CHAPTER 17

Financial Planning and Forecasting

Elements of Strategic Plans

 Mission statement
 Corporate scope
 Statement of corporate objectives
 Corporate strategies
 Operating plan
 Financial plan

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Definition

 Financial planning establishes guidelines for

change and growth in a firm.

 It focuses on the major elements of a firm's

financial and investment policies without examining
the individual components of those policies in
detail.
How it works
 Forecast sales
 Forecast growth in assets needed to support sales
and matched with the corresponding growth in
financing
 Start with forecasting the growth in assets
 Determine how much additional financing is needed
 Determine whether internal funds are sufficient
 If necessary, plan for external financing
 See effects of plan on ratios

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 Example: Dalimot Co. Balance sheet (Php) & Income Statement

Cash 160
Accounts receivable 440
Inventory 600
Current assets 1200
Sales 1,000
Fixed assets 1,800
Costs (800)
Total assets 3,000
Taxable income 200

Accounts payable 300 Tax (34%) (68)

Notes payable 100 Net income 132

Current liabilities 400 Addition to RE 88

Long-term debt 800 Dividends 44

Common stock 800

Retained earnings 1,000
Equity 1,800
Total liabilities 3,000
Assumption

 Sales are forecasted to increase by 25%

Pro-forma income statement (Php)

This year Forecasted

Sales 1,000 1,250
Costs (800) (1,000)
Taxable income 200 250
Tax (68) 85
Net income 132 165
Addition to RE 88 110
Dividends 44 55
Pro-forma balance sheet (Php)
This year Forecasted
Cash 160 200
Accounts receivable 440 550
Inventory 600 750
Current assets 1,200 1,500
Fixed assets 1,800 2,250
Total assets 3,000 3,750

Accounts payable
Notes payable
Current liabilities
Long-term debt
Common stock
Retained earnings
Equity
Total liabilities
Pro-forma balance sheet (Php)
This year Forecasted
Cash 160 200
Accounts receivable 440 550
Inventory 600 750
Current assets 1,200 1,500
Fixed assets 1,800 2,250
Total assets 3,000 3,750

Accounts payable 300 375

Notes payable 100 100
Current liabilities 400 475
Long-term debt 800 800
Common stock 800 800
Retained earnings 1,000 1,110
Equity 1,800 1,910
Total liabilities 3,000
Pro-forma balance sheet (Php)
This year Forecasted
Cash 160 200
Accounts receivable 440 550
Inventory 600 750
Current assets 1,200 1,500
Fixed assets 1,800 2,250
Total assets 3,000 3,750

Accounts payable 300 375

Notes payable 100 100
Current liabilities 400 475
Long-term debt 800 800
Common stock 800 800
Retained earnings 1,000 1,110
Equity 1,800 1,910
Total liabilities 3,000 3,185 (?!)
Implication:

 We need Php565 in external financing!

External financing and growth
 AFN = Increase in TA - Addition to RE

 AFN = (A)(sg) - (p)(S)(R)(1+sg)

 AFN = Php750 - Php110 = Php640

 The difference between Php565 and Php640 = Php75, the increase in accounts payable.
 If you consider accounts payable internal financing, then
 AFN = Increase in TA - Addition to RE - Increase in Acc. payable

 where:
 A = total assets
 S = current sales
 p = profit margin = net income/sales
 R = retention ratio
 sg = rate of growth in sales
Internal growth rate:

The growth rate a firm can maintain with internal financing only (ignore
increase in accounts payable)

IGR = (p)(S)(R) / [A - (p)(S)(R)]

IGR = ROA(R) / [1-ROA(R)]
IGR = (0.132)(1,000)(2/3) / [3,000 - (0.132)(1,000)(2/3)] = 3.02%
Sustainable growth rate:

The growth rate a firm can maintain given its capital structure, ROE, and
retention ratio.

AFN = Increase in TA - Addition to RE - New borrowing

SGR = (ROE)(R) / [1 - (ROE)(R)] = (0.0734)(2/3) / [1 - (0.073)(2/3)]

SGR = 5.14%

SGR = (p)(S/A)(1+D/E)(R)/[1- (p)(S/A)(1+D/E)(R)]

Growth and capacity usage

What happens if the firm is not operating at full capacity?

Case (i): Firm operates at 70% capacity

Case (ii): Firm operates at 90% capacity

Additional information: when reaching full capacity the firm will have to
expand production by building additional operating plants. Each plant has the
potential to increase output/sales by 30 percentage points.
Case (i): Pro-forma balance sheet at 25% growth

This year Forecasted

Cash 160 200
Accounts receivable 440 550
Inventory 600 750
Current assets 1,200 1,500
Fixed assets 1,800 1800
Total assets 3,000 3,300

Accounts payable 300 375

Notes payable 100 100
Current liabilities 400 475
Long-term debt 800 800
Common stock 800 800
Retained earnings 1,000 1,110
Equity 1,800 1,910
Total liabilities 3,000 3,185 (?!)
Case (i): AFN

We need Php3,300 - Php3,185 = Php115 in external

financing.

We could borrow Php115 in the short term by issuing

commercial paper or short-term notes.
Case (ii): Pro-forma balance sheet at 25% growth

This year Forecasted

Cash 160 200
Accounts receivable 440 550
Inventory 600 750
Current assets 1,200 1,500
Fixed assets 1,800 2340
Total assets 3,000 3,840

Accounts payable 300 375

Notes payable 100 100
Current liabilities 400 475
Long-term debt 800 800
Common stock 800 800
Retained earnings 1,000 1,110
Equity 1,800 1,910
Total liabilities 3,000 3,185 (?!)
 Case (ii): AFN

We need Php3,840 - Php3,185 = Php655 in external

financing.

We need to borrow in the long-run and/or issue

additional equity.
Comment

CalculatingAFN, IGR, SGR with the help of formulas makes the implicit
assumption that the firm is operating at full capacity. In reality this is
seldom the case.

Forecasting financial growth with the help of pro-forma financial

statements is always preferable.
Definitions of Variables in AFN

 A0*/S0: Assets required to support sales: called

capital intensity ratio.
 S: Increase in sales.
 L0*/S0: Spontaneous liabilities ratio.
 M: Profit margin (Net income/Sales)
 POR: Payout ratio (Dividends/Net income)

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AFN Equation

AFN = (A0*/S0)∆S −(L0*/S0)∆S −M(S1)(1−POR)

Key Factors in AFN Equation

 Sales growth (g): The higher g is, the larger AFN

will be—other things held constant.
 Capital intensity ratio (A0*/S0): The higher the
capital intensity ratio, the larger AFN will be—
other things held constant.
 Spontaneous-liabilities-to-sales ratio (L0*/S0): The
higher the firm’s spontaneous liabilities, the
smaller AFN will be—other things held constant.

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AFN Key Factors (Continued)

 Profit margin (Net income/Sales): The higher the

profit margin, the smaller AFN will be—other
things held constant.
 Payout ratio (DPS/EPS): The lower the payout
ratio, the smaller AFN will be—other things held
constant.

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