6 6 Chapter Financial Planning Slides Developed by: Terry Fegarty Seneca College.

66Chapt

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er Financial PlanningFinancial Planning

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 6 – Outline (1)

• Business Planning Component Parts of a Business Plan The Purpose of Planning and Plan Information Four Kinds of Business Plan Financial Plans as a Component of a Business Plan

• Making Financial Projections Planning for New and Existing Businesses The General Approach and Planning Assumptions The Procedural Approach and the Debt/Interest

Problem Percentage of Sales Method


Chapter 6 – Outline (2)

External Funding Requirement The Sustainable Growth Rate Plans With More

Complicated Assumptions Planning at the Department Level The Cash Budget Receivables and Payables—Forecasting with Time

Lags Debt and Interest

• Management Issues in Financial Planning Risk in Financial Planning in General Financial Planning and Computers


Business Planning

• A business plan is a model of what management expects a business to become in the future Expressed in words and financial projections

• Financial statements are pro forma What the firm’s financial statements will look like if

the planning assumptions are true

• A good business plan should be comprehensive Includes projections concerning products, markets,

employees, technology, facilities, capital, revenue, profitability, etc.


Component Parts of a Business Plan(1)• Typical outline

Contents Executive summary Mission and strategy statement

• Basic charter and long-term direction

Market analysis• Why the business will succeed against its competitors

Operations of the business• How the firm creates and distributes its products/services


Component Parts of a Business Plan (2)

Management and staffing• Firm’s projected personnel needs

Financial projections• Projects the firm’s financial statements into the

future• The firm’s financial plan

• Main focus of this chapter

Contingencies• What the firm will do if things don’t go as planned


The Purpose of Planning and Plan Information• Major audience of business plan includes

Firm’s own management• Planning process helps pull management team together• Provides a road map for running the business• Provides a statement of goals• Helps predict financing needs

• Especially important for firms that use outside financing

Outside investors• Tells equity investors what returns they can expect• Tells debt investors where firm will get the money to repay

loans


Four Kinds of Business Plan

• Four variations on basic idea of business planning Strategic planning Operational planning Budgeting Forecasting

• All contain financial projections



• Four variations on basic idea of business planning Strategic planning

• Addresses broad, long-term issues; contains summarized, approximate financial projections

• Three to five-year horizon is common• Deals with concepts expressed mainly in words;

numbers are summarized• Firm analyzes itself, the industry and the competitive

situation• Firm states its mission and goals



• Four variations on basic idea of business planning Operational planning

• One-year planning horizon• States goals and managers responsible for

meeting the goals• Translates business ideas (day-to-day operations)

into detailed, annual projections• Includes projected income statements and balance

sheets• Even mix of words and numbers



• Four variations on basic idea of business planning Budgeting

• Short-term updates of the annual plan when business conditions change rapidly

• Typically covers a quarter (3 months)• Predominately financial projections



• Four variations on basic idea of business planning Forecasting

• Very short-term projections of profit and cash flow • Consist almost entirely of numbers• Most large firms perform monthly cash forecasts



• The Business Planning Spectrum Most large companies produce all the parts of a

business plan Strategic plan and operating plan are updated

annually 4 quarterly budgets and 12 monthly forecasts Small businesses tend to develop a single business

plan when in need of funding• Contains strategic, operating and budgeting elements


Figure 6.2: The Business Planning Spectrum


Financial Plans as a Component of a Business Plan• Financial plan is a set of pro forma

financial statements projected over the time periods covered by the business plan

• Financial statements are a piece of the projection, but not usually the center of the projection However, with annual operating plans the

financial projections are the centerpiece


Planning for New and Existing Businesses• Harder to forecast an operation that is very new

or not yet begun No history on which to base projections

• The Typical Planning Task Most financial planning involves forecasting changes

in ongoing businesses based on planning assumptions

Pro forma statements must reflect the assumptions made such as

• Unit sales will rise by 10% annually• Overall labour costs will rise by 4%, etc.


The General Approach and Planning Assumptions• What We Have and What We Need to Project

We must forecast future financial statements, based upon last period’s results and our planning assumptions

• Planning Assumption An expected condition that dictates the size of one or

more financial statement items• Could be planned management actions such as cost control• Could be items outside management control such as interest

rate levels or demand by consumers


Example 6.1: Planning Assumptions

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Q: This year Crumb Baking Corp. sold 1 million coffee cakes per month at $1 each for a total of $12 million.

