Transcript Forecasting Financial Statements. Part I: Financing Needs
Forecasting Financial Statements. Part I: Financing Needs
173A
• Financial planning • Additional Funds Needed (AFN) formula • Pro forma financial statements – Sales forecasts – Percent of sales method
Financial Planning and Pro Forma Statements • Three important uses: – Forecast the amount of external 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
Financial Forecasting
• •
1) Project sales revenues and expenses.
2) Estimate current assets and fixed assets necessary to support projected sales.
–
Percent of sales forecast
–
Assumptions driven forecast
Steps in Financial Forecasting • First and Most important: Forecast sales a) Historical growth?
b) Will future growth be different?
c) Sources of assumptions • Project the assets needed to support sales a) Spontaneous assets grow with sales, IF management not different b) Discretionary assets grow as “management decision” • Project internally generated funds a) Spontaneous liabilities grow with sales b) Retention of all or part of Net Income • Project outside funds needed a) Do forecasted assets > Forecasted Funding?
• Decide how to raise funds • See effects of plan on ratios and stock price
2006 Balance Sheet (Millions of $)
Cash & sec.
Accounts rec.
Inventories Total CA Net fixed assets Total assets $ 20 240 240 $ 500 500 $1,000 Accts. pay. & accruals Notes payable Total CL L-T debt Common stk Retained earnings Total claims $ 100 100 $ 200 100 500 200 $1,000
2006 Income Statement (Millions of $)
Sales Less: COGS (60%) EBIT SGA costs Interest EBT Taxes (40%) Net income Dividends (40%) Add’n to RE $2,000.00
1,200.00
700.00
$ 100.00
10.00
$ 90.00
36.00
$ 54.00
$21.60
$32.40
AFN (Additional Funds Needed): Key Assumptions • Operating at full capacity in 2006.
• Each type of asset grows proportionally with sales as no changes in management are made • Payables and accruals grow proportionally with sales.
• 2006 profit margin ($54/$2,000 = 2.70%) and payout (40%) will be maintained.
• Sales are expected to increase by $500 million.
Definitions of Variables in AFN
• A*/S 0 : assets required to support sales; called capital intensity ratio.
S: increase in sales.
• L*/S 0 : spontaneous liabilities ratio • M: profit margin (Net income/sales) • RR: retention ratio; percent of net income not paid as dividend.
Assets 1,250 1,000 Assets = 0.5 sales
Assets = (A*/S 0 )
Sales = 0.5($500) = $250.
Sales 0 2,000 2,500 A*/S 0 = $1,000/$2,000 = 0.5
= $1,250/$2,500.
Assets must increase by $250 million. What is the AFN, based on the AFN equation?
AFN = (A*/S 0 ) S - (L*/S 0 ) S - M(S 1 )(RR) = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0270($2,500)(1 - 0.4) = $184.5 million.
How would increases in these items affect the AFN?
• Higher sales: – Increases asset requirements, increases AFN.
• Higher dividend payout ratio: – Reduces funds available internally, increases AFN.
• Higher profit margin: – Increases funds available internally, decreases AFN.
• Higher capital intensity ratio, A*/S 0 : – Increases asset requirements, increases AFN.
• Pay suppliers sooner: – Decreases spontaneous liabilities, increases AFN.
Projecting Pro Forma Statements with the Percent of Sales Method • Project sales based on forecasted growth rate in sales • Forecast “spontaneous” items as a percent of the forecasted sales – Costs – Cash – Accounts receivable – Inventories – Net fixed assets – Accounts payable and accruals
• Determine “discretionary” items – Debt (issue/obtain more, pay back) a) Short term Notes Payable b) Long Term Debt (Bank or Bonds) – Dividend policy (which determines retained earnings) – Common stock (issue more, purchase back shares)
Sources of Financing Needed to Support Asset Requirements • Given the previous assumptions and choices, we can estimate: – Required assets to support sales – Specified sources of financing • Additional funds needed (AFN) is: – Required assets minus specified sources of financing
Implications of AFN • If AFN is positive, then you must secure additional financing.
• If AFN is negative, then you have more financing than is needed.
– Pay off debt.
– Buy back stock.
– Buy short-term investments. Especially, IF cash will be needed sometime soon
How to Forecast Interest Expense • Interest expense is actually based on the daily balance of debt during the year. Thus, it will not grow with sales!
