Chapter 9 Discussion

You are supposed to provide reasonable explanation based on your textbook and lecture
first and then if desired, add other information collected from other sources. For
problems, show all you work for full credit.
1. List and discuss briefly the major components of a firm’s financial plan. What role do
projections of financial statements play in the development of the financial plan?

The major components of a firm’s financial plan are: Operating plan and financial plan.
i) Operating plan provides guidance on detailed implementation for a firm’s operations.
These operations include the firm’s choice of market segments, product lines, sales and
marketing strategies, production processes, and logistics. An operating plan can be
developed for any time horizon, but companies typically use a 5-year horizon. They plan
on being detailed for the first year but less specific for each succeeding year. The
important part of the operating plan is forecasting sales, production costs, inventories,
and other operating items. This part is a forecast of company’s expected cash flows.
ii) The financial plan: The importance of the financial plan is to forecast the sources of
additional financing required to fund the operating plan. A company’s assets can only
grow by purchasing additional assets. Some are generated from operations, but some
might come externally from shareholders or debtholders. The financial plan determines
how a company would use free cash flows.
Projections of financial statements are used to estimate the impact that various
operating plans have on intrinsic value. They are also used to identify deficits that must
be financed in order to implement the operating plans.

2. A major component of financial planning is to forecast future financial statements. If you

had a company’s balance sheets and income statements for the past five years but no
other information, how would you use the forecasted financial statement approach to
forecast the following items for the coming year? (A) its sales revenues, (B) its financial
statements, (C) its fund requirements (AFN), (D) its financial condition and profitability as
shown by its ROE and other key ratios.

A) You could forecast sales revenues for the coming year by using the past years’ sales
numbers from the income statement and creating a forecasted growth rate by using a
weighted average, leveraging more weight towards the more recent years. For example,
if the forecasted growth rate was 10%, then you would take the sales of the past year
and multiply it times 1+0.10 or 1.10.
B) Using the basic approach, one can forecast the financial statements for the coming
year by following three steps: forecasting operating items, forecasting debt, equity, and
dividends that are determined from the short-term financial policy, and ensuring that the
company has sufficient (but not excessive) funding for the operating plan. In order to
forecast the operating items, you must first forecast sales revenue to build the beginning
of the income statement. From that point, other income statement information, such as
Operating assets and liabilities, can be derived as a percentage of the sales from the
past year. Operating assets minus operating liabilities results in NOWC (Net Operating
Working Capital), which helps to calculate Free Cash Flow (FCF). Those Free Cash
Flows are used as a basis towards an estimated intrinsic value of the company, which is
 the final operating item to be found. Debt, equity, and dividends can be found in the past
year’s balance sheet as the liabilities. Lastly, the AFN, or Additional Funds Needed,
equation is used to find if the company has a financial deficit, how it can be improved,
and the amount of additional finances that are needed to make the operating plan work
efficiently.
C) AFN, or additional funds needed, is the equation used to identify any financial surplus
or deficit that the company has in terms of implementing the operating plan. It can be
found by using the difference between the additional assets and the sum of spontaneous
liabilities and reinvested net income of the company.
D) Once the financial statements are forecasted (as shown in part B), the profitability of
the company and the ROE (return on equity) can be found using the information in the
forecasted income statement and balance sheet.

3. If you had a set of industry average ratios for the firm you are analyzing, how would you
use these data?

Using industry average ratios can be incredibly useful for a firm that is looking to alter
certain elements of their operational structure to improve overall performance compared
to their industry as a whole. Depending on the ratios used, a firm can see how their
general industry compares to their own return on equity, return on assets, net profit
margin, or debt-to-equity, and make the appropriate decisions needed to either increase
or decrease their numbers in comparison. While these comparisons are very useful to
corporations looking to improve their performance, it should be noted that industry
average ratios are more unreliable than looking at the performance of the industry
leaders and using their numbers as a benchmark. Additionally, the fewer firms that you
look at, the less distorted the ratios will be. It may be more useful for a firm to use
industry average ratios to set broad goals for themselves and formulate the proper
questions to ask about their own performance than to rely heavily on the data that they
find.

4. Daniel Sawyer, the CEO of the Sawyer Group, is initiating planning for the company's
operations next year, and he wants you to forecast the firm's additional funds needed
(AFN). The firm is operating at full capacity. Data for use in your forecast are shown
below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in
millions.
Last year's sales = S0 $350 Last year's accounts $40
payable

Sales growth rate = g 30% Last year's notes payable $50

Last year's total assets = $880 Last year's accruals $30

A0*

Last year's profit margin = 5% Target payout ratio 60%

PM

S1: 455 Last Year Liabilities: $70 =(30+40)

 (350*1.30= $455)

S = $105
(455-350= 105)

RR = 40%
(1-.6= .40)

AFN = (880/350)*(105)-(70/350)*(105)-5%*455*40%
AFN = $233.90