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Chapter 16

Chapter 16. Financial Planning and Forecasting. Financial Forecasting Steps. 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. Our Problem: Zippy Drives, Inc.

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Chapter 16

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  1. Chapter 16 Financial Planning and Forecasting

  2. Financial Forecasting Steps • 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

  3. Our Problem: Zippy Drives, Inc. • 2006 Sales 10,000,000 • 2006 Total Assets 8,000,000 • Want to project 2007 financial statements based on a 30% increase in sales. • Projected 2007 Sales 10,000,000(1.30) = $13,000,000

  4. Zippy Drives Inc. 2006 Balance Sheet ($000)

  5. Zippy Drives 2006 Income Statement

  6. AFN formula Key Assumptions: Known as percentage of sales approach. • Zippy is operating at full capacity in 2006. • Each type of asset grows proportionally with sales. • Accounts payable and accruals grow proportionally with sales. • 2006 profit margin (15%) and payout (30%) will be maintained. • Sales are expected to increase by $3 million. (%S = 30%)

  7. Income Statement Projection

  8. Balance Sheet Projection: The Assets

  9. Projected Liabilities & Equity

  10. Oh no! Here come the Accounting Police! Projected 2007 Assets 10,400 Projected 2007 Liab&Eq 9,815 Additional Financing Needed 585 • Assume Zippy will raise 40% of additional financing needed through Notes Payable and the rest (60%) through Long-term Debt. • Addition to Notes Payable 234 • Addition to Long-term Debt 351

  11. Projected Liab & Eq to keep away the accounting police.

  12. AFN equation: When you just need to know additional financing needed. AFN = (A*/S)S - (L*/S)S - M(S1) (RR) RR = retention ratio = 1 – dividend payout AFN = ($8,000 / $10,000) ($3,000) - ($1,500 / $10,000) ($3,000) - 0.15($13,000) (1- 0.3) = $585.

  13. Key Zippy Ratios

  14. Key Determinants of External Funds Requirements (AFN) • Sales growth: higher growth leads to more AFN • Capital Intensity Ratio (A/S): higher A/S leads to more AFN • Spontaneous liabilities to sales ratio (L/S): higher ratio means more internal financing and less AFN • Profit Margin (M): higher profit margin means higher net income and less AFN • Retention Ratio: higher ratio means more retained earnings and less AFN

  15. Forecasting with less than Full Capacity • Assume Zippy’s net fixed assets were operating at 80% capacity and current assets at 100% capacity in 2006. • How would Zippy’s additional financing needed change? • Need to know what level of sales Zippy’s existing net fixed assets can support or produce = Full Capacity Sales

  16. Zippy’s Full Capacity Sales and projected new fixed assets • Full Capacity Sales (FCS) = Current Sales/% of Capacity • Zippy’s 2006 Sales = 10,000 • 80% Capacity • Full Capacity Sales = 10,000/0.8 = 12,500 • Target FA Ratio = 2006 FA/ FCS • 4000/12,500 = 0.32 = 32% • Proj FA = 0.32(proj sales) = 0.32(13,000) = 4,160

  17. Projected Assets with 80% capacity

  18. New AFN is -455 • This means Zippy can reduce debt to make the projected balance sheet balance or just add the surplus financing to the cash account.

  19. Caveats • We have assumed a constant profit margin which means interest expense is assumed to increase proportionally with sales. • A company’s financing decision may cause the actual interest expense to be higher or lower than this projection. • If the additional financing decision causes interest expense to be higher, then even more financing will be needed.

  20. Other Financial Forecasting Approaches • Instead of assuming individual assets will remain a constant percentage of sales, a company can modify their forecast by: • using regression analysis to project individual asset accounts. • using target financial ratios to project individual asset accounts.

  21. Target Financial Ratio Example • Zippy’s 2006 DSO is 73 days, they plan to improve their collection policy and lower their DSO to 60 days in 2007. What is their projected 2007 receivables (projected sales 13,000,000) and reduction in AFN vs. their current DSO? • DSO = Receivables/(sales/365) • Receivables = DSOx(sales/365)

  22. New Receivables projection = 60 x (13,000,000/365) = 2,136,986 • Our “original” projection = 73 x (13,000,000/365) = 2,600,000 • Reduction in projected receivables = 2,600,000 – 2,136,986 = 463,014 • 463,014 is also the reduction in AFN.

  23. Financial ForecastingSummary • Unless stated otherwise, all expenses are assumed to increase proportionally with sales, yielding the same profit margin • At full capacity, all assets increase proportionally with sales • Only accounts payable and accrued taxes and wages(accruals) increase proportionally with sales • Forecasted Retained Earnings are added to the previous year’s b/s acct. 1

  24. Chapter 16 Summary (cont.) • With financial statement forecast, AFN = projected total assets - projected liab&eq • Proj. spontaneous assets and liabilities = last year’s ratio of each account to sales times forecasted sales • AFN is plug amount that makes the balance sheet balance • With AFN equation, AFN = projected change in assets - proj. change in liabilities - projected new retained earnings 2

  25. End of Chapter 16 Summary • If fixed assets are operating at less than 100% capacity, determine full capacity sales • Full capacity sales = old sales/ % of capacity • If projected sales < full capacity sales, no increase in fixed assets is needed • If projected sales > full capacity sales, then proj. FA = old FA/Full capacity sales times projected sales 3

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