Forecasting Financial Needs-13!2!2009
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FORECASTING FINANCIAL NEEDS William M. Kinai
1.1
Introduction
A financial plan is blueprint in which management analyzes a firm’s financial needs over a duration of time and includes suggestions on how funds may be raised where necessary. Financial plans relate to a specified time period. A financial plan could be either a shortterm or long-term plan. A short-term financial plan relates to the next 12 months. A cash budget is an example of a short-term financial plan. A long-term plan relates to periods longer than 12 months. This session focuses on the formulation of a long-term plan.
1.2
Financial Planning Models
On average a financial planning model requires the following elements. a.
Sales forecast: This is a forecast of sale to be made over a duration of time in future. This duration of time is also referred to as the planning horizon. The sales forecast takes into consideration expected increase in the production levels over the planning horizon.
b.
Budgeted financial statements: These are financial statement (profit and loss account and balance sheet) at the end of the planning horizon.
c.
Asset requirements: This is a forecast of the investments required in capital and working capital over the planning horizon.
d.
Financial requirements: This is a proposal of how debt and equity funds will be raised to finance investments in capital and working capital over the planning horizon. It takes into consideration the firm’s dividend policy.
e.
External funds requirement: This is an estimate of the amount of fund that is to be raised from outside source to support the expected increases in capital and working capital over the planning horizon.
1.3
Percentage of Sales Financial Planning Model
The percentage of sales financial planning model is a tool of long-term financial management. This method takes into consideration the relationship between sales, expenses, assets and liabilities.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan. Copyright © 2009 William M. Kinai. This article may be reprinted free of charge in any publication or website provided that the article is unedited, and that the copyright, author's bio, and contact information appears with each reproduction and/or posting.
FORECASTING FINANCIAL NEEDS
1.3.1
2
Items That Move Proportionately to Sales
Some items move in direct proportion to sales, while others are dependent on company policies. Company policies are strongly influence by the company’s shareholders. For example, the cost of goods sold move in proportion to the level of sales. There is often a direct relationship between the level of sales and additional investments in assets. A business will need to increase investment in assets to achieve an increase in sales. Some liability items such as trade creditors (suppliers who accept to sale to the business under credit terms) the financing availed will be proportional to the level of sale. The higher the sales the more the purchases and the greater will be the purchases made on credit.
1.3.2
Items Influenced by Company Policy
The company’s debt policy will influence the extent to which long term liabilities such as leases and new bond issues will be utilized as a source of additional financing. The company’s dividend policy will provide a guide as to the extent to which retained earnings will be used as a source of long term financing. Further, the raising of equity capital is at the discretion of shareholders on recommendation of management. Generally, financing decisions are not directly related to sale but on other factors such as the availability of found in the capital markets and the company’s polices which reflect the preferences of shareholders. The percentage of sales financial planning model takes into consideration the relationship between sales and individual cost, assets and liabilities. The following is an illustration for how the percentage of sales financial planning model can be applied in forecasting financial needs in the context of growing businesses.
1.3.3
Percentage of Sales Financial Planning Model: Illustrated
Mwangaza Times Ltd publishes a weekly newspaper under the brand Mwangaza Times. Mwangaza Times current circulation is 120,000 copies annually. The management of Mwangaza Times plans to double circulation to 240,000 copies annually in next 2 years. Mwangaza Times Ltd will purchase a new printing press from International Printing Machines Ltd. The suppliers of the new industrial printing press will take one year to manufacture and install the new plant. This new machine will be ready for operation on an industrial scale on 1 January 2010. In the financial year 2010, sales are expected to double at 240,000 copies annually. Profit and loss account for the financial year ended 31 December 2007 and balance sheet as at 31 December 2007 is presented in Exhibit 2.1a and 2.1b.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
3
Exhibit 2.1a Mwangaza Times Ltd. Profit and Loss Account for the financial year end 31 December 2008 Sh.000 Sales
Sh.000 20,000
Cost of sales and expenses
-16,000
Net profits before tax
4,000
Taxes (30%)
-1200
Net profits after tax
2,800
Dividend
1,400
Transferred to retained earnings
1,400
The following information is available: a.
Mwangaza Times’ cost of sales and operating expenses amount to 80 percent of sales revenues.
b.
The company faces a 30 percent tax rate.
c.
The company retains half of its profits after taxes.
d.
The company has issued 2,300,000 shares of Sh.10 each.
e.
Noncurrent liabilities consist of amounts owing to the holders of a 12 percent interest bond with a floating charge on the assets of the company. The bonds are redeemable on the 31 December 2015.
f.
The following items are directly proportional to the level of sale: i.
