Financial Planning and Funds Forecasting

1
Chapter 3

• Financial Planning and Funds Forecasting

Shapiro and Balbirer Modern Corporate Finance
A Multidisciplinary Approach to Value
Creation Graphics by Peeradej Supmonchai
2
Learning Objectives

• Explain the role of financial planning in the
  strategic planning process.
• Describe the working capital flows within a
  company, and how shortening the cash conversion
  cycle can minimize external financial needs.
• Prepare proforma financial statements and use
  them to identify a firms external financing
  requirements.
• Explain the relationship between a companys
  financing needs and its working capital policy.
• Understand the concept of sustainable growth and
  how it is related to a firms profitability,
  asset utilization, leverage, and dividend policy.

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Learning Objectives (Cont.)

• Prepare a cash budget and use it to identify the
  amounts and timing of a firms short-term needs.
• Discuss the risk-return tradeoffs of the
  strategies that can be used to finance a firms
  working capital requirements.
• Explain the vehicles that can be used to finance
  a companys short-term needs.
• Understand why the proper handling of inflation
  is critical in identifying a companys financing
  needs.

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Condensed Balance Sheet- Accounting View

• ASSETS
  LIABILITIES EQUITY
• Current Assets
  Current Liabilities
• Noncurrent Assets
  Noncurrent Liabilities
• 
  Equity

5
Condensed Balance Sheet- Financial Planning View

• ASSETS
  LIABILITIES EQUITY
• Permanent Assets Permanent
  Current Liabilities
• Temporary Assets Short-Term
  Liabilities
• Long-Term Capital

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Cash Conversion Cycle
Purchase Made
Cash Received
123
Sales on Credit
Inventory Conversion Period
Collection Period
Operating Cycle
Payables Period
Cash Conversion Cycle
Cash Outlay
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Elements of the Cash Conversion Cycle

• Inventory Conversion Period
• Collection Period
• Operating Cycle
• Payables Period

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Sales Forecasting

• Sales Force Estimates
• Customer Surveys
• Time Series Analysis
• Economic Models

9
Percent of Sales Method

• Assumes that each expense, asset and liability
  item can be estimated using a percentage of
  sales. The percent of sales method assumes a
  linear relationship between projected sales and a
  specific expense, asset, and liability category.

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Percent of Sales-Sources and Uses of Funds
USES OF FUNDS SOURCES OF FUNDS Net
Investment in Assets to Internal
Sources Support Sales Change
External Sources
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Percent of Sales - Net Assets Required
Increase in Increase in - Increase in Net
Assets Total Assets Current
Liabilities (DS)(A) -
(DS)(CL/S) Where DS Change in
sales A/S Assets needed to support a
dollar of sales CL/S Ratio of spontaneous
current liabilities to sales
12
Percent of Sales- Internal Financing Provided
Internal Financing Provided (1-a)(NPM)(S) Wh
ere a Proportion of earnings paid out
in dividends NPM After-tax profit
margin on sales S Forecasted level of
sales.
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Percent of Sales- External Financing Needed (EFN)

• EFN (DS)(A/S) - (DS)(CL/S) - (1-a)(NPM)(S)

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External Financing Needed- An Example

• Specialty Steel Products (SSP) wants to assess
  its financing needs for the coming year. The
  firms sales are 200 million and are expected to
  rise 10 to 220 million in 2000. Because making
  steel is capital intensive, 0.90 in assets are
  needed to generate a dollar of sales. Current
  liabilities are 20 of sales. After-tax profit
  margins are 5.1, and SSP typically pays out 40
  of its earnings in dividends.

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External Financing Needed-An Example

• These characteristics of SSP yield the following
  values for the parameters for the EFN formula DS
  20 million, (A/S) 0.90, (C/L) 0.20, NPM
  0.05, a 0.40, and S 220 million. Using these
  values, we find that SSPs financing needs (EFN)
  are
• EFN 20,000,000 (0.90) - 20,000,000 (0.20)
• - (1 - 0.40)(0.051)(220,000,000)
• 7,268,000

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• SPECIALTY STEEL COMPANY
• RELATIONSHIP BETWEEN SALES GROWTH AND FINANCING
  REQUIREMENTS
• Sales Growth Change
  Forecasted External Financing
• Rate () in Sales
  Sales Needs
• 30 60,000,000
  260,000,000 34,044,000
• 20 40,000,000
  240,000,000 20,656,000
• 10 20,000,000
  220,000,000 7,268,000
• 0 - 0 -
  200,000,000 - 6,120,000
• - 10 - 20,000,000
  180,000,000 - 19,508,000
• - 20 - 40,000,000
  160,000,000 - 32,896,000
• - 30 - 60,000,000
  140,000,000 - 46,284,000

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Specialty Steel CompanyPro Forma Financial
Statements

• 
  Percent
• Income Statement 1999 Actual of
  Sales 2000 Forecast
• Sales 200,000
  220,000
• Cost of Goods Sold 140,000
  70 0.7 x 220,000 154,000
• Gross Profits 60,000
  
  66,000
• Operating Expenses 40,000
  20 0.2 x 220,000 44,000
• Operating Profits (EBIT) 20,000
  22,000
• Interest
  3,000
  3,000
• Profit Before Taxes 17,000
  
  19,000
• Taxes _at_ 40 6,800
  
  7,600
• Net Income 10,200
  11,400
• Dividends_at_40 of Net Income 4,080
  4,560
• Additions to Ret. Earnings 6,120
  6,840
  
• 
  
• Assumes that no new debt is issued.

