SUMMARY OF LECTURE AND ADDITIONAL, IMPORTANT POINTS

Part 1 Strategic Planning

Read pp.574 576 of the text book (including foot notes) for the important
concepts on strategic planning (may come out in the theory portion of the exam)
such as mission statement, corporate scope, financial plan, etc.

Part 2 - Construct a Sales Forecast

As mentioned in the discussion, forecast of the financial statements (called

pro-forma statements) which consists of the forecasted income statement
and balance sheet starts with the forecast of sales. This involves the
determination of growth rate.

In addition to the four factors mentioned in the discussion, a fifth factor in

determining growth rate is information about the influence of any
anticipated events that may materially affect sales trends such as start of a
major advertising expense which will boost sales or a change in the firms
pricing policy that could expand the firms market. The fifth factor can be
related to the second factor on the growth rate based on the most probable
scenario since companies can determine whether what factor (based on the
fifth factor) may certainly, probably and remotely occur thus set their growth
rate based on the most probable events that will occur.

Part 3 Prepare the Forecasted Income Statement and Balance Sheet

After determining the forecasted growth rate based one of the five factors
discussed or combination thereof, we can now forecast the income
statement and balance sheet.

The most commonly known method is the percent of sales method. In this
method, income statement and balance sheets accounts will be presented as
a % of sales (can be the current years sales or average of past years sales),
as follows:

a) Expenses: Cost of goods sold and operating expenses may be dependent

on sales, hence will increase if sales increase. The costs and expenses
can be presented as percentage of sales; if fixed costed can be
determined and segregated, then it can have a different computation
(either fixed or may increase depending on other information such as
rent expense based from rental contracts, etc.). Unless otherwise stated,
costs and expenses can be represented as percentage of sales. In
principle, the forecasted costs and expenses will increase by the ratio of
the costs and expense to sales. For example, if the current years costs
 and expenses are P800 and current years sales is P1,000, cost will
increase by P0.80 (800/1000 = 0.80) per P1 increase in sales. So if the
growth rate in sales is 25%, sales will grow by P250 (P1,000 x 25%),
while costs and expenses will increase by P200 (P250 x P0.80).
Forecasted sales will be P1,250 and forecasted cost and expenses will be
P1,000.

b) Assets: Both current assets and fixed assets may be dependent on sales.
Thus if sales increase, current assets and fixed assets will increase.
Current assets and fixed assets can be presented as a percentage of
sales. However, there are instances wherein sales may not be dependent
or directly dependent with sales. If this happens, a different computation
will be used.

If the current assets amount to P1,200 given a sales of P1,000, it means

that current assets will increase by P1.20 (P1,200/1,000 = P1.2) per P1
increase in sales. If fixed assets amount to P1,800, it means that fixed
assets will increase by P1.80 (P1,800/1,000 = P1.80) per P1 increase in
sales. Thus, since total assets amount to P3,000 (P1,200 + P1,800), total
assets will increase by P3 (P3,000/1,000 = P3) per P1 peso increase in
sales. The ratio of total assets to sales (P3,000/1,000 = P3) is what we
call as the capital intensity ratio.

c) Liabilities: Accounts payable and accruals may be dependent on sales.

Thus if sales increase, accounts payable and accruals also increase.
These are known as spontaneous liabilities or spontaneous generated
funds because these arise in the normal course of business operations
trigged by the increase in sales to support increase in assets. If the AP
and accruals amount to P300 given a sales of P1,000, it means that
current assets will increase by P0.30 (P300/1,000 = P0.30) per P1
increase in sales.

Notes payable and long-term liabilities (such as bonds payable) are not
dependent on sales. It means that they are not directly affected when
sales change, specifically when sales increase. This may be called as
discretionary liabilities (part of discretionary funds) since these amounts
are influenced by management decisions. Hence, notes payable and
long-term payables may not be represented as a percentage of sales.

d) Stockholders Equity: Paid in capital (Ordinary Share and Share

Premium) are not dependent on sales. This can also be considered as
discretionary equity (or source of financing) since it is influenced by
management decision not based sales. This cannot be presented as a
percentage of sales.

