LongTerm Financial Planning, Financial Forecasting, and Growth

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• Long-Term Financial Planning, Financial
  Forecasting, and Growth

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Business Planning

• Through the process of business planning,
  management sets goals and objectives that seek to
  position the company relative to the economic,
  competitive, technological, and political
  environment. Business plans are structured around
  goals and objectives specified by management.
• It formulates strategies and tactics to achieve
  these goals and objectives.
• These strategies and tactics result in specific
  plans for operational performance and
  investments.

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Business Planning (Continued)

• Planning provides a company with a roadmap to the
  future it makes explicit where the company
  wants to go and how it intends to get there
• It provides a vehicle for developing strategy in
  pursuit of value creation
• Value creating strategies are commonly stated in
  terms of growth targets.
• Growth targets should not be ends in themselves,
  but the outcome of value-creating investment,
  operating, and financing policies.

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Financial Planning

• Financial planning is a aspect of more general
  business planning.
• Financial planning deals with the financial
  consequences of operating decisions and with
  investment and financial activities.

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Functions of Financial Planning (Continued)

• Planning provides an integrative, systematic view
  of company activities.
• Identifies interactions among activities and
  decisions e.g., interaction between credit and
  inventory policy and financing needs
• Makes explicit linkages
• among key functional areas of the firm, and
• among different areas or aspects of a firm's
  business
• It provides a vehicle for exploring options.
• Can clarify the implications of alternative
  policy choices, given assumptions about the
  economic, political, regulatory, and other
  relevant environments
• Can highlight the impact of alternative
  investment and financing options

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Functions of Financial Planning (Concluded)

• Provides a vehicle for anticipating potential
  problems and avoiding unpleasant surprises
• Helps management identify possible outcomes and
  to plan accordingly
• Can prevent unpleasant surprises by looking at
  worst case scenarios
• Allows for the development of contingency plans
• Ensuring Feasibility and Internal Consistency
• Helps management determine if goals are feasible
  (can be accomplished) and if the various goals of
  the firm are consistent with one another

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Basic Policy Considerations That Shape Financial
Planning

• The firms growth policy What are the firms
  growth objectives, and how does it intend to
  achieve them?
• How aggressively to pursue growth?
• What operating strategies and investment policies
  will it employ to achieve the growth objectives?
• How to grow e.g., through acquisitions or
  through internal growth?
• The firms working capital policy How much does
  it invest in the different components of working
  capital to support the firms sales targets and
  to provide liquidity.
• Includes credit and inventory policies Its
  policies regarding the terms of credit it offers
  to customers, (which determines its investment in
  accounts receivable), and regarding how much
  inventory to hold

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Basic Policy Considerations that Shape Financial
Planning (Continued)

• The firms fixed asset investment policy
  Decisions regarding investments in additional
  fixed assets (how much and what kinds) to support
  growth and other strategic opportunities.
  Determined by capital budgeting decisions.
• The firms capital structure policy its policy
  regarding financial leverage, i.e., the
  proportion of debt, and the types of debt, to use
  to finance its investments.

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Basic Policy Considerations that Shape Financial
Planning (Concluded)

• The firms dividend policy determines the
  proportion of after-tax cash flow to be paid to
  shareholders versus the proportion of cash flow
  reinvested in the firm.
• The firms payment policy toward its suppliers
  and others Its policy regarding the use of
  trade credit (financing through accounts
  payable).

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Basic Elements of Financial Planning Models

• Inputs and assumptions
• The planning model
• Model outputs

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Elements of Financial Planning Models (Continued)

• Inputs and Assumptions
• Sales forecasts (generally, the key driver of the
  model)
• Assumptions about the relationships between
  individual financial statement items and sales
  in particular, assumptions about how each
  financial statement item will change as sales
  change?
• Assumptions about the future economic environment
  in which the firm is expected to operate.
  Includes assumptions about the future state of
  the economy, interest rates, inflation, product
  demand (hence sales growth), character and degree
  of competition, and other aspects of the future
  economic environment.

