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© 2010 Institute of Business ManagementFinancial Management,

Prepared by: Amyn Wahid

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The Ingredients of a Financial The Ingredients of a Financial PlanPlan

A financial plan consists of several ingredients• Expectations about the economic

environment• A sales forecast• Cash Budget• Pro forma (forecasted) financial statements• Asset requirements• Required new financing

We will focus on developing the pro formas financial statements

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Financial Statements Financial Statements ForecastingForecasting

The Percent of Sales Method

• Once sales have been forecasted , we must forecast future balance sheet and income statements.

• The most common method is the percent of sales method • Many items on the income statement and the balance

sheet are assumed to increase proportionately with sales.• Each item will grow at the same rate (%) as sales and this

approach is called the constant ratio method.• Every case could vary so the assumptions pertaining to a

particular question need to be strictly followed.

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Types of Assets and Types of Assets and LiabilitiesLiabilities

There are two types of assets:• Current assets are the firm’s short-term assets and

can generally be expected to vary directly with sales• Fixed assets are the firm’s long-term assets and

generally do not vary directly with sales There are two types of liabilities:

• Spontaneous liabilities are those that occur naturally during the ordinary course of doing business. These sources vary directly with sales

• Discretionary liabilities are those that require a special effort for the firm to obtain. These sources do not vary directly with sales

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Elvis Products InternationalElvis Products InternationalKey DataKey Data

Lets analyze this method in detail with the subsequent example of Elvis Products International

The company will be operating below capacity in 1998. Sales is expected to increase by 10% Spontaneous assets & liabilities grows proportionally with

sales. Cash & equivalent levels are expected to be maintained at

the same as the previous year. The company expects to give $22,000 as dividends in

1998. We need to prepare here the forecasted financial

statements of EPI for 1998.

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No change

Forecasting the Income Forecasting the Income StatementStatement

Elvis Products International

Pro Forma Income Statement

For the Year Ended December 31, 1998 (figures in ‘000)

  1998* 1997 1996

Sales $4,235.00 $3,850.00 $3,432.00

Cost of Goods Sold $3,575.00 $3,250.00 $2,864.00

Gross Profit $660.00 $600.00 $568.00

Selling and G&A Expenses $363.33 $330.30 $280.00

Fixed Expenses $100.00 $100.00 $100.00

Depreciation Expense $20.00 $20.00 $18.90

EBIT $176.67 $149.70 $169.10

Interest Expense $76.00 $76.00 $62.50

Earnings Before Taxes $100.67 $73.70 $106.60

Taxes @ 40% $40.27 $29.48 $42.64

Net Income $60.40 $44.22 $63.96

  * Forecasted      

Other Data    

Cash Dividends $22.00 $15.00 $10.00

Increase in Retained Earnings $38.40 $29.22 $53.96

       

Note:- The company expects to give cash dividends of $22,000 in 1998      

Sales forecastedto increase

by 10%

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Forecasting the Balance Forecasting the Balance SheetSheetElvis Products International Elvis Products International

Pro Forma Balance Sheet

As of December 31, 1998 (figures in ‘000)

Assets 1998* 1997 1996

Cash and Equivalents $52.00 $52.00 $57.60

Accounts Receivable $442.20 $402.00 $351.20

Inventory $919.60 $836.00 $715.20

Total Current Assets $1,413.80 $1,290.00 $1,124.00

Plant & Equipment $527.00 $527.00 $491.00

Accumulated Depreciation $186.20 $166.20 $146.20

Net Fixed Assets $340.80 $360.80 $344.80

Total Assets $1,754.60 $1,650.80 $1,468.80

Liabilities and Owner's Equity      

Accounts Payable $192.72 $175.20 $145.60

Short-term Notes Payable $225.00 $225.00 $200.00

Other Current Liabilities $154.00 $140.00 $136.00

Total Current Liabilities $571.72 $540.20 $481.60

Long-term Debt $424.61 $424.61 $323.43

Total Liabilities $996.33 $964.81 $805.03

Common Stock $460.00 $460.00 $460.00

Retained Earnings $264.39 $225.99 $203.77

Total Shareholder's Equity $724.39 $685.99 $663.77

Total Liabilities and Owner's Equity $1,720.72 $1,650.80 $1,468.80

Discretionary Financing Needed -$33.88 Deficit  

* Forecasted      

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Discretionary Financing Discretionary Financing NeededNeeded

Ordinarily, the pro-forma balance sheet will not balance!

