 (see slide 14-7),
because there have been no improvements in operations
(i.e., all percent of sales items have same percentages in
2001 and 2002). Also, there are no differences between 1st
pass and 2nd pass because changes in financing do not
affect measures of operating performance.
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4 - 28
What is the forecasted free cash flow
for 2002?
2001 2002(E)
Net operating WC $400 $500
(CA - AP & accruals)
Total operating capital $900 $1,125
(Net op. WC + net FA)
NOPAT $60 $75
(EBITx(1-T))
Less Inv. in op. capital $225
Free cash flow -$150
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4 - 29
Suppose in 2001 fixed assets had been
operated at only 75% of capacity.
Actual sales
Capacity sales =
% of capacity
$2,000
= = $2,667.
0.75
With the existing fixed assets, sales
could be $2,667. Since sales are
forecasted at only $2,500, no new
fixed assets are needed.
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4 - 30
How would the excess capacity
situation affect the 2002 AFN?
The projected increase in fixed assets
was $125, the AFN would decrease by
$125.
Since no new fixed assets will be
needed, AFN will fall by $125, to
$179 - $125 = $54.
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Q. If sales went up to $3,000,
not $2,500, what would the
F.A. requirement be?
A. Target ratio = FA/Capacity sales
= $500/$2,667 = 18.75%.
Have enough F.A. for sales up to
$2,667, but need F.A. for another
$333 of sales:
∆FA = 0.1875($333) = $62.4.
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How would excess capacity affect the
forecasted ratios?
1. Sales wouldn’t change but assets
would be lower, so turnovers would
be better.
2. Less new debt, hence lower interest,
so higher profits, EPS, ROE (when
financing feedbacks considered).
3. Debt ratio, TIE would improve.
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2002 Forecasted Ratios: S02 = $2,500
% of 2001 Capacity
100% 75% Industry
BEP 10.00% 11.11% 20.00%
Profit Margin 2.27% 2.51% 4.00%
ROE 7.68% 8.44% 15.60%
DSO 43.20 43.20 32.00
Inv. Turnover 8.33x 8.33x 11.00x
F.A. turnover 4.00x 5.00x 5.00x
T.A. turnover 2.00x 2.22x 2.50x
D/A ratio 40.34% 33.71% 36.00%
TIE 4.12x 6.15x 9.40x
Current ratio 1.99x 2.48x 3.00x
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How is NWC performing with regard to
its receivables and inventories?
DSO is higher than the industry
average, and inventory turnover is
lower than the industry average.
Improvements here would lower
current assets, reduce capital
requirements, and further improve
profitability and other ratios.
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Improvements in Working Capital
Management
Before After
DSO (days) 43.20 32.00
Accts. rec./Sales 12.00% 8.89%
Inventory turnover 8.33x 11.00x
Inventory/Sales 12.00% 9.09%
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Impact of Improvements in Working
Capital Management
Before After
Free cash flow (1999) -$150.0 $0.5
ROIC (NOPAT/Capital) 6.7% 7.7%
ROE 7.7% 8.59%
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Assets Declining A/S Ratio
1,100
1,000
0
} Base
Stock
2,000 2,500
Sales
$1,000/$2,000 = 0.5; $1,000/$2,500 = 0.44. Declining
ratio shows economies of scale. Going from S = $0
to S = $2,000 requires $1,000 of assets. Next $500 of
sales requires only $100 of assets.
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4 - 38
Assets
1,500
1,000
500
Sales
500 1,000 2,000
A/S changes if assets are lumpy. Generally will have
excess capacity, but eventually a small ∆S leads to a
large ∆A.
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4 - 39
Summary: How different factors affect
the AFN
forecast.
Excess capacity:
Existence lowers AFN.
Base stocks of assets:
Leads to less-than-proportional asset
increases.
Economies of scale:
Also leads to less-than-proportional asset
increases.
Lumpy assets:
Leads to large periodic AFN requirements,
recurring excess capacity.
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4 - 40
Regression Analysis for Asset
Forecasting
Get historical data on a good
company, then fit a regression line
to see how much a given sales
increase will require in way of
asset increase.
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4 - 41
Example of Regression
Inventory Constant
ratio forecast
For a Well-Managed Co. Regression
Year Sales Inv. line
1999 $1,280 $118
2000 1,600 138
2001 2,000 162
2002E 2,500E 192E Sales
1.28 1.6 2.0 2.5 (000)
Constant ratio overestimates inventory required
to go from S1 = $2,000 to S2 = $2,500.
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Regression with 10B for Our Example
Same as finding beta coefficients.
Clear all
1280 Input 118Σ+
1600 Input 138Σ+
2000 Input 162Σ+
0 ^ m 40.0 = Inventory at sales = 0.
y,
SWAP 0.0611 = Slope coefficient.
Inventory = 40.0 + 0.0611 Sales.
LEAVE CALCULATOR ALONE!
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4 - 43
Equation is now in the calculator. Let’s
use it by inputting new sales of $2,500
and getting forecasted inventory:
2500 ^
y, m 192.66.
The constant ratio forecast was
inventory = $300, so the regression
forecast is lower by $107. This would
free up $107 for use elsewhere, which
would improve profitability and raise P0.
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4 - 44
How would increases in these items
affect the AFN?
Higher dividend payout ratio?
Increase AFN: Less retained
earnings.
Higher profit margin?
Decrease AFN: Higher profits, more
retained earnings.
(More…)
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4 - 45
Higher capital intensity ratio, A*/S0?
Increase AFN: Need more assets for
given sales increase.
Pay suppliers in 60 days rather than
30 days?
Decrease AFN: Trade creditors
supply more capital, i.e., L*/S0
increases.
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