Financial Forecasting

Condensed Balance SheetAccounting View

ASSETS
Current Assets

LIABILITIES + EQUITY
Current Liabilities

Noncurrent Assets

Noncurrent Liabilities

Equity

Condensed Balance SheetFinancial Planning View

ASSETS
Permanent Assets

LIABILITIES + EQUITY
Permanent Current Liabilities

Temporary Assets

Short-Term Liabilities

Long-Term Capital

Sales Forecasting

Sales Force Estimates Customer Surveys

Time Series Analysis Economic Models

Pro Forma Financial Statements

They show the effect of the firms decisions
on its future financial statements.

Effect of alternative decisions can be

examined:
Effect of sales variations. Effect of interest rate changes. Effect of financing decisions. Effect of dividend decisions.

Percent of SalesSources and Uses of Funds

USES OF FUNDS
Net Investment in Assets to

= SOURCES OF FUNDS
= Internal Sources +

Support Sales Change

External Sources

Percent of Sales Method

Assumes that each expense, asset and liability item can be estimated using a percentage of sales. The percent of sales method assumes a linear relationship between projected sales and a specific expense, asset, and liability category.

Percent of Sales Forecasting Method

Allows firm to estimate funds required to
finance growth.

Sales growth results in:

increase in current and fixed assets. increase in spontaneous short-term financing. increase in profitability.

The increase in current assets must be

financed from internally generated funds or external funds.

Percent of Sales Forecasting Method

If internally generated funds are insufficient
to finance the growth, the firm may:
Reduce the growth rate. Sell assets not required to run the firm. Obtain new external financing. Reduce or stop paying cash dividends.

Additional Financing Needed (AFN)

Let
A/S = the increase in assets per dollar increase in sales. L/S = the increase in spontaneous liabilities per dollar increase in sales. S0 = current level of sales. g = projected growth rate in sales. M = net profit margin on sales. D = cash dividends planned for common stock.

Additional Financing Needed (AFN)

Additional Financing Needed
Required increase Increase in Increase in AFN in assets liabilitie s retained earnings
AFN = (A/S)gS0 (L/S)gS0 [M(1+g)S0D]

Additional Financing Needed

Peak Plastics expects rapid sales growth next year. Sales for the current year were $4 million, and are expected to grow by 20% next year. Peak wants to estimate the external capital that will be required to finance this growth. The firm estimates that additional assets equal to 50% of the increase in sales will be required. Liabilities will increase by 18% of sales. The net profit margin is 6% and Peak expects to pay $84,000 in dividends to its common stockholders.

Additional Financing Needed

Required increase Increase in Increase in AFN in assets liabilitie s retained earnings

A L AFN gS0 gS0 [ M( 1 g)S 0 D] S S

AFN = (.50)(.20)$4m (.18)(.20)$4m [.06(1.20)$4m $84,000] = $52,000

Percent of Sales - Net Assets Required

Increase in = Net Assets

= Where: DS = A/S =

Increase in Total Assets

(DS)(A/S) -

Increase in Current Liabilities

(DS)(CL/S)

CL/S =

Change in sales Assets needed to support a dollar of sales Ratio of spontaneous current liabilities to sales

Percent of SalesInternal Financing Provided

Internal Financing Provided = (1-a)(NPM)(S)
Where:
a = Proportion of earnings paid out in dividends After-tax profit margin on sales Forecasted level of sales.

NPM S

= =

External Financing NeededAn Example

Specialty Steel Products (SSP) wants to assess its financing needs for the coming year. The firms sales are $200 million and are expected to rise 10% to $220 million in 2000. Because making steel is capital intensive, $0.90 in assets are needed to generate a dollar of sales. Current liabilities are 20% of sales. After-tax profit margins are 5.1%, and SSP typically pays out 40% of its earnings in dividends.

External Financing NeededAn Example

These characteristics of SSP yield the following values for the parameters for the EFN formula: DS = $20 million, (A/S) = 0.90, (C/L) = 0.20, NPM = 0.05, a = 0.40, and S =$220 million. Using these values, we find that SSPs financing needs (EFN) are: EFN
= $20,000,000 (0.90) - $20,000,000 (0.20) - (1 - 0.40)(0.051)($220,000,000)

$7,268,000

SPECIALTY STEEL COMPANY

RELATIONSHIP BETWEEN SALES GROWTH AND FINANCING REQUIREMENTS
Sales Growth Rate (%) 30 20 10 0 - 10 - 20 - 30 Change in Sales Forecasted Sales $260,000,000 240,000,000 220,000,000 200,000,000 180,000,000 160,000,000 140,000,000 External Financing Needs $34,044,000 20,656,000 7,268,000 - 6,120,000 - 19,508,000 - 32,896,000 - 46,284,000

$60,000,000 40,000,000 20,000,000 -0- 20,000,000 - 40,000,000 - 60,000,000

Specialty Steel Company Pro Forma Financial Statements

Income Statement 1999 Actual Percent of Sales 2000 Forecast $220,000 0.7 x $220,000 = 154,000 $ 66,000 0.2 x $220,000 = 44,000 $ 22,000 3,000* $ 19,000 7,600 $ 11,400 4,560 $ 6,840

Sales $200,000 Cost of Goods Sold 140,000 Gross Profits $ 60,000 Operating Expenses 40,000 Operating Profits (EBIT) $ 20,000 Interest 3,000 Profit Before Taxes 17,000 Taxes @ 40% 6,800 Net Income $ 10,200 Dividends@40% of Net Income 4,080 Additions to Ret. Earnings $ 6,120 * Assumes that no new debt is issued.

