Chapter 15
Financial Planning
BUSINESS PLAN
A picture or model of what a business unit is expected to become.
Consists of Words and Numbers
COMPONENT PARTS OF A BUSINESS PLAN
A. Contents
B. Executive Summary
C. Mission and Strategy Statement
D. Market Analysis
E. Operations (of the business)
F. Management and Staffing
G. Financial Projections
H. Contingencies
THE PURPOSE OF PLANNING AND PLAN
INFORMATION
Two major audiences: management and outside investors
THE MANAGERIAL VALUE OF PLANNING
The Planning Process
Creates a cohesive unit with common goals
Promotes an understanding of objectives and policies
Forces a thinking through of everything that has to be done
Makes people understand what they individually have to do
A Road Map for Running the Business
Formulates method by which goals are to be achieved
Comparing operating performance to plan
Investigate deviations
Propose Solutions
Figure 15-1 Using a Plan to Guide Business Performance
A Statement of Goals and Targets
A measurement of success
A reward system - bonuses
Predicts Outside Financing Needs
THE PLAN TO OUTSIDE INVESTORS
Communicates management's ideas about what the
company will be in the future
Tells: Equity investors their expected return
Debt investors the source of repayment
In small firms: Use the business plan document
In large firms: Information is conveyed to
securities analysts
Business Planning in Divisions of Large Companies
Divisions produce their own plans which are consolidated
into a corporate plan
The planning and review process is a major vehicle for communication between
division and corporate managements
Success and failure at the division are defined
relative to the business plan
Credibility and Supporting Detail
A plan needs to contain enough detail to convince its audience
that it represents management's best thinking
FOUR KINDS OF BUSINESS PLANNING
Strategic Planning
Operational Planning
Budgeting
Forecasting
...differ according to three attributes:
(1) Length of the planning horizon
(2) Kinds of issues addressed
(3) Level of detail projected
Budgets:
Operating Budget—a collection of individual budgets combined to form a part of an
integrated business plan, usually for next year
Used to Coordinate activity
Control-serving as performance measurement
Capital Budget-listing of capital projects it plans to place in service during some future
period,usually next year
Cash Budget- projection of a company’s cash receipts and disbursements over some
future time period
The Business Planning Spectrum
Annual
Operating
Plan
Strategic
Plan
Quarterly
Budgets
Long Term
General,
Conceptual
Short-Term
Forecasts
Short Term
Detailed,
Numerical
BUSINESS PLANS FOR
SMALL BUSINESSES
THE FINANCIAL PLAN
A firm's projected financial statements
Generally a part of a broader business plan
MAKING FINANCIAL PROJECTIONS
Translating physical and economic activity into dollars
Forecast sales first
Then forecast the support required by the implied activity
PLANNING FOR NEW AND EXISTING BUSINESSES
Harder to plan for a new or proposed business
No history - must make assumptions about everything
THE TYPICAL PLANNING TASK
Most financial planning is for existing businesses
Forecast changes to past history
The changes are planning assumptions
Anything about which an assumption isn't made is implicitly assumed to remain
unchanged. For a new business, everything has to be explicitly assumed.
PLANNING ASSUMPTIONS
A physical or economic condition expected to exist
during the planning period
Can originate outside the company: interest rates, taxes
(economic and industry forecast)
Can be internal: pricing, cost control
Can come from customer behavior: response to pricing
Each line on a projected set of financial statements is generally forecast based on
one or more assumptions
THE PROCEDURAL APPROACH
Make a revenue projection
Then forecast the income statement and balance sheet line by line
until come to interest and debt
THE INTEREST/DEBT PLANNING PROBLEM
We need debt to forecast interest and interest to forecast debt.
EAT (less dividends) is added to Beginning Equity to arrive at
Ending Equity, which is required to compute Ending Debt.
Ending Debt is averaged with Beginning Debt and multiplied
by the interest rate to calculate Interest Expense.
SOLUTION THROUGH AN ITERATIVE, NUMERICAL
APPROACH
1. Interest: Guess a value of interest expense.
2. EAT: Complete the income statement.
3. Ending Equity: Calculate ending equity as beginning equity plus EAT (less
dividends plus new stock to be sold if either exist).
