Financial Planning
3.1 to 3.4
Contents
3.1 Overview of financial planning
3.2 Developing a long-term financial
plan
3.2.1 Spontaneous and discretionary
financing
3.2.2 Determining discretionary
financing needs
Percent of sales method
Judgmental method
3.2.3 Excess capacity adjustments
3.2.4 Growth rates
3.2.4.1 Internal growth rate
3.2.4.2 Sustainable growth rate
Contents
3.3 Developing a short-term financial plan
3.3.1 Kinds of budget
3.3.2 Cash budget
3.3.3 Master budget
3.3.3.1 Operating budgets
3.3.3.2 Financial budgets
3.4 Leverage
3.4.1 Business and financial risk
3.4.2 Types of leverage
3.4.2.1 Operating leverage
3.4.2.2 Financial leverage
3.4.2.3 Total leverage
Financial Planning
• also called value-based management
• a process of determining financial needs or goals and how
to achieve them in line with the company’s corporate goals,
strategies, and operating plan
• primary objective: estimate the future financing
requirements in advance of when the financing will be
needed
• results to the development of financial plan/s
Source: Pursuit of Passion dated Oct 15 2019
P312,000 to
1,020,000
annually
26,000 to 85,000 per month
How do you plan to finance these?
• savings
• allowance
• part-time job
• loan from bank
• business income
Where do you put your excess funds?
• savings
• mutual funds/ UITF
• buy stocks
Estimate
expenses
“
“A goal without a plan is
just a wish”
-Antoine de Saint Exupery
Expected income
Determine
source/ use of
shortage/ excess
of funds
“Planning is bringing the future
into the present so you can do
something about it now”
-Alan Lakein
Developing a
financial plan/
Financial
forecasting
Financial Plan
• document that lays out a company’s planned financial actions
and anticipated impact of those actions
• includes assumptions, projected financial statements, and
projected financial ratios and ties the entire (strategic) planning
process together
• Types of financial plans
• Short-term (operating) – covers the next 12 months
•Long-term (strategic)- covers more than 1 year
Financial Forecasting
Forecast sales
Project income
statement
Project assets
needed to
support sales
Project sources of
financing
See effect of plan
on ratios
Decide how to
raise/use needed/
excess funds
Estimate financing
needs
Sales Forecast
• prediction of a firm’s sales over a given period
• key (most critical) input to the financial planning process
• based on external and/or internal data such as economic indicators,
consensus of salespeople, past trends (usually past 5 years), and any
anticipated events that might materially affect that trend
Sales Forecasting approach
1.
2.
3.
4.
Naïve approach- simplest approach, future sales
will be equal to that of the latest observed period
Average approach- future sales will be equal to the
average historical value across some relevant
period
Historical growth rate- future sales will increase
using growth rate computed over some relevant
period
Regression analysis- complex approach, future
sales is determined using a linear equation based
on the relationship of sales with another variable
(e.g. GDP)
Sales forecast using historical growth rate
• compute historical growth rate using modified FV of a lump sum
equation as follows:
• Hence, a growth rate using sales trend for the past 5 years can be
computed as follows:
Sales forecast using historical growth rate
ACYFMG Inc.’s Sales for the past five years are as follows:
20xy
P 78,600
20xx
75,000
20xw
76,570
20xv
72,100
20xu
70,080
Using these data, compute for ACYFMG historical growth rate and
projected sales for 20xz.
Pro-forma Financial Statements
• projected, or forecast, income statements and balance
sheets
• techniques in developing pro-forma financial statements:
Percent of sales method - expresses expenses, assets, and
liabilities for a future period as a percentage of sales
Judgmental method – involves estimating the level of an asset,
liability, or expense for a future period based on a certain set of
assumptions
Pro-forma Financial Statements
• Percent of sales method - expresses expenses, assets, and
liabilities for a future period as a percentage of sales
• assumes that past financial relationships (ratios) remain
constant
• assumes all costs and expenses varies with sales
• assumes all assets and spontaneous liabilities are salesdriven
• assumes interest-bearing liabilities remain the same
Spontaneous vs. Discretionary Financing
•Spontaneous Financing- funds that arise out of normal business
operations from suppliers, employees and government that
reduce the firm’s need for external financing
Sources: Accounts payable, accrued expenses
• Discretionary Financing- funds that arise out of managerial
decision / discretion
Sources: Debt (Notes payable or LT debt), Equity (PS, RE or CS)
Pro-forma FS: Percent of Sales
• using ACYFMG 20xy FS to project 20xz FS
•Income statement- using sales forecast and previous year’s
common-size IS/[previous year’s balance x (1+g)]
Projected 20xz sales= 78,600 x 102.91% = 80,887.26
• Balance sheet- using capital intensity ratio (TA/Sales)
20xy capital intensity ratio= 82,500/78,600= 1.0496
Projected 20xz total assets= 80,887.26 x 1.0496 = 84,900.75
OR simply TA x (1 + g)
=82,500 x 102.91% = 84,900.75
Pro-forma IS: Percent of sales
20xy
Vertical %
Proj. 20xz
Sales
₱78,600
100%
₱80,887.17
Less: Cost of Goods Sold
(46,900)
-59.67%
(48,264.74)
Gross Profit or Gross margin
₱31,700
₱32,622.44
Less: Operating expenses
Selling expense
₱3,930
5.00%
₱4,044.36
General and administrative expense
5,120
6.51%
5,268.99
Depreciation and amortization expense
2,500
3.18%
2,572.75
Total operating expense
Net Operating income
Other Income
Earning before interest and taxes (EBIT)
-₱11,550
-₱11,886.09
₱20,150
₱20,736.34
800
₱20,950
Less: Interest expense
(4,950)
Earnings before taxes
₱16,000
Less: Income tax expense (25%)
Net Income
1.02%
(4,000)
₱12,000
823.28
₱21,559.62
-6.30%
(5,094.04)
₱16,465.58
-5.09%
(4,116.40)
₱12,349.19
From Sales
forecast
59.67% x
80,887.26
OR
46,900 x
102.91%
Pro-forma BS: Percent of sales
20xy
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Property, plant and equipment, gross
Less: Accumulated depreciation
Property, plant and equipment, net
Other non-current assets
Total non-current assets
Total Assets
% of sales
Proj. 20xz
₱4,250
5.41%
9,500
12.09%
9,776.44
13,750
17.49%
14,150.11
5,000
6.36%
5,145.49
₱32,500
₱58,400
(13,700)
80,887.26 x 5.4071%
Or
4,250 x 102.91%
₱33,445.71
74.30%
₱60,099.38
-17.43% (14,098.65)
₱44,700
5,300
₱4,373.67
₱46,000.72
6.74%
5,454.22
₱50,000
₱51,454.94
₱82,500
₱84,900.66
Based on sales
forecast and 20xy
capital intensity
ratio
Pro-forma FS: Percent of Sales
• Balance sheet- using projected net income and dividend payout
ratio
Projected 20xz retained earnings= 31,200 + (12,349.19 x (1-70%))
= 34,904.76
where, 70% is 20xy dividend payout while 31,200 is 20xy retained earnings
Pro-forma BS: Percent of sales
20xy
Accounts Payable
Notes Payable
% of sales
Proj. 20xz
₱10,000
12.72%
₱10,290.99
2,500
no change
2,500
4,800
₱17,300
6.11%
4,939.67
₱17,730.66
22,000
no change
22,000
80,887.26 x 12.7226%
Or
10,000 x102.91%
Accrued expenses
Total current liabilities
Long-term debt
Total Liabilities
₱39,300
₱39,730.66
Additional paid-in less treasury stock
no change
12,000
31,200 beg + (rr*NI)
34,904.76
12,000
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and SHE/ Projected
sources of financing
Discretionary financing needs (plug figure)
Total financing needs= total assets
₱43,200
₱46,904.76
₱82,500
₱86,635.42
(1,734.76)
₱84,900.66
Based on projected
20xz net income and
20xy dividend
payout
84,900.66 –
86,635.42
Pro-forma Financial Statements
• Judgmental method – involves estimating the level of an
asset, liability, or expense for a future period based on a
certain set of assumptions
• assumes that past financial relationships (ratios) remain
constant
• assumes certain costs and expenses as fixed
• estimate values for certain balance sheet accounts
