2 Corinthians 1: 20 - 22

For no matter how many promises

God has made, they are YES in
Christ. And so through Him, the
AMEN is spoken by us to the Glory
of God. Now it is God that makes
both us and you stand firm in
Christ. He anointed us, set his seal
of ownership on us, and put his
Spirit in our hearts, as a deposit,
guaranteeing what is to come.

CHAPTER 17
Financial Planning and Forecasting
Pro-Forma Financial Statements

Some Bad Forecasts

"Everything that can be invented has

been invented."
--Commissioner, U.S. Office of Patents,
1899.
"640K ought to be enough for
anybody."
-- Bill Gates, 1981

Some Bad Forecasts

"But what ... is it good for?"

--Engineer at the Advanced Computing
Systems Division of IBM, 1968,
commenting on the microchip.

"There is no reason anyone would

want a computer in their home."
--President, Chairman and founder of
Digital Equipment Corp., 1977

Some Bad Forecasts

"I think there is a world market for

maybe five computers."
--Chairman of IBM, 1943

"We don't like their sound, and guitar

music is on the way out."
--Decca Recording Co. rejecting the
Beatles, 1962.

Forecasting

What is generally the first item to

estimate when starting a business?
What is the most difficult aspect of
forecasting?

Steps in Financial Forecasting

Forecast sales
Project the assets needed to
support sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and
stock price

The Sales Forecasting

Process
Marketing
(sales estimate)
Top Management
(policy, strategy)

Finance
Department

Production
(capacity, schedules)
Accounting
(financial statements,
depreciation, taxes)

SALES
FORECAST

Forecasting sales

Review past sales (five to ten years).

You can use average growth rate but it
may not give you a correct estimate.
Use regression slope to compute growth
rate.
Consider changes in economy, market
conditions, etc.
Improper sales forecast can lead to
serious financial planning issues.

Sales Forecast

Sales forecasts are usually based on the analysis of historic

data.
An accurate sales forecast is critical to the firms
Sales
Forecast
profitability:
Company will fail to meet demand
Market share will be lost

Under-optimistic

Over-optimistic

Too much inventory

and/or fixed assets

Low turnover ratio

High cost of depreciation and storage
Write-offs of obsolete inventory

Low profit
Low rate of return on equity
Low free cash flow
Depressed stock price

Forecast future sales based on past

sales growth
Sales
SalesEstimates
Estimatesfor
for
next
next22years
years
Sales

Growth Rate

94 95

96 97 98

99 00 01 02

03

Time

 Forecast future sales based on past sales

growth
Also include the effects of any events
which are expected to impact future
sales (new products or economic
conditions)
Sales

New Product Introduced

94 95

96 97 98

99 00 01 02

03

Time

 Forecast future sales based on past sales

growth
Also include the effects of any events
which are expected to impact future
sales (new products or economic
conditions)
Sales

New Product Introduced

94 95

96 97 98

99 00 01 02

03

Time

Sales Growth Imposes Costs on the Firm

Will require additional resources

Current Assets: Inventory, A/R, Cash

Fixed Assets: Plant and Equipment

2009

2010

What are the affects on the

financials?

Sold off stores

Borrowed money
Expanded to new markets
Out-sourced labor to China
Lowered retail prices
Increased advertising
Purchased inventory management
system

The Percent of Sales Method

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.

A Better Financial Planning Model

The Income Statement
The pro forma income statement is generated by

recognizing all variable costs that change directly

with sales.
Two key ratios are calculated dividend payout ratio
and retention ratio.
The first measures the percentage of net income paid

out as dividends to shareholders, while the second

measures the percentage of net income reinvested by
the firm as retained earnings.

A Better Financial Planning Model

The Balance Sheet
Some balance sheet items vary directly with sales

while others do not.

To determine which accounts vary directly with sales,

a trend analysis may be conducted on historic

balance sheets of the firm.
Typically, working capital accounts like inventory,

accounts receivables and accounts payables vary

directly with sales.

A Better Financial Planning Model

The Balance Sheet
Fixed assets do not always vary directly with sales.

It will do so, only if the firm is operating at 100

percent capacity and fixed assets can be
incrementally changed.
The ratio of total assets to net sales is called the

capital intensity ratio. This ratio tells us the amount of

assets needed by the firm to generate $1 sales.

A Better Financial Planning Model

The Balance Sheet
The higher the ratio, the more capital the firm needs

to generate salesthe more capital intensive the

firm.
Firms that are highly capital intensive are more risky

than those that are not because a downturn can

reduce sales sharply but fixed costs do not change
rapidly.

A Better Financial Planning Model

Liabilities and Equity
Only current liabilities are likely to vary directly with

sales. The exception here is notes payables (shortterm borrowings) that changes as the firm pays it
down or makes an additional borrowing.
Long-term liabilities and equity accounts change as a

direct result of managerial decisions like debt

repayment, stock repurchase, issuing new debt or
equity.

