Chapter 2

Financial Planning

To Thi Thanh Truc

Faculty of Finance and Banking
University of Economics and Law

05/15/2024 2-1
 Learning outcomes
After finishing this chapter you should be able to:
 Understand the financial planning process

 Explain how firms forecast sales.

 Develop pro-forma financial statements using the

percentage of sales approach.

 Use the Additional Funds Needed (or AFN) equation and

discuss the relationship between asset growth and the

need for funds.

2-2
 Materials
 Handout
 Brigham & Houston, Fundamentals of financial
management, chapter 17.

2-3
Outline

 The role and process of financial planning

 Sales forecasting
 The Percentage of Sales Approach
 Additional Funds Needed (AFN) formula

2-4
 Financial planning
 Project the future financial positions of the
firm in the long range.
 Summarized in a financial plan
 Financial plan: The document that includes
assumptions, projected financial
statements, and projected ratios and ties
the entire planning process together

2-5
 Role of Financial Planning
 Examine interactions – help management see the
interactions between decisions
 Explore options – give management a systematic
framework for exploring its opportunities
 Avoid surprises – help management identify possible
outcomes and plan accordingly
 Ensure feasibility and internal consistency – help
management determine if goals can be accomplished
and if the various stated (and unstated) goals of the
firm are consistent with one another

4-6
 Pro Forma Statements
 Three important uses:
 Forecast the amount of external financing
that will be required
 Evaluate the impact that changes in the
operating plan have on the value of the
firm
 Set appropriate targets for compensation
plans

4-7
 Elements of the firm’s financial policy
To develop an explicit financial plan, managers must
establish certain basic elements of the firm’s financial
policy
 The firm’s needed investment in new assets: Capital
budgeting decision
 The degree of financial leverage the firm chooses to employ:
Capital structure policy
 The amount of cash the firm thinks is necessary and
appropriate to pay shareholders: Dividend policy
 The amount of liquidity and working capital the firm needs
on an ongoing basis: net working capital decision.
4-8
 Steps in Financial Forecasting

 First, assumptions are made about the future levels of

sales, costs, interest rates, and so forth, for use in the
forecast.
 Second, a set of projected financial statements is
developed.
 Third, the ratios and stock price are calculated based on
the forecasted financial statements.
 Fourth, the entire plan is reexamined, the assumptions
are reviewed, and the management team considers how
additional changes in operations might improve results.

2-9
 Steps in developing the pro-
forma financial statements
 Sales Forecast – many cash flows depend directly on the
level of sales (often estimated using sales growth rate)
 Project income statement. Pro-forma income statement
help to identify earnings, dividend, and internal fund
generated to support assets
 Asset Requirements –the additional assets that will be
required to meet sales projections
 Financial Requirements – the amount of financing needed
to pay for the required assets
 Plug Variable – determined by management deciding what
type of financing will be used to make the balance sheet
balance.

2-10
 Sales forecast

The sales growth rate is forecasted based on:

 Sales of past years (5 to 10 years)

 The firm’s strategies and plans of market expansion.
 Competition in the market
 Macroeconomic conditions

2-11
Percent of Sales Approach
 Some items vary directly with sales, while others
do not

 Income Statement
 Costs may vary directly with sales - if this is the case,
then the profit margin is constant
 Depreciation and interest expense may not vary directly
with sales – if this is the case, then the profit margin is
not constant
 Dividends are a management decision and generally do
not vary directly with sales – this affects additions to
retained earnings

2-12
 Percent of Sales Approach
 Balance Sheet
 Current assets normally vary directly with sales.
 Fixed assets may or may not vary directly with sales.
 Accounts payable will also normally vary directly with
sales
 Notes payable, long-term debt and equity generally do
not vary directly with sales because they depend on
management’s decisions on capital structure
 The change in the retained earnings, a portion of equity
will come from the dividend decision

2-13
 2018 Balance Sheet
(Millions of $)

Cash & sec. $ 20 Accts. pay. &

accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000

2-14
2018 Income Statement
(Millions of $)

Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA costs 700.00
EBIT $ 100.00
Interest 10.00
EBT $ 90.00
Taxes (40%) 36.00
Net income $ 54.00
Dividends (40%) $21.60
Add’n to RE $32.40
2-15
 Projecting Pro Forma Statements
with the Percent of Sales approach
 Project sales based on forecasted growth rate
in sales
 Forecast some items as a percent of the
forecasted sales
 Costs

 Cash

 Accounts receivable

(More...)
2-16
 Items as percent of sales (Continued...)
 Inventories

 Net fixed assets (may or may not)

 Accounts payable and accruals

 Choose other items

 Debt

 Dividend policy (which determines retained earnings)

 Common stock

2-17
 Percent of Sales: Inputs
2018 2019
Actual Proj.
COGS/Sales 60% 60%
SGA/Sales 35% 35%
Cash/Sales 1% 1%
Acct. rec./Sales 12% 12%
Inv./Sales 12% 12%
Net FA/Sales 25% 25%
AP & accr./Sales 5% 5%
2-18
 Other Inputs

Percent growth in sales 25%

Growth factor in sales (g) 1.25
Interest rate on debt 10%
Tax rate 40%
Dividend payout rate 40%

2-19
Sources of Financing Needed to
Support Asset Requirements

 Given the previous assumptions and

choices, we can estimate:
 Required assets to support sales

 Specified sources of financing

 Additional funds needed (AFN) is:

 Required assets minus specified

sources of financing

2-20
Implications of AFN
 If AFN is positive, then you must
secure additional financing.
 If AFN is negative, then you have
more financing than is needed.
 Pay off debt.
 Buy back stock.
 Buy short-term investments.

2-21
 2019 Forecasted Income
Statement
2019
2018 Factor 1st Pass
Sales $2,000 g=1.25 $2,500.0
Less: COGS Pct=60% 1,500.0
SGA Pct=35% 875.0
EBIT $125.0
Interest 0.1(Debt18) 20.0
EBT $105.0
Taxes (40%) 42.0
Net. income $63.0
Div. (40%) $25.2
Add. to RE $37.8
2-22
How to Forecast Interest Expense

 Interest expense is actually based on the

daily balance of debt during the year.
 There are three ways to approximate interest
expense. Base it on:
 Debt at end of year

 Debt at beginning of year

 Average of beginning and ending debt

More…
2-23
Basing Interest Expense
on Debt at End of Year
 Will over-estimate interest expense if debt
is added throughout the year instead of all
on January 1.
 Causes circularity called financial feedback:
more debt causes more interest, which
reduces net income, which reduces
retained earnings, which causes more debt,
etc.

More…
2-24
Basing Interest Expense
on Debt at Beginning of Year
 Will under-estimate interest expense if debt
is added throughout the year instead of all
on December 31.
 But doesn’t cause problem of circularity.

More…
2-25
Basing Interest Expense on Average
of Beginning and Ending Debt

 Will accurately estimate the interest

payments if debt is added smoothly
throughout the year.
 But has problem of circularity.

More…
2-26
A Solution that Balances Accuracy
and Complexity

 Base interest expense on beginning

debt, but use a slightly higher interest
rate.
 Easy to implement

 Reasonably accurate

2-27
 2019 Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.
2019 Sales = $2,500

Factor 2019
Cash Pct= 1% $25.0
Accts. rec. Pct=12% 300.0
Inventories Pct=12% 300.0
Total CA $625.0
Net FA Pct=25% 625.0
Total assets $1,250.0
2-28
 2019 Preliminary Balance Sheet
(Claims)
2019 Sales = $2,500
2019
2018 Factor Without AFN
AP/accruals Pct=5% $125.0
Notes payable 100 100.0
Total CL $225.0
L-T debt 100 100.0
Common stk. 500 500.0
Ret. earnings 200 +37.8* 237.8
Total claims $1,062.8

*From forecasted income statement.

2-29
 What are the additional funds
needed (AFN)?