As for retained earnings, although this is affected by sales, but since the
increase or decrease in this account is not directly related or directly
proportional with the increase or decrease in sales, this cannot be
presented also as a percentage of sales. Retained earnings increase by
the amount of net income less dividends (or amount plowed back).
 Sample Illustration: JMV Company has the following current IS and BS
information
JMV Corporation
IS
Sales P1,000
Costs 800
Taxable income 200
Tax (34%) 68
Net income P 132
Dividends P 44
Plowback (P132-44) 88
Payout ratio (44/132) 33.33%

If sales will increase by 25%, then:

JMV Corporation
Pro Forma or Forecasted IS
Sales(P1,000x1.25) P1,250
Costs(P1,250x0.80*) 1,000
Taxable income 250
Tax (34%) 85
Net income P 165

Dividends(33.33%xP165) P 55
Plowback (P165-55) 110

*Ratio of costs to sales = P800/P1,000 =P0.8

JMV Corporation
BS
ASSETS LIABILITIES AND EQUITY
% of % of
Sales Sales
Current Assets P1,200 120% Current Liabilities
Fixed Assets 1,800 180% AP P 300 30%
Total Assets P3,000 300% NP 100 n/a
Total CL 400 n/a
Long-term Liabilities 800 n/a
Owners Equity
CS 800 n/a
RE 1,000 n/a
Total SHE 1,800 n/a
Total L & E P3,000 n/a
 JMV Corporation
Pro Forma BS
ASSETS LIABILITIES AND EQUITY
Change Change
from from
previous previous
year year
Current Assets P1,500 P300 Current Liabilities
Fixed Assets 2,250 450 AP P 375 P75
Total Assets P3,750 P750 NP 100 0
Total CL 400 P75
Long-term Liabilities 800 0
Owners Equity
CS 800 0
RE 1,000 110
Total SHE 1,800 110
Total L & E P3,000 185

Part 4 Additional Financing Needed

The difference between the increase on the asset side of P750 and the increase in the
liabilities and equity side of P185 amounting to P565 (P750 185) is the additional
financing needed (AFN). AFN refers to the additional funds or financing required to
support increase in assets due to increase in sales after using available retained
earnings and spontaneous liabilities. This is sometimes called s the external
financing needed (EFN) or discretionary financing needed (DFN). AFN comes in the
form of either short-term interest bearing liability (notes payable), long-term debt or
common stock.

The general formula of AFN is:

AFN = Increase in assets - Increase in spontaneous liabilities - Increase in RE

AFN = (Capital intensity ratio or (Total Assets/Sales) x Increase in Sales)

- ( (AP and Accruals)/Sales) x Increase in Sales)
- ((ROS or NPM) x (New Sales) x Plowback ratio)

= (P3,000/P1,000) x (P1,000 x 25%)

- (P300/P1,000) x (P1,000 x 25%)
- (P132/P1,000) x (P1,000 x 125%) x (1 (P44/132))

= (P3 x 250) - (P0.30 x P250) - (13.20% x P1,250 x 66.66%)

= P750 - P75 - P110

= P575
Please take note of the following:

The capital intensity ratio is the ratio of total assets to sales. This measures
the increase in the total assets required per P1 increase in sales. The higher
the capital intensity ratio, the higher the assets should increase per increase
in sales and vice-versa. In the example, since capital intensity ratio is P3,
P1 peso increase in sales needs P3 increase in assets. If total assets amount
to P5,000, capital ratio will become P5 (P5,000/P1,000), and P1 peso
increase in sales needs P5 increase in total assets. This will increase the
AFN.

Growth rate also affects the AFN, the higher the growth rate (all other things
held constant), the higher the increase in total assets, the higher the AFN.

As for the ratio of AP and accruals to sales, the higher the ratio, the lower
the AFN. The higher the ratio, the more funds will be available, the lower
the additional funds needed. In the example, the ratio of AP and Accruals to
sales is P0.30. If the total amount of AP and Accruals is P500, then the
ratio will be P0.50 (P500/P1000). Per P1 increase in sales, financing from
AP and accruals will increase by P0.50 (instead of P0.30) per P1 increase in
sales, thus reducing the required AFN.

For the NPM or ROS, the higher the NPM or ROS, the lower the AFN since
higher ratio means higher net income available for plowback assuming
constant dividend payout, due to higher funds available from RE.

For the plowback ratio, considering all other things held constant, the
higher the plowback ratio, the higher the increase in retained earnings, the
lower the AFN.

Part 5 Special growth rates: Internal Growth Rate and Sustainable Growth Rate

As mentioned in the earlier part, forecasts start with sales and the estimated
growth in sales. There are various bases of the growth rates, as discussed
earlier.

There are two special growth rates that we will be discussing and needs to
be clarified, as follows:

1) Internal growth rate: as the name implies, this is the maximum growth
rate that the company can achieve as reflected in its sales wherein no
additional or external or discretionary funding needed. Meaning this is
the maximum growth rate wherein growth is supported only by internal
source (RE) and at times including spontaneous liabilities. It is the
growth rate wherein AFN is zero. Hence to compute for this, the formula
is:

0 = ((Total Assets/Sales) x (Sales x g)) -

((AP and Accruals)/Sales) x (Sales x g))
 ((ROS or NPM) x (Sales x (1 + g)) x Plowback ratio)

Using our first example above (JMV Company), the internal growth rate:

0 = ((P3,000/P1,000) x (P1,000 g))

((P300/P1,000) x (P1,000 g)
((P132/P1,000) x (P,1000 x (1 + g)) x 66.67%)

g = 3.37%

To check, you may substitute 3.37% as the growth rate in the AFN
equation, the answer will be zero (with some minor rounding-off
differences).

