week 7

Slide 1

Introduction

Welcome to Financial Management. In this lesson we will discuss financial planning and forecasting financial statements.

Next slide

Slide 2

Topics

The following topics will be covered in this lesson:

Overview of financial planning;

Sales forecast;

Additional funds needed method;

Forecasted financial statements method; and

Forecasting when the ratios change.

Next slide

Slide 3

Overview of financial planning

A majority of companies prepare strategic plans, operating plans, and financial plans. The cornerstone of the strategic plan is a mission statement because it defines the company’s overall purpose. Strategic plans also include statements for corporate scope, corporate objectives, and strategies. The corporate scope specifies the firm’s line or lines of business and the geographical area in which it operates. This statement of corporate objectives specifies goals to assist operating managers in focusing on the firm’s primary objectives. The last part of the strategic plan requires that the firm develop broad statements or corporate strategies that support the firm’s purpose, scope, and objectives.

Operating plans provide detailed information that helps the firm implement its strategic vision. While operating plans can be developed over any time horizon for it is customary for the firm to use a five-year time horizon. Additionally, these plans give details of things like who is responsible for each function, when tasks are to be completed, sales targets, and profit targets.

Developing the financial plan involves five steps:

First, using several versions of the operating plan forecast financial statements;

Second, determine the amount of capital required to support the plan;

Third, forecast the level of internally generated funds or retained earnings;

Fourth, establish a long-run compensation system is performance-based;

Last, after implementing the plan monitor operations. The development of a financial plan involves three key components namely, the sales forecast, the forecasted financial statements and the methods for raising any necessary external financing.

Next slide

Slide 4

Sales forecast

Whenever a company forecast sales it always starts with a review of sales from the last five to ten years including a graphical representation and using this information, the company calculates its past growth rate. While it is important to determine past sales growth it is incorrect to forecast a continuation of past sales growth without incorporating things like current conditions in the national and international markets and new products expected to be introduced by the firm and its competitors. An accurate sales forecast is critical for the health of the company because if the market expands more than the firm anticipates, it will be unable to satisfy consumer demand. On the other hand, if the firm’s sales forecast is too high, it may purchase too high a level of fixed assets and acquire too high a level of inventories and therefore reduced profits. There are two methods the firm can use to forecast its financial requirements, the additional funds needed or AFN method and the forecasted financial statements or FFS method.

Next slide

Slide 5

Additional funds needed (AFN) method

The AFN method assumes that the firm’s financial ratios remain constant. If the firm has no excess capacity, sales growth must be accompanied by a growth in assets. Asset growth requires additional funds and the funds are raised either with internally generated funds and if these are not sufficient it is necessary to raise the additional funds in the external market. The increase in sales leads to an increase in assets which in turn results in an increase in accounts receivable which must be financed from the time of the sale until they are collected. Hence, both fixed and current assets increase and liabilities and equity must increase by the same amount so the balance sheet balances. When sales increase accounts payable and accrued wages and taxes also increased. These are spontaneous increases in funds that can be used to finance growth to the extent possible but the firm has very little flexibility in their usage. A second source of funding is included in net income. Part of net income is paid in the form of dividends and the balance is reinvested in operating assets. The firm has some flexibility in the amount of new funds generated because it can change its dividend policy. If we start with the required new assets and subtract the increase in spontaneous liabilities and the increase in retained earnings we obtain the additional funds needed or AFN which must come from external sources.

Mathematically, AFN is given by the quantity:

A subzero star divided by S subzero times delta S minus the quantity L subzero star divided by S subzero times delta S minus S sub one times M times the quantity one minus POR equals AFN;

Where A subzero star is the capital intensity ratio;

Delta S equals G, the forecasted growth rate in sales;

Times S subzero, last year’s sales level;

L subzero star, the spontaneous liabilities to sales ratio;

S sub one is the coming year’s sales level;

M is the profit margin; and

POR is the payout ratio.

Recall, the AFN method assumes that the firm’s financial ratios remain constant at their base-year level but this assumption may not be realistic.

Next slide

Slide 6

Forecasted financial statements method

The forecasted financial statements method or FFS relaxes the assumption of constant financial ratios and projects a complete set of financial statements. To project a set of financial statements we use a six step procedure. First, forecast all operating items on the income statement and balance sheet; second, forecast items that depend on the firm’s financial policies; third, using the levels of debt and preferred stock that were forecasted in the financial plan, forecast interest expense and preferred dividends; fourth, complete the income statement using the forecasted interest expense and preferred dividends; fifth, calculate total common dividend payments; last, to make the balance sheet balances either issue or repurchase additional common stock. The FSS method is an iterative process using what-if questions and this type of problem is easiest solved using Excel.

Next slide

Slide 7

Forecasting when the ratios change

The AFN method assumes that the assets to sales ratio and liabilities to sales ratio remain constant. This assumption implies that each spontaneous asset and liability increases at the same rate as sales. Sometimes this assumption is realistic but there are times when it is not. Two reasons this assumption may be invalid is because of economies of scale and lumpy assets.

Economies of scale occur in the long-run and pertain to the decrease in unit cost of production as the firm expands. If a firm must add fixed assets in large, discrete units its assets are called lumpy assets. This situation is usually a result of technological considerations that dictate how the firm adds assets to its portfolio.

A third reason this assumption may be invalid is if the firm has excess capacity which allows it to grow before adding capacity. The firm’s level of full capacity sales is given by actual sales divided by the percentage at which fixed assets were operated.

In terms of full capacity sales, the targeted fixed assets to sales ratio is given by actual fixed assets divided by full capacity sales. Then, the firm’s required level of fixed assets is given by targeted fixed assets divided by sales times projected sales. Note that when the firm has excess capacity, sales can increase up to full capacity sales with no increase in fixed assets. Beyond the full capacity sales level the firm will need additional fixed assets. Additionally, this analysis can be applied to inventories and the required additions are determined exactly as they are for fixed assets. Theoretically, this situation could occur with other types of assets however, excess capacity normally exists only for fixed assets and inventories.

Next slide

Slide 8

Check your understanding

Slide 9

Summary

We have now reached the end of this lesson. Let’s review what we’ve covered.

First, we provided an overview of financial planning. Specifically we elaborated on strategic plans, operating plans, and identified five steps in financial plans.

Next, we discussed sales forecasts. Essentially, companies review sales from the last five to ten years. However, it is incorrect to forecast a continuation of past sales growth without incorporating things like current conditions in the national and international markets and new products expected to be introduced by the firm and its competitors.

Then, we identified the AFN method. This method operates on the assumption that the firm’s financial ratios remain constant. If the firm has no excess capacity, sales growth must be accompanied by a growth in assets.

Also, we discussed the forecasted financial statements method. This involves a six step procedure beginning with forecasting all operating items on the income statement and balance sheet and ending with making the balance sheet balances either by issuing or repurchasing additional common stock.

Finally, we learned what happens to the forecast when the ratios change. The AFN assumption that ratios remain constant isn’t always realistic. Two reasons the assumption may be invalid is because of economies of scale and lumpy assets. A third reason concerns if the firm has excess capacity which allows it to grow before adding capacity.

This concludes this lesson.