4. Ending Debt: Calculate ending debt as total L&E (=Total Assets) less current
liabilities less ending equity.
5. Interest: Average beginning and ending debt. Calculate interest by multiplying
average debt by the interest rate.
6. Test Results: Compare the calculated interest from step 5 to the original guess in
step 1.
a. If the two are significantly different, return to step 1 replacing the
guess at interest with the value just calculated and repeat steps 2 through 6.
b. If the calculated value is close to the guess, stop.
PLANS WITH SIMPLE ASSUMPTIONS
Quick Estimates Based on Sales Growth
Percentage of Sales Method
All line items grow by the same percentage as sales
(A very unrealistic assumption)
Modified Percentage of Sales Method
Most line items grow by the same percentage as sales
Percentage of Sales Forecasting Method
permits a company to forecast the amount of financing it will need for a given
increase in sales.
Assumes:
(1)
present asset levels are optimal with respect to present sales.
(2)
most items on balance sheet increase in proportion to sales increase.
(3)
firm's profit margin on sales (EAT/sales) remains constant.
How much funds will be necessary to support growth?
(1)
Determine the level of assets that will need to vary proportionately with
sales.
How to determine this?
look at ratios
what has happened over last few years within the company
forecast for future economic state
(2)
Determine the level of liabilities that will need to vary proportionately
with sales
(3)
Separate the financing decisions
Notes payable
LT debt
Common stock
TotalFinancingNeeded 
A
CL
S 
S
S
S
A: present level of assets
S: present sales level
CL: present level of current liabilities
ΔS: forecasted sales increase
Internal Financing Provided = Forecasted Net Income - Dividends
NI – D
(NI +Noncash) - D
Additional Financing Needed = Total Financing Needed - Internal
(
A
CL
S 
S )  ( NI  D)
S
S
(
A
CL
S 
S )  (CF  D)
S
S
S = 15m
Sales will increase 25%
S  3.75m 
CA=6.5M
FA 1M
CL= 2M
Notes Payable = .5 M
E (Expense)
E (NI)
Dividends
17.75m
1m
.25 M
Total Financing Needed
=.25(7.5M)-.25(2M-.5M)=1.5 M
Additional Financing Needed
=(7.5M(.25)-(2M-.5M).25)-(1M-.25M)=.75 M
Example:
Expected Sales
Expected NI
Expected D
$ 6,000,000
400,000
50,000
Find additional financing needed
A: $6,300,000
S: 4,000,000
CL: 600,000
NI: 400,000
D: 50,000
ΔS: 6,000,000 - 4,000,000 = 2,000,000
ΔS/S= 50%
AF= (6.3(.5)-.6(.5)) - (.4-.05)
Adjustments to Process
If can use some economics of scale then the relationships may not be strictly proportions.
Ex.:
often fixed assets increase in step-wise fashion.
Sales Forecast
Fixed Assets
Not at Full Capacity
Cash
A.R.
I.N.
Total C.A.
F.A.
5,000
20,000
40,000
65,000
50,000
115,000
A.P.
N.P.
Total C.L.
LT Debt 30,000
S. Equity
15,000
10,000
25,000
60,000
115,000
Sales $150,000. Expect 25% increase in sales to generate after-tax cash flow $16,000 dividend
of $5,000 F.A. at 90% capacity.
(1)
What additional financing will be needed?
(2)
What is Full Capacity Sales?
.90x = 150,000
x = 166,666
so $50,000 F.A. will support $166,666 of sales
(3)
For every dollar of sales-need, what in F.A.?
F.A. = 50,000 = .30 increase in F.A.
F.C.S. 166,666
(4)
Difference between Full Capacity Sales & Expected Sales?
Expected Sales: 150,000 (1.25) = 187,500
187,500 - 166,666 = 20,834
(5)
What need in additional F.A.
