Financial Management

Chapter 4

Financial Planning
(Financial
Forecasting)

Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

McGraw-Hill/Irwin
 Chapter Outline

• What Is Financial Planning?

• Financial Planning Models: A First Look
• The Percentage of Sales Approach
• Growth and external financing

4-2
 Elements of Financial Planning
• Investment in new assets – determined by
investment decision (capital budgeting decision).
• Degree of financial leverage – determined by
financing decision (capital structure decision).
• Liquidity requirements – determined by asset
management decision (net working capital decision).
• Cash paid to shareholders – determined by dividend
policy decisions.

4-3
Dimensions of Financial Planning
• Planning Horizon - divide decisions (period of
planning) into short-run decisions (usually next 12
months) and long-run decisions (usually 2 – 5
years).
• Aggregation - combine capital budgeting decisions
into one large project.
• Assumptions and Scenarios
– Make realistic assumptions about important variables.
– Run several scenarios where you vary the assumptions
by reasonable amounts.
– Determine, at a minimum, worst case, normal case, and
best case scenarios.

4-4
 Importance of Financial Planning
• Helps management to see the interactions
between decisions.
• Gives management a systematic framework for
exploring and capitalizing on its opportunities.
• Helps management to avoid surprises by
identifying possible outcomes and making
contingency plans.
• Helps management to determine if goals are
feasible and internally consistent with one another.
• Helps management to forecast or estimate the
required capital (external financing needed).

4-5
 Financial Planning Model
Ingredients
• Sales forecast – many cash flows depend directly
on the level of sales (often estimated using sales
growth rate).
• Relationship of Balance Sheet (B/S) items and
Income Statement (I/S) items with sales.
• Economic assumptions – explicit assumptions
about the coming economic environment.

4-6
 Financial Planning Model Output
• The projected financial statements or pro forma
statements
– show the amount of financing needed to pay for the
required assets.
– provide a projection of the internally generated funds.
– compute the plug variable (also known as external
funds needed).

• Management has to decide what type of financing

will be used to make the balance sheet balance
Percentage of Sales Approach

• 2 equivalent ways:
– projected balance sheet method
– formula method

• Note that on the balance sheet and income

statements
– Some items vary directly with sales (spontaneous
accounts)
– Some items vary but not directly with sales (non-
spontaneous accounts), and
– others do not vary with sales at all (non-
spontaneous)
 Spontaneous versus
Non-spontaneous items
• Income Statement
– If all the items above net profit vary directly with sales, then profit is
a constant percentage of sales (profit margin is constant).
– If all the items above net profit vary directly with sales and if the
retention ratio is constant, then the addition to retained earnings is
a constant percentage of sales.
– If depreciation and interest expense does not vary directly with
sales , then the profit margin is not constant.
– Dividends are a management decision and may not vary directly
with sales. This will influence additions to retained earnings.

• Balance Sheet
– Initially assume all assets, including fixed, vary directly with sales.
– Accounts payable will vary directly with sales.
– Notes payable, long-term debt and equity generally do not vary
directly with sales because they depend on management decisions
about capital structure.
– The change in the retained earnings portion of equity will come
from the dividend decision.
4-9
 Steps in Generating Pro Forma
Statements
• Examine most recent B/S and I/S
– Note the relationships to sales

• Generate pro forma I/S

– Projected sales = current sales (1 + rate of increase)
– For each spontaneous item, compute projected figure
– Obtain the retained earnings to be reflected on B/S

• Generate pro forma B/S

– for each spontaneous item, compute projected figure

• Obtain external financing needed (EFN) = the

difference between total assets and total liabilities &
owners equity.
Example: Rosengarten Corporation
Most Recent Income Statement
Sales $1,000
Costs (80% of sales) 800
---------
Taxable Income $ 200
Taxes (34% of sales) 68
----------
Net Income (13.2% of sales) $ 132
======
Dividends 44
Addition to retained earnings $ 88

Profit Margin = net income / sales = 132/1000 = 0.132

Dividend payout ratio = dividends / net income= 44/132 = 0.3333
Retention ratio = 1 – dividend payout ratio = 1 – 0.333 = 0.6667
 Rosengarten Corporation
Most Recent Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets % of sales Current liabilities % of sales
Cash $160 16% Accounts payable $300 30%
Accounts receiv 440 44 Notes payable 100 n/a
Inventory 600 60 $400 n/a
$1,200 120%
Long-term debt $800 n/a
Net fixed assets $1,800 180%
Owners’ equity
Common stock $800 n/a
Retained earnings 1,000 n/a

Total assets $3,000 300% Total liab & OE $3,000 n/a

 Rosengarten Corporation
Most Recent Balance Sheet
(continued)

If sales increased by a dollar

• Cash increased by $0.16
• Accounts receiv increased by $0.44
• Inventory increased by $0.60
• FA increased by $1.80
• TA increased by $3.00
• Accounts payable increased by $0.30
 Key Assumptions
• Operating at full capacity.
• Each type of asset grows proportionally with sales.
• Accounts Payable grow proportionally with sales.
• Profit margin (13.2%) and dividend payout (33.33%)
will be maintained.
• Sales are expected to increase by 25% or $250
million. (%S = 25%)

