Financial planning and forecasting

Warren Buffet, a great investor of all times, once said,

“If you don’t know where you’re going, you probably
won’t get there.”

That’s certainly true for a company—it needs a plan,

one that starts with the firm’s general goals and
details the steps that will be taken to get there.
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 The importance of strategic planning and financial
forecasting for the firm
 How firm forecast sales
 Use the Additional Funds Needed (or AFN) equation
and discuss the relationship between asset growth and
the need for funds
 Use spreadsheet to forecast starting with historical
statements, ending with projected statements, and
including a set of financial ratios based on those
projected statements.
 Discuss how planning is an iterative process.
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 What is strategic planning?
 Mission statement and objectives
 Chairman’s letter in the annual report: We expect our

businesses to achieve 10%+ earnings growth most years,

with long-term returns on equity of 20%. We expect our
businesses to be industry leaders in market share, value,
and profitability.
 Corporate Scope:
 The lines of business the firm plans to pursue and the

geographic areas in which it will operate

 Operating plan: 5-year horizon, those people responsible for
each particular function, deadlines for specific tasks, sales and
profit targets, and the like.
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 What is Financial planning?
 Financial plan sets out methods to achieve financial goals

 Investment decisions, funding, and dividend payments are

based on the growth and profitability of the company.

 The plan has two dimensions: time frame and aggregate

level.
 The statement will take place in the near future, long time, given before
implementation
 Identify policy changes in the company. These principles include:
Identification of the company's financial goals.
 Compare this goal vs the current financial situation of the company
 Action strategy for the company to achieve financial goals

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17-5
 Part 1: Forecasting the financial
statements of a specific company

17-6
 Financial statements for Coop

Income statement Balance sheet

Assets $500 Liability $250
Sales $1,000
Cost 800 Equity 250

Net profit $200 Total $500 Total $500

assets capital

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Projected/Pro-forma income statement for Coop

 Assume a 20% increase in sales next year

 Cost is also forecasted to increase by 20% next year
OLD Income statement Projected income
statement
Sales $1,000
Sales $1,200
Cost 800
Cost 960
Net profit $200
Net profit $240

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 Projected/Pro-forma Balance sheet for Coop

 Assume that all parameters will increase by 20%.

 Dividend payment is $190.
 Dividend is the hidden variable (plug).
 If dividend is paid in cash, so how much?
 If dividend is retained, then what changes?

OLD Balance sheet Projected balance sheet

Assets $500 Liability $250
Assets $600 Liability $300
(+100) (+50)
Equity 250
Equity 300
(+50)
Total $500 Total $500
Total $600 Total $600
(+100)
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 Projected/Pro-forma Balance sheet for Coop

 Assume that all parameters will increase by 20%.

 The after-tax profit will be fully retained
 Debts to be withdrawn are $ 140. Debt is a hidden variable to find (plug)
 Presents the interaction between sales growth &financing policy & dividend
payment policy
OLD balance sheet Projected balance sheet

Assets $500 Liability $250 Assets $600 Liability $110

(+100) (-140)
Equity 250 Equity 490
(+240)
Total $500 Total $500 Total $600 Total $600
(+100)
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 The percentage of sales approach


Assume that revenue increases by 25% in the following year

 Percentage of total cost by revenue 80% ($ 800 / 1,000)
OLD Income statement FINA
Sales $1,000
Cost 800
EBT $200
Tax(34%) 68
Net Income $132
Dividend $44
Additions to retained earning 88
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 Projected income statement FINA
 Assume that revenue increases by 25% in the following year
 Total cost ratio by revenue 80% ($ 800 / 1,000)
 Constant profit margin (Profit margin) is 13.2%
 Dividend payout ratio is 33.03%
 The rate of retention ratio (retention ratio / plowback ratio) is 66.07%

Projected income statement

Sales (projected) $1,250
Cost (80% sales) 1,000
EBT $250
Tax (34%) 85
Net Income $165
Dividend $55
Addition to retained earnings $110 17-12
 OLD balance sheet FINA
Balance sheet FINA
Assets $ % Sales Liability and $ %
Equity Sales

