Transcript SHORT-TERM FINANCIAL MANAGEMENT Chapter 13 – Short-Term Financial Planning Chapter 13 Agenda S/T FINANCIAL PLANNING Differentiate between a long-term and short-term financial planning model, develop a.

SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 13 – Short-Term Financial Planning
2
Chapter 13 Agenda
S/T FINANCIAL PLANNING
Differentiate between a long-term and
short-term financial planning model,
develop a financial planning model, and
discuss and interpret the sustainable
growth rate.
S/T Financial Planning
3


Short-term financial planning differs from long-term
financial decisions in two important ways:

Decisions are easily reversed in most cases.

There is far less uncertainty about the decision variables
since the planning horizons are shorter.
Short-term financial decisions ensure the firm's liquidity
and are critical to the short-term survival of the
business.

Rapidly growing companies focused on sales often run out
of cash given the need to have additional cash tied up in
assets.
S/T Financial Planning
4

We assume it requires additional assets to support
incremental sales.
This includes new, permanent current assets as well as new
fixed assets (unless the firm is not operating at capacity).
The additional assets must have a financing source.




Some might be supported by financial slack (excess cash or ready
access to debt).
Short-term financial planning allows a firm to model
different assumptions about sales growth rates and plan for
the impact on:



Cash flow
The Balance Sheet
The Income Statement
Types of Models
5

Deterministic
 Data
inputs are single point estimates
 Example

– Sales growth is expected to be 5%
Stochastic
 Data
inputs include probability distributions
 Example
– Sales growth is normally distributed with an
expected value of 5% and a standard deviation of 3%
6 Steps in Modeling Process
6



Determine question asked – What is the dependent
variable?
Variable specification – What are the independent
variables? Generally, the longer the time period, the
less detail needed.
Determine relationship between variables
Example – Ct = a1CSt + a2CSt-1 + a3CSt-2
 Where: Ct = Cash flow from sales
CSt = Credit sales in month t

6 Steps in Modeling Process – cont.
7



Parameter estimation – a1, a2, and a3 in previous
slide. Estimates may be simple historical average or
may be found by using fancy statistics.
Model validation – Run the model using some real
data and check the results.
Model documentation – Write down the logic
behind the model.
Basics of Model Building
8




Decide on driving variable (Usually sales)
Avoid the temptation to make model too detailed
Build model into electronic worksheet
Use cell references to minimize model changes
Growth Ratios
9

It is important to understand the impact on the
balance sheet based on different assumptions
around growth rates.
 Assets

should grow (or shrink) in relationship to sales.
We’ll look at two forecasting models:
%
of Sales (Needed External Financing – NEF)
 Sustainable
Growth Rate (SGR)
Forecasting Models
10

% of Sales (Needed External Financing – NEF)

The amount of external financing needed for a desired
level of sales growth.
Firms that grow faster than the SGR must support growth with
incremental external capital.
 Conversely, firms growing slower than the SGR have excess cash
to retire debt, increase dividends, etc.


Sustainable Growth Rate (SGR)

Maximum sales growth rate using both internal and external
sources of financing, but without increasing leverage ratio or
changing existing financial policies:

D/E, A/S, capital structure, profit margin, and dividend payout
ratio.
Forecasting Models
11

% of Sales (Needed External Financing-NEF)
 Answers
the question: “What amount of new capital
do I need if I plan to grow X% or by $Y?”

Sustainable Growth Rate (SGR)
 Answers
the question: “How much can I grow without
changing existing financing policies?”
% of Sales Forecasting Model
12
We assume it requires additional assets to support
incremental sales and that balance sheet relationships stay
consistent and proportional (+/-) to sales volume.

e.g.: If Total Assets are 45% of sales this year and we are at
100% capacity, we assume the same relationship next year
based on next year’s projected sales.
The additional assets must have a financing source.