70% 20%

Specialty Steel Company Pro Forma Financial Statements

Balance Sheet 1999 Actual Percent of Sales 2000 Forecast

Assets Current Assets $ 80,000 Net Fixed Assets 100,000 Total Assets $180,000 Liabilities Current Liabilities $ 40,000 Long-Term Debt 30,000 Common Stock 20,000 Retained Earnings 90,000 Total Liabilities+Equity $180,000 Total Internal Sources Additional External Financing Total Liabilities+Equity

40%

0.4 x $220,000

$ 88,000 112,000 $200,000

20%

$ 44,000 30,000 20,000 $90,000+ $6,840 = 96,840

$ 190,840 9,260 $ 200,000

0.2 x $220,000

Financing Needs and Working Capital PolicyGale Supply Company

Income Statement 1999 Actual 2000 Forecast

Sales

$3,200

$3,840 2,304 $1,536

Cost of Goods Sold @ 60% of Sales 1,920 Gross Profits $1,280

Operating Expenses @ 30% of Sales

Profit Before Taxes Taxes @ 30%

960
$ 320 96

1,152
$ 384 115

Net Income

$ 224

$ 269

Financing Needs and Working Capital PolicyGale Supply Company

Balance Sheet 1999 Actual 2000 Forecast Assets Cash (Plug) $ 12 $ 18 Accounts Receivable ( 60 day Collection Period) 526 631 Inventory (Turnover = 3.7 Times) 519 623 Current Assets $ 1,057 $ 1,272 Net Fixed Assets 240 300 Total Assets $ 1,297 $ 1,572 Liabilities Accounts Payable (30 day Payable Period) $ 165 $ 198 Accruals (Assumed Increase With Sales) 12 15 Bank Loans -0- 0Current Liabilities $ 177 $ 213 Long-Term Debt 340 310 Net Worth 780 1,049 Total Liabilities + Net Worth $ 1,297 $ 1,572

Financing Needs and Working Capital PolicyGale Supply Company

Income Statement Sales Cost of Goods Sold @ 60% of Sales Plus: Cash Discounts Taken Gross Profits Interest Profit Before Taxes Forego Discounts Take Discounts $3,840 2,304 - 0$1,536 0 $ 384 $ 3,840 2,304 $1,536 48 $ 1,584 1,152 10 $ 422

Gross Profits Before Cash Discount $1,536

Operating Expenses @ 30% of Sales 1,152

Taxes @ 30%
Net Income

115
$ 269

127
$ 295

Financing Needs and Working Capital PolicyGale Supply Company

Balance Sheet Forego Discounts Assets Cash (Plug) $ 18 Accounts Receivable ( 60 day Collection Period) 631 Inventory (Turnover = 3.7 Times) 623 Current Assets $ 1,272 Net Fixed Assets 300 Total Assets $ 1,572 Take Discounts

15** 631 623 $1,269 300 $ 1,569

Financing Needs and Working Capital PolicyGale Supply Company

Forego Discounts Liabilities Accounts Payable Accruals Bank Loans Current Liabilities Long-Term Debt Net Worth Total Liabilities + Net Worth Take Discounts

$ 198 15 - 0$ 213 310 1,049 $ 1572

$ 66 15 103 $ 184 310 1,075 $ 1,569

Internal Growth Rate

The maximum growth rate that can be
achieved by a firm with no external financing.

Internal growth rate =

ROA X b 1 - ROA X b

Where ROA = return on asset

b = retention ratio

Sustainable Growth
A companys sustainable growth is the maximum rate that it can expand without a new common stock issue. The sustainable growth (g*) is approximately equal to:

g* =
Where:

ROE X b 1 - ROE X b
ROE b = = Return on equity Retention ratio

Factors Influencing Sustainable Growth

SUSTAINABLE GROWTH RATE

FACTOR INCREASES Dividend Payouts

CHANGE IN SUSTAINABLE GROWTH Decreases

Net Profit Margins

Asset Utilization Leverage

Increases
Increases Increases

Calculating Specialty Steels Sustainable Growth Rate

CONDENSED BALANCE SHEET AND INCOME STATEMENTS -1999 (in million $ except ratios) Sales $ 200.0 Profit After Tax @ 5.1% Sales 10.2 Current Assets @ 40% Sales 60.0 Fixed Assets 100.0 Total Assets $ 180.0 Current Liabilities @ 20% Sales $ 40.0 Long-Term Debt 30.0 Common Stock 110.0 Total Liabilities+Equity $ 180.0 Dividends as Proportion of Earnings = 0.40 Retained Earnings as Proportion of Net Income = 0.60 Net Profit Margin = $10.2/$200.0 = 0.051 Asset Turnover = Sales/Assets = $200.0/$180.0 = 1.11 Equity Multiplier = Assets/Common Stock = $180.0/$110 = 1.66

Increasing the Sustainable Growth Rate

Increase Net Profit Margin Improve Asset Utilization Increase leverage

Increase Earning Retention Rate