How Managers Use Financial Statement

•A vital step in financial planning is to forecast financial statements, which are called projected financial statements or pro forma statements.
•Managers use projected financial statements in four ways: 

(1) By looking at projected statements, they can assess whether the firm’s anticipated performance is in line with the firm’s own general targets and with investors’ expectations.

(2) Pro forma statements can be used to estimate the effect of proposed operating changes, enabling managers to conduct “what if” analyses.

(3) Managers use pro forma statements to anticipate the firm’s future financing needs.

(4) Managers forecast free cash flows under different operating plans, forecast their capital requirements, and then choose the plan that maximizes shareholder value.


Operating Plan and Financial Plan

•An operating plan provides detailed implementation guidance for a firm’s operations, including 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 most companies use a 5-year horizon, with the plan being quite detailed for the first year but less and less specific for each succeeding year. The plan explains who is responsible for each particular function and when specific tasks are to be accomplished.
•An important part of the operating plan is the forecast of sales, production costs, inventories, and other operating items. In fact, this part of the operating plan actually is a forecast of the company’s expected free cash flow. Free cash flow is the primary source of a company’s value. Using what-if analysis, managers can analyze different operating plans to estimate their impact on value. In addition, managers can apply sensitivity analysis, scenario analysis, and simulation to estimate the risk of different operating plans, which is an important part of risk management.


Growing Operating Assets

•A company’s operating assets can grow only by the purchase of additional assets. Therefore, a growing company must continually obtain cash to purchase new assets. Some of this cash might be generated internally by its operations, but some might have to come externally from shareholders or debtholders. This is the essence of financial planning—forecasting the additional sources of financing required to fund the operating plan.


Connection between Financial Planning and Free Cash Flow

•There is a strong connection between financial planning and free cash flow. A company’s operations generate the free cash flow, but the financial plan determines how the company will use the free cash flow.
•Free cash flow can be used in five ways:
(1) pay dividends
(2) repurchase stock
(3) pay the net after-tax interest on debt
(4) repay debt
(5) purchase financial assets such as marketable securities.
•A company’s financial plan must use free cash flow differently if FCF is negative than if FCF is positive.


Allocating Free Cash Flow

•If free cash flow is positive, the financial plan must identify how much FCF to allocate among its investors (shareholders or debtholders) and how much to put aside for future needs by purchasing marketable securities. If free cash flow is negative, either because the company is growing rapidly (which requires large investments in operating capital) or because the company has low NOPAT, then the total uses of free cash flow must also be negative.
•For example, instead of repurchasing stock, the company might have to issue stock; instead of repaying debt, the company might have to issue debt.


Components of a Financial Plan

•The financial plan must incorporate:

(1) the company’s dividend policy, which determines the targeted size and method of cash distributions to shareholders.

(2) the capital structure, which determines the targeted mix of debt and equity used to finance the firm, which in turn determines the relative mix of distributions to shareholders and payments to debtholders.




Last modified: Tuesday, August 14, 2018, 8:52 AM