Current liabilities (primarily A/P and accruals) are a spontaneous
source of financing.
Another source of financing is new retained earnings.
Any gap is needed external financing (NEF) and must be supplied
by external financing (probably short-term debt (N/P), but could
include long-term debt and/or new equity).
% of Sales Forecasting Model
13
NEF =
1.
2.
3.
Total Assets / Sales
×
Change in Sales
1
-
Current Liabilities / Sales
×
Change in Sales
2
-
Sales × Net Profit Margin
×
[1 - (Dividends / Net Profit)] 3
Additional Total Assets are required to support incremental sales.
Some of these additional Assets (e.g.: Inventory) will be supported by
‘spontaneous financing’ through increased Current Liabilities.
Some of these assets are supported by earnings retained by the firm
(profits not paid out as dividends).
The NEF can be acquired through either new debt or new equity, but
must be acquired externally from somewhere to support sales growth.
% of Sales Forecasting Model
14
1
NEF =
Total Assets / Sales
1
×
Change in Sales
-
Current Liabilities / Sales
×
Change in Sales
-
Sales × Net Profit Margin
×
[1 - (Dividends / Net Profit)]
2
Make sure you’re using the right inputs.

3
1.
Previous year’s sales
2.
Projected sales
3.
Change in sales
% of Sales Forecasting Model
15
NEF =

Total Assets / Sales
×
Change in Sales
-
Current Liabilities / Sales
×
Change in Sales
-
Sales × Net Profit Margin
×
[1 - (Dividends / Net Profit)]
Using notation, the formula is:
% of Sales Forecasting Model Example
16

This firm anticipates an increase in sales to $15 million (an
increase of $2.75 million, or 22.4%) …will it require
external financing?
BALANCE SHEET
Total Asssets
Total Assets
$
$
15,580,000
15,580,000
Current Liabilities
$
4,261,000
Long-Term Debt
$
3,638,000
Net Worth
$
7,681,000
Total Liabilities & NW
$
15,580,000
INCOME STATEMENT
Net Sales
$
12,250,000
Net Profit
$
692,000
Dividends
$
429,000
% of Sales Forecasting Model Example
17
BALANCE SHEET
Total Asssets
Total Assets
NEF =
$
$
15,580,000
15,580,000
INCOME STATEMENT
Current Liabilities
$
4,261,000
Net Sales
$
12,250,000
Long-Term Debt
$
3,638,000
Net Profit
$
692,000
Net Worth
$
7,681,000
Dividends
$
429,000
Total Liabilities & NW
$
15,580,000
Total Assets / Sales
×
Change in Sales
-
Current Liabilities / Sales
×
Change in Sales
-
Sales × Net Profit Margin
×
[1 - (Dividends / Net Profit)]
$15,580,000 / $12,250,000
×
$2,750,000
-
$4,261,000 / $12,250,000
×
$2,750,000
-
$15,000,000 × ($692,000 / $12,250,000)
×
[1 - ($429,000 / $692,000)]
1.2718
×
$2,750,000
=
$3,497,551
-
0.3478
×
$2,750,000
=
$956,551
-
$847,347
×
0.3801
=
$322,041
NEF =
NEF =
$2,218,959
Firm must prearrange this
amount of
incremental
external
financing to
support planned
sales growth.
% of Sales Forecasting Model Example
18
The sales growth will impact the financial statements.
LAST YEAR
BALANCE SHEET
Total Asssets
Total Assets
$
$
15,580,000
15,580,000
INCOME STATEMENT
Current Liabilities
$
4,261,000
Net Sales
$
12,250,000
Long-Term Debt
$
3,638,000
Net Profit
$
692,000
Net Worth
$
7,681,000
Dividends
$
429,000
Total Liabilities & NW
$
15,580,000
PRO-FORMA FOR THIS YEAR
BALANCE SHEET
Total Asssets
Total Assets
$
$
19,077,551
19,077,551
INCOME STATEMENT
Current Liabilities
$
5,217,551
Net Sales
$
15,000,000
Long-Term Debt
$
3,638,000
Net Profit
$
847,347
Net Worth
$
8,003,041
Dividends
$
525,306
Total Liabilities & NW
$
16,858,592
SHORTFALL (NEF)
$
2,218,959
% of Sales Forecasting Model Example
19

Given the shortfall, the firm must have grown faster than the SGR, since the
Debt/Equity ratio increased.