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Elements of Financial Planning Models (Continued)

• The planning model
• Consists of equations that relate sales, assets,
  and financial requirements and that generate
  outputs from model inputs
• Key Outputs of the Forecasting Model
• Pro forma statements
• Financial statement projections are important
  outputs
• Provides data for calculating projected financial
  ratios and other measures

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Elements of Financial Planning Models (Concluded)

• The plug
• The amount of external financing, or excess cash,
  that makes the balance sheet balance
• An estimate of financial requirements
• Management decisions determine what types of
  financing will be obtained or how excess cash
  will be used.
• Sources of external funds are influenced by the
  firms debt and and dividend policies and by the
  costs of alternative sources of financing,
  whereas uses of excess cash are influenced by the
  firms working capital and long-term investment
  policies

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The Percentage of Sales Approach General Formulas

• Given a sales forecast and an estimated profit
  margin, what addition to retained earnings can be
  expected?
• Let
• S previous (last) periods sales
• g projected change (increase/decrease) in
  sales
• PM profit margin
• b earnings retention (plowback) ratio
• The expected addition to retained earnings is
• S(1 g) x PM x b.
• The expected addition to retained earnings
  represents the level of internal financing the
  firm is expected to generate over the coming
  period.

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The Percentage of Sales Approach General
Formulas (continued)

• What level of asset investment is needed to
  support a given level of sales growth? For
  simplicity, assume that the firm is operating at
  full capacity with respect to a given asset, and
  that investment in this asset changes
  proportionately with sales. Then, the indicated
  change (increase or decrease) in the asset
  required is given by
• Ai x g
• where,
• Ai ending asset balance from the previous
  period, and
• g projected change in sales.

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The Percentage of Sales Approach General
Formulas (concluded)

• If the required increase in total assets exceeds
  the spontaneous financing and the amount of
  internally generated funding (the addition to
  retained earnings) available, i.e., ?A (SL
  ?RE), then the difference is an estimate of the
• External Financing Needed (EFN).
• Otherwise, the difference is an estimate of the
• Excess Cash Available.
• Spontaneous financing ? defined as liabilities
  that require no explicit financing decision,
  i.e., assets that increase spontaneously with
  sales. The most important of these are payables.

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EFN Equation

• The EFN equation says that the amount of
  additional external financing needed is the
  investment in additional assets that must be
  funded less the funds raised spontaneously
  (largely through increases in accounts payable,
  but also through increases in accruals) and
  internally generated funds (additions to retained
  earnings).
• EFN Addition to Assets Increase in
  spontaneous liabilities Addition to retained
  earnings
• This equation provides a quick way to assess plan
  outcomes.
• For quick but rough forecasting it is often
  assumed that all assets increase proportionately
  with sales, in which case ?TA TA x g.
• Realistically, however, not all assets can be
  expected to increase proportionately with sales.
  An accurate estimate of the amount of these
  assets needed to support the growth in sales must
  be estimated in a different way, such as with
  T-account forecasting.

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EFN Equation (Concluded)

• The formulation of the simple EFN forecasting
  equation is
• EFN (A/S0)(?S) (SL/S0)(?S) (PM)(S1)(1 d).
  
• Expressing all sales in term of current (most
  recent) sales, the EFN equation becomes,
• EFN (A/S)(g)(S) (SL/S)(g)(S)
  (PM)(S)(1g)(1 d).
• This simplifies to,
• EFN (A)(g) (SL)(g) (PM)(S)(1g)(1 d).
• Where,
• A total assets thus this simple
  forecasting model assumes that ?A TA
  x g.
• SL spontaneous liabilities, defined as
  liabilities that increase
  spontaneously with sales, i.e., liabilities
  requiring no explicit financing decision
  (the most important of which are
  payables)

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Financial Forecasting Relationship between
different accounts and sales

• The EFN equation is a quick way to approximate
  the amount of external financing needed.
  However, it is only an approximation.
• A more accurate estimate can be obtained by
  adjusting each item on the financial statements
  according to how they are expected to change with
  growth in sales.
• HYBRID FORECASTING METHODS The percentage of
  sales forecasting method can be used for those
  assets presumed to change proportionately with
  sales, while other methods can be used to
  determine the required changes in assets that do
  not.

