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1. Goals of Long-Term Financial Planning

2. Forecasting Financial Statements: The Percent of Sales Method

3. Forecasting a Planned Expansion

LECTURE 4 Financial Modeling

and Pro Forma Analysis

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1. Goals of Long-Term Financial Planning

Identify important linkages
Sales, costs, capital investment, financing, etc.

Analyze the impact of potential business plans

Plan for future funding needs

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2. Forecasting Financial Statements: The Percent of Sales Method

A forecasting method that assumes that balance sheet and income statement items grow proportionately with sales.

Percent of sales remains constant in future periods.

Forecasts of balance sheet and income statement items are made as a percent of the expected sales figure for that period.

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Table 1 KMS Designs 2013 Income Statement and Balance Sheet

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KMS Designs forecasts 18% growth in sales from 2013 to 2014.

In 2013:
Costs excluding depreciation were 78% of sales
Depreciation was 7.333% of sales
Tax rate = 3,737 / 10,678 = 35%
Debt interest rate = 306 / 4,500 = 6.8%

For now, assume interest expense remains the same as 2013.

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Table 2 KMS Designs’ Pro Forma First Pass Income Statement for 2014

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Pro Forma Balance Sheet

Make assumptions about how equity and debt will grow with sales.

The difference between Assets and L+E indicates the net new financing to fund growth

Now let us go back to the case when KMS expects sales to grow by 18% next year.

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Table 3 First-Pass Pro Forma Balance Sheet for 2014

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Notes:

Dividend in 2014

= Net income  payout ratio= $8,226  30% = $2,468

Addition to retained earnings in 2014

= Net income  retention ratio = $8,226  70% = $5,758

Shareholders’ equity in 2014

= Shareholders’ equity in 2013

+ addition to retained earnings in 2014

= $74,134 + $5,758 = $ 79,892

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Making the Balance Sheet Balance:

Net New Financing (or, Additional Funds Needed)

= Total Assets – Total Liabilities and Equity

Management must choose new funding

Debt, equity, etc.

If debt is chosen, it will change the interest assumption on the pro forma income statement.

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Table 4 Second-Pass Pro Forma Balance Sheet for KMS

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Choosing a Forecast Target

Target specific ratios that the company wants or needs to maintain.
Debt covenants to maintain liquidity or interest coverage

Investment, payout, and financing decisions are linked together
Financial managers must balance these decisions
Careful forecasting helps see consequences

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Second Pass Income Statement

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Adjusted Second-Pass Balance Sheet

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Extra new funding is needed.

Debt or equity.

If debt is chosen, it will again change the interest assumption on the pro forma income statement…

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3. Forecasting a Planned Expansion

Percent of sales method ignores real-world “lumpy” investments in capacity.

Can’t buy half of a factory, or add retail space by the square foot.

Added in one lump investment in new Property, Plant and Equipment.

Firms often make large investments that will provide capacity for several years.

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Analyzing the effect of a planned expansion on firm value:

Identify capacity needs and financing options

Construct pro forma income statements and forecast future cash flows

Use forecasted free cash flows to assess the impact of expansion

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Table 5 KMS’s Forecasted Production Capacity Requirements

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Capital Expenditures for the Expansion

New PP&E = $20 million

Must be purchased in 2014 to meet minimum capacity requirements

KMS must invest $5 million each year to replace depreciated equipment

After expansion, KMS must invest $8 million per year for depreciation 2015-2018

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Table 6 KMS’s Forecasted Capital Expenditures

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Financing the Expansion

KMS will fund recurring investment from operating cash flows

KMS will finance the new equipment by issuing 10-year coupon bonds with a coupon rate of 6.8%.

Interest in Year t = Interest Rate x Ending balance in year (t-1)

(Eq. 18.1)

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Table 7 KMS’s Planned Debt and Interest Payments

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Forecasting Earnings

Sales = Market Size x Market Share x Average Sales Price

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Table 8 Pro Forma Income Statement for KMS Expansion

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Working Capital Requirements

Net operating working capital (NOWC)

= operating current assets – operating current liabilities

= cash + A/R + Inventory – A/P

Net non-operating working capital

= non-operating current assets – non-operating current liabilities

= short term investment – short term notes payable

Increases in working capital reduce free cash flow

KMS Example:
We assume minimum cash requirements will remain 16% of sales, A/R = 19% of sales, Inventory = 20% of sales, A/P = 16% of sales as in 2013

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Table 9 Projected Working Capital Needs

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Table 10 Pro Forma Balance Sheet, 2014

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Balance the Balance Sheet

When we forecast L+E>A, excess cash is available
Options:
Build extra cash reserves
Buy investment assets
Retire debt
Distribute excess as dividends
Repurchase stock shares, etc.

When L+E<A, additional financing is needed
Options:
Sell investment assets
Raise debt
Reduce dividends
Sell stocks, etc.

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Lecture Highlights

Percent of sales method

Net new financing (or, additional funds needed); how do you adjust financial variables to eliminate it?

In a planned expansion, how do you forecast production volume, sales, PPE, and debt and interest expenses?

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Project

Download the last three years’ income statements and balance sheets.

Forecast future sales.

Forecast next three years’ income statements and balance sheets, using the percent-of–sales methods.