financial planning chapter 16 © 2003 south-western/thomson learning

Financial Planning

Chapter 16

© 2003 South-Western/Thomson Learning

2

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 Good business plan should be comprehensive

Include projections concerning products, markets, employees, technology, facilities, capital, revenue, profitability, etc.

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Component Parts of a Business Plan

Typical outline Contents Executive summary Mission and strategy statement

• Basic charter and establishes long-term direction

Market analysis• Why the business will succeed against its competitors

Operations (of the business)• How the firm creates and distributes its product/service

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Component Parts of a Business Plan

Management and staffing• Firm’s projected personnel needs

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

future• Main focus of this chapter

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

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The Purpose of Planning and Plan Information Major audience of business plan include

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

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Credibility and Supporting Detail

A good business plan shows enough supporting detail to indicate it is the product of careful thinking

May display summarized financial projections but enough detail to explain the projections Important to match the level of detail to the

purpose of the plan

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Four Kinds of Business Plan

Four variations on basic idea of business planning Strategic planning

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

• Five-year horizon is common• Deals with concepts expressed mainly in words,

not numbers• Firm analyzes itself, the industry and the competitive

situation

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Operational planning• Translates business ideas (day-to-day operations) into

concrete, short-term projections• Even mix of words and numbers

Budgeting• Short-term updates of the annual plan when business

conditions change rapidly

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

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

business plan• May also perform quarterly budgets and numerous

forecasts

Relating Planning Processes of Small and Large Businesses Small businesses tend to develop a single business

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

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Figure 16.2: The Business Planning Spectrum

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Financial Plan as a Component of a Business Plan

Financial plan is a set of pro forma financial statements projected over the time period covered by the business plan

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

projections are the centerpiece

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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 labor costs will rise by 4%, etc.

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The General Approach, Assumptions, and the Debt/Interest Problem

What We Have and What We Need to Project Only need to project an income statement and

balance sheet• Statement of cash flows will be created from these

documents

Planning Assumptions 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

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Planning Assumptions—Example

Q: This year Crumb Baking Corp. sold 1 million coffee cakes per month to grocery distributors 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 with respect to sales and receivables for next year are:

1. Price will be decreased by 10% in order to sell more product.2. As a result of the price decrease, unit sales volume will

increase to 15 million coffee cakes.3. Collection efforts will be increased so that only one month of

sales will be in receivables at year end.

Forecast next year’s revenue and ending receivables balance on the basis of these assumptions. Assume sales are evenly distributed over the year.

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Planning Assumptions—Example

A: There are three inter-related planning assumptions: (1) a management action regarding pricing; (2) the expected customer response to the price change; and (3) and change in collection efforts.

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 decrease from two months of revenue to only one month; thus receivables are expected to be $13,500,000 12, or $1,125,000.

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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

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 debt

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To complete the BS we need to know the amount of debt

However, this depends on the amount of retained earnings generated during the year But, retained earnings depend on net income and net income

depends on how much interest expense is paid on debt Results in a circular argument Every financial plan runs into this technical problem Can be resolved using a numerical approach

beginning with a guess at the solution

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Figure 16.5: The Debt/Interest Planning Problem

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An Iterative Numerical Approach Procedure works as follows

Interest: Guess a value of interest expense EAT: Complete the income statement Ending equity: Calculate ending equity as beginning equity plus

EAT (less dividends plus new stock to be sold if either of these exist) Ending debt: Calculate ending debt as total L&E (= total assets) less

current liabilities less ending equity Interest: Average beginning and ending debt then calculate interest

expense on that value Test the results: Compare the calculated interest from previous step

to the original guess• If the two are significantly different repeat the process replacing the

original interest expense guess with the interest expense just calculated• If the calculated value of interest is close to the guess, stop

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An Iterative Numerical Approach—Example

Q: The following partial financial forecast has been done for Graybarr Inc. Complete the financial plan, assuming that Graybarr pays interest at 10% and has a flat income tax rate of 40% including federal and state taxes. Also assume no dividends are to be paid and no new stock is to be sold.

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Next Year Beginning EndingRevenue 10,000$ ASSETSCost/Expense 9,000$ Total Assets 1,000$ 3,000$ EBIT 1,000$ LIABILITIESInterest ? Current Liabilities 300$ 700$ EBT ? Debt 100$ ?Tax ? Equity 600$ ?EAT ? 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 is represented below, with the steps enumerated.

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e Next Year Beginning EndingRevenue 10,000$ ASSETSCost/Expense 9,000$ Total Assets 1,000$ 3,000$ EBIT 1,000$ LIABILITIESInterest 200$ Current Liabilities 300$ 700$ EBT 800$ Debt 100$ 1,220$ Tax 320$ Equity 600$ 1,080$ EAT 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 EAT.

