Financial Planning System: Introduction • Long-Range Financial Planning: • means of systematically thinking about the future and anticipating possible problems before they arrive. • to avoid financial distress and failure • establishes guidelines for change and growth in a firm • concerned with the major elements of a firm’s financial and investment policies • interrelatedness of the various investment and financing decisions a firm makes
Basic elements of firm’s financial policy • The firm’s needed investment in new assets. • Capital Budgeting Policy • The degree of financial leverage the firm chooses to employ. • Capital Structure Policy • The amount of cash the firm thinks is necessary and appropriate to pay shareholders. • Dividend Policy • The amount of liquidity and working capital the firm needs on an ongoing basis. • Working Capital Policy
These Policies and Decisions affect • Future Profitability • Need for external financing • Opportunities for growth Firm’s investment and financing policies interact and thus cannot truly be considered in isolation from one another. Most company use explicit, company wide growth rate as a major component of their long-run financial planning Financial Planning Models can be used to better understand how growth shall be achieved.
What are 4 Ps of Marketing ? Proper Prior Planning Prevents Poor Performance What are 6 Ps of Financial Planning ?
What is Financial Planning ? • Making a roadmap for what is to be done in future so as to formulate the way in which financial goals are to be achieved. • Remember ? • Financial Management operates in an uncertain world
Growth as a Financial Management Goal • Growth, by itself, is not an appropriate goal for the financial manager. • Growth may thus be a desirable consequence of good decision making, but it is not an end unto itself. • But, growth rates are very commonly used in planning process. • Growth is a convenient means of summarizing various aspects of a firm’s financial and investment policies. • If we think of growth as growth in the market value of the equity of the firm, then its equivalent to goal of maximizing the shareholder’s wealth.
Dimensions of Financial Planning • Planning Horizon: • Short Run: 12 months • Long Run: 2 to 5 years • Establish the Planning Horizon • Aggregation: • Of all the individual projects and investments the firm will undertake • Fix the Level of Aggregation • Assumptions regarding the important variables • Eg. Preparing alternative business plans for three scenarios: Worst Case, Normal Case, and Best Case • Make realistic Assumptions regarding the forthcoming events and variables
Why spend time on planning ? What can Planning Accomplish ? • Examining Interactions • Between investment proposals and financing choices • Exploring Options • Various investment and financing options explored • Their impact on the firm’s shareholders can be evaluated. • Avoiding Surprises • Contingency Planning • Ensuring Feasibility and Internal Consistency • Making explicit linkages between various specific goals • Imposing unified structure for reconciling different goals and objectives. • Establishing priorities
Financial Planning Models • Sales Forecast • It is generally the “driver” • Given as the growth rate in sales • Perfect forecast is IMPOSSIBLE. • Pro-forma Statements • Forecasted Balance Sheet, Income Statement and Statement of Cash Flow • Pro formas are the output of financial planning models • Assets Requirements • Projected Capital Spending = changes in total fixed assets and net working capital = Total Capital Budget A Financial Planning Model: Elements
A Financial Planning Model: Elements (contd…) • Financial Requirements • What are the necessary financing arrangements and how shall those be raised • The Plug • The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance. • Economic Assumptions • State explicitly the economic environment in which the firm expects to reside over the life of the plan
Example • Assumption: All variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. • Suppose the sales increase by 20 %, rising from $ 1,000 to $ 1,200. • Make Pro forma Income Statement and Balance Sheet
Example (contd…) • Reconcile these two pro formas • Can net income be equal to $ 240 and equity increase by only $ 50 ? • ABC must have paid out the difference of $ 240 - $ 50 = $ 190 possibly as cash dividend. • In this case, dividends are the plug variable.
