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) Production (capacity, schedules) Finance Department

Accounting (financial statements, depreciation, taxes)

SALES FORECAST

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 firms profitability:
Sales Forecast
Company will fail to meet demand Market share will be lost

Under-optimistic

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

Forecast future sales based on past sales growth

Sales Estimates for next 2 years
Sales

Growth Rate

94 95

96 97 98

99 00 01 02

03

Time

 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

94 95

96 97 98

99 00 01 02

03

Time

 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

94 95

96 97 98

99 00 01 02

03

Time

Sales Growth Imposes Costs on the Firm

Will require additional resources

Current Assets: Inventory, A/R, Cash Fixed Assets: Plant and Equipment

2009

2010

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 salesthe 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 (shortterm 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 firms 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 years number for all the

accounts for which the next years 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

firms 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 firms 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 firms 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 firms 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 firms dividend policy also affects EFN.

Holding growth rate constant, the higher the firms 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 profit margin:

Increases funds available internally, decreases EFN. Increases asset requirements, increases EFN.

Higher capital intensity ratio, A/S0:

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-thanproportional asset increases. Lumpy assets: leads to large periodic EFN requirements, recurring excess capacity.

Assets

Lumpy Assets

1,500

1,000
500

500

1,000

2,000

Sales

A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A.