Chapter 15



Chapter 15

Financial Planning

BUSINESS PLAN

A picture or model of what a business unit is expected to become.

Consists of Words and Numbers

COMPONENT PARTS OF A BUSINESS PLAN

A. Contents

B. Executive Summary

C. Mission and Strategy Statement

D. Market Analysis

E. Operations (of the business)

F. Management and Staffing

G. Financial Projections

H. Contingencies

THE PURPOSE OF PLANNING AND PLAN INFORMATION

Two major audiences: management and outside investors

THE MANAGERIAL VALUE OF PLANNING

The Planning Process

Creates a cohesive unit with common goals

Promotes an understanding of objectives and policies

Forces a thinking through of everything that has to be done

Makes people understand what they individually have to do

A Road Map for Running the Business

Formulates method by which goals are to be achieved

Comparing operating performance to plan

Investigate deviations

Propose Solutions

Figure 15-1 Using a Plan to Guide Business Performance

A Statement of Goals and Targets

A measurement of success

A reward system - bonuses

Predicts Outside Financing Needs

THE PLAN TO OUTSIDE INVESTORS

Communicates management's ideas about what the

company will be in the future

Tells: Equity investors their expected return

Debt investors the source of repayment

In small firms: Use the business plan document

In large firms: Information is conveyed to

securities analysts

Business Planning in Divisions of Large Companies

Divisions produce their own plans which are consolidated

into a corporate plan

The planning and review process is a major vehicle for communication between division and corporate managements

Success and failure at the division are defined

relative to the business plan

Credibility and Supporting Detail

A plan needs to contain enough detail to convince its audience

that it represents management's best thinking

FOUR KINDS OF BUSINESS PLANNING

Strategic Planning Operational Planning

Budgeting Forecasting

...differ according to three attributes:

(1) Length of the planning horizon

(2) Kinds of issues addressed

(3) Level of detail projected

Budgets:

Operating Budget—a collection of individual budgets combined to form a part of an integrated business plan, usually for next year

Used to Coordinate activity

Control-serving as performance measurement

Capital Budget-listing of capital projects it plans to place in service during some future period,usually next year

Cash Budget- projection of a company’s cash receipts and disbursements over some future time period

The Business Planning Spectrum

Annual

Strategic Operating Quarterly Short-Term

Plan Plan Budgets Forecasts

Long Term Short Term

General, Detailed,

Conceptual Numerical

BUSINESS PLANS FOR

SMALL BUSINESSES

THE FINANCIAL PLAN

A firm's projected financial statements

Generally a part of a broader business plan

MAKING FINANCIAL PROJECTIONS

Translating physical and economic activity into dollars

Forecast sales first

Then forecast the support required by the implied activity

PLANNING FOR NEW AND EXISTING BUSINESSES

Harder to plan for a new or proposed business

No history - must make assumptions about everything

THE TYPICAL PLANNING TASK

Most financial planning is for existing businesses

Forecast changes to past history

The changes are planning assumptions

Anything about which an assumption isn't made is implicitly assumed to remain unchanged. For a new business, everything has to be explicitly assumed.

PLANNING ASSUMPTIONS

A physical or economic condition expected to exist

during the planning period

Can originate outside the company: interest rates, taxes

(economic and industry forecast)

Can be internal: pricing, cost control

Can come from customer behavior: response to pricing

Each line on a projected set of financial statements is generally forecast based on one or more assumptions

THE PROCEDURAL APPROACH

Make a revenue projection

Then forecast the income statement and balance sheet line by line

until come to interest and debt

THE INTEREST/DEBT PLANNING PROBLEM

We need debt to forecast interest and interest to forecast debt.

EAT (less dividends) is added to Beginning Equity to arrive at

Ending Equity, which is required to compute Ending Debt.

Ending Debt is averaged with Beginning Debt and multiplied

by the interest rate to calculate Interest Expense.

SOLUTION THROUGH AN ITERATIVE, NUMERICAL APPROACH

1. Interest: Guess a value of interest expense.

2. EAT: Complete the income statement.

3. Ending Equity: Calculate ending equity as beginning equity plus EAT (less dividends plus new stock to be sold if either exist).