The firm had year-end receivables equal to two months of sales, or $2 million.

Crumb’s operating assumptions for next year are:

Price will be decreased by 10%

Sales volume will increase to 15 million units

Only one month of sales will be in receivables at year end.

Forecast next year’s revenue and ending receivables balance. Assume sales are evenly distributed over the year.


Example 6.1: Planning Assumptions

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A: The first two assumptions establish the revenue forecast.

Next year, the firm expects to sell 15 million coffee cakes at $0.90 each, for total revenue of $13,500,000.

The third assumption regarding receivables requires the use of the total revenue forecast.

Receivables are expected to be $13,500,000 12, or $1,125,000.


The Procedural Approach and the Debt/Interest Problem• The Procedural Approach

Financial plans are built line-by-line beginning with revenues• First, all income statement (IS) items are

projected, stopping just before interest expense line

• Then all balance sheet (BS) items are projected except long-term debt and equity


The Procedural Approach and the Debt/Interest Problem• Debt/Interest Planning Problem

The next items needed are interest expense (IS) and debt (BS)

However, this causes a dilemma because• Planned debt is required to forecast interest, but interest is

required to forecast net income, retained earnings and debt

• Results in a circular argument• Every financial plan runs into this technical

problem• Can be resolved using an iterative approach

beginning with a guess at the solution


Figure 6.5: The Debt/Interest Planning Problem


Example 6.2: An Iterative Numerical Approach

Q: Complete the financial plan for Graybarr Inc., assuming that Graybarr pays interest at 10% and has a tax rate of 40%. No dividends are to be paid and no new shares are to be sold.

Next Year Beginning EndingRevenue 10,000$ ASSETSCost/Expenses 9,000$ Total Assets 1,000$ 3,000$ EBIT 1,000$ LIABILITIES AND EQUITYInterest ? Current Liabilities 300$ 700$ EBT ? LT Debt 100$ ?Tax ? Equity 600$ ?NI ? Total L&E 1,000$ 3,000$

Next YearBalance SheetsIncome Statements

Financial Plan for Graybarr Inc. ($000)

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A: The huge increase in assets will cause the company’s debt to increase at a dramatic rate. The first iteration:

Next Year Beginning EndingRevenue 10,000$ ASSETSCost/Expenses 9,000$ Total Assets 1,000$ 3,000$ EBIT 1,000$ LIABILITIES AND EQUITYInterest 200$ Current Liabilities 300$ 700$ EBT 800$ LT Debt 100$ 1,220$ Tax 320$ Equity 600$ 1,080$ NI 480$ Total L&E 1,000$ 3,000$

Next YearBalance SheetsIncome Statements

Financial Plan for Graybarr Inc. ($000)

1: Guess at the firm’s interest expense. Most firms use last

year’s value as a guess.

2: Compute NI.

3: Calculate Ending

equity as beginning equity plus

NI less dividends.

4: Calculate Ending LT debt as total L&E less ending equity less ending current

liabilities.

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A: Average debt: ($100,000 + $1,220,000) 2 = $660,000.Calculated interest: 10% × $660,000 = $66,000

Initial guess: $200,000. Perform a second iteration using an interest guess of $66,000

Next Year Beginning EndingRevenue 10,000$ ASSETSCost/Expenses 9,000$ Total Assets 1,000$ 3,000$ EBIT 1,000$ LIABILITIES AND EQUITYInterest 66$ Current Liabilities 300$ 700$ EBT 934$ LT Debt 100$ 1,140$ Tax 374$ Equity 600$ 1,160$ NI 560$ Total L&E 1,000$ 3,000$

Financial Plan for Graybarr Inc. ($000)Income Statements Balance Sheets

Next Year

Using the guess of

$66,000, the average LT

debt is $620,000 and the calculated

interest is $62,000, a

difference of only $4,000.

