Chapter 8
Financial Planning and Forecasting Financial Statements
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
We like to use discussion questions along with relatively simple and easy to follow calculations for our lectures. Unfortunately, forecasting is by its very nature relatively complex, and it simply cannot be done in a realistic manner without using a spreadsheet. Accordingly, our primary “question” for Chapter 8 is really a problem, but one that can be discussed. Therefore, we base our lecture primarily on the BOC model, ch08BOC-model, and we use the class period to discuss forecasting and Excel modeling. We cover the chapter in about 2 hours, and then our students work a case on the subject later in the course.
8-1 The major components of the strategic plan include the firm’s purpose, the scope of its operations, its specific (quantified) objectives, its operating strategies, its operating plan, and its financial plan.
Engineers, economists, marketing experts, human resources people, and so on all participate in strategic planning, and development of the plan is a primary function of the senior executives. Regional and world economic conditions, technological changes, competitors’ likely moves, supplies of resources, and the like must all be taken into account, along with the firm’s own R&D activities.
The effects of all these forces, under alternative strategic plans, are analyzed by use of forecasted financial statements. In essence, the financial statements are used to simulate the company’s operations under different economic conditions and corporate strategic plans.
Since the strategic plan is necessarily somewhat nebulous, it is sometimes neglected in practice on the grounds that it is difficult to quantify. We can only note that if a company doesn’t think about the direction in which its industry is going, it is likely to end up in bankruptcy, as most bankruptcies occur because an inaccurate business plan.
8-2 a. The sales forecast is the primary driver of the financial plan. Forecasted sales determine the amount of capacity needed, inventory and receivables levels, profits, and capital requirements. If a company forecasts its sales incorrectly, this can be disastrous, as Cisco and Lucent learned recently.
We discuss sales forecasting in the BOC model.
b. See the BOC model for a detailed explanation. Essentially, we take the prior year’s financial statements and then change them to reflect (1) changes in sales and (2) policies that will affect things like the amount of inventories carried to support a given amount of sales.
c. See the BOC model for a detailed explanation. Essentially, we project the assets that will be required to support the forecasted level of sale, and we also project the amount of funds that will be available from retained income and spontaneous sources of funds. The difference is the AFN.
Generally, faster growth would mean the requirement for more assets. That would reduce FCF and thus increase AFN. Of course, if the firm were extremely profitable, then faster growth might produce enough extra profits to support that growth, but that would be unusual. In our illustrative case, the higher the growth rate, the greater the AFN and the smaller the FCF. Note, though, that since sales are profitable, the more the firm sells, the higher its profits. Therefore, the faster the growth rate, the larger is EPS and ROE. This result is shown in the model.
d. See the BOC model for a detailed explanation. Given the projected financial statements, we can calculate various ratios, EPS, and FCF and then compare the projected values with historical data and industry benchmarks. Various policies can be considered, and their effects as revealed by the computer model can be analyzed. A set of feasible policies that will produce the desired results, or perhaps the best attainable results, will be adopted. Of course, that’s the easy part. The hard part is operating the business so that the projected results will be realized.
8-3 The performance of the firm could be compared with the industry average. Also, as shown in the model, we could see how the firm’s ROE, EPS, etc. would look if it could get its operating ratios to the same level as the industry average.
Industry average data is also useful when preparing a business plan for a new business. We could forecast sales, then forecast the financial statements based on industry average date. The capital requirements (the amount of required debt and equity) could be determined, and then the new firm could seek to raise the required funds. Many new businesses fail because they don’t raise enough funds at the outset and are forced out of business when they run out of cash. Forecasting as done in the model could head off such disasters.
8-4 Managers are obviously concerned about forecast errors. The effects of such errors can be analyzed by use of scenario and sensitivity analysis. Both types of analysis are illustrated in the BOC model.
8-5 Economies of scale refer to situations where unit costs decline as sales increase. Lumpy assets are assets that must be added in very large units, often resulting in excess capacity immediately after they go on line and before sales can grow into them. Excess capacity simply means that the firm could produce more than it is currently producing, in which case sales can expand with very little increase in capital.
