CHAPTER 12
FINANCIAL PLANNING AND CONTROL
o Forecasting is an essential part of the planning process, and a sales forecast is the most
important ingredient of financial forecasting.
o The sales forecast generally starts with a review of sales during the past five to ten years,
which can be shown in a graph.
o If the sales forecast is inaccurate, the consequences can be serious. Thus, an accurate sales
forecast is critical to the firm’s well-being.
Any forecast of financial requirements involves (1) determining how much money the firm
will need during a given period, (2) determining how much money the firm will generate
internally during the same period, and (3) subtracting the funds generated from the funds
required to determine the external financial requirements. The projected, or pro forma,
balance sheet method is one way to estimate a firm’s external financial requirements.
o The methodology involves projecting the asset requirements for the coming period, then
projecting the liabilities and equity that will be generated under normal operations, and
subtracting the projected liabilities and equity from the required assets to estimate the
additional funds needed (AFN) to support the level of forecasted operations.
o The first step is to forecast the next year’s income statement to obtain an initial estimate of
the amount of retained earnings the company will generate during the year.
o A sales forecast is needed.
o Assumptions about the operating cost ratio, the tax rate, interest charges, and the dividend
payout ratio are made to determine how much income the company will earn and then
retain for reinvestment in the business during the forecasted year.
o It is assumed that the firm currently operates at full capacity.
o The assumption is made that no change in the firm’s financing will take place, because, at
this point, it is not known if additional financing is needed.
o The second step is to forecast the next year’s balance sheet.
o All asset accounts are assumed to vary directly with sales unless the firm is operating at
less than full capacity; in which case only cash, receivables, and inventory accounts
increase in proportion to the increase in sales.
o Liabilities, equity, or both must also increase if assets increase—asset expansions must be
financed in some manner.
o Certain liability accounts, such as accounts payable and accruals, provide spontaneously
generated funds, because they increase spontaneously at the same rate as sales due to
normal business relationships.
o Retained earnings will increase, but not proportionately with sales. The new retained
earnings will be determined from the projected income statement.
o Changes in other financing accounts, such as notes payable, long-term debt, and common
stock, are not directly related to sales, and result from conscious financing decisions. For
the initial forecast, it is assumed that these account balances remain unchanged from their
prior-year level.
o The difference between projected total assets and projected liabilities and equity is the
amount of additional funds needed that must be financed from external sources, either by
borrowing or by selling new stock.
o The third step is the decision on how to finance the additional funds needed (AFN).
o A firm’s decision on how to raise the additional funds will be based on several factors,
including its ability to handle additional debt, conditions in the financial markets, and
restrictions imposed by existing debt agreements.
o One complexity that arises in financial forecasting relates to financing feedbacks, which are
the effects on the income statement and balance sheet of actions taken to finance forecasted
increases in assets.
o The external funds raised to pay for new assets creates additional expenses that must be
reflected in the income statement, lowering the initially forecasted addition to retained
earnings, and thus, requiring more external funds to compensate for the lower amount
added to retained earnings.
o Financing feedbacks are incorporated into the pro forma financial statements through
additional calculations, or passes, of the projected income statement and balance sheet until
AFN is equal to zero.
o Appendix 12A gives a more detailed description of the iterations required to generate the
final forecasts.
Financial breakeven analysis is a method of determining the operating income, or EBIT, the
firm needs to just cover all of its financing costs and produce earnings per share equal to
zero. Typically, the financing costs involved in financial breakeven analysis consist of interest
payments to bondholders and dividend payments to preferred stockholders.
o Financial breakeven analysis deals with the lower portion of the income statement—the
portion from operating income (EBIT) to earnings available to common stockholders.
o The lower portion of the income statement is generally referred to as the financing section,
because it contains the expenses associated with the financing arrangements of the firm.
o The point at which EPS equals zero is referred to as the financial breakeven point.
o The financial breakeven point can be calculated as:
o
Earnings available
to common stockholders
=0
EPS =
Number of
common shares outstanding
=
(EBIT − I)(1 − T) − D ps
Shrs C
= 0.
o Here I represents debt interest payments, T is
the marginal tax rate, Dps equals preferred
dividends, and SharesC is the number of
common shares outstanding.
o EPS equals zero when the numerator of the
EPS
3
2
Financial
BEP
1
0
EBIT
20
40
60
80
-1
-2
2
equation above is equal to zero. The numerator can then be rewritten to solve for the EBIT
needed to produce EPS equal to zero:
o EBITFinBEP = I +
D ps
(1 − T )
.
o The amount of preferred dividends must be stated on a before-tax basis to determine the
financial breakeven point. However, if a firm has no preferred stock the firm only needs to
cover its interest payments, so the financial breakeven point simply equals the interest
expense.
o Financial breakeven analysis can be used to help determine the impact of the firm’s
financing mix on the earnings available to common stockholders.
o Financial leverage affects the financing section of the income statement like operating
leverage affects the operating section.
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