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Financial Planning and Control

Financial Planning and Control. The information derived from financial statement analysis can be used to establish future operating goals ( financial planning ) and to determine how to meet established goals ( financial control ).

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Financial Planning and Control

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  1. Financial Planning and Control The information derived from financial statement analysis can be used to establish future operating goals (financial planning) and to determine how to meet established goals (financial control). Developing pro forma(forecasted) financial statements is an important part of the planning and control processes.

  2. Primary goal of financial planning is to make arrangements for forecasted cash flows—that is, for future funding needs or for investment of excess funds expected in the future. • Sales Forecast • Most important part of financial planning. • Generally based on the trend in sales in recent periods. • Inaccurate sales forecasts can have serious repercussions. Pro Forma Financial Statements

  3. Trend in Sales for AgriCorp Sales ($ millions) 600 500 400 300 200 100 0 2013 2014 2015 2016 2017 2018 Average growth = 12%

  4. Help the firm determine what is needed to finance expected future operating activities. These statements indicate how much financing will be generated internally and how much must be generated externally. Projected (Pro Forma) Financial Statements

  5. Projected (Pro Forma) Financial Statements To construct a pro forma balance sheet and a pro forma income statement: Step 1: Forecast next period’s income statement Step 2:Forecast next period’s balance sheet Step 3:Raising the additional funds needed Step 4:Financing feedbacks

  6. Step 1: Construct a Pro Forma Income Statement Estimate the percentage growth (increase or decrease) in sales, cost of goods sold, and other variable revenues and expenses. Change appropriate current values by the estimates: An easy way to approach this task is to apply a single growth rate to all revenue and expense categories that change when production changes. To be more accurate, each category should be examined individually to determine the effect of any forecasted change.

  7. Step 1: Construct AgriCorp’s Pro Forma Income Statement for Next Year Assumptions: • AgriCorp operated at full capacity last year. • Sales are expected to grow by 12 percent. • The variable cost ratio remains at 80 percent (same as last year) • Next year’s dividend payout will be maintained at 60 percent of net income.

  8. AgriCorp’s Pro Forma Income Statement for Next Year ($ millions) Last Year’s Results Sales $500.00 Variable costs (80%) (400.00) Fixed Costs ( 55.00) EBIT = NOI 45.00 Interest ( 10.00) Taxable income (EBT) 35.00 Taxes @ 40% ( 14.00) Net Income 21.00 Dividends (60% of NI) 12.60 Addition to RE 8.40 Next Year’s x (1 + g) Initial Forecast x 1.12 $560.00 x 1.12 (448.00) x 1.12( 61.60) 50.40 ( 10.00) 40.40 ( 16.16) 24.24 14.54 9.70

  9. Step 2: Construct AgriCorp’s Pro Forma Balance Sheet for Next Year Assumptions: • AgriCorp operated at full capacity last year. • Each type of asset grows proportionally with sales. • Payables and accruals (spontaneous sources of financing) grow proportionally with sales.

  10. AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions) Last Year’s Results Current assets $155.00 Fixed assets 120.00 Total assets $275.00 Payables & accruals 30.00 Notes Payable 13.00 Current liabilities 43.00 Long-term debt 100.00 Total liabilities 143.00 Common stock 44.00 Retained earnings 88.00 Total equity 132.00 Total liabilities & equity $275.00 x 1.12 $176.60 x 1.12 134.40 $308.00 x 1.12 $ 33.60 Next Year’s x (1 + g)Initial Forecast 13.00 46.60 100.00 146.60 44.00 +9.70 Δ RE 97.70 141.70 $288.30

  11. Additional Funds Needed (AFN) If AgriCorp does not raise additional capital by borrowing from the bank or issuing new stocks or bonds, then, based on the pro forma balance sheet, the following exists: Total assets $308.00 Total liabilities and equity 288.30 Additional funds needed (AFN) 19.70

  12. Step 3: Raising the Additional Funds Needed (AFN) AgriCorp plans to raise the additional funds needed (AFN) as follows: Proportion Notes payable 15.0% New long-term debt 20.0 New common stock 65.0 100.0 Amount $2.96 3.94 12.80 19.70 Cost 7.0% 10.0 Δ dividend

  13. Step 4: Financing Feedbacks Issuing new debt and common stock affects the amount of interest and dividends paid by the firm. Any increase in financing costs decreases the funds the firm has to invest—that is, the amount of income added to retained earnings will be less than originally forecasted. Because of the increased interest and dividend payments, the firm’s AFN is actually greater than originally expected. Financing feedbacks—that is, the effects of externally financing forecasted increases in assets—must be considered to determine the exact amount of AFN.

