FINANCIAL PLANNING AND CONTROL

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

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.

Financial Planning and Control

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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

determine if we need external funds – borrowing or a new stock issue$424$

Percentage of Sales Method

Projected Balance sheet forecasting of AFNIncreased 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 to refine the estimate.$424$

Projected balance sheet

A = L + OE on a balance sheetIf A = L + OE both at the beginning and end of an accounting periodThen

A = L + OE

Which is the fundamental basis for the sources and uses of funds statements

In other words the accounting works rightThe concern is about acquiring outside capitalDebt and EquityBond issue or loansStock IssueExternal sources take a lead time and planning

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 stockCalculate TA - (TL+E) = AFNAFN = additional funds needed from external sources

Hand out simple example

Two pass method example: Northwest Chemical: next year’s Sales Projection(millions of dollars)

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Northwest ChemicalsOregon producer of Ag Chemicals

Prepare financial forecast, main assumption is a 25% increase in salesWant to know how performance/ratios changes.One of the main 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.

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North West Chemical:

Key

Ratios last year

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Key Assumptions

Sales are expected to increase by $500 million. (%S = 25%). Sales factor 1.25

Operated at full capacity last year

Capacity factor 1.25 also

Payables and accruals grow proportionally with sales.Dividend payout (30%) will be maintained.No new common stock will be issued. To finance AFN half notes and half long term debt will be usedInterest rate = 8% for any debt.

Projected Financial StatementsStep 1. Forecast next year’s Income Statement to get Ret. Earn.

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Use to increase

fixed assets and fixed

cost.

NWC: Projected Income Statement:

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Projected Financial Statements

Step 2. Forecast

the Balance Sheet

At full capacity, so all assets must

increase in proportion to sales.

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Projected Financial Statements

Step 2. Forecast the 2001

Balance Sheet (Liability & Equity)

*From projected income statement.

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Forecasted total assets = $1,250

Forecasted financing = $1,071

Forecast AFN

1

= $ 179NWC must have the assets to makeforecasted sales. The balance sheet must balance. So, we must raise $179 externally.

Projected Financial StatementsStep 3. Raising the Additional Funds Needed

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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

reduce NI and retained earnings.How will the AFN be financed?$424$

Projected Financial Statements

Step 4. Financing Feedbacks

The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets.

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NWC:

Revised

Forecast

of Income Statement

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NWC:

Revised

Forecast

of Balance Sheet (Assets)

No change in asset requirements.

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NWC:

Feedback on the Forecast

of

the Balance

Sheet

(Liabilities & Equity)

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Look at a spreadsheet with all of this on one page.

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.

Results of the Adjusted Forecast:

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North West Chemical:

Adjusted Key Ratios

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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 shape

and doesn’t appear to be improving.Analysis of the Forecast:How does North West Chemical Compare?

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Suppose last year fixed assets had been operated at only 75% of capacity:1.25 x .75 = .9375; will be at 93.75% of capacity

Would keep fixed assets and fixed cost the same as last year.

Other Considerations in Forecasting: Excess Capacity

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Suppose last year fixed assets had been operated at 90% of capacity:

1.25 x .90 = 1.125; will be at 112.5% of capacityIncrease fixed assets and fixed cost by 12.5% (example in spreadsheet)

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.

How would excess capacity affect the forecasted ratios?

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Forecasted Ratios:

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Summary: How different factors affect the AFN forecast.

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.

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