8/2/2007

Chapter 12. Tool Kit for Financial Planning and Forecasting Financial Statements

MicroDrive's recent financial statements are shown below.

INCOME STATEMENT(in millions of dollars) 2007 2008

Sales $2,850.0 $3,000.0Costs except depreciation $2,497.0 $2,616.2Depreciation $90.0 $100.0Total operating costs $2,587.0 $2,716.2EBIT $263.0 $283.8Less Interest $60.0 $88.0Earnings before taxes (EBT) $203.0 $195.8Taxes (40%) $81.2 $78.3NI before preferred dividends $121.8 $117.5Preferred dividends $4.0 $4.0NI available to common $117.8 $113.5

Dividends to common $53.0 $57.5$64.8 $56.0

Shares of common equity 50 50Dividends per share $1.06 $1.15Price per share $26.00 $23.00

BALANCE SHEET (in millions of dollars)

2007 2008AssetsCash $15.0 $10.0ST Investments $65.0 $0.0Accounts receivable $315.0 $375.0Inventories $415.0 $615.0Total current assets $810.0 $1,000.0Net plant and equipment $870.0 $1,000.0Total assets $1,680.0 $2,000.0

2007 2008Liabilities and equityAccounts payable $30.0 $60.0Accruals $130.0 $140.0Notes payable $60.0 $110.0Total current liabilities $220.0 $310.0Long-term bonds $580.0 $754.0Total liabilities $800.0 $1,064.0Preferred stock $40.0 $40.0Common stock $130.0 $130.0Retained earnings $710.0 $766.0Total common equity $840.0 $896.0Total liabilities and equity $1,680.0 $2,000.0

SALES FORECAST (Section 12.2)

Sales Ln(Sales)2004 $2,058 7.632005 2,534 23.1% 7.842006 2,472 -2.4% 7.812007 2,850 15.3% 7.962008 3,000 5.3% 8.01

Average = 10.3%

THE SALES FORECAST

Add. to retained earnings (DRE)

Strategic planning is one of the core functions of an organization, and it involves the coordination of operating plans with financial plans. While operational plans outline how the firm intends to reach its corporate objectives, financial plans outline the manner in which the firm will obtain the necessary productive assets to operate. Financial planning generally begins with a sales forecast, and that forecast generally starts with a review of the firm's recent history. Here are MicroDrive Inc.'s sales over the past 5 years:

Annual Growth Rate

The first step in a sales forecast are several ways to estimate the historical growth rate, ranging from the simple to the complicated. The simplest are to estimate the average annual growth rate and the compound annual growth rate.

B C D E F G H I123456789

1011121314151617181920212223242526272829303132333435363738394041424344454647484950515253545556575859606162636465666768697071727374

Average annual growth rate = 10.3%

Compound annual growth rate = 9.9% (Use the RATE function.)

Intercept = -438,737 (Using the INTERCEPT function)

Slope = 220 (Using the SLOPE function)

The first step in a sales forecast are several ways to estimate the historical growth rate, ranging from the simple to the complicated. The simplest are to estimate the average annual growth rate and the compound annual growth rate.

We could also use regression analysis to estimate future sales. The easiest way is to plot the points using the Chart Wizard, as we did below. Then select the Chart, go the menu bar and select Chart, Add Trendline…, go to the Options tab (see screen shot below), check "Display equation on chart" and set the Forecast for 1 unit Forward. This will print the regression line on the chart and show the forecast for the next year.

The chart shows the regression line. If you actually want the regression intercept and slope, the easiest way is to use the function Wizard to create the INTERCEPT and SLOPE functions, as shown below.

You could always use the estimated interecept and slope to project the future sales, but an even easier way is to use the TREND function. This allows you to specify the past years and sales, and then specify a projected year. It then fits the regression line and gives you the projected value. See below for details.

2004 2005 2006 2007 2008$0

$1,000

$2,000

$3,000

$4,000

f(x) = 220 x − 438737.2f(x) = 220 x − 438737.2

Annual Sales

Year

NetSales

D66:D70

C66:C70

D66:D70

D66:D70

C66:C70

C66:C70C15:C19C156

B C D E F G H I75767778798081828384858687888990919293949596979899100101102103104105106107108109110111112113114115116117118119120121122123124125126127128129130131132133134135136137138139140141142143144145146147

Projected sales for 2009 = 3,243 (Using the TREND function)Implied growth rate = 8.1%

Slope = 8.7% (Using the SLOPE function)

g = 9.1%

(1+g) rate using LOGEST = 1.0910358g = 9.1%

The historical growth rates range from 8.1% to 10.3 percent, depending on the method.

