Financial Forecasting and Short-term

Financing

Forecasting and Pro Forma Analysis

Timing of financial needs Amount of financial needs Flow of funds Check the covenants

Pro forma Income

Statement

Pro forma Balance

Sheet

Plug Figure Financing Options

Depreciation

Capital ExpendituresChange in Net Plant & Equipment

SalesForecast

Net Income

Dividend Policy Change in Retained

Earnings

Working Capital Accounts External

FinancingRequired

Short-Term Debt

Long-Term Debt

Steps in Financial 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 and stock

price

Sales Forecast

Seasonal changes Business cycle

Recession Expansion

Market segment High growth Contraction

Inflation

2001 Balance Sheet (Millions of $)

Cash & sec. $20 Accts. pay. &  

    accruals $100

Accounts rec. 240 Notes payable 100

Inventories 240 Total CL $200

Total CA $500 L-T debt 100

    Common stk 500

Net fixed   Retained  

Assets 500 Earnings 200

Total assets $1000 Total claims $1000

2001 Income Statement (Millions of $)

Sales $2,000.00

Less: COGS (60%) 1,200.00

SGA costs 700.00

EBIT $100.00

Interest 16.00

EBT $84.00

Taxes (40%) 33.60

Net income $50.40

Dividends (30%) $15.12

Add’n to RE 35.28

AFN (Additional Funds Needed)

Key Assumptions Operating at full capacity in 2001. Each type of asset grows proportionally with

sales. Payables and accruals grow proportionally with

sales. 2001 profit margin (2.52%) and payout (30%) will

be maintained. Sales are expected to increase by $500 million.

(%ΔS = 25%)

AFN (Additional Funds Needed)

AFN= (A*/S0) ΔS - (L*/S0) ΔS - M(S1)(1 - d)

= ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0252($2,500)(1 - 0.3)

= $180.9 million.

Projecting Pro Forma Statements with the

Percent of Sales Method: Project sales based on forecasted growth rate in sales Forecast some items as a percent of the forecasted sales

Costs Cash Accounts receivable

Items as percent of sales Inventories Net fixed assets Accounts payable and accruals

Choose other items Debt (which determines interest) Dividends (which determines retained earnings)

Common stock

Percent of Sales: Inputs

  2001 2002

  Actual Proj.

COGS/Sales 60% 60%

SGA/Sales 35% 35%

Cash/Sales 1% 1%

Acct. rec./Sales 12% 12%

Inv./Sales 12% 12%

Net FA/Sales 25% 25%

AP & accr./Sales 5% 5%

Other Inputs

Percent growth in sales 25%

Growth factor in sales (g) 1.25

Interest rate on debt 8%

Tax rate 40%

Dividend payout rate 30%

2002 1st Pass Income Statement       2002

  2001 Factor 1st Pass

Sales $2,000 g=1.25 $2,500

Less: COGS   Pct=60% 1,500

SGA   Pct=35% 875

EBIT     $125

Interest 16   16

EBT     $109

Taxes (40%)     44

Net. Income     $65

Div. (30%)     $19

Add. to RE     $46

2002 1st Pass Balance Sheet (Assets)

Forecasted assets are a percent of sales.

  2002 Sales = $2,500  

      2002

    Factor 1st Pass

Cash   Pct= 1% $25

Accts. rec.   Pct=12% 300

Inventories   Pct=12% 300

Total CA     $625

Net FA   Pct=25% $625

Total assets     $1250

2002 1st Pass Balance Sheet (Claims)   2002 Sales = $2,500

2002     

  2001 Factor 1st Pass

AP/accruals   Pct=5% $125

Notes payable 100   100

Total CL     $225

L-T debt 100   100

Common stk. 500   500

Ret. earnings 200 +46* 246

Total claims     $1,071

What are the additional funds needed (AFN)?

Forecasted total assets = $1,250 Forecasted total claims = $1,071 Forecast AFN = $ 179

NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must raise $179 externally

How will the AFN be financed?