This is intentional, and the amount needed to make it balance is referred to as the Discretionary Financing Needed, DFN (or External Financing Needed, EFN)

This is a “plug figure” that represents the amount of discretionary financing that the firm will need to obtain in order to support its forecasted level of sales

In the case of Elvis Products International , the discretionary financing figure is $33.88 which has to be provided in one of the following ways (shown in the next slide)

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Discretionary Financing Discretionary Financing NeededNeeded

The four common methods of discretionary financing

are as follows:-

Borrow more short-term (Notes Payable) Borrow more long-term (LT Debt) Sell more common stock (CS & APIC) Decrease dividend payout, which increase

Add. To RE

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Most Firms forecast their capital requirements by constructing pro forma income statements and balance sheets as explained before.

However if the ratios are expected to remain constant, then the following formula can be used to forecast financial requirements

AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)

The AFN FormulaThe AFN Formula

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AFN = (A*/S0)S (L*/S0)S M(S1)(1 - d)

AFN =

A* = assets that are tied directly to sales, hence must increase if sales are to increase.

S0 = Sales during the last year. L* = Liabilities that increase spontaneously. S1 = total sales projected for next year. S = change in sales. M = profit margin

However if the ratios are expected to remain constant, then the following formula can be used to forecast financial requirements

Spontaneous

liabilityincrease

Required

assets

increas

e

Increase in retainedearnings

The AFN FormulaThe AFN Formula

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AFN (Additional Funds AFN (Additional Funds Needed):Needed):

Key AssumptionsKey Assumptions To illustrate the calculation of AFN, consider the

given data of Funky House for 2001. Operating at full capacity in 2001. Each type of asset grows proportionally with

sales. Payables and accruals grow proportionally with

sales. 2001 profit margin (2.52%) and payout (30%) will

be maintained. Sales are expected to increase by $500 million.

(%S = 25%)

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2001 Balance Sheet2001 Balance Sheet(Millions of $)(Millions of $)

Cash & sec. $ 20 Accts. pay. &accruals $ 100

Accounts rec. 240 Notes payable 100Inventories 240 Total CL $ 200 Total CA $ 500 L-T debt 100

Common stk 500Net fixedassets

Retainedearnings 200

Total assets $1,000 Total claims $1,000 500

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2001 Income Statement2001 Income Statement(Millions of $)(Millions of $)

Sales $2,000.00Less: COGS (60%) 1,200.00 SGA costs 700.00 EBIT $ 100.00Interest 16.00 EBT $ 84.00Taxes (40%) 33.60Net income $ 50.40Dividends (30%) $15.12Add’n to RE $35.28

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Assets

Sales0

1,000

2,000

1,250

2,500

A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.

Assets =(A*/S0)Sales= 0.5($500)= $250.

Assets = 0.5 sales

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What is the AFN, based on What is the AFN, based on the AFN equation?the AFN equation?

AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)

= ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0252($2,500)(1 - 0.3)

= $180.9 million.

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Assumptions about How AFN Assumptions about How AFN Will Will

Be RaisedBe Raised

No new common stock will be issued. Any external funds needed will be

raised as debt, 50% notes payable, and 50% L-T debt.

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How will the AFN be How will the AFN be financed?financed?

Additional notes payable = 0.5 ($180.9) = $90.45 $90.

Additional L-T debt = 0.5 ($ 180.9) = $90.45 $90.

But this financing will add 0.08($180.9) = $14.472 to interest expense, which willlower NI and retained earnings.(assuming the average interest rate of 8% on the debt)

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