The afn equation and the financial statement forecasting

CHAPTER 17: Financial Planning and Forecasting

Effective Forecasting Is Even More Important During Volatile Times

In February 2010, GE CEO Jeffrey Immelt began his letter to shareholders with the following statement:

Time magazine called this era “The Decade from Hell,” and “when you are going through hell,” Winston Churchill advised, “keep going.”

The previous few years had been rough for GE. Its reported net income at year-end 2009 was roughly half of what it was 2 years earlier, and its stock had significantly underperformed the overall market—its share price had gone from $38 per share in April 2008 to less than $15 per share in early July 2010. Nevertheless, Immelt was quick to stress that GE was still profitable and (hopefully) well positioned for the future.

Indeed, a year later, in early 2011, Immelt was happy to report that GE was beginning to turn things around. During 2010, its earnings grew 15%, and the company twice increased its dividend. By July 2011, GE’s stock was trading around $19 per share—which was still only half of where it had been 3 years earlier; however, it was nevertheless moving in the right direction.

As GE knows all too well, the economic environment is always changing, which makes it difficult to develop reasonable forecasts of the company’s future performance. Forecasting has become increasingly challenging given the tremendous volatility in the economy and financial markets during the past few years. With numbers changing faster than you can update your forecasts, it is tempting to throw your hands up and say “Why bother?” Expressing this sentiment, UPS’s CFO, Kurt Kuehn, recently was quoted saying:

“Normally, we are very obsessive about building good and accurate plans,” he says, but as the recession dragged on, “we realized that trying to build a forecast was almost a waste of time. We didn’t have enough precedent or trends to do anything viable.”

Despite this urge to throw in the towel, during volatile times effective forecasting is more important than ever. Well-run companies know that you can’t just operate on auto-pilot and assume that next year will be like last year. Indeed, under Kuehn’s guidance, UPS has taken this opportunity to adopt a more expansive and flexible approach in setting its budget. So far, the results appear to have paid off—the company’s earnings and stock price have steadily increased over the past 4 years.

Likewise, GE has also continued to move in the right direction. Its earnings and stock price have continued to rebound.

Immelt reflected on GE’s improved position in his 2013 report:

We are positive about the future. We have positioned GE to capitalize on the growth themes of the era. We are investing to lead in the new technologies that will drive efficiency for the Company and our customers. We are improving our speed and lowering our cost. We plan to deliver a valuable financial performance. We are making progress.

Notwithstanding their strong track record, both UPS and GE know that you can never rest on your laurels, and effective financial forecasting is an important component of continued success.

Sources: Jeffrey Immelt, GE 2010 and 2013 Annual Reports; and Kate O’Sullivan, “From Adversity, Better Budgets,” CFO ( cfo.com ), June 1, 2010.

Putting Things in Perspective

Yogi Berra, the former player and manager for the New York Yankees, once said, “You’ve got to be very careful if you don’t know where you’re going, because you might not get there.” That’s certainly true for a company—it needs a plan, one that starts with the firm’s general goals and details the steps that will be taken to get there.

When you finish this chapter, you should be able to:

· Discuss the importance of strategic planning and the central role that financial forecasting plays in the overall planning process.

· Explain how firms forecast sales.

· Use the Additional Funds Needed (or AFN) equation and discuss the relationship between asset growth and the need for funds.

· Explain how spreadsheets are used in the forecasting process, starting with historical statements, ending with projected statements, and including a set of financial ratios based on those projected statements.

· Discuss how planning is an iterative process.

Financial planners begin with a set of assumptions, see what is likely to happen based on those assumptions, and then see if modifications can help the firm achieve better results. Although we focus on forecasting from the corporation’s standpoint, top security analysts go through the same process. Analysts with hedge and private equity funds are especially active as forecasters, and they are particularly interested in the iterative process of forecasting.

17-1: Strategic Planning

Management textbooks often list the following as the key elements of a strategic plan:

· Mission Statement. Many but not all firms articulate a mission statement . For example, here is Pepsi’s mission statement: 1

Mission Statement

A condensed version of a firm’s strategic plan.

