Financial Planning and Forecasting

Forecast Sales Project the Assets Needed to Support

Sales Project Internally Generated Funds Project Outside Funds Needed Decide How to Raise Funds See Effects of Plan on Ratios

2006 Sales 10,000,000 2006 Total Assets 8,000,000 Want to project 2007 financial

statements based on a 30% increase in sales.

Projected 2007 Sales 10,000,000(1.30) = $13,000,000

Assets 2006 Liabilities and Equity 2006Cash 500$ Accounts payable 1,000$ Receivables 2,000$ Accruals 500$ Inventory 1,500$ Notes payable 900$

Total Current Assets 4,000$ Total Current Liabilities 2,400$ Long-term debt 1,600$

Net fixed assets 4,000$ Common stock 1,700$ Retained earnings 2,300$

Total Assets 8,000$ Total Liabilities and Equity 8,000$

Income Statement 2006Sales 10000Operating Expenses(72.5%) 7250Operating Income 2750Interest Expense 250Income before taxes 2500Taxes (40%) 1000Net Income 1500Dividends (30%) 450Addition to Retained Earnings 1050

Known as percentage of sales approach. Zippy is operating at full capacity in

2006. Each type of asset grows proportionally

with sales. Accounts payable and accruals grow

proportionally with sales. 2006 profit margin (15%) and payout

(30%) will be maintained. Sales are expected to increase by $3

million. (%S = 30%)

Income Statement 2006 times = 2007 ProjSales 10000 1.3 13000Operating Expenses(72.5%) 7250 1.3 9425Operating Income 2750 3575Interest Expense 250 1.3 325Income before taxes 2500 1.3 3250Taxes (40%) 1000 1.3 1300Net Income 1500 1.3 1950Dividends (30%) 450 585Addition to Retained Earnings 1050 1365

Assets 2006 times = 2007 ProjCash 500 1.3 650Receivables 2000 1.3 2600Inventory 1500 1.3 1950Total Current Assets 4000 5200Net fixed assets 4000 1.3 5200Total Assets 8000 10400

Liabilities and Equity 2006 times = 2007 ProjAccounts payable 1000 1.3 1300Accruals 500 1.3 650Notes payable 900 same 900Total Current Liabilities 2400 2850Long-term debt 1600 same 1600Common stock 1700 same 1700Retained earnings 2300 +1365 3665Total Liabilities and Equity 8000 9815

Projected 2007 Assets 10,400Projected 2007 Liab&Eq 9,815Additional Financing Needed 585 Assume Zippy will raise 40% of additional

financing needed through Notes Payable and the rest (60%) through Long-term Debt.

Addition to Notes Payable 234 Addition to Long-term Debt 351

Liabilities and Equity 2006 times = Proj2007Accounts payable 1000 1.3 1300Accruals 500 1.3 650Notes payable 900 + 234 = 1134Total Current Liabilities 2400 3084Long-term debt 1600 + 351 = 1951Common stock 1700 same 1700Retained earnings 2300 + 1365 = 3665Total Liabilities and Equity 8000 10400

AFN = (A*/S)S - (L*/S)S - M(S1) (RR)RR = retention ratio = 1 – dividend payout

AFN = ($8,000 / $10,000) ($3,000) - ($1,500 / $10,000) ($3,000) - 0.15($13,000) (1- 0.3)

= $585.

2006

Current 1.67

Quick 1.04

DSO 73.00

InvTurn 6.67

debt/assets 50.0%

FAT 2.50

TAT 1.25

ROA 18.8%

ROE 37.5%

Proj2007

Current 1.69

Quick 1.05

DSO 73.00

InvTurn 6.67

debt/assets 48.4%

FAT 2.50

TAT 1.25

ROA 18.8%

ROE 36.3%

Sales growth: higher growth leads to more AFN Capital Intensity Ratio (A/S): higher A/S leads to

more AFN Spontaneous liabilities to sales ratio (L/S):

higher ratio means more internal financing and less AFN

Profit Margin (M): higher profit margin means higher net income and less AFN

Retention Ratio: higher ratio means more retained earnings and less AFN

Assume Zippy’s net fixed assets were operating at 80% capacity and current assets at 100% capacity in 2006.

How would Zippy’s additional financing needed change?

Need to know what level of sales Zippy’s existing net fixed assets can support or produce = Full Capacity Sales

Full Capacity Sales (FCS)= Current Sales/% of Capacity

Zippy’s 2006 Sales = 10,000 80% Capacity Full Capacity Sales = 10,000/0.8 =

12,500 Target FA Ratio = 2006 FA/ FCS 4000/12,500 = 0.32 = 32% Proj FA = 0.32(proj sales) = 0.32(13,000)

= 4,160

Assets 2006 % of Sales Pro.Sales Proj2007Cash 500 5% 13000 650Receivables 2000 20% 13000 2600Inventory 1500 15% 13000 1950Total Current Assets 4000 40% 13000 5200Net fixed assets 4000 32% 13000 4160Total Assets 8000 9360

Liabilities and Equity 2006 % of Sales Proj2007Accounts payable 1000 10% 13000 1300Accruals 500 5% 13000 650Notes payable 900 same 900Total Current Liabilities 2400 2850Long-term debt 1600 same 1600Common stock 1700 same 1700Retained earnings 2300 + 1365 = 3665Total Liabilities and Equity 8000 9815

AFN -455Total 9360

New AFN is -455 This means Zippy can reduce debt to

make the projected balance sheet balance or just add the surplus financing to the cash account.

We have assumed a constant profit margin which means interest expense is assumed to increase proportionally with sales.

A company’s financing decision may cause the actual interest expense to be higher or lower than this projection.

If the additional financing decision causes interest expense to be higher, then even more financing will be needed.

Instead of assuming individual assets will remain a constant percentage of sales, a company can modify their forecast by: using regression analysis to project individual

asset accounts. using target financial ratios to project

individual asset accounts.

Zippy’s 2006 DSO is 73 days, they plan to improve their collection policy and lower their DSO to 60 days in 2007. What is their projected 2007 receivables (projected sales 13,000,000) and reduction in AFN vs. their current DSO?

DSO = Receivables/(sales/365) Receivables = DSOx(sales/365)

New Receivables projection = 60 x (13,000,000/365) = 2,136,986

Our “original” projection = 73 x (13,000,000/365) = 2,600,000

Reduction in projected receivables = 2,600,000 – 2,136,986 = 463,014

463,014 is also the reduction in AFN.

1

Unless stated otherwise, all expenses are assumed to increase proportionally with sales, yielding the same profit margin

At full capacity, all assets increase proportionally with sales

Only accounts payable and accrued taxes and wages(accruals) increase proportionally with sales

Forecasted Retained Earnings are added to the previous year’s b/s acct.

2

With financial statement forecast, AFN = projected total assets - projected liab&eq

Proj. spontaneous assets and liabilities = last year’s ratio of each account to sales times forecasted sales

AFN is plug amount that makes the balance sheet balance

With AFN equation, AFN = projected change in assets - proj. change in liabilities - projected new retained earnings

3

If fixed assets are operating at less than 100% capacity, determine full capacity sales Full capacity sales = old sales/ % of capacity

If projected sales < full capacity sales, no increase in fixed assets is needed

If projected sales > full capacity sales, then proj. FA = old FA/Full capacity sales times projected sales