Pro-forma FS: Judgmental Approach
•using ACYFMG 20xy FS to project 20xz FS
•Income statement- additional information
Only 70% of CGS are variable
Only 40% of selling expenses are variable
Only 20% of General and admin expenses are variable
Interest expense is expected to be P50 lower than 20xy
Income tax rate is 25% of Earnings before tax
Other items remain constant regardless of change in sales
Pro-forma IS: Judgmental
Sales
Less: Cost of Goods Sold- variable (70%)
Cost of Goods Sold- fixed
Gross Profit or Gross margin
20xy
Proj. 20xz
₱78,600
100%
₱80,887.17
(32,830)
-41.77%
(33,785.32)
(14,070)
no change
(14,070.00)
₱31,700
₱33,031.86
From Sales forecast
80,887.26 x 41.7684%
Or
32,830 x 102.91%
Same as 20xy amount
Less: Operating expenses
Selling expense- variable (40%)
₱1,572
2.00%
₱1,617.74
2,358
no change
2,358.00
1,024
1.30%
1,053.80
General and admin expenses- fixed
4,096
no change
4,096.00
Depreciation and amortization expense
2,500
no change
2,500.00
Selling expense- fixed
General and admin expenses- variable (20%)
Total operating expense
Net Operating income
Other Income
Earning before interest and taxes (EBIT)
Less: Interest expense
Earnings before taxes
Less: Income tax expense (25%)
Net Income
-₱11,550
-₱11,625.54
₱20,150
₱21,406.32
800
no change
₱20,950
(4,950)
₱22,206.32
P50 lower
₱16,000
(4,000)
₱12,000
800.00
(4,900.00)
4,950 - 50
₱17,306.32
25% of EBT
(4,326.58)
₱12,979.74
17,306.32 x 25%
Pro-forma FS: Judgmental Approach
•using ACYFMG 20xy FS to project 20xz FS
• Balance sheet- additional information
Minimum cash balance of P4,000
Accounts receivable on average represents 40 days of sales
Ending inventory should remain at a level of about P15,000
A fully depreciated asset costing P6,000 would be disposed next year
Purchases represent approximately 40% of sales and the firm targets to pay
its accounts payable within its credit terms of 60 days
The 2,500 notes payable would be repaid next year
Accrued expenses is expected to vary with sales
Dividend payout ratio of 0.70 will remain the same next year
No change in other accounts is expected
Pro-forma BS: Judgmental Approach
20xy
Cash
Accounts Receivable
Inventories
Other current assets
info
₱4,250 minimum
40 days
8,987.46
13,750
target
15,000.00
5,000 no change
5,000.00
₱32,500
Property, plant and equipment
₱58,400
Property, plant and equipment,
net
Other non-current assets
₱4,000.00
9,500
Total current assets
Less: Accumulated depreciation
Proj. 20xz
(13,700)
80,887.26 x 40/360
₱32,987.46
-P6K
-P6K,
+P2.5K
₱44,700.00
5,300 no change
₱52,400.00
(10,200.00)
₱42,200.00
5,300.00
Total non-current assets
₱50,000
₱47,500.00
Total Assets
₱82,500
₱80,487.46
58,400 – 6,000
-13,700 +6,000 -2,500
Pro-forma BS: Judgmental Approach
20xy
Accounts Payable
Notes Payable
Accrued expenses
Total current liabilities
Long-term debt
Total Liabilities
Paid-in capital less treasury stock
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and SHE / Projected
sources of financing
Discretionary financing needs (plug
figure)
Total financing needs= total assets
info
Proj. 20xz
₱10,000
2,500
4,800
₱17,300
60 days
-P2.5K
6.11%
₱5,392.48
4,939.67
₱10,332.15
22,000
no change
22,000
₱39,300
12,000
(80,887.26 x 40%) x
(60/360)
₱32,332.15
no change
12,000
31,200 beg + (rr*NI)
35,093.92
₱43,200
₱47,093.92
₱82,500
₱79,426.07
1,061.39
₱80,487.46
31,200 + (12,979.74
* (1-70%))
80,487.46 –
79,426.07
Use of Pro Forma Statements for financial
decisions
• Financial managers and lenders can use pro forma statements
to analyze the firmʼs inflows and outflows of cash, as well as its
liquidity, activity, debt, profitability, and market value.
• Various ratios can be calculated from the pro forma income
statement and balance sheet to evaluate performance.
• Cash inflows and outflows can be evaluated by preparing a pro
forma statement of cash flows.
• After analyzing the pro forma statements, the financial
manager can take steps to adjust planned operations to achieve
short-term financial goals.
Limitations of Pro-forma statements
• unrealistic assumptions: (1) past financial performance will not
be replicated in the future and (2) certain variables (cash, AR and
inventories) cannot be forced to take on certain “desired” values
•Unforeseen factors lead to inaccurate results and poor decisions
• Unknown and unavailable information requires the use of
estimates which might be inaccurate
• Using discretionary financing as a “plug” or balancing figure
tends to overlook projection errors
Additional Limitations of Pro-forma statements using
percentage of sales
•Ignored fixed expenses which tends to understate profits when
sales are increasing and vice versa
•assets may be purchased in larger quantities due to economies of
scale
•Some assets must be purchased in large, non-divisible quantities
(“lumpy assets”), like equipment. When newly purchased, there is
excess capacity until sales grow to the point where capacity is
fully utilized
•Firms might have to carry a minimum level of assets, such as
minimum level of inventory
Estimating Financing Needs
• Discretionary financing needs (“plug” figure)
-the amount needed to bring the statement into balance
• Once the firm determine the form of financing or the use available funds; the
pro forma balance sheet is modified to replace the “plug” figure with planned
increases/reductions in the debt and/or equity accounts
Discretionary financing needed (DFN)
• also known as External Funds Needed (EFN) and Additional
Funds Needed (AFN)
• if positive, is the amount of external capital (interest
bearing debt, preferred stock and common stock) that will be
necessary to acquire the required assets
• if negative, is the amount of internal funds in excess of total
financing needs to acquire assets
Discretionary financing needed (DFN)
•Two ways of computing
1. Plug figure in pro-forma balance sheet
2. Use equation as follows:
DFN = Projected Assets – Projected Liabilities – Projected SHE
DFN= Change in Assets – Change in Liabilities – Change in SHE
Alternative DFN/AFN/EFN equation
If all assets are sales driven and existing discretionary financing do not
change, the formula can be revised as follows:
DFN= Required Increase in Assets – Spontaneous Increase in Liabilities –
Increase in R/E
DFN=(Assets0/ Sales0)Δ Sales+1 - (L0* / Sales0)ΔSales+1
- (NPM0)(Sales+1)(1- DPR0)
where, L* are liabilities that increase spontaneously with sales
OR
DFN=(Assets0 x g) - (L0* x g) - [(NI0)x (1+g)x (1- DPR0)]
where, g is the sales growth rate
Interpreting DFN
• If positive, it means that firm will not generate enough
internal financing to support its forecast growth in assets;
hence, the firm must raise funds externally by: borrowing
(short-term or long-term), issuing of stocks, reducing
dividends, or a combination thereof
• If negative, it indicates that the firm will generate more
financing internally than it needs to support its forecast
growth in assets; hence, the firm may use the available
funds to repay debt, repurchase stock, increase dividends or
a combination thereof
DFN equation: percentage of sales
• ACYFMG 20xz DFN under percentage of sales approach
using DFN formula= (Assets0/ Sales0)Δ Sales+1 - (L0* / Sales0)ΔSales+1 (NPM0)(Sales+1)(1- DPR0)
=[( 82,500/78,600)*2,287.17] – {[(10,000+4,800)/78,600]*2,287.17} –
[(14.25%*80,887.26)*(1-70%)]
=2,400.66 – 430.66 – 3,704.76
=-1,734.76 (Same with plug figure)
ACYFMG may use excess P1,734.76 to repay debt, repurchase
stocks, increase dividends or combination thereof
DFN equation: judgmental
• ACYFMG 20xz DFN under judgmental approach
using DFN= Change in Assets – Change in Liabilities – Change in
SHE
=-2012.54 - -6,967.85 – 3,893.92
=1,061.39 (Same with plug figure)
• ACYFMG needs to raise P1,061.39 with debt, equity or lower
dividends or combination thereof
DFN computation
Miller Industries is planning its operations for next year. Ashton Miller,
the CEO, wants you to forecast the firm's additional funds needed (AFN).
