Financial Planning

Task of financial planning
Cover a short time span
Take a long term perspective
Focus on required resources for a specific projects

Financial plan
Adaptable tool for management to use to achieve its strategic goals
Translation of strategic plan into measurable quantities that express the expected resources and anticipated return over a certain period
Presents the estimated future financial statements

Goals of financial planning
Three important uses:
Forecast the amount and sources of financing that will be required
Evaluate the impact that changes in the operating plan have on the value of the firm
Set appropriate targets for compensation plans

What answers should Financial planning give to the manager?
What is the size of financial funds that company has?
What are their sources?
Do we have enough funds to reach our goals?
What part of funds we should transact to the budget, state funds, to banks and to other lenders?
How should we use our profit?
Are our real revenues and planned expenses balanced?

Financial planning
Long term – more than 3 years
Medium-term – for 1-3 years
Short-term - budgeting

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 Planning

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

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

2013 Balance Sheet
(Millions of $)

2013 Income Statement
(Millions of $)

AFN (Additional Funds Needed):
Key Assumptions
Operating at full capacity in 2013.
Each type of asset grows proportionally with sales.
Payables and accruals grow proportionally with sales.
2013 profit margin (2.52%) and payout (30%) will be maintained.
Sales are expected to increase by $500 million. (%ΔS = 25%)

Assets
Sales
0
1,000
2,000
1,250
2,500
A*/S0 = $1,000/$2,000 = 0.5
= $1,250/$2,500.
Δ Assets =
(A*/S0)ΔSales
= 0.5($500)
= $250.
Assets = 0.5 sales

Additional Funds Needed
AFN = Asset requirement - Spontaneous financing
- Retained earnings
= (A*/S0)ΔS - (L*/S0) Δ S - M(S1)(1 - d)
Where:
A* = Assets tied directly to sales and will increase
L* = Spontaneous liabilities that will be affected by sales.
S0 = Sales during the last year
S1 = Total sales projected for next year (the new level of sales).
ΔS = The increase in sales between S0 and S1
M = Profit margin, or the profit per unit of sales
d = payout ratio

Assets must increase by $250 million. What is the AFN, based on the AFN equation?
AFN = (A*/S0)ΔS - (L*/S0)ΔS - M(S1)(1 - d)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0252($2,500)(1 - 0.3)
= $180.9 million.

Projecting Pro Forma Statements with the Percent of Sales Method
Project sales based on forecasted growth rate in sales
Forecast some items as a percent of the forecasted sales
Costs
Cash
Accounts receivable
(More...)

Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt (which determines interest)
Dividends (which determines retained earnings)
Common stock

Percent of Sales: Inputs

Other Inputs

2014 1st Pass Income Statement

2014 1st Pass Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.

2014 1st Pass Balance Sheet (Claims)
*From 1st pass income statement.

What are the additional funds needed (AFN)?
Forecasted total assets = $1,250
Forecasted total claims = $1,071
Forecast AFN = $ 179
NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally.

Assumptions about How AFN Will Be Raised
No new common stock will be issued.
Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt.

How will the AFN be financed?
Additional notes payable =
0.5 ($179) = $89.50 ≈ $90.
Additional L-T debt =
0.5 ($179) = $89.50 ≈ $89.
But this financing will add 0.08($179) = $14.32 to interest expense, which will
lower NI and retained earnings.

2014 2nd Pass Income Statement

2014 2nd Pass Balance Sheet (Assets)
No change in asset requirements.

2014 2nd Pass Balance Sheet (Claims)

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 the $6 reduction in retained earnings. Additional passes could be made until assets exactly equal claims. $6(0.08) = $0.48 interest on 3rd pass.
Results After the Second Pass

Equation method assumes a constant profit margin.
Pro forma method is more flexible. More important, it allows different items to grow at different rates.
Equation AFN = $181
vs.
Pro Forma AFN = $185.
Why are they different?

Suppose in 2014 fixed assets had been operated at only 75% of capacity.
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 the excess capacity situation affect the 2014 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, to
$179 - $125 = $54.

Q. If sales went up to $3,000,
not $2,500, what would the
F.A. requirement be?
A. Target ratio = FA/Capacity sales
= $500/$2,667 = 18.75%.
Have enough F.A. for sales up to
$2,667, but need F.A. for another
$333 of sales:
ΔFA = 0.1875($333) = $62.4.

How would excess capacity affect the forecasted ratios?
1. Sales wouldn’t change but assets would be lower, so turnovers would be better.
2. Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks considered).
3. Debt ratio, TIE would improve.

Regression Analysis for Asset Forecasting
Get historical data on a good company, then fit a regression line to see how much a given sales increase will require in way of asset increase.

How would increases in these items affect the AFN?
Higher dividend payout ratio?
Increase AFN: Less retained earnings.
Higher profit margin?
Decrease AFN: Higher profits, more retained earnings.
(More…)

Higher capital intensity ratio, A*/S0?
Increase AFN: Need more assets for given sales increase.
Pay suppliers in 60 days rather than 30 days?
Decrease AFN: Trade creditors supply more capital, i.e., L*/S0 increases.

Budgeting
Revenue budget
Cash budget
Budgeted balance sheet
For 1 year
Quarterly