Alternative formula for internal growth rate is

= ROA x plowback ratio OR ROA x plowback ratio

(ROA x plowback ratio)

The first equation is a more complicated but an exact ratio (using the
year-end Total Assets). The second equation is a simple one but is less
exact than the first one and uses the beginning total assets.

Details of the alternative computations will not be discussed further and

will not be included anymore in the exam. This is just for your
information and future use.

2) Sustainable growth rate: This is the maximum growth rate which the
company can achieve without using external equity financing and
maintaining a constant debt-to-equity ratio or without changing leverage:

It has two computations:

First:
Sustainable growth rate = ROE x plowback
1 (ROE x plowback)

Second:
Sustainable growth rate = ROE x plowback

The first equations is the one which results into a more exact result and
uses the ending equity.

The second equation is quite familiar to you because this is the growth
rate formula that we usually use specially in getting the dividend growth
rate. However, in terms of AFN, the formula results to less exact results
and necessitate the use of the beginning equity in the computation.
 Other details of the computations of the sustainable growth rate will not
be discussed anymore and will not be included in the exam. This is just
for your information and future use.

Part 6 Excess Capacity Adjustment or Capacity Usage

As mentioned above for assets, fixed assets are at times not directly
dependent on sales. One issue is on the capacity usage. In the earlier
example, we assume that the fixed assets are used at full capacity. Let us
examine the capacity intensity ratio below:

Capacity intensity ratio = Total Assets/ Sales

= P3,000/P1,000 = P3 or 300%

To distinguish only the ratio for fixed assets, we can breakdown the capacity
intensity ratio in to the CA and Fixed assets to sales ratio, as follows:

CA to Sales Ratio = P1,200/P1,000 = P1.2 or 120%

FA to Sales Ratio = P1,800/P1,00 = P1.80 or 180%

Hence, per P1 peso increase in sales, fixed assets should increase by P1.80
(assuming that the fixed assets are used at their full capacity). If the
increase in sales is 25%, then increase in the amount of sales is P250 (25%
x P1,000), from P1,000 to P1,250. This P250 increase in sales needs to be
supported by P450 (P1.80 x P250) increase in assets.

However, if the current sales of P1,000 is only the effect of 90% utilization of
the fixed assets amounting to P1,800, this means that the 10% can still be
used to increase sales without further spending for additional investment or
payment in fixed assets.

To get the full capacity sales, we use this formula:

Full-capacity sales = Actual Sales/ Current Capacity = P1,000/90%

= P1,111

This means that if the company fully utilizes the P1,800 fixed assets, it will
generate not only P1,000 sales but P1,111 of sales. Hence, we only need to
pay for or invest in assets amounting to the equivalent sales from P1,112 to
P1,250 target new sales or a total of P139 (P1,250 P1,111).

Thus, we need to compute for the new or target fixed assets to sales ratio
based on full capacity sales, as follows:

Target FA to Full Capacity Sales ratio = P1,800/1,111 = P1.62 or 162%

To get the increase in FA due to the increase in sales (using the incremental
approach), please refer to below:
 Adjusted increase in FA due to the increase in sales using full capacity =
Target FA to Full Capacity Sales Ratio x Increase in Sales (which need
additional FA)
= P1.62 x P139 (P1,250 1,111) = P225

Another way of computing for the adjusted increase in FA is using the total
approach. Please refer to below:

Adjusted increase in FA using Total Approach

= New FA based on full capacity Existing or Original FA
= ((Target FA to Full Capacity Sales Ratio) x New or Target Sales)
Existing or Original FA)
= (P1.800/1,111) x P1,250) - P1,800
= (P1.62 x P1,250) P1,800
= P2,025 P1,800
= P2,025

Note: Please be reminded that our new or target sales is always based on
the current or given sales x the growth rate regardless whether the
current or given sales is based on the current or full capacity of fixed
assets. Thus, the new or target sales will still be P1,250 (P1,000 x 25%).

Hence, our adjusted AFN will look like this:

AFN = New Increase in Total Assets

(Original Increase in CA + New Increase in FA based on full capacity) -
Increase in Spontaneous liability Increase in RE

= (P300 + P225) P75 P110 = P525 P75 P110 = P340

You may also compute for the new AFN using the incremental approach. The
main difference is on the FA. The difference between the forecasted FA based
on the full and forecasted FA based on the normal capacity is the reduction in
the AFN. Please refer to the computation below for the difference between the
Forecasted FA based on the full and normal capacity.

