CHAPTER 18



CHAPTER 18

FINANCIAL PLANNING

CHAPTER IN PERSPECTIVE

This second of three planning chapters is dedicated to the concepts of long-term financial planning. Beginning with an assumption of volume (sales, production), the financial planning process, top-down or down-up, focuses all estimates and iterations in financial terms to a certain point in the future (balance sheet) or during the period (income statement or statement of cash flows). Every businessperson becomes involved in the planning process, formally or informally, so the financial planning concepts covered here have considerable value to all majors. Just like other chapters, the concepts of this chapter are easily applied to personal financial planning.

After an introduction to the planning process, we use the percentage of sales financial planning model to demonstrate the general framework of a financial plan. Estimating the amount and timing of the funds needed gives valuable insights to the financial manager. The key issue is not the single right estimate of what will exactly take place, but reviewing and understanding a series of likely financial results under varying assumptions is the real value of planning for the financial manager.

The last section of the chapter interrelates investment policy, debt policy, dividend policy, and growth policy into a financial planning format. The concepts of internal growth rate (maximum sales or asset growth rate without external financing) and the sustainable growth rate (maximum growth rate within specific debt and dividend policy) are valuable concepts that tie several important financial policy areas together and provide connective tissue among the chapters.

CHAPTER OUTLINE

18.1 WHAT IS FINANCIAL PLANNING?

Financial Planning Focuses on the Big Picture

Why Build Financial Plans?

18.2 FINANCIAL PLANNING MODELS

Components of a Financial Planning Model

An Example of a Planning Model

An Improved Model

18.3 PLANNERS BEWARE

Pitfalls in Model Design

The Assumptions in Percentage-of-Sales Models

The Role of Financial Planning Models

18.4 EXTERNAL FINANCING AND GROWTH

18.5 SUMMARY

TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS

18.1 WHAT IS FINANCIAL PLANNING?

A. Financial planning is a process consisting of:

1. Analyzing the investment and financing choices available to the business.

2. Projecting the future consequences of current decisions under varying scenarios.

3. Deciding which alternative to undertake.

4. Later, measuring performance or results with the goals of the financial plan—the planning and control cycle.

B. The time line of financial planning includes both short-term planning, perhaps the next twelve months with a focus on cash flow timing, and long-term financial planning where the planning horizon or time associated with the plan is around five years or longer. This chapter focuses on long-term planning. Chapter 19 focuses on short-term planning.

Financial Planning Focuses on the Big Picture

A. Financial plans include the strategic plan of the business or a “big picture” perspective, rather than the implications of individual investments and other decisions.

B. Alternative business plans might consider three scenarios relating to best case, normal growth, or worst case or retrenchment.

Why Build Financial Plans?

A. Planning allows managers to consider a variety of alternative opportunities or future options. Thinking about possible outcomes allows the company to make contingency plans.

B. Financial planning provides an opportunity to identify and evaluate options available, such as expansion, plant closure, etc.

C. Building a financial plan forces managers to make connections between plans for growth and financing requirements. This helps to ensure that firm's goals are mutually consistent.

18.2 FINANCIAL PLANNING MODELS

A. Financial planning models are most useful if they can be used to explore what might happen.

B. Financial models using spreadsheet programs enable the planner to quickly and conveniently study a wide range of possible outcomes and prepare the firm to handle what may occur.

Components of a Financial Planning Model

A. Financial plans include three components: inputs, the planning model, and outputs. See Figure 18.1.

B. The inputs include current financial statements and forecasts. In most financial plans, expected sales are the major independent variable that drives the plan. Other variables, such as assets, are related to expected sales.

C. Macroeconomic and industry forecasts can be valuable inputs to the planning process. A plan that reflects the forecasts of the general level of economic activity and the anticipated actions of competitors will be a more useful plan.

D. The planning model, with the established relationships between sales and assets, etc., calculates the estimated levels of resources needed, the expected amount of financing needed, and the expected profit and cash flow.

E. The equations or relationships in the financial model may be derived from past relationships (correlations) or expected relationships based on forecasts.

F. The output of the financial plans includes estimated financial statements based on the assumptions and relationships of the plan, called pro forma financial statements. Financial ratios, based on the pro forma financial statements, are usually calculated.

An Example of a Planning Model

A. The percentage of sales model is a financial planning model in which the future level of asset investment, and subsequent financing needs, is a function of forecasted sales. The assumption is that sales drives asset requirements and asset requirements drive the financing needed. See Tables 18.1 to 18.3.

B. A simple percentage of sales model assumes no spare capacity in the asset (production) structure, so increased sales will require added current assets, fixed assets, perhaps some spontaneous financing from current liabilities, and added equity financing via addition to retained earnings (net income minus dividends).