Data for use in your forecast are shown below.
Current year's sales
Sales growth rate
330,000
11%
Current year's total assets
P1,505,000
Current year’s Net Profit
margin
20%
Current year's accounts
payable
Current year's notes
payable
Current year's accruals
Target payout ratio
P140,000
P50,000
P70,000
65%
Based on the AFN equation, what is the AFN for the coming year?
Excess Capacity Adjustment
• If the firm has excess capacity in its fixed assets, then fixed assets may
not have to increase in order to support the forecasted sales level.
• Moreover, if fixed assets need to increase in order to support the
forecasted sales level, then they will not have to increase by as much as
would be required if they were being used at full capacity.
•Alternative DFN equation assumes full capacity:
DFN =(Assets0/ Sales0)Δ Sales+1 - (L0* / Sales0)ΔSales+1 - (NPM0)(Sales+1)(1- DPR0)
DFN=(Assets0 x g) - (L0* x g) - [(NI0)x (1+g)x (1- DPR0)]
Alternative DFN/AFN/EFN equation
If the firm is operating at less than full capacity, fixed asset will not
increase (proportionately) with sales; hence we expect DFN to be less
than the DFN operating at full capacity
If all assets, except fixed assets, are sales driven and existing discretionary
financing do not change, the alternative DFN equation is revised as
follows:
DFN= =(A0*/ Sales0)Δ Sales+1 + Δ Fixed assets+1 - (L0* / Sales0)ΔSales+1
- (NPM0)(Sales+1)(1- DPR0)
where, A* assets that increase spontaneously with sales
L* liabilities that increase spontaneously with sales
OR
DFN=(A0* x g) + Δ Fixed assets+1 -(L0* x g) – [(NI0)x (1+g)x (1- DPR0)]
where, g is the sales growth rate
Excess Capacity Adjustment
• When a firm has excess
capacity in its fixed assets,
the first step is to
determine the sales level
that the existing fixed
assets can support –
called the Full Capacity
Sales, SFC
SFC =
Where:
S0
------------------------
% of Capacity
S0 – current sales
% of capacity – percentage
of capacity at which the
fixed assets are
presently being utilized
Excess Capacity Adjustment
• If forecasted sales (S1)are greater than full capacity sales, then fixed
assets will have to increase, but not proportionately, with sales. In this
case, change in FA is computed as:
Δ Fixed assets+1 = (FA0/SFC x S1) - FA0
where, FA0/SFC = amount of FA required for every peso of sales
(FA0/SFC x S1) = the required level of fixed assets to support forecasted sales
•If forecasted sales (S1)are less than full capacity sales, then fixed
assets do not need to increase to support the forecasted sales level. In
this case, change in FA is 0 (nil).
Excess Capacity Adjustment
If ACYFMG fixed assets are sales driven, compute DFN if it was operating
at (a) full capacity, (b) 99% capacity and (c) 95% capacity in 20xy (use
percentage of sales to apply equation)
DFN = (A0* x g) + Δ Fixed assets+1 -(L0* x g) – [(NI0)x (1+g)x (1- DPR0)]
Δ Fixed assets+1 = (FA0/SFC x S1) - FA0
ΔA* +
ΔFA -
ΔL* -
ΔRE =
Full
SFC = 78,600
37,800 x
2.91%=
1,100
44,700 x 2.91%= 1,300.72
14,800 x
2.91%
12,000 x
-1,734.76
(1+2.91%) x 30%
99%
SFC
37,800 x
2.91%=
1,100
((44,700/79,394) x
80,887) – 44,700= 840.71
14,800 x
2.91%
12,000 x
-2,194.77
(1+2.91%) x 30%
95%
SFC =
37,800 x
2.91%=
1,100
((44,700/82,737) x
80,887) – 44,700=
(999.32) =0; hence, no
increase
14,800 x
2.91%
12,000 x
-3,035.48
(1+2.91%) x 30%
=78,600/99%=
79,394
78,600/95%=
82,737
DFN
Excess capacity computation
Miller Industries is planning its operations for next year. Ashton Miller,
the CEO, wants you to forecast the firm's additional funds needed (AFN).
Data for use in your forecast are shown below.
DFN = (A0* x g) + Δ Fixed assets+1 -(L0* x g) – [(NI0)x (1+g)x (1- DPR0)]
Current year's sales
Sales growth rate
330,000
11%
Current year's total assets
P1,505,000
Current year’s Net Profit
margin
20%
Current year's accounts
payable
Current year's notes
payable
Current year's accruals
Target payout ratio
P140,000
P50,000
P70,000
65%
If Miller was operating only at 95% capacity and fixed asset amounted to
970,000, how much is full capacity sales? How much is the required level
of fixed asset to support projected sales? Compute for the AFN with
excess capacity adjustment.
Financial Forecasting
Forecast sales
Project income
statement
Project assets
needed to
support sales
Project sources of
financing
See effect of plan
on ratios
Decide how to
raise/use needed/
excess funds
Estimate financing
needs
Summarizing financial forecast
• ACYFMG used the judgmental approach of forecasting its FS,
and it has 3 financing options for the P1,061.39 DFN as follows:
1. the DFN will be fully financed by LT debt
2. the DFN will be financed by 50% LT debt and 50% equity
3. the DFN will be fully financed by common equity (sell stocks
at current market price)
Pro-forma BS: Judgmental Approach
Projected 20xz balances
Undecided
Accounts Payable
Notes Payable
Accrued expenses
Total current liabilities
Long-term debt
₱5,392.48
-
DFN-50/50
DFN-Equity
₱5,392.48
-
₱5,392.48
-
₱5,392.48
-
4,939.67
4,939.67
₱10,332.15 ₱10,332.15
4,939.67
₱10,332.15
4,939.67
₱10,332.15
23,061.39
22,530.69
22,000
₱32,332.15 ₱33,393.54
₱32,862.85
₱32,332.15
12,000
12,531
13,061
35,093.92 35,093.92
₱47,093.92 ₱47,093.92
35,093.92
₱47,624.62
35,093.92
₱48,155.31
₱79,426.07 ₱80,487.46
₱80,487.46
₱80,487.46
22,000
Total Liabilities
DFN-Debt
Common Stock
12,000
Retained Earnings
Total Stockholders’ Equity
Total Liabilities and SHE
DFN “plug” figure
1,061.39
Financial Forecasting
Forecast sales
Project income
statement
Project assets
needed to
support sales
Project sources of
financing
See effect of plan
on ratios
Decide how to
raise/use needed/
excess funds
Estimate financing
needs
Effect of plan on key ratios
• Assume that ACYFMG wants to consider the impact of their decision on
key ratios listed below:
20xy
20xz-LT debt
20xz-50/50
20xz-Equity
ROA*
14.77%
15.93%
15.93%
15.93%
ROE*
28.85%
28.75%
28.58%
28.42%
EPS*
1.20
1.30
1.29
1.29
Equity multiplier
1.91
1.71
1.69
1.67
16.00
17.31
17.25
17.19
3.70
3.67
3.63
3.59
(Est.) Market price
(using 20xy P/E 13.33)
M/B ratio*
*assuming same NI regardless of financing
decision; shares will be issued at their
20xy price of P16; hence 34 and 67 shares
issued for 2nd and 3rd financing options
Importance and Use of Financial Planning
• force managers to think systematically about the future
• Provides clearer long-term view of allocation of funds/ financial
needs
• Serves as a basis for financial decisions
• Measures the impact of the firm’s strategies on financial
statements, profit/loss and market value
• Evaluates financial viability and/or profitability of firm’s strategies
• Identifies which strategies or operating plan to prioritize
Summarizing financial forecast
ACYFMG used the judgmental approach of forecasting its FS, it
has 3 financing options for the P1,061.39 DFN.