A third iteration using $62,000 would finalize the forecast with LT Debt = $1,137,000

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Percentage of Sales Method

• A short-cut, less exact, easier method of forecasting financial statements (The “quick and dirty” approach)

• Based upon forecast for the firm’s sales growth rate

• Assumes most financial statement line items will vary directly with sales


Example 6.3: Percentage of Sales Method

Q: The Overland Manufacturing Company expects next year’s revenues to increase by 15% over this year’s. No new capital assets beyond normal replacements will be needed. This year’s income statement and ending balance sheet:

Revenue 13,580$ ASSETSCOGS 7,470$ Cash 348$ Gross Margin 6,110$ Accounts receivable 1,698$ Expenses 3,395$ Inventory 1,494$ EBIT 2,715$ Current assets 3,540$ Interest 150$ Net capital assets 2,460$ EBT 2,565$ Total Assets 6,000$ Tax 1,077$ LIABILITIES AND EQUITYNI 1,488$ Accounts payable 125$

Accruals 45$ Current Liabilities 170$ LT Debt 1,330$ Equity 4,500$ Total L&E 6,000$

Income StatementOverland Manufacturing Company This Year ($000)

Balance Sheet

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Assume the firm pays income taxes at a rate of 42%, borrows at 12% interest, and expects to pay no dividends. Project next year’s income statement and balance sheet by using the modified percentage of sales method.

A: We’ll increase everything except net capital assets by 15%.

Revenue 15,617$ ASSETSCOGS 8,591$ Cash 400$ Gross Margin 7,027$ Accounts receivable 1,953$ Expenses 3,904$ Inventory 1,718$ EBIT 3,122$ Current assets 4,071$ Interest - Net capital assets 2,460$ EBT - Total Assets 6,531$ Tax - LIABILITIES AND EQUITYNI - Accounts payable 144$

Accruals 52$ Current Liabilities 196$ LT Debt - Equity - Total L&E 6,531$

Income Statement Balance SheetOverland Manufacturing Company This Year ($000)

All highlighted items were

increased by 15%.

At this point we are at the debt/interest impasse. We’ll guess at interest (using last

year’s interest of $150,000 as a starting point) and work

through the procedure.

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A:

Taking the average debt at 12% yields a calculated interest of $86,000 which is considerably less than the $150,000 assumed. 2 more iterations should yield a final projection of $84,000.

Next Year This Year Next YearRevenue 15,617$ ASSETSCOGS 8,591$ Cash 348$ 400$ Gross Margin 7,027$ Accounts receivable 1,698$ 1,953$ Expenses 3,904$ Inventory 1,494$ 1,718$ EBIT 3,122$ Current assets 3,540$ 4,071$ Interest 150$ Net capital assets 2,460$ 2,460$ EBT 2,972$ Total Assets 6,000$ 6,531$ Tax 1,248$ LIABILITIES AND EQUITYNI 1,724$ Accounts payable 125$ 144$

Accruals 45$ 52$ Current Liabilities 170$ 196$ LT Debt 1,330$ 112$ Equity 4,500$ 6,224$ Total L&E 6,000$ 6,531$


Balance Sheet EAT was computed using an Interest of

$150,000. The resulting NI was

added to Equity and the LT Debt figure was a plug, calculated by

subtracting Equity and Current Liabilities from

Total L&E.

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Percentage of Sales Method—Algebraic Approach• Algebraic Approach

Forecast total assets - forecast current liabilities - last years equity + forecast dividends = forecast debt + (1-T)[EBIT – Int%(.5)(last year’s debt + forecast debt)]



• Algebraic Approach For Example 6.3 $6,531 – $196 – $4,500 + 0 = forecast debt + (1-.42)

[3,122 - .12($1330 + forecast debt/2)]

$1,835 = forecast debt + $1,810.76 – $46.284 - .0348 forecast debt

$70.524 = .9652 forecast debt

forecast debt = $73.07

interest cost = .12($1,330 + $73)/2 = 84

equity = $4,500 + $1,762 = $6,262

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Percentage of Sales Method—Spreadsheet Approach

• Spreadsheet Approach for Example 6.3 Use the Goal Seek function in Excel. Set cell for E16 (Total L&E) To value: $6,531 (the value for total assets) By changing cell: E14 (Long term debt) Click OK. Goal Seek will then solve for the Long term debt

and the income statement and balance sheet

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Accruals 52$ Current Liabilities 196$ LT Debt 73$ Equity 6,262$ Total L&E 6,531$

Income StatementOverland Manufacturing Company Next Year ($000)

Balance Sheet

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External Funding Requirement

• Forecasting Cash Needs A growing firm must buy assets to support growth Some funds will be generated internally via

• Current liabilities• Retained earnings

When a plan shows increasing debt, the implication is that additional external financing will be needed

A key reason for doing financial projections is to forecast the firm’s External Funding Requirement

Funds can be obtained by• Issuing debt or bank financing• Issuing new shares


External Funding Requirement

• External Funding Requirement (EFR)

growth in assets– growth in current liabilities– earnings retained= external funding requirement