  14. AgriCorp’s Pro Forma Income Statement for Next Year ($ millions)—2nd Pass Last Year’s Next Year’s Results x (1+g)Initial Forecast EBIT = NOI $ 45.00 x 1.12 $ 50.40 Interest (10.00)(10.00) Taxable income 35.00 40.40 Taxes @ 40% (14.00)(16.16) Net Income 21.00 24.24 Dividends (60% of NI) 12.60 14.54 Addition to RE 8.40 9.70 2nd Pass Forecast $ 50.40 (10.60) 39.80 (15.92) 23.88 14.33 9.55 New interest = 10.00 + (2.96 x 0.07) + (3.94 x 0.10) = 10.60 Δ in addition to RE = 9.55 – 9.70 = –0.15

  15. AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—2nd Pass Last Year’s Next Year’s Results x (1+g)Initial Forecast Total assets $275.00 x 1.12 $308.00 Payables & accruals 30.00 x 1.12 33.60 Notes payable 13.00 13.00 Current liabilities 43.00 46.60 Long-term debt 100.00100.00 Total liabilities 143.00 146.60 Common stock 44.00 44.00 Retained earnings 88.00 97.70 Total equity 132.00 141.71 Total liabilities & equity 275.00 288.30 2nd Pass Forecast $308.00 33.60 15.96 + 2.96 49.56 103.94 + 3.94 153.50 56.80 +12.80 + 9.70 - 0.15 97.55 154.35 307.85 AFN1 = 2.96+3.94+12.80 = 19.70 AFN2 = 308.00 – 307.85 = 0.15

  16. Last Year’s Next Year’s Results x (1+g)Initial Forecast Total assets $275.00 x 1.12 $308.00 Payables & accruals 30.00 x 1.12 33.60 Notes payable 13.00 13.00 Current liabilities 43.00 46.60 Long-term debt 100.00100.00 Total liabilities 143.00 146.60 Common stock 44.00 44.00 Retained earnings 88.00 97.70 Total equity 132.00 141.71 Total liabilities & equity 275.00 288.30 AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—Final Pass Final Forecast $308.00 33.60 15.98 + 2.98 49.58 103.97 + 3.97 153.55 56.90 +12.90 + 9.70 -0.15 97.55 154.45 308.00 Total AFN = 2.98+3.97+12.90= 19.85 > 19.70 = AFN1

  17. Other Considerations in Forecasting Excess capacity—If the firm has excess capacity, it will not have to increase plant and equipment at the same growth rate as sales. To determine the level of sales current plant capacity can handle, use the following equation: • Example—If AgriCorp currently operates at 80 percent capacity, then existing plant and equipment can produce sales equal to: In this case, sales can grow by 25 percent before AgriCorp needs to expand its plant and equipment.

  18. Other Considerations in Forecasting • Excess capacity—If the firm has excess capacity, it will not have to increase plant and equipment at the same growth rate as sales. • Economies of scale—If economies of scale exist, the variable cost ratio might change with changes in production activity. • Lumpy assets—Many assets are not completely divisible • some assets might have to be purchased in larger increments than the firm would prefer • “lumpy assets” must be purchased in discrete increments, say, $10 million per addition, which means we cannot simply increase assets by a growth rate like 12 percent

  19. Proper financial control helps to ensure the firm meets the expectations developed in the planning stage, and, when results fall short of expectations, helps management determine the reasons. Financial Control

  20. Breakeven analysis—evaluation of the level of operations to determine the ability of the firm to generate profits • Leverage analysis—examination as to how well the firm can cover its fixed costs, both operating and financial; gives an indication of risk Breakeven Analysis and Leverage Analysis

  21. Operating Breakeven Analysis Operating breakeven point is defined as the level of operations where the net operating income, NOI = EBIT, equals zero—that is, NOI = 0 At the operating breakeven point: Total operating costs = sales revenues

  22. Operating Breakeven Analysis—Example Worldwide Widgets, Inc.’s operations have the following characteristics: Selling price (P) $8.00 Variable cost per unit (V) $6.00 Variable cost ratio = V/P 0.75 Fixed operating costs $12,000.00 Existing sales 10,000 units