ACYFMG CFO proposed that the firm simply reduce its cash
dividends for 20xz so that there’s no need for external
financing.
How much will dividend per share decrease?
Compute for the proposed dividend payout ratio.
Consider the impact of this on pro-forma B/S and key ratios.
Computing growth rates
Two growth rates in financial planning: internal and sustainable
(1) Internal growth rate (IGR)
! The maximum growth rate a firm can achieve without
external financing of any kind (no additional debt or equity).
! Maximum growth using retained earnings only
! The required increase in assets is exactly equal to the
addition to retained earnings, and DFN is therefore zero.
Internal Growth Rate (IGR)
Simplified formula (using beg. TA): IGR = ROA x RR
or IGR = Reinvested earnings/ (TA less reinvested earnings)
Simplified formula (using end TA): IGR = (ROA x RR) / [1-(ROA x RR)]
Where, RR is retention ratio aka plow-back ratio computed as (1-DPR)
Reinvested earnings is NI x RR
Accurate if:
• all assets are sales driven
• no liabilities are sales driven
• existing discretionary financing do not change
Internal Growth Rate (IGR)
Using DFN equation:
DFN=(Assets0 x g) - (L0* x g) - [(NI0)x (1+g)x (1- DPR0)]
Look for g that would make DFN = 0 (nil) using:
• Solve for “x “
NOTE: We will use the derived equation for
ACYFMG1 unless the question explicitly
•Use excel goal seek
stated to use the simplified equation
• Derived equation below
1
𝐼𝐺𝑅 =
−1
𝑁𝐼 × 𝑅𝑅
1−
𝐴 − 𝐿∗
𝑁𝐼 × 𝑅𝑅
𝐼𝐺𝑅 =
𝐴 − 𝐿∗ − (𝑁𝐼 × 𝑅𝑅)
Accurate if:
• all assets and spontaneous liabilities are sales driven
• existing discretionary financing do not change
Computing growth rates
Two growth rates in financial planning: internal and sustainable
(2) Sustainable growth rate (SGR)
! The maximum growth rate a firm can achieve without
external EQUITY financing while maintaining a constant
debt-equity ratio.
! The firm can borrow, but no increase in financial leverage
and D/E ratio is therefore constant.
Sustainable Growth Rate (SGR)
Simplified formula (using beg. SHE): SGR = ROE x RR
or SGR = Reinvested earnings/ (SHE less reinvested earnings)
Simplified formula (using end SHE): SGR =
(ROE x RR)/[1-(ROE x RR)
Where, RR is retention ratio aka plow-back ratio computed as (1-DPR)
Reinvested earnings is NI x RR
Accurate if:
• all assets are sales driven
• spontaneous liabilities are sales driven
Sustainable Growth Rate (SGR)
Using DFN equation:
DFN=(Assets0 x g) - (L0* x g) - [(NI0)x (1+g)x (1- DPR0)]
Look for g that would make D/E ratio the same as current year:
where, [debt = L0 + (L0* x g) + DFN] and {equity= SHE0+ [(NI0)x (1+g)x RR]}
• Solve for “ x“
• Excel goal seek
• Derived equation below- same with simplified equation
𝑅𝑂𝐸 × 𝑅𝑅
𝑆𝐺𝑅 =
1 − 𝑅𝑂𝐸 × 𝑅𝑅
𝑁𝐼 × 𝑅𝑅
𝑆𝐺𝑅 =
𝑆𝐻𝐸 − 𝑁𝐼 × 𝑅𝑅
Accurate if:
• ROE is computed as NI divide by ending SHE
• all assets are sales driven
• spontaneous liabilities are sales driven
IGR and SGR
• Since sustainable growth rate allows for external financing,
it is higher than the internal growth rate (except if firm has
zero D/E ratio).
Computing IGR and SGR
• Using ACYFMG 20xy FS, compute for IGR using percentage of sales
𝑁𝐼 × 𝑅𝑅
assumptions:
𝐼𝐺𝑅 =
𝐴 − 𝐿∗ − (𝑁𝐼 × 𝑅𝑅)
20xy RR = 1-70% = 30%
IGR = (12,000 x 30%)/ [82,500-10,000-4,800-(12,000 x 30%)]
IGR = 3,600/ 64,100
IGR= 5.6162%, where DFN is zero (nil)
Note: using the simplified formula would yield an IGR of 4.56% (or 4.43%
using ratios computed) and DFN of -675.29 (-759.88).
Computing IGR and SGR
• Using ACYFMG 20xy FS, compute for SGR using percentage of sales
assumptions:
𝑁𝐼 × 𝑅𝑅
𝑆𝐺𝑅 =
𝑆𝐻𝐸 − 𝑁𝐼 × 𝑅𝑅
20xy RR = 1-70% = 30%
SGR= (12,000 x 30%) / [43,200-(12,000 x 30%)]
SGR = 3,600 / 39,600
SGR= 9.0909%, where D/E is same with 20xy of 90.97%
Note: using the simplified formula would yield same SGR of 9.09% (or
8.65% using ratios computed) and D/E of 90.97% (90.27%)
IGR and SGR computation
Miller Industries is planning its operations for next year. Ashton Miller,
the CEO, wants you to know the firm's internal growth rate (IGR) and
sustainable growth rate (SGR). Data for use in your forecast are shown
below.
Current year's sales
330,000
Debt to equity ratio
40%
Current year's total assets
P1,505,000
Current year’s Net Profit
margin
20%
𝑁𝐼 × 𝑅𝑅
𝐼𝐺𝑅 =
𝐴 − 𝐿∗ − (𝑁𝐼 × 𝑅𝑅)
Current year's accounts
payable
Current year's notes
payable
Current year's accruals
Target payout ratio
𝑁𝐼 × 𝑅𝑅
𝑆𝐺𝑅 =
𝑆𝐻𝐸 − 𝑁𝐼 × 𝑅𝑅
P140,000
P50,000
P70,000
65%
3.3
Budgeting
Budget
a detailed plan, expressed in
quantitative terms, that
specifies how resources will be
acquired and used during a
specified period of time.
Purposes of Budgeting
Systems
1. Planning
2. Facilitating
Communication and
Coordination
The procedures used to develop
3. Allocating Resources
a budget constitute a
4. Controlling Profit and
Budgeting System
Operations
5. Evaluating
Performance and
Providing Incentives
Advantages of Budgeting
Communicate
plans
Coordinate
activities
Define goal
and objectives
Advantages
Uncover potential
bottlenecks
Think about and
plan for the future
Means of allocating
resources
Common Budgeting Method
1.
