Financial Forecasting and Short-term Financing

Forecasting and Pro Forma Analysis Timing of financial needs Amount of financial needs Flow of funds Check the covenants

Pro forma Income Statement Pro forma Balance Sheet Plug Figure Financing Options Depreciation Capital Expenditures Change in Net Plant & Equipment Sales Forecast Net Income Dividend Policy Change in Retained Earnings Working Capital Accounts External Financing Required Short-Term Debt Long-Term Debt

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

Sales Forecast Seasonal changes Business cycle Market segment Recession Expansion Market segment High growth Contraction Inflation

2001 Balance Sheet (Millions of $) Cash & sec. $20 Accts. pay. &   accruals $100 Accounts rec. 240 Notes payable 100 Inventories Total CL $200 Total CA $500 L-T debt Common stk 500 Net fixed Retained Assets Earnings 200 Total assets $1000 Total claims

2001 Income Statement (Millions of $) Sales $2,000.00 Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $100.00 Interest 16.00 EBT $84.00 Taxes (40%) 33.60 Net income $50.40 Dividends (30%) $15.12 Add’n to RE 35.28

AFN (Additional Funds Needed) Key Assumptions Operating at full capacity in 2001. Each type of asset grows proportionally with sales. Payables and accruals grow proportionally with sales. 2001 profit margin (2.52%) and payout (30%) will be maintained. Sales are expected to increase by $500 million. (%ΔS = 25%)

AFN (Additional Funds Needed) AFN= (A*/S0) ΔS - (L*/S0) ΔS - M(S1)(1 - d) = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0252($2,500)(1 - 0.3) = $180.9 million.

Projecting Pro Forma Statements with the Percent of Sales Method: Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales Costs Cash Accounts receivable Items as percent of sales Inventories Net fixed assets Accounts payable and accruals Choose other items Debt (which determines interest) Dividends (which determines retained earnings) Common stock

Percent of Sales: Inputs   2001 2002 Actual Proj. COGS/Sales 60% SGA/Sales 35% Cash/Sales 1% Acct. rec./Sales 12% Inv./Sales Net FA/Sales 25% AP & accr./Sales 5%

Other Inputs Percent growth in sales 25% Growth factor in sales (g) 1.25 Interest rate on debt 8% Tax rate 40% Dividend payout rate 30%

2002 1st Pass Income Statement   2002 2001 Factor 1st Pass Sales $2,000 g=1.25 $2,500 Less: COGS Pct=60% 1,500 SGA Pct=35% 875 EBIT $125 Interest 16 EBT $109 Taxes (40%) 44 Net. Income $65 Div. (30%) $19 Add. to RE $46

2002 1st Pass Balance Sheet (Assets) Forecasted assets are a percent of sales.   2002 Sales = $2,500 2002 Factor 1st Pass Cash Pct= 1% $25 Accts. rec. Pct=12% 300 Inventories Total CA $625 Net FA Pct=25% Total assets $1250

2002 1st Pass Balance Sheet (Claims)   2002 Sales = $2,500 2002 2001 Factor 1st Pass AP/accruals Pct=5% $125 Notes payable 100 Total CL $225 L-T debt Common stk. 500 Ret. earnings 200 +46* 246 Total claims $1,071

What are the additional funds needed (AFN)? Forecasted total assets = $1,250 Forecasted total claims = $1,071 Forecast AFN = $ 179 NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally

How will the AFN be financed? Additional notes payable= 0.5 ($179) = $89.50  $90. Additional L-T debt= 0.5 ($179) = $89.50  $89. But this financing will add 0.08($179) = $14.32 to interest expense, which will lower NI and retained earnings.

2002 2nd Pass Income Statement   1st Pass Feedback 2nd Pass Sales $2,500 Less: COGS $1,500 SGA 875 EBIT $125 Interest 16 +14 30 EBT $109 $95 Taxes (40%) 44 38 Net income $65 $57 Div (30%) $19 $17 Add. to RE $46 $40

2002 2nd Pass Balance Sheet (Assets)   1st Pass AFN 2nd Pass Cash $25 Accts. rec. 300 Inventories Total CA $625 Net FA 625 Total assets $1,250

2002 2nd Pass Balance Sheet (Claims)   1st Pass Feedback 2nd Pass AP/accruals $125 Notes payable 100 +90 190 Total CL $225 $315 L-T debt +89 189 Common stk. 500 Ret. earnings 246 -6 240 Total claims $1,071 $1,244

Results After the Second Pass 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 the $6 reduction in retained earnings. Additional passes could be made until assets exactly equal claims.

Financial Forecasting and Firm Capacity Balance Sheet ($ in Millions) Assets 1999 Liabilities and Owners' Equity Current Assets   Current Liabilities Cash 200 Accounts Payable 400 Accounts Receivable Notes Payable Inventory 600 Total Current Liabilities 800 Total Current Assets 1200 Long-Term Liabilities Long-Term Debt 500 Fixed Assets Total Long-Term Liabilities Net Fixed Assets Owners' Equity Common Stock ($1 Par) 300 Retained Earnings Total Owners' Equity 700 Total Assets 2000 Liab. and Owners' Equity

Income Statement ($ in Millions), 1999   Sales 1200 Cost of Goods Sold 900 Taxable Income 300 Taxes 90 Net Income 210 Dividends 70 Addition to Retained Earnings 140

Full Capacity The equation used to calculate EFN when fixed assets are being utilized at full capacity is given below.