Our mission is to be the world’s premier consumer products company focused on convenient foods and beverages. We seek to produce financial rewards to investors as we provide opportunities for growth and enrichment to our employees, our business partners and the communities in which we operate. And in everything we do, we strive for honesty, fairness and integrity. GE does not have one, but it states that its chairman’s letter in the annual report serves this purpose. In his letter, Jeffrey Immelt discusses his goals for GE’s major businesses and for the firm as a whole.

· Corporate Scope. Corporate scope defines the lines of business the firm plans to pursue and the geographic areas in which it will operate. Some firms deliberately limit their scope, on the theory that it is better for top managers to focus sharply on a narrow range of functions as opposed to spreading the company over many different types of businesses. Academics have studied which is the better choice. Some studies suggest that investors generally value focused firms more highly than diversified ones. 2 However, if a firm is successful in combining a group of diversified businesses so that they help one another, as GE tries to do, the result may be synergistic effects that raise the value of the overall enterprise. 3 In any event, the stated corporate scope should be logical and consistent with the firm’s capabilities.

Corporate Scope

Defines a firm’s lines of business and geographic areas of operation.

· Statement of Corporate Objectives. A firm’s statement of corporate objectives is that part of the corporate plan that sets forth the specific goals that operating managers are expected to meet. Like most firms, GE has both qualitative and quantitative objectives. GE has a history of selling business units that do not meet its objectives and of replacing underperforming managers, but GE also rewards managers generously when they meet their targets.

Statement Of Corporate Objectives

Sets forth specific goals to guide management.

· Corporate Strategies. GE has several broad corporate strategies . One is to be highly diversified by both products and geographic scope in order to achieve earnings stability and financial strength. Its management believes that financial strength will lead to a low cost of capital, which will benefit all its units. Also, because GE’s management believes that the company should be at the forefront in addressing environmental issues, it is investing heavily in infrastructure technologies to purify air and water. Immelt expects to do good by doing good.

Corporate Strategies

Broad approaches developed for achieving a firm’s goals.

· Operating Plan. Each of GE’s units must develop a detailed operating plan that is consistent with the corporate strategy to help it achieve the firm’s objectives. Operating plans can be developed for any time horizon, but most companies use a 5-year horizon. The plan explains in considerable detail the people responsible for each particular function, deadlines for specific tasks, sales and profit targets, and the like.

Operating Plan

Provides management detailed implementation guidance, based on the corporate strategy, to help meet the corporate objectives.

· Financial Plan. GE’s financial planning is a multistep process. Likewise, Allied’s financial plan involves four steps. First, assumptions are made about the future levels of sales, costs, interest rates, and so forth, for use in the forecast. Second, a set of projected financial statements is developed. Third, projected ratios such as those discussed in Chapter 4 are calculated and analyzed. Fourth, the entire plan is reexamined, the assumptions are reviewed, and the management team considers how additional changes in operations might improve results. This last step requires reconsideration of all the earlier parts of the overall plan, from the mission statement to the operating plan. Thus, the financial plan ties the entire planning process together.

Financial Plan

The document that includes assumptions, projected financial statements, and projected ratios and ties the entire planning process together.

Financial planning as described previously is often called value-based management, meaning that the effects of various decisions on the firm’s financial position and value are studied by simulating their effects within the firm’s financial model. For example, if GE was considering a shift in appliance manufacturing from Kentucky to Mexico, it would simulate the effects through its financial model and then make the move if it appeared that profits and thus shareholder wealth would be increased. 4

SELF TEST

What are the key elements of a corporation’s strategic plan?

How is the financial plan related to the other parts of a firm’s overall strategic plan?

How can the financial plan be used to help management provide guidance to security analysts?

17-2: The Sales Forecast

Financial plans generally begin with a sales forecast, which starts with a review of sales during the past 5 years, shown as a graph such as the one in Figure 17.1 for Allied Food. These numbers are based on Allied’s financial statements, which were first presented in Chapter 3 . The data below the graph show 5 years of historical sales.