  23. Operating Breakeven Analysis—Graph Sales/Cost ($) Operating profit Total sales Operating BEP 48,000 Total operating costs Operating loss Fixed operating costs = $12,000 Quantity Produced and Sold

  24. Operating Breakeven Analysis—Computation = 6,000 x $8

  25. Determine the level of sales a product must achieve to make a profit. Indicate the impact of general growth on the cost structure of the firm. Show how modernization to improve efficiency affects fixed and variable costs, thus profitability of operations Operating Breakeven Analysis—Uses

  26. In business, leverage refers to the existence of fixed costs. The presence of any leverage (operating or financial) means that a change in sales will result in a larger change in operating income (EBIT), net income, or both. Operating leverage exists if fixed operating costs, such as depreciation, are present. The degree of operating leverage (DOL) is defined as the percent change in net operating income, NOI, that results from a particular percent change in sales. Operating Leverage Analysis

  27. DOL is computed as follows: Operating Leverage Analysis Generally, a firm with a high DOL is considered to have high risk associated with its operations. Risk = Variability

  28. Pro Forma Income Statement for Worldwide Widgets Sales in units 10,000 Sales @ $8 per unit $80,000 Variable costs @ $6 per unit (60,000) Gross Profit 20,000 Fixed operating costs (12,000) NOI = EBIT $ 8,000 Does Worldwide Widgets have operating leverage? Yes

  29. Worldwide’s degree of operating leverage is: Operating Leverage Analysis DOL = 2.5x means that for every 1 percent deviation in sales from expectations, there will be a 2.5 percent deviation in EBIT (in the same direction) from expectations.

  30. Current Forecast Sales ($8/unit) Variable costs ($6/unit) Gross Profit Fixed operating costs NOI = EBIT Effect of DOL for Worldwide Widgets If Sales are Percent 10% LowerDeviation -10.0% $72,000 $80,000 (60,000) 20,000 (12,000) $ 8,000 (54,000) -10.0% -10.0% 18,000 (12,000) - 0.0% -25.0% $ 6,000 DOL = 2.5; as a result, a 10 percent decrease in sales will result in a 25 percent (2.5 x 10%) decrease in EBIT

  31. Operating Leverage and Operating Breakeven Generally, a higher degree of operating leverage (DOL) implies that greater risk is associated with the firm’s operations. Risk is variability. The closer the firm operates to its breakeven point, the riskier its operations are considered. Everything else equal, firms with higher DOLs operate closer to their operating breakeven points, and thus cannot cover fixed operating costs as easily as firms with lower DOLs.

  32. Operating Leverage and Operating Breakeven Firm A Firm B Firm C Selling price Variable cost per unit Variable cost ratio Fixed costs Operating BEP Existing sales Sales/Operating BEP DOL $8 $8 $15 $6 $6 $12 0.75 0.75 0.80 $12,000 $12,000 $30,000 6,000 6,000 10,000 10,000 18,000 15,000 1.7 3.0 1.5 2.5 1.5 3.0 $8 $8 $15 $6 $6 $12 0.75 0.75 0.80 $12,000 $12,000 $30,000 6,000 6,000 10,000 10,000 18,000 15,000 1.7 3.01.5 2.5 1.53.0 $8 $8 $15 $6 $6 $12 0.75 0.75 0.80 $12,000 $12,000 $30,000 6,000 6,000 10,000 10,000 18,000 15,000 1.7 3.0 1.5 2.5 1.5 3.0

  33. Financial Breakeven Analysis Financial breakeven point is defined as the level of operating income (NOI or EBIT) that covers all fixed financing charges. At the financial breakeven point, EPS = $0, which means the earnings available to pay common dividends equal $0. For the most part, fixed financial charges include interest paid on debt and preferred stock dividends. For firms that do not have preferred stock, the financial breakeven point, EBITFinBE, is simply interest on debt. Most firms do not have preferred stock.

