Finance for Non-Financial Managers , 6 th edition

Finance for Non-Financial Managers, 6th edition PowerPoint Slides toaccompany Prepared by Pierre Bergeron, University of Ottawa

Finance for Non-Financial Managers, 6th edition CHAPTER 7 PLANNING, BUDGETING, AND CONTROLLING

Planning, Budgeting and Controlling • Chapter Objectives • Describe the meaning of planning, its process and how to measure organizational performance. • Explain why the SWOT analysis and planning assumptions are important for formulating goals, preparing plans, budgets and projected financial statements. • Show how budgeting fits within the overall planning process, the different types of budgets and how to make budgeting a meaningful exercise. • Explain the nature of a business plan, its benefits and contents. • Describe projected financial statements and how to measure financial performance. • Comment on the importance of controlling, the control system, and the different types of controls. Chapter Reference Chapter 7: Planning, Budgeting and Controlling

Planning, Budgeting, Financial Projections and Controlling Planning Budgeting Business Plans & Financial Projections Controlling A. Planning assumptions Corporate level D. F. H. J. B. • Mission • Value goals • Corporate priorities • Strategic goals and plans • Consolidated budget • Capital budget • Cash budget • Consolidated business plan • Financial projections Results and monitoring corporate performance SWOT analysis Divisional level E. G. I. K. • Operational priorities • Tactical and operational goals • Tactical and operational plans C. Operating budgets • sales • manufacturing • staff • Divisional business plans • Financial projections Results and monitoring operational performance SWOT analysis

1. The Planning Process Decisions Activities What have we achieved so far and what are our strengths, weaknesses, opportunities and threats? What do we want to accomplish and what impact will these goals have on the profile of our financial statements? How and when are we going to implement our plans? Who is going to implement them? How much will these plans cost and what are the financial benefits? What should we do to ensure that we will be on course and that the goals and plans will materialize as planned? Did we reach our goals and implement our plans? Are the financial results in line with our financial projections? SWOT Goals Planning Implementation Controlling

Why Planning is Important Creative, innovative, resourceful. Goal congruence. Sense of purpose and direction. Cope with change. Simplifies managerial control.

Hierarchy of Plans Strategic plans Tactical plans Operational plans

Performance Indicators Pursuing the wrong goals but not wasting resources Pursuing the right goals and not wasting resources High Low Efficiency (good use of resources and doing things right) Pursuing the right goals but wasting resources Pursuing the wrong goals and wasting resources High Low Effectiveness (goal achievement and doing the right things)

economical effective Budgeting by Results The aim How Mechanism This means being … To reach the highest level of performance with the least expenditure of resources. things right the right things By doing ________________ By doing ________________ Planning • priority setting • objective setting Budgeting Proper use of resources ________________ ________________ ________________ efficient

Budgeting by Results 1. ___________________________________ 2. ___________________________________ 3. ___________________________________ 4. ___________________________________ 5. ___________________________________ 6. ___________________________________ 7. ___________________________________ 8. ___________________________________ 9. ___________________________________ 10. ___________________________________ 11. ___________________________________ 12. ___________________________________ Demassing Planned downsizing Productivity indicators Reengineering (activity based budgeting) Reward simplification Cut useless activities Reward quality Employee empowerment Balanced scorecard Reward good behaviour Cut salaries and benefits Arbitrary cuts

2. SWOT Analysis and Planning Assumptions Projected statement of income and statement of financial position Operating budgets and consolidated budgets Goals and Plans Planning assumptions SWOT analysis How much does it cost to realize our goals and implement our plans? What are our strengths, weaknesses, opportunities and threats? What are the boundaries within which we should set our priorities, goals and plans? What should we try to accomplish (goals) and how should we implement them (plans)? How will the planning assumptions impact on our revenue, expense, asset, equity and liability accounts?

