Financial Planning and Forecasting

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CHAPTER 16Financial Planning and Forecasting

Forecasting sales Projecting the assets and

internally generated funds Projecting outside funds needed Deciding how to raise funds

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Key assumptions in preliminary financial forecast for NWC

Operating at full capacity in 2005. Each type of asset grows proportionally

with sales. Payables and accruals grow

proportionally with sales. 2005 profit margin (2.52%) and payout

(30%) will be maintained. Sales are expected to increase by $500

million. (%S = 25%)

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Preliminary financial forecast: Income statements

2005 2006E

Sales $2,000.0 $2,500.0

Less: Variable costs 1,200.0 1,500.0

Fixed costs 700.0 875.0

EBIT $100.0 $125.0

Interest 16.0 16.0

EBT $84.0 $109.0

Taxes (40%) 33.6 43.6

Net income $50.4 $65.40

Dividends (30% of NI) $15.12 $19.62

Addition to retained earnings $35.28 $45.78

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Preliminary financial forecast:Balance sheets (Assets)

2005 2006E

Cash and equivalents $ 20 $ 25

Accounts receivable 240 300

Inventories 240 300

Total current assets $ 500 $ 625

Net fixed assets 500 625

Total assets $1,000 $1,250

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Preliminary financial forecast: Balance sheets (Liabilities and equity)

2005 2006E

Accts payable & accrued liab.

$ 100 $ 125

Notes payable 100 190

Total current liabilities 200 315

Long-term debt 100 190

Common stock 500 500

Retained earnings 200 245

Total liabilities & equity $1,000 $1,250

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Key financial ratios2005 2006E Ind Avg Comme

ntBasic earning power 10.00% 10.00% 20.00% PoorProfit margin 2.52% 2.62% 4.00% PoorReturn on equity 7.20% 8.77% 15.60% PoorDays sales outstanding

43.8 days

43.8 days

32.0 days

Poor

Inventory turnover 8.33x 8.33x 11.00x PoorFixed assets turnover

4.00x 4.00x 5.00x Poor

Total assets turnover

2.00x 2.00x 2.50x Poor

Debt/assets 30.00% 40.34% 36.00% OKTimes interest earned

6.25x 7.81x 9.40x Poor

Current ratio 2.50x 1.99x 3.00x PoorPayout ratio 30.00% 30.00% 30.00% OK

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Determining additional funds needed, using the AFN equation

AFN = (A*/S0)ΔS – (L*/S0) ΔS – M(S1)(RR)

= ($1,000/$2,000)($500) – ($100/$2,000)($500) – 0.0252($2,500)(0.7)= $180.9 million.

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Management’s review of the financial forecast

Consultation with some key managers has yielded the following revisions: Firm expects customers to pay quicker next year,

thus reducing DSO to 34 days without affecting sales.

A new facility will boost the firm’s net fixed assets to $700 million.

New inventory system to increase the firm’s inventory turnover to 10x, without affecting sales.

These changes will lead to adjustments in the firm’s assets and will have no effect on the firm’s liabilities on equity section of the balance sheet or its income statement.

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Revised (final) financial forecast:Balance sheets (Assets)

2005 2006E

Cash and equivalents $ 20 $ 67

Accounts receivable 240 233

Inventories 240 250

Total current assets $ 500 $ 550

Net fixed assets 500 700

Total assets $1,000 $1,250

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Key financial ratios – final forecast

2005 2006F Ind Avg Comment

Basic earning power 10.00% 10.00% 20.00% PoorProfit margin 2.52% 2.62% 4.00% PoorReturn on equity 7.20% 8.77% 15.60% PoorDays sales outstanding

43.8 days

34.0 days

32.0 days

OK

Inventory turnover 8.33x 10.00x 11.00x OKFixed assets turnover

4.00x 3.57x 5.00x Poor

Total assets turnover

2.00x 2.00x 2.50x Poor

Debt/assets 30.00% 40.34% 36.00% OKTimes interest earned

6.25x 7.81x 9.40x Poor

Current ratio 2.50x 1.75x 3.00x PoorPayout ratio 30.00% 30.00% 30.00% OK

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What was the net investment in operating capital?

OC2006E = NOWC + Net FA

= $625 - $125 + $625= $1,125

OC2005 = $900

Net investment in OC = $1,125 - $900

= $225

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How much free cash flow is expected to be generated in 2006?

FCF = NOPAT – Net inv. in OC= EBIT (1 – T) – Net inv. in OC= $125 (0.6) – $225= $75 – $225= -$150

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Suppose fixed assets had only been operating at 85% of capacity in 2005

The maximum amount of sales that can be supported by the 2005 level of assets is: Capacity sales = Actual sales / % of

capacity= $2,000 / 0.85 = $2,353

2006 forecast sales exceed the capacity sales, so new fixed assets are required to support 2006 sales.

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How can excess capacity affect the forecasted ratios?

Sales wouldn’t change but assets would be lower, so turnovers would improve.

Less new debt, hence lower interest and higher profits EPS, ROE, debt ratio, and TIE would

improve.

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How would the following items affect the AFN?

Higher dividend payout ratio? Increase AFN: Less retained earnings.

Higher profit margin? Decrease AFN: Higher profits, more retained

earnings. Higher capital intensity ratio?

Increase AFN: Need more assets for given sales.

Pay suppliers in 60 days, rather than 30 days? Decrease AFN: Trade creditors supply

more capital (i.e., L*/S0 increases).