Lecture 5– Financial Planning and Forecasting

Lecture 5 - Financial Strategy

Planning and A company’s strategy consists of the competitive
moves, internal operating approaches, and action
Forecasting 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.

Strategic Planning versus

Strategic Planning
Operational Planning

Strategic planning is a systematic process n Strategic Planning n Operational Planning

through which an organization agrees on and – formulation – implementation
builds commitment among key stakeholders
to priorities that are essential to its mission – What, where – how
and are responsive to the environment. – ends – means
Strategic Planning guides the acquisition and – vision – plans
allocation of resources to achieve these – effectiveness
priorities. – efficiency
– risk
– control

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 Lecture 5– Financial Planning and Forecasting

Financial Planning and Pro Forma Steps in Financial Forecasting

Statements
Financial plans evaluate the economics behind the strategy and Forecast sales
operations. They consist of six steps:
1. Project financial statements to analyze the effects of the Project the assets needed to support sales
operating plan on projected profits and financial ratios.
2. Determine the funds needed to support the plan. Project internally generated funds
3. Forecast funds availability.
Project outside funds needed
4. Establish and maintain a system of controls to govern the
allocation and use of funds within the firm. Decide how to raise funds
5. Develop procedures for adjusting the basic plan if the
economic forecasts upon which the plan was based do not
materialize
See effects of plan on ratios and stock price
6. Establish a performance-based management compensation
system.

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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
•Company will fail to meet demand
Under-optimistic
•Market share will be lost

Over-optimistic •Low turnover ratio

Too much inventory
•High cost of depreciation and storage
and/or fixed assets
•Write-offs of obsolete inventory

•Low profit
•Low rate of return on equity
•Low free cash flow
•Depressed stock price
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 Lecture 5– Financial Planning and Forecasting

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.
*
*

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*Spontaneous generated funds - increase spontaneously with sales
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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

More…
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 Lecture 5– Financial Planning and Forecasting
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.
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Step 3 – Forecast the Balance Sheet
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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
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Step 4 – Raising the Additional Funds Needed
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 Lecture 5– Financial Planning and Forecasting

2009 Income Statement (Millions of $)

2009 Balance Sheet(Millions of $)

Cash & sec. $ 10 Accts. pay. & Sales $3,000.00

accruals $ 200 Less: COGS (87.2%) 2616.00
Accounts rec. 375 Notes payable 110 Dep costs 100.00
Inventories 615 Total CL $ 310 EBIT $ 283.80
Total CA $ 1000 L-T debt 754 Interest 88.00
Common +pr stk 170 EBT $ 195.80
Net fixed Retained Taxes (40%) +pr.div 82.30
assets 1000 earnings 766
Net income $ 113.50
Total assets $2,000 Total Liabilities $2,000
Dividends (Com+Pr $57.50
Add’n to RE $56.00
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AFN (Additional Funds Needed):

Key Assumptions Assets vs. Sales
Operating at full capacity in 2009.
Assets
Each type of asset grows proportionally with Assets = 0..667sales
sales. 2,200
∆ Assets =
Payables and accruals grow proportionally 2,000
(A*/S0)∆
∆Sales
with sales. = 0..667($300)
= $200.
2009 profit margin ($113.5/$3,000 = 3.80%)
and retention ratio (56/114) = .49 will be
maintained.
Sales
Sales are expected to increase by $300 0 3,000 3,300
million. A*/S0 = $2,000/$3,000 = 0.667 = $2200/$3,300.
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 Lecture 5– Financial Planning and Forecasting

Definitions of Variables in AFN If assets increase by $200 million,

what is the AFN?

A*/S0: assets required to support AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)

sales; called capital intensity ratio.
AFN = ($2,000/$3,000)($300)
∆S: increase in sales. (0.667) x $300

L*/S0: spontaneous liabilities ratio - ($200/$3,000)($300)

(0.067) x ($300)

M: profit margin (Net income/sales) - 0.0380($3,300)(0.49) = $118 million

RR: retention ratio; percent of net AFN = $118 million.
income not paid as dividend.
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How Would Increases in Various Items

Implications of AFN
Affect the AFN?
Higher sales:
If AFN is positive, then you must

Increases asset requirements, increases AFN.
secure additional financing.
Higher dividend payout ratio:

Reduces funds available internally, increases AFN.
If AFN is negative, then you have more
financing than is needed.
Higher profit margin:

Increases funds available internally, decreases
Pay off debt.
AFN.

Buy back stock.
Higher capital intensity ratio, A*/S0:

Increases asset requirements, increases AFN.
Buy short-term investments.
Pay suppliers sooner:

Decreases spontaneous liabilities, increases AFN.
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 Lecture 5– Financial Planning and Forecasting

What if Balance Sheet Ratios are Economies of Scale

Subject to Change
We have so far assumed that ratios 1,100
of both assets and liabilities to sales 1,000
are constant over time

}
Assets
Declining A/S Ratio
Sometimes this assumption is Base
incorrect. Stock

0 Sales
2,000 2,500
$1,000/$2,000 = 0.5; $1,100/$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.
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Lumpy Assets – Buying Discrete Units What if 2009 fixed assets had been
operated at 96% of capacity:

Actual sales
Capacity sales =
% of capacity
1,500
$3,000
Assets

1,000 = = $3,125.
0.96
500
Target Fixed Assets/Sales = Actual Fixed Asset = $1,000 = 32%
Full Capacity Sales $3,125
Sales
500 1,000 2,000 Thus, if sales increase to $3,300 fixed assets would
A/S changes if assets are lumpy. Generally will have excess only have to increase to 3,300 x .32 = $1,056
capacity, but eventually a small ∆S leads to a large ∆A.
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 Lecture 5– Financial Planning and Forecasting

Summary: How different factors affect

the AFN forecast.

Excess capacity: lowers AFN.

Economies of scale: leads to less-than-
proportional asset increases.
Lumpy assets: leads to large periodic
AFN requirements, recurring excess
capacity.

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