Property, plant and equipment
ii.
Inventories
iii.
Trade debtors
iv.
Cash
v.
Trade creditors
g.
Directors, subject to the approval of shareholders, decide on when to raise additional short term debt, long term debt and equity. The directors approve certain types of current liabilities such as bank overdrafts. Thus, share capital, noncurrent liabilities and certain types of current liabilities such as bank loans are at the discretion of directors and shareholders. As a consequence these items will bear no relationship with the level of sales.
h.
The dividend payout and retention rate are at the discretion of the directors subject to the approval of shareholders. Over the planning horizon both the dividend payout
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
4
Exhibit 2.1b Mwangaza Times Ltd. Balance Sheet as at 31 December 2008 Sh.000 Noncurrent assets: Property, plant and equipment
16,000
Current assets: Inventories
10,000
Trade debtors
6,000
Cash
4,000
Total current assets
20,000
Total assets
36,000 Sh.000
Share capital
23,000
Retained earnings
1,400
Shareholders funds
24,400
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
10,000
Total equity and liabilities
36,000
and retention rates will remain at the current levels. The dividend payout and retention rate will bear no relationship with the level of sales. i.
From the 2009 financial year all retained earnings will be invested in short-term investments in Treasury bills. These investments will be sold to raise cash if the company faces contingencies that were not planned for.
j.
Management has proposed that 70 percent of the financing gap will be finance by issuing new ordinary share capital. Each newly issued share will be priced at a premium of Sh.8.20. The remaining 30 percent of the financing gap will be finance by the issue of 13.5 percent, 10 year bonds.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
5
Suppose that Mwangaza Times double circulation to 240,000 copies annually in 2 years as planned, how would the company’s profit and loss account for the financial year ended 31 December 2009 look? How would the company’s balance sheet at the end of 31 December 2009 look? How would the company’s profit and loss account for the financial year ended 31 December 2010 look? How would the company’s balance sheet at the end of 31 December 2010 look before the financing gap is filed? What is the financing gap? How much debt and equity should be raised? How would the company’s balance sheet at the end of 31 December 2010 look after the financing gap is filed? Exhibit 2.2 presents the profit and loss account of Mwangaza Times Ltd. for the financial year ended 31 December 2009. Note that the profit and loss account for the financial year ended 31 December 2009 in identical to that for financial year ended 31 December 2008. The reason for this is that the production level for the financial year ended 2009 is based on a production estimate120,000 copies , a production level that is identical to that of the financial year ended 31 December 2008. Exhibit 2.2 Mwangaza Times Ltd. Profit and Loss Account for the financial year end 31 December 2009 Sh.000 Sales
Sh.000 20,000
Cost of sales and expenses
-16,000
Net profits before tax
4,000
Taxes (30%)
-1200
Net profits after tax
2,800
Dividend
1,400
Transferred to retained earnings
1,400
Exhibit 2.3 presents the balance sheet of Mwangaza Times Ltd. as at 31 December 2009. Note that the balance sheet as at 31 December 2009 includes a new asset category “Investments” which represents retained earnings invested in short-term investments in Treasury bills. The balance in the retained earnings account grows by the amount of retained earnings to Sh.2,800,000. Exhibit 2.4 presents the profit and loss account of Mwangaza Times Ltd. for the financial year ended 31 December 2010. Note that all items in this profit and loss account are double the figures in the profit and loss account for the financial year ended 31 December 2008. The reason for this is that the production level for the financial year ended 2010 is
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
6
Exhibit 2.3 Mwangaza Times Ltd. Balance Sheet as at 31 December 2009 Sh.000 Noncurrent assets: Property, plant and equipment Investments
16,000 1,400
Current assets: Inventories
10,000
Trade debtors
6,000
Cash
4,000
Total current assets
20,000
Total assets
37,400 Sh.000
Share capital
23,000
Retained earnings
2,800
Shareholders funds
25,800
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
10,000
Total equity and liabilities
37,400
based on a production estimate 240,000 copies. Recall that in the on 1 January 2010 the new machine will be ready for operation on an industrial scale, allowing Mwangaza Times Ltd. to increase capacity to 240,000 copies. As the company plans to double its sales over the next 2 years, all profit and loss items double. This is not necessarily the case with the balance sheet items. Recall the certain balance sheet items, namely, share capital, noncurrent liabilities and some types of
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
7
Exhibit 2.4 Mwangaza Times Ltd Pro forma Profit and Loss Account for the financial year end 31 December 2010 Sh.000 Sales
Sh.000 40,000
Cost of sales and expenses
-32,000
Net profits before tax
8,000
Taxes (30%)
-2400
Net profits after tax
5,600
Dividend
2,800
Transferred to retained earnings
2,800