S0 = Current Sales, S1 = Forecasted Sales = S0(1 + g), g = the forecasted growth rate is Sales, A*0 = Assets (at time 0) which vary directly with Sales, L*0 = Liabilities (at time 0) which vary directly with Sales, PM = Profit Margin = (Net Income)/(Sales), and b = Retention Ratio = (Addition to Retained Earnings)/(Net Income).

Full Capacity Example Given that Fixed Assets are being utilized at full capacity and the forecasted growth rate in Sales is 25%. Forecasted Sales: S1 = 1200(1 + .25) = $1500

Excess Capacity If the firm has excess capacity in its Fixed Assets then the Fixed Assets may not have to increase in order to support the forecasted sales level. Moreover, if the Fixed Assets do need to increase in order to support the forecasted sales level, then they will not have to increase by as much as would be required if they were being used at full capacity. If Forecasted Sales are less than Full Capacity Sales, then fixed assets do not need to increase to support the forecasted sales level. On the other hand, if Forecasted Sales are greater than Full Capacity Sales, then Fixed Assets will have to increase.

Case 1: S1 Less Than SFC Given that Fixed Assets are currently being utilized at 60% of capacity and the forecasted growth rate in Sales is 25%. S1 = 1200(1 + .25) = $1500 SFC = 1200/.60 = $2000 Forecasted Sales are less than Full Capacity Sales the EFN can be found in one step. Here A*0 is equal to Total Current Assets which equals $1200.

Case 2: S1 Greater Than SFC When the Forecasted Sales are greater than Full Capacity Sales, EFN can be determined in two steps. The first step, EFN1, finds the EFN needed to get to Full Capacity Sales. The second step, EFN2, finds the additional EFN to get from Full Capacity Sales to the Forecasted Sales. The total EFN is simply EFN1 plus EFN2.

Excess Capacity Example: S1 > SFC Given that Fixed Assets are currently being utilized at 90% of capacity and the forecasted growth rate in Sales is 25%. S1 = 1200(1 + .25) = $1500 SFC = 1200/.90 = $1333.33

Tracing Cash and Net Working Capital Current Assets are cash and other assets that are expected to be converted to cash with the year. Cash Marketable securities Accounts receivable Inventory Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payable Accrued wages Taxes

The Operating Cycle and the Cash Cycle Order Placed Stock Arrives Raw material purchased Cash received Finished goods sold Inventory period Accounts receivable period Time Accounts payable period Firm receives invoice Cash paid for materials Operating cycle Cash cycle

Operating Cycle, Inventory turnover, and A/R turnover Inventory turnover = Sales / Average Inventory, or COGS / Average Inventory [Inventory Conversion = 365 / Inventory turnover] Accounts Receivable turnover = Sales / AR [Days A/R outstanding = 360 / Accounts Receivable turnover] Payable turnover = Purchase (or COGS) / AP [Days A/P outstanding = 360 / Payable turnover] Operating Cycle = Inventory Conversion + Days A/R outstanding

The Operating Cycle and the Cash Cycle = Operating cycle – Accounts payable period In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables.

Dell’s Working Capital Policy DSI DSO DPO CCC 1996 Q4 31 42 33 40 Improvement -18 -5 +21 -44 1997 Q4 13 37 54 -4 Dell’s daily sales was about $20M per day. Dell was able to reduce the need of short term financing $800M. Assuming a 6% short term cost of capital, Dell was able to created $48M more pre tax earnings.

Beginning Inventory $ 400,000 Purchase $2,600,000 You find the following information from a firm’s financial statements, please calculate its cash (conversion) period? Beginning Inventory $ 400,000 Purchase $2,600,000 Ending Inventory $ 600,000 Accounts Receivable $ 800,000 Sales $3,600,000 Accounts Payable $ 600,000

Operating Cycle = Inventory Conversion + A/R Days Cash Cycle = Operating cycle – A/P days Operating Cycle = 75 + 80 = 155 days Cash Cycle = 155 days – 83 days = 72 days

Short term financing: Advantages: Disadvantages Could be obtained quicker. The amount raised can be flexible. Usually cheaper. (comparing with long-term finance) Disadvantages High solvency risk: need to be repaid in a short period. High refinance risk: face highly volatile short-term interest rates.

Short-term financing strategies Moderate Approach: matching maturities. Finance long term assets and permanent current assets with long term financing; finance transitory current assets with short term. Aggressive Approach: Finance part of permanent assets and all transitory assets with short term financing. Conservative Approach: Finance part of transitory current assets with long-term financing.

The Short-Term Financial Plan The most common way to finance a temporary cash deficit to arrange a short-term loan. Unsecured Loans Line of credit down at the bank Secured Loans Accounts receivable financing can be either assigned or factored. Inventory loans use inventory as collateral. Other Sources Banker’s acceptances Commercial paper.