Fina5340-001 Teaching Notes Spring 2019

CH03 Financial Forecasting

1. Limitations of Ratio Analysis

• Historical performance <> future performance
• Industry average is not
• Inflation not considered
• Changes of future operating policies (such as dividend payment etc)

2. Financial planning and forecasting: Strategic, Operating and Financial

• Pro forma financial statements: pro forma balance sheet, pro forma income statements;
what will the future financial statement look like?
• External Funding Required=Total Uses-Total Sources; based on the same assumptions
as the interim pro forma income statement and balance sheet;
• Cash Budgets: Pro forma statements rely on accrual accounting. Cash budgets are
strictly cash accounting;

3. Pro forma statements could

• forecast external financing needed(EFN),
• forecast impact of change of operating on value of the company,
• set appropriate compensation plan;

4. Financial planning ingredients

• Sales Forecast – most other considerations depend upon the sales forecast, so it is said
to “drive” the model
• Pro Forma Statements – the output summarizing different projections
• Asset Requirements – investment needed to support sales growth
• Financial Requirements – debt and dividend policies
• The “Plug” – designated source(s) of external financing
• Economic Assumptions – state of the economy, anticipated changes in interest rates,
inflation, etc.

5. Methods of pro forma:

-Sales forecast
-Percentage of sales method
-Additional Funds Needed,

6. Steps in pro forma statements;

1) Forecast sales;
2) Project assets to support sales;
3) Project internally needed funds;

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 4) Project outside funds needed;
5) Decide how to raise funds
6) See effects of plan on ratios and stock price;

7. Sales forecast Method

• Sales generate retained earnings (unless all income is paid out in dividends). Retained
earnings, plus external funds raised, support an increase in assets. More assets lead to
more sales, and the cycle starts again.
• This simplified approach assumes that certain items are fixed and other vary
proportionally with sales. Once forecasted, you must select a plug account that will be
used to make the balance sheet balance. This number generally reflects External
Financing Needed (EFN).
• Question “Does a company’s capacity level affect the percentage of sales approach?”
Sales forecast assumptions (better check with sales department and get numbers from them)
1) Naive approach: assume future period’s sales will be equal to last observed period
2) Based on historical growth
3) Level of economic activity and overall demand of the product
4) Market share for each product line in each market
5) Inflation
6) Cost of sales, expenses, advertising, promotions and credit terms

8. Percentage of Sales Method;

• Projecting sales based on forecasted growth rate in sales(based on average of previous
two or three years);
• Forecast some items as a percentage of the forecasted sales(based on average of
previous two or three years)
-Costs of goods
-Cash
-Account receivables
• Items as percentage of sales
-Inventories
-Net fixed assets
-Accounts payable and accruals
• Other Items
-Debt (for interest)
-Dividends (for retained earnings)
-Common stock

9. External Financing Required

EFR= Required Asset Increase
-Spontaneous Liability Increase

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 -Increase in retained earnings

10. Sensitivity Analysis

11. Scenario Analysis
12. Simulation

13. Other pro forma statements

1) Cash budget
2) Operating budget
3) Sales budget
4) Production budget
5) Sales and distribution expense budget
6) Administrative overheads budget

CH03 Example Case-Cartwright Lumber Company Questions:

1) Create funds flow statement for period December 31, 2001 through December 31, 2003
2) Create Pro forma balance sheet at December 31, 2004
3) Create Pro forma income statement at December 31, 2004
4) Why does the company have to borrow to support business growth?
5) How much does the company need to borrow to finance business expansion?
6) Do you agree with the company’s business expansion decisions and the loan
requirement?
7) How attractive is it to take the trade discounts?

CH03 Spreadsheet Exercise 1:

Textbook page 109-111: Problems #7, #8, #9 (only #8 needs to be answered. Please read and
understand solutions to #7 and #9 at end of the book)

CH03 Spreadsheet Exercise 2: creating pro forma financial statements

This is an exercise of how to create pro forma financial statements using Excel. Please use attached Excel
file named as “CH03_Spreadsheet Exercise_Financial_Forecasting” in BB “Course Materials” to answer
the questions in each of the problem.

Part A: Create pro forma financial statements.

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Follow the steps below to prepare pro formas for 2017, assuming that New England Corp. will make up
any funding shortfall with long-term debt, and will use any funding surplus to pay down long-term debt
(i.e., let long-term debt be the plug figure).

1. Starting from sales growth, assume that sales growth in 2017 will be equal to the average sales
growth for 2015 and 2016. Enter the formula for this assumption in the Assumptions section, and then
enter the formula for projected sales in 2017.

2. For all financial statement items that would be expected to vary with sales, use the historical average
over the past three years of the ratio of that item to sales as a projection of the percentage of sales for
2017. In addition to items that typically vary as a percentage of sales, also assume that depreciation
expense, Gross PPE, and short-term debt vary as a percentage of sales.

3. Fill in the 2017 forecast for each item that would be expected to vary with sales

4. Fill in all cells in the 2017 forecast that are just formulas (e.g., pre-tax income is just EBIT – interest
expense).

5. Fill in the other items that would not be expected to vary with sales, that is, everything else except
for long-term debt. Assumptions for the tax rate, dividend payout rate, and interest rates should be
made above in the Assumptions section. For the tax rate and dividend payout rate assume a 2017
projection equal to the average of the previous three years. Assume that interest rates will remain the
same as the previous year. Also assume no new equity will be issued in 2017.