current liabilities such as bank overdrafts, the dividend payout and the retention rate, are at the discretion of directors and shareholders. These items will not bear no relationship with the level of sales. To prepare the balance sheet of Mwangaza Times Ltd. for the financial year ended 31 December 2010, we need to first determine the relationships between balance sheet items and the level of sales. This information is derived from the balance sheet as at 31 December 2008. Exhibit 2.5 presents the balance sheet of Mwangaza Times Ltd. as at 31 December 2008 with the various balance sheet items being expressed as a percentage of sales, as well as instances where a percentage of sales expression is not applicable. Where an item bears no direct relationship with the level of sales indicate “N/A” meaning “not applicable.” Recall that sales made in the financial year ended 31 December 2008 amounted to Sh.20,000,000. It is expected that as the sales of Mwangaza Times increase or alternatively decrease, property, plant and equipment, inventories, trade debtors, cash and trade creditors will adjust to retain a percentage of sales level as presented in Figure 2.5. Note that the total assets as a percentage of sales are 180%. This means that it is expected the total assets employed by the company will be 180% of sales, other factors such as level of operational efficency and technology remaining constant. Thus, if the company wishes to increase sales, it will have to increase the investments in total assets to maintain the total assets as a percentage of sales at a 180% level. The ratio of total assets to sales is called the capital intensity ratio. The capital intensity ratio is higher for businesses whose nature of production requires a relatively high investment in assets.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
8
Exhibit 2.5 Mwangaza Times Ltd. Balance Sheet as at 31 December 2008 Sh.000
Percentage of sales
16,000
80%
10,000
50%
Trade debtors
6,000
30%
Cash
4,000
20%
Total current assets
20,000
100%
Total assets
36,000
180%
Noncurrent assets: Property, plant and equipment Current assets: Inventories
Sh.000 23,000
N/A
Retained earnings
1,400
N/A
Shareholders funds
24,400
N/A
Noncurrent liabilities
1,600
N/A
Trade creditors
10,000
50%
Total equity and liabilities
36,000
N/A
Share capital
Current liabilities:
Also note that on the equity and liabilities side of the balance sheet, the only item that has a direct relationship with sales are the trade creditors. This is because as more credit facilities will be “spontaneously” availed to the company as it increases its purchases of materials. All other items on the equity and liabilities side of the balance sheet are marked “N/A” (not applicable) because the decision to raise or retire these sources of funds is at the discretion of directors or shareholders of the company. Therefore they do not vary directly with sales. The investments and retained earnings have no relationship with sales. If Mwangaza Times Ltd double its sales in 2 years to 240,000 copies annually, property, plant and equipment, inventories, trade debtors, cash, and trade creditors are adjusted to
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
9
Exhibit 2.6 Mwangaza Times Ltd. Pro forma Balance Sheet extract as at 31 December 2010 Sh.000 Noncurrent assets: Property, plant and equipment Investments
32,000 2,800
Current assets: Inventories
20,000
Trade debtors
12,000
Cash
8,000
Total current assets
40,000
Total assets
74,800 Sh.000
Share capital
23,000
Retained earnings
4,200
Shareholders funds
27,200
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
20,000
Total equity and liabilities
48,800
there new levels bearing in mind that the adjustment will be directly proportional to the percentage of sales at 31 December 2007. Initially, no adjustments are made to share capital, noncurrent liabilities and current liabilities such as bank overdraft. The dividend payout and the retention rate remain unchanged. Exhibit 2.6 show the balance sheet extract of Mwangaza Times Ltd as at 31 December 2010 before any adjustments for share capital, noncurrent liabilities and current liabilities such as bank overdraft, which are at the discretion of management are made. Note that the total assets and total equity and liabilities do not balance.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
10
Exhibit 2.7 Mwangaza Times Ltd. Pro forma Balance Sheet extract as at 31 December 2010 Sh.000 Noncurrent assets: Property, plant and equipment Investments
32,000 2,800
Current assets: Inventories
20,000
Trade debtors
12,000
Cash
8,000
Total current assets
40,000
Total assets
74,800 Sh.000
Share capital
23,000
Retained earnings
4,200
Shareholders funds
27200
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
20,000
External financing required
26,000
Total equity and liabilities
74,800
Having adjusted the items that vary with sales, and with capital, noncurrent liabilities and current liabilities such as bank overdraft remaining unchanged, it is observed that the total equity and liabilities amount to Sh.48,800,000. The total assets amount to Sh.74,800,000. The difference between the total assets and the total equity and liabilities is a financing gap that will be filled by raising external financing. The amount of external financing required will be calculated as follows:
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
11
External financing required = Total assets - Total equity and liabilities External financing required = Sh.74,800,000 - Sh.48,800,000 External financing required = Sh.26,000,000 Exhibit 2.7 shows the balance sheet extract of Mwangaza Times Ltd as at 31 December 2010, after indicating the amount of external financing required. On this balance sheet the total assets and the total equity and liabilities balance. The implication here is that if Mwangaza Times Ltd intends to double sales form Sh.20 million to Sh.40 million in three years the company will have to raise Sh.26,000,000 additional financing from external sources. Assume that the shareholders of the company accept the proposal to bridge 70 percent of the financing gap by issuing new ordinary share capital. Each newly issued share being priced at a premium of Sh.8.20. The remaining 30 percent of the financing gap being finance by the issue of 13.5 percent, 10 year bonds. The amount to be raised from the issue of new equity and debt are as follows.