4. Ending Debt: Calculate ending debt as total L&E (=Total Assets) less current liabilities less ending equity.

5. Interest: Average beginning and ending debt. Calculate interest by multiplying average debt by the interest rate.

6. Test Results: Compare the calculated interest from step 5 to the original guess in step 1.

a. If the two are significantly different, return to step 1 replacing the guess at interest with the value just calculated and repeat steps 2 through 6.

b. If the calculated value is close to the guess, stop.

PLANS WITH SIMPLE ASSUMPTIONS

Quick Estimates Based on Sales Growth

Percentage of Sales Method

All line items grow by the same percentage as sales

(A very unrealistic assumption)

Modified Percentage of Sales Method

Most line items grow by the same percentage as sales

Percentage of Sales Forecasting Method

permits a company to forecast the amount of financing it will need for a given increase in sales.

Assumes:

(1) present asset levels are optimal with respect to present sales.

(2) most items on balance sheet increase in proportion to sales increase.

(3) firm's profit margin on sales (EAT/sales) remains constant.

How much funds will be necessary to support growth?

(1) Determine the level of assets that will need to vary proportionately with sales.

How to determine this?

- look at ratios

- what has happened over last few years within the company

- forecast for future economic state

(2) Determine the level of liabilities that will need to vary proportionately with sales

(3) Separate the financing decisions

Notes payable

LT debt

Common stock

[pic]

A: present level of assets

S: present sales level

CL: present level of current liabilities

ΔS: forecasted sales increase

Internal Financing Provided = Forecasted Net Income - Dividends

NI – D

(NI +Noncash) - D

Additional Financing Needed = Total Financing Needed - Internal

[pic]

[pic]

S = 15m

Sales will increase 25%

S 8 3.75m “

CA=6.5M

FA 1M

CL= 2M

Notes Payable = .5 M

E (Expense) 17.75m

E (NI) 1m

Dividends .25 M

Total Financing Needed

1

=.25(7.5M)-.25(2M-.5M)=1.5 M

Additional Financing Needed

=(7.5M(.25)-(2M-.5M).25)-(1M-.25M)=.75 M

Example:

Expected Sales $ 6,000,000

Expected NI 400,000

Expected D 50,000

Find additional financing needed

A: $6,300,000

S: 4,000,000

CL: 600,000

NI: 400,000

D: 50,000

ΔS: 6,000,000 - 4,000,000 = 2,000,000

ΔS/S= 50%

AF= (6.3(.5)-.6(.5)) - (.4-.05)

Adjustments to Process

If can use some economics of scale then the relationships may not be strictly proportions.

Ex.: often fixed assets increase in step-wise fashion.

Sales Forecast

Fixed Assets

Not at Full Capacity

Cash 5,000 A.P. 15,000

A.R. 20,000 N.P. 10,000

I.N. 40,000 Total C.L. 25,000

Total C.A. 65,000 LT Debt 30,000

F.A. 50,000 S. Equity 60,000

115,000 115,000

Sales $150,000. Expect 25% increase in sales to generate after-tax cash flow $16,000 dividend of $5,000 F.A. at 90% capacity.

(1) What additional financing will be needed?

(2) What is Full Capacity Sales?

.90x = 150,000

x = 166,666

so $50,000 F.A. will support $166,666 of sales

(3) For every dollar of sales-need, what in F.A.?

F.A. = 50,000 = .30 increase in F.A.

F.C.S. 166,666

(4) Difference between Full Capacity Sales & Expected Sales?

Expected Sales: 150,000 (1.25) = 187,500

187,500 - 166,666 = 20,834

(5) What need in additional F.A.