FIGURE 17.1: Allied Food Products: 2016 Sales Projection (Millions of Dollars)

Allied had its ups and downs from 2011 through 2015. In 2013, poor weather in California’s fruit-producing regions resulted in below-average crops, which caused 2013 sales to fall below the 2012 level. Then a bumper crop in 2014 pushed sales up by 15%, an unusually high growth rate for a mature food processor. The compound annual growth rate over the 4-year period was 9.88%. 5 Due to planned new products, increased production, distribution capacity, a new advertising campaign, and other factors, management expects the growth rate to increase slightly, to 10%, in 2016. Therefore, sales should rise from $3,000 million to $3,300 million.

Of course, management likes higher sales growth, but not at any cost. For example, sales could be increased by cutting prices, spending more on advertising, granting easier credit, and the like. However, all of those actions would have a cost. Also, sales growth cannot occur without a concurrent increase in capacity, and that too is costly. So the sales growth must be balanced against the cost of achieving that growth.

If the sales forecast is off, the consequences can be serious. First, if the market expands by more than Allied expects, it will not be able to meet demand, its customers will buy from competitors, and it will lose market share. On the other hand, if its projections are overly optimistic, Allied could end up with too much plant, equipment, and inventory, leading to low turnover ratios, high costs for depreciation and storage, and write-offs of spoiled inventory. This would result in low profits and a depressed stock price. Moreover, if Allied financed its expansion with debt, high interest expenses would compound the firm’s problems.

Finally, note that the sales forecast is the most important input in the firm’s forecast of financial statements, including the projected EPS, which we cover in Section 17-4 . The importance of the sales forecast is highlighted when we forecast the financial statements.

SELF TEST

Why is an accurate sales forecast critical for financial planning?

17-3: The AFN Equation

We saw in Chapter 3 that in 2015, Allied had assets of $2,000 million and sales of $3,000 million. Thus, it required $2,000/$3,000 = $0.6667 of assets to generate each dollar of sales. Moreover, the company plans to increase sales by 10%, or $300 million, in 2016:

Increase in sales = ΔSales = 0.10 ($3,000 million) = $300 million

Assuming the assets-to-sales ratio remains constant, Allied will need an additional $200 million of assets to support the $300 million increase in sales:

Required increase in assets = 0.6667 (ΔSales) = 0.6667($300) = $200 million

Note that if growth is low (say, 0%), ΔSales will be zero, and there will be no required increase in assets. On the other hand, if sales grow very rapidly, the requirement for additional assets will be large. Thus, the increase in assets is fundamentally dependent on the growth rate in sales.

Naturally, if assets are to grow by $200 million, liabilities and equity must also grow by the same amount—the balance sheet must balance. But from where will this capital come? Here are a firm’s primary capital sources:

· 1. Spontaneous Increases in Accounts Payable and Accruals. Allied must make additional purchases to increase its inventories, and it must hire more workers. Its purchases will automatically lead to additional accounts payable, which amount to “loans” from its suppliers. Also, hiring more workers will automatically lead to higher accrued wages, which amount to short-term “loans” from its workers. Hence, some of the required $200 million will come spontaneously from suppliers and workers—this is called spontaneously generated funds . Also, assuming profit margins are maintained, higher sales will mean higher profits and thus higher taxes and accrued taxes. So “spontaneous” increases in payables, accrued wages, and accrued taxes will take care of part of the required $200 million.

Spontaneously Generated Funds

Funds that arise out of normal business operations from its suppliers, employees, and the government (such as accounts payable and accrued wages and taxes) that reduce the firm’s need for external financing.

· 2. Addition to Retained Earnings. Assuming Allied has positive earnings and does not pay out all of those earnings as dividends, its retained earnings will grow. The addition to retained earnings depends on the firm’s profit margin and its retention ratio , which is the proportion of net income that is reinvested in the firm. This addition to retained earnings will help finance growth.

Retention Ratio

It is the proportion of net income that is reinvested in the firm, and is calculated as 1 minus the dividend payout ratio.

· 3. AFN: Additional Funds Needed. It is possible that spontaneous funds and additional retained earnings will offset the forecasted increase in assets. Normally, though, that situation does not occur—normally, there is a shortfall, called additional funds needed (AFN) , which has to be made up by additional borrowing and/or the sale of new stock. Note, though, that if a company is growing very slowly and thus not increasing assets very much, its spontaneous funds plus its addition to retained earnings may be larger than the required increase in assets. In that case, the AFN is negative, indicating that a surplus of capital is forecasted.