C. The pro forma balance sheet associated with the percentage of sales financial planning model uses any one of a number of ledger accounts as a variable to “balance” the balance sheet. Dividends paid, a financing decision, may be the balancing item as might the debt/equity ratio, bank financing, or a generic “funds needed” liability account.

An Improved Model

A. The Executive Fruit Company pro forma example, Tables 18.4 to 18.8, is a good example of the percentage of sales financial planning model.

B. A relationship between sales and specific balance sheet dependent variables are established before the planning begins.

C. Sales are estimated for the coming periods. Sales, the independent variable, drive the level of assets needed and the estimated required external financing needed. See Table 18.5.

D. The next stage of the plan focuses on the debt/equity mix and specific types of financing the firms may seek. See Table 18.6.

E. Alternative estimates of financing needed, given varied sales estimates, provide a range of possible outcomes that the financial manager should be prepared to handle.

F. The statement of cash flow can be forecasted along with the income statement and balance sheet. Looking at cash flow from assets helps to see where cash is being used and where is it coming from.

18.3 PLANNERS BEWARE

Pitfalls in Model Design

A. Will a more sophisticated financial planning model give the financial manager an improved forecast of funds needed in the future? Is having “the” right forecast the real purpose of financial planning, or is financial planning really about estimating the range of possible outcomes?

B. The value of the financial plan is to prepare for a variety of outcomes, not build the ultimate, realistic financial planning model.

The Assumptions in Percentage-of-Sales Models

A. Do not naively assume that the percentage-of-sales forecast factors must be based on the previous year's financial statements. Think of the previous year as a starting point for determining appropriate forecast factors. If the firm is undergoing major change, it may be inappropriate to assume that the relationship between sales and costs will not change.

B. Though a good “rough” first estimate for financial planning, the percentage-of-sales model is limited in that many estimated variables, such as assets, are not or are not always proportional to sales.

C. Fixed assets are not easily added in small amounts, but are more economically added in large investments. Thus, the firm must plan based on expected production utilization rates. Asset investment is not usually proportional to sales in a shorter time span, and is better related over a longer planning horizon.

The Role of Financial Planning Models

A. Financial planning models estimate accounting statements, and do not focus on financial decision tools such as incremental cash flows, time value, market risk etc.

B. Financial planning models are not focused on financial decisions that would increase market value, though the debt/equity standards of the firm and the dividend policy of the business are built into financial planning.

18.4 EXTERNAL FINANCING AND GROWTH

A. Financial planning produces consistency between growth, investment, and financing goals of the business, for all are included in the plan. This section studies the relationships between growth objectives and requirements for external financing.

B. The general idea is that the faster the firm grows, the more financing, and probably more external financing, will be needed. The extent of external financing will be related to the asset intensity of the firm, the profitability of the firm and the debt/equity and dividend policies of the firm.

C. Sales growth drives asset growth drives funds needed. The higher the sales growth, the more assets/sales needed, the lower the profitability of the firm, the higher the dividend payout, the greater the more likely external funds (debt or equity) will be needed.

D. The internal growth rate of the firm is the maximum rate of growth without external financing. See Figure 18.5. Where the upward sloping (slope related to profitability and dividend policy) line intersects the horizontal line (growth rate scale) is the internal growth rate, or the maximum growth rate at which the firm can grow and finance all its needs from internal sources (equity). The internal growth rate is the ratio of the addition to retained earnings divided by assets. The higher the historic contribution of retained earnings to finance assets, the higher is the growth rate the firm can maintain without external capital. See Figure 18.5.

E. The internal growth rate is the product of the plowback ratio times the ROE times the leverage ratio or:

Internal growth rate = × ×

= plowback ratio × ROE ×

The higher the plowback ratio (lower dividend payout), the higher the profitability (ROE) and the higher the proportion of assets financed by equity, the greater the internal growth rate.

F. The sustainable growth rate is the maximum growth rate (sales or assets) the firm can maintain without changing the debt/equity ratio and without any external equity financing (sale of stock). While the internal growth rate is the maximum growth rate without any external financing (debt or equity), the sustainable growth rate is the maximum growth rate sustainable without any external equity financing.

G. The sustainable growth rate will be greater than the internal growth rate for the former considers added debt financing along with added equity financing provided by earnings retained (not paid in dividends) in the period.

H. The sustainable growth rate is the product of the plowback ratio (proportion of net income retained in the firm) times the return on equity (ROE).

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Outputs

Projected financial

statements (pro formas).

Financial ratios.

Planning Model

Equations specifying

key relationships, such as the cost of producing the forecasted sales and asset investment

Inputs

Current financial

statements.

Forecasts of key

variables such as sales and interest rates.

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