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Relationship between different accounts and sales
(Continued)

• Illustrate the financial statement forecasting
  method where different accounts have different
  relationships with sales.

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Forecasting External Funds Needed

• Income Statement
• _____2003
  Forecast_____
• 2002 Forecast First
  Second Actual Basis
  Pass Feedback Pass
• Sales 2,000.00 x 1.25
  2,500.00 2,500.00
• Less Variable costs (1,200.00) x 1.25
  (1,500.00) (1,500.00)
• Fixed costs (700.00) x
  1.10 (770.00)
  (770.00)
• EBIT 100.00
  230.00
  230.00
• Interest (16.00)
  (16.00) 11.20
  (27.20)
• EBT 84.00
  214.00
  202.80
• Taxes (40) (33.60)
  (85.60)
  (81.80)
• Net income 50.40
  128.40
  121.68
• Dividends 15.12 (30)
  38.52
  36.50
• RE Addition 35.28
  89.88 -4.70 85.18
• External funds 50 Notes Payable and 50
  Long-Term Debt.
• ?Interest Expense 0.06 (80.06) 0.08
  (80.06) 4.80
  6.40 11.20.

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• Balance Sheet
• _____2003
  Forecast_____
• 2002 Forecast First
  Second Actual Basis Pass
  Feedback Pass
• Cash and securities 20 x
  1.25 25.00 25.00
• Accounts Receivable 240 x 1.25
  300.00 300.00
• Inventories 240
  x 1.25 300.00
  300.00
• Total current assets 500
  625.00 625.00
• Net fixed assets 600 x
  1.25 750.00
  750.00
• Total assets 1,100
  1,375.00
  1,375.00
• Accounts payable/accruals 100 x 1.25
  125.00 125.00
• Notes payable 100 100.00
  80.06 180.06
• Total current liabilities 200
  225.00 305.06
• Long-term debt 200
  200.00 80.06 280.06
• Common stock 500 500.00 500.00
• Retained earnings 200 89.88 289.88
  -4.70 285.18
• Total liabilities equity 1,100 1,214.88 1
  ,370.30
• AFN 160.12 4.70
• ? in Notes Payable 160.12 x 0.5 80.06.
• ? in Long-Term Debt 204.22 x 0.5 80.06.

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Excess Capacity in Fixed Assets

• So far, 100 capacity has been assumed. Suppose,
  instead, that current capacity use is less than
  full capacity.
• Actual sales Capacity Used x Full Capacity
  Sales
• Rearranging gives the equation for full capacity
  sales,
• Full Capacity Sales Actual Sales / Capacity
  Used

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Excess Capacity in Fixed Assets (Continued)

• The firms target amount of fixed assets to
  support sales can be estimated by its Fixed
  Asset-to-Sales Ratio (FA-to-Sales Ratio)
• FA-to-Sales Ratio (FA / S) Current Fixed
  Assets / Full Capacity Sales
• This ratio is used to forecast any needed
  additions to fixed assets.

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Excess Capacity in Fixed Assets (continued)

• Amount of Fixed Assets (FA) Needed
• If projected sales gt Full capacity sales,
  then
• Projected FA FA-to-sales ratio x
  projected sales,
• If projected sales lt full capacity sales,
  then
• Projected FA current level of fixed
  assets

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Excess Capacity in Fixed Assets (concluded)

• Addition to Fixed Assets (FA)
• If projected sales gt full capacity sales,
  then
• Addition to FA FA-to-Sales Ratio x
  (Projected Sales Full Cap. Sales)
• If projected sales lt full capacity sales,
  then
• Addition to FA 0

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The Percentage of Sales Approach What About
Capacity Utilization?