The compound growth rate is very sensitive to the particular starting and ending dates that are chosen. One way to smooth this out is to regress the natural log (LN) of sales versus the years. The slope coefficient is the estimate of the historical sales growth rate. See the chart below; we plotted the trendline and the regression equation.

To find the growth rate, raise e to the slope (this is eslope) and then subtract 1.

Instead of doing a full regression with the Y variable being the log of sales, we could find the slope of the "log" regression directly using the LOGEST function. In this function, we simply specify the original sales as the Y variable, the years as the X variable, and the function finds the "log-based" slope coefficient, which is an estimate of (1+g).

Management started with the regression prediction, then modified it based on qualitative data to $3,300, the forecasted value given in the text. Management's sales forecast represents a growth rate of 10%.

2004 2005 2006 2007 2008 20097.40

7.50

7.60

7.70

7.80

7.90

8.00

8.10f(x) = 0.0871275214894114 x − 166.929554320406

Natural Log (LN) of Sales

B C D E F G H I148149150151152153154155156157158159160161162163164165166167168169170171172173174175176177178179180181182183184185186187188189190191192193194195196197198199200201202

THE AFN FORMULA (Section 12.3)

Forecast growth rate in sales = 10%

AFN= - -

= Asset to Sales Ratio x

= 0.6667 x $300.00= $200.00

= x

= 0.067 x $300.00= $20.00

= Profit Margin x Sales x

= 0.0378 x $ 3,300.0 x 0.493= $61.58

AFN= - -

= $200.00 - $20.00 - $61.58AFN= $118.42

We can look at the additional funds needed using the AFN equation described in the text. This method identifies the additional funds needed as being the difference between the change in assets and 'the cumulative change in spontaneous liabilities and retained earnings.

D Required Assets

D Spontaneous Liabilities

D Retained Earnings

D Required Assets D Sales

D Sponta-neous

LiabilitiesSpontaneous Liab.

to Sales RatioD Sales

D Retained Earnings

Retention Ratio

D Required Assets

D Spontaneous Liabilities

D Retained Earnings

We can also rearrange the AFN formula to find the growth rate at which no external financing is required. At each place in the equation, we substitute gS0 for DS and we substitute S0+gS0 for S1. We then solve for g.

B C D E F G H I203204205206207208209210

211

212

213

214215216

217

218219220

221

222223224

225

226227228229230231

g for zero AFN= Profit margin x Retention ratio ÷ -

= 0.038 x 0.493 ÷ 0.667 - 0.067= 0.01866 ÷ 0.581333333

g for zero AFN= 3.21%

Therefore, if MicroDrive's ratios remain constant, MicroDrive can grow at about 3.21% without needing external financing.

FINANCIAL STATEMENT FORECASTING: THE PERCENT OF SALES METHOD (Section 12.4)

Asset to Sales Ratio

Spontaneous Liab. to

Sales Ratio

The text examines a forecast for a firm using the percentage of sales of method. This forecasting method assumes that many items on the financial statements are proportional to sales. In particular, it assumes that the following items are proportional to sales: (1) Costs; (2) Cash (i.e., the company needs a certain amount of cash on hand, since it does not know exactly when the checks it writes or deposits will clear the bank); (3) Accounts receivable; (4) Inventories; (5) Net plant and equipment (this is reasonable for the long-term; in the short-term, firm's often have excess capacity, which we discuss later in this model); (6) Accounts payable; and (7) Accruals. It also assumes that Depreciation is proportional to Net plant and equipment. Other items on the financial statements are a direct result of the firm's financial policies (i.e., dividend policy and capital structure policy), which we discuss below.

The next step is to analyze the historical "Pro Forma" ratios. The actual historical statements are shown above in Rows 7-53. The ratios needed for the Pro Forma analysis are shown below.

Note: If you change the inputs below, you can view a summary of results beginning

in Row 374.

B C D E F G H I232

233

234

235236237238239240241242243244245246247248249250251252253

254

Pro Forma Ratios Actual Historical Industry Forecast2007 2008 Average Composite 2009

Costs / Sales 87.614% 87.207% 87.410% 87.064% 87.200%Depreciation / Net plant & equip. 10.345% 10.000% 10.172% 10.200% 10.000%Cash / Sales 0.526% 0.333% 0.429% 1.000% 0.333%Accounts Rec. / Sales 11.053% 12.500% 11.776% 10.000% 12.500%Inventory / Sales 14.561% 20.500% 17.531% 11.111% 20.500%Net plant & equip. / sales 30.526% 33.333% 31.930% 33.333% 33.333%Accounts Pay. / Sales 1.053% 2.000% 1.526% 1.000% 2.000%Accruals / Sales 4.561% 4.667% 4.614% 2.000% 4.667%