Forecasted FA based on the normal capacity

= Original FA plus additional FA based on normal capacity
= P1,800 + ((P1,800/1,000) x (P1,000 x 25%))
= P1,800 + (P1.80 x P250*)
= P1,800 + P450
= P2,250

*Note: At the normal capacity, the increase in sales from P1,000 to

P1,250, that is the total amount of P250, necessitates an increase of
P1.80 increase per P1 of sales or a total of P450.

Forecasted FA based on the full capacity

= Original FA plus additional FA based on full capacity
= P1,800 + ((P1,800/1,111*) x ((P1,000 x 25%) (P1,111 P1,000))
 = P1,800 + (P1.62 x (P250 111))
= P1,800 + (P1.62 x 139**)
= P1,800 + P225
= P2,025

Note: *Full capacity sales = P1,111 (P1000/ 90%)

** Since the full capacity is used, for the increase in sales of P250
(from P1,000 to P1,250), sale P1,001 to P1,111 does not need any additional
investment in FA since the unused 10% will be used to generate these sales.
Only the P1,112 sale to P1,250 sale needs additional FA, which is P1.62
increase in FA per P1 increase in sales for a total of P225 (P1.62 x P139).

Decrease in FA = Forecasted FA based on the normal capacity

- Forecasted FA based on the full capacity
= P2,250 2,025 = P225

Take note that there is a decrease in the required FA if you use the full
capacity, the total increase in sales of P250 (from P1,000 to P1,250) does
not necessitate increase in FA. Only the P139 sales (P1,250 P1,111)
needs the increase in FA when using the full capacity.

New AFN = Current AFN less decrease in AFN (due to decrease in FA

required)

= P565 P225 = P340

In relation to the excess capacity adjustment or capacity usage, if the company is

using the full capacity of its FA, capital intensity ratio before and after will be the
same (capital intensity ratio based on the current years amounts will be the same
with the forecasted years amounts). However, this is not the same when there is
excess capacity.

Using the original figures from the example above (JMV Corporation), assuming that
the company operates at full capacity, the capital intensity ratios are as follows:

Capital intensity ratio (based on current years figures) P3,000/P1,000 = P3

Capital intensity ratio (based on forecasted years figures) P3,750/P1,250 = P3

If the company only operates at 90% capacity, the capital intensity ratios are as
follows:

Capital intensity ratio (based on current years figures) P3,000/P1,000 = P3

Capital intensity ratio (based on forecasted years figures) P3,525*/P1,250 =
P2.82

*Note: New Total Assets = P1,500 (New CA) + P2,025 (New FA based on full
capacity)
Part 7 Variation of Percentage of Sales

So far, using the percentage of sales method, we use the ratio of the IS and
BS accounts and the sales for the current year to project or forecast IS and
BS (Pro Forma Statements). But there may be variations of this one. Like
the example of Brigham on pp. 583 to 584, the ratios used to project the
2013 FS (e.g. operating expense to sales, inventory to sales, AR to sales,
debt ratio, payout ratio) are not merely the 2012 ratios. The 2013 ratios
used are figures in between the 2012 ratios and industry ratios. It is the
prerogative of each company on what ratios to use, as long as these will give
them the best estimates for the pro-forma FS. In the example, only cash, FA
and accounts payable used the ratios for 2012. The other accounts used
the in between ratios of 2012 and the industry ratios.

Part 8 Using Regression to Improve Forecast

Regression is a statistical technique that fits a line to observed data points

so that the resulting equation can be used to forecast other data points. It
is a more accurate tool to forecast accounts.
As discussed by Brigham, we can enhance forecasts of AR and inventory
thru regression.
We can regress AR and inventory with sales and create the regression
equation where X is the sales and Y is the AR or inventory.
For example, if the regression equation is:
Inventory = P40 + 0.555 (Sales), then if project sales is P5,000, then the
projected inventory is = P40 + 0.555(P5,000) = P2,815
Same concept applies for inventory

Part 9 Analyzing the Effects of Changing Ratios

As discussed by Brigham, since forecasted amounts and balances are based

on ratios, this balances may change if there are changes in the ratios.
Specifically accounts receivable will be affected by changing the age of
receivables or DSO and inventories will be affected by changing the age of
inventories of DSI.

For example, if a companys projected DSO is 45 days, and projected sales is

P4,500, using 360 days, its projected AR would be P562.50 ((P4,500/360 ) x
45 days). But if the company could operate at the industry DSO of 35 days,
then its AR would be P437.50 ((P4,500/360) x 35 days). There will be a
reduction of P125 which results to an cash flow or reduce the required asset
investment.