Chapter 8

Financial Planning and Control

Financial Planning and Control

• Financial Planning:– The projection of sales, income, and assets based

on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projections

• Financial Control– The phase in which financial plans are

implemented, control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes.

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Financial Planning: The Sales Forecast

• A forecast of a firm’s unit and dollar sales for some future period, generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc.

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Projected (Pro Forma) Financial Statements• A method of forecasting financial requirements

based on forecasted financial statements• AFN = additional funds needed to support the

level of forecasted operations• Determine how much money the firm will need

in a given period.• Determine how much money the firm will

generate internally during the same period.• Subtract the funds generated internally from the

funds required to determine the external financial requirements.

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Step 1. Forecast the 2014 Income Statement

Unilate Textiles Company

Assumptions:Unilate operated at full capacity in

2013.Sales are expected to grow by 10

percent.The variable cost ratio remains at 82

percent (same as 2013).2014 dividend per share will be the

same as in 2013.

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Step 1. Forecast the 2014 Income Statement ($ millions)

Unilate Textiles2013 Forecast Initial

Results Basis ForecastNet Sales 1,500.0$ x 1.10 1,650.0$ Cost of Goods Sold (1,230.0) x 1.10 (1,353.0)

Gross Profit 270.0 297.0 Fixed operating Costs (90.0) x 1.10 (99.0) Depreciation (50.0) x 1.10 (55.0)

EBIT 130.0 143.0 Less Interest (40.0) (40.0)

EBT 90.0 103.0 Taxes (40%) (36.0) (41.2)

Net Income 54.0$ 61.8$ Common Dividends (29.0) (29.0)

Addition to Retained Earnings 25.0$ 32.8$

Earnings per Share 2.16$ 2.47$ Dividends per Share 1.16$ 1.16$ Number Common Shares (millions) 25.0 25.0

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Step 2. Forecast the 2014 Balance Sheet ($ millions)

Unilate Textiles 2014

2013 Forecast Initial Balances Basis Forecast

Cash 15.0$ x 1.10 16.5$ Accounts Receivable 180.0 x 1.10 198.0 Inventory 270.0 x 1.10 297.0

Total Current Assets 465.5 511.5 Net Plant & Equipment 380.0 x 1.10 418.0

Total Assets 845.0$ 929.5$

Accounts Payable 30.0 x 1.10 33.0 Accruals 60.0 x 1.10 66.0 Notes Payable 40.0 40.0

Total Current Liabilities 130.0 139.0 Long-Term Bonds 300.0 300.0

Total Liabilities 430.0$ 439.0$ Common Stock 130.0 130.0 Retained Earnings 285.0 +$32.8 317.8

Owner's Equity 415.0$ 447.8$ Total Liabilites & Equity 845.0$ 886.8$

Additional Funds Needed 42.7$

Step 3. Raising the Additional Funds Needed

• Higher sales must be supported by higher assets.• Asset increase can be financed by spontaneous increases

in accounts payable and accruals and by retained earnings.

• Any short fall must be financed from external sources--by borrowing or by selling new stock.

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Unilate has decided that any additional funds needed to support future operations will be raised mainly by issuing new common stock.

Step 4. Financing Feedbacks

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The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets

2014 Adjusted Forecast of Income Statement ($ millions)

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Initial Adjusted FinancingForecast Forecast Adjustment

Net Sales 1,650.0$ 1,650.0$ Cost of Goods Sold (1,353.0) (1,353.0) Gross Profit 297.0 297.0

Fixed operating Costs 99.0 99.0 Depreciation (55.0) (55.0)

EBIT 143.0 143.0 Less Interest (40.0) (41.4) (1.4)$

EBT 103.0 101.6 (1.4) Taxes (40%) (41.2) (40.6) 0.6

Net Income 61.8$ 61.0$ (0.8) Common Dividends (29.0) (30.5) (1.5)

Addition to Retained Earnings 32.8$ 30.5$ (2.3)$ Earnings per Share 2.47$ 2.32$ Dividends per Share 1.16$ 1.16$ Number Common Shares 25.0 26.3

Unilate Textiles

2014 Adjusted Forecast of Balance Sheet ($ millions)

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Unilate TextilesInitial Adjusted Financing

Forecast Forecast AdjustmentCash 16.5$ 16.5$ Accounts Receivable 198.0 198.0 Inventory 297.0 297.0

Total Current Assets 511.5 511.5 Net Plant & Equipment 418.0 418.0

Total Assets 929.5$ 929.5$ Accounts Payable 33.0$ 33.0$

Accruals 66.0 66.0 Notes Payable 40.0 46.8 6.8$

Total Current Liabilities 139.0 145.8 Long-Term Bonds 300.0 309.0 9.0

Total Liabilities 439.0 454.8 Common Stock 130.0 159.3 29.3 Retained Earnings 317.8 315.5 (2.3)

Owner's Equity 447.8 474.8

Total Liabilites & Equity 886.8$ 929.5$ Additional Funds Needed 42.7 - 42.8$

Unilate Textiles: Adjusted Key Ratios

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AdjustedPreliminary Industry

2013 2014 AverageCurrent Ratio 3.6x 3.5x 4.1xInventory Turnover 4.6x 5.6x 7.4xDays Sales Outstanding 43.2 days 43.2 days 32.1 daysTotal Assets Turnover 1.8x 1.8x 2.1xDebt Ratio 50.9% 48.9% 45.0%Times Interest Earned 3.3x 3.5x 6.5xProfit Margin 3.6% 3.7x 4.7%Return on Assets 6.4% 6.6% 12.6%Return on Equity 13.0% 12.8% 17.2%

Suppose in 2013 fixed assets had been operated at only 80% of capacity:

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Full Capacity SalesActual sal

es

% of capacity

$1,

.$1, million.

