Chapter 17 Financial Planning and Forecasting Companies base their operating plans on forecasted financial statements. The company must first forecast sales for the next few years. Then determine the assets required to meet the sales targets. Next comes forecasting the financial requirements necessary. Forecasting financial requirements involves: 1. Project the asset requirements for the coming period 2. Project the liabilities and equities that will be generated under normal operating conditions during the same period 3. subtract the projected liabilities and equity from the required assets to estimate the additional funds needed (AFN) to support the level of forecasted operations. Projected Balance Sheet Method Steps: 1. Forecast income statement 2. Forecast balance sheet 3. Determine how to raise the additional funds needed 4. Financing feedbacks Example: NWC 2005 sales were $2 billion, and the marketing department is forecasting a 25% increase for 2006. Assume that the company was operating at full capacity with respect to all assets in 2005. Assume that a) Each type of asset, as well as payables, accruals, and costs, and depreciation, grows at the same rate as sales b) The dividend payout ratio is held constant at 30% c) External funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock will be issued) d) All debt carries an interest rate of 8%
Actual 2005 and Projected 2006 Income Statement ( millions of dollars) Actual 2005 Forecast basis 2006Forecast Sales Costs except deprec. Depreciation $2,000.00 (1,800.00) (.00) 1.25 x 2003 Sales.90 x 2004 Sales.05 x 2004 Sales EBIT Interest Expense $.00 (16.00) EBT Taxes (40%) $ 84.00 (33.60) Net Income $ 50.40 Dividends (30%) Addition to R.E. $ 15.12 $ 35.28 Balance Sheet ( millions of dollars) Forecasted balance sheet items are a percent of forecasted sales 2006 sales forecasted to be $2,500. Assets 2005 Forecast basis 2006 1 st Pass Cash and securities $ 20.01 x FS* Accounts receivable Inventories Total current assets 500 Net fixed assets 500.25 * FS Total assets 1,000 Liabilities and equity Accounts payables & accruals Notes payable Total current liabilities 200 Long-term debt Common stock 500 Retained earnings 200.05 x FS +$46** AFN 2006 2nd Pass Total liabilities and equity 1,000 *FS2006 forecasted sales **increase in retained earnings from the first pass income statement.
What are the additional funds needed (AFN)? Forecasted total assets $ Forecasted total claims $ Forecast AFN $ How AFN will be raised? No new common stock will be issued, any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt. Additional notes payable Additional long-term debt This additional financing will add to interest expense 8 % which will lower net income and the addition to retained earnings The AFN Formula A* L* AFN S S M S1 RR S S 0 0 Example: Carter Corporation s sales are expected to increase from $5 million in 2005 to $6 million in 2006, or by 20 percent. Its assets totaled $3 million at the end of 2005. Carter is at full capacity. At the end of 2005, current liabilities are $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued liabilities. The after-tax profit margin is forecasted to be 5 percent, and the forecasted retention ratio is 30 percent. What is AFN for the upcoming year?
Other Considerations in Forecasting 1. excess capacity. Can we always assume % capacity utilization? What if asset use is less than % of capacity? Let s assume that in fixed assets in 2003 were being utilized to only 90% of capacity. Actual sales $2,000 Full capacity sales $2,222 % capacity at which 90% FA were operated T arg et FA Sales Actual FA Full capacity sales $500 $2,222 22.5% Forecasted balance sheet items are a percent of forecasted sales 2006 sales forecasted to be $2,500. Assets 2005 Forecast basis 2006 1 st Pass Cash and securities $ 20.01 x FS* Accounts receivable Inventories Total current assets 500 Net fixed assets 500.225 * FS Total assets 1,000 Liabilities and equity Accounts payables & accruals Notes payable Total current liabilities 200 Long-term debt Common stock 500 Retained earnings 200.05 x FS +$46** AFN 2006 2nd Pass Total liabilities and equity 1,000 *FS2006 forecasted sales **increase in retained earnings from the first pass income statement.
2. economies of scale -- variable cost of good sold ratio may change with the size of the firm 3. lumpy assets -- not all assets can be acquired in small increments, but must obtained in large discrete amounts. A small increase in sales can require significant increase in plant and equipment