CHAPTER 9

Financial Planning and Forecasting Financial Statements

Topics in Chapter
Financial planning
Additional Funds Needed (AFN) formula
Forecasted financial statements
Financial Planning and Pro Forma 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
Steps in Financial Forecasting
1. Forecast sales
2. Project the assets needed to support sales
3. Project internally generated funds
4. Project outside funds needed
5.Decide how to raise funds
6. See effects of plan on ratios and stock price

Problem: If Sales Co. needs to buy assets to support S.

What assets?
Goal: Determine the source of funds to support Assets:
Note: Balance sheet must remain balanced.
Therefore, Assets Liab &/or owners equity.
1.) Spontaneously generated liability- liabilities that automatically
w/o a specific action between creditor and firm.
Ex: Accounts Payables and accruals
Note: Notes Payable is not a spontaneous liability because it involves an
action between creditor and firm.
2.) Sales NI
We know NI goes to 2 places: dividends or additions to RE.
Note: additions to RE owners equity.
define: payout ratio (d) - the percentage of NI that goes to shareholders.
retention ratio (RR)- the percentage of NI that is retained.
d + RR = 1
3.) External funding

AFN Model
A crude model to estimate external funds needed to support Sales
after accounting for internally generated and automatically generated
sources of funds.
Assumptions:
1. Firm is operating at full capacity
2. Each type of asset grows proportionally w/ sales
3. Spontaneously generated liabilities grow proportionally w/ Sales.
4. Profit margin (M) is constant
5. Firm can accurately forecast in Sales.

AFN

= Required - in Spontaneous
in Assets
Liabilities

AFN = (A*/S0) S -

(L*/S0) S

- in RE

- (M) (S1) (RR)

where:
A* = assets required to support sales
S0= Sales last year
S = in Sales = S1 - S0
L* = in Spontaneous Liabilities
M = Profit Margin = NI/ Sales profit per $ of Sales
RR= Retention Ratio
S1= S0 + S

Notes:
1. A*/S0 = capital intensity ratio
= required $s of assets for every $ in Sales
A*/S0 AFN
Why?

2. L*/S0 = spontaneous liability to sales ratio

= $ amt of spontaneously generated liab for every $ in Sales
L*/S0 AFN
Why?

3. M AFN
Why?

4. RR AFN
Why?

Ex:
2009 Balance Sheet (Millions of $)

2009 Income Statement (Millions of $)

Key Assumptions:
Operating at full capacity in 2009.
Each type of asset grows proportionally with sales.
Account Payables and accruals grow proportionally with sales.
2009 profit margin and payout will be maintained.

If Sales are expected to by $500 million in 2010, find:

a. the capital intensity ratio:
b. the spontaneous liability to sales ratio:
c. the payout ratio:
d. the retention ratio:
e. the profit margin:

f. Expected Sales in 2010:

g. How much do we expect assets to increase by?

Since we expect the capital intensity ratio will be maintained

Assets vs. Sales

h. Find AFN:

i. How would increases in these items affect the AFN?

- Higher sales:
- Higher dividend payout ratio:
- Higher profit margin:

i continued. How would increases in these items affect the AFN?

- Higher capital intensity ratio, A*/S0:

-If company pays suppliers sooner:

Forecasted Financial Statements (FFS) Method

Contrast AFN model and FFS model
1. Both begin with Sales forecast
2. Both fore cast assets and spontaneous liability
- AFN capital intensity (A/S) assumed constant for all assets
- AFN spontaneous liab. to sales intensity (L/S) assumed constant
for all spontaneous liabs
- FFS (each Asset)/S different for all assets
- FFS (each spon. liab)/S different for all spon. liabs.
Percent of Sales Method to forecast financial statements
Steps:
1. Project sales based on forecasted growth rate in sales

2. Forecast some items as a percent of the forecasted sales

- Costs
- Cash
- Accounts receivable
- Inventories
- Net fixed assets
- Accounts payable and accruals
3. Choose other items
- Debt
- Dividend policy (which determines retained earnings)
- Common stock
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Sources of Financing Needed to Support Asset Requirements

Given the previous assumptions and choices, we can estimate:
- Required assets to support sales
- Specified sources of financing
Additional funds needed (AFN) is:
- Required assets minus specified sources of financing
Note:
- If AFN is positive, then you must secure additional financing.
- If AFN is negative, then you have more financing than is needed.
1. Pay off debt.
2. Buy back stock.
3. Buy short-term investments.