6. Fill in long-term debt as the plug figure. This will be the balancing item that makes assets = liabilities
+ equity. Be careful don’t enter the formula as total assets – (total liabilities + equity) which could cause
a circular reference. Instead, make the formula be total assets – current liabilities – total equity. This
will balance the balance sheet and not be circular.

Q1: Under the assumptions outlined above, what level of long-term debt will be required by New
England Corporation in 2017? _________________

Q2: What is projected net income for New England in 2017? _________________

Part B: Scenario Analysis

1. Scenario 1: Economic downturn-Assume increased competition and a depressed economy limits

sales growth to 7% in 2017. In addition, rising interest rates push the rate on short-term debt to 9.5%.
Also, rising costs lower gross margins, pushing COGS/Sales to 68.5%.

Q3: Under the contraction scenario, what level of long-term debt will be required in 2017?
_________________

Q4: What is projected net income? _________________

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2. Scenario 2-High growth. Unexpected demand pushes sales growth to 30% in 2017. Because some
costs are fixed, SG&A/Sales drops to 7.5%. Also, much of the sales growth is supported by existing
excess capacity, so PPE/Sales is projected to be only 425%. COGS/Sales returns to its initial level
(average of previous 3 years). The interest rate on short-term debt returns to its initial level.

Q5: Under the high-growth scenario, what level of long-term debt will be required in 2017?
_________________

Q6: What is projected net income? _________________

Part C: Break-Even Decisions

Return all assumptions to their initial (Part A) values, including returning sales growth back to the
average of the previous two years, and returning SG&A/Sales and PPE/Sales back to the average of the
previous 3 years.

Assume now that New England Corp. has determined that they cannot exceed $100 million in long-term
debt. So they are looking for other ways to remedy the shortfall in financing. Determine what changes
they would have to make under the following options:

Q7: What if they opt to remedy the shortfall by reducing sales growth? What is the highest growth rate
they could achieve and not exceed the debt limit? _________________

Q8: Return sales growth to its initial level (average of previous 2 years). Now suppose that they want to
remedy the shortfall by cutting the dividend payout ratio. Will this get them under the debt ceiling?
_________________

Q9: Return the dividend payout rate to its initial level (average of previous 3 years). Now suppose that
they want to remedy the shortfall by using fixed assets more efficiently (i.e., by cutting PPE/Sales). Use
Solver to find what PPE/Sales would have to be reduced to in order to stay under the debt ceiling.
_________________

Part D: Sensitivity Analysis

Return all assumptions to their initial (Part A) values, including returning PPE/Sales to the average of the
previous 3 years.

Create a data table to more interactively demonstrate how the requirements for long-term debt
respond to sales growth.

1. In a series of cells in a blank part of the spreadsheet (let’s put them in K8 through P8) enter a series of
growth rates we may want to test on the model (let’s try 5%, 10%, 15%, 20%, 25%, and 30%).

2. In the cell one down and one to the left from your first value (J9 if your first value is in K8), set the cell
equal to projected long-term debt in 2017 with the formula =F47 (if projected long-term debt for 2017 is
in F47).

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3. Now highlight one block of cells that takes in the values and the formula you entered (it should be 2
rows and 7 columns).

4. With that block still highlighted, choose the option Data Table under Data | What-if Analysis. A
dialog box will come up. Here you enter as the Row Input Cell the reference of the cell in which you
would want to test the various growth rates listed in the row in your table (i.e., the reference of the cell
containing the growth rate assumption for 2017). In this example, we’re only creating a one-
dimensional table, so no Column Input Cell is required.

5. When you click on OK, the remainder of the table will fill in with the level of long-term debt that
would be required under the different sales-growth assumptions. This allows you to see a summary of
how much debt is required in different scenarios without changing the spreadsheet each time. Notice
that the data table is interactive; if you change assumptions in the model, the data table adjusts
accordingly.

6. You should add a heading and some labels to your table to remind you of what the data shows.

Q10: Suppose New England Corp. let its accounts payable balloon to 80% of sales. What level of long-
term debt would be required under the six growth rates listed above?

_________________

Part E: Create a Chart

Now create a chart to provide a more visual representation of the information in your data table.
Highlight the two rows and six columns that contain the growth rates and corresponding debt levels.
Select Insert | Scatter and choose straight lines with markers for the sub-type. Next, add titles under
Chart Tools | Layout (the chart must be selected first). A chart title would be something like “Sensitivity
of LT debt to growth rate”, the x-axis title would be “sales growth” and the y-axis title would be “LT debt
in millions”. Once you’ve finished, move and size the table to an appropriate location and shape.

Once your chart is completed, notice that it is also interactive; if you change assumptions in the model,
the chart adjusts accordingly.

Part F: ROE Analysis

Return all assumptions at their initial (Part A) values, including returning accounts payable/sales to the
average of the previous three years.

1. Below the balance sheet (e.g., in row 58) calculate return on equity for each year 2014 to 2016.
(Note: To calculate ROE, one could reasonably divide net income by equity in the same year, equity in
the previous year, or an average of the two. Here let’s just divide by equity in the same year.)

Q11: How does projected ROE for 2017 compare to 2015? _______________________

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2. To better understand projected ROE for 2017, calculate the three levers of ROE for 2014 to 2016 in
the rows below ROE. Recall that the three levers are profit margin, asset turnover and leverage
(assets/equity).

Q12: What is primarily responsible for the projected fall in ROE in 2017 compared to 2015?
_______________

Q13: Why is leverage projected to increase so much for 2017, given that the increase in previous years
has been relatively moderate? ______________________________________________________