Chapter 17 Financial Planning and Forecasting

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Simon Rose
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1 Chapter 17 Financial Planning and Forecasting Companies base their operating plans on forecasted financial statements. The company must first forecast sales for the next few years. Then determine the assets required to meet the sales targets. Next comes forecasting the financial requirements necessary. Forecasting financial requirements involves: 1. Project the asset requirements for the coming period 2. Project the liabilities and equities that will be generated under normal operating conditions during the same period 3. subtract the projected liabilities and equity from the required assets to estimate the additional funds needed (AFN) to support the level of forecasted operations. Projected Balance Sheet Method Steps: 1. Forecast income statement 2. Forecast balance sheet 3. Determine how to raise the additional funds needed 4. Financing feedbacks Example: NWC 2003 sales were $2 billion, and the marketing department is forecasting a 25% increase for Assume that the company was operating at full capacity with respect to all assets in Assume that a) Each type of asset, as well as payables, accruals, and costs, and depreciation, grows at the same rate as sales b) The dividend payout ratio is held constant at 30% c) External funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock will be issued) d) All debt carries an interest rate of 8%

2 Actual 2003 and Projected 2004 Income Statement ( millions of dollars) Actual 2003 Forecast basis 2004Forecast Sales Costs except deprec. Depreciation $2, (1,800.00) (.00) 1.25 x 2003 Sales.90 x 2004 Sales.05 x 2004 Sales EBIT Interest Expense $.00 (16.00) EBT Taxes (40%) $ (33.60) Net Income $ Dividends (30%) Addition to R.E. $ $ Balance Sheet ( millions of dollars) Forecasted balance sheet items are a percent of forecasted sales 2004 sales forecasted to be $2,500. Assets 2003 Forecast basis st Pass Cash and securities $ x FS* Accounts receivable Inventories Total current assets 500 Net fixed assets * FS Total assets 1,000 Liabilities and equity Accounts payables & accruals Notes payable Total current liabilities 200 Long-term debt Common stock 500 Retained earnings x FS +$46** AFN nd Pass Total liabilities and equity 1,000 *FS2004 forecasted sales **increase in retained earnings from the first pass income statement.

3 What are the additional funds needed (AFN)? Forecasted total assets $ Forecasted total claims $ Forecast AFN $ A* L* AFN S S M S1 RR S S 0 0 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. Additional notes payable Additional long-term debt This additional financing will add to interest expense 8 % which will lower net income and the addition to retained earnings

4 Other Considerations in Forecasting 1. excess capacity. Can we always assume % capacity utilization? What if asset use is less than % of capacity? Let s assume that in fixed assets in 2003 were being utilized to only 90% of capacity. Actual sales $2,000 Full capacity sales $2,222 % capacity at which 90% FA were operated T arg et FA Sales Actual FA Full capacity sales $500 $2, % Forecasted balance sheet items are a percent of forecasted sales 2004 sales forecasted to be $2,500. Assets 2003 Forecast basis st Pass Cash and securities $ x FS* Accounts receivable Inventories Total current assets 500 Net fixed assets * FS Total assets 1,000 Liabilities and equity Accounts payables & accruals Notes payable Total current liabilities 200 Long-term debt Common stock 500 Retained earnings x FS +$46** AFN nd Pass Total liabilities and equity 1,000 *FS2004 forecasted sales **increase in retained earnings from the first pass income statement.

5 2. economies of scale -- variable cost of good sold ratio may change with the size of the firm 3. lumpy assets -- not all assets can be acquired in small increments, but must obtained in large discrete amounts. A small increase in sales can require significant increase in plant and equipment

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