If economies of scale exist, then profits should rise rapidly with sales, so management should take steps to increase volume. If assets are lumpy, then management will probably do things like go to second and third shifts to avoid increasing plant and equipment, or working out arrangements with other firms to sell some capacity until it is needed. If excess capacity exists, then the marginal cost per unit will be relatively low, so sales promotions and the like might be used to increase sales. In all of these situations, management must be concerned with the long-run effects of actions. For example, before air conditioning was widely used, electric utilities had excess capacity in the summer. Then they promoted air conditioning through advertising and low summer rates. Demand increased so much that the peak load was shifted from winter (for heating) to summer. This resulted in capacity shortages and forced companies to expand their generating capacity.
8-6 The AFN equation is useful in a pedagogic sense to get an idea of how sales increases lead to required asset increases, and hence to a need for new capital. The equation is not used in practice today because spreadsheet models provide so much more information and are relatively easy to construct.
AFN = (A*/S0)DS - d(L*/S0)DS - MS1(RR).
A* is assets that increase at the same rate as sales, L* is liabilities that increase spontaneously at the same rate as sales, S0 is last year’s sales, S1 is forecasted sales for the coming year, and DS is the forecasted increase in sales, M is the profit margin, and RR is the percentage of earnings the firm retains.
The formula is simple and easy to use, but it assumes a constant relationship between sales, assets, and liabilities, and a constant profit margin and retention ratio. As indicated above, the formula is not used in practice because the financial statement approach is so much better.
8-7 We could set the AFN equation up and use it to get an idea of the maximum sales growth rate without external capital. However, we can use the model go get a better approximation. The solution growth rate is 3.675 under the “base case” conditions as set forth in the model. See the explanation at about cell I127. Note that the max rate would vary.
ANSWERS TO END-OF-CHAPTER QUESTIONS
8-1 a. The operating plan provides detailed implementation guidance designed to accomplish corporate objectives. It details who is responsible for what particular function, and when specific tasks are to be accomplished. The financial plan details the financial aspects of the corporation’s operating plan. In addition to an analysis of the firm’s current financial condition, the financial plan normally includes a sales forecast, the capital budget, the cash budget, pro forma financial statements, and the external financing plan. A sales forecast is merely the forecast of unit and dollar sales for some future period. Of course, a lot of work is required to produce a good sales forecast. Generally, sales forecasts are based on the recent trend in sales plus forecasts of the economic prospects for the nation, industry, region, and so forth. The sales forecast is critical to good financial planning.
b. A pro forma financial statement shows how an actual statement would look if certain assumptions are realized. With the percent of sales forecasting method, many items on the income statement and balance sheets are assumed to increase proportionally with sales. As sales increase, these items that are tied to sales also increase, and the values of these items for a particular year are estimated as percentages of the forecasted sales for that year.
c. Funds are spontaneously generated if a liability account increases spontaneously (automatically) as sales increase. An increase in a liability account is a source of funds, thus funds have been generated. Two examples of spontaneous liability accounts are accounts payable and accrued wages. Note that notes payable, although a current liability account, is not a spontaneous source of funds since an increase in notes payable requires a specific action between the firm and a creditor.
d. Additional funds needed (AFN) are those funds required from external sources to increase the firm’s assets to support a sales increase. A sales increase will normally require an increase in assets. However, some of this increase is usually offset by a spontaneous increase in liabilities as well as by earnings retained in the firm. Those funds that are required but not generated internally must be obtained from external sources. Although most firms’ forecasts of capital requirements are made by constructing pro forma income statements and balance sheets, the AFN formula is sometimes used to forecast financial requirements. It is written as follows:
Capital intensity is the dollar amount of assets required to produce a dollar of sales. The capital intensity ratio is the reciprocal of the total assets turnover ratio.
e. “Lumpy” assets are those assets that cannot be acquired smoothly, but require large, discrete additions. For example, an electric utility that is operating at full capacity cannot add a small amount of generating capacity, at least not economically.
8-2 Accounts payable, accrued wages, and accrued taxes increase spontaneously and proportionately with sales. Retained earnings increase, but not proportionately.
8-3 The equation gives good forecasts of financial requirements if the ratios A*/S and L*/S, as well as M and d, are stable. Otherwise, another forecasting technique should be used.
8-5 a. +.
b. +. It reduces spontaneous funds; however, it may eventually increase retained earnings.
c. +.
d. +.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
8-1 AFN = (A*/S0)DS - (L*/S0)DS - MS1(1 - d)
= $1,000,000 - $1,000,000 - 0.05($6,000,000)(1 - 0.7)
= (0.6)($1,000,000) - (0.1)($1,000,000) - ($300,000)(0.3)
= $600,000 - $100,000 - $90,000
= $410,000.