• 1. Suppose a 30 increase in the 2,000
  current sales is expected.
• 2. At 2,000 current sales and 80 capacity,
  full capacity sales will be
• 2000 .80 x full capacity sales
• Full capacity sales 2000/.80 2500
• 3. At full capacity, fixed assets to sales will
  be
• FA-to-Sales Ratio Current FA / Full Capacity
  Sales
• 600/2500 24.00
• 4. So, at projected sales, NFA will need to be
• NFA 24.00 x 2600 624.00
• At full capacity, the NFA would be 780 (600 x
  1.30)
• Thus the level of NFA is 780 - 624.00 156.00
  less than projected assuming full capacity.
• 5. In this case, this means that the estimate
  of EFN is 156.00 less than it would be
  assuming full capacity.
• So, the impact of different capacity assumptions
  is critical to asset, hence financing,
  projections.

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Growth and Available Financing

• Key issues regarding financing and sales growth
• So far we have examined the relationship between
  sales growth and financing requirements. We have
  addressed the issue What is the relationship
  between sales growth and the amount of external
  financing needed? In this case, sales growth
  determines the amount of financing needed.
• Now we are going to examine the following issue
  What growth rate in sales is possible when the
  amount of financing available is constrained? In
  this case, sales growth determined the amount of
  financing.
• We will examine this question through two
  financing-determined growth rates the internal
  growth rate and the sustainable growth rate.

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Growth and Available Financing (Continued)

• Recent Financial Statements
• Income statement Balance sheet
• Sales 100 Total Assets 50
• Less Costs 90 Debt 20
  Equity 30
• Net Income 10 Total 50
• Note D/E 2/3 and D/A 40

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Internal Growth Rate Formula (IGR)

• The IGR is the maximum growth rate that can be
  achieved with no external financing (debt or
  equity). If no external financing is to be used,
  then the sole sources of financing for additional
  investment are increases in spontaneous
  liabilities and addition to retained earnings
  (internally generated funding). The internal
  growth rate (IGR) is the growth rate that can be
  funded from these sources.

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Internal growth rate (IGR) (Continued)

• Assume that
• 1. All costs and assets grow at the same rate
  as sales
• 2. 60 of net income is paid out in dividends
• 3. No external financing is available (debt
  or equity)
• Q. What is the maximum growth rate achievable?
• A. The maximum growth rate is given by
• ROA x b
• Internal growth rate (IGR)
• 1 - (ROA x b)
• where ROA return on assets (Net income/assets)
• b earnings retention or plowback ratio
• ROA 10/50 20
• b 1 - .60 .40
• IGR (20 x .40)/1 - (20 x .40)
• .08/.92 .08695656 ? 8.7

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Growth and Financing Needed for a Company with a
10 IGR
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The Internal Growth Rate (continued)

• Assume sales do grow at 8.7 percent. How are the
  financial statements affected?
• Pro Forma Financial Statements
• Income Statement Balance Sheet
• Sales 108.70 Assets 54.35 Debt
  20.00
• - Costs 97.83 Equity 34.35
• Net Inc 10.87 Total 54.35 Total
  54.35
• Dividends 6.52
• Add to R/E 4.35

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The Sustainable Growth Rate (SGR)

• The sustainable growth rate (SGR) is the maximum
  growth rate that can be achieved with no external
  equity financing while maintaining a constant
  debt/equity ratio.
• If the firm elects to issue no additional
  external equity but chooses to use additional
  debt in amounts that preserves its existing
  capital structure (D/E ratio), then the amount of
  available new financing is the sum of the
  increase in spontaneous liabilities, the addition
  to retained earnings, and the additional debt
  financing proportional to the addition to
  retained earnings (?D D/E x ?RE).