Other Inputs

Sales Growth Rate 10%Tax rate 40%Dividend growth rate 8%Interest rate on notes payable and short-term investments 9%Interest rate on long-term bonds 11%Coupon rate on preferred stock 10%

Table 12-2 MicroDrive, Inc.: Actual and Projected Income Statements (Millions of Dollars)Actual Forecast2008 Forecast basis 2009(1) (2) (3)

Sales $ 3,000.0 110% x 2008 Sales = $ 3,300.0 Costs except depreciation 2,616.2 87.2% x 2009 Sales = $ 2,877.6 Depreciation 100.0 10% x 2009 Net plant = $ 110.0 Total operating costs $ 2,716.2 $ 2,987.6 EBIT $ 283.8 $ 312.4 Less Interest 88.0 Interest rate x 2008 debt = $ 92.8 Earnings before taxes (EBT) $ 195.8 $ 219.6 Taxes (40%) 78.3 $ 87.8 NI before preferred dividends $ 117.5 $ 131.8 Preferred dividends 4.0 Dividend rate x 2008 preferred = $ 4.0 NI available to common $ 113.5 $ 127.8

Shares of common equity 50.0 $ 50.0 Dividends per share $ 1.15 108% x 2008 DPS = $ 1.25 Dividends to common $ 57.5 2009 DPS x # shares = $ 62.5 Additions to retained earnings $ 56.0 $ 65.3

Table 12-3 MicroDrive, Inc.: Actual and Projected Balance Sheets (Millions of Dollars)Actual Forecast2008 Forecast basis 2009(1) (2) (3)

AssetsCash $ 10.0 0.33% x 2009 Sales = $ 11.0 ST investments 0.0 Previous plus "plug" if needed 0.0 Accounts receivable 375.0 12.50% x 2009 Sales = 412.5 Inventories 615.0 20.50% x 2009 Sales = 676.5 Total current assets $ 1,000.0 $ 1,100.0 Net plant and equipment 1,000.0 33.33% x 2009 Sales = 1,100.0 Total assets $ 2,000.0 $ 2,200.0

Liabilities and equity Accounts payable $ 60.0 2.00% x 2009 Sales = $ 66.0 Accruals 140.0 4.67% x 2009 Sales = 154.0 Notes payable 110.0 Previous plus "plug" if needed 224.7 Total current liabilities $ 310.0 $ 444.7 Long-term bonds 754.0 Same: no new issue 754.0 Total liabilities $ 1,064.0 $ 1,198.7 Preferred stock 40.0 Same: no new issue 40.0 Common stock 130.0 Same: no new issue 130.0 Retained earnings 766.0 2008 RE + 2009 Add. to RE = 831.3 Total common equity $ 896.0 $ 961.3 Total liabilities and equity $ 2,000.0 $ 2,200.0

$ 2,200.0

$ 2,085.3

Note: If you change the inputs below, you can view a summary of results beginning

in Row 374.

Note: we have used the ROUND function to make the calculations consistent with

the textbook.

Note: we have used the ROUND function to make the calculations consistent with

the textbook.

Required assetsa

Specified sources of financingb

B C D E F G H I

255

256257258259260261262263264265266267268269270271272273274275276277278279280281282283284285286287288289290291292293294295296297298299300301302303304305306307308309310311312313314315316317318319320321322323324325326327

328

Additional funds needed (AFN) $ 114.7

Required additional notes payable $ 114.7 Additional short-term investments 0.0

Required assets include all forecasted operating assets plus the short-term investments from the previous year.

MicroDrive Statement of Cash Flows for Years Ending Dec. 31 Actual Forecast(in millions of dollars) 2008 2009

(1) (3)Operating Activities Net Income before preferred dividends $ 117.5 $ 131.8 Noncash adjustments Depreciation and amortization $ 100.0 $ 110.0 Due to changes in working capital Increase in accounts receivable $ (60.0) $ (37.5) Increase in inventories $ (200.0) $ (61.5) Increase in accounts payable $ 30.0 $ 6.0 Increase in accruals $ 10.0 $ 14.0 Net cash provided by operating activities $ (2.5) $ 162.8

Long-term investing activities Cash used to acquire fixed assets $ (230.0) $ (210.0)

Financing Activities Sale of short-term investments $ 65.0 $ - Increase in notes payable $ 50.0 $ 114.7 Increase in bonds $ 174.0 $ - Payment of common and preferred dividends $ (61.5) $ (66.5)Net cash provided by financing activities $ 227.5 $ 48.2

Net cash flow $ (5.0) $ 1.0 Cash and securities at beginning of the year $ 15.0 $ 10.0 Cash and securities at end of the year $ 10.0 $ 11.0

ANALYSIS OF THE PLAN: FREE CASH FLOW, RATIOS, AND AFN

Specified sources of financing include forecasted operating current liabilities, forecasted long-term bonds, forecasted preferred stock, forecasted common equity, and the amount of notes payable from the previous year.

