CHAPTER 19 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) SALES FORECAST Accounting (financial statements, depreciation, taxes)

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 firm’s profitability: Sales Forecast Under-optimistic Company will fail to meet demand Market share will be lost 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

Sales Estimates for next 2 years Forecast future sales based on past sales growth Sales Estimates for next 2 years Sales Growth Rate Time 94 95 96 97 98 99 00 01 02 03

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 Time 94 95 96 97 98 99 00 01 02 03

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 Time 94 95 96 97 98 99 00 01 02 03

Sales Growth Imposes Costs on the Firm Current Assets: Inventory, A/R, Cash Fixed Assets: Plant and Equipment Will require additional resources 2010 2009

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 sales—the 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 (short-term 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 firm’s 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 year’s number for all the accounts for which the next year’s 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 firm’s 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 firm’s 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. Go to exhibit 19.6

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. Go to exhibit 19.7

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. Go to exhibit 19.8

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 firm’s leverage and putting it at risk.

Beyond the Basic Planning Models External Funding 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. See equation 19.5. 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. See equation 19.6 and 19.7.

Beyond the Basic Planning Models External Funding Needed First, holding dividend policy constant, the amount of EFN depends on the firm’s 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 firm’s dividend policy also affects EFN. Holding growth rate constant, the higher the firm’s payout ratio, the larger the amount of debt or equity financing needed. Go to exhibit 19.9 -19.11

How would increases in these items affect the EFN? Higher dividend payout ratio: Reduces funds available internally, increases EFN. (More…)

Higher capital intensity ratio, A/S0: Higher profit margin: Increases funds available internally, decreases EFN. Higher capital intensity ratio, A/S0: Increases asset requirements, increases EFN.

If EFN is positive, then you must secure additional financing. 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 less-than-proportional asset increases. Lumpy assets: leads to large periodic EFN requirements, recurring excess capacity.

Lumpy Assets Assets 1,500 1,000 500 Sales 500 1,000 2,000 A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.