Financing gap to be filled
Sh. 26,000,000
Amount to be raise by issuing new equity Amount to be raise by issuing new bonds Total amount of equity and debt to be raised
18,200,000 7,800,000 26,000,000
Exhibit 2.8 presents the balance sheet of Mwangaza Times Ltd. as at 31 December 2010 assuming the external financing required is raised as approved by the shareholders. Total amount for each new ordinary share issued: Sh. Par value Share premium Total amount for each new ordinary share issued
10.00 8.20 18.20
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
12
Exhibit 2.8 Mwangaza Times Ltd. Pro forma Balance Sheet extract as at 31 December 2010 Sh.000 Noncurrent assets: Property, plant and equipment Investments
32,000 2,800
Current assets: Inventories
20,000
Trade debtors
12,000
Cash
8,000
Total current assets
40,000
Total assets
74,800
Share capital Share premium Retained earnings
Sh.000 33,000 8,200 4,200
Shareholders funds
45,400
Noncurrent liabilities
9,400
Current liabilities: Trade creditors
20,000
Total equity and liabilities
74,800
Number of new shares issued will be calculated as follows: = Amount to be raise by issuing new equity Total amount for each new ordinary share issued = Sh.18,200,000 Sh.18.20
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
13
= 1,000,000 shares Share capital issued by 31 December 2010 is calculated as follows: Sh.000 Share capital issued by 31 December 2008 Nominal value of 1,000,000 ordinary shares (1,000,000 shares × Sh.10 par) Share capital issued by 31 December 2010
23,000 10,000 33,000
Share premium is calculated as follows: Sh.000 Sh.8.20 share premium per share on 1,000,000 ordinary shares (1,000,000 shares × Sh.10 )
8,200
Share premium by 31 December 2010
8,200
Noncurrent liabilities are calculated as follows: Sh.000 Bonds—12 percent, redeemable 31 December 2015
1,600
Bonds—13.5 percent, redeemable 31 December 2019
7,800
Noncurrent liabilities owing by 31 December 2010
9,400
The balance sheet presented in figure 2.6 above concludes the financial plan of the Mwangaza Times Ltd. The following is an abbreviated financial plan of Mwangaza Times Ltd.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
14
Exhibit 2.9: An abbreviated financial plan of Mwangaza Times Ltd. Mwangaza Times Ltd. Financial Plan 2009-2010
1.4
Sales forecasts:
Sh.40 million by end of 2010
Budgeted financial statements:
See Exhibits 2.4 and 2.8
Asset requirements:
an investment of Sh.38,800,000 in assets is required including Sh.2,800,000 held in invests for unplanned contingencies
Financial requirements:
Management has proposed that 70 percent of the financing gap will be finance by issuing new ordinary share capital. Each newly issued share will be priced at a premium of Sh.8.20. The remaining 30 percent of the financing gap will be finance by the issue of 13.5 percent, 10 year bonds.
External funds requirement:
Sh.26,000,000 to be raised by issuing 1,000,000 ordinary shares of Sh.10 par at a premiums of Sh.8.20 per share raising Sh.18,200,000; and by issuing 13.5 percent, 10 year bonds with a nominal value of Sh.7,800,000.
Need for Financial Planning
It is imperative for any business embarking on an expansion initiative to carefully plan for their financial requirements before they implement the expansion plans. Financial planning provides perspective of the quantity of fund that will be required to achieve strategic goals. With this quantification of financial need, concrete arrangement for raising these funds can be made.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
1.1
Introduction
A financial plan is blueprint in which management analyzes a firm’s financial needs over a duration of time and includes suggestions on how funds may be raised where necessary. Financial plans relate to a specified time period. A financial plan could be either a shortterm or long-term plan. A short-term financial plan relates to the next 12 months. A cash budget is an example of a short-term financial plan. A long-term plan relates to periods longer than 12 months. This session focuses on the formulation of a long-term plan.