3. Budgeting Within the Planning Process Phase 1 Corporate planning Phase 2 Management by objectives Phase 3 Budgeting by results Phase 4 Operational planning Phase 5 Controlling • Mission statement • Key success factors • Value goals • Corporate priorities • Strategic goals and plans • Roll-down process • Objectives (on-going activities) • Objectives (projects)

Projected statements Financial projections Investment plan Financing plan Cash budget Staff budget Manufacturing budget Sales budget Operating budgets Budgeting and Financial Projections

Types of Budgets Operating budgets • Sales budgets • Flexible budgets • Overhead unit budgets Complementary budgets • Product budgets • Program budgets • Item-of-expenditure budgets • Cash budgets Comprehensive budgets • Projected financial statements Capital budgets • New plants • Expansion/modernization

Rules for Sound Budgeting 1. Pinpoints authority 2. Integrates all planning activities 3. Insists on sufficient and accurate information 4. Encourages participation 5. Links budgeting to monitoring 6. Tailors budgeting to the organization's needs 7. Communicates budget guidelines and planning assumptions 8. Relates costs to benefits 9. Establishes standards for all units 10. Be flexible

4. The Business Plan What it is A business plan is a document that gives a complete picture about an organization’s goals, plans, operating activities, financial needs and financing requirements. Benefits - for the company • Shows how management intends to implement plans. • Forces managers to be realistic. • Helps managers to monitor plans. • Helps to pinpoint how resources should be deployed.

The Business Plan Benefits - for the investors • Provides base for judging the company. • Assures that managers are aware of the opportunities and threats (external environment). • Shows the ability of the business to repay its debt. • Helps to analyze all components related to the company (internal and external). • Identifies the timing and nature of future cash requirements. • Helps to assess management’s ability. • Indicates funding requirements and sources.

Contents of The Business Plan • Cover sheet • Executive summary • Company and ownership • External environment • Mission, statement of purpose and strategy statements • Products and services • Management team • Operations • Financial projections • Appendixes

5. Projected Statement of Income Modern Industries Ltd. Projected Statement of Income For the Period ended December 31 2011 2010 Revenue Cost of sales Gross profit Other income and expenses Profit before taxes Income tax expense Profit for the year 15% increase 54% of revenue from 56% 20.2% increase 36.8% of revenue from 37.6% 64.4% increase 64.4% increase 64.4% increase $ 2,500,000 (1,400,000) 1,100,000 (940,000) 160,000 (80,000) $ 80,000 $ 2,875,000 (1,553,000) 1,322,000 (1,059,000) 263,000 (131,500) $ 131,5 00 4.6 3.2 ____% ____%

Projected Statement of Financial Position Modern Industries Ltd. Projected Statement of Financial Position as at December 31 2011 2010 $ 900,000 (100,000) 800,000 150,000 190,000 10,000 50,000 400,000 $ 1,200,000 $ 1,200,000 (160,000) 1,040,000 160,000 194,500 10,000 57,000 421,500 $ 1,461,500 Refer to the capital budget for details Adjusted for increase in non-current assets 1.0 time improvement 3-day collection improvement No change 2% of revenue Non-current assets Property, plant and equipment Accumulated depreciation Total non-current assets Current assets Inventories Trade receivables Marketable securities Cash Total current assets Total assets Equity Share capital Retained earnings Total equity Non-current liabilities Mortgage Long-term borrowings Total non-current liabilities Current liabilities Trade and other payables Notes payable Accruals Total current liabilities Total equity & liabilities No change See the statement of income and the statement of changes in equity for details Increase to purchase non-current assets Increase to purchase non-current assets From 7.1% of cost of sales to 6.5% Working capital loan No change $ 100,000 300,000 400,000 500,000 100,000 600,000 100,000 80,000 20,000 200,000 $ 100,000 381,500 481,500 650,000 130,000 780,000 101,000 79,000 20,000 200,000 $ 1,200,000 $ 1,461,500

Projected Inflows and Outflows of Cash Modern Industries Ltd. Projected Inflows and Outflows of Cash as at December 31 Inflows Outflows $ 300,000 ----- 10,000 4,500 ----- 7,000 --- 60,000 ----- ----- ----- ----- $ 900,000 (100,000) 800,000 150,000 190,000 10,000 50,000 400,000 $ 1,200,000 $ 1,200,000 (160,000) 1,040,000 160,000 194,500 10,000 57,000 421,500 $ 1,461,500 2011 2010 Non-current assets Property, plant and equipment Accumulated depreciation Total non-current assets Current assets Inventories Trade receivables Marketable securities Cash Total current assets Total assets Equity Share capital Retained earnings Total equity Non-current liabilities Mortgage Long-term borrowings Total non-current liabilities Current liabilities Trade and other payables Notes payable Accruals Total current liabilities Total equity & liabilities $ 100,000 381,500 481,500 650,000 130,000 780,000 101,000 79,000 20,000 200,000 ----- 81,500 150,000 30,000 1,000 ----- ----- $ 100,000 300,000 400,000 500,000 100,000 600,000 100,000 80,000 20,000 200,000 ----- ----- ----- ----- ----- 1,000 ----- $ 1,461,500 $ 1,200,000 $ 322,500 $ 322,500

