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Corporate Financial Planning
Goals of Financial Planning
Identify external financing needs to achieve a target growth rate
Sources of financing– Internal
• Retained earnings
– Autonomous (Spontaneous)• E.g. accounts payable
– External• Debt: Bonds (public) and Loans (private)• Equity: IPO (initial public offerings) and SEO (seasoned
equity offerings)
Pro Forma Financial Statements
Basic Pro Forma Financial Statements – Balance Sheet– Income Statement– Cash Flow Statement
Integrating Pro Forma Financial Statements
The statements are interdependent• Income Statement changes affect Balance
Sheet and Cash Flow (e.g., higher profit may lead to increased cash balances).
• Balance Sheet changes affect Income Statement and Cash Flow (e.g., borrowing leads to interest expense and reduces taxes).
An financial model should integrate the statements
Constructing Pro Forma Financial Statements
Asset-driven versus Sales-driven– Asset-driven: sales depend on total assets– Sales-driven: total assets depend on sales– Both connect sales and assets through total asset
turnover• Total Assets Turnover = Sales / Total Assets
Choosing the Key Forecast Variable: Sales or Assets
Assumptions– Unlimited demand
• Asset-driven: a firm can sell as much as it can make. Sales is limited by available capital funding.
– Unlimited capital funding• Sales-driven: project can raise as much money as it needs to
obtain sales projections. Sales is limited by other factors. No reason to raise funds beyond predicted sales needs.
Key Questions to be Answered in a Sales Forecast
How rapidly will revenue grow?– Sales growth rate
Over what span of time should the forecast be made?– 3 years, 5 years, 10 years, etc.
What is an appropriate forecasting interval?– weekly, monthly, annually, etc.
Factors to Consider in Forecasting
Based on the existing track record of the business– Forecasting in levels or percentages
– Forecasting in real or nominal terms
– Weighting of historical sales data
– Incorporating other factors
Based on historic accounting ratios– Adjust for known changes
• E.g. change in tax rules, new lease contract
Types of Sales Forecast Models
Judgmental– Surveys
• Sales forces• customers
– Market research– Delphi method
Time series– Moving or weighted average– Exponential smoothing– Linear regressions
Causal – multivariable regression models
Principles of Financial Forecasting: Part 1
List ALL assumptions Real versus nominal
– Real (net of inflation)– Nominal (include effects of inflation)– E.g. Unit sales grow at real rate, unit price growth rates include
effects of inflation• Revenue (unit * price) is a nominal cash flow
– Costs items• Cash expenses usually increase with inflation unless a price contract exists• Noncash expenses (e.g. depreciation) are usually not affected by inflation
– Be consistent• Use real discount rate for real cash flows and nominal discount rate for
nominal cash flows
Principles of Financial Forecasting: Part 2
When using historical sales data in forecasting, consider a weighting scheme that focuses on most recent experiences.
For new ventures, choose several “yardstick” firms to use in developing underlying assumptions regarding expected performance.
Percent of Sales Approach– Some items tend to vary directly with sales, while
others do not
Income Statement
If all costs vary directly with sales, then the profit margin is constant
Interpretation of variable and fixed costs depend on forecast horizon.– The constant ratio approach assumes a
linear function. Some costs are better described by a step function or other functions.
Income Statement (continued)
Most operating expenses are estimated as a percentage of sales
Exceptions:– Depreciation expense is related to fixed assets– Interest expense depends on coupon rate and
par value• Interest expense = coupon rate * loan balance• Should we use beginning balance, ending balance
or average balance?
Balance Sheet
Some accounts: e.g. accounts payables, accounts receivables, inventory, will normally vary directly with sales
Notes payable, long-term debt and equity generally depend on management decisions about capital structure
Change in retained earnings (part of total equity) depends on dividend decision
Common Size (Standardized) Financial Statements
Income Statement– Restate all items as a % of Sales
Balance Sheet– Restate all items as a % of Total Assets
Useful for– Comparative analysis against other firms– Comparative analysis overtime
• Using % is especially important for a growing firm
– Creating pro forma statements if past ratios are expected to continue
• Future sales forecast is a KEY assumption in pro forma statements
Financial Ratios
Categories of Financial Ratios – Short-term solvency or liquidity ratios– Long-term solvency or financial leverage ratios– Asset management or turnover ratios– Profitability ratios– Market value ratios
Balance Sheet Items– End of year value versus Average value– This dilemma does not affect income statement items
• Why not?
