Financial Planning
Chapter 16
© 2003 South-Western/Thomson Learning
Business Planning

A business plan is a model of what
management expects a business to become in
the future
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Financial statements are pro forma
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Expressed in words and financial projections
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.
2
Component Parts of a Business
Plan

Typical outline
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Contents
Executive summary
Mission and strategy statement
• Basic charter and establishes long-term direction
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Market analysis
• Why the business will succeed against its competitors
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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
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Contingencies
• What the firm will do if things don’t go as planned
4
The Purpose of Planning and
Plan Information

Major audience of business plan include
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Firm’s own management
•
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•
•
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
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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
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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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Four Kinds of Business Plan

Operational planning
• Translates business ideas (day-to-day operations) into
concrete, short-term projections
• Even mix of words and numbers
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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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Four Kinds of Business Plan

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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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

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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
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No history on which to base projections
The Typical Planning Task

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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
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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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The General Approach, Assumptions,
and the Debt/Interest Problem

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
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Debt/Interest Planning Problem
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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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The General Approach, Assumptions,
and the Debt/Interest Problem
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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
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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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An Iterative Numerical
Approach
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Procedure works as follows
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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
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• If the calculated value of interest is close to the guess, stop
Plans with Simple Assumptions
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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

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
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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
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Purpose is to estimate external financing
requirements (EFR)
A growing firm must buy assets to support
growth
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Some funds will be generated internally via
• Current liabilities
• Retained earnings
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The Percentage of Sales
Method—A Formula Approach
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Representing a firm’s growth rate in sales as g,
then
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Growth in assets = g  assetsthis year and
Growth in current liabilities = g x current liabilitiesthis
year
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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 Sustainable Growth Rate

A firm can grow at its sustainable growth rate
without selling new stock if its financial ratios
remain constant
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The growth in equity created by profits
Business operations create new equity equal to
the amount of current retained earnings, or (1 –
DPR)EAT
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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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The Sustainable Growth Rate

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
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Sustainable growth concept gives an
indication of the determinants of a firm’s
inherent growth capability
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The Sustainable Growth Rate

Incorporating equations from the DuPont
equations into the gs equation we obtain
EAT sales assets
gs  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

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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
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Operational plans projections are much more
detailed than the single numbers appearing on
the income statement
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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
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Forecasting cash is an important part of
financial planning
The cash budget is a detailed projection of
receipts and disbursements of cash
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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
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Forecasting receivables collection is difficult
because you never know exactly when a
customer will pay his bill
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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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Debt and Interest
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Forecasting short-term debt and interest can be tricky if
a company is funding current cash needs directly by
borrowing
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The current month’s interest payment is based on the
preceding month’s loan balance
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Not unusual
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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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
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• 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
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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
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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
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Underforecasting—The Other Extreme
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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
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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
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Scenario Analysis—”What If”ing
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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

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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
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