short-term financial management chapter 13 – short-term financial planning

SHORT-TERMFINANCIAL MANAGEMENT

Chapter 13 – Short-Term Financial Planning

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S/T FINANCIAL PLANNING

Chapter 13 Agenda

Differentiate between a long-term and short-term financial planning model, develop a financial planning model, and discuss and interpret the sustainable growth rate.

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S/T Financial Planning

Short-term financial planning differs from long-term financial decisions in two important ways: Decisions are easily reversed in most cases.

There is far less uncertainty about the decision variables since the planning horizons are shorter.

Short-term financial decisions ensure the firm's liquidity and are critical to the short-term survival of the business. Rapidly growing companies focused on sales often

run out of cash given the need to have additional cash tied up in assets.

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S/T Financial Planning

We assume it requires additional assets to support incremental sales. This includes new, permanent current assets as well as

new fixed assets (unless the firm is not operating at capacity).

The additional assets must have a financing source. Some might be supported by financial slack (excess cash or

ready access to debt).

Short-term financial planning allows a firm to model different assumptions about sales growth rates and plan for the impact on: Cash flow The Balance Sheet The Income Statement

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Types of Models

Deterministic Data inputs are single point estimates

Example – Sales growth is expected to be 5%

Stochastic Data inputs include probability distributions

Example – Sales growth is normally distributed with an expected value of 5% and a standard deviation of 3%

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6 Steps in Modeling Process

Determine question asked – What is the dependent variable?

Variable specification – What are the independent variables? Generally, the longer the time period, the less detail needed.

Determine relationship between variables Example – Ct = a1CSt + a2CSt-1 + a3CSt-2

Where: Ct = Cash flow from sales

CSt = Credit sales in month t

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6 Steps in Modeling Process – cont. Parameter estimation – a1, a2, and a3 in

previous slide. Estimates may be simple historical average or may be found by using fancy statistics.

Model validation – Run the model using some real data and check the results.

Model documentation – Write down the logic behind the model.

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Basics of Model Building

Decide on driving variable (Usually sales) Avoid the temptation to make model too

detailed Build model into electronic worksheet Use cell references to minimize model

changes

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Growth Ratios

It is important to understand the impact on the balance sheet based on different assumptions around growth rates. Assets should grow (or shrink) in relationship to

sales.

We’ll look at two forecasting models: % of Sales (Needed External Financing – NEF)

Sustainable Growth Rate (SGR)

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Forecasting Models

% of Sales (Needed External Financing – NEF) The amount of external financing needed for a desired

level of sales growth. Firms that grow faster than the SGR must support growth

with incremental external capital. Conversely, firms growing slower than the SGR have excess

cash to retire debt, increase dividends, etc.

Sustainable Growth Rate (SGR) Maximum sales growth rate using both internal and

external sources of financing, but without increasing leverage ratio or changing existing financial policies: D/E, A/S, capital structure, profit margin, and dividend

payout ratio.

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Forecasting Models

% of Sales (Needed External Financing-NEF)

Answers the question: “What amount of new capital do I need if I plan to grow X% or by $Y?”

Sustainable Growth Rate (SGR)

Answers the question: “How much can I grow without changing existing financing policies?”

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% of Sales Forecasting Model

We assume it requires additional assets to support incremental sales and that balance sheet relationships stay consistent and proportional (+/-) to sales volume.

e.g.: If Total Assets are 45% of sales this year and we are at 100% capacity, we assume the same relationship next year based on next year’s projected sales.

The additional assets must have a financing source. Current liabilities (primarily A/P and accruals) are a

spontaneous source of financing.

Another source of financing is new retained earnings.

Any gap is needed external financing (NEF) and must be supplied by external financing (probably short-term debt (N/P), but could include long-term debt and/or new equity).

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1. Additional Total Assets are required to support incremental sales.

2. Some of these additional Assets (e.g.: Inventory) will be supported by ‘spontaneous financing’ through increased Current Liabilities.

3. Some of these assets are supported by earnings retained by the firm (profits not paid out as dividends).

The NEF can be acquired through either new debt or new equity, but must be acquired externally from somewhere to support sales growth.

1

2

3

NEF = Total Assets / Sales × Change in Sales

- Current Liabilities / Sales × Change in Sales

- Sales × Net Profit Margin × [1 - (Dividends / Net Profit)]

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1

2

3NEF = Total Assets / Sales × Change in Sales



Make sure you’re using the right inputs.

1. Previous year’s sales

2. Projected sales

3. Change in sales

1

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Using notation, the formula is:

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% of Sales Forecasting Model Example

This firm anticipates an increase in sales to $15 million (an increase of $2.75 million, or 22.4%) …will it require external financing?