1.2
Financial Planning Models
On average a financial planning model requires the following elements. a.
Sales forecast: This is a forecast of sale to be made over a duration of time in future. This duration of time is also referred to as the planning horizon. The sales forecast takes into consideration expected increase in the production levels over the planning horizon.
b.
Budgeted financial statements: These are financial statement (profit and loss account and balance sheet) at the end of the planning horizon.
c.
Asset requirements: This is a forecast of the investments required in capital and working capital over the planning horizon.
d.
Financial requirements: This is a proposal of how debt and equity funds will be raised to finance investments in capital and working capital over the planning horizon. It takes into consideration the firm’s dividend policy.
e.
External funds requirement: This is an estimate of the amount of fund that is to be raised from outside source to support the expected increases in capital and working capital over the planning horizon.
1.3
Percentage of Sales Financial Planning Model
The percentage of sales financial planning model is a tool of long-term financial management. This method takes into consideration the relationship between sales, expenses, assets and liabilities.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan. Copyright © 2009 William M. Kinai. This article may be reprinted free of charge in any publication or website provided that the article is unedited, and that the copyright, author's bio, and contact information appears with each reproduction and/or posting.
FORECASTING FINANCIAL NEEDS
1.3.1
2
Items That Move Proportionately to Sales
Some items move in direct proportion to sales, while others are dependent on company policies. Company policies are strongly influence by the company’s shareholders. For example, the cost of goods sold move in proportion to the level of sales. There is often a direct relationship between the level of sales and additional investments in assets. A business will need to increase investment in assets to achieve an increase in sales. Some liability items such as trade creditors (suppliers who accept to sale to the business under credit terms) the financing availed will be proportional to the level of sale. The higher the sales the more the purchases and the greater will be the purchases made on credit.
1.3.2
Items Influenced by Company Policy
The company’s debt policy will influence the extent to which long term liabilities such as leases and new bond issues will be utilized as a source of additional financing. The company’s dividend policy will provide a guide as to the extent to which retained earnings will be used as a source of long term financing. Further, the raising of equity capital is at the discretion of shareholders on recommendation of management. Generally, financing decisions are not directly related to sale but on other factors such as the availability of found in the capital markets and the company’s polices which reflect the preferences of shareholders. The percentage of sales financial planning model takes into consideration the relationship between sales and individual cost, assets and liabilities. The following is an illustration for how the percentage of sales financial planning model can be applied in forecasting financial needs in the context of growing businesses.
1.3.3
Percentage of Sales Financial Planning Model: Illustrated
Mwangaza Times Ltd publishes a weekly newspaper under the brand Mwangaza Times. Mwangaza Times current circulation is 120,000 copies annually. The management of Mwangaza Times plans to double circulation to 240,000 copies annually in next 2 years. Mwangaza Times Ltd will purchase a new printing press from International Printing Machines Ltd. The suppliers of the new industrial printing press will take one year to manufacture and install the new plant. This new machine will be ready for operation on an industrial scale on 1 January 2010. In the financial year 2010, sales are expected to double at 240,000 copies annually. Profit and loss account for the financial year ended 31 December 2007 and balance sheet as at 31 December 2007 is presented in Exhibit 2.1a and 2.1b.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
3
Exhibit 2.1a Mwangaza Times Ltd. Profit and Loss Account for the financial year end 31 December 2008 Sh.000 Sales
Sh.000 20,000
Cost of sales and expenses
-16,000
Net profits before tax
4,000
Taxes (30%)
-1200
Net profits after tax
2,800
Dividend
1,400
Transferred to retained earnings
1,400
The following information is available: a.
Mwangaza Times’ cost of sales and operating expenses amount to 80 percent of sales revenues.
b.
The company faces a 30 percent tax rate.
c.
The company retains half of its profits after taxes.
d.
The company has issued 2,300,000 shares of Sh.10 each.
e.
Noncurrent liabilities consist of amounts owing to the holders of a 12 percent interest bond with a floating charge on the assets of the company. The bonds are redeemable on the 31 December 2015.
f.
The following items are directly proportional to the level of sale: i.
Property, plant and equipment
ii.
Inventories
iii.
Trade debtors
iv.
Cash
v.
Trade creditors
g.