B C D E F G H I329330331332333334

335336337338339340341342343344345346347348349350351352353354355356357358359360361362363364365366367368369

Table 12-4 Model Inputs, AFN, and Key Ratios (Millions of Dollars)

Preliminary Revised IndustryActual Actual Forecast Forecast Average2007 2008 2009 2009 2008 2009

(1) (2) (3) (4)Model InputsCosts (excluding depreciation) as percent of sales 87.2% 87.2% 86.0% 87.1% 87.2%Accounts receivable as percent of sales 12.5% 12.5% 11.8% 10.0% 12.5%Inventory as percent of sales 20.5% 20.5% 16.7% 11.1% 20.5%

Model OutputsNet operating profit after taxes (NOPAT) $ 170.3 $ 187.4 $ 211.2 $ 187.4 Net operating working capital (NOWC) $585 $ 800.0 $ 880.0 $ 731.5 $ 880.0 Total operating capital $1,455 $ 1,800.0 $ 1,980.0 $ 1,831.5 $ 1,980.0 Free cash flow (FCF) $ (174.7) $ 7.4 $ 179.7 $ 7.4 Additional funds needed (AFN) $ 114.7 $ (57.5) $ 114.7

Ratio AnalysisCurrent ratio 3.2 2.5 3.1 4.2 2.5Inventory turnover 4.9 4.9 6.0 9.0 4.9Days sales outstanding 45.6 45.6 43.1 36.0 45.6Total assets turnover 1.5 1.5 1.6 1.8 1.5Debt ratio 53.2% 54.5% 51.4% 40.0% 54.5%Profit margin 3.8% 3.9% 4.6% 5.0% 3.9%Return on assets 5.7% 5.8% 7.2% 9.0% 5.8%Return on equity 12.7% 13.3% 15.4% 15.0% 13.3%Return on invested capital 9.5% 9.5% 11.5% 11.4% 9.5%

EXCESS CAPACITY ADJUSTMENTS

The following table shows key outputs of the preliminary plan. We used the Scenario Manager to develop the key outputs for the revised plan. See the worksheet "Scenario Summary."

Forecast Based on Current Values of Inputs in Rows

259-276

B C D E F G H I370371372373374

375

376377378379380381382383384385386387388389390391392393394395396397398399400401402403404405406407408409410411412413414415416417418419420421422423424425426427428429430431432433434435436437438439440441442443444

2007 Sales $3,0002008 Sales $3,300Percentage of capacity 96%2007 Fixed Assets $1,000

Full capacity sales = $3,125

Target FA/Sales = 0.32

Required level of FA = $1,056

We have just stated that assuming current assets to grow at the same rate of sales is not necessarily correct. The same can be said of fixed assets. For instance, let us assume that the firm in our example is not operating at full capacity. This means that they could achieve a greater level of production from their fixed assets. Remember, sales for the last year were $3,000 million, while fixed assets were $1,000 million. Now, let us hypothesize that the firm was only operating at 96 percent of full capacity. We can use this information to calculate the firm's full capacity sales and the target fixed assets-to-sales ratio.

B C D E F G H I445446447448449450451452453454455456457458459460461

Preliminary

Page 10

0.8720.1

0.0033266670.1250.205

0.3333333330.02

Preliminary

Page 11

0.046666667

0.10.4

0.080.090.11

0.1

Revised

Page 12

0.860.1

0.0033266670.1180.167

0.3333333330.02

Revised

Page 13

0.046666667

0.10.4

0.080.090.11

0.1

RevisedHiGrowth

Page 14

0.860.1

0.0033266670.1180.167

0.3333333330.02

RevisedHiGrowth

Page 15

0.046666667

0.20.4

0.080.090.11

0.1

Scenario SummaryCurrent Values: Preliminary Revised

Changing Cells:$H$259 87.200% 87.200% 86.000%$H$260 10.000% 10.000% 10.000%$H$261 0.333% 0.333% 0.333%$H$262 12.500% 12.500% 11.800%$H$263 20.500% 20.500% 16.700%$H$264 33.333% 33.333% 33.333%$H$265 2.000% 2.000% 2.000%$H$266 4.667% 4.667% 4.667%$H$271 10% 10% 10%$H$272 40% 40% 40%$H$273 8% 8% 8%$H$274 9% 9% 9%$H$275 11% 11% 11%$H$276 10% 10% 10%

Result Cells:NOPAT $ 187.4 $ 187.4 $ 211.2 NOWC $ 880.0 $ 880.0 $ 731.5 TotalCapital $ 1,980.0 $ 1,980.0 $ 1,831.5 FCF $ 7.4 $ 7.4 $ 179.7 AFN $ 114.7 $ 114.7 $ (57.5)

Notes: Current Values column represents values of changing cells attime Scenario Summary Report was created. Changing cells for eachscenario are highlighted in gray.

