Question

This week the lesson is Financial Planning. The text focuses on two approaches for coming up with an answer to the same question; how much external financing will be needed next year. One is the final step in projecting financial statements for the next period and the other is the AFN Equation. Which approach do you consider superior and why?

Answer 1

The Projected financial statements approach can be considered superior for the following reasons:
The AFN equation is:
AFN = [(Assets / Sales) x Δ sales] - [(Spontaneous liabilities / Sales) x Δ sales] - [(Projected sales x Profit margin) x (1-Dividend payout ratio)]
	As can be seen, the AFN equation assumes that each component
	of total assets & each component of spontaneous liabilites
vary directly with sales. Further, it assumes that the % variation
is the same as last year.
These assumptions are faulty, as each component of the total
assets would vary with respect to increase in sales differently.
So is the case with the components of spontaneous liabilities.
In actual practice, with growth, scale economies would arise and
the uniform increase envisaged would be incorrect.
Again, the last term of the equation which, deals with the
addition to retained earnings, is also over simplified, as it
assumes a constant % of net income on sales. This is also not
rational as some expenses do not vary with sales [fixed expenses].
In contrast, the projected financial statements method of finding the
AFN, provides for flexibility in projections. Each component of
assets and spontaneous liabilities can be projected separately
using the % of sales metric or other target parameters like average
collection period for receivables, days' sales in inventory and so on.
It can also accommodate disproportionate growth in fixed assets.
As for the income statement, the projected statements can use
different criteria for different items of expenses and consider
improvements in cost ratios.
Further, the projected statements method can be used to replan
the entire operations of the firm if, the initial AFN projected is not
feasible.
In summary, while the AFN equation is simple to calculate, it would
give only a first stage estimate, which should be refined using the
projected statements method.