.3(20,834) = 6,250

(6) AFN = TFN - IFP

[(65,000(.25) + 6,250) - (15,000(.25))] - [16,000 - 5,000] = 7,750

ESTIMATING EXTERNAL FUNDING REQUIREMENTS USING A FORMULA APPROACH BASED ON THE PERCENTAGE OF SALES METHOD

Growth in Assets

- Growth in Current Liabilities

- Current earnings retained

= External Funding Requirement

EFR = g(Assetsthis yr)

- g(Current Liabilitiesthis yr)

- [(1-d)ROS][(1+g)Salesthis yr]

The EFR gives a very rough estimate of external funding needs

THE SUSTAINABLE GROWTH RATE

A theoretical measure of a business's strength

The rate at which the firm can grow without newly sold equity

if none of its financial ratios change

Equivalent to forecasting growth using the Unmodified

Percentage of Sales Method

Simply the Growth in Equity Created by Retained earnings

where d is the dividend payout ratio

Using the Sustainable Growth Concept through the extended Du Pont Equation:

A firm's ability to grow is dependent on

1. Earnings

2. Using assets to generate sales

3. Using leverage (borrowed money)

4. The percent of earnings retained

Use to analyze a firm's growth relative to others

T/A Equity

gs = (1-d) x ROS x Turnover x Multip

Industry 13.5% .75 6% 1.2 2.5

Slowly Inc. 4.8% .40 8% 1.0 1.5

Two Kinds of Planning Assumption

DIRECT AND INDIRECT

MANAGEMENT BY RATIOS

Example 15-6

Next year's revenue is forecast at $7,900,000. What receivables figure should be included in a financial plan to reflect a 40 day ACP assumption.

Solution:

ACP =(AR/Sales) * 360

40=(AR/7,900,000)*360

A/R = $877,777

The Cash Budget

There are two ways to forecast cash.

1. Deriving a projected statement of cash flows

2. Cash Budgeting - forecasting cash receipts and disbursements as they’re likely to occur.

COMPREHENSIVE EXAMPLE (15-7)

A COMPLEX PLAN FOR AN EXISTING BUSINESS

MACADAM COMPANY - INCOME STATEMENTTHIS YEAR ($000)

$ %

Revenue $14,200 100.0%

COGS 7,810 55.0

Gross Margin $ 6,390 45.0

Expenses:

Marketing $ 2,556 18.0

Engineering 1,065 7.5

Fin & Admin 1,349 9.5

Total Expense $ 4,970 35.0

EBIT $ 1,420 10.0

Interest $ 568 4.0

EBT $ 852 6.0

Income Tax $ 341 2.4

EAT $ 511 3.6

MACADAM COMPANY BALANCE SHEET - THIS YEAR($000)

ASSETS LIABILITIES & EQUITY

Cash $ 1,560 Accts Payable $ 716

Accts Rec $ 3,550 Accruals $ 230

Inventory $ 2,603 Current Liab $ 946

Curr Assets $ 7,713

Long Term Debt $ 4,000

Fixed Assets Equity

Gross $12,560 Stock Accts $ 6,000

Accum Depr ($ 3,620) Retained Earn $ 5,707

Net $ 8,940 Total Equity $11,707

Total Assets $16,653 Total L&E $16,653

FACTS

1. Virtually all payables are due to inventory purchases, and the COGS is approximately 60% purchased material.

2. Assets currently on the firm's books will generate depreciation of $510,000 next year.

3. The only balance sheet accrual represents unpaid wages. Preliminary estimates indicate that next year's payroll will be about $6.1M. Next year's closing balance sheet date will be nine working days after a payday.

4. The combined state and federal income tax rate is 40%.

5. Interest on current and future borrowing will be at a rate of 10%.

PLANNING ASSUMPTIONS

Income, Cost, and Expense

1. During the coming year, the firm will mount a major program to expand sales. The expected result is a 20% growth in revenue. Pricing and product mix will remain unchanged.

2. The revenue growth will be accomplished by increasing efforts in the marketing/sales department. The increased expenses generated will be accommodated by planning Marketing Department expenses at 19% of the expanded revenue rather than the current 18%.

3. A major cost reduction effort is underway in the Manufacturing Department which is expected to reduce the Cost Ratio (COGS/Revenue) to 53% from its current level of 55%.

4. The Engineering Department will be unaffected by the expansion in sales. Its dollar expenses will increase by normal inflation at a 4% rate over last year.