Additional Funds Needed (AFN)

The amount of external capital (interest-bearing debt and preferred and common stock) that will be necessary to acquire the required assets.

We can combine these concepts to develop Equation 17.1 , the AFN equation . AFN is the total amount of new interest-bearing debt and preferred and common stock the firm must issue to support its planned growth. 6

AFN Equation

An equation that shows the relationship of external funds needed by a firm to its projected increase in assets, the spontaneous increase in liabilities, and its increase in retained earnings.

Allied Food’s CFO used Equation 17.1 in the following manner. Every fall the company’s Executive Committee, which includes the CEO, the CFO, and other top executives, meets to consider plans for the coming year. The meeting this year is especially important for two reasons: (1) The national credit crunch is constraining the firm’s ability to raise capital, so the amounts needed and available must be determined. (2) Corporate raiders and private equity firms have targeted a number of food processors, and when they take over, heads roll in the acquired firm. Allied’s executives are aware of both factors.

Allied’s CFO plans to proceed in two steps. First, he will use the AFN equation to give the others an idea of how much new capital the firm will need to support the targeted 10% growth rate, assuming the various operating ratios remain constant. Second, he will present the results of a full-scale financial planning model. The model shows forecasted financial statements in addition to a set of forecasted ratios like those discussed in Chapter 4 , along with an estimate of the 2016 EPS.

The CFO brought copies of Table 17.1 , which is based on Equation 17.1 , and data from the financial statements presented in Chapter 3 to the Executive Committee. 7 Part I of the table picks up selected data from the 2015 balance sheet and income statement. Part II uses the Part I data to calculate inputs for Equation 17.1 . Note that all the calculations in Part II assume that the company’s operating ratios in 2016 continue at 2015 levels. Part III uses the items calculated in Part II to calculate the AFN. To increase sales by $300 million, Allied must increase assets by $200 million. The asset increase will be supported by $20 million from spontaneous increases in payables and accruals, and another $66 million will come from retained earnings. In total, $114 million of new outside funds will be needed, and because Allied does not use preferred stock, the amount must come from interest-bearing debt in addition to new common stock.

TABLE 17.1: Additional Funds Needed (AFN) Model (Millions of Dollars)

As noted, the AFN equation assumes that the 2016 ratios will remain constant at the 2015 levels. 8 If economic conditions or managerial decisions cause the ratios to change, the forecasted AFN will change. Part IV of the table shows how some specific input changes will change the forecasted AFN. For example, if the target growth rate was increased from 10% to 15% with other things held constant, the AFN would increase from $114 million to $201 million. On the other hand, if the target growth rate was lowered to 5%, the AFN would be only $27 million. Also, as shown in Part V , if the company grew at a rate of 3.45% while other things were held constant, AFN would be zero. Thus, 3.45% is called Allied’s sustainable growth rate . As you can see from the model, the sustainable growth rate can be easily estimated using the Goal Seek tool in Excel. Finally, note that if the growth rate slowed and other inputs were changed in the manner specified in Part IV of the table, Allied would end up with a large negative AFN, indicating that retained earnings and spontaneous capital were far more than sufficient to finance the now smaller amount of additional assets needed.

Sustainable Growth Rate

The maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm’s AFN equals zero.

17-3a: Excess Capacity Adjustments

The AFN equation includes the term A0*/S0, which is called the capital intensity ratio . For Allied, this ratio is calculated as $2,000/$3,000 = 0.6667. When multiplied by ΔS = $300 million, this ratio indicated that Allied must increase its assets by $200 million. However, the CFO thought that in 2015, Allied had more fixed assets than it really needed; he wanted to demonstrate to the Executive Committee how excess capacity adjustments might affect the firm’s need for external funds. He noted that Allied had $1,000 million of current assets and $1,000 million of fixed assets; so he split A0*/S0 into two parts, one for fixed assets and one for current assets:

Capital Intensity Ratio

The ratio of assets required per dollar of sales (A0*/S0).