.3(20,834) = 6,250
(6)
AFN = TFN - IFP
[(65,000(.25) + 6,250) - (15,000(.25))] - [16,000 - 5,000] = 7,750
ESTIMATING EXTERNAL FUNDING REQUIREMENTS USING A FORMULA
APPROACH BASED ON THE PERCENTAGE OF SALES METHOD
Growth in Assets
- Growth in Current Liabilities
- Current earnings retained
= External Funding Requirement
EFR =
g(Assetsthis yr)
- g(Current Liabilitiesthis yr)
- [(1-d)ROS][(1+g)Salesthis yr]
The EFR gives a very rough estimate of external funding needs
THE SUSTAINABLE GROWTH RATE
A theoretical measure of a business's strength
The rate at which the firm can grow without newly sold equity
if none of its financial ratios change
Equivalent to forecasting growth using the Unmodified
Percentage of Sales Method
Simply the Growth in Equity Created by Retained earnings
where d is the dividend payout ratio
Using the Sustainable Growth Concept through the extended Du Pont
Equation:
A firm's ability to grow is dependent on
1. Earnings
2. Using assets to generate sales
3. Using leverage (borrowed money)
4. The percent of earnings retained
Use to analyze a firm's growth relative to others
gs =
Industry
13.5%
Slowly Inc. 4.8%
(1-d)
.75
.40
x ROS x
6%
8%
T/A
Equity
Turnover x Multip
1.2
2.5
1.0
1.5
Two Kinds of Planning Assumption
•
DIRECT AND INDIRECT
• MANAGEMENT BY RATIOS
Example 15-6
Next year's revenue is forecast at $7,900,000. What receivables figure should be
included in a financial plan to reflect a 40 day ACP assumption.
Solution:
ACP =(AR/Sales) * 360
40=(AR/7,900,000)*360
A/R = $877,777
The Cash Budget
There are two ways to forecast cash.
1. Deriving a projected statement of cash flows
2. Cash Budgeting - forecasting cash receipts and disbursements as they’re likely to
occur.
COMPREHENSIVE EXAMPLE (15-7)
A COMPLEX PLAN FOR AN EXISTING BUSINESS
MACADAM COMPANY - INCOME STATEMENTTHIS YEAR ($000)
$
%
Revenue
$14,200
100.0%
COGS
7,810
55.0
Gross Margin
$ 6,390
45.0
Expenses:
Marketing
$ 2,556
18.0
Engineering
1,065
7.5
Fin & Admin
1,349
9.5
Total Expense
$ 4,970
35.0
EBIT
Interest
EBT
Income Tax
EAT
$ 1,420
$ 568
$ 852
$ 341
$ 511
10.0
4.0
6.0
2.4
3.6
MACADAM COMPANY BALANCE SHEET - THIS YEAR($000)
ASSETS
Cash
$ 1,560
Accts Rec $ 3,550
Inventory $ 2,603
Curr Assets
$ 7,713
Fixed Assets
Gross
$12,560
Accum Depr ($ 3,620)
Net
$ 8,940
Total Assets
$16,653
LIABILITIES & EQUITY
Accts Payable
Accruals
Current Liab
Long Term Debt
Equity
Stock Accts
Retained Earn
Total Equity
Total L&E
$ 716
$ 230
$ 946
$ 4,000
$ 6,000
$ 5,707
$11,707
$16,653
FACTS
1. Virtually all payables are due to inventory purchases, and the COGS is
approximately 60% purchased material.
2. Assets currently on the firm's books will generate depreciation of $510,000 next
year.
3. The only balance sheet accrual represents unpaid wages. Preliminary estimates
indicate that next year's payroll will be about $6.1M. Next year's closing balance
sheet date will be nine working days after a payday.
4. The combined state and federal income tax rate is 40%.
5. Interest on current and future borrowing will be at a rate of 10%.
PLANNING ASSUMPTIONS
Income, Cost, and Expense
1. During the coming year, the firm will mount a major program to expand sales.
The expected result is a 20% growth in revenue. Pricing and product mix will
remain unchanged.
2. The revenue growth will be accomplished by increasing efforts in the
marketing/sales department. The increased expenses generated will be
accommodated by planning Marketing Department expenses at 19% of the
expanded revenue rather than the current 18%.
3. A major cost reduction effort is underway in the Manufacturing Department
which is expected to reduce the Cost Ratio (COGS/Revenue) to 53% from its
current level of 55%.
4. The Engineering Department will be unaffected by the expansion in sales. Its
dollar expenses will increase by normal inflation at a 4% rate over last year.
