Overview of Financial Planning 409
Chapters 9 and 10 described what financial statements are and showed how both man-
agers and investors analyze them to evaluate a firm’s past performance. While this is
clearly important, it is even more important to look ahead and to anticipate what is
likely to happen in the future. So, both managers and investors need to understand
how to forecast future results.
Managers make pro forma,or projected, financial statementsand then use them
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 in-
vestors’ expectations. For example, if the projected financial statements indicate that
the forecasted return on equity is well below the industry average, managers should in-
vestigate the cause and then seek a remedy. (2) Pro forma statements can be used to esti-
mate the effect of proposed operating changes. Therefore, financial managers spend a
lot of time doing “what if” analyses. (3) Managers use pro forma statements to antici-
pate the firm’s future financing needs. (4) Projected financial statements are used to esti-
mate future free cash flows, which determine the company’s overall value. Thus, man-
agers forecast free cash flows under different operating plans, forecast their capital
requirements, and then choose the plan that maximizes shareholder value. Security an-
alysts make the same types of projections, forecasting future earnings, cash flows, and
stock prices.
We will have more to say about managers’ and investors’ use of projections in
Chapter 12, when we discuss corporate valuation and value-based management. First,
though, in this chapter we explain how to create and use pro forma financial state-
ments. We begin with an overview of the planning process.
Overview of Financial Planning
Our primary objective in this book is to explain what managers can do to make their
companies more valuable. Managers must understand how investors determine the
values of stocks and bonds if they are to identify, evaluate, and implement projects that
meet or exceed investor expectations. However, value creation is impossible unless the
company has a well-articulated plan. As Yogi Berra once said, “You’ve got to be care-
ful if you don’t know where you’re going, because you might not get there.”
Strategic Plans
Strategic plans usually begin with a statement of the overall corporate purpose.Most
companies are very clear about their corporate purpose: “Our mission is to maximize
shareowner value over time.”
This corporate purpose is increasingly common for U.S. companies, but that has
not always been the case. For example, Varian Associates, Inc., a New York Stock
Exchange company with sales of almost $2 billion, was, in 1990, regarded as one of the
most technologically advanced electronics companies. However, Varian’s management
was more concerned with developing new technology than with marketing it, and its
stock price was lower than it had been ten years earlier. Some of the larger stockhold-
ers were intensely unhappy with the state of affairs, and management was faced with
the threat of a proxy fight or forced merger. In 1991, management announced a
change in policy and stated that it would, in the future, emphasize both technological
excellence andprofitability, rather than focusing primarily on technology. Earnings
improved dramatically, and the stock price rose from $6.75 to more than $60 within
four years of that change in corporate purpose.
The textbook’s web site
contains an Excelfile that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 11
Tool Kit.xlsand we encour-
age you to open the file and
follow along as you read the
chapter.
406 Financial Planning and Forecasting Financial Statements
