Financial Planning And Forecasting Financial Statements

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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 Copyright © 2002 by Harcourt, Inc.

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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 Copyright © 2002 by Harcourt, Inc.

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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 Copyright © 2002 by Harcourt, Inc.

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2001 Balance Sheet (Millions of $) Cash & sec. Accounts rec. Inventories Total CA Net fixed Assets Total assets

$20 Accts. pay. & accruals 240 Notes payable 240 Total CL $500 L-T debt Common stk Retained 500 Earnings $1000 Total claims

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$100 100 $200 100 500 200 $1000

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2001 Income Statement (Millions of $) Sales Less: COGS (60%) SGA costs EBIT Interest EBT Taxes (40%) Net income Dividends (30%) Add’n to RE Copyright © 2002 by Harcourt, Inc.

$2,000.00 1,200.00 700.00 $100.00 16.00 $84.00 33.60 $50.40 $15.12 35.28 All rights reserved.

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Key Ratios BEP Profit Margin ROE DSO Inv. turnover F.A. turnover T.A. turnover Debt/assets TIE Current ratio Payout ratio

NWC Industry 10.00% 20.00% 2.52% 4.00% 7.20% 15.60% 43.20 days 32.00 days 8.33x 11.00x 4.00x 5.00x 2.00x 2.50x 30.00% 36.00% 6.25x 9.40x 2.50x 3.00x 30.00% 30.00%

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Condition Poor Poor Poor Poor Poor Poor Poor Good Poor Poor O.K. All rights reserved.

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Key Ratios (Continued) Net oper. prof. margin after taxes

NWC

Ind.

Cond.

3.00%

5.00% Poor

(NOPAT/Sales) Oper. capital requirement (Net oper. capital/Sales)

45.00% 35.00% Poor

Return on invested capital (NOPAT/Net oper. capital)

6.67% 14.00% Poor

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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%) Copyright © 2002 by Harcourt, Inc.

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Assets

Assets = 0.5 sales

1,250

∆ Assets = (A*/S0)∆Sales = 0.5($500) = $250.

1,000

0

2,000

2,500

Sales

A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500. Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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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 Copyright © 2002 by Harcourt, Inc.

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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 Copyright © 2002 by Harcourt, Inc.

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Percent of Sales: Inputs

COGS/Sales SGA/Sales Cash/Sales Acct. rec./Sales Inv./Sales Net FA/Sales AP & accr./Sales Copyright © 2002 by Harcourt, Inc.

2001

2002

Actual 60% 35% 1% 12% 12% 25% 5%

Proj. 60% 35% 1% 12% 12% 25% 5% All rights reserved.

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Other Inputs Percent growth in sales Growth factor in sales (g) Interest rate on debt

25% 1.25 8%

Tax rate

40%

Dividend payout rate

30%

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2002 1st Pass Income Statement

Sales Less: COGS SGA EBIT Interest EBT Taxes (40%) Net. Income Div. (30%) Add. to RE Copyright © 2002 by Harcourt, Inc.

2002 2001 Factor 1st Pass $2,000 g=1.25 $2,500 Pct=60% 1,500 Pct=35% 875 $125 16 16 $109 44 $65 $19 $46 All rights reserved.

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2002 1st Pass Balance Sheet (Assets) Forecasted assets are a percent of forecasted sales. 2002 Sales = $2,500

Cash Accts. rec. Inventories Total CA Net FA Total assets Copyright © 2002 by Harcourt, Inc.

Factor Pct= 1% Pct=12% Pct=12% Pct=25%

2002 1st Pass $25 300 300 $625 $625 $1250 All rights reserved.

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2002 1st Pass Balance Sheet (Claims) 2002 Sales = $2,500

2001 AP/accruals Notes payable Total CL L-T debt Common stk. Ret. earnings Total claims

100 100 500 200

2002 Factor 1st Pass Pct=5% $125 100 $225 100 500 +46* 246 $1,071

*From 1st pass income statement. Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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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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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. Copyright © 2002 by Harcourt, Inc.

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2002 2nd Pass Income Statement Sales

1st Pass Feedback $2,500

Less: COGS SGA EBIT Interest EBT Taxes (40%) Net income Div (30%) Add. to RE Copyright © 2002 by Harcourt, Inc.