8-2 AFN = $1,000,000 – (0.1)($1,000,000) – ($300,000)(0.3)
= (0.8)($1,000,000) - $100,000 - $90,000
= $800,000 - $190,000
= $610,000.
The capital intensity ratio is measured as A*/S0. This firm’s capital intensity ratio is higher than that of the firm in Problem 11-1; therefore, this firm is more capital intensive--it would require a large increase in total assets to support the increase in sales.
8-3 AFN = (0.6)($1,000,000) - (0.1)($1,000,000) - 0.05($6,000,000)(1 - 0)
= $600,000 - $100,000 - $300,000
= $200,000.
Under this scenario the company would have a higher level of retained earnings which would reduce the amount of additional funds needed.
8-4 S2003 = $2,000,000; A2003 = $1,500,000; CL2003 = $500,000;
NP2003 = $200,000; A/P2003 = $200,000; Accruals2003 = $100,000;
PM = 5%; d = 60%; A*/S0 = 0.75.
AFN = (A*/S0)DS - (L*/S0)DS - MS1(1 - d)
= (0.75)DS - DS -(0.05)(S1)(1 - 0.6)
= (0.75)DS - (0.15)DS - (0.02)S1
= (0.6)DS - (0.02)S1
= 0.6(S1 - S0) - (0.02)S1
= 0.6(S1 - $2,000,000) - (0.02)S1
= 0.6S1 - $1,200,000 - 0.02S1
$1,200,000 = 0.58S1
$2,068,965.52 = S1.
Sales can increase by $2,068,965.52 - $2,000,000 = $68,965.52 without additional funds being needed.
8-5 a. AFN = (A*/S)(DS) – (L*/S)(DS) – MS1(1 – d)
= ($70) - ($70) - ($420)(0.6) = $13.44 million.
b. Upton Computers
Pro Forma Balance Sheet
December 31, 2004
(Millions of Dollars)
Forecast Pro Forma
Basis % after
2003 2004 Sales Additions Pro Forma Financing Financing
Cash $ 3.5 0.01 $ 4.20 $ 4.20
Receivables 26.0 0.743 31.20 31.20
Inventories 58.0 0.166 69.60 69.60
Total current
assets $ 87.5 $105.00 $105.00
Net fixed assets 35.0 0.1 42.00 42.00
Total assets $122.5 $147.00 $147.00
Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80
Notes payable 18.0 18.00 +13.44 31.44
Accruals 8.5 0.0243 10.20 10.20
Total current
liabilities $ 35.5 $ 39.00 $ 52.44
Mortgage loan 6.0 6.00 6.00
Common stock 15.0 15.00 15.00
Retained earnings 66.0 7.56* 73.56 73.56
Total liab.
and equity $122.5 $133.56 $147.00
AFN = $ 13.44
*PM = $10.5/$350 = 3%.
Payout = $4.2/$10.5 = 40%.
NI = $350 ´ 1.2 ´ 0.03 = $12.6.
Addition to RE = NI - DIV = $12.6 - 0.4($12.6) = 0.6($12.6) = $7.56.
8-6 a. Stevens Textiles
Pro Forma Income Statement
December 31, 2004
(Thousands of Dollars)
Forecast Pro Forma
2003 Basis 2004
Sales $36,000 1.15 ´ Sales03 $41,400
Operating costs $32,440 0.9011 ´ Sales04 37,306
EBIT $ 3,560 $ 4,094
Interest 460 0.10 x Debt03 560
EBT $ 3,100 $ 3,534
Taxes (40%) 1,240 1,414
Net income $ 1,860 $ 2,120
Dividends (45%) $ 837 $ 954
Addition to RE $ 1,023 $ 1,166
Stevens Textiles
Pro Forma Balance Sheet
December 31, 2004
(Thousands of Dollars)
Forecast Pro Forma
Basis % after
2003 2004 Sales Additions Pro Forma Financing Financing
Cash $ 1,080 0.03 $ 1,242 $ 1,242
Accts receivable 6,480 0.1883 7,452 7,452
Inventories 9,000 0.25 10,350 10,350
Total curr.
assets $16,560 $19,044 $19,044
Fixed assets 12,600 0.35 14,490 14,490
Total assets $29,160 $33,534 $33,534
Accounts payable $ 4,320 0.12 $ 4,968 $ 4,968