Incremental budgeting- last year’s actual figures and adds or
subtracts a percentage to obtain current year’s budget
2. Activity-based budgeting- top down budgeting that determines
the amount of inputs (in terms of activities) required to support
target output of the company
3. Value proposition budgeting- assesses each item in the budget
as to whether it creates value for customer, staff or other
stakeholder and if the value outweigh its cost; any unjustified cost
will be deleted
4. Zero-based budgeting- assumes that all department’s budget are
zero and must rebuilt from scratch wherein every single expense
must be justified for its continued usefulness
Kinds/Types of Budget
• By time period: short-term, long-term, or rolling budget
• By capacity: static or flexible budget
• By scope:
• Master Budget
• Operating Budget
• Sales Budget
• Production Budget
• Financial Budget
•Capital Expenditure Budget
• Cash Budget
Types of Budget (by time period)
0
1.
2.
3.
1
2
3
4
5
Short-term budget- aka short-range budget, is a budget with a term of one year
or less
Long-term budget- aka long-range budget, covers periods longer than a year
Rolling budget- also called revolving, continuous, or perpetual budget, is
continually updated by periodically adding a new incremental time period (such
as a month or quarter), and dropping the period just completed. This approach
keeps managers focused on the future at least one period ahead.
Types of Budget (by capacity)
1.
Static budget- is prepared for a single, planned level of activity. It
contains elements were expenditures remain unchanged with
variations to activity levels. Though suitable for planning, it is
inadequate for evaluating how well costs are controlled because the
actual level of activity is unlikely to equal the planned level of activity
1.
Flexible budget- provides estimates of what costs should be for any
level of activity, within a specified range. When used for performance
evaluation purposes, actual costs are compared to what the costs
should have been for the actual level of activity during the period
Static vs. Flexible Budget evaluation
Kinds of Budget (by scope)
1. Master Budget- is an overall single budget that shows how the firm
expects to conduct all aspects of business over the budget period.
This is usually approved by top management. It summarizes
projected activities and shows how functional or subset budgets are
interdependent.
2. Functional or subset budget- applies to a certain area of the
company like a function, division, department, or project. Most
common types of functional budget are: sales budget, production
budget, selling & administrative expense budget, capital expenditure
budget, and cash budget
Sales Budget
Ending
Inventory
Budget
Production
Budget
Work in Process
and Finished
Goods
Ending
Inventory
Budget
Direct Materials
Direct
Materials
Budget
Direct
Labor
Budget
Overhead
Budget
Cash Budget
Budgeted Statement of
Cash Flows
Budgeted Balance
Sheet
Selling and
Administrative
Budget
Budgeted Income
Statement
Sales Budget
Ending
Inventory
Budget
Work in Process
and Finished
Goods
Production
Budget
When the interactions of the elements of
the masterDirect
budget are
expressed
as
a
set
of
Ending
Selling
and
Direct
Overhead
Inventory
Materials relations,
Labor
Administrative
mathematical
it
becomes
a
Budget
Budget
Budget
Budget
Budget
Direct Materials
financial planning model that can be used to
answer “what if”Cash
questions
Budget about unknown
Budgeted Income
variables.
Budgeted Statement of
Cash Flows
Budgeted Balance
Sheet
Statement
Financial Planning Model
• a mathematical expression of all the relationships expressed in a
master budget flow chart
• a set of mathematical relationships that express the interactions
among the various operational, financial, and environmental events
that determine the overall results of an organization’s activities
• In a fully developed model, all of the key estimates and
assumptions are expressed as general mathematical relationships.
Then the model is run on a computer many times to determine the
impact of different combinations of these unknown variables.
• “What if” questions can be answered about such unknown
variables as inflation, interest rates, the exchange rate, demand,
competitors’ actions, union demands, and a host of other factors.
Kinds of Budget (by scope)
1. Operating Budget- is a set of functional budgets that specify how its
operations will be carried out to meet the demand for its goods or services.
It comprises budget for income statement elements leading to the creation
of budgeted income statement. It usually covers a one-year period but
maybe divided into quarterly, monthly or weekly budgets.
1. Financial budget- is a plan that shows how the company will acquire its
financial resources, such as through the issuance of stock or incurrence of
debt. It is based on the operating budget comprising the budget for balance
sheet elements leading to the creation of the budgeted balance sheet and
the budgeted statement of cash flows.
Kinds of Budget (by scope)
• Most common functional budgets are:
• Sales Budget- aka Revenue Budget, provides an estimate of the volume
of goods and services (both in units and amounts) that a company
proposes to sell in a future period
• Production Budget- outlines the number of units the company need to
manufacture to meet the requirements of the sales budget
• Purchase Budget- contains the amount of inventory that a company
must purchase during each budget period to ensure sufficient inventory on
hand in satisfying customer demands/orders
Kinds of Budget (by scope)
• Most common functional budgets are:
• Selling and Administrative expense Budget- aka period expense
budget or operating expense budget, indicates the planned operating
expenses of the company during the budget period
• Capital (Expenditure) Budget is a plan that states the amount and
timing capital asset acquisitions, such as buildings and equipment. It
identifies the amount of investment in projects and long-term assets
• Cash Budget (Cash Forecast)- is a statement of the company’s planned
inflows and outflows of cash over the budget period.
Basic Operating Budget Steps
1.
2.
3.
4.
5.
6.
7.
8.
9.
Prepare the revenues budget.
Prepare the production or purchase budget.
Prepare the direct materials usage budget and direct materials
purchases budget.
Prepare the direct manufacturing labor budget.
Prepare the manufacturing overhead costs budget.
Prepare the ending inventories budget.
Prepare the cost of goods sold budget.
Prepare the selling and administrative expense budget.
Prepare the budgeted income statement.
Basic Financial Budget Steps
1.
2.
3.
4.
Prepare the capital expenditures budget.
Prepare the cash budget.
Prepare the budgeted balance sheet.
Prepare the budgeted statement of cash flows.
ACYFMG Budgeting
! ACYFMG, Inc. is preparing budgets for the quarter 1 of year
20xz.
"Budgeted sales volume for the coming year are:
January
February
March
April
May
June
800 units
500 units
300 units
150 units
250 units.
400 units
#The selling price is P25 per unit.
ACYFMG Sales Budget for Q1 of 20xz
Jan
Budgeted sales
volume
Feb
Mar
Q1
800
500
300
1600
Selling price
25
25
25
25
Gross Sales
₱20,000
₱12,500
₱7,500
₱40,000
Purchase Budget
Sales
Budget d
e
t
e
pl
m
o
C
Purchase
Budget
Purchases must be adequate to meet budgeted
sales and provide for sufficient ending inventory.
Purchase Budget
The management of ACYFMG, Inc. targets ending
inventory to be equal to 70% of the following
month’s budgeted sales in units.
On December 31 20xy, 915 units were on hand.
Let’s prepare the purchase budget.
Purchase Budget
January
February
March
Quarter 1*
Budgeted sales volume
800
500
300
1600
Add: target ending inventory
350
210
105
105
1150
710
405
1705
Less: beginning inventory
915
350
210
915
Units to be purchased
235
360
195
790
Total inventory needed
*Sales in units for the quarter is the sum of Jan, Feb and Mar sales. Since the end of Mar is also the
end of the quarter, the ending inventory for the quarter is the same as the ending inventory for Mar.
Since the beginning of Jan is also the beginning of the quarter, the beginning inventory for the
quarter is the same as Jan’s beginning inventory. Total units needed for the quarter is the sum of the
sales units and the ending inventory. The beginning inventory is subtracted from the total units
needed to arrive at the units to be purchased for the quarter.
Selling and Administrative Expense Budget
• ACYFMG’s variable operating expenses are P0.80 per
unit sold.
• Fixed operating expenses are P525 per month.
• The fixed operating expenses include P150 in
depreciation expense that does not require a cash
outflow for the month.
