Long-term Financial
Planning
What is Financial Planning?
• Formulates the way financial goals are to be
achieved.
• Requires that decisions be made about an
uncertain future.
• Recall that the goal of the firm is to maximise the
market value of the owner’s equity—growth will
result from this goal being achieved.
Dimensions of Financial Planning
• The planning horizon is the long-range period
that the process focuses on (usually two to five
years).
• Aggregation is the process by which the smaller
investment proposals of each of a firm’s
operational units are added up and treated as one
big project.
• Financial planning usually requires three
alternative plans: a worst case, a normal case and
a best case.
Accomplishments of Planning
•
Interactions—linkages between investment proposals and
financing choices.
•
Options—firm can develop, analyze and compare different
scenarios.
•
Avoiding surprises—development of contingency plans.
Prediction is very difficult, particularly when it concerns the future (M. Twain)
•
Feasibility and internal consistency—develops a structure for
reconciling different objectives.
Elements of a Financial Plan
•
An externally supplied sales forecast (either an explicit sales
figure or growth rate in sales).
•
Projected financial statements (pro-formas).
•
Projected capital spending.
•
Necessary financing arrangements.
•
Amount of new financing required (‘plug’ figure).
•
Assumptions about the economic environment.
Example—A Simple Financial
Planning Model
Recent Financial Statements
Financial performance
Sales
$100
Costs
90
Net Income
$ 10
Assets
Total
Financial position
$50
Debt
$20
Equity
30
$50
Total
$50
Assume that:
1. Sales are projected to rise by 25 per cent
2. The debt/equity ratio stays at 2/3
3. Costs and assets grow at the same rate as sales
Example—A Simple Financial
Planning Model
Pro-Forma Financial Statements
Financial performance
Sales
$ 125
Costs
112.5
Net
$ 12.5
Assets
Total
Financial position
$ 62.5
Debt
$25
Equity 37.5
$ 62.5
Total $ 62.5
What is the plug?
Notice that projected net income is $12.50, but equity only
increases by $7.50. The difference, $5.00 paid out in cash
dividends, is the plug.
Percentage of Sales Approach
•
A financial planning method in which accounts are varied
depending on a firm’s predicted sales level.
•
Dividend payout ratio is the amount of cash paid out to
shareholders.
•
Retention ratio is the amount of cash retained within the firm
and not paid out as a dividend.
•
Capital intensity ratio is the amount of assets needed to
generate $1 in sales. i.e. Total Asset / Sales
Example—Financial Performance
Statement
Sales
Costs
Taxable Income
Tax (30%)
Net profit
Retained earnings
Dividends
$1000
800
200
60
$ 140
$112
$28
Example—Pro-Forma Financial
Performance Statement
Sales (projected)
Costs (80% of sales)
Taxable Income
Tax (30%)
Net profit
$1 250
1 000
250
75
$ 175
Example—Steps
• Use the original financial position statement to
create a pro-forma; some items will vary directly
with sales.
• Calculate the projected addition to retained
earnings and the projected dividends paid to
shareholders.
• Calculate the capital intensity ratio.
Example—Financial Position
Statement
Assets
Current assets
Cash
Accounts receivable
Inventory
Total
($)
160
440
600
1 200
(% of sales)
16
44
60
120
Non-current assets
Net plant and equipment
Total assets
1 800
3 000
180
300
Example—Financial Position
Statement
Liabilities and owners’ equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Shareholders’ equity
Issued capital
Retained earnings
Total
Total liabilities & s’holders’ equity
($)
300
100
400
800
800
1 000
1 800
3 000
(% of sales)
30
n/a
n/a
n/a
n/a
n/a
n/a
n/a
Example—Partial Pro-Forma
Financial Position Statement
Assets
Current assets
($)
Change
Cash
Accounts receivable
Inventory
Total
200
550
750
1 500
$ 40
110
150
$300
Non-current assets
Net plant and equipment
Total assets
2 250
3 750
$450
$750
Example—Partial Pro-Forma
Financial Position Statement
Liabilities and owners’ equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Shareholders’ equity
Issued capital
Retained earnings
Total
Total liabilities & s’holders’ equity
External financing needed
($)
375
100
475
800
Change
$ 75
0
$ 75
0
800
1 140
1 940
3 215
535
0
$140
$140
$215
$535
Example—Results of Model
• The good news is that sales are projected to
increase by 25 per cent.
• The bad news is that $535 of new financing is
required.
• This can be achieved via short-term borrowing,
long-term borrowing and new equity issues.
• The planning process points out problems and
potential conflicts.
Example—Results of Model
(continued)
• Assume that $225 is borrowed via notes payable
and $310 is borrowed via long-term debt.
• ‘Plug’ figure now distributed and recorded within
the financial position statement.
• A new (complete) pro-forma financial position
statement can be derived.