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EX: Recall, the following financial statements for a company. We have

calculate AFN using the AFN method. Let's recalculate the AFN using
the FFS method. Recall: Sales are projected to increase $500 million in
2010. Assume interest rate on debt is 10 %. No new common stock will
be issued to raise the AFN. Any external funds needed will be raised as
debt, 50% notes payable, and 50% L-T debt.

Percent of Sales: Inputs

2009 Actual

2010 Proj.

COGS/Sales

60%

60%

SGA/Sales

35%

35%

Cash/Sales

1%

1%

Acct. rec./Sales

12%

12%

Inv./Sales

12%

12%

Net FA/Sales

25%

25%

AP & accr./Sales

5%

5%

Other Inputs
Percent growth in sales

25%

Growth factor in sales (1 + g)

1.25

Interest rate on debt

10%

Tax rate

40%

Dividend payout rate

40%

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2010 First-Pass Forecasted Income Statement

2010 1st Pass

Calculations
Sales

1.25 Sales09 =

$2,500.0

Less: COGS

60% Sales10 =

1,500.0

35% Sales10 =

875.0

SGA
EBIT
Interest

$125.0
0.1(Debt09) =

20.0

EBT

$105.0

Taxes (40%)

42.0

Net Income

$63.0

Div. (40%)

$25.2

Add to RE

$37.8

2010 Balance Sheet (Assets)

Calcuations

2010

Cash

1% Sales10 =

$25.0

Accts Rec.

12%Sales10 =

300.0

Inventories

12%Sales10 =

300.0

Total CA
Net FA
Total Assets

$625.0
25% Sales10 =

625.0
$1,250.0

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2010 Preliminary Balance Sheet (Claims)

Calculations
AP/accruals
Notes payable

100

2010 Without AFN

5% Sales10 =

$125.0

Carried over

100.0

Total CL

$225.0

L-T debt

100

Carried over

100.0

Common stk

500

Carried over

500.0

Ret earnings

200

+37.8*

237.8

Total claims

$1,062.8

What are the additional funds needed (AFN)?

- Required assets = $1,250.0
- Specified sources of fin. = $1,062.8
- Forecast AFN: $1,250 - $1,062.8 = $187.2
How will the AFN be financed?
Additional notes payable = 0.5 ($187.2) = $93.6.
Additional L-T debt = 0.5 ($187.2) = $93.6.

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2010 Balance Sheet (Claims)

w/o AFN

AFN

With AFN

AP accruals

$125.0

$125.0

Notes payable

100.0

Total CL

$225.0

L-T Debt

100.0

Common stk

500.0

500.0

Ret earnings

237.8

237.8

Total claims

$1,071.0

$1250.0

+93.6

193.6
$318.6

+93.6

193.6

Equation AFN = $184.5 vs. Pro Forma AFN = $187.2.

Note: 1. Equation method assumes a constant profit margin.
2. Pro forma method is more flexible. More important, it allows
different items to grow at different rates.

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Excess Capacity
Note: Excess capacity lowers AFN.

Economies of Scale
Recall from ECN 250 economies of scale
1. marginal costs associated with increasing output
2. 'ing additions to output associated with increasing assets.
Note: this indicates that increased sales will not require
proportional increase in assets.

Lumpy Assets
In many industries, fixed assets are added in large discrete units.

Note: Lumpy assets leads to large periodic AFN requirements

because of recurring excess capacity.

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