External Funding Requirement (EFR)

• If we assume that Net capital assets will grow at the same rate as sales growth (g), then Growth in assets = g Assetsthis year

Growth in current liabilities = g x Current liabilitiesthis

year

NInext year = ROS (1 + g)Salesthis year

d = dividends/net income Earnings retained = (1 – d) NInext year

this year thisyearEFR=g[Assets -Current liabilities

- NI(1-d)] - NI(1-d)


Example 6.4: External Funding Requirement

Q: Reforecast the external funding requirements of the Overland

Manufacturing Company (Example 6.3) assuming net capital assets and NI grow at the same rate as sales (15%). Assume the firm plans to pay a dividend equal to 25% of earnings next year.


Accruals 45$ Current Liabilities 170$ LT Debt 1,330$ Equity 4,500$ Total L&E 6,000$


Balance Sheet

The line items needed to apply the EFR equation are

highlighted. We also need the expected revenue growth of

15% and the dividend payout ratio of 25%.

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Example 6.4: External Funding Requirement

EFR = g[Assetsthis year - Current liabilitiesthis year - NI(1 – d)] - NI(1 – d)

A: Applying the EFR equation we have:

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e = 0.15[$6,000 – 170 - $1,488(1 - 0.25)] - $1,488(1 - 0.25)

= -$408.9

A negative EFR figure means no additional outside funds are needed. A negative result says that Overland will generate enough funds during the period to reduce its debt by about $409,000.


The Sustainable Growth Rate

• The rate at which a firm can grow without selling new shares Results from growth in retained earnings (Net

income – dividends) Business operations create new equity equal to the

amount of current retained earnings, or (1 – d)NI

Sustainable growth rate =

Assumes that new long-term debt will need to be raised to keep the debt/equity ratio constant

s NI(1-d)

g = Equity


The Sustainable Growth Rate

• Incorporating equations from the DuPont equations into the gs equation we obtain

s

EAT sales assetsg 1 d

sales assets equity

Thus, a firm’s ability to grow depends on the following

Its ability to earn profits on sales (ROS) Its talent at using assets to generate sales (total

asset turnover) Its use of leverage (equity multiplier) The percentage of earnings retained (1 – d)


Plans With More Complicated Assumptions• The percentage of sales method is appropriate

for quick estimates, but generally isn’t used in formal plans because it glosses over too much detail

• Real plans generally incorporate separate planning assumptions for each important financial item Assumption depends on the way the related item is

managed and on its accounting treatment


Plans With More Complicated Assumptions• Direct planning assumptions reflect the

factors that will affect the forecasted dollar value of a line item on the financial statements. For example Capital assets are forecast by projecting

• New expenditures using the capital plan • Amortization based upon total gross cost

Lease expenses are based upon existing and new lease contracts


Plans With More Complicated Assumptions• Indirect planning assumptions are made

about financial ratios, which in turn lead to line item values Accounts receivable are generally forecast by

making an assumption about the Average Collection Period and calculating the implied balance

Inventory is generally forecast indirectly thru the Inventory Turnover ratio


Planning at the Department Level

• Operational plans Departmental detail supports the expense

entries on the planned income statement

• Manufacturing Departments A detailed manufacturing plan forecasts

spending levels in factory departments, production quantities, and inventory levels at the beginning and end of the year


Figure 6.6: Detail for Annual Planning at the Department Level


The Cash Budget

• Forecasting cash is an important part of financial planning

• The cash budget is a detailed projection of receipts and disbursements of cash Receipts generally come from cash sales, collecting

receivables, borrowing and selling shares Disbursements include paying for purchases,

wages, taxes and other expenses including rent, utilities, supplies, etc.

• It also shows whether the company needs short-term external financing during the budget period.


Receivables and Payables—Forecasting with Time Lags

• Collections of receivables lag projected credit sales

• Purchases may lead sales

• Payments for purchases may lag purchases, depending on vendors’ credit terms


Receivables and Payables—Forecasting with Time Lags—Example

Q: A firm experiences the following time lags in its collections:

The firm expects its credit sales from January through March to be:

Determine the company’s expected cash collections from receivables.A:

8%30%60%% collected

321Months after sale

$700$600$500Credit sales

MarFebJan

56258640510300Total collections

56210420 Mar

48180360 Feb

40150300 Jan

Collections from sales in

MayApr Jun

700

Mar

600500Credit sales

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Debt and Interest

• Forecasting short-term debt and interest can be tricky if a company is funding current cash needs directly by borrowing If the month’s cash flow is negative, borrow If the month’s cash flow is positive, repay

prior loans The current month’s interest payment may

be based on the preceding month’s loan balance


Example 6.8: The Cash Budget

Q: The Pulmeri Company’s revenues (actual and forecast) for the six months ended June 30 are as follows ($000).

