Chapter 18 Financial
Planning
Topics Covered
What is Financial Planning?
n Financial Planning Models
n Planners Beware
n External Financing and Growth
n
Objectives
n
Forecast Financial Statements with the
Percentage of Sales Approach
n With
a simple (strict) model
a better model to determine External Financing
Needed.
n With
Discuss Limitations of Percentage of Sales
Approach.
n Determine Internal and Sustainable Growth
Rate.
n
1
Financial Planning
The Financial Planning Process
n Analyzing
the investment and financing choices
open to the firm.
n Projecting the future consequences of current
decisions.
n Deciding which alternatives to undertake.
n Measuring subsequent performance against the goals
set forth in the financial plan.
Financial Planning
Planning Horizon - Time horizon for a financial plan.
Departments are often asked to submit 3 alternatives
n
n
n
n
Optimistic case = best case
Expected case = normal growth
Pessimistic case = retrenchment
Financial plans help managers ensure that their financial
strategies are consistent with their capital budgets. They
highlight the financial decisions necessary to support the
firm’s production and investment goals.
Financial Planning
Why Build Financial Plans?
n Contingency planning
n Considering options
n Forcing consistency
2
Financial Planning Models
Inputs
Planning Model
Outputs
Inputs - Current financial statements. Forecasts of key
variables (such as sales or interest rates).
Planning Model - Equations specifying key
relationships.
Outputs - Projected financial statements (pro forma).
Financial ratios. Sources and uses of funds.
Financial Planning Models
Pro Formas - Projected or forecasted financial
statements.
Percentage of Sales Model - Planning model in which
sales forecasts are the driving variable and most other
variables are proportional to sales.
Balancing Item - Variable that adjusts to maintain the
consistency of a financial plan. Also called plug.
Example of Simple Percentage of
Sales Model: Indigo Inc.
n
Here are abbreviated financial statements for Indigo
Inc.
2003 Income Statement
Sales
$5,000
Costs
$4,000
Net Income
$1,000
n
2003 Balance Sheet
Assets
$4,000
Debt
$1,000
Equity $3,000
Total
$4,000
Total
$4,000
If sales increase by 30% in 2004 and the company uses
a strict (simple) %age of sales model where all income
statement and balance sheet items increase by the same
rate as sales, what must be the “plug”? What will be its
value?
3
Example: Indigo Inc. projections
2004 Income Statement
Sales 5000(1.3) = 6,500
Cost 4000(1.3) = 5,200
Net Income
1,300
2004 Balance Sheet
Assets4000(1.3) = 5,200
Debt 1000(1.3) = 1,300
Equity 3000(1.3) = 3,900
Total
5,200
Increase in Equity is 900, which is less than projected income of
1,300 meaning the equity increase can be funded through retained
earnings.
•This means Indigo Inc. can pay out $400 in dividends (1300-900).
What if Indigo Inc. wants to payout
50% of net income as dividends?
2004
IncomeStatement
Statement
2004
Income
Sales5000(1.3)
5000(1.3)
6,500
Sales
= =6,500
Cost4000(1.3)
4000(1.3)
5,200
Cost
= =5,200
Income 1,300
NetNet
Income
1,300
Dividends(50%)
650
Retained Earnings 650
2004 Balance Sheet
Assets 4000(1.3) = 5,200
Debt 1000(1.3) =
Equity 3000(1.3) =
Total
1,300 or 1550
3,900 or 3650
5,200
Now, Indigo has to issue $250 (900-650) of new stock (2004 equity =
3,900) to maintain their original 2003 financing mix OR issue an
additional $250 in new debt (2004 debt = 1,550) which would increase
their debt-equity ratio.
An Improved Financial Forecasting
Model
1) Project sales revenues and expenses.
2) Estimate current assets and fixed assets
necessary to support projected sales.
n Percent
rate.
of sales forecast: increase at sales growth
3) Estimate potential internal financing: noninterest bearing current liabilities and retained
earnings
4) Difference between 2 and 3 is required external
financing needed.
4
Our Example: Zippy Disks
Suppose this year’s sales will total $20 million.
n Next year, we forecast sales of $25 million, an
increase of 25%
n Net income should be 10% of sales.
n Dividends should be 40% of earnings.
n Our task: forecast balance sheet and determine
external financing needed (debt and/or stock).
n
Zippy Disks Current Balance Sheet
Assets
Current Assets
$6m
Fixed Assets
$10m
Total Assets
$16m
Liab. and Equity
Accounts Payable
$4m
Current Liabilities
$4m
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$4m
$8m
$3m
$5m
$8m
$16m
Zippy’s projected Net Income and
Dividends
Next year, we forecast sales of $25 million, an
increase of 25%
n Net income should be 10% of sales.
n Dividends should be 40% of earnings.
n Projected Net Income = $25m x 10% = $2.5m
n Projected Dividends = $2.5m x 40% = $1.0m
n Projected additional retained earnings = Net
Income – Dividends = $2.5m - $1.0m = $1.5m
n
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Assets
Current Assets
Fixed Assets
Total Assets
Liab. and Equity
Accounts Payable
Current Liabilities
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
This year
Next year
$6m x 1.25=
$10m x 1.25=
$16m x 1.25=
$7.5m
$12.5m
$20.0m
$4m x 1.25=
$4m x 1.25=
$5.0m
$5.0m
$4m same
$8m
$3m same
$5m + 1.5m=
$8m
$16m
$4.0m
$9.0m
$3.0m
$6.5m
$9.5m
$18.5m
Oh, no! Here come the
Accounting Police!
n
n
n
n
n
n
n
Projected Assets
$20.0m
Projected Liabilities & Equity
$18.5m
External Financing Needed
$1.5m
Zippy must decide how to raise this financing.