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Specialty Steel Company Pro Forma Financial
Statements

• Percent
• Balance Sheet 1999 Actual of Sales
  2000 Forecast
• Assets
• Current Assets 80,000 40
  0.4 x 220,000 88,000
• Net Fixed Assets 100,000
  112,000
• Total Assets 180,000
  200,000
• Liabilities
• Current Liabilities 40,000 20
  0.2 x 220,000 44,000
• Long-Term Debt 30,000
  30,000
• Common Stock 20,000
  20,000
• Retained Earnings 90,000
  90,000 6,840 96,840
• Total LiabilitiesEquity 180,000
• Total Internal Sources 190,840
• Additional External Financing
  9,260
• Total LiabilitiesEquity 200,000

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Financing Needs and Working Capital Policy- Gale
Supply Company

• Income Statement 1999
  Actual 2000 Forecast
• Sales
  3,200 3,840
• Cost of Goods Sold _at_ 60 of Sales 1,920
  2,304
• Gross Profits
  1,280 1,536
• Operating Expenses _at_ 30 of Sales 960
  1,152
• Profit Before Taxes
  320 384
• Taxes _at_ 30
  96 115
• Net Income
  224 269

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Financing Needs and Working Capital Policy- Gale
Supply Company

• Balance Sheet
  1999 Actual 2000 Forecast
• Assets
• Cash (Plug) 12
  18
• Accounts Receivable ( 60 day Collection
  Period) 526 631
• Inventory (Turnover 3.7 Times) 519
  623
• Current Assets
  1,057 1,272
• Net Fixed Assets
  240 300
• Total Assets
  1,297 1,572
• Liabilities
• Accounts Payable (30 day Payable Period)
  165 198
• Accruals (Assumed Increase With Sales)
  12 15
• Bank Loans
  - 0 - - 0-
• Current Liabilities
  177 213
  
  
• Long-Term Debt
  340 310
• Net Worth
  780 1,049
• Total Liabilities Net Worth
  1,297 1,572

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Financing Needs and Working Capital Policy- Gale
Supply Company

• Income Statement Forego Discounts
  Take Discounts
• Sales
  3,840 3,840
• Cost of Goods Sold _at_ 60 of Sales 2,304
  2,304
• Gross Profits Before Cash Discount 1,536
  1,536
• Plus Cash Discounts Taken - 0
  - 48
• Gross Profits
  1,536 1,584
• Operating Expenses _at_ 30 of Sales 1,152
  1,152
• Interest 0 10
• Profit Before Taxes
  384 422
• Taxes _at_ 30
  115 127
• Net Income
  269 295

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Financing Needs and Working Capital Policy- Gale
Supply Company

• Balance Sheet
  Forego Take
• Discounts Discounts
• Assets
• Cash (Plug) 18
  15
  
• Accounts Receivable ( 60 day Collection Period)
  631 631
• Inventory (Turnover 3.7 Times)
  623 623
• Current Assets
  1,272 1,269
• Net Fixed Assets
  300 300
• Total Assets
  1,572 1,569

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Financing Needs and Working Capital Policy- Gale
Supply Company

• Forego Take
• Discounts Discounts
• Liabilities
• Accounts Payable
  198 66
• Accruals
  15 15
• Bank Loans
  - 0- 103
• Current Liabilities
  213 184
  
  
• Long-Term Debt
  310 310
• Net Worth
  1,049 1,075
• Total Liabilities Net Worth
  1572 1,569

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Sustainable Growth

• A companys sustainable growth is the maximum
  rate that it can expand without a new common
  stock issue. The sustainable growth (g) is
  approximately equal to
• g RE/NIROE
• Where
• RE Retained earnings
• NI Net Income after-taxes
• ROE Return on equity

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Sustainable Growth and the DuPont Formula
RE Net Income
Sales Assets g ¾¾
¾¾¾¾¾¾ x ¾¾¾¾ x ¾¾¾¾ NI
Sales Assets Equity
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Factors Influencing Sustainable Growth

• SUSTAINABLE GROWTH RATE
• FACTOR INCREASES CHANGE IN SUSTAINABLE
  GROWTH
• Dividend Payouts
  Decreases
• Net Profit Margins
  Increases
• Asset Utilization
  Increases
  
• Leverage
  Increases

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Calculating Specialty Steels Sustainable Growth
Rate

• CONDENSED BALANCE SHEET AND INCOME STATEMENTS
  -1999
• (in million except ratios)
• Sales
  200.0
• Profit After Tax _at_ 5.1 Sales
  10.2
• Current Assets _at_ 40 Sales
  60.0
• Fixed Assets
  100.0
• Total Assets
  180.0
• Current Liabilities _at_ 20 Sales
  40.0
• Long-Term Debt
  30.0
• Common Stock
  110.0
• Total LiabilitiesEquity
  180.0
• Dividends as Proportion of Earnings
  0.40
• Retained Earnings as Proportion of Net
  Income 0.60
• Net Profit Margin 10.2/200.0
  0.051
• Asset Turnover Sales/Assets
  200.0/180.0 1.11
• Equity Multiplier Assets/Common Stock
  180.0/110 1.66

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Calculating Specialty Steels Sustainable Growth
Rate
RE Net Income
Sales Assets g ¾¾
¾¾¾¾¾¾ x ¾¾¾¾ x ¾¾¾¾ NI
Sales Assets
Equity
(0.6)(0.051)(1.11)(1.66) 0.056
or 5.6 percent
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Increasing the Sustainable Growth Rate

• Increase Net Profit Margin
• Improve Asset Utilization
• Increase leverage
• Increase Earning Retention Rate

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Cash Budgets

• Details cash inflows and outflows over some time
  period.
• Can be prepared on a daily, weekly, monthly, or
  quarterly basis.
• Indicates a firms cash balances and defines its
  borrowing needs.