A simple financial planning model we can begin our

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Unformatted text preview: mmarize the projected future financial status of a company. A Simple Financial Planning Model We can begin our discussion of long-term planning models with a relatively simple example. The Computerfield Corporation’s financial statements from the most recent year are as follows: C O M P U T E R FI E LD C O R P O R AT I O N Fi n a n c i a l S t a t e m e n t s Income Statement Sales Costs Net income $1,000 800 $ 200 Assets Total Balance Sheet $500 $500 Debt Equity Total $250 250 $500 Unless otherwise stated, the financial planners at Computerfield assume that all variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. This is obviously oversimplified; we use this assumption only to make a point. Suppose sales increase by 20 percent, rising from $1,000 to $1,200. Planners would then also forecast a 20 percent increase in costs, from $800 to $800 1.2 $960. The pro forma income statement would thus be: P r o Fo r m a Income Statement Sales Costs Net income $1,200 960 $ 240 The assumption that all variables will grow by 20 percent will enable us to easily construct the pro forma balance sheet as well: P r o Fo r m a B a l a n c e S h e e t Assets Total $600 ( 100) $600 ( 100) Debt Equity Total $300 ( 50) 300 ( 50) $600 ( 100) Planware provides insight into forecasting cash flow (and other items) (www.planware.org). Notice we have simply increased every item by 20 percent. The numbers in parentheses are the dollar changes for the different items. Now we have to reconcile these two pro formas. How, for example, can net income be equal to $240 and equity increase by only $50? The answer is that Computerfield must have paid out the difference of $240 50 $190, possibly as a cash dividend. In this case, dividends are the “plug” variable. 66 PART 1 Overview ros82361_ch03.indd 66 5/27/08 10:15:07 AM Confirming Pages Suppose Computerfield does not pay out the $190. In this case, the addition to retained earnings is the full $240. Computerfield’s equity will thus grow to $250 (the starting amount) plus $240 (net income), or $490, and debt must be retired to keep total assets equal to $600. With $600 in total assets and $490 in equity, debt will have to be $600 490 $110. Since we started with $250 in debt, Computerfield will have to retire $250 110 $140 in debt. The resulting pro forma balance sheet would look like this: P r o Fo r m a B a l a n c e S h e e t Assets Total $600 ( 100) $600 ( 100) Debt Equity Total $110 ( 140) 490 ( 240) $600 ( 100) In this case, debt is the plug variable used to balance out projected total assets and liabilities. This example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Because assets are growing, total liabilities and equity, the right-hand side of the balance sheet, will grow as well. The thing to notice from our simple example is that the way the liabilities and owners’ equity change...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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