Excess Capacity Adjustments

Changes made to the existing asset forecast because the firm is not operating at full capacity.

Now suppose that the current assets were used at full capacity but that fixed assets had been used at only 96% of capacity in 2015. Therefore, if fixed assets had been used to full capacity, sales could have reached $3,125 million before any additions to fixed assets were required versus the actual $3,000 million of sales. In this example, the calculated $3,125 million sales is Allied’s full capacity sales:

This indicates that Allied’s Target fixed assets/Sales ratio should be 32% rather than the indicated 33.3% calculated previously:

Under these conditions, sales could increase to $3,125 million with no increase in fixed assets, and a sales increase to $3,300 million would require only $1,056 million of fixed assets, or an additional $56 million of fixed assets:

Thus, the existence of excess capacity in its fixed assets would lower Allied’s required AFN from $114 million to $114 million − $44 million = $70 million.

A similar situation could occur with respect to inventories, cash, or any other asset. Moreover, the L0*/S0 ratio could be increased if the firm negotiated longer credit terms for its purchases. Similarly, it might be possible for Allied to improve its profit margin or to lower its dividend payout ratio. Because so many conditions can change, it is useful to go beyond the AFN equation analysis and construct Allied’s forecasted financial statements , the topic of the next section. Also, we want to know how good or bad the firm’s financial ratios will be and what the impact will be on its EPS. The AFN tells us nothing about those things, but the forecasted financial statements do.

Forecasted Financial Statements

Financial statements that project the company’s financial position and performance over a period of years.

SELF TEST

If the key ratios are expected to remain constant, the AFN equation can be used to forecast the need for external funds. Write out the equation and explain its logic.

How would an increase in each of the following factors affect the AFN?

· 1. Payout ratio

· 2. Capital intensity ratio, A0*/S0

· 3. Profit margin

· 4. Days sales outstanding, DSO

· 5. Sales growth rate

Is it possible for the AFN to be negative? If so, what would this indicate?

If excess capacity exists, how would that affect the calculated AFN?

17-4: Forecasted Financial Statements 9

The AFN equation provides useful insights into the forecasting process—if you understand the AFN, you will find it easier to understand forecasted financial statements. Therefore, Allied’s CFO used the AFN calculations in Table 17.1 as a warm up for his presentation of the forecasted 2016 financial statements. We describe how he developed the forecast presented in Table 17.2 in this section.

TABLE 17.2: Forecasted Financial Statements (Total Dollars and Shares in Millions)

17-7

PRO FORMA INCOME STATEMENT At the end of last year, Roberts Inc. reported the following income statement (in millions of dollars):

Sales

$3,000

Operating costs excluding depreciation

2,450

EBITDA

$ 550

Depreciation

250

EBIT

$ 300

Interest

125

EBT

$ 175

Taxes (40%)

70

Net income

$ 105

Looking ahead to the following year, the company’s CFO has assembled this information:

· Year-end sales are expected to be 10% higher than the $3 billion in sales generated last year.

· Year-end operating costs, excluding depreciation, are expected to equal 80% of year-end sales.

· Depreciation is expected to increase at the same rate as sales.

· Interest costs are expected to remain unchanged.

· The tax rate is expected to remain at 40%.

On the basis of that information, what will be the forecast for Roberts’ year-end net income?

17-8

LONG-TERM FINANCING NEEDED At year-end 2015, total assets for Ambrose Inc. were $1.2 million and accounts payable were $375,000. Sales, which in 2015 were $2.5 million, are expected to increase by 25% in 2016. Total assets and accounts payable are proportional to sales, and that relationship will be maintained; that is, they will grow at the same rate as sales. Ambrose typically uses no current liabilities other than accounts payable. Common stock amounted to $425,000 in 2015, and retained earnings were $295,000. Ambrose plans to sell new common stock in the amount of $75,000. The firm’s profit margin on sales is 6%; 60% of earnings will be retained.

· a. What were Ambrose’s total liabilities in 2015?

· b. How much new long-term debt financing will be needed in 2016? (Hint: AFN − New stock = New long-term debt.)