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