Additional notes payable= 0.5 ($179) = $89.50 $90.

Additional L-T debt= 0.5 ($179) = $89.50 $89.

But this financing will add 0.08($179) = $14.32 to interest expense, which will lower NI and retained earnings.

2002 2nd Pass Income Statement

  1st Pass Feedback 2nd Pass

Sales $2,500   $2,500

Less: COGS $1,500   $1,500

SGA 875   875

EBIT $125   $125

Interest 16 +14 30

EBT $109   $95

Taxes (40%) 44   38

Net income $65   $57

Div (30%) $19   $17

Add. to RE $46   $40

2002 2nd Pass Balance Sheet (Assets)

  1st Pass AFN 2nd Pass

Cash $25   $25

Accts. rec. 300   300

Inventories 300   300

Total CA $625   $625

Net FA 625   625

Total assets $1,250   $1,250

2002 2nd Pass Balance Sheet (Claims)

  1st Pass Feedback 2nd Pass

AP/accruals $125   $125

Notes payable 100 +90 190

Total CL $225   $315

L-T debt 100 +89 189

Common stk. 500   500

Ret. earnings 246 -6 240

Total claims $1,071   $1,244

Results After the Second Pass

Forecasted assets= $1,250 (no change) Forecasted claims= $1,244 (higher) 2nd pass AFN = $ 6 (short) Cumulative AFN= $179 + $6 = $185. The $6 shortfall came from the $6

reduction in retained earnings. Additional passes could be made until assets exactly equal claims.

Financial Forecasting and Firm Capacity

Balance Sheet ($ in Millions)

Assets 1999 Liabilities and Owners' Equity

1999

Current Assets   Current Liabilities  

Cash 200 Accounts Payable 400

Accounts Receivable 400 Notes Payable 400

Inventory 600 Total Current Liabilities 800

Total Current Assets 1200 Long-Term Liabilities  

    Long-Term Debt 500

Fixed Assets   Total Long-Term Liabilities 500

Net Fixed Assets 800 Owners' Equity  

    Common Stock ($1 Par) 300

    Retained Earnings 400

    Total Owners' Equity 700

Total Assets 2000 Liab. and Owners' Equity 2000

Income Statement ($ in Millions), 1999

 

Sales 1200

Cost of Goods Sold 900

Taxable Income 300

Taxes 90

Net Income 210

Dividends 70

Addition to Retained Earnings 140

Full Capacity

The equation used to calculate EFN when fixed assets are being utilized at full capacity is given below.

S0 = Current Sales, S1 = Forecasted Sales = S0(1 + g), g = the forecasted growth rate is Sales, A*0 = Assets (at time 0) which vary directly with

Sales, L*0 = Liabilities (at time 0) which vary directly with

Sales, PM = Profit Margin = (Net Income)/(Sales), and b = Retention Ratio = (Addition to Retained

Earnings)/(Net Income).

Full Capacity Example

Given that Fixed Assets are being utilized at full capacity and the forecasted growth rate in Sales is 25%.

Forecasted Sales: S1 = 1200(1 + .25) = $1500

Excess Capacity If the firm has excess capacity in its Fixed Assets then the Fixed

Assets may not have to increase in order to support the forecasted sales level. Moreover, if the Fixed Assets do need to increase in order to support the forecasted sales level, then they will not have to increase by as much as would be required if they were being used at full capacity.

If Forecasted Sales are less than Full Capacity Sales, then fixed assets do not need to increase to support the forecasted sales level. On the other hand, if Forecasted Sales are greater than Full Capacity Sales, then Fixed Assets will have to increase.

Case 1: S1 Less Than SFC

Given that Fixed Assets are currently being utilized at 60% of capacity and the forecasted growth rate in Sales is 25%.

S1 = 1200(1 + .25) = $1500 SFC = 1200/.60 = $2000 Forecasted Sales are less than Full Capacity Sales the EFN can

be found in one step. Here A*0 is equal to Total Current Assets

which equals $1200.