Operating Expense Budget
Jan
Feb
Mar
Q1
Unit sales
800
500
300
1600
Variable expense per unit
0.80
0.80
0.80
0.80
Variable operating exp
640
400
240
1,280
Fixed operating exp
525
525
525
1,575
Total operating exp
1,165
925
765
2,855
Less: Noncash expenses*
150
150
150
450
Cash operating expenses
₱1,015
₱775
₱615
₱2,405
*The noncash expenses like depreciation and amortization are deducted from the total expenses to
determine the amount of cash disbursements required for each month and the quarter.
Capital Expenditure Budget
• ACYFMG plans to upgrade its delivery van on February
20xz amounting to P35,000.
• ACYFMG have no plans of disposing any fixed asset
during the 1st Quarter of 20xz.
Capital Expenditure Budget
Item
Transportation equipment
Jan
Feb
₱0
₱35,000
Mar
Q1
₱0
₱35,000
Since all CAPEX are material in amount, some firms include justification of each CAPEX item
in the budget
Cash Budget
• Typically includes the following main elements:
• Cash receipts- cash inflow from cash sales, AR collections, etc.
• Cash disbursements- cash outlays for cash purchases, payment of AP,
payment of S&A expenses, etc.
• Net change in cash (or net cash flow)- difference between cash
receipts and cash disbursements in each period
• Ending cash balance-sum of beginning cash balance and net cash
flow
•Target (or minimum) cash balance- desired balance the firm plans to
maintain
Cash Budget
• Typically includes the following main elements:
• New financing needed (or required total financing)- Amount of
funds needed if the ending cash for the period is less than the target
cash balance; typically represented by notes payable.
• Excess cash balance- Amount available for investment if the period’s
ending cash is greater than the minimum cash balance; assumed to be
invested in marketable securities
•Uses: (a) monitor and control firm’s operations, and (2) predict amount
and timing of future cash requirements.
The General Format of the Cash Budget
Expanded Format of the Cash Budget
Preparing the Cash Budget
01
Cash Receipts
02
03
Cash Disbursements
Net Cash Flow and ending balance
04
New financing
or excess cash
Preparing the Cash Budget
1. Prepare the cash receipts budget (using sales budget)
1.1 Refer to collection pattern of credit sales
1.2 Take note of other cash receipts such as interest/dividend
income, bond/stock issuance, sale of fixed assets
2. Prepare the cash disbursements budget (using production/purchase
budget, OPEX budget and CAPEX budget)
2.1 Refer to payment period of credit purchases
2.2 Identify timing of payment for expenses (e.g. utilities payment
are lagged one month because this are usually due the following
month)
Preparing the Cash Budget
2. Prepare the cash disbursements budget
2.3 Take note of other cash payments like interest payment
debt repayment, stock repurchases
3. Compute net cash flow and ending balance
4. Compare ending balance with minimum cash balance to
determine if new financing is needed or there is excess cash
for short-term investment
Cash Receipts Budget
• All sales of ACYFMG are on account.
• The company’s collection pattern is:
75% collected in the month of sale,
25% collected in the month following the month of sale,
• All 20xy accounts receivable will be collected on
January 20xz.
• No other cash receipt is expected for the first quarter
aside from sales.
Cash Receipts Budget
Jan
20xy accounts receivable
January sales (75% &
25%)
Feb
9,500
15,000
February sales (75% &
25%)
5,000
9,375
₱24,500
Q1
9,500
March sales (75%)
Total cash receipt
Mar
₱14,375
20,000
3,125
12,500
5,625
5,625
₱8,750
₱47,625
Cash Disbursement Budget
• All ACYFMG purchases are on account and have an ave. unit cost
of P15.
• The company pays its accounts payable as follows:
• 20% in the month of purchase
• 60% in the month following the month of purchase
• 20% in 2 months following the month of purchase
• 20xy Accounts payable of P10,000 is composed of 1,000 from
November purchases and 9,000 from December purchases
• 20xy Accrued expenses of P4,800 will be paid on January 20xz
• 20xy Notes payable of P2,500 will be repaid on January 20xz
Cash Disbursement Budget
• All operating expenses, except deprecation and
amortization, are assumed to be paid in cash on the
month incurred
• For CAPEX, 50% down payment is paid on the month of
purchase while the balance is paid on the next month.
• Interest expense on LT debt is paid quarterly amounting
to P1,225
• No other cash disbursement is expected for the first
quarter aside from the items mentioned above.
Cash Disbursement Budget
Jan
20xy accrued expenses
20xy notes payable
20xy AP-Nov purchase*
20xy AP- Dec purchase*
Jan purchases (20-60-20%)
4,800
2,500
1,000
6,750
705
Feb purchases (20-60%)
Feb
2,250
2,115
1,080
Mar purchases (20%)
Cash operating expenses
1,015
775
17,500
₱16,770
₱23,720
CAPEX
Interest expense
Total cash disbursement
Mar
Q1
705
3,240
585
615
17,500
1,225
₱23,870
4,800
2,500
1,000
9,000
3,525
4,320
585
2,405
35,000
1,225
₱64,360
*20xy AP-dec purchase paid Jan 20xz= (9,000 x 60%/80%) = 6,750; paid Feb: 9,000 x 20%/80% = 2,250
Jan purchases: 235 x 15 = 3,525; Feb purchases: 360 x 15 = 5,400; Mar purchases: 195 x 15 = 2,925
Cash Budget
• 20xy balances are: cash at P4,250, no marketable
securities, notes payable at P2,500
• ACYFMG maintains a minimum cash balance of P4,000
• ACYFMG has an agreement with its bank to
issue/repay notes payable on the last day of the
month
• ACYFMG use excess cash to first repay notes payable
before investing marketable securities
• Assume that ACYFMG would liquidate marketable
securities first to meet deficits before borrowing with
notes payable
ACYFMG Cash Budget for Q1 of 20xz
Jan
Total cash receipts
Feb
Mar
Q1
24,500
14,375
8,750
47,625
(16,770)
(23,720)
(23,870)
(64,360)
Net cash flow
7,730
(9,345)
(15,120)
(16,735)
Beginning cash*
4,250
11,980
2,635
4,250
11,980
2,635
(12,485)
(12,485)
(4,000)
(4,000)
(4,000)
(4,000)
-₱1,365
-₱16,485
-₱16,485
Total cash disbursements
Ending cash
Minimum cash balance
Excess cash (MS)**
New financing needed (NP)**
₱7,980
*to avoid distortion, add MS or deduct NP balance here if not liquidated or paid within first month
**the excess cash (or new financing needed) figures refer to how much will be invested (owed) at the end of the
month, they do NOT represent monthly changes in ST investments (borrowings)
Financial Activities from Cash Budget
For ACYFMG to maintain a 4,000 cash balance, it will need to:
• January: Repay P2,500 notes payable and Invest P7,980 excess
cash balance in marketable securities
• February: Liquidate P7,980 of marketable securities and borrow
P1,365 of notes payable
• March: Borrow P15,120 notes payable
• Financial manager should arrange for a line of credit of at least
P16,485.
Evaluating Cash Budget
• Cash budgets indicate the extent to which cash shortages or
surpluses are expected in the periods covered.
