Financial Planning and Forecasting

Long-Term Planning

Spring 2004

4.3 Fundamentals of Preparing Pro Forma Statements A cash budget is not the only statement that must be forecasted. Future profits and financial needs must also be projected. The three main outputs of financial forecasting are 1. Pro forma income statement 2. Pro forma balance sheet 3. A statement of external financing required (EFR)

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4.3 Fundamentals of Preparing Pro Forma Statements Preparing pro forma statements requires a set of assumptions about • the increase in sales, • the increase in costs, • the increase in assets, • the increase in debt, • etc...

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4.3 Fundamentals of Preparing Pro Forma Statements Preparing the pro forma statements requires the use of plug variables. A plug variable varies to ensure that the balance sheet balances and to ensure that the pro forma balance sheet figures are consistent with the pro forma income statement figures. That is, the growth assumptions cannot concern all items on the statements. How plug variables vary will determine the firm’s external financing required.

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A Simple Financial Planning Model Computerfield Corporation Current Financial Statements Income Statement Sales Costs Net income

1,000 (800) 200

Dividends Earnings retained

Balance Sheet Assets

500

Total

500

Debt Equity Total

250 250 500

100 100

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A Simple Financial Planning Model Example 1 Assumptions: Sales, costs, assets, debt and equity are all expected to increase by 20% in the coming year. “Dividends” is the plug variable: Computerfield Corporation Pro Forma Financial Statements Balance Sheet

Income Statement Sales Costs Net income Dividends Earnings retained

1,200 (960) 240

Assets

600

Total

600

Debt Equity Total

300 300 600

? 50

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A Simple Financial Planning Model Example 1 (continued) Equity is expected to increase by 50 while net income is expected to be 240. For the pro forma income statement to be consistent with the pro forma balance sheet, dividends must be 240 − 50 = 190. “Dividends” is used at the plug variable in the present example. The next example uses a different plug variable.

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A Simple Financial Planning Model Example 2 Assumptions: Sales, costs, assets, are all expected to increase by 20% in the coming year. The dividend payout ratio will remain 50% of net income, so debt is the plug variable. Computerfield Corporation Pro Forma Financial Statements Balance Sheet

Income Statement Sales Costs Net income Dividend Earnings retained

1,200 (960) 240

Assets

600

Total

600

Debt Equity Total

? 370 600

120 120

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A Simple Financial Planning Model Example 2 (continued) Total liabilities and equity are expected to increase to 600 while equity is expected to be 370. For the pro forma balance sheet to balance, future debt has to be 600 − 370 = 230, i.e. debt has to be reduced by 20.

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A Simple Financial Planning Model In the last example, EFR is -20, i.e. the firm will be able to repay $20 of long-term debt if the projections are correct. There are many ways to construct pro forma statements. Two of these are: • The percent-of-sales approach. • The judgemental approach.

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The Percent-of-Sales Approach The percent-of-sales approach assumes that some items on the income statement and balance sheet always vary in proportions with sales. For example, it may be reasonable to assume that current assets increase by 20% whenever sales increase by 20%. There are some items, however, that do not have to vary in the same proportions as sales. These are debt, common stock, retained earnings, short-term debt and interest payments, among others. Other balance sheet items, such as accounts receivable, can also be relatively independent of sales, as we will see in the judgemental approach. 11

The Percent-of-Sales Approach: An Illustration Consider the following statements: Rosengarten Corporation Current Financial Statements (in millions of $) Income Statement Sales Costs Taxable income Taxes (34%) Net income Dividend (33.33%) Earnings retained

Balance Sheet

1,000 (800) 200 (68) 132 44 88

Cash A/R Inventory C.A.

160 440 600 1,200

NFA

1,800

Total

3,000

A/P N/P C.L.

