4-1 FINANCIAL PLANNING AND CONTROL Sales forecasts Projected financial statements – Additional Funds Needed –Also called External Funds Needed (EFN) Financial control Hypothetical Data for Northwest Chemical Company

4-2 n Financial Planning The projection of sales, income, and assets based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projections. Forecasting also is important for production planning and human resource planning. Financial Control The phase in which financial plans are implemented; control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes. Financial Planning and Control

4-3 Financial Planning: Growth is a key theme behind financial forecasting. Remember that growth should not be the underlying goal of a corporation – creating shareholder value is the appropriate goal. In many cases, however, shareholder value creation is enabled through corporate growth. The sales forecast predicts a firm’s unit and dollar sales for some future period; generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc. We want to forecast if we need external funds – borrowing or a new stock issue

4-4 Percentage of Sales Method 1. Projected Balance sheet forecasting of AFN 2. Increased sales requires increased assets that must be financed. We will discuss the strategy for forecasting assets. 3. Increased sales automatically increases spontaneous liabilities. 4. Some financing will come from retained earnings. Depending on the information, we formulate a strategy for determining RE. 5. If additional funds are needed we have to choose to finance with external funds -- debt or stock. 6. #5 affects #4 -- thus, we sometimes use an iterative approach.

4-5 Steps to get AFN – simple one-pass forecast balance sheet method 1. Calculate RE with the data given (method varies) 2. Increase CA and spontaneous liabilities proportionately with sales 3. Increase FA if needed based on capacity information given 4. Carry over bonds/bank-loans and stock 5. Calculate TA - (TL+E) = AFN  AFN = additional funds needed from external sources

4-6 Hand out simple example

4-7 Two pass method example: Northwest Chemical: 2001 Sales Projection (millions of dollars)

4-8 Northwest Chemicals Oregon producer of Ag Chemicals Prepare financial forecast, main assumption is a 25% increase in sales Want to know how performance/ratios changes. One of the hard items is Additional Funds Needed We will use the percentage of sales method of forecasting financial statements. This will give you a thorough feel for the process of forecasting financial statements.

4-9 North West Chemical: Key Ratios

4-10 Key Assumptions  Interest rate = 8% for any debt.  Operating at full capacity in  Each type of asset grows proportionally with sales.  Payables and accruals grow proportionally with sales.  2000 payout (30%) will be maintained.  No new common stock will be issued.  Sales are expected to increase by $500 million. (%  S = 25%) Projected Financial Statements Step 1. Forecast the 2001 Income Statement Implications for fixed assets and fixed cost?

4-11 There will be simpler problems than this in lab

4-12 NWC: Projected 2001 Income Statement:

4-13 Projected Financial Statements Step 2. Forecast the 2001 Balance Sheet (Assets) At full capacity, so all assets must increase in proportion to sales.

4-14 Projected Financial Statements Step 2. Forecast the 2001 Balance Sheet (Liability & Equity) *From projected income statement.

4-15 : Forecasted total assets=$1,250 : Forecasted total claims=$1,071 : Forecast AFN 1 =$ 179 NWC must have the assets to make forecasted sales. The balance sheet must balance. So, we must raise $179 externally. Projected Financial Statements Step 3. Raising the Additional Funds Needed

4-16 Additional notes payable= 0.5 ($179)= $89.50 Additional L-T debt= 0.5 ($179)= $89.50 But this financing will add 0.08 ($179) = $14.32 to interest expense, which will lower NI and retained earnings. How will the AFN be financed?

4-17 Projected Financial Statements Step 4. Financing Feedbacks The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets.

4-18 NWC: 2001 Adjusted Forecast of Income Statement

4-19 NWC: 2001 Adjusted Forecast of Balance Sheet (Assets) No change in asset requirements.

4-20 NWC: 2001 Adjusted Forecast of Balance Sheet (Liabilities & Equity)

4-21 : Forecasted assets= $1,250(no change) : Forecasted claims= $1,244(higher) : 2nd pass AFN= $ 6(short) : Cumulative AFN= $179 + $6 = $185. : The $6 shortfall came from reduced net earnings. Additional passes could be made until assets exactly equal liabilities/equity. ex: $6 (0.08) = $0.48 interest 3rd pass. Results of the Adjusted Forecast:

4-22 North West Chemical: Adjusted Key Ratios

4-23  Not very profitable relative to other companies in the industry.  Carrying excess inventory and receivables.  Debt ratio projected to move ahead of average. not in good shape  Overall, not in good shape and doesn’t appear to be improving. Analysis of the Forecast: How does North West Chemical Compare?

4-24 Capacity Issues Sales last year $500 Last year at 80% of capacity Sales will increase 50% What percentage will fixed cost and fixed assets increase?

4-25 Suppose in 2000 fixed assets had been operated at only 75% of capacity: Full Capacity Sales Actual sales  % of capacity usage Other Considerations in Forecasting: Excess Capacity

4-26 With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. Does NWC need additional fixed assets? How would fixed costs change? Fixed cost would not increase.

4-27 With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. If NWC had been operating at full capacity, what would its fixed assets/sales ratio be?

4-28 Projected Financial Statements Step 2. Forecast the 2001 Balance Sheet (Assets) At full capacity, so all assets must increase in proportion to sales.

4-29  The projected increase in fixed assets was $125, the AFN would decrease by $125.  Since no new fixed assets will be needed, AFN will fall by $125. How would the excess capacity situation affect the 2001 AFN?

4-30 NWC: Projected 2001 Income Statement:

4-31  Fixed cost would not increase, increasing EBIT by $175  In turn net income and RE would increase, thus more internal financing and AFN would be smaller. How would the excess capacity situation affect the 2001 AFN?

4-32  Sales wouldn’t change but assets would be lower, so turnovers would be better.  Less new debt, hence lower interest, so higher profits, EPS,ROE.  Debt ratio, TIE would improve. How would excess capacity affect the forecasted ratios?

Forecasted Ratios:

4-34 Summary: How different factors affect the AFN forecast. n Dividend payout ratio changes. If reduced, more RE, reduce AFN. n Profit margin changes. If increases, total and retained earnings increase, reduce AFN. n Plant capacity changes. Less capacity used, less need for AFN. n AP Payment terms increased to 60 days from 30. Accts. payable would double, increasing liabilities, reduce AFN.