5000 80

875

Other Considerations in Forecasting: Excess Capacity

Other Considerations in Forecasting: Economies of Scale

• Unilate’s variable cost ratio is 82% of sales.• Ratio might decrease to 80% if operations

increase significantly.

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Changes in variable cost ratio affect the addition to retained earnings which affects the amount of AFN.

Other Considerations in Forecasting: Lumpy Assets

• Assets that cannot be acquired in small increments, but must be obtained in large, discrete amounts

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Summary: How different factors affect the AFN forecast.

• Dividend payout ratio changes.– If reduced, more RE, reduce AFN.

• Profit margin changes.– If increases, total and retained earnings increase, reduce

AFN.• Plant capacity changes.

– Less capacity used, less need for AFN.• Payment terms increased to 60 days.

– Accts. payable would double, increasing liabilities, reduce AFN.

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Financial Control - Budgeting and Leverage

• The phase in which financial plans are implemented; control deals with the feedback and adjustment processes required to ensure the firm is following the right financial path to accomplish its goals, and, if not, to make necessary corrections. 

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Operating Breakeven Analysis

• An analytical technique for studying the relationship between sales revenues, operating costs, and profits

• Operating breakeven analysis deals only with the upper portion of the income statement - the portion from sales to NOI

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Unilate’s 2014 Forecasted Operating Income ($ millions)

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Sales (S)--(110 million units) 1,650.00$ Variable cost of goods sold (VC) (1,353.00) Gross profit (GP) 297.00 Fixed operating costs (F) (154.00) Net operating income (NOI = EBIT) 143.00$

Operating Breakeven Chart

200 20 40 57 60 80 100 120

1,400

1,200

1,000

600

400

0

Units QOpBE

Revenues & Costs

Total Fixed Costs (F)

Total OperatingCosts (F + Q x V)

Total Sales Revenues (P x Q)

SOpBE =

200154

856800

Operating BreakevenPoint (EBIT = 0)

Operating Profit(EBIT > 0)

Operating Loss

(EBIT < 0)

Breakeven Computation

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Sales Total operating Total Totalrevenues costs variable costs fixed costs

= = +

(P x Q) = TOC = (V x Q) + F

QOpBE F

P-V

FContribution margin= =

QOpBE $154.0 million$15.00 - $12.30

= =$154.0 million

$2.70

57.04 million units 57.0 million units

=

Operating Breakeven Point

For the proposal to break even, Unilate must sell 57 million units or $855,600,000 of product.

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SOpBE

F FGross profit margin= =

1- VP

( )SOpBE $154.0

$12.30$15.00

= = $154.0 1 - 0.82

1-

= $154.0 0.18( )

= 855.6 million

Operating Leverage

• The existence of fixed operating costs, such that a change in sales will produce a larger change in operating income (EBIT)

• The percentage change in NOI (or EBIT) associated with a given percentage change in sales

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Calculating the Degree of Operating Leverage

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DOLS Gross Profit

EBIT

Each 1 percent change in sales, will result in a 2.08 percent change in operating income.

$297$143 2.08x= =

Operating Income at Sales Levels of 110 and 99 Million Units

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2014Forcasted Sales Unit PercentOperations Decrease Change Change

Sales in units 110 99 (11) -10.0%Sales revenues 1,650.0$ 1,485.0$ (165.0)$ -10.0%Variable cost of goods sold (1,353.0) (1,217.7) 135.3 -10.0%

Gross profit 297.0 267.3 (29.7) -10.0%Fixed operating costs (154.0) (154.0) - 0.0%

Net operating income (EBIT) 143.0$ 113.3$ (29.7)$ -20.8%

Financial Breakeven Analysis

• Determining the operating income (EBIT) the firm needs to just cover all of its fixed financing costs and produce earnings per share equal to zero

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Financial Breakeven Computation

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EPS = Earnings available to common stockholders

Number of common shares outstanding = 0

= (EBIT - I)(1 - T) - Dps

Shrsc= 0

EBITFinBE = I +(1 - T)

Dps= $41.4 + 0 = $41.4

Financial Leverage

• The existence of fixed financial costs such as interest and preferred dividends when a change in EBIT results in a larger change in EPS

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Unilate Textiles:Degree of Financial Leverage

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DFLEBIT

EBIT I EBIT

EBIT [financial BEP]

DFL110

$143.0$143.0 - $41.4

$143.0$101.6 1.41x

Degree of Total Leverage

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DTLGross profit

- [Financial BEP]EBIT

S - VC- IEBIT

Q(P - V) [Q (P - V) - F] - I

$297.0$101.6

2.92x

= DOL x DFL = 2.08 x 1.41 = 2.92x

Importance of Forecasting and Control Functions

• If projected operating results are not satisfactory, management can reformulate its plans.

• If funds required to meet sales forecast cannot be obtained, management can sale back projected levels of operations.

• If required funds can be raised, it is best to plan for their acquisition in advance.

• Any deviation from projections needs to be handled to improve future forecasts.

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