300 100 400

LTD C/S R/E Total

800 800 1,000 3,000

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The Percent-of-Sales Approach: An Illustration Main assumption: Sales are expected to increase by 25%. Assumptions concerning the income statement: • Costs are a constant fraction of sales (800/1, 000 = 80%). • The tax rate is not expected to change (34%). • Dividend payout ratio will remain constant (33.33%).

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The Percent-of-Sales Approach: An Illustration Assumptions concerning the balance sheet (assets): • Each current asset is a constant fraction of sales: 160 = 16% for Cash, 1, 000 440 = 44% for A/R, 1, 000 600 = 60% for inventory. 1, 000

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The Percent-of-Sales Approach: An Illustration Assumptions concerning the balance sheet (assets): • The firm will keep operating at the same capacity level, measured by NFA 1, 800 = = 1.8. Sales 1, 000 That is, NFA in the pro forma balance sheet have to be equal to 1.8 times sales.

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The Percent-of-Sales Approach: An Illustration Assumptions concerning the balance sheet (liabilities): • Accounts payable are a constant fraction of sales (30%). • Notes payable and long-term debt are independent of sales (these are plug variables). • Retained earnings increase depends on the “plowback ratio”, which is 66.66% in this example. • Common stock is independent of sales (also a plug variable).

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The Percent-of-Sales Approach: An Illustration Before adjusting the plug variables: Rosengarten Corporation Partial Pro Forma Financial Statements (in millions of $) Balance Sheet

Income Statement Sales Costs Taxable income Taxes (34%) Net income Dividend (33.33%) Earnings retained

1,250 (1,000) 250 (85) 165

Cash A/R Inventory C.A.

55 110

200 550 750 1,500

NFA

2,250

Total

3,750

A/P N/P C.L.

375 ? ?

LTD C/S R/E Total

? ? 1,110 3,750

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The Percent-of-Sales Approach: An Illustration This 25% growth has to be financed with debt and/or equity. The external financing required (EFR) is EFR = 3, 750 − 3, 000 | {z } Change in T.A.

−

= $565 million. (110 + 75) | {z } Internal financing

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The Percent-of-Sales Approach: An Illustration The firm might follow some guidelines as to how funds can be raised. These guidelines could be, for instance, 1. Use debt first (short-term then long-term); 2. Sell stocks only if necessary.

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The Percent-of-Sales Approach: An Illustration How much new debt to issue? This depends on the firm’s constraints. Example of constraints: • The current ratio must not be smaller than 3, say (the actual current ratio). This constraint limits short-term borrowing. • The total debt ratio must not exceed 0.4, say (the actual total debt ratio). This constraint limits long-term borrowing once short-term borrowing has been exhausted. • Raise the remaining funds through equity offering.

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The Percent-of-Sales Approach: An Illustration Possible Financing Scenario • Current ratio: 3 • Total debt ratio: 0.4 Short-Term Borrowing (Notes Payable) Current Ratio =

C.A. 1, 500 = = 3 C.L. C.L.

⇒

C.L. = $500 million.

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The Percent-of-Sales Approach: An Illustration Actual current liabilities are $475 million, so they can be increased by $25 million. Hence, Rosengarten can raise up to $25 million using N/P. The firm has to find $565 million. If $25 million are obtained through N/P, $540 million have to be raised using long-term debt and common stock.

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The Percent-of-Sales Approach: An Illustration Long-Term Debt Total Debt Ratio =

Total debt Total debt = = 0.4, Total assets 3, 750

which gives Total debt = $1, 500 million. Thus the firm can raise up to 1, 500 − 500 − 800 = $200million in long-term debt, which leaves us with 540 − 200 = $340 million to find. 23

The Percent-of-Sales Approach: An Illustration The remaining $340 million will be raised through a common stock issue, which gives the following pro forma statements: Rosengarten Corporation Pro Forma Financial Statements (in millions of $) Income Statement Sales Costs Taxable income Taxes (34%) Net income Dividend (33.33%) Earnings retained

Balance Sheet

1,250 (1,000) 250 (85) 165 55 110

Cash A/R Inventory C.A.