3: Calculate Ending

equity as beginning equity plus EAT less dividends.

4: Calculate Ending debt as total L&E less

ending equity less ending current

liabilities.

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A: Now we check to see if the the interest implied by our calculated debt (average debt x interest rate) [which is (($100,000 + $1,220,000) 2) 10% = $66,000] is significantly different from the initial guess. Our original guess of $200,000 is much higher than the calculated interest of $66,000. Thus, a second iteration is performed.

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Next Year Beginning EndingRevenue 10,000$ ASSETSCost/Expense 9,000$ Total Assets 1,000$ 3,000$ EBIT 1,000$ LIABILITIESInterest 66$ Current Liabilities 300$ 700$ EBT 934$ Debt 100$ 1,140$ Tax 374$ Equity 600$ 1,160$ EAT 560$ Total L&E 1,000$ 3,000$

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

Next Year

Given these results the

average debt is $620,000

and interest is $62,000. The

second iteration and

the calculated result differ by only $4,000.

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Plans with Simple Assumptions

A rough plan can be generated with just a few assumptions

A detailed financial plan can involve numerous assumptions

The Quick Estimate Based on Sales Growth The percentage of sales method assumes most

financial statement line items vary directly with revenues

• Involves estimating only the company’s sales growth rate and assuming the firm’s efficiency and all its operating ratios remain constant throughout the growth period

• In practice modifications are made to the assumptions

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Plans with Simple Assumptions—Example

Q: The Overland Manufacturing Company expects next year’s revenues to increase by 15% over this year’s. The firm has some excess factory capacity, so no new fixed assets beyond normal replacements will be needed to support the growth. This year’s income statement and ending balance sheet are estimated as follows:

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

Accruals 45$ Current Liabilities 170$ 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 state and federal income taxes at a combined flat 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 fixed assets by 15%.

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

Accruals 52$ Current Liabilities 196$ 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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Taking the average debt at 12% yields a calculated interest of $86,000 which is considerably less than the $150,000 assumed. Additional iterations should yield a more accurate projection.

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

Accruals 45$ 52$ Current Liabilities 170$ 196$ 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 EAT was

added to Equity and the Debt figure was a

plug, calculated by subtracting Equity and Current Liabilities from

Total L&E.

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Plans with Simple Assumptions

Forecasting Cash Needs A key reason for doing financial projections

is to forecast the firm’s external financing needs

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

• Can be obtained by• Issuing debt or bank financing• Issuing new stock

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The Percentage of Sales Method—A Formula Approach If we assume that net fixed assets will rise in

tandem with sales, the percentage of sales method can be condensed into a single formula Purpose is to estimate external financing

requirements (EFR) A growing firm must buy assets to support

growth Some funds will be generated internally via

• Current liabilities• Retained earnings

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The Percentage of Sales Method—A Formula Approach Representing a firm’s growth rate in sales as g,

then Growth in assets = g assetsthis year and Growth in current liabilities = g x current liabilitiesthis

year

EATnext year = ROS (1 + g)salesthis year

Current earnings retained = (1 – dividend payout ratio) EATnext year

EFR = g(assetsthis year) - g current liabilitiesthis year - (1 – dividend payout ratio) EATnext year

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The Percentage of Sales Method—A Formula Approach—Example

Q: Forecast the external financing requirements of the Overland Manufacturing Company assuming net fixed assets and EAT grow at the same rate as sales. However, also assume the firm plans to pay a dividend equal to 25% of earnings next year.

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

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


Balance Sheet

The items needed to apply the EFR equation are

highlighted. We also need the ROS figure

of 11% (EAT sales, or $1,488 $13,580) and the expected dividend

payout ratio of 25%. Revenues are

expected to increase by 15%.

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The Percentage of Sales Method—A Formula Approach—Example

A: Applying the EFR equation we have:

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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 $414,000.

this year this year next yearEFR = g(assets ) - g(current liabilities ) - (1 - DPR) EAT

.15($6,000) - .15($170) - [(1 - .25)(.11)][(1.15)($13,580)]

-$413.9

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The Sustainable Growth Rate

A firm can grow at its sustainable growth rate without selling new stock if its financial ratios remain constant The growth in equity created by profits

Business operations create new equity equal to the amount of current retained earnings, or (1 – DPR)EAT This implies a sustainable growth rate in equity, gs, of

• gs = EAT(1 – d) equity• Since ROE = EAT equity, gs = ROE(1 – d)