Pulmeri collects its receivables according to the following pattern.

The firm purchases and receives inventory one month in advance of sales. Materials cost about half of sales revenue. Invoices for inventory purchases are paid 50% in the first and 50% in the second month after purchase.

Payroll is $2.5M per month, and general expenses are $1.5M per month. A $0.5M tax payment is scheduled for mid-April. Pulmeri has a short-term loan outstanding that is expected to stand at $5M at the end of March. Monthly interest is 1% of the previous month end balance. Pulmeri does not require any balance in its cash account.

Prepare Pulmeri’s cash budget for the April May and June (its second quarter).

9,000

Mar

8,000

Feb

5,000

Jan

9,0008,0005,000Revenue

JunMayApr

10%25%65%% collected

321Months after sale

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A: First lay out revenue and collections according to the historical pattern.

7,3506,3008,350Second qtr. collections

5,200 May

1,2503,250 Apr

9002,2505,850 Mar

8002,0005,200 Feb

5001,2503,250 Jan

Collections from sales made in

8,000

May

5,000

Apr

9,000

Jun

9,000

Mar

8,0005,000Revenue

FebJan

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A: Next, time inventory purchases (half of sales dollars) one month prior to sale.Time the payments so that 50% of the purchases are paid for in the month after purchase, and the remainder 2 months after purchase.

4,2503,2503,500Payment for materials

2,250 May

2,0002,000 Apr

1,2501,250 Mar

2,2502,250 Feb

Payment

4,500

May

4,000

Apr Jun

2,500

Mar

4,500Purchases

FebJan

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A: Summarize these results along with payroll and other disbursements

Pulmeri CompanyCash Budget

Second Quarter 20x1($000)

500 Tax payment

1,5001,5001,500 General expenses

2,5002,5002,500 Payroll

4,2503,2503,500 Materials purchases

Disbursements

7,3506,3008,350Collections

8,000

May

5,000

Apr

9,000

Jun

9,000

Mar

8,0005,000Revenue

FebJan

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(6,654)(5,697)(4,700)(5,000)Cumulative cash flow/loan

(957)(997)300Net cash flow

(57)(47)(50)Interest

(900)(950)350Cash flows before interest

8,2507,2508,000Disbursements

Pulmeri CompanyCash Budget

Second Quarter 20x1($000)

MayApr JunMarFebJan

A: Calculate the interest charges , based upon 1% of the prior month’s loan balance, and the net cash flow

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Management Issues in Financial Planning• The Financial Plan as a Set of Goals

The financial plan can be a tool with which to manage the company and motivate desirable performance

Problems arise when top management puts in stretch goals• A target for which the organization strives, but is

unlikely to achieve• People may give up if they consider the goal impossible


Risk in Financial Planning in General• Stretch planning and aggressive optimism can

lead to unrealistic plans that have little chance of coming true

• Top-down plans are forced on the organization by senior management and are often unrealistically optimistic Middle and lower level managers often feel that such

plans are unrealistic The risk in financial planning is that the plan

overstates achievable performance


Risk in Financial Planning in General• Underforecasting—The Other Extreme

Underforecasting sets up a goal that is easy to meet and ensures future success

Bottom-up plans are consolidated from lower management’s inputs and tend to understate what the firm can do

• The Ideal Process Ideally the process is a combination of the top-

down and bottom-up approaches The end result is a realistic compromise that is

achievable


Risk in Financial Planning in General• Scenario Analysis—”What If”ing

Many companies produce a number of plans reflecting different scenarios—”what if”

Gives planners a feel for the impact of their assumptions not coming true

• Communication A business unit is expected to have confidence in its

plan A single plan tends to be published along with its

attendant risks


Financial Planning and Computers

• Virtually all planning is done with the aid of computers

• Computers make planning quicker and more thorough, but don’t improve the judgments at the heart of the plan

6 6 Chapter Financial Planning Slides Developed by: Terry Fegarty Seneca College.

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Transcript of 6 6 Chapter Financial Planning Slides Developed by: Terry Fegarty Seneca College.