Financial Planning and Forecasting The Judgmental Approach September 2003 Weaknesses of the Percent-of-Sales Approach The percent-of-sales approach has three weaknesses: 1. It is unrealistic to assume that all expenses will remain exactly the same percent of sales from one fiscal year to the next. 2. With the percent-of-sales method, a company is essentially locked into a given profit margin. 3. The percent-of-sales approach assumes that all of the firm s costs are variable. Fixed costs create leverage. 2
Example Vectra Manufacturing Actual and Pro Forma Income Statements (POS Approach) 2002 Percent 2003 Percent (Actual) of sales (Pro Forma) of sales Sales 100,000 140,000 Less: COGS 80,000 80% 112,000 80% Gross Margin 20,000 20% 28,000 20% Less: Operating expenses 10,000 10% 14,000 10% Operating earnings 10,000 14,000 Less: Interest expenses 1,000 1% 1,400 1% Earnings before taxes 9,000 12,600 Less: Taxes (15%) 1,350 1,890 Net income after tax 7,650 7.7% 10,710 7.7% Common share dividends 4,000 5,600 Earnings retained 3,650 5,110 3 Example (Continued) Suppose Vectra is not happy with its current profit margin of 7.7%. The average ratios for gross and profit margins are 28% and 12.5%, respectively, in Vectra s industry. Hence Vectra should be able to better control costs and increase margins. 4
Example (Continued) Suppose that Vectra has the following figures in mind: COGS: 76% of sales instead of 80%. Operating expenses: 11% of sales instead of 10%. Note that a new, more efficient, machine implies greater amortization expense, which could be the cause of this increase. Interest expenses: Should not be greater than $1,100. Dividends: Will remain constant at $4,000. What s your opinion on this one? 5 Example (Continued) Vectra Manufacturing Actual and Pro Forma Income Statements (Judgmental Approach) 2002 Percent 2003 Percent (Actual) of sales (Pro Forma) of sales Sales 100,000 140,000 Less: COGS 80,000 80% 106,400 76% Gross Margin 20,000 20% 33,600 24% Less: Operating expenses 10,000 10% 15,400 11% Operating earnings 10,000 18,200 Less: Interest expenses 1,000 1% 1,100 0.8% Earnings before taxes 9,000 17,100 Less: Taxes (15%) 1,350 2,565 Net income after tax 7,650 7.7% 14,535 10.4% Common share dividends 4,000 4,000 Earnings retained 3,650 10,535 6
Percent-of-Sales Approach and Fixed Costs The POS approach assumes that the firm has no fixed costs, i.e. all costs increase with sales. A growing firm benefits from having fixed costs since these remain constant as sales increase, thus increasing the profit margin. Rent, amortization, management salaries, property taxes, marketing, and research and development are examples of fixed costs. 7 Variable and Semi-Variable Costs Variable costs, on the other hand, always vary with sales. Examples of these are raw material, labour, factory overhead and sales commissions. Note that there also are semi-variable costs, which vary with sales only once they have reached a certain level. That is, semi-variable costs will not vary for low sales levels. Take equipment maintenance, for example. A minimum amount of maintenance must always be performed regardless of the sales level but more maintenance must be performed as sales increase beyond a certain point. 8
Profit Margin and Fixed Costs Let S Sales (in $), v Variable costs per $ sold, F Fixed Costs, t Corporate Tax Rate. EBT = S vs F NIAT = (1 t)((1 v)s F), where NIAT is net income after taxes. 9 Profit Margin and Fixed Costs This gives Profit Margin = NIAT S = (1 t)((1 v)s F) S = (1 t)(1 v) (1 t)f S. 10
Profit Margin and Fixed Costs Profit Margin = (1 t)(1 v) (1 t)f S Remarks: In the absence of fixed costs (F = 0), profit margin is constant. In the presence of fixed costs (F > 0), profit margin increases when sales increase. 11 Profit Margin and Fixed Costs In the Vectra example, suppose that, in 2002, fixed costs were $21,000: $12,000 in COGS, $8,000 in operating expenses (OE) and $1,000 in interest expenses. As a fraction of sales, variable costs were then Variable Costs Sales = = = Variable COGS + Variable OE S (80,000 12,000) + (10,000 8,000) 100, 000 68,000 + 2,000 = 70%. 100, 000 12
Profit Margin and Fixed Costs If variable costs remain 70% of sales and if fixed costs remain $21,000, net income after taxes (NIAT) in 2003 is expected to be NIAT = (1 t)((1 v)s F) = 0.85 (0.30 140,000 21,000) = 17, 850 and the profit margin is expected to be NIAT S = 17,850 140,000 = 12.75%. 13 Same thing, but using the income statements. Vectra Manufacturing Actual and Pro Forma Income Statements (Judgmental Approach) 2002 Percent 2003 Percent (Actual) of sales (Pro Forma) of sales Sales 100,000 140,000 Less: COGS Fixed 12,000 12,000 Variable 68,000 68% 95,200 68% Gross Margin 20,000 32,800 Less: Operating expenses Fixed 8,000 8,000 Variable 2,000 2% 2,800 2% Operating earnings 10,000 22,000 Less: Interest expenses 1,000 1,000 Earnings before taxes 9,000 21,000 Less: Taxes (15%) 1,350 3,150 Net income after tax 7,650 7.65% 17,850 12.75% 14