Case 2: S1 Greater Than SFC When the Forecasted Sales are greater than Full

Capacity Sales, EFN can be determined in two steps. The first step, EFN1, finds the EFN needed to get to Full Capacity Sales. The second step, EFN2, finds the additional EFN to get from Full Capacity Sales to the Forecasted Sales.

The total EFN is simply EFN1 plus EFN2.

Excess Capacity Example: S1 > SFC Given that Fixed Assets are currently being utilized at

90% of capacity and the forecasted growth rate in Sales is 25%.

S1 = 1200(1 + .25) = $1500 SFC = 1200/.90 = $1333.33

Tracing Cash and Net Working Capital

Current Assets are cash and other assets that are expected to be converted to cash with the year. Cash Marketable securities Accounts receivable Inventory

Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payable Accrued wages Taxes

The Operating Cycle and the Cash Cycle

TimeAccounts payable period

Cash cycle

Operating cycle

Cash received

Accounts receivable periodInventory period

Finished goods sold

Firm receives invoice Cash paid for materials

Order Placed

Stock Arrives

Raw material purchased

Operating Cycle, Inventory turnover, and A/R turnover

Inventory turnover = Sales / Average Inventory, or COGS / Average Inventory [Inventory Conversion = 365 / Inventory turnover]

Accounts Receivable turnover = Sales / AR [Days A/R outstanding = 360 / Accounts Receivable

turnover]

Payable turnover = Purchase (or COGS) / AP [Days A/P outstanding = 360 / Payable turnover]

Operating Cycle = Inventory Conversion + Days A/R outstanding

The Operating Cycle and the Cash Cycle

In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables and days in payables.

Cash cycle = Operating cycle –Accounts payable period

Dell’s Working Capital Policy

Dell’s daily sales was about $20M per day. Dell was able to reduce the need of short term financing $800M. Assuming a 6% short term cost of capital, Dell was able to created $48M more pre tax earnings.

DSI DSO DPO CCC

1996 Q4 31 42 33 40

Improvement -18 -5 +21 -44

1997 Q4 13 37 54 -4

You find the following information from a firm’s financial statements, please calculate its cash (conversion) period?

Beginning Inventory $ 400,000 Purchase $2,600,000 Ending Inventory $ 600,000 Accounts Receivable $ 800,000 Sales $3,600,000 Accounts Payable $ 600,000

$400,000 $2,600,000 $600,000Cost of Goods SoldInventory turnover = 4.8

$400,000 $600,000Average Inventory2

360 360= 75 days

4.8 Inventory Conversion

Inventory Turnover

Sales $3,600,000A/R turnover = 4.5

A/R $800,000

360 360= 80 days

4.5 A/R Days

A/R Turnover

Purchases $2,600,000A/P turnover = 4.33

A/P $600,000

360 360= 83 days

4.33 A/P Days

A/P Turnover

Operating Cycle = Inventory Conversion + A/R Days

Cash Cycle = Operating cycle – A/P days

Operating Cycle = 75 + 80 = 155 days

Cash Cycle = 155 days – 83 days = 72 days

Short term financing:

Advantages: Could be obtained quicker. The amount raised can be flexible. Usually cheaper. (comparing with long-term finance)

Disadvantages High solvency risk: need to be repaid in a short

period. High refinance risk: face highly volatile short-term

interest rates.

Short-term financing strategies Moderate Approach: matching maturities.

Finance long term assets and permanent current assets with long term financing; finance transitory current assets with short term.

Aggressive Approach: Finance part of permanent assets and all transitory assets with short term financing.

Conservative Approach: Finance part of transitory current assets with long-term financing.

The Short-Term Financial Plan The most common way to finance a temporary cash

deficit to arrange a short-term loan. Unsecured Loans

Line of credit down at the bank Secured Loans

Accounts receivable financing can be either assigned or factored.

Inventory loans use inventory as collateral. Other Sources

Banker’s acceptances Commercial paper.