Directors, subject to the approval of shareholders, decide on when to raise additional short term debt, long term debt and equity. The directors approve certain types of current liabilities such as bank overdrafts. Thus, share capital, noncurrent liabilities and certain types of current liabilities such as bank loans are at the discretion of directors and shareholders. As a consequence these items will bear no relationship with the level of sales.
h.
The dividend payout and retention rate are at the discretion of the directors subject to the approval of shareholders. Over the planning horizon both the dividend payout
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
4
Exhibit 2.1b Mwangaza Times Ltd. Balance Sheet as at 31 December 2008 Sh.000 Noncurrent assets: Property, plant and equipment
16,000
Current assets: Inventories
10,000
Trade debtors
6,000
Cash
4,000
Total current assets
20,000
Total assets
36,000 Sh.000
Share capital
23,000
Retained earnings
1,400
Shareholders funds
24,400
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
10,000
Total equity and liabilities
36,000
and retention rates will remain at the current levels. The dividend payout and retention rate will bear no relationship with the level of sales. i.
From the 2009 financial year all retained earnings will be invested in short-term investments in Treasury bills. These investments will be sold to raise cash if the company faces contingencies that were not planned for.
j.
Management has proposed that 70 percent of the financing gap will be finance by issuing new ordinary share capital. Each newly issued share will be priced at a premium of Sh.8.20. The remaining 30 percent of the financing gap will be finance by the issue of 13.5 percent, 10 year bonds.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
5
Suppose that Mwangaza Times double circulation to 240,000 copies annually in 2 years as planned, how would the company’s profit and loss account for the financial year ended 31 December 2009 look? How would the company’s balance sheet at the end of 31 December 2009 look? How would the company’s profit and loss account for the financial year ended 31 December 2010 look? How would the company’s balance sheet at the end of 31 December 2010 look before the financing gap is filed? What is the financing gap? How much debt and equity should be raised? How would the company’s balance sheet at the end of 31 December 2010 look after the financing gap is filed? Exhibit 2.2 presents the profit and loss account of Mwangaza Times Ltd. for the financial year ended 31 December 2009. Note that the profit and loss account for the financial year ended 31 December 2009 in identical to that for financial year ended 31 December 2008. The reason for this is that the production level for the financial year ended 2009 is based on a production estimate120,000 copies , a production level that is identical to that of the financial year ended 31 December 2008. Exhibit 2.2 Mwangaza Times Ltd. Profit and Loss Account for the financial year end 31 December 2009 Sh.000 Sales
Sh.000 20,000
Cost of sales and expenses
-16,000
Net profits before tax
4,000
Taxes (30%)
-1200
Net profits after tax
2,800
Dividend
1,400
Transferred to retained earnings
1,400
Exhibit 2.3 presents the balance sheet of Mwangaza Times Ltd. as at 31 December 2009. Note that the balance sheet as at 31 December 2009 includes a new asset category “Investments” which represents retained earnings invested in short-term investments in Treasury bills. The balance in the retained earnings account grows by the amount of retained earnings to Sh.2,800,000. Exhibit 2.4 presents the profit and loss account of Mwangaza Times Ltd. for the financial year ended 31 December 2010. Note that all items in this profit and loss account are double the figures in the profit and loss account for the financial year ended 31 December 2008. The reason for this is that the production level for the financial year ended 2010 is
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
6
Exhibit 2.3 Mwangaza Times Ltd. Balance Sheet as at 31 December 2009 Sh.000 Noncurrent assets: Property, plant and equipment Investments
16,000 1,400
Current assets: Inventories
10,000
Trade debtors
6,000
Cash
4,000
Total current assets
20,000
Total assets
37,400 Sh.000
Share capital
23,000
Retained earnings
2,800
Shareholders funds
25,800
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
10,000
Total equity and liabilities
37,400
based on a production estimate 240,000 copies. Recall that in the on 1 January 2010 the new machine will be ready for operation on an industrial scale, allowing Mwangaza Times Ltd. to increase capacity to 240,000 copies. As the company plans to double its sales over the next 2 years, all profit and loss items double. This is not necessarily the case with the balance sheet items. Recall the certain balance sheet items, namely, share capital, noncurrent liabilities and some types of
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
7
Exhibit 2.4 Mwangaza Times Ltd Pro forma Profit and Loss Account for the financial year end 31 December 2010 Sh.000 Sales
Sh.000 40,000
Cost of sales and expenses
-32,000
Net profits before tax
8,000
Taxes (30%)
-2400
Net profits after tax
5,600
Dividend
2,800
Transferred to retained earnings
2,800