4.3 Preparing the Pro Forma Balance Sheet In what follows, the pro forma balance sheet for Vectra Manufacturing will be prepared using the judgmental approach. Income Statement Sales 100,000 COGS (80,000) Op. expenses (10,000) Interest (1,000) EBT 9,000 Taxes (15%) (1,350) Net income 7,650 Dividends 4,000 Earnings ret. 3,650 Vectra Manufacturing 2002 Financial Statements (Actual) Balance Sheet Cash 6,000 A/P 7,000 M/S 4,000 Taxes payable 300 A/R 13,000 Line of credit 8,300 Inv. 16,000 Other 3,400 C.A. 39,000 C.L. 19,000 LTD 18,000 NFA 51,000 C/S 30,000 R/E 23,000 Total 90,000 Total 90,000 15 4.3 Preparing the Pro Forma Balance Sheet The pro forma income statement is as below. For all items other than retained earnings, the firm will proceed step by step. Vectra Manufacturing 2003 Financial Statements (Pro Forma) Income Statement Balance Sheet Sales 140,000 COGS (106,400) Op. expenses (15,400) Interest (1,100) EBT 17,100 Taxes (15%) (2,565) Net income 14,535 Dividends 4,000 Earnings ret. 10,535 Cash? A/P? M/S? Taxes payable? A/R? Line of credit? Inv.? Other? C.A.? C.L.? LTD? NFA? C/S? R/E 33,535 Total? Total? 16
4.3 Preparing the Pro Forma Balance Sheet Let s first look at assets: Cash: Vectra wants a minimum cash balance of $8,000. Marketable Securities (M/S): These are assumed to remain constant at $4,000. 17 4.3 Preparing the Pro Forma Balance Sheet Accounts Receivable: In 2002, average collection period was 100,000/13,000 = 47.45 days. This happens to be 10 days higher than the industry average. Vectra wants its average collection period to be 41 days in 2003, which means that accounts receivable at the end of 2003 should be 140,000/A/R = 41 A/R = 41 140,000 = 15,726. 18
4.3 Preparing the Pro Forma Balance Sheet Inventory: In 2002, average days in inventory was 80,000/16,000 = 73 days. Vectra is happy with this number and wants to have the same in 2003. That is, 106, 400/Inv. = 73 Inv. = 73 106,400 = 21,280. 19 4.3 Preparing the Pro Forma Balance Sheet Net Fixed Assets: Vectra plans to acquire a new machine for $35,000 in 2003, from which $7,000 will be amortized in that year (reflected in the increase in operating expenses). Net fixed assets then increase by 35,000 7,000 = $28,000, which means that NFA in 2003 are expected to be 51,000 + 28,000 = $79,000. 20
4.3 Preparing the Pro Forma Balance Sheet Note that we have enough information so far to determine what total assets will be in 2003: Vectra Manufacturing 2003 Financial Statements (Pro Forma) Income Statement Balance Sheet Sales 140,000 COGS (106,400) Op. expenses (15,400) Interest (1,100) EBT 17,100 Taxes (15%) (2,565) Net income 14,535 Dividends 4,000 Earnings ret. 10,535 Cash 8,000 A/P? M/S 4,000 Taxes payable? A/R 15,726 Line of credit? Inv. 21,280 Other? C.A. 49,006 C.L.? LTD? NFA 79,000 C/S? R/E 33,535 Total 128,006 Total? 21 4.3 Preparing the Pro Forma Balance Sheet Let s now consider liabilities and equity: Accounts Payable: Purchases are 45% of COGS and Vectra s average payment period in 2002 was (0.45 80,000)/7,000 = 71 days. Suppliers want this average to be reduced to 62 days in 2003, which translates into (0.45 106,400)/A/P = 62 days A/P = 62 0.45 106,400 = 8,133. 22
4.3 Preparing the Pro Forma Balance Sheet Taxes Payable: These are assumed to be 25% of the tax amount that appears on the income statement, which is, for 2003, 25% 2,565 = 641. Other Current Liabilities: Remain unchanged. Line of Credit: Depends on the financing plan. Long-Term Debt: Depends on the financing plan. Common Stock: Depends on the financing plan. 23 4.3 Preparing the Pro Forma Balance Sheet We thus have, before adjusting the plug variables, Vectra Manufacturing 2003 Financial Statements (Pro Forma) Income Statement Balance Sheet Sales 140,000 COGS (106,400) Op. expenses (15,400) Interest (1,100) EBT 17,100 Taxes (15%) (2,565) Net income 14,535 Dividends 4,000 Earnings ret. 10,535 Cash 8,000 A/P 8,133 M/S 4,000 Taxes payable 641 A/R 15,726 Line of credit 8,300 Inv. 21,280 Other 3,400 C.A. 49,006 C.L. 20,474 LTD 18,000 NFA 79,000 C/S 30,000 R/E 33,535 Total 128,006 Total 102,009 24
4.3 Preparing the Pro Forma Balance Sheet From these statements, we can find the total financing required (TFR) TFR = Change in Total Assets = 128,006 90,000 = 38,006. Vectra does not need to raise the whole amount from outside investors since some of this change in assets will be financed internally, i.e. using the increases in accounts payable, taxes payable and retained earnings. 25 4.3 Preparing the Pro Forma Balance Sheet The funds raised from outside investors, the external financing required, is found as follows: Total financing required 38,006 Less: Internal sources Increase in accounts payable 1,133 Increase in taxes payable 341 Reinvested profits 10,535 Total internal sources 15,009 External financing required 25,997 26
4.3 Preparing the Pro Forma Balance Sheet Note that my example differs from the one in the book as I assumed the dividend payment to remain $4,000. Now that you know Vectra s external financing required, what are your suggestions regarding a possible financing plan? 27