200 550 750 1,500

NFA

2,250

Total

3,750

A/P N/P C.L.

375 125 500

LTD C/S R/E Total

1,000 1,140 1,110 3,750

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Weaknesses of the Percent-of-Sales Approach The percent-of-sales approach has three weaknesses: 1. It is unrealistic to assume that all expenses will remain exactly the same percent of sales from one fiscal year to the next. 2. With the percent-of-sales method, a company is essentially locked into a given profit margin. 3. The percent-of-sales approach assumes that all of the firm’s costs are variable. Fixed costs create “leverage”.

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Example Vectra Manufacturing Actual and Pro Forma Income Statements (POS Approach) 2002 (Actual) Sales Less: COGS Gross Margin Less: Operating expenses Operating earnings Less: Interest expenses Earnings before taxes Less: Taxes (15%) Net income after tax

100,000 80,000 20,000 10,000 10,000 1,000 9,000 1,350 7,650

Common share dividends Earnings retained

4,000 3,650

Percent of sales 80% 20% 10% 1%

7.7%

2003 (Pro Forma) 140,000 112,000 28,000 14,000 14,000 1,400 12,600 1,890 10,710

Percent of sales 80% 20% 10% 1%

7.7%

5,600 5,110

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Example (Continued) Suppose Vectra is not happy with its current profit margin of 7.7%. The average ratios for gross and profit margins are 28% and 12.5%, respectively, in Vectra’s industry. Hence Vectra should be able to better control costs and increase margins.

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Example (Continued) Suppose that Vectra has the following figures in mind: COGS: 76% of sales instead of 80%. Operating expenses: 11% of sales instead of 10%. Note that a new, more efficient, machine implies greater amortization expense, which could be the cause of this increase. Interest expenses: Should not be greater than $1,100. Dividends: Will remain constant at $4,000. What’s your opinion on this one?

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Example (Continued) Vectra Manufacturing Actual and Pro Forma Income Statements (Judgmental Approach) 2002 (Actual) Sales Less: COGS Gross Margin Less: Operating expenses Operating earnings Less: Interest expenses Earnings before taxes Less: Taxes (15%) Net income after tax

100,000 80,000 20,000 10,000 10,000 1,000 9,000 1,350 7,650

Common share dividends Earnings retained

4,000 3,650

Percent of sales 80% 20% 10% 1%

7.7%

2003 (Pro Forma) 140,000 106,400 33,600 15,400 18,200 1,100 17,100 2,565 14,535

Percent of sales 76% 24% 11% 0.8%

10.4%

4,000 10,535

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Percent-of-Sales Approach and Fixed Costs The POS approach assumes that the firm has no fixed costs, i.e. all costs increase with sales. A growing firm benefits from having fixed costs since these remain constant as sales increase, thus increasing the profit margin. Rent, amortization, management salaries, property taxes, marketing, and research and development are examples of fixed costs.

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Variable and Semi-Variable Costs Variable costs, on the other hand, always vary with sales. Examples of these are raw material, labour, factory overhead and sales commissions. Note that there also are semi-variable costs, which vary with sales only once they have reached a certain level. That is, semi-variable costs will not vary for low sales levels. Take equipment maintenance, for example. A minimum amount of maintenance must always be performed regardless of the sales level but more maintenance must be performed as sales increase beyond a certain point. 31

Profit Margin and Fixed Costs Let S ≡ Sales (in $),

v ≡ Variable costs per $ sold,

F ≡ Fixed Costs, t ≡ Corporate Tax Rate. EBT = S − vS − F NIAT = (1 − t)((1 − v)S − F), where NIAT is net income after taxes.