 Required assets =
$1,250.0
 Specified sources of fin. =
$1,062.8
NWC mustAFN
Forecast have the assets to = make
$
forecasted
187.2 sales, and so it needs an
equal amount of financing. So, we must
secure another $187.2 of financing.
2-30
 Assumptions about How AFN Will

Be 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.

2-31
 How will the AFN be financed?

Additional notes payable =

0.5 ($187.2) = $93.6.

Additional L-T debt =

0.5 ($187.2) = $93.6.

2-32
 2019 Balance Sheet (Claims)

w/o AFN AFN With AFN

AP/accruals $ 125.0 $ 125.0
Notes payable 100.0 +93.6 193.6
Total CL $ 225.0 $ 318.6
L-T debt 100.0 +93.6 193.6
Common stk. 500.0 500.0
Ret. earnings 237.8 237.8
Total claims $1,062.8 $1,250.0
2-33
 AFN Equation

Additional Additional Additional Addition to

Fund = Asset - Spontaneous - Retained
Needed Required Financing Earning

AFN = (A*/S0).S - (L*/S0) .S - PM. S1.RR

2-34
 AFN Equation

AFN = (A*/S0).S - (L*/S0) .S - PM. S1.RR

A*/S0: assets required to support a dollar of sales; called

capital intensity ratio.
 S: increase in sales.
L*/S0: spontaneous liabilities to sales ratio, spontaneous
generated fund per dollar of sales
PM: profit margin (Net income/sales)
RR: retention ratio; percent of net income not paid as
dividend. 2-35
 Assets must increase by $250
million. What is the AFN, based
on the AFN equation?

AFN = (A*/S0)S - (L*/S0)S - PM(S1)(RR)

= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0270($2,500)(1 - 0.4)
= $184.5 million.

2-36
 AFN (Additional Funds Needed):
Key Assumptions
 Operating at full capacity in 2008.
 Each type of asset grows proportionally with
sales.
 Payables and accruals grow proportionally
with sales.
 2008 profit margin ($54/$2,000 = 2.70%)
and payout (40%) will be maintained.
 Sales are expected to increase by $500
million.
2-37
 Assets
Assets = 0.5 sales

1,250  Assets =
(A*/S0)Sales
1,000
= 0.5($500)
= $250.

0 2,000 2,500
Sales
A*/S0 = $1,000/$2,000 = 0.5 = $1,250/$2,500.
2-38
 How would increases in these
items affect the AFN?
 Higher sales:
 Increases asset requirements, increases
AFN.
 Higher dividend payout ratio:
 Reduces funds available internally,
increases AFN.

(More…)
2-39
 Higher profit margin:
 Increases funds available internally,
decreases AFN.
 Higher capital intensity ratio, A*/S0:
 Increases asset requirements, increases
AFN.
 Pay suppliers sooner:
 Decreases spontaneous liabilities, increases
AFN. 2-40
 Equation AFN = $184.5
vs. Pro Forma AFN = $187.2.
Why are they different?

 Equation method assumes a constant profit

margin.
 Pro forma method is more flexible. More
important, it allows different items to grow
at different rates.

2-41
Operating at Less than Full
Capacity
If the company is operating at less than
full capacity, fixed assets required
should be adjusted.

Sales at Actual Sales

Full =
% capacity
Capacity

2-42
Operating at Less than Full
Capacity

Target ratio of Actual Fixed Assets

Fixed =
Sales at full Capacity
assets/Sales

Fixed Assets Required = (Target ratio of

Fixed assets/Sales) x Projected Sales

2-43
 Suppose in 2018 fixed assets had
been operated at only 75% of
capacity.

Actual sales
Capacity sales =
% of capacity
$2,000
= = $2,667.
0.75
With the existing fixed assets, sales could
be $2,667. Since sales are forecasted at
only $2,500, no new fixed assets are
needed.
2-44
 How would the excess capacity
situation affect the 2019 AFN?

 The previously projected increase in

fixed assets was $125.
 Since no new fixed assets will be
needed, AFN will fall by $125, to
$187.2 - $125 = $62.2.

2-45