• At the end of the 3 months, ACYFMG expects the following
balances in cash, marketable securities, and notes payable:
Account
Jan 20xz
Feb 20xz
Mar 20xz
Cash
4,000
4,000
4,000
Marketable Securities
7,980
0
0
0
1,365
16,485
Notes payable
Cash Budget- with financing cost and investment
income
• ACYFMG has an agreement with its bank to issue/repay
notes payable on the last day of the month with a fixed
annual rate of 12%
• ACYFMG invest any excess cash in marketable securities
which earns an annual rate of 8%
• Assume that ACYFMG would liquidate marketable
securities first to meet deficits before borrowing with
notes payable
• ACYFMG use excess cash to first repay notes payable
before investing marketable securities
ACYFMG Cash Budget for Q1 of 20xz
Jan
Total cash receipts
Feb
Mar
Q1
24,500
14,375
8,750
47,625
(16,770)
(23,720)
(23,870)
(64,360)
7,730
(9,345)
(15,120)
(16,735)
(25)
53
(13)
15
4,250
11,955
2,663
4,250
Ending cash
11,955
2,663
(12,470)
(12,470)
Minimum cash balance
(4,000)
(4,000)
(4,000)
(4,000)
Excess cash (MS)
₱7,955
-₱1,337
-₱16,470
-₱16,470
Total cash disbursements
Net cash flow
Interest (MS or NP)*
Beginning cash
New financing needed (NP)
*Jan: 2500 x 12%/12 =25; Feb: 7,955 x 8%/12 = 53; Mar: 1,337 * 12%/12 = 13
Identify the financial activities of ACYFMG every end of month of Q1 based on the cash budget:
borrow, invest, repay, and/or liquidate how much? What’s the minimum credit line to be
maintained for the quarter?
Illustrative: Cash Budget
Alyssa, a financial analyst for Best Value Store, has prepared the following sales and cash
disbursement estimates for the period August through December of the current year.
Month
Sales
Cash Disbursements
August
40,000
35,000
September
50,000
40,000
October
50,000
65,000
November
60,000
50,000
December
70,000
55,000
Ninety percent of sales are for cash, the remaining 10 percent are collected one month
later. All disbursements are on a cash basis. The firm wishes to maintain a minimum cash
balance of P5,000. The beginning cash and marketable securities balance in September is
P5,000 and P1500, respectively. Prepare a cash budget for the months of September,
October, November, and December, noting any needed financing or excess cash available.
Sep
Total cash receipts
Oct
Nov
Dec
Illustrative:
Cash Budget
August sales
September sales
November sales
Financial activities
(borrow, invest, repay
or liquidate and how
much?)
December sales
Sep:
October sales
Total cash disbursements
Net cash flow
Add: beginning cash
Ending cash
Less: Minimum cash balance
Excess cash (MS)
New financing needed (NP)
Oct:
Nov:
Dec:
Minimum credit line:
New Financing Needed – Coping with Uncertainty
• The computed financing arrangement may not be sufficient if actual
situation turns out to be less favorable than expected
• One way to cope with cash budgeting uncertainty is to prepare
several cash budgets based on several forecasted scenarios (e.g.,
pessimistic, most likely, optimistic).
• From this range of cash flows, the financial manager can determine
the amount of financing necessary to cover the most adverse
situation.
• A much more sophisticated way is to do a simulation to develop
probability distribution of endings cash flows for each month.
• Furthermore, month-end cash budget does not ensure the firm will
be able to meet its daily cash requirements. Financial manager may
need to plan or monitor cash flow more frequently than monthly
Sample Scenario Analysis of Cash Budget
3.4
Leverage
Business risk
• Is the riskiness inherent in the firm’s operations (or riskiness of
firm’s assets) if no debt is used
• Is the risk of being unable to cover operating costs
• Common measure: standard deviation of Return on invested
capital (sROIC)
Probability density
Low risk
High risk
0
EBIT
Factors affecting business risk
Sales and
cost
variability
Competition
Product
obsolescence
Business
risk
Legal,
regulatory
and foreign
risk exposure
Operating
Leverage
Financial risk
• Is the increase in stockholder’s risk, over and above the firm’s business
risk, resulting from the use of financial leverage
• Is the risk of being unable to cover financial costs
• More debt or preferred stock results to more financial risk
Analysis and impact of Leverage
• Leverage results from the use of fixed-cost assets or fixed cost funds
to magnify returns to the firm’s owners.
• Generally, increases in leverage result in increases in risk and
return, whereas decreases in leverage result in decreases in risk and
return.
Operating Leverage
• Is the extent to which fixed operating costs are used in the firm’s operations
• The higher the operating leverage, the higher the business risk
• Compare EBIT at 150 unit sales and 800 unit sales
Rev.= 80
P
Rev.= 85
P
TC
TC
VC=50
VC=50
FC
=5K
QBE
=167
Sales
QBE
=200
FC
=7K
Sales
Financial Leverage
• Is the extent to which fixed-income securities are used in a
firm’s capital structure
• The higher the financial leverage, the higher the financial risk
• Ignoring taxes, compare owner’s share in profit/loss at -600
EBIT and 1,200 EBIT
P1,200 EBIT
P9,000 capital
-P600 EBIT
10% interest
Total Leverage
• results from the combined effect of using both fixed
operating and fixed financial costs;
• Hence, DTL = DOL x DFL
Measuring degree of leverage
Effect
Formula
(measuring
sensitivity)
Formula
(at base
level)
Degree of Operating
Leverage (DOL)
Degree of Financial
Leverage (DFL)
Use of Fixed Operating
Costs to magnify effect of
changes in Sales to EBIT
Use of Fixed Financial
Costs (interest on debt
and PS dividends)
to magnify effect of
changes in EBIT to EPS
Degree of Total
Leverage (DTL)
Use of Fixed costs (both
operating and financial)
to magnify effect of
changes in Sales to EPS
=DOL x DFL
ACYFMG is evaluating two different operating structures which are
described below.
The firm has common shares outstanding of 1,000, and a tax rate of 25%.
Sales price per unit is at P1.
Operating
structure
@ 10,000 units sold
@ 20,000 units sold
#1
EBIT = P1,500
EPS= 0.375
EBIT = P3,500
EPS= 1.875
#2
EBIT = P1,500
EPS= 0.9375
EBIT = P4,500
EPS = 3.1875
Using the sensitivity formula, the percentage changes are as follows:
% change in Sales
% change in EBIT
% change in EPS
#1
(20,000 – 10,000)/ 10,000 =
100%
(3,500-1,500)/1,500=
133.3333%
(1.875-0.375)/0.375=
400%
#2
(20,000 – 10,000)/ 10,000 =
100%
(4,500-1,500)/1,500=
200%
(3.1875-0.9375)/0.9375=
240%
Measuring degree of leverage
(using sensitivity)
DOL
DFL
Structure #1
133.3333%/100% 400%/133.3333%
= 1.33
= 3.0
400%/100% or 1.33 x 3.0
= 4.0
Structure #2
200%/100%
= 2.0
240%/100% or 2.0 x 1.2
= 2.4
240%/ 200%
= 1.2
DTL
Operating structure #2 has greater business risk, while operating
structure #1 has higher financial risk. In terms of total risk,
operating structure one is riskier.
Interpreting the degree of leverage:
• DOL #2 - For every 1% change in sales, there is an equivalent 2% change in EBIT
• DFL #1 - For every 1% change in EBIT, there would be an equivalent 3% change in EPS
• DTL #1- For every 1% change in sales, there would be an equivalent 4% change in EPS
Cost data of the two operating structure of ACYFMG are as follows:
Fixed costs
Price per
unit
VC per unit
Interest exp.
Structure #1
P500
P1
0.80
P1,000
Structure #2
P1,500
P1
0.70
P250
Calculate DOL, DFL and DTL using 20,000 units as a base sales level with
preferred stock dividends as follows:
EBIT
PS dividends
EPS (with PS
div.)
Structure #1
P3,500
P280
1.595
Structure #2
P4,500
P420
2.7675
Contents
3.1 Overview of financial planning
3.2 Developing a long-term financial
plan
3.2.1 Spontaneous and discretionary
financing
3.2.2 Determining discretionary
financing needs
Percent of sales method
Judgmental method
3.2.3 Excess capacity adjustments
3.2.4 Growth rates
3.2.4.1 Internal growth rate
3.2.4.2 Sustainable growth rate
Contents
3.3 Developing a short-term financial plan
3.3.1 Kinds of budget
3.3.2 Cash budget
3.3.3 Master budget
3.3.3.1 Operating budgets
3.3.3.2 Financial budgets
3.4 Leverage
3.4.1 Business and financial risk
3.4.2 Types of leverage
3.4.2.1 Operating leverage
3.4.2.2 Financial leverage
3.4.2.3 Total leverage
End of 3.1-3.4
Questions?
