FIL 440 - Ahlgrim

Ch. 12 Forecasting

Ch. 12 Financial Planning and Forecasting Financial Statements

Other MBA courses focus on strategic plans, operations, and organizational behavior Strategic plans are statements that provide a vision for the company
Mission/purpose, scope/businesses, objectives, and strategies Help to define a direction for the company

The Financial Plan

Assesses the firms anticipated performance under alternate operating plans by forecasting financial statements Some benefits
Estimate effects of proposed operating changes (what if?) Project future financing needs? Establish a performance based compensation system Use as a benchmark to monitor actual performance

Operating plans provide more implementation guidance over the short-term (1-5 years)
Specific tasks and responsibilities

Forecasting Financial Statements: Percent of Sales Method

Forecasted items are a percent of future sales ASSUMPTION: Many financial statement items increase proportionately with sales
COGS, Cash, A/R, inventory ?Fixed assets (at full capacity)? Spontaneous liabilities (A/P, accruals)

Sales Forecast
Forecasting depends on ability of marketing/sales to gauge demand for product Entire chapter is worthless without accurate sales forecast Improving sales forecasts
Recent history New products Competition

Other items SG&A(?), debt, common stock

May look at some sensitivity analysis and contingency plans

FIL 440 - Ahlgrim

Ch. 12 Forecasting

Steps in Forecasting Financial Statements: % of Sales

1. Analyze relationship of sales to I/S and B/S items 2. Project I/S based on sales forecast
May need information to project interest expense

3. 4. 5. 6.

Project B/S Determine AFN and external funds Financing feedbacks Analysis and testing

Operating at capacity, so all assets (including FA) grow (proportionally) with sales Payables and accruals grow (proportionally) with sales No growth in financing accounts (N/P, bonds, and stock) Total dividends will grow 15% Projected sales growth of $300 million (15%) Historical financial statements on p.509

Case Assumptions

Percent of Sales Method

Step 1: Analyze Historical Ratios
Op. Costs/Sales (1,200/2000) Cash/Sales AR/Sales Inv/Sales Net Fixed Assets/Sales AP & Accruals/Sales (20/2000) = 60% = 1% = 14.5% = 19.5% = 25% = 5%

Percent of Sales Method

Step 2: Forecast the Income Statement
2010
Sales Op. Costs EBIT Less Interest EBT Taxes (40%) Net Income Dividends Add. To ret. earnings 2,000.00 1,900.00 100.00 60.00 40.00 16.00 24.00 9.00 15.00

Forecast basis
Growth % of Sales 10%*Avg Debt - see (f) 1.15 95.00%

2011
2,300.00 2,185.00 115.00 60.00 55.00 22.00 33.00 10.35 22.65

15% growth

FIL 440 - Ahlgrim

Ch. 12 Forecasting

Percent of Sales Method

Step 3: Forecast the Balance Sheet
2010 Assets Cash Accounts receivable Inventories Total current assets Net plant and equipment Total assets $ 20 290 390 700 500 1,200
Forecast basis

Percent of Sales Method

Step 3: Forecast the Balance Sheet
2011
Accounts payable & Accruals Notes payable Total current liabilities Long-term bonds Total debt Common stock Retained earnings Total common equity Total liabilities and equity 2010 100.00 80.00 180.00 520.00 700.00 300.00 200.00 500.00 1,200.00
Forecast basis % of Sales Carry-over Carry-over Carry-over RE10 + D RE11 5.00%

% of Sales % of Sales % of Sales % of Sales

1.00% 14.50% 19.50% 25.00%

23 334 449 805 575 1,380

2011 115.00 80.00 195.00 520.00 715.00 300.00 222.65 522.65 1,237.65

Percent of Sales Method

Step 3: Forecast the Balance Sheet
You will notice that the Balance Sheet does not balance: Forecasted Assets = $1,380.00 Forecasted Claims = $1,237.65 AFN = $ 142.35

Percent of Sales Method

Step 4: Raising the AFN Company needs to decide upon financing strategy Suppose at end of year, company takes out line of credit
N/P increase 142.35

Where will this money come from?

