Lecture 5 - Financial Planning and Forecasting

Lecture 5 - Financial

Planning and

Forecasting

Strategy

A company’s strategy consists of the competitive moves, internal operating approaches, and action plans devised by management to produce successful performance.

Strategy is management’s “game plan” for running the business.

Managers need strategies to guide HOW the organization’s business will be conducted and HOW performance targets will be achieved.

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Strategic Planning

Strategic planning is a systematic process

through which an organization agrees on and

builds commitment among key stakeholders

to priorities that are essential to its mission

and are responsive to the environment.

Strategic Planning guides the acquisition and

allocation of resources to achieve these

priorities.

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Strategic Planning versus

Operational Planning

Strategic Planning

– formulation

– What, where

– ends

– vision

– effectiveness

– risk

Operational Planning

– implementation

– how

– means

– plans

– efficiency

– control

Financial Planning and Pro Forma

Statements

Financial plans evaluate the economics behind the strategy and

operations. They consist of six steps:

1. Project financial statements to analyze the effects of the operating plan on projected profits and financial ratios. 2. Determine the funds needed to support the plan. 3. Forecast funds availability.

4. Establish and maintain a system of controls to govern the allocation and use of funds within the firm.

5. Develop procedures for adjusting the basic plan if the economic forecasts upon which the plan was based do not materialize

6. Establish a performance-based management compensation system.

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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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Sales Forecast

Sales forecasts are usually based on the analysis of historic data. An accurate sale forecast is critical to the firm’s profitability:

Under-optimistic

Too much inventory and/or fixed assets

•Low turnover ratio

•High cost of depreciation and storage •Write-offs of obsolete inventory

•Low profit

•Low rate of return on equity •Low free cash flow •Depressed stock price Over-optimistic

•Company will fail to meet demand •Market share will be lost

Sales Forecast

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The Percent of Sales Method

This is the most common method, which

begins with the sales forecast expressed as

an annual growth rate in dollar sale revenue.

Many items on the balance sheet and income

statement are assumed to change

proportionally with sales.

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Step 1 - Analyze the Historical Ratios

*Spontaneous generated funds - increase spontaneously with sales

*

*

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Step 2 – Forecast the Income Statement

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How to Forecast Interest Expense

Interest expense is actually based on the

daily balance of debt during the year.

There are three ways to approximate interest

expense. Base it on:

Debt at end of year

Debt at beginning of year

Average of beginning and ending debt

More…

Basing Interest Expense on Debt at End of Year Will over-estimate interest expense if debt is added throughout the year instead of all on January 1. Causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.

Basing Interest Expense on Debt at Beginning of Year Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. But doesn’t cause problem of circularity.

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A Solution that Balances Accuracy and

Complexity

Base interest expense on beginning debt, but use a slightly higher interest rate.

Easy to implement

Reasonably accurate

Basing Interest Expense on Average of Beginning and Ending Debt

Will accurately estimate the interest payments if debt is added smoothly throughout the year.

But has problem of circularity.

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15 Step 3 – Forecast the Balance Sheet

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2009 Balance Sheet(Millions of $)

Cash & sec. $ 10 Accts. pay. &

accruals $ 200 Accounts rec. 375 Notes payable 110 Inventories 615 Total CL $ 310 Total CA $ 1000 L-T debt 754 Common +pr stk 170 Net fixed

assets Retainedearnings 766 Total assets $2,000 Total Liabilities $2,000

1000

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2009 Income Statement (Millions of $)

Sales $3,000.00 Less: COGS (87.2%) 2616.00 Dep costs 100.00 EBIT $ 283.80 Interest 88.00 EBT $ 195.80 Taxes (40%) +pr.div 82.30 Net income $ 113.50 Dividends (Com+Pr $57.50 Add’n to RE $56.00

AFN (Additional Funds Needed):

Key Assumptions

Operating at full capacity in 2009.

Each type of asset grows proportionally with

sales.

Payables and accruals grow proportionally

with sales.

2009 profit margin ($113.5/$3,000 = 3.80%)

and retention ratio (56/114) = .49 will be

maintained.

Sales are expected to increase by $300

million.

Assets = 0..667sales

Assets vs. Sales

Definitions of Variables in AFN

A*/S

: assets required to support

sales; called capital intensity ratio.

∆S: increase in sales.

L*/S

: spontaneous liabilities ratio

M: profit margin (Net income/sales)

RR: retention ratio; percent of net

income not paid as dividend.

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If assets increase by $200 million,

what is the AFN?

AFN = (A*/S

)∆S - (L*/S

)∆S - M(S

)(RR)

AFN = ($2,000/$3,000)($300)

- ($200/$3,000)($300)

- 0.0380($3,300)(0.49) = $118 million

AFN = $118 million.

How Would Increases in Various Items

Affect the AFN?

Higher sales:

Increases asset requirements, increases AFN. Higher dividend payout ratio:

Reduces funds available internally, increases AFN. Higher profit margin:

Increases funds available internally, decreases AFN.

Higher capital intensity ratio, A*/S0:

Increases asset requirements, increases AFN. Pay suppliers sooner:

Decreases spontaneous liabilities, increases AFN. 23

Implications of AFN

If AFN is positive, then you must

secure additional financing.

If AFN is negative, then you have more

financing than is needed.

Pay off debt.

Buy back stock.

Buy short-term investments.

What if Balance Sheet Ratios are

Subject to Change

We have so far assumed that ratios

of both assets and liabilities to sales

are constant over time

Sometimes this assumption is

incorrect.

Declining A/S Ratio

$1,000/$2,000 = 0.5; $1,100/$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.

Base Stock

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Economies of Scale

A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small ∆∆∆∆S leads to a large ∆∆∆∆A.

500 1,000 1,500

Lumpy Assets – Buying Discrete Units

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What if 2009 fixed assets had been

operated at 96% of capacity:

Capacity sales =

Actual sales

% of capacity

= = $3,125.

$3,000

0.96

Thus, if sales increase to $3,300 fixed assets would only have to increase to 3,300 x .32 = $1,056 Target Fixed Assets/Sales = = = 32%Actual Fixed Asset $1,000

Summary: How different factors affect

the AFN forecast.

Excess capacity: lowers AFN.

Economies of scale: leads to

less-than-proportional asset increases.

Lumpy assets: leads to large periodic

AFN requirements, recurring excess

capacity.