Total Asssets 15,580,000$ Current Liabilities 4,261,000$

Long-Term Debt 3,638,000$

Net Worth 7,681,000$

Total Assets 15,580,000$ Total Liabilities & NW 15,580,000$

Net Sales 12,250,000$

Net Profit 692,000$

Dividends 429,000$

BALANCE SHEET

INCOME STATEMENT

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NEF = $15,580,000 / $12,250,000 × $2,750,000

- $4,261,000 / $12,250,000 × $2,750,000

- $15,000,000 × ($692,000 / $12,250,000) × [1 - ($429,000 / $692,000)]

NEF = 1.2718 × $2,750,000 = $3,497,551

- 0.3478 × $2,750,000 = $956,551

- $847,347 × 0.3801 = $322,041

$2,218,959

Firm must pre-arrange this amount

of incremental

external financing to

support planned

sales growth.


Total Asssets 15,580,000$ Current Liabilities 4,261,000$ Net Sales 12,250,000$

Long-Term Debt 3,638,000$ Net Profit 692,000$

Net Worth 7,681,000$ Dividends 429,000$


BALANCE SHEET INCOME STATEMENT

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The sales growth will impact the financial statements.









SHORTFALL (NEF) 2,218,959$


LAST YEAR

PRO-FORMA FOR THIS YEAR



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= ($4,261,000 + $3,638,000) / $7,681,000

= 1.028

= ($5,217,551 + $5,856,959) / $8,003,041

= 1.384

Given the shortfall, the firm must have grown faster than the SGR, since the Debt/Equity ratio increased. Here, the shortfall was added to LTD; the firm could have

increased STD or equity instead.

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Sustainable Growth Rate (SGR) Sustainable growth can be estimated by equating

annual sources of capital to annual uses. If Uses = Sources

Then New Assets = New Equity + New Debt

And gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E)

Where, S = Prior year sales gS = Dollar change in sales during planning year A/S = Target ratio of total assets to total sales m = Projected after-tax profit margin d = Target dividend payout ratio (dividends/earnings) D/E = Target debt-to-equity ratio

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Sustainable Growth Rate

gS(A/S) = m(S + gS)(1-d) + m(S + gS)(1-d)(D/E)

gS(A/S) is the increase in assets required to support the expected increase in sales.

It is assumed the firm is operating efficiently.

Therefore, the uses of cash (the left-hand side of the equation) must be supported by new sources on the right-hand side).

A portion of the incremental assets

will come from additions to retained earnings (profits less

dividends paid).

As equity increases, liabilities can increase proportionately and

still maintain a constant value for D/E.

The growth in assets is limited to a constant proportion of D/E.

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The sales growth rate (g) that satisfies the previous equation is given by:

Where, S = Prior year sales gS = Dollar change in sales during planning year A/S = Target ratio of total assets to total sales m = Projected after-tax profit margin d = Target dividend payout ratio (dividends/earnings) D/E = Target debt-to-equity ratio

D/E1 d-1 m-A/S

)D/E1 d-1 mg*

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For this same firm, what is the SGR?

Total Asssets 15,580,000$ Current Liabilities 4,261,000$




Net Sales 12,250,000$

Net Profit 692,000$

Dividends 429,000$

BALANCE SHEET

INCOME STATEMENT


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m = $692,000 / $12,250,000 = 5.65%

1 - d = 1 - ($429,000 / $692,000) = (1-62%) = 38%

1 + D/E = 1 + (($4,261,000 + $3,638,000) / $7,681,000)

A/S = $15,580,000 / $12,250,000

=0.043548114

3.545%1.228288621

D/E1 d-1 m-A/S

)D/E1 d-1 mg*

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The firm can only grow sales to $12.7 million (3.545%) without changing its financial policies.

3.545%


3.545%

A/S = 1.272

A/S = 1.272

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NEF v. SGR

NEF SGR

D/E = 1.028

D/E = 1.384

Current Liabilities 4,261,000$



Total Liabilities & NW 15,580,000$

Current Liabilities 4,412,071$



Total Liabilities & NW 16,132,378$

LAST YEAR

PRO-FORMA FOR THIS YEAR

D/E = 1.028

D/E = 1.028

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SGR = ROE x (1 - dividend-payout ratio)= ($716,534 / $7,681,000) x ((1 – ($444,210 / $716,534))

3.545%

Alternative SGR Formula

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SGR = (ROE x b)/(1 – ROE x b)= ($692,000/7,681,000) x (.38)/(1 – $692,000/7,681,000)

3.545%

Alternative SGR Formula

b = (692,000 – 429,000)/692,000 = 0.38

short-term financial management chapter 13 – short-term financial planning

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