ISBN: 0-03-028931-9
Chapter 4 Financial Planning and Forecasting
Both investors and corporations regularly use forecasting techniques to help value a company's stock, to estimate future benefits of potential projects, and to estimate how changes in capital structure, dividend policy, and working capital policy will influence shareholder value. This is an outline of a few of the main concepts, please refer to the textbook for more comprehensive coverage.
The first element in strategic planning is the mission statement. The mission statement is a condensed version of a company's strategic plan. The mission statement and strategic plans often begin with a statement of the overall corporate purpose, generally regarding the creation of value for shareholders. Within the overall strategic plan, a corporation must define the corporate scope, which defines the firm's lines of businesses and geographic area of operations. Whereas the corporate purpose provides the general philosophy of business, it fails to provide managers with operational objectives. The statement of corporate objectives sets forth specific goals (both qualitative and quantitative) to guide management.
Once a firm has defined its purpose, scope, and objectives, it must develop a strategy for achieving its goals. Corporate strategies represent broad approaches for achieving corporate goals, and should be both attainable and compatible with the firm's purpose, scope, and objectives.
Operating plans provide detailed guidance to help meet corporate objectives, and are based upon the corporate strategy.
The financial plan outlines the manner in which funds are anticipated to be generated to support the firm's operating plans. It can be broken down into the following six steps: (1) projecting financial statements and using these projections to analyze the effects of the operating plan, (2) determining the funds needed to support the plan over its duration, (3) forecasting the funds availability over the plan's duration, (4) establishing and maintaining a system of controls to govern the allocation and use of funds by the firm, (5) developing procedures for adjusting the basic plan if the economic forecasts expected do not materialize, and (6) establishing a performance-based management compensation system.
The first step in any financial forecast is to estimate the growth of the firm's sales. This can be accomplished by looking at past growth rates, growth rates of comparable firms, linear regression, or some other method.
From that point, some assumptions must be made about the manner in which productive assets are expected to behave as sales grow. Either the financial statement method or the AFN formula method can be used to forecast financial requirements. Though, the financial statement method is more reliable and can be used in the evaluation of alternative business plans.
A firm can determine its additional funds needed (AFN) by estimating the amount of new assets necessary to support the forecasted level of sales and then subtracting from that the spontaneous funds that will be generated from operations. The firm can then plan how to raise the AFN most efficiently. The AFN can be determined as the increase in assets minus the increase in spontaneous liabilities and the increase in retained earnings.
The higher a firm's sales growth rate, the greater will be its need for additional financing. Similarly, the smaller its retention ratio, the greater its need for additional funds.
The four most common relationships between the growth of sales and productive assets are: (1) constant ratios, in which the firm's productive assets stay a constant percentage of sales, (2) economies of scale, in which firms are able to capitalize on comparative advantages and generate synergies regarding the efficiency of productive assets, (3) curvilinear relationship, in which the relationship between sales and assets ceases to be linear, and becomes a curve that also allows for increased efficiency of productive assets, and (4) lumpy assets, in which assets cannot be acquired in small increments but must be obtained in large, discrete units. In addition, another scenario can occur where future AFN is distorted because previous forecasting errors result in either a surplus or deficiency of productive assets.
Still other methods of forecasting asset requirements include linear regression and excess capacity adjustments.
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