What were your key
learnings?
Prepare for Quiz #2
Knowledge Check
KC: True or False
1.
2.
3.
4.
5.
Generating a higher profit margin provides fuel for a higher sustainable growth
rate, holding everything else equal.
The cash budget typically only impacts the financing area of the firm.
The percentages used in the percent-of-sales method comes from expected
return on investments.
If a firm utilizes debt financing, a 10% decline in earnings before interest and
taxes (EBIT) will result in a decline in earnings per share that is larger than 10%,
and the higher the debt ratio, the larger this difference will be.
Spontaneous sources of financing are those sources that vary automatically
with a firm’s level of sales.
KC: True or False
6. If a firm has a positive free cash flow, then it must have either a zero or a
negative AFN
7. The projected change in retained earnings equals projected net income
less any dividends to be paid.
8. If the project has mostly variable costs, it is said to have high operating leverage.
9. The Master budget can be use to develop a financial planning model.
10. Financial Budget comprises budget for income statement elements
leading to the creation of budgeted income statement
KC: True or False
11. Whenever the percentage change in earnings per share (EPS)
resulting from a given percentage change in sales is greater than the
percentage change in sales, financial leverage exists.
12. A strategic financial plan is one that has a period of less than one year.
13. Additional funds needed (AFN) are typically raised using a combination
of notes payable, long-term debt, and common stock.
KC: Multiple Choice
14. The degree of financial leverage for Huff Company is 3.0, and the degree of
financial leverage for Puff Corporation is 6.2. According to this information,
which firm is considered to have greater overall (total) risk?
A.
Huff Company
B.
Puff Company
C.
We can determine which firm has the greater total risk if financial breakeven point of
each firm is given
D.
We cannot determine which firm has greater total risk due to limited information
given
KC: Multiple Choice
15. The growth rate at which a company can grow without issuing new
shares of common stock while maintaining a constant equity multiplier
is called a(n):
A.
Internal growth rate
B.
Sustainable growth rate
C.
D.
Maximum growth rate
Optimal growth rate
KC: Multiple Choice
16. What is the first and most critical step in developing a firm’s forecasted
financial statements?
A.
Forecasting sales revenues
B.
C.
Determining the amount of dividends to pay shareholders
Projecting the rate of interest on proposed new debt
D.
Deciding upon which method of depreciation a firm should
utilize
KC: Multiple Choice
17. Spontaneous sources of financing include:
A.
accounts payable and accrued expenses
B.
notes payable and mortgages payable
C.
long-term debt and capital leases
D.
common stock and paid-in capital
KC: Multiple Choice
18. Which of the following will decrease discretionary funds needed?
A.
An increase in projected accounts receivable
B.
An increase in projected dividends
C.
An increase in projected accounts payable
D.
Both A and B
KC: Multiple Choice
19. Because the degree of total leverage is multiplicative and not
additive, when a firm has very high operating leverage it can
moderate its total risk by
A.
increasing EBIT.
B.
increasing sales.
C.
using more financial leverage.
D.
using a lower level of financial leverage.
KC: Multiple Choice
20. Jefferson City Computers has developed a forecasting model to
estimate its AFN for the upcoming year. All else being equal, which
of the following factors is most likely to lead to an increase of the
additional funds needed (AFN)?
A.
The company reduces its dividend payout ratio.
B.
C.
D.
The company switches its materials purchases to a supplier
that sells on terms of 1/5, net 90, from a supplier whose
terms are 3/15, net 35
The company discovers that it has excess capacity in its
fixed assets.
A sharp increase in its forecasted sales.
KC: Multiple Choice
21. Which of the following is an assumption of the percent-of-sales
method but NOT of the judgmental approach of forecasting financial
statements?
A.
B.
C.
D.
assumes that past financial relationships (ratios) remain
constant
assumes certain costs and expenses as fixed
assumes all assets and spontaneous liabilities are salesdriven
All of the above
KC: Multiple Choice
22 . A company expects sales to increase during the coming year, and it is
using the AFN equation to forecast the additional capital that it must
raise. Which of the following conditions would cause the AFN to
increase?
A.
B.
C.
D.
The company begins to pay employees monthly rather than
weekly.
The company decides to stop taking discounts on purchased
materials.
The company previously thought its fixed assets has excess
capacity, but now it learns that it actually operated at full
capacity.
The company increases its plowback ratio
KC: Multiple Choice
23. All of the following affect business risk EXCEPT:
A.
interest rate stability.
B.
operating leverage.
C.
D.
cost stability.
revenue stability
KC: Multiple Choice
24. ____ will normally make use of both Sales and Purchase budgets; while
___ will neither use of any of the two.
A.
Cash budget, Capital Expenditure Budget
B.
Capital Expenditure Budget, Selling & Administrative Budget
C.
Cash budget, Selling & Administrative Budget
D.
Selling & Administrative Budget, Production Budget
KC: Multiple Choice
25. Suppose a firm forecasts sales growth larger than its sustainable
growth rate, but plans to add fewer assets than the current asset to
sales ratio implies. If other aspects of the firm’s performance remain
constant, the external funds needed (EFN)
A.
will likely be larger than the sustainable growth rate implies.
B.
will likely be smaller than the sustainable growth rate implies
C.
will likely be the same as the sustainable growth rate implies.
D.
cannot be determined from this information.
KC: Multiple Choice
26. ___ is a budget that is continually updated by periodically adding a new
incremental time period and dropping the period just completed.
A.
Rolling Budget
B.
Continuous Budget
C.
Revolving Budget
D.
All of the above
KC: Problems
27. Milestone Inc’s sales budget is shown below:
May
June
July
August
55,000
80,000
67,000
42,000
All of Milestone’s sales are credit sales. The company collects 60% of its
sales in the next month and the remainder in the month after that.
a. Compute for Milestone’s cash collection in July
b. What is the balance Milestone’s receivables account at the end of July?
c. What is Milestone’s cash collection in August?
d. What is the balance Milestone’s receivables account at the end of
August?
e. Due to a change in economic conditions Milestone will only be able to
collect 40% of its July sales in August. As a result of this, cash receipts
in August will decline by____.
KC: Problems
28. Big Deal, Inc. wants to grow 30% next year. If it maintains its 40%
dividend payout ratio, liabilities to equity ratio of 1, and total asset
turnover of 2, what must its profit margin be to achieve this growth?
29. Consider the following information for Smart Products: total
assets=P1000; sales=P1540; net profit margin=12%; dividend payout
ratio=40%; accounts payable=P308. If sales are forecast to increase
30%, what is the estimated of external funds needed (EFN)?
KC: Problems
30. As of December 31, Budget, Inc. had a cash balance of 45,000.
December sales were 170,000 and are expected to be 90,000 in
January. 20% of sales in any month are cash sales, and 80% of sales
are collected during the following month. In January, Budget is
expected to have total cash disbursements of P120,000, and Budget
requires a minimum cash balance of P50,000.
a. Budget’s expected cash receipts for January are:
b. How much is Budget’s excess cash or new financing needed at the
end of January?
KC: Problems
31. Daisy’s Dairy reported sales of P1.5 million in 2018 and P2.25
million in 2019. Their EBIT in 2018 was P550,000 and in 2019
the EBIT rose to P925,000. What is the company’s operating
leverage?
32. Last year Hamper-Chief Inc. fixed asset turnover was 2.5 and it had
P33.2 million of fixed assets that were used at only 80% of capacity.
What is the maximum sales growth rate the company could achieve
before it had to increase its fixed assets?