Company adjusts the financial statements to reflect financing strategy

FIL 440 - Ahlgrim

Ch. 12 Forecasting

Percent of Sales Method

2010 100.00 80.00 180.00 520.00 700.00 300.00 200.00 500.00 1,200.00
Forecast basis % of Sales AFN Carry-over Carry-over RE10+ D RE11 5.00%

AFN Equation
AFN = (A*/S0) S - (L*/S0) S - MS1(RR)
2011 115.00 222.35 337.35 520.00 857.35 300.00 222.65 522.65 1,380.00

Accounts payable & Accruals Notes payable Total current liabilities Long-term bonds Total debt Common stock Retained earnings Total common equity Total liabilities and equity

A* = Assets that are tied directly to sales S0 = Sales during the last year L* = Liabilities that increase spontaneously S1 = Total sales projected for next year S = Change in sales M = Profit Margin RR = Percent of net income retained or (1 - Payout Ratio)

Self-Supporing Growth Rate

What is the maximum growth rate so the company needs no external capital? Use AFN equation with:
S1=S0 x (1+g) DS = S1 - S0 = S0 x (1+g) - S0 = gS0 AFN = 0 Solve for g

Step 6: Analysis
Review financial ratios Implementation of strategies (what if) and impact on financial results

FIL 440 - Ahlgrim

Ch. 12 Forecasting

Key Ratios Profit Margin ROE DSO Inventory Turnover Fixed Asset Turnover Debt/Assets TIE Op. Costs / Sales

Actual 2010 1.20% 4.80% 52.93 5.13 4.00 58.3% 1.67 95.0%

Forecast 2011 1.43% 6.31% 53.00 5.13 4.00 62.1% 1.92 95.0%

Industry 2.74% 11.64% 40.15 6.67 4.35 53.0% 5.20 93.0%

Proposed Improvements
Before
DSO (days) Accts. rec./Sales Inventory turnover Inventory/Sales Fixed Assets/Sales Op.SGA/Sales 53.00 14.50% 5.13x 19.50% 25.0% 95.0%

After
40.15 11.00% 6.67x 15.00% 23.0% 93.0%

Percent of Sales Method

More efficient company
Previous New Forecast basis
Sales Op Costs EBIT Less Interest EBT Taxes (40%) Net Income Dividends Add. To retained earnings 2,300.00 2,185.00 115.00 60.00 55.00 22.00 33.00 10.35 22.65
% of Sales 93.00%

Percent of Sales Method

Tighten A/R and Inventory management
2011
2,300.00 2,139.00 161.00 60.00 101.00 40.40 60.60 10.35 50.25

Previous Assets Cash Accounts receivable Inventories Total current assets Net plant and equipment Total assets $ 23 334 449 806 575 1,381

Forecast basis

2011 23.00 253.00 345.00 621.00 529.00 1,150.00

% of Sales % of Sales % of Sales

11.00% 15.00% 23.00%

FIL 440 - Ahlgrim

Ch. 12 Forecasting

Percent of Sales Method

Tighten A/R and Inventory management
Accounts payable & Accruals Notes payable Total current liabilities Long-term bonds Total debt Common stock Retained earnings Total common equity Total liabilities and equity Previous Forecast basis 115.00 80.00 195.00 520.00 715.00 300.00 222.65 RE10 + DRE11 522.65 1,237.65 2011 115.00 80.00 195.00 520.00 715.00 300.00 250.25 550.25 1,265.25

Impact of Current Asset Improvements

Before
AFN Free cash flow ROIC ROE +$142 -$96 5.45% 6.31%

After
-$115 +$162 9.33% 13.92%

Case Questions
What if operating at 75% capacity?
Effects on AFN? Effects on projected ratios?

Improving asset projections

Previously, % of sales remained fixed How do B/S items actually increase with sales? 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.