Here, the shortfall was added to LTD; the firm could have increased STD or
equity instead.
= ($4,261,000 + $3,638,000) / $7,681,000
= 1.028
= ($5,217,551 + $5,856,959) / $8,003,041
= 1.384
Sustainable Growth Rate (SGR)
20

Sustainable growth can be estimated by equating annual
sources of capital to annual uses.
 Uses = Sources

If

Then 
New Assets = New Equity + New Debt

And 
gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E)
Where,






S=
gS =
A/S =
m=
d=
D/E =
Prior year sales
Dollar change in sales during planning year
Target ratio of total assets to total sales
Projected after-tax profit margin
Target dividend payout ratio (dividends/earnings)
Target debt-to-equity ratio
Sustainable Growth Rate
21
The growth in assets is limited to a constant proportion of D/E.
gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E)
A portion of the incremental
assets will come from
additions to retained earnings
(profits less dividends paid).

gS(A/S) is the increase in assets required to support the
expected increase in sales.


As equity increases, liabilities
can increase proportionately
and still maintain a constant
value for D/E.
It is assumed the firm is operating efficiently.
Therefore, the uses of cash (the left-hand side of the equation)
must be supported by new sources on the right-hand side).
Sustainable Growth Rate
22

The sales growth rate (g) that satisfies the previous
equation is given by:
m 1 - d  1  D/E) 
g* 
A/S - m 1 - d  1  D/E
Where,
S=
 gS =
 A/S =
m=
d=
 D/E =

Prior year sales
Dollar change in sales during planning year
Target ratio of total assets to total sales
Projected after-tax profit margin
Target dividend payout ratio (dividends/earnings)
Target debt-to-equity ratio
Sustainable Growth Rate
23

For this same firm, what is the SGR?
BALANCE SHEET
Total Asssets
Total Assets
$
$
15,580,000
15,580,000
Current Liabilities
$
4,261,000
Long-Term Debt
$
3,638,000
Net Worth
$
7,681,000
Total Liabilities & NW
$
15,580,000
INCOME STATEMENT
Net Sales
$
12,250,000
Net Profit
$
692,000
Dividends
$
429,000
Sustainable Growth Rate
24
BALANCE SHEET
Total Asssets
Total Assets
$
$
15,580,000
15,580,000
INCOME STATEMENT
Current Liabilities
$
4,261,000
Net Sales
$
12,250,000
Long-Term Debt
$
3,638,000
Net Profit
$
692,000
Net Worth
$
7,681,000
Dividends
$
429,000
Total Liabilities & NW
$
15,580,000
m
m 1 - d  1  D/E) 
g* 
A/S - m 1 - d  1  D/E
= $692,000 / $12,250,000 = 5.65%
1-d
= 1 - ($429,000 / $692,000) = (1-62%) = 38%
1 + D/E
= 1 + (($4,261,000 + $3,638,000) / $7,681,000)
A/S
= $15,580,000 / $12,250,000
0.043548114
3.545%
=
1.228288621
Sustainable Growth Rate
25
The firm can only grow sales to $12.7 million
(3.545%) without changing its financial policies.
A/S = 1.272
3.545%
A/S = 1.272
3.545%
NEF v. SGR
26
NEF
SGR
D/E = 1.028
LAST YEAR
D/E = 1.028
Current Liabilities
$
4,261,000
Long-Term Debt
$
3,638,000
Net Worth
$
7,681,000
Total Liabilities & NW
$ 15,580,000
D/E = 1.028
D/E = 1.384
PRO-FORMA FOR THIS YEAR
Current Liabilities
$
4,412,071
Long-Term Debt
$
3,766,983
Net Worth
$
7,953,324
Total Liabilities & NW
$ 16,132,378
Alternative SGR Formula
27
SGR = ROE x (1 - dividend-payout ratio)
= ($716,534 / $7,681,000) x ((1 – ($444,210 / $716,534))
3.545%
Alternative SGR Formula
28
SGR = (ROE x b)/(1 – ROE x b)
= ($692,000/7,681,000) x (.38)/(1 – $692,000/7,681,000)
b = (692,000 – 429,000)/692,000 = 0.38
3.545%