Chapter 4 Financial Planning

1. Chapter 4 Financial Planning

2. Business Plan • A business plan is a model of what management expects a business to become in the future • Financial statements are pro forma • Good business plans are comprehensive

3. Component Parts of a Business Plan • Typical outline • Contents • Executive summary • Mission and strategy statement • Market analysis • Operations (of the business) • Management and staffing • Financial projections • Contingencies

4. The Purpose of Planning and Plan Information • Major audiences of business plan • 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 • Outside investors • Tells equity investors what returns can be expected • Tells debt investors how firm will repay loans

5. The Purpose of Planning and Plan Information • Planning process • Roadmap for running the business • Statement of goals • Predicting financing needs • Investor communication

6. Figure 4-1 Using a Plan to Guide Business Performance

7. Credibility and Supporting Detail • Shows enough supporting detail to indicate it is the product of careful thinking • Displays summarized financial projections

8. Four Kinds of Business Plan • Kinds of planning • Strategic Planning • Operational Planning • Budgeting • Forecasting

9. Four Kinds of Business Plan • Strategic Planning • Addresses broad, long-term issues, contains summarized, approximate financial projections • Five-year horizon is common • Concepts expressed mainly in words, not numbers • Firm analyzes itself, the industry and the competitive situation

10. Four Kinds of Business Plan • Operational Planning • Translates business ideas (day-to-day operations) into concrete, short-term projections • Usually one year or less • Specifies how much the firm will sell, to whom, and at what prices

11. Four Kinds of Business Plan • Budgeting • Short-term updates of the annual plan • Usually Covers a three month quarter • Attempts a precise estimate of company expenses • Mostly financial detail with a few words

12. Four Kinds of Business Plan • Forecasting • Very short-term projections of profit and cash flow • Where will the business’s financial momentum carry it in the next few weeks • Consists almost entirely of numbers • Cash forecasts are projections of short-term cash needs • Most large firms do monthly cash forecasts

13. Four Kinds of Business Plan • The Business Planning Spectrum • Broad, long-term planning on one end and numerical short-term forecasting on other • Relating Planning Processes of Small and Large Businesses • Small businesses tend to develop a single business plan containing both strategic and operating elements

14. Figure 4-2 The Business Planning Spectrum

15. Figure 4-3 Relating Business Planning in Large and Small Firms

16. Financial Plan as a Component of a Business Plan Financial plan is the financial portion of the business plan • A set of pro forma financial statements projected over a time period • Financials are only pieces of the projection

17. Planning for New and Existing Businesses • Hard to forecast a new operation • No history on which to base projections • The typical planning task • In ongoing businesses, based on planning assumptions such as • Unit sales will increase by 10% • Overall labor costs will rise by 4%, etc.

18. Figure 4-4 The Planning Task

19. Planning Assumptions • Planning Assumptions: expected physical or economic condition that dictates the size of one or more financial statement items

20. Concept Connection Example 4-1 Planning Assumptions • This year Crumb Baking Corp. sold 1 million coffee cakes per month at $1 each for a total of $12 million. Year-end receivables equal to two months of sales or $2 million.

21. Concept Connection Example 4-1 Planning Assumptions Crumb’s operating assumptions for sales and receivables are: 1. Price will be decreased by 10%. 2. As a result unit sales volume will increase to 15 million coffee cakes. 3. Collection efforts increased - only one month of sales in receivables at year end. Forecast next year’s revenue and ending receivables balance.

22. Concept Connection Example 4-1 Planning Assumptions • Three interrelated planning assumptions • a management action with respect to pricing, • the expected customer response to that action • 15 million coffee cakes will be sold at $.90 • Rev = 15,000,000 x $.90 = $13,500,000 • Collection activities will be more effective • one months of revenue in accounts receivable at year end. A/R = $13,500,000/12 = $1,125,000

23. The General Approach, Assumptions, and the Debt/Interest Problem • The Procedural Approach • Financial plans are built line-by-line beginning with revenues • Debt/Interest Planning Problem • The next items needed are interest expense and debt • Planned debt is required to forecast interest, but interest is required to forecast debt

24. An Iterative Numerical Approach Solves the debt/interest problem • Interest: Guess a value of interest expense • Net Income: Complete the income statement • Ending equity: Calculate as beginning equity plus net income • Ending debt: Calculate 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 calculated interest to the original guess

25. Figure 4-5 The Debt/Interest Planning Problem

26. Plans with Simple Assumptions • The Quick Estimate Based on Sales GrowthThe percentage of sales method assumes all financial statement line items vary directly with sales revenue • This is an unrealistic assumption • Management virtually always has more insight • The modified percentage of sales method assumes most but not all line items vary with sales

27. Example 4.3 Plans with Simple Assumptions Q: The Underhill 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:

28. Example 4.3 Plans with Simple Assumptions 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%. 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.