$1,500 875 $125 16 $109 44 $65 $19 $46

2nd Pass $2,500 $1,500 875 $125 +14 30 $95 38 $57 $17 $40 All rights reserved.

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2002 2nd Pass Balance Sheet (Assets) 1st Pass $25

Cash Accts. rec. Inventories Total CA Net FA Total assets

300 300 $625 625 $1,250

AFN

2nd Pass $25 300 300 $625 625 $1,250

No change in asset requirements. Copyright © 2002 by Harcourt, Inc.

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2002 2nd Pass Balance Sheet (Claims)

AP/accruals

1st Pass Feedback $125

Notes payable Total CL L-T debt Common stk. Ret. earnings Total claims Copyright © 2002 by Harcourt, Inc.

100 $225 100 500 246 $1,071

2nd Pass $125 190 +90 $315 189 +89 500 240 -6 $1,244 All rights reserved.

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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. Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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Ratios After 2nd Pass BEP Profit Margin ROE DSO (days) Inv. turnover FA turnover TA turnover D/A ratio TIE Current ratio Payout ratio

2001 10.00% 2.52% 7.20% 43.20 8.33x 4.00x 2.00x 30.00% 6.25x 2.50x 30.00%

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2002(E) 10.00% 2.27% 7.68% 43.20 8.33x 4.00x 2.00x 40.34% 4.12x 1.99x 30.00%

Industry 20.00% 4.00% 15.60% 32.00 11.00x 5.00x 2.50x 36.00% 9.40x 3.00x 30.00%

Cond Poor Poor Poor Poor Poor Poor Poor Good Poor Poor 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. Copyright © 2002 by Harcourt, Inc.

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What is the forecasted free cash flow for 2002? Net operating WC (CA - AP & accruals) Total operating capital (Net op. WC + net FA) NOPAT (EBITx(1-T)) Less Inv. in op. capital Free cash flow Copyright © 2002 by Harcourt, Inc.

2001 2002(E) $400 $500 $900

$1,125

$60

$75 $225 -$150 All rights reserved.

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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. Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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2002 Forecasted Ratios: S02 = $2,500

BEP Profit Margin ROE DSO Inv. Turnover F.A. turnover T.A. turnover D/A ratio TIE Current ratio

% of 2001 Capacity 100% 75% 10.00% 11.11% 2.27% 2.51% 7.68% 8.44% 43.20 43.20 8.33x 8.33x 4.00x 5.00x 2.00x 2.22x 40.34% 33.71% 4.12x 6.15x 1.99x 2.48x

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Industry 20.00% 4.00% 15.60% 32.00 11.00x 5.00x 2.50x 36.00% 9.40x 3.00x All rights reserved.

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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. Copyright © 2002 by Harcourt, Inc.

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Improvements in Working Capital Management Before

After

DSO (days)

43.20

32.00

Accts. rec./Sales

12.00%

Inventory turnover Inventory/Sales Copyright © 2002 by Harcourt, Inc.

8.33x 12.00%

8.89% 11.00x 9.09% All rights reserved.

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Impact of Improvements in Working Capital Management Before

After

-$150.0

$0.5

ROIC (NOPAT/Capital)

6.7%

7.7%

ROE

7.7%

8.59%

Free cash flow (1999)

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Declining A/S Ratio

Assets 1,100 1,000

}

Base Stock

0

Sales

2,000 2,500 $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. Copyright © 2002 by Harcourt, Inc.

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4 - 38 Assets

1,500 1,000 500

500

1,000

2,000

Sales

A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small ∆S leads to a large ∆A. Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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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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Example of Regression Inventory

For a Well-Managed Co. Year Sales Inv. $1,280 $118 1999 1,600 138 2000 2,000 162 2001 192E 2002E 2,500E

Regression line

1.28 1.6

Constant ratio forecast

2.0

2.5

Sales (000)

Constant ratio overestimates inventory required to go from S1 = $2,000 to S2 = $2,500. Copyright © 2002 by Harcourt, Inc.

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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+ ^ m 40.0 = Inventory at sales = 0. 0 y, SWAP 0.0611 = Slope coefficient. Inventory = 40.0 + 0.0611 Sales. LEAVE CALCULATOR ALONE! Copyright © 2002 by Harcourt, Inc.

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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. Copyright © 2002 by Harcourt, Inc.

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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.

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 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. Copyright © 2002 by Harcourt, Inc.

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