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ForecastingBusiness Analysis using Financial StatementIntroductionStrategic ManagementDefine explicit strategyFit with the organization and environmentTo achieve organizational goal

Levels of strategyCorporate-level : What business are we inBusiness-level : How do we compete?Functional-level : How do we support the business-level strategy?

Strategy formulation and execution

IntroductionFinancial statements historical data evaluationPlanning Future conditions -- ??

Financial strategyProvide financial resources Analyze impact of strategy to financial condition

Financial ManagementAsset allocationFunding decisions

ForecastingGoal Indicators:SalesProfitAsset

Pro-forma statementsPercent-of-Sales External funding required = TA Liab. -Equity

Percent-of-Sales ForecastingDetermine which financial statement items have varied in proportion to sale

Forecast sales

Estimate individual financial statement itemsPercent of Sales MethodSuppose this years sales will total $32 million.Next year, we forecast sales of $40 million.Net income should be 5% of sales.Dividends should be 50% of earnings.This year % of $32mAssetsCurrent Assets$8m25%Fixed Assets$16m50% Total Assets $24mLiab. and EquityAccounts Payable$4m 12.5%Accrued Expenses$4m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$15mCommon Stock$7mn/aRetained Earnings$2m Equity $9m Total Liab. & Equity$24m7Next year % of $40mAssetsCurrent Assets25%Fixed Assets50% Total AssetsLiab. and EquityAccounts Payable12.5%Accrued Expenses12.5%Notes Payablen/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets50% Total AssetsLiab. and EquityAccounts Payable12.5%Accrued Expenses12.5%Notes Payablen/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total AssetsLiab. and EquityAccounts Payable12.5%Accrued Expenses12.5%Notes Payablen/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable12.5%Accrued Expenses12.5%Notes Payablen/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses12.5%Notes Payablen/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payablen/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debtn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m 12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total LiabilitiesCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stockn/aRetained Earnings Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings Equity Total Liab. & EquityPredicting Retained EarningsNext years projected retained earnings = last years $2 million, plus:

projected net income cash dividends sales sales net income

$40 million x .05 x(1 - .50)

= $2 million + $1 million = $3 million x x ( 1 - )18Next year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings$3m Equity Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings$3m Equity$10m Total Liab. & EquityNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings$3m Equity$10m Total Liab. & Equity$27mNext year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings$3m Equity$10m Total Liab. & Equity$27mHow muchDiscretionaryFinancing will weNeed?

Next year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings$3m Equity$10m Total Liab. & Equity$27mHow muchDiscretionaryFinancing will weNeed?

Next year % of $40mAssetsCurrent Assets$10m25%Fixed Assets$20m50% Total Assets$30mLiab. and EquityAccounts Payable$5m12.5%Accrued Expenses$5m12.5%Notes Payable$1mn/aLong Term Debt$6mn/a Total Liabilities$17mCommon Stock$7mn/aRetained Earnings$3m Equity$10m Total Liab. & Equity$27mHow muchDiscretionaryFinancing will weNeed?

Predicting Discretionary Financing NeedsDiscretionary Financing Needed =

Projected TA - Projected Liab. projected Equity

$30 million - $17 million - $10 million

= $3 million in discretionary financingSimilar to the B/S methodDFN= required in assets - spontaneous in liabilities - in retained earnings = shortfall in the partial B/S= (A* / S) S - (L* / S) S - M S1 (1 - d)whereA*/S = assets that spontaneously /original sales L*/S = liab that spontaneously /original salesS = original salesS1 = total sales projected for next year (based on projection)S = change in sales (based on projection)M = profit margin d = dividend payout ratio

PS: Note that the formula method must be used with caution. In particular, check that the profit margin has not changed. If it has, use the new profit margin.The Formula MethodBe careful with the assumptions:Example:Operating in full capacity vs. operating in less than full capacityRelationship between variables (constant, increasing or decreasing)Dealing with UncertaintySensitivity analysisWhat if analysisChanges in one variable

Scenario analysisHow a number of assumptions might change

SimulationGrowth and External FinancingAt low growth levels, internal financing (retained earnings) may exceed the required investment in assets. As the growth rate increases, the internal financing will not be enough and the firm will have to go to the capital markets for moneyExamining the relationship between growth and external financing required is a useful tool in long-range planningDiscuss two growth rates that are useful for financial planning.Internal growth rateSustainable growth rate

29Obviously, for young, high-growth, start-up firms this relationship is imperative, particularly since their access to the capital markets may be limited and internally generated financing has yet to develop. In fact, there are many examples of firms growing themselves out of business. These situations are the specialty for angel investors and venture capitalists.Growth RateThe internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. That is, with no external financingThe 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.Where b = retention ratioInternal growth = ROA x bSustainable growth = ROE x b30Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firms leverage will decrease over time. If there is an optimal amount of leverage, as we will discuss in later chapters, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.Determinants of GrowthProfit 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 firm31The first three components come from the ROE and the Du Pont identity.

It is important to note at this point that growth is not the goal of a firm in and of itself. Growth is only important so long as it continues to maximize shareholder value. For example, we could grow sales by cutting prices, but this would squeeze margins and possibly reduce overall earnings.BudgetsBudgets indicate the amount and timing of future financing needs.Budgets provide a basis for taking corrective action if budgeted and actual figures do not match.Budgets provide the basis for performance evaluation.Cash Flow ForecastsA listing of all anticipated source of cash to and uses of cashCash BudgetsA listing of all anticipated receipts of cash and disbursement of cash