Short-term asset Short-term deb

Cash 160 16% A/P $300 30%
A/C 440 44 Note payables 100 n/a
Inventory 600 60 Total $400 n/a
Total $1,200 120 Long-term debt $800 n/a
Fixed asset Equity
Net plan and $1,800 180 Common stock $800 n/a
equipment
Retained earnings 1,000 n/a
Total $1,800 n/a
Total assets $3,000 300% Total capital $3,000 n/a
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 Projected balance sheet FINA
Projected balance sheet
Assets $ Change Liability and equity $ Change
from from
previous previou
year s year

Short-term asset Short-term debt

Cash $200 $40 A/P $375 $75
A/R 550 110 Notes payable 100 0
Inventory 750 150 Total $475 $75
Total $1,500 300 Long-term liability $800 $0
Fixed asset Equity
Net plan and equipment $2,250 $450 Common stock $800 $0

Retained earnings $1,110 $110

Total $1,910 $110
Total assets $3,750 $750 Total capital $3,185 $185
EFN $565 $565

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 External financing needed (EFN)

 Formula 1: projected increase in assets (Capital intensity ratio)

 Formula 2: Spontaneous increase in liabilities
 Formula 3: projected addition to retained earnings 17-15
 In case of external debt:
short-term debt and long-term debt (plug)
Projected balance sheet
Assets $ Change Liability and $ Change
from equity from
previous previous
year year

Short-term asset Short-term

debt
Cash $200 $40 A/P $375 $75
A/R 550 110 Notes payable 325 225
Inventory 750 150 Total $700 $300
Total $1,500 300 Long-term liability $1,140 $340
Fixed asset Equity
Net plan and equipment $2,250 $450 Common stock $800 $0

Retained earnings $1,110 $110

Total $1,910 $110
Total assets $3,750 $750 Total capital $3,750 $750
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 Financing policy và growth

 All other things remain the same, the higher

the growth rate of sales or assets, the greater
the need for external funding.

 Preset the company's financing policy and

then examine the relationship between the
company's financial policy and the ability to
finance new investments and developments

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 External financing and growth

OLD income statement OLD balance sheet

Sales $500 $ % $ % sales
sales
Cost 400
Short- 200 40% Total $250 n/a
EBT $100 term liability
asset
Tax (34%) 34

Net income $66 Net 300 60 Equity 250 n/a

fixed
Dividend $22 assets

Additions to 44 Total $500 100% Total $500 n/a

retained earnings assets

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 External financing and growth

Báo cáo thu nhập dự kiến Bảng cân đối kế toán dự kiến
Projected Sales $600 $ % $ % theo
theo DT
Cost (80% sales) 480 DT
Short- 240 40% Total $250 n/a
EBT $120 term liability
asset
Tax (34%) 40.8

Net income $79.2 Net 360 60 Equity 302. n/a

fixed 8
Dividend $26.4 assets

Additions to retained 52.8 Total $600 100% Total $55 n/a

earnings assets 2.8

EFN
$47.
2

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Growth and expected EFN/AFN

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Growth and expected EFN

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 Financing policy and growth: Internal growth


is the maximum growth rate that can be achieved without external

funding of any kind
 Internal growth rate because this is the ratio of companies that can
maintain only with internal financing (point of intersection of two
diagonal lines, EFN = 0)

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 Financing policy and growth:
Sustainable growth


The maximum growth rate that a company can maintain does not
need to increase the mobilized equity capital (maintain a fixed debt
to equity ratio)

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 Financing policy and growth:
Sustainable growth
 Suppose Hoffman sustained growth of 21.36%.
Projected income statement Projected balance sheet
Projected Sales $606.8 $ % $ % sales
sales
Cost (80% sales) 485.4
Short- 242 40% Total $250 n/a
EBT $121.4 term liability
asset
Tax (34%) 41.3
Net fixed 364.1 60 Equity 303.4 n/a
assets
Net income $80.1

Dividend $26.7 Total $606.8 100% Total $553.4 n/a

assets
Additions to retained 53.4
earnings
EFN $53.4
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 Determine growth
 The company's growth ability depends on the
following four factors:
 Operational efficiency: Profit margin (profit margin)
 Dividend payment policy
 Financing policy: increase debt / equity ratio
 Total asset turnover

If a company does not want to raise new shares and all four
indicators remain the same, there is only one growth rate.

