Financial Planning and Forecasting Financial Statements

Financial Planning and Forecasting Financial Statements Chapter 9 “In preparing for battle I have always found that plans are useless, but planning is indispensable.” - Dwight D. Eisenhower 1 The Financial Plan • Steps – Project statements and use to analyze effects of operating plan on profits & ratios – Determine funds needed to support plan – Forecast available funds (internal AND external) – Establish performance-based compensation system • Methods – Formula approach – Pro forma financial statements (% of sales method) 2 Example: Mini Case • Betty Simmons, the new financial manager of Southeast Chemicals (SEC), a Georgia producer of specialized chemicals for use in fruit orchards, must prepare a financial forecast for 2004. SEC’s 2003 sales were $2 billion, and the marketing department is forecasting a 25% increase for 2004. Simmons thinks the company was operating at full capacity in 2003, but she is not sure about this. • Assume that you were recently hired as Simmon’s assistant. Your first major task is to help her develop the financial forecast. 3 SEC: 2003 Balance Sheet (millions) Cash Accounts receivable Inventory Total CA 20 240 240 500 AP & accruals Notes payable Total CL Long-term debt Common stock Retained earnings Total liabilities & Equity 100 100 200 100 500 200 1000 Net fixed assets Total assets 500 1000 4 SEC: 2003 Income Statement (millions) Sales COGS (60% of sales) SGA EBIT Interest EBT Taxes (40%) Net income Dividends (40% of NI) Addition to RE 2000 1200 700 100 10 90 36 54 21.60 32.40 5 SEC • Key assumptions – Operating at full capacity in 2003 – All assets are proportional to sales – Accounts payable and accruals are also proportional to sales – 2003 profit margin (54/2000 = 2.70%) will be maintained – Sales are expected to increase by $500 million 6 SEC: Additional Funds Needed AFN • Goal: Find AFN – In general, higher sales must be supported by additional assets. Some of the asset increases can be financed by payables, accruals, and retained earnings. Any shortfall (AFN) must be financed from external sources, using debt, preferred, and/or common. 7 AFN • Variables in equation – A*/S0: assets required to support sales; called capital intensity ratio  S: increase in sales (S1 – S0) - L*/S0: spontaneous liabilities ratio - M: profit margin (Net income/sales) - RR: retention ratio; percent of net income not paid as dividend (equal to 1 – dividend payout ratio) - NOTE: * means those that increase “spontaneously” 8 SEC Assets Assets 1,250 1,000 Assets = 0.5 sales  Assets = (A*/S0)Sales = 0.5($500) = $250. 0 2,000 2,500 Sales 9 A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500. AFN Formula • Assets must increase by $250. What is AFN? – Formula • AFN = Required increase in assets - Spontaneous increases in liabilities - Increase in retained earnings • AFN = (A*/S0)S - (L*/S0)S - M(S1)(RR) 10 How Do the Following Affect AFN? • • • • • Higher sales? Lower dividend payout ratio? Higher profit margin? Higher capital intensity (A*/S0) ratio? Pay suppliers in 60 days rather than 30 days? 11 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 12 Pro Forma Approach • Project sales based on forecasted growth rate in sales • Forecast some items as a percent of the forecasted sales – Cash, accounts receivable, costs, inventory, net fixed assets, accounts payable, and accruals • Spontaneous! • Choose other items – Debt, dividends (determines RE), and common stock • Financing choices! • Process – Estimate required assets to support sales – Estimate sources of funding – AFN is required assets minus specified sources of funding 13 Forecasting Interest Expense • Interest expense is actually based on the daily balance of debt during the year • Three approaches . . . base 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 circular issue called financing feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc. – Debt at beginning of year • Will under-estimate interest expense if debt is added throughout the year instead of all on December 31 – Average of beginning and ending debt • Will accurately