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Sustainable growth rate assumes that the debt/equity ratio is constant Equity growth occurs via retained earnings

so no new stock needs to be issued However, new debt will need to be raised to

keep the debt/equity ratio constant Sustainable growth concept gives an

indication of the determinants of a firm’s inherent growth capability

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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)

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Plans With More Complicated Assumptions

The percentage of sales method is appropriate for quick estimates, but generally aren’t used in formal plans because they gross over too much detail

Real plans general incorporate complex assumptions about important financial items Specific accounts can be forecast separately

• Fixed assets are forecast by projecting the gross amount using the capital plan and handling depreciation separately

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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

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Planning at the Department Level Operational plans projections are much more

detailed than the single numbers appearing on the income statement Departmental detail supports the expense entries on the

planned income statement Manufacturing Departments

Spending in manufacturing departments is incorporated in the product’s cost through cost accounting procedures

• Money spent is absorbed into inventory and becomes COGS on the income statement when the product is sold

• The cost ratio assumption summarizes enormous detail in manufacturing departments

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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 stock Disbursements include paying for purchases,

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

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Receivables and Payables— Forecasting with Time Lags Forecasting receivables collection is difficult

because you never know exactly when a customer will pay his bill Some pay by the due date (terms of trade, usually

30 days), while others lean on the trade and others may never pay

However, a firm generally knows the trend in receivables collection, such as what percentage of customers pay over time from the day of sale

If a prompt payment discount is offered that can complicate matters

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Receivables and Payables— Forecasting with Time Lags—Example

Q: A firm has discerned that its collections exhibit the following pattern:

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

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

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8%30%60%% collected

321Months after sale

$700$600$500Credit sales

MarFebJan

$56$258$640$510$300Total collections

$56$210$420 Mar

$48$180$360 Feb

$40$150$300 Jan

Collections from sales made in

MayApr Jun

$700

Mar

$600$500Credit sales

FebJan

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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 Not unusual

The current month’s interest payment is based on the preceding month’s loan balance But that balance depends on whether the month’s cash flow is

positive or negative Other Items

Forecasting most other items is relatively straightforward• Payroll dates are known in advance so wages are easy to

forecast, as are dates for interest payments on bonds and taxes, etc.

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The Cash Budget—Example

Q: The Pulmeri Company’s revenues tend to go through a quarterly cycle. It’s now mid-March and management expects the first quarter’s pattern to be repeated in the second quarter. The six-month period is as follows ($000).

Historically, Pulmeri collects its receivables according to the following pattern.

No prompt payment discount is offered, and there are virtually no bad debts. 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 45 days after receipt of material.

Payroll runs a constant $2.5M per month, and other expenses such as rent, utilities, and supplies are a fairly steady $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.

Prepare Pulmeri’s cash budget for the second quarter.

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$9,000

Mar

$8,000

Feb

$5,000

Jan

$9,000$8,000$5,000Revenue

JunMayApr

10%25%65%% collected

321Months after sale

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

$7,350$6,300$8,350Second quarter collections

$5,200 May

$1,250$3,250 Apr

$900$2,250$5,850 Mar

$800$2,000$5,200 Feb

$500$1,250$3,250 Jan

Collections from sales made in

$8,000

May

$5,000

Apr

$9,000

Jun

$9,000

Mar

$8,000$5,000Revenue

FebJan

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A: Next, lag inventory purchases (half of sales dollars) back one month from the date of sale and then lag the payment two months forward in two equal parts.

$4,250$3,250$3,500Payment for materials

$2,250 May

$2,000$2,000 Apr

$1,250$1,250 Mar

$2,250$2,250 Feb

Payment

$4,500

May

$4,000

Apr Jun

$2,500

Mar

$4,500Purchases

FebJan

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A: Finally, summarize these results along with payroll and other disbursement and work through the interest charges.

Pulmeri Company

Cash Budget

Second Quarter 20x1

($000)

$500 Tax payment

$1,500$1,500$1,500 General expenses

$2,500$2,500$2,500 Payroll

$4,250$3,250$3,500 Materials purchases

Disbursements

$7,350$6,300$8,350Collections

$8,000

May

$5,000

Apr

$9,000

Jun

$9,000

Mar

$8,000$5,000Revenue

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

$8,250$7,250$8,000Disbursements before interest

Pulmeri Company

Cash Budget

Second Quarter 20x1

($000)

MayApr JunMarFebJan

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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

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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 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

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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

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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

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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

Repetitive Calculations Before computers, recomputing a plan was time

consuming and labor-intensive However, with computers repetitive calculations can

be done quickly and easily

financial planning chapter 16 © 2003 south-western/thomson learning

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