Example—Pro-Forma Financial
Position Statement
Assets
Current assets
($)
Change
Cash
Accounts receivable
Inventory
Total
200
550
750
1 500
$ 40
110
150
$300
Non-current assets
Net plant and equipment
Total assets
2 250
3 750
$450
$750
Example—Pro-Forma Financial
Position Statement
Liabilities and owners’ equity
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
($)
375
325
700
1 110
Change
$ 75
$225
$300
$310
Shareholders’ equity
Issued capital
Retained earnings
Total
Total liabilities & s’holders’ equity
800
1 140
1 940
3 750
0
$140
$140
$750
External Financing and Growth
• The higher the rate of growth in sales/assets, the
greater the external financing needed (EFN).
• Need to establish a relationship between EFN and
growth (g).
Example—Statement of Financial
Performance
Sales
Costs
Taxable Income
Tax (30%)
Net profit
$ 500
400
$ 100
30
$ 70
Retained earnings
Dividends
$
$
25
45
Example—Statement of Financial
Position
($)
Assets
(% of
sales)
($)
(% of
sales)
450
n/a
550
n/a
1000
n/a
Liabilities
Current assets
400
Non-current
assets
600
Total assets
1000
80 Total debt
120 Owners’ equity
200 Total
Ratios Calculated
p (profit margin)
=
14%
R (retention ratio)
=
36%
ROA (return on assets)
=
7%
ROE (return on equity)
=
12.7%
D/E (debt/equity ratio)
=
0.818
Growth
• Next year’s sales forecasted to be $600.
• Percentage increase in sales:
$100

 20%
$500
• Percentage increase in assets also 20 per cent.
Increase in Assets
• What level of asset investment is needed to
support a given level of sales growth?
• For simplicity, assume that the firm is at full
capacity.
• The indicated increase in assets required equals:
A×g
where A = ending total assets from the previous period
• How will the increase in assets be financed?
Internal Financing
•
•
•
Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
This addition to retained earnings represents the level of
internal financing the firm is expected to generate over the
coming period.
The expected addition to retained earnings is:
 pS R  1  g 
where:
S = previous period’s sales
g = projected increase in sales
p = profit margin
R = retention ratio
External Financing Needed
• If the required increase in assets exceeds the
internal funding available (that is, the increase in
retained earnings), then the difference is the
external financing needed (EFN).
EFN
=
=
Increase in Total Assets –
Addition to Retained Earnings
A(g) – p(S)R × (1 + g)
Example—External Financing Needed
= $1000 × 20%
= $200
Addition to retained earnings = 0.14($500)(36%) × 1.20
= $30
Increase in total assets
• The firm needs an additional $200 in new financing.
• $30 can be raised internally.
• The remainder must be raised externally (external
financing needed).
Example—External Financing
Needed (continued)
EFN  Increase in total assets  Addition to RE
 A( g )  p( S ) R  (1  g )
 $1000 (0.20)  0.14($500)36% 1.20
 $170
Relationship
• To highlight the relationship between EFN and g:
EFN   pS R  A  pS R  g
  0.14$50036%   $1000  0.14$500(36%) g
  25  975  g
• Setting EFN to zero, g can be calculated to be 2.56
per cent.
• This means that the firm can grow at 2.56 per cent
with no external financing (debt or equity).
Financial Policy and Growth
• The example so far sees equity increase (via
retained earnings), debt remain constant and D/E
decline.
• If D/E declines, the firm has excess debt capacity.
• If the firm borrows up to its debt capacity, what
growth can be achieved?
Sustainable Growth Rate (SGR)
The sustainable growth rate is the growth rate a
firm can maintain given its debt capacity, ROE and
retention ratio.
SGR 
ROE  R 
1  ROE  R 
Example—Sustainable Growth Rate
• Continuing from the previous example:
(0.127  0.36)
SGR 
1  0.127 0.36
 4.82%
• The firm can increase sales and assets at a rate of
4.82 per cent per year without selling any
additional equity and without changing its debt ratio
or payout ratio.
Sustainable Growth Rate (SGR)
• Growth rate depends on four factors:
–
–
–
–
profitability (profit margin)
dividend policy (dividend payout)
financial policy (D/E ratio)
asset utilisation (total asset turnover)
• Do you see any relationship between the SGR and
the Du Pont identity?
Summary of Growth Rates
1. Internal growth rate
This growth rate is the maximum growth rate that
can be achieved with no external debt or equity
financing.
2. Sustainable growth rate
The SGR is the maximum growth rate that can be
achieved with no external equity financing while
borrowing to maintain a constant D/E ratio.
Important Questions
• It is important to remember that we are working
with accounting numbers and we should ask
ourselves some important questions as we go
through the planning process.
• How does our plan affect the timing and risk of our
cash flows?
• Does the plan point out inconsistencies in our
goals?
• If we follow this plan, will we maximise owners’
wealth?