RevisedHiGrowth

86.000%10.000%

0.333%11.800%16.700%33.333%

2.000%4.667%

20%40%

8%9%

11%10%

$ 230.4 $ 798.0 $ 1,998.0 $ 32.4 $ 89.8

Due to its use of the automatic iteration feature, the Web 12A Tool Kit is shown in a separate file, CF3 Ch12 Web 12A Tool Kit.xls.

REGRESSION APPROACH

Financial Statement Data for MicroDrive ($ Millions)

Year Sales Inventories2004 $2,058 $387 $268 2005 2,534 398 2982006 2,472 409 3042007 2,850 415 3152008 3,000 615 3752009 3,300

Inventories vs. Sales

Accounts Receivable vs. Sales

Tool Kit for Web Extension 12B: Advanced Techniques for Forecasting Financial Statement Accounts

Relationships between sales and other financial statement accounts are not always proportional. Therefore, in some cases it is preferrable to use a regression approach.

Accounts Receivable

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $0

$100

$200

$300

$400

$500

$600

$700

f(x) = 0.18603956343385 x − 35.7029844369485R² = 0.505467821620517

Sales ($ Millions)

Inve

ntor

ies

($ M

illio

ns)

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $0

$50

$100

$150

$200

$250

$300

$350

$400

f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845

Sales ($ Millions)

Acco

unts

Rec

eiva

ble

($ M

illio

ns)

Rather than actually run a regression, we use the SLOPE and INTERCEPT functions to show the regression coefficients.

Forecasting InventoriesSales

Inventories = Intercept x coefficient x 2009 = -35.703 0.186 $ 3,300 = $578.23

Now, we will repeat this procedure to forecast accounts receivables

Forecasting Accounts ReceivableSales

Receivables = Intercept x coefficient x 2009 = 62.433 0.097 $ 3,300 = $381.30

This value for inventories is much less than the original value calculated using the percentage of sales method. Looking at the "R2" value in the chart, we see that the correlation between sales and inventories in this linear framework is 0.505. This implies that there is a moderately strong relationship between sales and inventories. While this figure is not a direct indicator of asset requirements, it does give financial managers a reasonable basis for forecasting the target inventory levels.

Again, we observe that our regression estimate is less than the estimate as predicted by the percentage of sales method. However, we also observe that there is a stronger correlation between sales and receivables, than with inventories. We see this through the R2 of 0.8076.

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $0

$50

$100

$150

$200

$250

$300

$350

$400

f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845

Sales ($ Millions)

Acco

unts

Rec

eiva

ble

($ M

illio

ns)

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $0

$100

$200

$300

$400

$500

$600

$700

f(x) = 0.18603956343385 x − 35.7029844369485R² = 0.505467821620517

Sales ($ Millions)

Inve

ntor

ies

($ M

illio

ns)

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $0

$50

$100

$150

$200

$250

$300

$350

$400

f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845

Sales ($ Millions)

Acco

unts

Rec

eiva

ble

($ M

illio

ns)

Rather than actually run a regression, we use the SLOPE and INTERCEPT functions to show the regression coefficients.

$2,000 $2,200 $2,400 $2,600 $2,800 $3,000 $3,200 $0

$50

$100

$150

$200

$250

$300

$350

$400

f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845f(x) = 0.0966267108451373 x + 62.4325312291793R² = 0.809855163490845

Sales ($ Millions)

Acco

unts

Rec

eiva

ble

($ M

illio

ns)

SECTION 12.3SOLUTIONS TO SELF-TEST

3 Suppose MicroDrive's growth rate in sales is forecast as 15 percent. If all ratios stay the same, what is the AFN?

Sales growth rate 15%$3,000 million

66.666%6.667%

Profit margin (M) 3.783%Retention ratio 49.330%

$450.00 million$3,450.00 million

AFN $205.62 million

S0

A*/ S0

L*/ S0

D SalesS1

3 Suppose MicroDrive's growth rate in sales is forecast as 15 percent. If all ratios stay the same, what is the AFN?