29. Example 4.3 Plans with Simple Assumptions Net Income was computed using an Interest of $150,000. The resulting Net Income was added to Equity and the Debt figure was a plug, calculated by subtracting Equity and Current Liabilities from Total L&E. Taking the average debt at 12% yields a calculated interest of $86,000 which is considerably less than the $150,000 assumed. Two additional iterations yield the following result.

30. Example 4.3 Plans with Simple Assumptions

31. Forecasting Cash Needs • Forecasting Cash Needs • A key reason for financial projections is to forecast the firm’s external financing needs • When a plan shows increasing debt, additional external financing will be needed

32. The Percentage of Sales MethodA Formula Approach Purpose – to estimate external financing requirements approximately and quickly growth in assets -growth in current liabilities -earnings retained _________________________________________________________________ =external funding requirements

33. The Percentage of Sales MethodA Formula Approach • If the firm’s growth rate in sales is g, it can be shown (see text) that external funds required (EFR) in the planned (next) year will be • EFR = g(assetsthis year) - (g  current liabilitiesthis year) - [(1 – d)ROS][(1+g)salesthis year] • Where d=dividend payout ratio • EFR = Growth in assets – growth in current liabilities – planned year’s retained earnings

34. Concept Connection Example 4-4

35. Concept Connection Example 4-4

36. The Sustainable Growth Rate • Assumes the debt/equity ratio is constant • Equity growth occurs via retained earnings • New debt will need to be raised to keep the debt/equity ratio constant • Gives an indication of the determinants of a firm’s inherent growth capability

37. The Sustainable Growth Rate • Business operations create new equity equal to the amount of current retained earnings, or (1 – d)Net Income • Implies sustainable growth rate in equity, gs gs = Net Income(1 – d) / equity • Because ROE = Net Income/equity gs = ROE(1 – d)

38. The Sustainable Growth Rate • Incorporating equations from the DuPont equations into the gs equation we obtain gs = (1-d)ROS x Total Asset Turnover x Equity Multiplier Firm’s ability to grow depends on 4 abilities: Ability to earn profits on sales (ROS) Use of assets to generate sales (T/A Turnover) Use of borrowed money - leverage (equity multiplier) Percentage of earnings retained (1 – d)

39. Concept Connection Example 4-5 Sustainable Growth Rate After several years of lower-than-average growth, Slowly, Inc. compared its sustainable growth rate with an industry average: Notice that Slowly’s sustainable growth rate is much lower than the average. Why?

40. Plans With More Complicated Assumptions • The percentage of sales method • Appropriate for quick estimates • Rarely used in formal plans due to lack of detail • Real plans generally incorporate complex assumptions about important financial items • Specific accounts can be forecast separately

41. More Complicated PlansIndirect Planning Assumptions • Financial planning assumptions can be made: • directly about the financial items • indirectly about a derivative of the item • Indirect planning assumptions are usually based on financial ratios • Receivables are usually managed through the Average Collection Period (ACP)

42. Concept Connection Example 4-8 Complex Plans • The Macadam Co. is developing its annual plan for next year. It expects to finish this year with the following financial results:

43. Concept Connection Example 4-8 Complex Plans

44. Concept Connection Example 4-8 Complex Plans

45. Concept Connection Example 4-8 Complex Plans

46. Concept Connection Example 4-8 Complex Plans

47. Concept Connection Example 4-8 Complex Plans

48. Figure 4-6 Supporting Detail for Annual Planning at the Department Level

49. The Cash Budget • The cash budget is a detailed projection of receipts and disbursementsof cash • A fundamentally different approach than projecting financial statements • In large part based on time lags between events and receipt or disbursement of related cash

50. Receivables and Payables—Forecasting with Time Lags Forecasting receivables collection is difficult because a company never knows when customers will pay their bills