current liabilities such as bank overdrafts, the dividend payout and the retention rate, are at the discretion of directors and shareholders. These items will not bear no relationship with the level of sales. To prepare the balance sheet of Mwangaza Times Ltd. for the financial year ended 31 December 2010, we need to first determine the relationships between balance sheet items and the level of sales. This information is derived from the balance sheet as at 31 December 2008. Exhibit 2.5 presents the balance sheet of Mwangaza Times Ltd. as at 31 December 2008 with the various balance sheet items being expressed as a percentage of sales, as well as instances where a percentage of sales expression is not applicable. Where an item bears no direct relationship with the level of sales indicate “N/A” meaning “not applicable.” Recall that sales made in the financial year ended 31 December 2008 amounted to Sh.20,000,000. It is expected that as the sales of Mwangaza Times increase or alternatively decrease, property, plant and equipment, inventories, trade debtors, cash and trade creditors will adjust to retain a percentage of sales level as presented in Figure 2.5. Note that the total assets as a percentage of sales are 180%. This means that it is expected the total assets employed by the company will be 180% of sales, other factors such as level of operational efficency and technology remaining constant. Thus, if the company wishes to increase sales, it will have to increase the investments in total assets to maintain the total assets as a percentage of sales at a 180% level. The ratio of total assets to sales is called the capital intensity ratio. The capital intensity ratio is higher for businesses whose nature of production requires a relatively high investment in assets.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
8
Exhibit 2.5 Mwangaza Times Ltd. Balance Sheet as at 31 December 2008 Sh.000
Percentage of sales
16,000
80%
10,000
50%
Trade debtors
6,000
30%
Cash
4,000
20%
Total current assets
20,000
100%
Total assets
36,000
180%
Noncurrent assets: Property, plant and equipment Current assets: Inventories
Sh.000 23,000
N/A
Retained earnings
1,400
N/A
Shareholders funds
24,400
N/A
Noncurrent liabilities
1,600
N/A
Trade creditors
10,000
50%
Total equity and liabilities
36,000
N/A
Share capital
Current liabilities:
Also note that on the equity and liabilities side of the balance sheet, the only item that has a direct relationship with sales are the trade creditors. This is because as more credit facilities will be “spontaneously” availed to the company as it increases its purchases of materials. All other items on the equity and liabilities side of the balance sheet are marked “N/A” (not applicable) because the decision to raise or retire these sources of funds is at the discretion of directors or shareholders of the company. Therefore they do not vary directly with sales. The investments and retained earnings have no relationship with sales. If Mwangaza Times Ltd double its sales in 2 years to 240,000 copies annually, property, plant and equipment, inventories, trade debtors, cash, and trade creditors are adjusted to
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
9
Exhibit 2.6 Mwangaza Times Ltd. Pro forma Balance Sheet extract as at 31 December 2010 Sh.000 Noncurrent assets: Property, plant and equipment Investments
32,000 2,800
Current assets: Inventories
20,000
Trade debtors
12,000
Cash
8,000
Total current assets
40,000
Total assets
74,800 Sh.000
Share capital
23,000
Retained earnings
4,200
Shareholders funds
27,200
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
20,000
Total equity and liabilities
48,800
there new levels bearing in mind that the adjustment will be directly proportional to the percentage of sales at 31 December 2007. Initially, no adjustments are made to share capital, noncurrent liabilities and current liabilities such as bank overdraft. The dividend payout and the retention rate remain unchanged. Exhibit 2.6 show the balance sheet extract of Mwangaza Times Ltd as at 31 December 2010 before any adjustments for share capital, noncurrent liabilities and current liabilities such as bank overdraft, which are at the discretion of management are made. Note that the total assets and total equity and liabilities do not balance.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
10
Exhibit 2.7 Mwangaza Times Ltd. Pro forma Balance Sheet extract as at 31 December 2010 Sh.000 Noncurrent assets: Property, plant and equipment Investments
32,000 2,800
Current assets: Inventories
20,000
Trade debtors
12,000
Cash
8,000
Total current assets
40,000
Total assets
74,800 Sh.000
Share capital
23,000
Retained earnings
4,200
Shareholders funds
27200
Noncurrent liabilities
1,600
Current liabilities: Trade creditors
20,000
External financing required
26,000
Total equity and liabilities
74,800
Having adjusted the items that vary with sales, and with capital, noncurrent liabilities and current liabilities such as bank overdraft remaining unchanged, it is observed that the total equity and liabilities amount to Sh.48,800,000. The total assets amount to Sh.74,800,000. The difference between the total assets and the total equity and liabilities is a financing gap that will be filled by raising external financing. The amount of external financing required will be calculated as follows:
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
11
External financing required = Total assets - Total equity and liabilities External financing required = Sh.74,800,000 - Sh.48,800,000 External financing required = Sh.26,000,000 Exhibit 2.7 shows the balance sheet extract of Mwangaza Times Ltd as at 31 December 2010, after indicating the amount of external financing required. On this balance sheet the total assets and the total equity and liabilities balance. The implication here is that if Mwangaza Times Ltd intends to double sales form Sh.20 million to Sh.40 million in three years the company will have to raise Sh.26,000,000 additional financing from external sources. Assume that the shareholders of the company accept the proposal to bridge 70 percent of the financing gap by issuing new ordinary share capital. Each newly issued share being priced at a premium of Sh.8.20. The remaining 30 percent of the financing gap being finance by the issue of 13.5 percent, 10 year bonds. The amount to be raised from the issue of new equity and debt are as follows.