Example ( contd….) • Suppose ABC doesn’t pay out the $ 190 • What happens to Equity ? • It grows to $ 240 + $ 250 = $ 490 • Now everything is fine ? • What happens to Debt ? • Debt must be retired to keep total assets $ 600 • Debt will have to be $ 600 - $ 490 = $ 110 • Debt to be retired = $ 250 - $ 110 = $ 140 • In this case Debt is the Plug Variable
Example (contd…) • Example shows the interaction between sales growth and financial policy. • As sales increase, so do total assets. WHY ? • The firm must invest in net working capital and fixed assets to support higher sales levels. • Since assets are growing, total liabilities and equity will grow as well
The Percentage of Sales Approach • Every item doesn’t increase at the same rate as sales. • Eg: Long-Term Borrowing – something that doesn’t necessarily relate directly to the level of sales • The basic idea is to separate the income statement and balance sheet accounts into two groups: • Those that do vary directly with sales • Those that don’t vary directly with sales. • Given the sales forecast, calculate how much financing the firm will need to support the predicted sales level.
PoS Approach for Income Statement • Assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship. • When using this method, a decision has to be taken about which historical cost ratios to be used. • Should these ratios pertain to the previous year • OR the average of two or more years.
PoS Approach for Income Statement (contd….) XYZ has projected a 25 % increase in sales for the coming year
PoS Approach for Income Statement (contd….) • What will be the sales for coming year ? • $ 1250 • What will be the cost for coming year ? • Assuming that the ratio of cost to sales shall remain same. • 80 % of $ 1250 = $ 1000 • What will be the Net Income ? • $ 165 • What was the percentage of NI to sales and what is it now ? • 13.2 % • Now what about dividend ? • Assume that the management of XYZ pays constant rate of dividend out of NI (Dividend payout ratio is constant) • What is dividend payout ratio of XYZ ? • $ 44 / $ 132 = 33.33 % • What is the retention or plowback ratio of XYZ ? • $ 88 / $ 132 = 66.67 % = 100 % - 33.33 % • Make pro forma income statement for coming year.
PoS Approach for Balance Sheet • Some of the items vary directly with sales and others do not. • For those items that do vary with sales, we express each as a percentage of sales for the year just ended. For others we write “n/a”
PoS Approach for Balance Sheet (contd…) • Ratio of total assets to sales = 3 • It is called Capital Intensity Ratio • What does this ratio tell us ? • Tells us the amount of assets needed to generate $ 1 in sales. • Its reciprocal of Total Assets Turnover Ratio • On the liability side, why only A/C payable is assumed to be varying with sales ? • What is Notes Payable ? • Short term debts such as bank and corporate borrowings. • What about Retained Earning ? Does it vary with sales ? • But we shall calculate it based on our projected net income and dividend (governed by dividend policy)
PoS Approach for Balance Sheet (contd…) • Construct a partial pro forma balance sheet • For each items, also find out the change from previous year in $. • For those items that don’t vary directly with sales, initially assume no change and simply write in the original amounts. • What about change in Retained Earnings ? Is it nil ? • Assets increase by $ 750 while liabilities and equity increase only by $ 185 • The difference $ 565 is External Financing Need (EFN)
Scenario 1 • Now there’s a good news and a bad news. • Good News – We’re projecting 25 % increase in sales. • Bad News – This isn’t going to happen unless XYZ can somehow raise $ 565 in new financing. • If for eg, XYZ has goal of not borrowing any additional funds and not selling any new equity, then 25% increase in sales is probably not feasible. • This is how the planning process can point out problems and potential conflicts.
Scenario 1 (contd…) • Given the EFN $ 565, XYZ has three possible sources: • Short-Term borrowing • Long-Term borrowing • Issuance of New Equity • Choice of any combination of above sources is up to management. • Lets say that XYZ decides to borrow $ 565- some over the short-term and some over the long-term
Scenario 1 (contd…) – Construct Pro Forma BS Leave net working capital unchanged
Accounts Payable rose by $ 75 How much could XYZ borrow in short-term Notes Payable ?
How much more is needed now ? How will XYZ raise $ 340 ? $ 565 - $ 225 = $ 340 Long Term Borrowings
Now fill up all the items of Pro Forma BS How much is common stock and paid-in surplus ?
PoS Approach for Balance Sheet (contd…) • Here, what have we used as plug ? • Plug – Combo of short and long term debt • This is just one possible strategy • While planning, we should investigate many of such scenarios • Now what can be the use of Ratio analysis here ? • We would surely like to examine the CURRENT RATIO and TOTAL DEBT RATIO • Now we can form projected statement of cash flows too. • TRY IT !