5. Finance and administration expenses will need to expand to support the higher
volume, but due to scale economies the expansion will be at a
lower
rate than the growth in sales. A target growth of 10% is planned for those
expenses.
Assets and Liabilities
6. A lock box system will reduce cash balances 20%.
7. The current 90 day collection period (ACP) is considered unacceptable.
Increased attention to credit and collections in both finance and sales is expected
to bring the ACP down to 65 days.
8. Top management feels that the firm is operating with more inventory that it
needs. Manufacturing management has been challenged to increase the
Inventory Turnover Ratio based on COGS to 5 from its present level of 3 .
9. The Capital Plan has been put together in preliminary form, and indicates capital
spending of $5M. The average depreciation life of the assets to be acquired is 10
years. Straight line depreciation will be used, and a convention of taking one half
year's depreciation in the first year will be followed.
10. Vendors are complaining because the firm pays its bills in 55 days even though
most terms call for payment within 30 days. Fearing that inventory
and supplies will be cut off, management has decided to shorten the payment
cycle to 45 days.
11. No dividends will be paid next year, and no new stock will be sold.
Solution: Income Statement Items
Revenue:
Revenue = $14,200  1.20 = $17,040
Cost of Goods Sold (COGS):
COGS = $17,040  .53 = $9,031
Marketing Expense:
Marketing Expense = $17,040  .19 = $3,238
Engineering Expense:
Engineering Expense = $1,065  1.04 = $1,108
Finance and Administrative Expense:
Fin & Admin Expense = $1,349  1.10 = $1,484
Balance Sheet Items
Cash:
Cash = $1,560  (1-.20) = $1,248
Accounts Receivable:
65=(AR/17040)x 360
A/R = $3,077
Inventory:
5.0=(9031/Inventory) =$1806
Fixed Assets:
Gross Fixed Asset Additions =
$5,000
Depreciation
New Equipment = [$5,000/10]  1/2 = $250
Old Equipment
= $510
$760
MACADAM COMPANY
PROJECTED CHANGES IN WORKING CAPITAL
NEXT YEAR (000)
Accts Rec
Inventory
Accts Pay
Accruals
Decr/(Incr)
in W/C
Beginning
$3,550
$2,603
$ 716
$ 230
Ending
$3,077
$1,806
$ 677
$ 211
Change
$ 473
$ 797
($ 39)
($ 19)
$5,207
$3,995
$1,212
MACADAM COMPANY
PROJECTED STATEMENT OF CASH FLOWS - NEXT YEAR (000)
OPERATING ACTIVITIES
EAT
$1,016
Depreciation
$ 760
Decrease in W/C
$1,212
Cash From Operating Activities
$2,988
INVESTING ACTIVITIES
Increase in Gross
Fixed Assets
($5,000)
Cash From Investing Activities
($5,000)
FINANCING ACTIVITIES
Increase in Debt
$1,700
Cash From Investing Activities.
$1,700
NET CASH FLOW
($ 312)
RECONCILIATION
Beginning Cash
$1,560
Net cash flow
($ 312)
Ending Cash
$1,248
MANAGEMENT ISSUES IN FINANCIAL PLANNING
THE FINANCIAL PLAN AS A SET OF GOALS
Performance Measures
Bonuses
Stretch goals
RISK IN FINANCIAL PLANNING IN GENERAL
Reexamine Macadam's overall plan for achievability
Assumptions are all marvelously positive:
Revenue up 20%,
Cost of production decreases by 2% (a lot)
Asset management is totally successful
Will all of these positive things come true
without any offsetting negatives?
Probably not
Typical of corporate business plans, everything is routinely forecast to improve in
the future.
Comes from:
- stretch planning
- aggressive optimism
- top down planning
It's never quite clear whether a company's plan is a candid statement of what's
likely to happen or a set of desirable goals.
Underforecasting - The Other Extreme
Bottom up planning
The Ideal Process
A give and take to arrive in the middle
Scenario Analysis
Producing more than one plan
FINANCIAL PLANNING AND COMPUTERS
Virtually all financial planning is done with computers.
Computers make repetitive calculations easy,
but
they don't do our thinking for us.
They don't help much in making planning assumptions,
which is the heart of the process.