Options: short and/or long term borrowing, sell new
common stock, cut dividends.
Let’s assume Zippy will borrow all financing needed
through Long Term Debt.
Here’s Zippy’s complete projected balance sheet.
Assets
Current Assets Whew! Now,
Fixed Assets the Accy Police
Total Assets will be happy!
Liab. and Equity
Accounts Payable
Current Liabilities
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
This year
Next year
$6m x 1.25=
$10m x 1.25=
$16m x 1.25=
$7.5m
$12.5m
$20.0m
$4m x 1.25=
$4m x 1.25=
$5.0m
$5.0m
$4m + 1.5m
$8m
$3m same
$5m + 1.5m=
$8m
$16m
$5.5m
$10.5m
$3.0m
$6.5m
$9.5m
$20.0m
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Zippy’s Forecast Post-mortem
n
n
n
n
n
n
Original total assets = $16m, original total debt = $8m
Original total debt ratio: 50%
Projected total assets = $20m, projected total debt =
$10.5m.
Projected total debt ratio = 52.5%
Raising the 1.5m external financing needed through
debt would increase Zippy’s debt ratio.
If Zippy wanted to maintain their original 50% debt
ratio, total debt could only be $10m. The other $0.5 of
needed financing would come from equity: selling new
stock or paying less dividends.
Predicting External Financing
Needs: A Formula Approach
n
n
The required external financing (EFN) formula approach gives
the same result as our first approach, but focuses on the
projected changes in the balance sheet.
EFN = Proj. Inc. in Net Assets –Proj Retained Earnings
n
n
n
n
n
Proj. Inc in Net Assets = Assets-Current Liab./Sales x Chg in sales or
Net Assets x growth rate in Sales
Proj. RE = NPM x Proj Sales x (1 – d), where d is dividend payout ratio
= Divs/Net Income
Zippy’s Original Net Assets = 16m-4m = 12m, g in sales = 25%,
proj sales = 25m, NPM = 10%, d = 40% or 0.4
Proj RE = 25m(10%)(1-.4) = 1.5m
EFN = 12m(.25) – 1.5m = 3m – 1.5m = $1.5m
EFN dynamics
Higher sales growth means more required
external financing.
n Higher dividend payout means more required
external financing.
n Higher net profit margin means less required
external financing.
n
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Planners Beware
Many models ignore realities such as
depreciation, taxes, etc.
n Percent of sales methods are not realistic
because fixed costs exist.
n Most models generate accounting numbers not
financial cash flows
n Adjustments must be made to consider these
and other factors.
n
The effects of other factors on the
forecast of EFN.
n
n
n
Excess capacity:
n Existence lowers EFN.
Base stocks of assets:
n Leads to less-than-proportional asset increases, less
EFN.
Lumpy assets:
n Leads to large periodic EFN requirements, recurring
excess capacity.
External Financing & Growth
n
Internal growth rate = maximum sales growth
without any additional external financing.
retained earnings
assets
retained earnings net income equity
=
x
x
net income
equity
assets
Internal growth rate =
Need assets net of non-interest bearing current
liabilities.
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Sustainable Rate of Growth
The maximum sales growth rate a firm can have
while maintaining its capital structure (financing
mix).
Sustainable growth rate = plowback ratio X ROE
n ROE = return on equity = net income/equity
n
n
Let’s return to Zippy’s original info.
Zippy Disks Current Balance Sheet
Assets
Current Assets
$6m
Fixed Assets
$10m
Total Assets
$16m
Liab. and Equity
Accounts Payable
$4m
Current Liabilities
$4m
Long Term Debt
Total Liabilities
Common Stock
Retained Earnings
Equity
Total Liab. & Equity
$4m
$8m
$3m
$5m
$8m
$16m
Original
sales = $20m
Net Profit
Margin = 10%
Dividend
payout = 40%
Plowback = 60%
Sustainable Growth rate for
Zippy.
n
n
n
n
n
n
Current Net income is 10% of $20m or $2m.
Current Equity = $8m, net assets = 16m – 4m = 12m
Dividend payout ratio = 40% or 0.4, Plowback = 60% or
0.6
Internal g = retained earnings/net assets = 2m(.6)/12m =
10%
Sustainable g = 2m/8m x (1 -.4) = 25% x .6 = 15%
Our forecast for Zippy: 25% growth in sales (20m to 25m).
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