Financial Planning and Forecasting

Financial Planning and Forecasting Long-Term Planning September 2003 Coping with Uncertainty The analysis of a case in the presence of uncertainty is usually done as follows: 1 Scenario Analysis This analysis provides a best case (sales are as high as possible, customers pay rapidly, costs are low, etc), an expected case and a worst case (sales are as low, customers take more time to pay, costs are high, etc) The goal of this analysis is to prepare the firm for unexpected situations A scenario analysis gives the figures that would arise in the case of a disaster 2

Coping with Uncertainty 2 Sensivity Analysis To avoid the catastrophic situation depicted in the scenario analysis (the worst-case scenario), the firm has a lot of variables to watch: variable costs, fixed costs, wages, salaries, collections of accounts receivable, payments of accounts payable, and so on Because it is costly to monitor all these items at the same time, the firm must concentrate on the most important ones Important variables are found through sensitivity analysis, which consists of looking at how end results vary with changes in one variable (collections of A/R, for example) 3 Coping with Uncertainty 2 Simulation Analysis This is a combination of the scenario and sensitivity analyses That is, values for variable costs, collections of A/R, payments of A/P, fixed asset outlays, to name only these few, would vary each period according to some prespecified probability distributions Running many simulations yields a distribution of outcomes that provides further information to the firm, such as the variability of the possible outcomes 4

Coping with Uncertainty Simulation Analysis For example, collections of accounts receivable (% of cash sales, % of sales paid after 30 days, % of sales paid after 60 days, % of sales never paid) for a given month s sales could have the following distribution: (30%, 50%, 20%, 0%) with 10% probability, (25%, 50%, 25%, 0%) with 15% probability, (20%, 50%, 30%, 0%) with 50% probability, (15%, 50%, 34%, 1%) with 15% probability, (10%, 50%, 38%, 2%) with 10% probability, 5 Coping with Uncertainty Simulation Analysis Using the above distribution and other distributions for all other variables (costs, for example), a computer (or dice) is used to run many simulations Suppose a simulation generating 1,000 observations is run and the following numbers for line of credit needed in November are obtained: 6

Simulation Analysis Line of credit Number of observations 20 5 21 8 74 39 75 100 76 150 77 99 80 50 100 8 105 4 1,000 What is this distribution telling us (center, dispersion)? 7 Coping with Uncertainty Simulation Analysis Suppose a another simulation generating 1,000 observations is run using different probability distributions for the relevant variables and the following numbers for line of credit needed in November are obtained: 8

Simulation Analysis Line of credit Number of observations 20 25 21 28 74 32 75 32 76 35 77 30 80 28 100 24 105 21 1,000 How is this distribution different from the first one? 9 43 Fundamentals of Preparing Pro Forma Statements A cash budget is not the only statement that must be forecasted Future profits and financial needs must also be projected The three main outputs of financial forecasting are 1 Pro forma income statement 2 Pro forma balance sheet 3 A statement of external financing required (EFR) 10

43 Fundamentals of Preparing Pro Forma Statements Preparing pro forma statements requires a set of assumptions about the increase in sales, the increase in costs, the increase in assets, the increase in debt, etc 11 43 Fundamentals of Preparing Pro Forma Statements Preparing the pro forma statements requires the use of plug variables A plug variable varies to ensure that the balance sheet balances and to ensure that the pro forma balance sheet figures are consistent with the pro forma income statement figures That is, the growth assumptions cannot concern all items on the statements How plug variables vary will determine the firm s external financing required 12

A Simple Financial Planning Model Income Statement Sales 1,000 Costs (800) Net income 200 Dividends 100 Earnings retained 100 Computerfield Corporation Current Financial Statements Balance Sheet Assets 500 Debt 250 Equity 250 Total 500 Total 500 13 A Simple Financial Planning Model Example 1 Assumptions: Sales, costs, assets, debt and equity are all expected to increase by 20% in the coming year Dividends is the plug variable: Income Statement Sales 1,200 Costs (960) Net income 240 Dividends? Earnings retained 50 Computerfield Corporation Pro Forma Financial Statements Balance Sheet Assets 600 Debt 300 Equity 300 Total 600 Total 600 14

A Simple Financial Planning Model Example 1 (continued) Equity is expected to increase by 50 while net income is expected to be 240 For the pro forma income statement to be consistent with the pro forma balance sheet, dividends must be 240 50 = 190 Dividends is used at the plug variable in the present example The next example uses a different plug variable A Simple Financial Planning Model 15 Example 2 Assumptions: Sales, costs, assets, are all expected to increase by 20% in the coming year The dividend payout ratio will remain 50% of net income, so debt is the plug variable Income Statement Sales 1,200 Costs (960) Net income 240 Dividend 120 Earnings retained 120 Computerfield Corporation Pro Forma Financial Statements Balance Sheet Assets 600 Debt? Equity 370 Total 600 Total 600 16

A Simple Financial Planning Model Example 2 (continued) Total liabilities and equity are expected to increase to 600 while equity is expected to be 370 For the pro forma balance sheet to balance, future debt has to be 600 370 = 230, ie debt has to be reduced by 20 17 A Simple Financial Planning Model In the last example, EFR is -20, ie the firm will be able to repay $20 of long-term debt if the projections are correct There are many ways to construct pro forma statements Two of these are: The percent-of-sales approach The judgemental approach 18

