Lecture 5 - Financial Planning and Forecasting

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1 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. 2 Strategic Planning Strategic Planning versus Operational 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. n Strategic Planning formulation What, where ends vision effectiveness risk n Operational Planning implementation how means plans efficiency control 3 4

2 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. 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 5 6 Sales Forecast Sales Forecast Sales forecasts are usually based on the analysis of historic data. An accurate sale forecast is critical to the firm s profitability: Sales Forecast Under-optimistic Company will fail to meet demand Market share will be lost Over-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 7 8

3 The Percent of Sales Method Step 1 - Analyze the Historical Ratios 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. * * 9 *Spontaneous generated funds - increase spontaneously with sales 10 Step 2 Forecast the Income Statement 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 11 More 12

4 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. 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. 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 Step 3 Forecast the Balance Sheet Step 4 Raising the Additional Funds Needed 15 16

5 2009 Balance Sheet(Millions of $) 2009 Income Statement (Millions of $) Cash & sec. $ 10 Accts. pay. & Accounts rec. 375 accruals Notes payable $ Inventories 615 Total CL $ 310 Total CA $ 1000 L-T debt 754 Common +pr stk 170 Net fixed assets 1000 Retained earnings 766 Total assets $2,000 Total Liabilities $2, Sales $3, Less: COGS (87.2%) Dep costs EBIT $ Interest EBT $ Taxes (40%) +pr.div Net income $ Dividends (Com+Pr $57.50 Add n to RE $ AFN (Additional Funds Needed): Key Assumptions Operating at full capacity in Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales 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. 2,200 2,000 Assets 0 Assets vs. Sales Assets = sales 3,000 3,300 A*/S 0 = $2,000/$3,000 = = $2200/$3,300. Assets = (A*/S 0 ) Sales = ($300) = $200. Sales 19 20

6 Definitions of Variables in AFN A*/S 0 : assets required to support sales; called capital intensity ratio. S: increase in sales. L*/S 0 : spontaneous liabilities ratio M: profit margin (Net income/sales) RR: retention ratio; percent of net income not paid as dividend. If assets increase by $200 million, what is the AFN? AFN = (A*/S 0 ) S - (L*/S 0 ) S - M(S 1 )(RR) AFN = ($2,000/$3,000)($300) (0.667) x $300 - ($200/$3,000)($300) (0.067) x ($300) ($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*/S 0 : 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. 24

7 What if Balance Sheet Ratios are Subject to Change Economies of Scale We have so far assumed that ratios of both assets and liabilities to sales are constant over time Sometimes this assumption is incorrect. 1,100 1,000 Assets Base }Stock Declining A/S Ratio 0 2,000 2,500 Sales $1,000/$2,000 = 0.5; $1,100/$2,500 = 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 Lumpy Assets Buying Discrete Units What if 2009 fixed assets had been operated at 96% of capacity: Assets 1,500 1, 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. Capacity sales = Actual sales % of capacity $3,000 = = $3, Target Fixed Assets/Sales = = = 32% Actual Fixed Asset $1,000 Full Capacity Sales $3,125 Thus, if sales increase to $3,300 fixed assets would only have to increase to 3,300 x.32 = $1,

8 Summary: How different factors affect the AFN forecast. Excess capacity: lowers AFN. Economies of scale: leads to less-thanproportional asset increases. Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity

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