FINANCIAL PLANNING AND CONTROL

1. FINANCIAL PLANNING AND CONTROL • Sales forecasts • Projected financial statements – Additional Funds Needed • Also called External Funds Needed (EFN) • Financial control • Hypothetical Data for Northwest Chemical Company

2. Financial Planning and Control $424$ • Financial Planning The projection of sales, income, and assets based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projections. • Forecasting also is important for production planning and human resource planning. • Financial Control The phase in which financial plans are implemented; control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes.

3. $424$ Financial Planning: • Growth is a key theme behind financial forecasting. Remember that growth should not be the underlying goal of a corporation – creating shareholder value is the appropriate goal. In many cases, however, shareholder value creation is enabled through corporate growth. • The sales forecast predicts a firm’s unit and dollar sales for some future period; generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc. • We want to forecast if we need external funds – borrowing or a new stock issue

4. $424$ Percentage of Sales Method • Projected Balance sheet forecasting of AFN • Increased sales requires increased assets that must be financed. We will discuss the strategy for forecasting assets. • Increased sales automatically increases spontaneous liabilities. • Some financing will come from retained earnings. Depending on the information, we formulate a strategy for determining RE. • If additional funds are needed we have to choose to finance with external funds -- debt or stock. • #5 affects #4 -- thus, we sometimes use an iterative approach.

5. Steps to get AFN – simple one-pass forecast balance sheet method • Calculate RE with the data given (method varies) • Increase CA and spontaneous liabilities proportionately with sales • Increase FA if needed based on capacity information given • Carry over bonds/bank-loans and stock • Calculate TA - (TL+E) = AFN • AFN = additional funds needed from external sources

6. Hand out simple example

7. Two pass method example: Northwest Chemical: 2001 Sales Projection(millions of dollars) $424$

8. $424$ Northwest ChemicalsOregon producer of Ag Chemicals • Prepare financial forecast, main assumption is a 25% increase in sales • Want to know how performance/ratios changes. • One of the hard items is Additional Funds Needed • We will use the percentage of sales method of forecasting financial statements. This will give you a thorough feel for the process of forecasting financial statements.

9. North West Chemical: Key Ratios $424$

10. Projected Financial StatementsStep 1. Forecast the 2001 Income Statement $424$ Key Assumptions • Interest rate = 8% for any debt. • Operating at full capacity in 2000. • Each type of asset grows proportionally with sales. • Payables and accruals grow proportionally with sales. • 2000 payout (30%) will be maintained. • No new common stock will be issued. • Sales are expected to increase by $500 million. (%S = 25%) Implications for fixed assets and fixed cost?

11. There will be simpler problems than this in lab

12. NWC: Projected 2001 Income Statement: $424$

13. Projected Financial StatementsStep 2. Forecast the 2001 Balance Sheet (Assets) $424$ At full capacity, so all assets must increase in proportion to sales.

14. Projected Financial StatementsStep 2. Forecast the 2001 Balance Sheet (Liability & Equity) $424$ *From projected income statement.

15. Projected Financial StatementsStep 3. Raising the Additional Funds Needed $424$ • Forecasted total assets = $1,250 • Forecasted total claims = $1,071 • Forecast AFN1 = $ 179 NWC must have the assets to make forecasted sales. The balance sheet must balance. So, we must raise $179 externally.

16. How will the AFN be financed? $424$ Additional notes payable = 0.5 ($179) = $89.50 Additional L-T debt = 0.5 ($179) = $89.50 But this financing will add 0.08 ($179) = $14.32 to interest expense, which will lower NI and retained earnings.

17. Projected Financial StatementsStep 4. Financing Feedbacks $424$ The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets.

18. NWC: 2001 Adjusted Forecast of Income Statement $424$

19. NWC: 2001 Adjusted Forecast of Balance Sheet (Assets) $424$ No change in asset requirements.

20. NWC: 2001 Adjusted Forecast of Balance Sheet (Liabilities & Equity) $424$

21. Results of the Adjusted Forecast: $424$ • 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 reduced net earnings. Additional passes could be made until assets exactly equal liabilities/equity. ex: $6 (0.08) = $0.48 interest 3rd pass.

22. North West Chemical:Adjusted Key Ratios $424$

23. Analysis of the Forecast: How does North West Chemical Compare? $424$ • Not very profitable relative to other companies in the industry. • Carrying excess inventory and receivables. • Debt ratio projected to move ahead of average. • Overall, not in good shapeand doesn’t appear to be improving.

24. Capacity Issues • Sales last year $500 • Last year at 80% of capacity • Sales will increase 50% • What percentage will fixed cost and fixed assets increase?

25. Actual sales = Full Capacity Sales % of capacity usage Other Considerations in Forecasting: Excess Capacity Suppose in 2000 fixed assets had been operated at only 75% of capacity: $424$

26. With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. Does NWC need additional fixed assets? $424$ How would fixed costs change? Fixed cost would not increase.

27. With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new fixed assets are needed. If NWC had been operating at full capacity, what would its fixed assets/sales ratio be? $424$

28. Projected Financial StatementsStep 2. Forecast the 2001 Balance Sheet (Assets) $424$ At full capacity, so all assets must increase in proportion to sales.

29. How would the excess capacity situation affect the 2001 AFN? $424$ • The projected increase in fixed assets was $125, the AFN would decrease by $125. • Since no new fixed assets will be needed, AFN will fall by $125.

30. NWC: Projected 2001 Income Statement: $424$

31. How would the excess capacity situation affect the 2001 AFN? $424$ • Fixed cost would not increase, increasing EBIT by $175 • In turn net income and RE would increase, thus more internal financing and AFN would be smaller.

32. How would excess capacity affect the forecasted ratios? $424$ • Sales wouldn’t change but assets would be lower, so turnovers would be better. • Less new debt, hence lower interest, so higher profits, EPS,ROE. • Debt ratio, TIE would improve.

33. 2001 Forecasted Ratios: $424$

34. Summary: How different factors affect the AFN forecast. $424$ • Dividend payout ratio changes. If reduced, more RE, reduce AFN. • Profit margin changes. If increases, total and retained earnings increase, reduce AFN. • Plant capacity changes. Less capacity used, less need for AFN. • AP Payment terms increased to 60 days from 30. Accts. payable would double, increasing liabilities, reduce AFN.