A Better Financial Planning Model

Liabilities and Equity
Retained earnings will vary as sales changes but

not directly. It is affected by the firms dividend

payout policy.

A Better Financial Planning Model

The Preliminary Pro-forma Balance Sheet
First, calculate the projected values for all the

accounts that vary with sales.

Second, calculate the projected value of any other

balance sheet account for which an end-of-period

value can be forecast or otherwise determined.
Third, enter the current years number for all the

accounts for which the next years figure cannot be

calculated or forecast.

A Better Financial Planning Model

The Preliminary Pro-forma Balance Sheet
At this point the balance sheet will be unbalanced. A

plug value is necessary to get the balance sheet to

balance.
First, determine the retained earnings based on the

firms dividend policy.

A Better Financial Planning Model

The Preliminary Pro-forma Balance Sheet
Next, the plug figure will represent the external

financing necessary to make the total assets equal

total liabilities and equity. This calls for management
to choose a financing option choosing debt, equity
or a combination to raise the additional funds
needed.

A Better Financial Planning Model

The Management Decision
The first decision relates to the firms dividend

policy. Should the firm alter its dividend policy to

increase the amount of retained earning?
If external funding is still needed, should the firm

issue new debt, or issue equity? Or, should it be a

mix of both?
It is important to recognize that while financial planning
models can identify the amount of external financing
needed, the financing option is a managerial decision.

Beyond the Basic Planning Models

Improving Financial Planning Models
There are several weaknesses in the previously

described models.
First, interest expense was not accounted for. This is

difficult to do so until all the financing options are

finalized.
Second, all working capital accounts do not

necessarily vary directly with sales, especially cash

and inventory.

Beyond the Basic Planning Models

Improving Financial Planning Models
Third, how fixed assets are adjusted plays a significant

role.
When a firm is not operating at full capacity, sales may

be increased without adding any new fixed assets.

Fixed assets are added in large discrete amounts

called lumpy assets. Since it requires time to get new

assets operational, they are added as the firm nears
full capacity.

Beyond the Basic Planning Models

Managing and Financing Growth
Managers prefer rapid growth as a goal to capture

market share and establish a competitive position.

Most firms experiencing rapid growth fund the growth

with debt, increasing the firms leverage and putting it

at risk.

Beyond the Basic Planning Models

External Funding Needed / Additional Fund Needed
External funding needed (EFN) is defined as the

additional debt or equity a firm needs to issue so it can

purchase additional assets to support an increase in
sales.
EFN is tied to new investments the management has

deemed necessary to support the sales growth.

Beyond the Basic Planning Models

External Funding Needed
The new investments are the projected capital

expenditure plus the increase in working capital

necessary to sustain increases in sales.
Companies first resort to internally generated

funds in the form of addition to retained

earnings.

Beyond the Basic Planning Models

External Funding Needed
Once internally generated funds are exhausted,

the firm looks to raise funds externally.

EFN/ AFN = Projected increase in Assets

Spontaneous Increase in Liabilities Increase

in Retained Earnings
EFN/ AFN = Projected increase in Assets

Spontaneous Increase in Liabilities Increase

in Retained Earnings

Beyond the Basic Planning Models

External Funding Needed
First, holding dividend policy constant, the amount

of EFN depends on the firms projected growth rate.

Higher growth rate implies that the firm needs more
new investments and therefore, more funds to have
to be raised externally.
Second, the firms dividend policy also affects EFN.

Holding growth rate constant, the higher the firms

payout ratio, the larger the amount of debt or equity
financing needed.

How would increases in these items

affect the EFN?
Higher dividend payout ratio:

Reduces funds available internally,

increases EFN.

(More)

Higher profit margin:

Increases funds available internally,

decreases EFN.

Higher capital intensity ratio, A/S0:

Increases asset requirements,

increases EFN.

Implications of EFN

If EFN is positive, then you must

secure additional financing.
If EFN is negative, then you have
more financing than is needed.

Pay off debt.

Buy back stock.
Buy short-term investments.

Summary: How different factors affect the

EFN forecast.

Excess capacity: lowers EFN.

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

Lumpy Assets

Assets

1,500
1,000
500

500

1,000

2,000

Sales

A/S changes if assets are lumpy. Generally will have

excess capacity, but eventually a small S leads to a
large A.

Other Techniques for

Forecasting Financial
Statements

Regression Analysis
for Asset Forecasting

Relationship between
type of asset and
sales is linear.
Get historical data on
a good company, then
fit a regression line to
see how much a given
sales increase will
require in way of
asset increase.

Excess Capacity
Adjustments

Full capacity sales

Target fixed assets-tosales ratio
Required level of fixed
assets
39