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Sustainable Growth Rate (continued)

• Assume
• 1. no external equity financing is available
• 2. the current debt/equity ratio is optimal
• Q. What is the maximum growth rate achievable
  now?
• A. The maximum growth rate is given by
• ROE
  x b
• Sustainable growth rate (SGR)
• 1 - (ROE x b)
• ROE 10/30 1/3( 33.333)
• b 1.00 - .60 .40
• SGR (1/3 x .40)/1 - (1/3 x .40)
• .1538462 ? 15.385

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The Sustainable Growth Rate (Continued)

• Assume sales do grow at 15.385 percent
• Pro Forma Financial Statements
• Income statement Balance sheet
• Sales 115.38 Assets 57.69 Debt 20.00
• Costs 103.85 Equity 34.61
• Net 11.53 Total 57.69 Total 54.61
• Dividends 6.92 EFN 3.08
• Add to R/E 4.61
• If we borrow the 3.08, the debt/equity ratio
  will be
• 23.08/34.61 2/3

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Summary of Internal and Sustainable Growth Rates

• ROA x b
• Internal growth rate (IGR)
• 1 - (ROA x b)
• Recall from the DuPont identity, ROA is a
  product of two measures of operating performance,
  the profit margin (PM) and total asset turnover
  (TAT). The IGR is thus a function of the firms
  operating performance and its dividend policy
  (retention rate).
• ROE x
  b
• Sustainable growth rate (SGR)
• 1 - (ROE x b)
• Recall from the DuPont identity that ROE is a
  product of ROA and the equity multiplier (EM),
  which reflects the firms capital structure
  policy. Thus the SGR is a function of the
  companys financing policies (its capital
  structure and dividend policies) and its
  operating performance.

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The Sustainable Growth Rate (concluded)

• The rate of sustainable growth depends on four
  factors
• 1. Profitability (profit margin)
• 2. Dividend Policy (dividend payout)
• 3. Financial policy (debt-equity ratio)
• 4. Asset utilization (total asset turnover)
• This can be seen by examining the DuPont
  Equation.
• Two of the above four factors reflect financing
  policies and two reflect operating performance.
  Can you name them?

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The Du Pont Identity

• 1. Return on equity (ROE) can be decomposed as
  follows
• ROE Net income/Total equity Net
  income/Total equity x Total assets/Total assets
  Net income/Total assets x Total assets/Total
  equity ROA x Equity multiplier
• 2. Return on assets (ROA) can be decomposed as
  follows
• ROA Net income/Total assets x
  Sales/Sales Net income/Sales x Sales/Total
  assets Profit margin x Total asset turnover

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The Du Pont Identity (Continued)

• 3. Putting it all together gives the Du Pont
  identity
• ROE ROA x Equity multiplier Profit
  margin x Total asset turnover x Equity
  multiplier
• 4. Profitability (or the lack thereof!) is
  examined through three dimensions
• Operating efficiency (measured by profit margin)
• Asset use efficiency (measured by total asset
  turnover)
• Financial leverage (measured by equity multiplier)

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Questions the Financial Planner Should Use to
Assess the Forecasting Model

• Mark Twain once said forecasting is very
  difficult, particularly if it concerns the
  future. The process of financial planning
  involves the use of mathematical models, which
  can provide the illusion of great accuracy.
• In assessing a financial forecast, the planner
  should ask the following questions
• Are the results generated by the model
  reasonable?
• Have I considered all possible outcomes?
• How reasonable were the economic assumptions that
  were used to generate the forecast?
• Which economic and other environmental
  assumptions have the greatest impact on the
  outcome?
• Which variables in the model are of the greatest
  importance in determining the outcome (e.g.,
  EFN)?
• Have I forgotten anything important?

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Concluding Comments Concerning Financial Planning

• It is important to note that these simple
  planning models use accounting numbers.
  Consequently, we must think in terms of the
  following question
• How does the plan affect the amount, timing, and
  risk of firm cash flows?
• The following questions should also be asked as
  we go through the planning process
• Does the plan highlight key tradeoffs for further
  examination?
• Does the plan point out inconsistencies in our
  goals (for example, the goals of maximizing sales
  volume and gross margins are inconsistent)?
• If we follow this plan, will we maximize firm
  value, and thus owners wealth?