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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

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Financial Planning and Control

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.

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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 firms 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

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Percentage of Sales Method

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.
1.

Steps to get AFN simple one-pass forecast balance sheet method

1. 2. 3. 4. 5.

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Calculate RE with the data given (method varies) Increase CA and spontaneous liabilities proportionately with sales Increase FA if needed based on capacity information given Carry over bonds/bank-loans and stock Calculate TA - (TL+E) = AFN AFN = additional funds needed from external sources

Hand out simple example

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Two pass method example: Northwest Chemical: 2001 Sales Projection

(millions of dollars)
$3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 1996 1997 1998 1999 2000 2001

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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.

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North West Chemical: Key Ratios

Profit Margin ROE DSO Inv. turnover F.A. turnover T.A. turnover Debt/ assets TIE Current ratio Payout ratio NWC 2.52% 7.20% 43.2 days 5.00x 4.00x 2.00x 30.00% 6.25x 2.50x 30.00% Industry 4.00% 15.60% 32.0 days 8.00x 5.00x 2.50x 36.00% 9.40x 3.00x 30.00% Condition Poor Good Poor O.K.

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Projected Financial Statements

Step 1. Forecast the 2001 Income Statement

Key Assumptions

Interest rate = 8% for any debt. Operating at full capacity in 2000. 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%)

Implications for fixed assets and fixed cost?

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There will be simpler problems than this in lab

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NWC: Projected 2001 Income Statement:

Sales Less: VC FC EBIT Interest EBT Taxes (40%) Net. income Div. (30%) Add. to RE 2000 $2,000 1,200 700 $ 100 16 $ 84 34 $ 50 $ 15 $ 35 Factor x1.25 x1.25 x1.25 Initial Forecast $2,500 1,500 875 $ 125 16 $ 109 44 $ 65 $ 19 $ 46

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Projected Financial Statements

Step 2. Forecast the 2001 Balance Sheet (Assets)
2000 Cash/sec. Accts. rec. Inventories Total CA Net FA Total assets $20 240 240 $500 500 $1,000 x1.25 Factor x1.25 x1.25 x1.25 Initial Forecast $25 300 300 $625 625 $1,250

At full capacity, so all assets must increase in proportion to sales.

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Projected Financial Statements

Step 2. Forecast the 2001 Balance Sheet (Liability & Equity)
2000 Factor $100 x1.25 100 $200 100 500 200 +46* $1,000 Initial Forecast $125 100 $225 100 500 246 $1,071

AP/accruals Notes payable Total CL L-T debt Common stk. Ret. earnings Total liab./eq.

*From projected income statement.

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Projected Financial Statements

Step 3. Raising the Additional Funds Needed
Forecasted

total assets Forecasted total claims Forecast AFN1

= = =

$1,250 $1,071 $ 179

NWC must have the assets to make forecasted sales. The balance sheet must balance. So, we must raise $179 externally.

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How will the AFN be financed?

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.

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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.

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NWC: 2001 Adjusted Forecast of Income Statement

1st Pass Feedback 2nd Pass Sales $2,500 $2,500 Less: VC 1,500 1,500 FC 875 875 EBIT $125 $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

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NWC: 2001 Adjusted Forecast of Balance Sheet (Assets)

1st Pass Cash/sec. Accts. rec. Inventories Total CA Net FA Total assets $25 300 300 $625 625 $1,250 Feedback 2nd Pass $25 300 300 $625 625 $1,250

No change in asset requirements.

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

1st Pass Feedback 2nd Pass AP/accruals $125 $125 Notes payable 100 +89.5 190 Total CL $225 $315 L-T debt 100 +89.5 189 Common stk. 500 500 Ret. earnings 246 -6 240 Total liab./eq. $1,071 $1,244

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Results of the Adjusted Forecast:

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.

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North West Chemical: Adjusted Key Ratios

NWC 2000 2001(E) 2.52% 2.27% 7.20% 7.68% 43.2 43.2 5.00x 5.00x 4.00x 4.00x 2.00x 2.00x 30.00% 40.34% 6.25x 4.12% 2.50x 1.99x 30.00% 30.00% Industry 4.00% 15.60% 32.0 11.00x 5.00x 2.50x 36.00% 9.40x 3.00x 30.00%

Profit Margin ROE DSO (days) Inv. turnover F.A. turnover T.A. turnover D/A ratio TIE Current ratio Payout ratio

Poor O.K.

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Analysis of the Forecast: How does North West Chemical Compare?

Not very profitable relative to other companies in the industry. Carrying excess inventory and receivables. Debt ratio projected to move ahead of average. Overall, not in good shape and doesnt appear to be improving.

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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?

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Other Considerations in Forecasting: Excess Capacity

Suppose in 2000 fixed assets had been operated at only 75% of capacity:
Full Capacity Sales
Actual sales = % of capacity usage

$2,000 = = $2,667. 0.75

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Does NWC need additional fixed assets?

With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.

How would fixed costs change? Fixed cost would not increase.

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If NWC had been operating at full capacity, what would its fixed assets/sales ratio be?
Actual fixed assets Target FA / sales = Full capacity sales
$500 = = 18.75% $2,667

With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed.

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Projected Financial Statements

Step 2. Forecast the 2001 Balance Sheet (Assets)
2000 Cash/sec. Accts. rec. Inventories Total CA Net FA Total assets $20 240 240 $500 500 $1,000 x1.25 Factor x1.25 x1.25 x1.25 Initial Forecast $25 300 300 $625 625 $1,250

At full capacity, so all assets must increase in proportion to sales.

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How would the excess capacity situation affect the 2001 AFN?

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.

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NWC: Projected 2001 Income Statement:

Sales Less: VC FC EBIT Interest EBT Taxes (40%) Net. income Div. (30%) Add. to RE 2000 $2,000 1,200 700 $ 100 16 $ 84 34 $ 50 $ 15 $ 35 Factor x1.25 x1.25 x1.25 Initial Forecast $2,500 1,500 875 $ 125 16 $ 109 44 $ 65 $ 19 $ 46

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How would the excess capacity situation affect the 2001 AFN?

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.

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How would excess capacity affect the forecasted ratios?

Sales wouldnt 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.

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2001 Forecasted Ratios:

% of Capacity in 2000 100% 75% 2.27% 2.51% 7.68% 8.44% 43.2 43.2 5.00x 5.00x 4.00x 5.00x 2.00x 2.22x 40.34% 33.71% 4.12% 6.15x 1.99x 2.48x 30.00% 30.00%

Profit Margin ROE DSO (days) Inv. turnover F.A. turnover T.A. turnover D/A ratio TIE Current ratio Payout ratio

Industry 4.00% 15.60% 32.0 8.00x 5.00x 2.50x 36.00% 9.40x 3.00x 30.00%

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Summary: How different factors affect the AFN forecast.

Dividend payout ratio changes. If reduced, more RE, reduce AFN. Profit margin changes. If increases, total and retained earnings increase, reduce AFN. Plant capacity changes. Less capacity used, less need for AFN. AP Payment terms increased to 60 days from 30. Accts. payable would double, increasing liabilities, reduce AFN.