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 Example:
 Sandar company has a debt-to-equity ratio of 0.5,
a company's profit margin of 3%, a dividend
payout ratio of 40%, and a total asset turnover
ratio of 1. Calculate sustainable growth rates for
the company? (2.77%)

 If Sandar wants 10% sustainable growth and

plans to achieve this goal by improving profits, do
you comment about this plan?

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Part 2: Applied company in Excel

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 1. Inputs/Assumptions
Forecasted sales
 Financial plans often start with sales growth forecasts
 Assume that most assets increase at the same rate as sales.
 Sales growth must be balanced with the cost to achieve
that growth
 A review of sales in the last 5 years.

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 1.Assumptions
 Operating at full capacity in 2009.
 Each type of asset grows proportionally with sales.
 Payables and accruals grow proportionally with sales.
 2008 profit margin (2.52%) and payout (30%) will be
maintained.
 Sales are expected to increase by $300 million. (%DS
= 10%)

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1. Assumptions based on financial ratios

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Using regression to improve
forecasts
 Allied’s sales, inventories, and receivables during
the last 5 years and scatter diagrams of inventories
and receivables versus sales.

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Forecasted financial
statements
Basic inputs/assumptions

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Forecasted income statement

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Projected income statement

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Forecasted Balance Sheet

17-35
Projected balance sheet

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 The AFN equation

 It is possible that spontaneous funds and additional retained

earnings will offset the forecasted increase in assets. Normally,
though, that situation does not occur—normally, there is a
shortfall, called Additional Funds Needed (AFN), which has
to be made up by additional borrowing and/or the sale of new
stock. 17-37
 Determining additional funds
needed, using the AFN equation

AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

= $200 - $20 - $66
= $114 million.

 How much new capital the firm will need to

support the targeted 10% growth rate, assuming
the various operating ratios remain constant.

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Raising the additional funds
needed

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 Other changes affect AFN ?
 Lower AFN
 Change in fixed assets, inventories, cash, any
other assets.
 Increase the L0*/S0 ratio due to longer credit
term for firm purchase
 Increase profit margin, lower dividend payout
ratio

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Notes on calculations

17-41
Ratios and EPS

17-42
 Excess capacity adjustments
 Allied had $1,000 million of current assets and $1,000
million of fixed assets; so he broke A0*/S0 into two parts,
one for fixed assets and one for current assets:

 Current assets: Ao*/S0 = $1,000/$3,000 = 0.333 = 33.3%

 Fixed assets: A0*F/S0 = $1,000/$3,000 = 0.333 = 33.3%

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 Excess capacity adjustments
 However, the CFO thought that in 2008, fixed assets had
been used at only 96% of capacity in 2008.

 If fixed assets had been used to full capacity, sales

could have reached $3,125 million with no increase
in fixed assets

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 Excess capacity adjustments
 A sales increase to $3,300 million would require
only $1,056 million of fixed assets

 We previously assumed that fixed asset grow

proportionally as sales, 10%

The existence of excess capacity would lower

Allied’s required AFN from $114 million to $114
million - $ $44 million = $70 million 17-45
 Using forecast to improve
operations
 Change the growth rate and the five key input variables
 Change the financing assumptions, perhaps using more bank debt
and fewer bonds , or only with debt or only with stock.

 Allied’s ratio analysis pointed out the firm’s weaknesses.

 The model demonstrates how improvements in the driver variables

will affect the firm’s ROE, its EPS, and (of course) its stock price.

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