Summary of Financial Ratios
Sample Balance Sheet
Cash 6,489 A/P 340,220
A/R 1,052,606 Notes 86,631
Inventory 295,255 Other CL 1,098,602
Other CA 199,375 Total CL 1,525,453
Total CA 1,553,725 LT Debt 871,851
Net FA 2,535,072 Equity 1,691,493
Total Assets
4,088,797 Total L.&E. 4,088,797
Numbers in thousands
Sample Income Statement
Revenues 3,991,997
Cost of Goods Sold 1,738,125
Expenses 1,269,479
Depreciation 308,355
EBIT 739,987
Interest Expense 42,013
Taxable Income 697,974Taxes 272,210
Net Income 425,764
EPS 2.17
Dividends per share 0.86
Numbers in thousands, except EPS & DPS
Computing Liquidity Ratios
Current Ratio = CA / CL– 1,553,725 / 1,525,453 = 1.02 times
Quick Ratio = (CA – Inventory) / CL– (1,553,725 – 295,225) / 1,525,453 = .825
times
Cash Ratio = Cash / CL– 6,489 / 1,525,453 = .004 times
Computing Leverage Ratios
Total Debt Ratio = (TA – TE) / TA– (4,088,797 – 1,691,493) / 4,088,797 = .5863 times or
58.63%
– The firm finances almost 59% of their assets with debt.
Debt/Equity = TD / TE (Note: TD=TA-TE)– (4,088,797 – 1,691,493) / 1, 691,493 = 1.417 times
Equity Multiplier = TA / TE = 1 + D/E– 1 + 1.417 = 2.417
Computing Coverage Ratios
Times Interest Earned = EBIT / Interest– 739,987 / 42,013 = 17.6 times
Cash Coverage = (EBIT + Depreciation) / Interest– (739,987 + 308,355) / 42,013 = 24.95 times
Computing Inventory Ratios
Inventory Turnover = Cost of Goods Sold / Inventory– 1,738,125 / 295,255 = 5.89 times
Days’ Sales in Inventory = 365 / Inventory Turnover– 365 / 5.89 = 62 days
Computing Receivables Ratios
Receivables Turnover = Sales / Accounts Receivable– 3,991,997 / 1,052,606 = 3.79 times
Days’ Sales in Receivables (Average Collection Period) = 365 / Receivables Turnover– 365 / 3.79 = 96 days
Computing Total Asset Turnover
Total Asset Turnover = Sales / Total Assets– 3,991,997 / 4,088,797 = .98 times
Measure of asset use efficiency
Computing Profitability Measures
Profit Margin = Net Income / Sales– 425,764 / 3,991,997 = .1067 times or 10.67%
Return on Assets (ROA) = Net Income / Total Assets– 425,764 / 4,088,797 = .1041 times or 10.41%
Return on Equity (ROE) = Net Income / Total Equity– 425,764 / 1,691,493 = .2517 times or 25.17%
Computing Market Value Measures
Market Price = $61.625 per shareShares outstanding = 205,838,594PE Ratio = Price per share / Earnings per share
– 61.625 / 2.17 = 28.4 timesMarket-to-book ratio = market value per share /
book value per share– Book value per share = $1,691,493,000 / 205,838,594
= 8.2176– Market-to-book ratio = 61.625 / 8.2176 = 7.5 times
Du Pont Identity
ROE = (NI/total equity)ROE = (NI/sales) x (sales/assets) x (assets/total equity)ROE = profit margin x total asset turnover x equity
multiplierUse Du Pont Identity to find strengths and weaknesses
Du Pont Identity Example
ROE = 425,764 / 1,691,493 = .2517– Profit Margin =.1067– Total Asset Turnover = .98– Equity Multiplier = 2.417
ROE = .1067 x .98 x 2.417 = .2517
Summary on Growth Rates
Payout and Retention Ratios
Dividend payout ratio = Total cash dividends / Net income = DPS / EPS
• = 0.86 / 2.17 = .3963 or 39.63%
Retention ratio = 1 – payout ratio• = 1 - .3963 = .6037 = 60.37%
Retention ratio = Additions to retained earnings / Net income
The Internal Growth Rate
The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.
%71.6
0671.6037.1041.1
6037.1041.bROA - 1
bROA RateGrowth Internal
Another definition of internal growth rate = ROA x b
The Sustainable Growth Rate
The sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.
%92.17
1792.6037.2517.1
6037.2517.bROE-1
bROE RateGrowth eSustainabl
Another definition of Sustainable Growth Rate = ROE x b
Determinants of Growth
Profit margin – operating efficiencyTotal asset turnover – asset use efficiencyFinancial leverage – choice of optimal debt
ratioDividend policy – choice of how much to
pay to shareholders versus reinvesting in the firm