The Percent-of-Sales Approach The percent-of-sales approach assumes that some items on the income statement and balance sheet always vary in proportions with sales For example, it may be reasonable to assume that current assets increase by 20% whenever sales increase by 20% There are some items, however, that do not have to vary in the same proportions as sales These are debt, common stock, retained earnings, short-term debt and interest payments, among others Other balance sheet items, such as accounts receivable, can also be relatively independent of sales, as we will see in the judgemental approach 19 The Percent-of-Sales Approach: An Illustration Consider the following statements: Rosengarten Corporation Current Financial Statements (in millions of $) Income Statement Sales 1,000 Costs (800) Taxable income 200 Taxes (34%) (68) Net income 132 Dividend (3333%) 44 Earnings retained 88 Balance Sheet Cash 160 A/P 300 A/R 440 N/P 100 Inventory 600 CL 400 CA 1,200 LTD 800 NFA 1,800 C/S 800 R/E 1,000 Total 3,000 Total 3,000 20

The Percent-of-Sales Approach: An Illustration Main assumption: Sales are expected to increase by 25% Assumptions concerning the income statement: Costs are a constant fraction of sales (800/1,000 = 80%) The tax rate is not expected to change (34%) Dividend payout ratio will remain constant (3333%) 21 The Percent-of-Sales Approach: An Illustration Assumptions concerning the balance sheet (assets): Each current asset is a constant fraction of sales: 160 = 16% 1,000 for Cash, 440 = 44% 1,000 for A/R, 600 = 60% 1,000 for inventory 22

The Percent-of-Sales Approach: An Illustration Assumptions concerning the balance sheet (assets): The firm will keep operating at the same capacity level, measured by NFA Sales = 1,800 1,000 = 18 That is, NFA in the pro forma balance sheet have to be equal to 18 times sales 23 The Percent-of-Sales Approach: An Illustration Assumptions concerning the balance sheet (liabilities): Accounts payable are a constant fraction of sales (30%) Notes payable and long-term debt are independent of sales (these are plug variables) Retained earnings increase depends on the plowback ratio, which is 6666% in this example Common stock is independent of sales (also a plug variable) 24

The Percent-of-Sales Approach: An Illustration Before adjusting the plug variables: Rosengarten Corporation Partial Pro Forma Financial Statements (in millions of $) Income Statement Sales 1,250 Costs (1,000) Taxable income 250 Taxes (34%) (85) Net income 165 Dividend (3333%) 55 Earnings retained 110 Balance Sheet Cash 200 A/P 375 A/R 550 N/P? Inventory 750 CL? CA 1,500 LTD? NFA 2,250 C/S? R/E 1,110 Total 3,750 Total 3,750 25 The Percent-of-Sales Approach: An Illustration This 25% growth has to be financed with debt and/or equity The external financing required (EFR) is EFR = 3,750 3,000 }{{} Change in TA (110 + 75) }{{} Internal financing = $565 million 26

The Percent-of-Sales Approach: An Illustration The firm might follow some guidelines as to how funds can be raised These guidelines could be, for instance, 1 Use debt first (short-term then long-term); 2 Sell stocks only if necessary 27 The Percent-of-Sales Approach: An Illustration How much new debt to issue? This depends on the firm s constraints Example of constraints: The current ratio must not be smaller than 3, say (the actual current ratio) This constraint limits short-term borrowing The total debt ratio must not exceed 04, say (the actual total debt ratio) This constraint limits long-term borrowing once short-term borrowing has been exhausted Raise the remaining funds through equity offering 28

The Percent-of-Sales Approach: An Illustration Possible Financing Scenario Current ratio: 3 Total debt ratio: 04 Short-Term Borrowing (Notes Payable) Current Ratio = CA CL = 1,500 CL = 3 CL = $500 million 29 The Percent-of-Sales Approach: An Illustration Actual current liabilities are $475 million, so they can be increased by $25 million Hence, Rosengarten can raise up to $25 million using N/P The firm has to find $565 million If $25 million are obtained through N/P, $540 million have to be raised using long-term debt and common stock 30

The Percent-of-Sales Approach: An Illustration Long-Term Debt Total Debt Ratio = Total debt Total assets = Total debt 3,750 = 04, which gives Total debt = $1, 500 million Thus the firm can raise up to 1,500 500 800 = $200million in long-term debt, which leaves us with 540 200 = $340 million to find 31 The Percent-of-Sales Approach: An Illustration The remaining $340 million will be raised through a common stock issue, which gives the following pro forma statements: Rosengarten Corporation Pro Forma Financial Statements (in millions of $) Income Statement Sales 1,250 Costs (1,000) Taxable income 250 Taxes (34%) (85) Net income 165 Dividend (3333%) 55 Earnings retained 110 Balance Sheet Cash 200 A/P 375 A/R 550 N/P 125 Inventory 750 CL 500 CA 1,500 LTD 1,000 NFA 2,250 C/S 1,140 R/E 1,110 Total 3,750 Total 3,750 32

The Judgemental Approach This method is more complex than the percent-of-sales approach and attempts to control for the weaknesses of the latter That is, there are many items on the financial statements that may be related to the firm s objectives more than the firm s sales For example, the firm may want to reduce its average collection period if it is much higher than the industry average Hence variables using this method are not strictly driven by the level of sales 33