• There are three ways to approximate interest expense. Base it on: – Debt at end of year – Debt at beginning of year – Average of beginning and ending debt – Assume that rates stay the same?
Basing Interest Expense on Debt at End of Year • Will over-estimate interest expense if debt is added throughout the year instead of all on January 1. • Causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc.
• Thus, to be accurate, must recalculate until no more changes are required…
Basing Interest Expense on Debt at Beginning of Year • Will under-estimate interest expense if debt is added throughout the year instead of all on December 31. • But doesn’t cause problem of circularity.
Basing Interest Expense on Average of Beginning and Ending Debt • Will accurately estimate the interest payments if debt is added smoothly throughout the year. • But has problem of circularity.
Solution that Balances Accuracy and Complexity • Base interest expense on beginning debt, but use a slightly higher interest rate.
– Easy to implement – Reasonably accurate
Percent of Sales: Inputs COGS/Sales SGA/Sales Cash/Sales Acct. rec./Sales Inv./Sales Net FA/Sales AP & accr./Sales
2006 Actual
60% 35% 1% 12% 12% 25% 5%
2007 Proj.
60% 35% 1% 12% 12% 25% 5%
Other Inputs Percent growth in sales 25% Growth factor in sales (g) 1.25
What is this? IF sales grow 25%, next year’s sales are 125% or this year’s or 1.25 * this year’s Interest rate on debt Tax rate Dividend payout rate 10% 40% 40%
2007 Forecasted Income Statement
Sales Less: COGS EBIT SGA Interest EBT Taxes (40%) Net. income Div. (40%) Add. to RE 2003
$2,000
Factor g= Pct= 1.25
60% Pct=35% 0.1(Debt 03 ) 2004 1st Pass
$2,500.0
1,500.0
875.0
$125.0
20.0
$105.0
42.0
$63.0
$25.2
$37.8
2007 Balance Sheet
Forecasted assets are a percent of forecasted sales. Because they stay same % of sales, they grow at g!
Cas Inventories Total CA Net FA Total assets 2007 Sales = $2,500 Factor!
1.25
1.25
1.25
1.25
2007 $25.0
300.0
300.0
$625.0
625.0
$1,250.0
AP/accruals Notes payable Total CL L-T debt Common stk.
Ret. earnings Total claims 2004 Sales = $2,500 2003 Factor 1.25
100 100 500 200 +37.8* 2007 Without AFN $125.0
100.0
$225.0
100.0
500.0
237.8
$1,062.8
*From forecasted income statement.
What are the additional funds needed (AFN)?
• Required assets • Specified sources of fin.
• Forecast AFN = $1,250.0
= $1,062.8
= $ 187.2
The company must have the assets to make forecasted sales, and so it needs an equal amount of financing. So, we must secure another $187.2 of financing
.
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? How Will that impact the L&E (claims) side of BS?
Additional notes payable = 0.5 ($187.2) = $93.6.
Additional L-T debt = 0.5 ($187.2) = $93.6
.
AP/accruals Notes payable Total CL w/o AFN AFN With AFN $ 125.0 $ 125.0 100.0 +93.6
$ 225.0 193.6
$ 318.6 L-T debt Common stk.
Ret. earnings Total claims 100.0 +93.6
500.0
237.8
$1,071.0
193.6 500.0
237.8
$1,250.0
Equation AFN = $184.5 vs. Pro Forma AFN = $187.2.
Why are they different?
Equation method assumes a constant profit margin, which does not take into account: a) Expenses don’t always grow as fast as sales b) Interest is not a function of sales Pro forma method is more flexible. More important, it allows different items to grow at different rates. And it allows forecasting improved asset management…
Forecasted Ratios
Profit Margin ROE DSO (days) Inv. turnover FA turnover Debt ratio TIE Current ratio 2006 2.70% 7.71% 43.80
2007(E) Industry 2.52% 4.00% 8.54% 43.80
15.60% 32.00
8.33x
4.00x
30.00% 40.98% 10.00x
6.25x
2.50x
8.33x
4.00x
1.96x
11.00x
5.00x
36.00% 9.40x
3.00x
So what do the forecasted ratios tell us????
What are the forecasted free cash flow and ROIC?