1. 2. 3. Projected Statement of Cash Flows Modern Industries Ltd. Projected Statement of Cash Flows Inflows Outflows Adjustments in working capital Increase in cash ---7,000 Increase in trade receivables ---4,500 Increase in inventories ---10,000 Increase in trade and other payables 1,000 --- Increase in notes payable --- 1,000 Total 1,00022,500 Net change in working capital ---21,500 Funds from operations Profit for the year 131,500--- Depreciation 60,000--- Net funds from operations 191,500--- Net change in operating activities 170,000 Changes in financing Proceeds from long-term note 30,000--- Proceeds from mortgage 150,000--- Payment of dividends --- 50,000 Total 180,00050,000 Net change in financing activities 130,000 Net change in investing activities ---300,000 Total 300,000300,000

Increase profit on sales Growth Funds New equity Pay less dividends New debt Invest in less assets 6. The Sustainable Growth Rate Finance costs Cost of goods sales Administrative expenses Inventories Distribution costs SALES Trade and other payables Non-current assets Depreciation Trade receivable

Modern Industries Ltd.’s Growth Potential Transparencies 4.4 and 4.5 • Ratio of profit for the year to revenue M = .032 • Ratio of reinvested profit to profit before dividends R = .50 • Ratio of total liabilities to net worth D/E = 2.00 • Ratio of total assets to revenue A = .48 The formula Growth = Growth = = = .111 • (R) (1 + D/E) • (A) – (M) (R) (1+ D/E) .048 .432 (.032) (.50) (1 + 2.00) (.48) – (.032) (.50) (1+ 2.00) With 4.6% ROR the new sustainable growth would be 20.4% Modern’s sales growth should not exceed 11.1% or $2,775,000. M = Profit for the year earned on each dollar of revenue R = Percentage of profit for the year reinvested in the business (subtract the dividend paid from profit and divide the result by the profit) D/E = Divide total liabilities by total net worth A = Assets needed to support each revenue dollar

Altman’s Financial Z-Score This is a linear analysis where five measures are objectively weighted to give an overall score that becomes the basis for classification of firms into one of three groupings: Green zone 3.0 and over Yellow zone 1.8 to 3.0 Red zone 0 to 1.8 Z = 1.2 ( a ) + 1.4 ( b ) + 3.3 ( c ) + 0.6 ( d ) + 1.0 ( e ) a = b = c = d = e = Working capital Total assets Retained earnings Total assets Earnings before interest and taxes Total assets Equity Total liabilities Revenue Total assets

Modern Industries Ltd.’s 2010 Z-Score Z = 1.2 ( a ) + 1.4 ( b ) + 3.3 ( c ) + 0.6 ( d ) + 1.0 ( e ) Z = 1.2 ( .17 ) + 1.4 ( .25 ) + 3.3 ( .196 ) + 0.6 ( .50 ) + 1.0 ( 2.08 ) = 3.581 a = = = .17 b = = = .25 c = = = .196 d = = = .50 e = = = 2.08 Working capital Total assets $200,000 $1,200,000 $300,000 $1,200,000 Retained earnings Total assets $235,000 $1,200,000 Earnings before interest and taxes Total assets $400,000 $800,000 Equity Total liabilities $2,500,000 $1,200,000 Revemie Total assets

6. The Control Process 1. Design the subsystem 2. 3. Planning • Objectives • Plans Performance indicators Performance standards 4. 6. 5. Measure performance Corrective action Analyze variations no yes There is no need to do anything

Types of Controls Start Action Finish Preventive controls Plans Results Screening controls Feedback controls

Finance for Non-Financial Managers , 6 th edition