Financing gap to be filled
Sh. 26,000,000
Amount to be raise by issuing new equity Amount to be raise by issuing new bonds Total amount of equity and debt to be raised
18,200,000 7,800,000 26,000,000
Exhibit 2.8 presents the balance sheet of Mwangaza Times Ltd. as at 31 December 2010 assuming the external financing required is raised as approved by the shareholders. Total amount for each new ordinary share issued: Sh. Par value Share premium Total amount for each new ordinary share issued
10.00 8.20 18.20
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
12
Exhibit 2.8 Mwangaza Times Ltd. Pro forma Balance Sheet extract as at 31 December 2010 Sh.000 Noncurrent assets: Property, plant and equipment Investments
32,000 2,800
Current assets: Inventories
20,000
Trade debtors
12,000
Cash
8,000
Total current assets
40,000
Total assets
74,800
Share capital Share premium Retained earnings
Sh.000 33,000 8,200 4,200
Shareholders funds
45,400
Noncurrent liabilities
9,400
Current liabilities: Trade creditors
20,000
Total equity and liabilities
74,800
Number of new shares issued will be calculated as follows: = Amount to be raise by issuing new equity Total amount for each new ordinary share issued = Sh.18,200,000 Sh.18.20
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
13
= 1,000,000 shares Share capital issued by 31 December 2010 is calculated as follows: Sh.000 Share capital issued by 31 December 2008 Nominal value of 1,000,000 ordinary shares (1,000,000 shares × Sh.10 par) Share capital issued by 31 December 2010
23,000 10,000 33,000
Share premium is calculated as follows: Sh.000 Sh.8.20 share premium per share on 1,000,000 ordinary shares (1,000,000 shares × Sh.10 )
8,200
Share premium by 31 December 2010
8,200
Noncurrent liabilities are calculated as follows: Sh.000 Bonds—12 percent, redeemable 31 December 2015
1,600
Bonds—13.5 percent, redeemable 31 December 2019
7,800
Noncurrent liabilities owing by 31 December 2010
9,400
The balance sheet presented in figure 2.6 above concludes the financial plan of the Mwangaza Times Ltd. The following is an abbreviated financial plan of Mwangaza Times Ltd.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
FORECASTING FINANCIAL NEEDS
14
Exhibit 2.9: An abbreviated financial plan of Mwangaza Times Ltd. Mwangaza Times Ltd. Financial Plan 2009-2010
1.4
Sales forecasts:
Sh.40 million by end of 2010
Budgeted financial statements:
See Exhibits 2.4 and 2.8
Asset requirements:
an investment of Sh.38,800,000 in assets is required including Sh.2,800,000 held in invests for unplanned contingencies
Financial requirements:
Management has proposed that 70 percent of the financing gap will be finance by issuing new ordinary share capital. Each newly issued share will be priced at a premium of Sh.8.20. The remaining 30 percent of the financing gap will be finance by the issue of 13.5 percent, 10 year bonds.
External funds requirement:
Sh.26,000,000 to be raised by issuing 1,000,000 ordinary shares of Sh.10 par at a premiums of Sh.8.20 per share raising Sh.18,200,000; and by issuing 13.5 percent, 10 year bonds with a nominal value of Sh.7,800,000.
Need for Financial Planning
It is imperative for any business embarking on an expansion initiative to carefully plan for their financial requirements before they implement the expansion plans. Financial planning provides perspective of the quantity of fund that will be required to achieve strategic goals. With this quantification of financial need, concrete arrangement for raising these funds can be made.
William M. Kinai ([email protected]; +254 020 2323 858) is the founder and principal of Concert Management Consulting, a firm that provides business assessment, business planning, interim management, and executive training services to growing businesses and nonprofit organizations in the East African region including Kenya, Uganda, Tanzania, Rwanda, Burundi, Ethiopia, and South Sudan.
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