 Prepare the pro forma statements and determine

the external financing needed (EFN) for
Rosengarten Corporation?
 Pro Forma Income Statement
Suppose sales is projected to increase by 25%
Construct pro forma I/S

Rosengarten Corporation
Pro Forma Income Statement
Sales (projected) $ 1,250
Costs (80 % of sales) 1,000
----------
Taxable income $ 250
Taxes (34%) 85
----------
Net income (13.2% of sales) $ 165
======
 Pro Forma Income Statement
(continued)
Assuming payout & retention ratios are constant
(here, retained earnings are a constant
percentage of sales)

Projected dividends = dividend payout ratio x net income

= 0.3333 x 165
= 55

Projected RE = retention ratio x net income

= 0.6667 x 165
= 110 (to be reflected in B/S)
 Partial Pro Forma Balance Sheet
Projected retained earnings reflected on B/S
Rosengarten Corporation
Partial Pro Forma Balance Sheet
Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash (16% of $1,250) $200 Accounts payable (30%) $375

Accounts receiv (44%) 550 Notes payable (n/a) 100

Inventory (60%) 750

total $1,500 total $475

Long-term debt (n/a) $800

Net fixed assets (180%) $2,250

Owners’ equity
Common stock (n/a) $800
B/S
B/S is
is “partial”
“partial” or
or incomplete.
incomplete. The
The 22 sides
sides do
do not
not balance.
balance.
 What is the External Financing
Needed (EFN)?
Forecasted total assets = $3,750
Forecasted total claims = $3,185
Forecast EFN = $ 565

The firm must have the assets to produce

forecasted sales. It has to raise $565.

The firm may choose one or a combination of the

following plug variables:
• borrow more short-term
• borrow more long-term
• sell more common stock
• decrease dividend payout
 How will Rosengarten Raise
the EFN?

• No new common stock will be issued.

• Any external funds needed will be raised as debt.
• Assume that company decides to increase
– Notes payable by $225
– Long term debt by $340
 Pro Forma Balance Sheet
The 2 sides “balance” now
Rosengarten Corporation
Pro Forma Balance Sheet
Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Cash (16% of $1,250) $200 Accounts payable (30%) $375
Accounts payable (44%) 550 Notes payable(+225) 325
Inventory (60%) 750 Total CL $700
Total CA $1,500

Long-term debt (+340) $1,140

Net fixed assets (180%) $2,250

Owners’ equity
Common stock (n/a) $800
Retained earnings (+110) 1,110
total 1,910
Total assets (300%) $3,750 Total liab &OE $3,750
===== =====
 The Formula Method
Similar to the B/S method
EFN = required  in assets - spontaneous  in
liabilities - in retained earnings
= shortfall in the “partial” B/S
= (A* / S) S - (L* / S) S - M S1 (1 - d)
where
A*/S = assets that  spontaneously /original sales
L*/S = liab that  spontaneously /original sales
S = original sales
S1 = total sales projected for next year (based on
projection)
S = change in sales (based on projection)
M = profit margin
d = dividend payout ratio
PS: Note that the formula method must be used with caution. In
particular, check that the profit margin has not changed. If it has,
use the new profit margin.
 The Formula Method (continued)
EFN = required  in assets - spontaneous  in liabilities
- in retained earnings
internally generated fund

EFN = (A* / S) S - (L* / S) S - M S1 (1 - d)

profit margin x new sales x RR
= retained earnings

=(3000 / 1000)250 - (300 / 1000)250 -

0.132 (1250)(1- 0.3333)
= 750 - 75 - 110 = $565
What if EFN is negative? Excess internal funds.
 Example: Operating at Less than
Full Capacity

Suppose that in the most recent financial

statements, Rosengarten’s FA were operated
at 70% instead of 100% capacity

Actual sales
Full capacity sales =
% of capacity
$1,000
= 0.70 = $1,429
With the existing fixed assets, sales could increase to $1,429
before any new fixed assets are needed. Since sales are
forecasted at only $1,250, no new fixed assets are needed.
 Example: Operating at Less than
Full Capacity (continued)

How will the excess capacity situation affect

the pro forma balance sheet and the EFN?

• The previously projected increase in fixed assets

was $450.
• Since no new fixed assets will be needed, EFN
will fall by $450, to
$565 - $450 = $115.
 Growth and External Financing
• At low growth levels, internal financing (retained
earnings) may exceed the required investment in
assets.
• As the growth rate increases, the internal financing
will not be enough and the firm will have to go to the
capital markets for money.

Determinants of Growth:
– Profit margin – operating efficiency
– Total asset turnover – asset use efficiency
– Financial leverage – choice of optimal debt ratio
– Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm.
4-25
End of Chapter

4-26