Alternative Scenario What if XYZ is using operating at only 70 % capacity ?
Alternative Scenario (contd….) • Assumption that assets are a fixed percentage of sales is convenient, but it may not be suitable in many cases. • In previous example, we assumed that XYZ was using its fixed assets at 100 % of capacity. • Hence, for any increase in sales, increase in investment in fixed assets seemed realistic.
XYZ operating at 70 % of capacity • It would mean that sales of $ 1000 is only 70 % of the full capacity sales. • Then, what is full capacity sales ? • $1000/ 0.70 = $ 1429 • That means sales could increase by almost 43 % before any new fixed assets would be needed. • For our previous example, we assumed that sales would increase by only 25 % < 43 %. • Now what shall be EFN ? Will it still be $ 565 ? • Hint : Now XYZ wont need $ 450 in net new assets investment.
What shall be EFN in this case ? • EFN = $ 565 - $ 450 = $ 115 • Lessons Learnt : • It is inappropriate to blindly manipulate financial statement information in the planning process. • Results depend critically on the assumptions made about the relationships between sales and assets need. • Projected growth rates play an important role in the planning process.
External Financing and Growth • What is the relationship between EFN and growth in sales and assets ? • Other things remaining constant, the relationship is directly proportional. Lets examine the relationship between Financial Policy of the firm and its ability to finance new investments and thereby grow. i.e. The Financial Policy of the firm is given – Sounds more practical
EFN and Growth (contd….) Example Debt = Short Term + Long Term
Example (contd….) Assumptions: • Sales grow by 20 % • PoS approach seems reasonable. • Retention Ratio is same. • PQR is operating in full capacity • Financing Policy: NO NEW EQUITY SALE, BORROW ALL NEEDED FUNDS AND USE ALL SURPLUS FUNDS IF ANY, TO RETIRE DEBT Questions: • Prepare prior Pro forma Income Statement and Balance Sheet • How much goes as addition to Retained Earnings ? • 66.67 % of 79.2 % = $ 52.8 • How much more PQR needs to invest in new assets ? • $ 600 - $ 500 = $ 100 • How much is EFN ? • $ 100 - $ 52.8 = $ 47.2
Example (contd….) • Due of financing policy of PQR, all EFN are borrowed. • What was original Debt-Equity Ratio of PQR ? • $ 250 / 250 = 1.00 • What shall be new Debt amount of PQR ? • $ 250 + $ 47.2 = $ 297.2 • What shall be new Debt-Equity Ratio after borrowing ? • $ 297 / $ 302.8 = 0.98 • PQR borrowed some funds but their Debt-Equity ratio fell ? WHY ? • Because, for this particular example, PQR earned and retained more than EFN which was borrowed. • i.e. Increase in Equity was more than Increase in Debt.
Example (contd….)- Exploring Relationships • What shall be Increase in Assets Required for PQR for various growth rates ? • What shall be Addition to Retained Earnings for PQR for various growth rates ? • What shall be EFN of PQR Co’ for various growth rates ? • What shall be Projected Debt-Equity ratio of PQR for various growth rates, given the Financing Policy of borrowing EFN and retiring debt with surplus if any ?
EFN and Growth (contd….) • Note: • Increase in assets required = % of growth rate of original assets. • Addition to retained earnings = Original Retained earnings + % of growth rate of original retained earnings. • For relatively low growth rates, PQR runs a surplus and Debt-Equity ratio will decline. • Once growth rate increases to about 10 %, surplus becomes deficit. • As growth rate exceeds approx 20 % the Debt Equity ratio passes its original value of 1.0
EFN and Growth (contd…) EFN > 0 (deficit) EFN < 0 (surplus) What can you infer from this diagram ?
EFN and Growth (contd…) • The need for new assets grows at much faster rate than the addition to retained earnings. • Internal financing provided by the addition to retained earnings rapidly disappears. • Whether a firm runs cash surplus or deficit depends upon growth. • It is possible for a firm to experience greater cash balance even when its growth has slowed down.