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Profit Margin and Fixed Costs This gives NIAT S (1 − t)((1 − v)S − F) = S (1 − t)F = (1 − t)(1 − v) − . S

Profit Margin =

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Profit Margin and Fixed Costs

Profit Margin = (1 − t)(1 − v) −

(1 − t)F S

Remarks: • In the absence of fixed costs (F = 0), profit margin is constant. • In the presence of fixed costs (F > 0), profit margin increases when sales increase.

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Profit Margin and Fixed Costs In the Vectra example, suppose that, in 2002, fixed costs were $21,000: $12,000 in COGS, $8,000 in operating expenses (OE) and $1,000 in interest expenses. As a fraction of sales, variable costs were then Variable Costs Sales

= = =

Variable COGS + Variable OE S (80, 000 − 12, 000) + (10, 000 − 8, 000) 100, 000 68, 000 + 2, 000 = 70%. 100, 000

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Profit Margin and Fixed Costs If variable costs remain 70% of sales and if fixed costs remain $21,000, net income after taxes (NIAT) in 2003 is expected to be NIAT = (1 − t)((1 − v)S − F) = 0.85 × (0.30 × 140, 000 − 21, 000) = 17, 850 and the profit margin is expected to be NIAT 17, 850 = = 12.75%. S 140, 000

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Same thing, but using the income statements. Vectra Manufacturing Actual and Pro Forma Income Statements (Judgmental Approach) 2002 (Actual) Sales Less: COGS Fixed Variable Gross Margin Less: Operating expenses Fixed Variable Operating earnings Less: Interest expenses Earnings before taxes Less: Taxes (15%) Net income after tax

Percent of sales

2003 (Pro Forma)

100,000

140,000

12,000 68,000 20,000

12,000 95,200 32,800

8,000 2,000 10,000 1,000 9,000 1,350 7,650

68%

2%

7.65%

8,000 2,800 22,000 1,000 21,000 3,150 17,850

Percent of sales

68%

2%

12.75%

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4.3 Preparing the Pro Forma Balance Sheet In what follows, the pro forma balance sheet for Vectra Manufacturing will be prepared using the judgmental approach. Income Statement

Vectra Manufacturing 2002 Financial Statements (Actual) Balance Sheet

Sales COGS Op. expenses Interest EBT Taxes (15%) Net income

100,000 (80,000) (10,000) (1,000) 9,000 (1,350) 7,650

Cash M/S A/R Inv. C.A.

6,000 4,000 13,000 16,000 39,000

NFA

51,000

Dividends Earnings ret.

4,000 3,650

Total

90,000

A/P Taxes payable Line of credit Other C.L. LTD C/S R/E Total

7,000 300 8,300 3,400 19,000 18,000 30,000 23,000 90,000

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4.3 Preparing the Pro Forma Balance Sheet The pro forma income statement is as below. For all items other than retained earnings, the firm will proceed step by step. Vectra Manufacturing 2003 Financial Statements (Pro Forma) Income Statement Balance Sheet Sales COGS Op. expenses Interest EBT Taxes (15%) Net income

140,000 (106,400) (15,400) (1,100) 17,100 (2,565) 14,535

Cash M/S A/R Inv. C.A.

? ? ? ? ?

NFA

?

Dividends Earnings ret.

4,000 10,535

Total

?

A/P Taxes payable Line of credit Other C.L. LTD C/S R/E Total

? ? ? ? ? ? ? 33,535 ?

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4.3 Preparing the Pro Forma Balance Sheet Let’s first look at assets: Cash: Vectra wants a minimum cash balance of $8,000. Marketable Securities (M/S): These are assumed to remain constant at $4,000.