estimate the interest payments if debt is added smoothly throughout the year • Still have circular issue 14 Forecasting Interest Expense • Solution based on balancing accuracy and complexity – Base interest expense on beginning debt, but use a slightly higher interest rate • Easy & reasonably accurate “Planning is a process that at best helps the firm avoid stumbling into the future backwards.” - GM board member 15 SEC: Percentage of Sales Inputs 2003 2004 Actual Forecast 60% 60% 35% 35% 1% 1% 12% 12% 12% 12% 25% 25% 5% 5% COGS/Sales SGA/Sales Cash/Sales AR/Sales Inv/Sales NFA/Sales AP & Accruals/Sales 16 SEC: Percentage of Sales Inputs • Other inputs Percent growth in sales Growth factor in sales (g) Interest rate on debt Tax rate Dividend payout ratio 25% 1.25 10% 40% 40% 17 2004 Forecasted Income Statement Sales COGS SGA EBIT Interest EBT Taxes (40%) Net income Dividend (40%) Add to RE 2003 2000 Factor g=1.25 Pct=60% Pct=35% .1(Debt03) 2004 Forecast 2500 1500 875 125 20 105 42 63 25.2 37.8 18 2004 Forecasted Balance Sheet: Assets Forecasted assets are a percent of forecasted sales. 2004 Sales = $2,500 2003 Cash Accts Rec Inv Total CA NFA Total Assets Factor Pct=1% Pct=12% Pct=12% Pct=25% 2004 Forecast 25 300 300 625 625 1250 19 2004 Forecasted Balance Sheet: Claims 2004 Sales = $2,500 2003 AP & Accruals Notes Payable Total CL LT Debt Common st. RE Total claims Factor Pct=5% financing financing financing +37.8* 2004 Forecast 125 100 225 100 500 237.8 1062.8 100 100 500 200 * From forecasted income statement 20 SEC: Pro Forma Statements • Now, can calculate AFN – Forecasted total assets Forecasted total claims AFN 1250.0 1062.8 187.2 • NOTE: Just remember that B/S must balance. AFN is the “plug”. • Financial mix considerations – target capital structure, effect of s-t borrowing on current ratio, conditions in debt and equity markets, restrictions from current debt, etc. 21 SEC: Raising AFN • Financing staff decided on that any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt Amount of New Capital (%) ($) 50% $93.6 50 93.6 100% $187.2 Rate (%) 10% 10% 22 Notes Payable LT debt 2004 Forecasted Balance Sheet: Claims AP & Accruals Notes Payable Total CL LT Debt Common st. RE Total claims w/o AFN 125 100 225 100 500 237.8 AFN +93.6 +93.6 +0 w/ AFN 125 193.6 318.6 193.6 500 237.8 1250.0 23 Formula vs. Pro Forma – Assumes profit margin remains constant – Pro forma method is more flexible. More important, it allows different items to grow at different rates “You’ve got to be careful if you don’t know where you’re going, because you might not get there.” - Yogi Berra 24 Forecasted Ratios 2003 2004(E) Industry Profit Margin 2.70% 2.52% ROE 7.71% 8.54% DSO (days) 43.80 43.80 Inv. turnover 8.33x 8.33x FA turnover 4.00x 4.00x Debt ratio 30.00% 40.98% TIE 10.00x 6.25x Current ratio 2.50x 1.96x 4.00% 15.60% 32.00 11.00x 5.00x 36.00% 9.40x 3.00x 25 FCF 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 2003 $400 $900 $60 2004(E) $500 $1,125 $75 $225 -$150 26 Proposed Improvements Before DSO (days) Accts. rec./Sales Inventory turnover Inventory/Sales SGA/Sales 43.80 12.00% 8.33x 12.00% 35.00% After 32.00 8.77% 11.00x 9.09% 33.00% 27 Effect of Improvements Before AFN Free cash flow ROE $187.2 -$150.0 7.7% After $15.7 $33.5 12.3% 28 SEC: Excess Capacity • Suppose they were operating at 75% capacity – Formula Capacity Sales = Actual Sales/% of Capacity = 2,000/.75 = 2,667 • So, with NO new FA, SEC can support sales of 2,667 • Since forecasted sales are 2,500, they would not need any new FA • Previously projected increase in FA was $125 • AFN will fall by 125 AFN = 187.2 – 125 = 62.2 29 HOMEWORK PROBLEM • Example – Pierce Furnishings generated $2.0 m in sales in 2003 and its year-end total assets were $1.5 m. Also, cl were $500,000 consisting of $200,000 notes payable, $200,000 of accounts payable and $100,000 accruals. Looking ahead to 2004, the company estimates that its assets must increase by 75 cents for every $1 increase in sales. Pierce’s profit margin is 5% and its payout ratio is 60%. How large a sales increase can the company achieve without having to raise funds externally? 30