Net operating WC (CA - AP & accruals) Total operating capital (Net op. WC + net FA) NOPAT (EBITx(1-T)) Less Inv. in op. capital Free cash flow ROIC (NOPAT/Capital) 2006 2007(E) $400 $500 $900 $60 $1,125 $75 $225 -$150 6.7%
Proposed Improvements DSO (days) Accts. rec./Sales Inventory turnover Inventory/Sales SGA/Sales Before 43.80
12.00% 8.33x
12.00% 35.00% After 32.00
8.77% 11.00x
9.09% 33.00%
How do we calculate the new balances now?
• We solve for the “x” in the formula DSO = AR/(Sales/365) => 32=x/(2,500/365) • OR, we can use the % already calculated for us!
Impact of Improvements
AFN Free cash flow ROIC (NOPAT/Capital) ROE
Before
$187.2
-$150.0
6.7% 7.7%
After
$15.7
$33.5
10.8% 12.3%
What if in 2006 fixed assets had been operated at only 75% of capacity.
Capacity sales = Actual sales % of capacity $2,000 = = $2,667.
0.75
With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. Fixed asset increase is a discretionary management decision
How would the excess capacity situation affect the 2007 AFN?
• The previously projected increase in fixed assets was $125.
• Since no new fixed assets will be needed, AFN will fall by $125, to $187.2 - $125 = $62.2.
Economies of Scale Assets 1,100 1,000
Base Stock
Declining A/S Ratio
0 2,000 2,500 Sales $1,000/$2,000 = 0.5;
$1,100/$2,500 = 0.44. Declining ratio shows economies of scale. Going from S = $0 to S = $2,000 requires $1,000 of assets. Next $500 of sales requires only $100 of assets.
Assets
Lumpy Assets
1,500 1,000 500 Sales 500 1,000 2,000
A/S changes if assets are lumpy. Generally will have excess capacity, but eventually a small S leads to a large A. This is typical pattern for fixed assets!
Summary: How different capacity factors affect the AFN forecast
.
• Excess capacity: lowers AFN.
• Economies of scale: leads to less-than proportional asset increases.
• Lumpy assets: leads to large periodic AFN requirements, recurring excess capacity.
• It is hard to add fixed asset capacity linearly with sales!
One more iteration
Percent of Sales Method Home Depot
• •
This year’s sales _________
•
Next year, we forecast sales of $_____ million. What assumption?
•
Net income should be ___% of sales.
Keep constant!
Dividends should be ___% of earnings. Keep constant!
Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity This year % of m % n/a * % n/a n/a n/a %
Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity Next year % of m n/a % n/a % n/a n/a %
Predicting Retained Earnings
• • •
Next year’s projected retained earnings = last year’s $___ million, plus This year’s Net Income of $___ million, minus Net Income= Last Year’s Margin %*This Year’s Sales This year’s Dividends of $___ million Dividends=Last Year’s Dividend Payout Ratio*This Year’s Net Income
Predicting Discretionary (Additional) Financing (Funding) Needs Discretionary Financing Needed = projected total assets projected total liabilities OR Total Assets – Total L&E projected owners’ equity
Predicting Discretionary Financing Needs
Discretionary Financing Needed = projected total assets projected total liabilities projected owners’ equity $___ million- ___ $ million $___million
The DFN (AFN)=________
Sustainable Rate of Growth g* = ROE (1 - b)
where b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or
Sustainable Rate of Growth
g* = ROE (1 - b) where b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or net income sales common equity sales assets assets
ROE = x x
Assumptions Driven Forecast Income Statement
• Same first step: What will sales growth be • Then need to determine line by line if * COGS will stay same % of sales - why, why not * OPEX will stay same % of sales - why, why not * Interest expense and taxes assumptions same? - why, why not • Calculate Net Income under assumptions
Assumptions Driven Forecast Income Statement
• When would the assumptions change?
• Company/product life cycles • Economies of scale (COGS), Re engineering Production • Investment in/hedging future (leading/lagging with R&D hiring etc,) • Restructuring (cost cutting, re-engineering) • New debt financing, etc.
Assumptions Driven Forecast Balance Sheet
• When would the assumptions change?
• Assume improvement in management practices (or deterioration due to external factors) * Accounts receivable * Inventory * Fixed Assets (Investment/Divestment) • Change financial or capital structure (more ST or LT debt/more equity) • IS/BS Iterations may be necessary
Assumptions Driven Forecast Balance Sheet
• What does not change?
• Assets = Liabilities+Equity • DFN= Assets-Liabilities-Equity • New Equity=Old Equity+Net Income Dividends