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4.3 Preparing the Pro Forma Balance Sheet

Accounts Receivable: In 2002, average collection period was 365 = 47.45 days. 100, 000/13, 000 This happens to be 10 days higher than the industry average. Vectra wants its average collection period to be 41 days in 2003, which means that accounts receivable at the end of 2003 should be 365 41 × 140, 000 = 41 ⇒ A/R = = 15, 726. 140, 000/A/R 365

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4.3 Preparing the Pro Forma Balance Sheet

Inventory: In 2002, average days in inventory was 365 = 73 days. 80, 000/16, 000 Vectra is happy with this number and wants to have the same in 2003. That is, 365 73 × 106, 400 = 73 ⇒ Inv. = = 21, 280. 106, 400/Inv. 365

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4.3 Preparing the Pro Forma Balance Sheet

Net Fixed Assets: Vectra plans to acquire a new machine for $35,000 in 2003, from which $7,000 will be amortized in that year (reflected in the increase in operating expenses). Net fixed assets then increase by 35, 000 − 7, 000 = $28, 000, which means that NFA in 2003 are expected to be 51, 000 + 28, 000 = $79, 000.

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4.3 Preparing the Pro Forma Balance Sheet Note that we have enough information so far to determine what total assets will be in 2003: Vectra Manufacturing 2003 Financial Statements (Pro Forma) Income Statement Balance Sheet Sales COGS Op. expenses Interest EBT Taxes (15%) Net income

140,000 (106,400) (15,400) (1,100) 17,100 (2,565) 14,535

Cash M/S A/R Inv. C.A.

8,000 4,000 15,726 21,280 49,006

NFA

79,000

Dividends Earnings ret.

4,000 10,535

Total

128,006

A/P Taxes payable Line of credit Other C.L. LTD C/S R/E Total

? ? ? ? ? ? ? 33,535 ?

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4.3 Preparing the Pro Forma Balance Sheet Let’s now consider liabilities and equity: Accounts Payable: Purchases are 45% of COGS and Vectra’s average payment period in 2002 was 365 = 71 days. (0.45 × 80, 000)/7, 000 Suppliers want this average to be reduced to 62 days in 2003, which translates into 365 62 × 0.45 × 106, 400 = 62 days ⇒ A/P = = 8, 133. (0.45 × 106, 400)/A/P 365

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4.3 Preparing the Pro Forma Balance Sheet

Taxes Payable: These are assumed to be 25% of the tax amount that appears on the income statement, which is, for 2003, 25% × 2, 565 = 641. Other Current Liabilities: Remain unchanged. Line of Credit: Depends on the financing plan. Long-Term Debt: Depends on the financing plan. Common Stock: Depends on the financing plan.

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4.3 Preparing the Pro Forma Balance Sheet We thus have, before adjusting the plug variables, Vectra Manufacturing 2003 Financial Statements (Pro Forma) Income Statement Balance Sheet Sales COGS Op. expenses Interest EBT Taxes (15%) Net income

140,000 (106,400) (15,400) (1,100) 17,100 (2,565) 14,535

Cash M/S A/R Inv. C.A.

8,000 4,000 15,726 21,280 49,006

NFA

79,000

Dividends Earnings ret.

4,000 10,535

Total

128,006

A/P Taxes payable Line of credit Other C.L. LTD C/S R/E Total

8,133 641 8,300 3,400 20,474 18,000 30,000 33,535 102,009

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4.3 Preparing the Pro Forma Balance Sheet From these statements, we can find the total financing required (TFR) TFR = Change in Total Assets = 128, 006 − 90, 000 = 38, 006.

Vectra does not need to raise the whole amount from outside investors since some of this change in assets will be financed internally, i.e. using the increases in accounts payable, taxes payable and retained earnings.

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4.3 Preparing the Pro Forma Balance Sheet The funds raised from outside investors, the external financing required, is found as follows: Total financing required Less: Internal sources Increase in accounts payable Increase in taxes payable Reinvested profits Total internal sources External financing required

38,006 1,133 341 10,535 15,009 25,997

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4.3 Preparing the Pro Forma Balance Sheet Note that my example differs from the one in the book as I assumed the dividend payment to remain $4,000. Now that you know Vectra’s external financing required, what are your suggestions regarding a possible financing plan?

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