  34. Worldwide Widgets, Inc. is financed with the following sources of long-term funds: Bonds @ 8% interest $ 50,000 Preferred stock 0 Financial Breakeven Analysis—Example Common stock (5,000 shares outstanding) 50,000 Total capital $100,000

  35. EPS ($) 2.00 1.50 1.00 0.50 0 -8,000 -4,000 0 4,000 8,000 12,000 16,000 -0.50 EBIT ($) -1.00 -1.50 -2.00 Financial Breakeven Analysis—Example Financial breakeven point = EBITFinBE

  36. The financial breakeven point is computed as follows: Financial Breakeven Analysis—Computation • If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is:

  37. Financial breakeven analysis gives an indication as to how the firm’s mix of debt and preferred stock (fixed financing) affects EPS (net income). Financial Breakeven Analysis—Uses

  38. Financial leverage exists if the firm has fixed financial charges: interest on debt preferred dividends The degree of financial leverage (DFL) is the percent change in EPS that results from a particular percent change in net operating income. Financial Leverage Analysis

  39. DFL is computed as follows: Financial Leverage Analysis If a firm has no preferred stock, the DFL simplifies to: Generally, a firm with a high DFL is considered to have high risk associated with its financing. Risk = Variability

  40. Sales $80,000 Variable costs (75% of sales) (60,000) Gross Profit 20,000 Fixed operating costs (12,000) NOI = EBIT $ 8,000 Pro Forma Income Statement for Worldwide Widgets Interest = $50,000 x 0.08 ( 4,000) Taxable income (EBT) 4,000 Taxes (40%) ( 1,600) Net income = EAC $ 2,400

  41. Does Worldwide Widgets have financial leverage? Yes, because the firm has a fixed financing cost—that is, interest—equal to $4,000. Worldwide’s degree of financial leverage is: Financial Leverage Analysis DFL = 2.0x means that for every 1 percent deviation from expectations in EBIT, there will be a 2.0 percent deviation in expected EPS (in the same direction).

  42. Effect of DFL for Worldwide Widgets Current Forecast EBIT Interest Taxable income (EBT) Taxes (40%) Net income = EAC EPS = EAC/5,000 If EBIT is Percent 25% LowerDeviation -25.0% $8,000 (4,000) 4,000 (1,600) $ 2,400 $6,000 (4,000) 0.0% -50.0% 2,000 -50.0% ( 800) $ 1,200 -50.0% $0.24 $0.48 -50.0% DFL = 2.0; as a result, a 25 percent decrease in EBIT will result in a 50 percent (2.0 x 25%) decrease in EPS

  43. Generally, a higher degree of financial leverage (DFL) implies greater risk is associated with the firm’s financial mix. Risk is variability. The closer the firms operates to its financial breakeven point, the riskier its financial position is. Everything else equal, firms with higher DFLs operate closer to their financial breakeven points, and thus cannot as easily cover fixed financial costs as firms with lower DFLs. Financial Leverage and Financial Breakeven

  44. Combining Operating and Financial Leverage (DTL) The degree of total leverage (DTL) is the combination of DOL and DFL. DTL is the percent change in EPS associated with a particular percent change in sales DTL = DOL x DFL • Everything else equal, a higher degree of total leverage, DTL,is associated with greater total risk—both operating risk and financial risk.

  45. Worldwide’s degree of total leverage is: Degree of Total Leverage (DTL) DTL = 5.0x means that for every 1 percent deviation in sales from expectations, there will be a 5.0 percent deviation in EPS (in the same direction) from expectations.

  46. Current Forecast Sales $80,000 Variable operating costs (60,000) Gross profit 20,000 Fixed operating costs (12,000) EBIT 8,000 Interest ( 4,000) Taxable income (EBT) 4,000 Taxes (40%) ( 1,600) Net income = EAC 2,400 EPS = EAC/5,000 $0.48 Effect of DTL for Worldwide Widgets If Sales are Percent 10% LowerDeviation $72,000 -10.0% (54,000) -10.0% 18,000 -10.0% (12,000) 0.0% 6,000 -25.0% ( 4,000) 0.0% 2,000 -50.0% ( 800) -50.0% 1,200 -50.0% $0.24 -50.0% DTL = 5.0; as a result, a 10 percent decrease in sales will result in a 50 percent (5.0 x 10%) decrease in EPS

  47. Using Leverage Analysis for Financial Control Knowledge of the degree of leverage, whether operating, financial, or both, helps determine how a change in sales will affect income—operating income, net income, or both. Greater leverage indicates that greater changes in income (either NOI or net income) will result from changes in sales. Greater variability associated with income, whether operating income, EPS, or both, suggests greater risk.

  48. Chapter 16 Questions Why should firms construct pro forma (forecasted) financial statements? How does a firm construct pro forma financial statements? What are some other factors that should be considered when constructing pro forma financial statements? Why is financial control an important ingredient in financial planning? How are breakeven analysis and leverage analysis used in the financial control process? Explain how profits or losses will be magnified for a firm with high leverage (operating, financial, or both) as opposed to a firm with low leverage.

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