5. Finance and administration expenses will need to expand to support the higher volume, but due to scale economies the expansion will be at a lower rate than the growth in sales. A target growth of 10% is planned for those expenses.

Assets and Liabilities

6. A lock box system will reduce cash balances 20%.

7. The current 90 day collection period (ACP) is considered unacceptable. Increased attention to credit and collections in both finance and sales is expected to bring the ACP down to 65 days.

8. Top management feels that the firm is operating with more inventory that it needs. Manufacturing management has been challenged to increase the Inventory Turnover Ratio based on COGS to 5( from its present level of 3 (.

9. The Capital Plan has been put together in preliminary form, and indicates capital spending of $5M. The average depreciation life of the assets to be acquired is 10 years. Straight line depreciation will be used, and a convention of taking one half year's depreciation in the first year will be followed.

10. Vendors are complaining because the firm pays its bills in 55 days even though most terms call for payment within 30 days. Fearing that inventory and supplies will be cut off, management has decided to shorten the payment cycle to 45 days.

11. No dividends will be paid next year, and no new stock will be sold.

Solution: Income Statement Items

Revenue:

Revenue = $14,200 ( 1.20 = $17,040

Cost of Goods Sold (COGS):

COGS = $17,040 ( .53 = $9,031

Marketing Expense:

Marketing Expense = $17,040 ( .19 = $3,238

Engineering Expense:

Engineering Expense = $1,065 ( 1.04 = $1,108

Finance and Administrative Expense:

Fin & Admin Expense = $1,349 ( 1.10 = $1,484

Balance Sheet Items

Cash:

Cash = $1,560 ( (1-.20) = $1,248

Accounts Receivable:

65=(AR/17040)x 360

A/R = $3,077

Inventory:

5.0=(9031/Inventory) =$1806

Fixed Assets:

Gross Fixed Asset Additions = $5,000

Depreciation

New Equipment = [$5,000/10] ( 1/2 = $250

Old Equipment = $510

$760

MACADAM COMPANY

PROJECTED CHANGES IN WORKING CAPITAL

NEXT YEAR (000)

Beginning Ending Change

Accts Rec $3,550 $3,077 $ 473

Inventory $2,603 $1,806 $ 797

Accts Pay $ 716 $ 677 ($ 39)

Accruals $ 230 $ 211 ($ 19)

Decr/(Incr)

in W/C $5,207 $3,995 $1,212

MACADAM COMPANY

PROJECTED STATEMENT OF CASH FLOWS - NEXT YEAR (000)

OPERATING ACTIVITIES

EAT $1,016

Depreciation $ 760

Decrease in W/C $1,212

Cash From Operating Activities $2,988

INVESTING ACTIVITIES

Increase in Gross

Fixed Assets ($5,000)

Cash From Investing Activities ($5,000)

FINANCING ACTIVITIES

Increase in Debt $1,700

Cash From Investing Activities. $1,700

NET CASH FLOW ($ 312)

RECONCILIATION

Beginning Cash $1,560

Net cash flow ($ 312)

Ending Cash $1,248

MANAGEMENT ISSUES IN FINANCIAL PLANNING

THE FINANCIAL PLAN AS A SET OF GOALS

Performance Measures

Bonuses

Stretch goals

RISK IN FINANCIAL PLANNING IN GENERAL

Reexamine Macadam's overall plan for achievability

Assumptions are all marvelously positive:

Revenue up 20%,

Cost of production decreases by 2% (a lot)

Asset management is totally successful

Will all of these positive things come true

without any offsetting negatives?

Probably not

Typical of corporate business plans, everything is routinely forecast to improve in the future.

Comes from: - stretch planning

- aggressive optimism

- top down planning

It's never quite clear whether a company's plan is a candid statement of what's likely to happen or a set of desirable goals.

Underforecasting - The Other Extreme

Bottom up planning

The Ideal Process

A give and take to arrive in the middle

Scenario Analysis

Producing more than one plan

FINANCIAL PLANNING AND COMPUTERS

Virtually all financial planning is done with computers.

Computers make repetitive calculations easy,

but

they don't do our thinking for us.

They don't help much in making planning assumptions,

which is the heart of the process.

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