Chapter 14Chapter 14

Short-term Financial PlanningShort-term Financial Planning

Chapter ObjectivesChapter Objectives

Percent of sales method to forecast financing requirements

Sustainable rate of growthLimitations of the percent of sales methodCash budgets

Financial ForecastingFinancial Forecasting

Process of attempting to estimate a firm’s future financing requirements

Steps:1. Project the firm’s sales revenues and expenses

over the planning period2. Estimate the levels of investment in current and

fixed assets that are necessary to support the projected sales

3. Determine the firm’s financing needs throughout the planning period

Sales ForecastSales Forecast

The key ingredient in a firm’s planning process is the sales forecast

Reflects:

1. Past trend in sales

2. Anticipated events

Percent of Sales MethodPercent of Sales Method

Estimating the level of an expense, asset, or liability for a future period as a percentage of the sales forecast.

The percentages used can come from recent financial statements or from averages over past years

Spontaneous FinancingSpontaneous Financing

The trade credit and other accounts payable that arise spontaneously in the firm’s day-to-day operations.

Normally vary directly with the level of sales

Accounts Payable and Accrued Expenses

Discretionary Financing (DFN)Discretionary Financing (DFN)

Require explicit decisions on the part of the firm’s management every time funds are raised.

Do not normally vary directly with the level of sales

Notes Payable, long-term debt, common stock, paid in capital

Calculation of DFNCalculation of DFN Four step process (Using percentage of sales method)

1. Covert each asset and liability account that varies directly with firm sales to a percentage of the current year’s sales

– Current Assets/Sales2. Project the level of each asset and liability account in the

balance sheet using its percentage of sale multiplied by projected sales or by leaving the account balance unchanged when the account does not vary with the level of sales

– Projected current assets = projected sales X (current assets/sales)

3. Project the addition to retained earnings available to help finance the firm’s operations. This equals projected net income for the period less planned common stock dividends.

Projected addition to retained earnings =

projected sales X Net income X {1-(cash dividends

Sales Net Income)}

4. Project the firm’s DFN as the projected level of total assets less projected liabilities and owners’ equity

DFN = Projected total assets – projected total liabilities – projected owners’ equity

DFN RelationshipsDFN Relationships

DFN = Predicted change in total assets – Predicted change in spontaneous liabilities – Predicted change in retained earnings

External Financing Needs External Financing Needs (EFN)(EFN)

All the firm’s needs for financing beyond the funds provided internally through the retention of earnings

EFN = Predicted change in total assets – Predicted change in retained earnings

DFN and EFNDFN and EFN

DFN = Predicted change in total assets – Predicted change in spontaneous liabilities – Predicted change in retained earnings

EFN = Predicted change in total assets – Predicted change in retained earnings

Difference between DFN and EFN is the inclusion/exclusion of spontaneous liabilities

Sustainable Rate of GrowthSustainable Rate of GrowthThe rate at which a firm’s sales can grow if

it wants to maintain its present financial ratios and does not want to resort to the sale of new equity shares.

Sustainable rate of Growth (g) = ROE (1-b)ROE is return on equity

or net income / common equityb is dividend payout ratio or dividends/net

income(1-b) = plowback ratio or the fraction of earnings

that are reinvested or plowed back into the firm

ROEROE

Return on equityNet income / common equityROE = (net income / sales) X (sales/assets)

X (total assets/common equity)

or NPM X Asset turnover X capital structure

Sustainable Rate of GrowthSustainable Rate of Growth

Firm NPM Asset Leverage Plowback Sustainable

turnover ratio rate of growth

A 15% 1.00 1.2 50% 9.0%

B 15% 1.00 1.2 100% 18.0%

C 15% 1.00 1.5 100% 22.5%

Limitations of the Percent of Limitations of the Percent of Sales Forecast MethodSales Forecast Method

Method provides reasonable estimates of financing requirements only when asset requirements and financing sources can be accurately forecast as a constant percent of sales

Economies of scale are sometimes realized from investing in certain types of assets

Some assets are lumpy assets or assets that must be purchased in large, nondivisible components

Budget FunctionsBudget Functions

A budget is a forecast of future eventsPerform three functions:

– Indicate the amount and timing of a firm’s needs for future financing

– Provide the basis for taking corrective action in the event of variances

– Provide the basis for performance evaluation and control

Cash BudgetCash Budget

Detailed plan of future cash flowsComposed of four elements:

– Cash Receipts– Cash Disbursement– Net change in cash for the period– New financing needed