Chapter 4 Financial Planning

Business Plan

A business plan is a model of what management expects a business to become in the futureFinancial statements are pro formaGood business plans are comprehensive

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Component Parts of a Business Plan

Typical outline– Contents– Executive summary– Mission and strategy statement– Market analysis– Operations (of the business)– Management and staffing– Financial projections– Contingencies

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The Purpose of Planning and Plan Information

Major audiences of business plan– Firm’s own management

Planning process helps pull management team togetherProvides a road map for running the businessProvides a statement of goalsHelps predict financing needs

– Outside investorsTells equity investors what returns can be expectedTells debt investors how firm will repay loans

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The Purpose of Planning and Plan Information

Planning processRoadmap for running the businessStatement of goalsPredicting financing needsInvestor communication

Figure 4-1 Using a Plan to Guide Business Performance

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Credibility and Supporting Detail

Shows enough supporting detail to indicate it is the product of careful thinkingDisplays summarized financial projections

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Four Kinds of Business Plan

Kinds of planning– Strategic Planning– Operational Planning– Budgeting– Forecasting

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Four Kinds of Business Plan

Strategic Planning– Addresses broad, long-term issues,

contains summarized, approximate financial projections

Five-year horizon is commonConcepts expressed mainly in words, not numbersFirm analyzes itself, the industry and the competitive situation

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Four Kinds of Business Plan

Operational Planning– Translates business ideas (day-to-day

operations) into concrete, short-term projections

– Usually one year or less– Specifies how much the firm will sell, to

whom, and at what prices

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Four Kinds of Business Plan

Budgeting– Short-term updates of the annual plan

Usually Covers a three month quarterAttempts a precise estimate of company expensesMostly financial detail with a few words

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Four Kinds of Business Plan

Forecasting– Very short-term projections of profit and

cash flow Where will the business’s financial momentum carry it in the next few weeks

– Consists almost entirely of numbers– Cash forecasts are projections of short-

term cash needsMost large firms do monthly cash forecasts

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Four Kinds of Business Plan

The Business Planning Spectrum– Broad, long-term planning on one end and

numerical short-term forecasting on otherRelating Planning Processes of Small and Large Businesses– Small businesses tend to develop a single

business plan containing both strategic and operating elements

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Figure 4-2 The Business Planning Spectrum

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Figure 4-3 Relating Business Planning in Large and Small Firms

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Financial Plan as a Component of a Business Plan

Financial plan is the financial portion of the business plan– A set of pro forma financial statements

projected over a time period– Financials are only pieces of the

projection

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Planning for New and Existing Businesses

Hard to forecast a new operation– No history on which to base projections

The typical planning task– In ongoing businesses, based on

planning assumptions such asUnit sales will increase by 10% Overall labor costs will rise by 4%, etc.

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Figure 4-4 The Planning Task

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Planning Assumptions

Planning Assumptions: expected physical or economic condition that dictates the size of one or more financial statement items

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Concept Connection Example 4-1 Planning Assumptions

This year Crumb Baking Corp. sold 1 million coffee cakes per month at $1 each for a total of $12 million. Year-end receivables equal to two months of sales or $2 million.

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Concept Connection Example 4-1 Planning Assumptions

Crumb’s operating assumptions for sales and receivables are:1. Price will be decreased by 10%.2. As a result unit sales volume will increase

to 15 million coffee cakes.3. Collection efforts increased - only one

month of sales in receivables at year end.

Forecast next year’s revenue and ending receivables balance.

Concept Connection Example 4-1 Planning Assumptions

Three interrelated planning assumptions– a management action with respect to pricing, – the expected customer response to that action – 15 million coffee cakes will be sold at $.90– Rev = 15,000,000 x $.90 = $13,500,000

Collection activities will be more effective– one months of revenue in accounts receivable

at year end.

A/R = $13,500,000/12 = $1,125,000

The General Approach, Assumptions, and the Debt/Interest Problem

The Procedural Approach– Financial plans are built line-by-line

beginning with revenues

Debt/Interest Planning Problem– The next items needed are interest expense

and debt – Planned debt is required to forecast interest,

but interest is required to forecast debt

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An Iterative Numerical Approach

– Interest: Guess a value of interest expense– Net Income: Complete the income statement– Ending equity: Calculate as beginning equity plus net

income– Ending debt: Calculate as total L&E (= total assets)

less current liabilities less ending equity– Interest: Average beginning and ending debt then

calculate interest expense on that value– Test the results: Compare calculated interest to the

original guess

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Solves the debt/interest problem

Figure 4-5 The Debt/Interest Planning Problem

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Plans with Simple Assumptions

The Quick Estimate Based on Sales GrowthThe percentage of sales method assumes all financial statement line items vary directly with sales revenue

This is an unrealistic assumptionManagement virtually always has more insight

– The modified percentage of sales method assumes most but not all line items vary with sales

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Example 4.3 Plans with Simple Assumptions

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Q: The Underhill Manufacturing Company expects next year’s revenues to increase by 15% over this year’s. The firm has some excess factory capacity, so no new fixed assets beyond normal replacements will be needed to support the growth. This year’s income statement and ending balance sheet are estimated as follows:

Example 4.3 Plans with Simple Assumptions

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Assume the firm pays state and federal income taxes at a combined flat rate of 42%, borrows at 12% interest, and expects to pay no dividends. Project next year’s income statement and balance sheet by using the modified percentage of sales method.

A: We’ll increase everything except net fixed assets by 15%.

All highlighted items were

increased by 15%.

At this point we are at the debt/interest impasse. We’ll guess at interest (using last year’s interest of $150,000

as a starting point) and work through the

procedure.

Example 4.3 Plans with Simple Assumptions

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Taking the average debt at 12% yields a calculated interest of $86,000 which is considerably less than the $150,000 assumed. Two additional iterations yield the following result.

Net Income was computed using an

Interest of $150,000. The resulting Net

Income was added to Equity and the Debt

figure was a plug, calculated by

subtracting Equity and Current Liabilities from

Total L&E.

Example 4.3 Plans with Simple Assumptions

Forecasting Cash Needs

Forecasting Cash Needs– A key reason for financial projections is

to forecast the firm’s external financing needs

– When a plan shows increasing debt, additional external financing will be needed

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The Percentage of Sales MethodA Formula Approach

Purpose – to estimate external financing requirements approximately and quickly

growth in assets

-growth in current liabilities

-earnings retained _________________________________________________________________

=external funding requirements

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The Percentage of Sales MethodA Formula Approach

If the firm’s growth rate in sales is g, it can be shown (see text) that external funds required (EFR) in the planned (next) year will be

EFR = g(assetsthis year) - (g current liabilitiesthis year) - [(1 – d) ROS][(1+g)salesthis year]

Where d=dividend payout ratio

EFR = Growth in assets – growth in current liabilities

– planned year’s retained earnings

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Concept Connection Example 4-4

Concept Connection Example 4-4

The Sustainable Growth Rate

Assumes the debt/equity ratio is constant– Equity growth occurs via retained

earnings – New debt will need to be raised to

keep the debt/equity ratio constant

Gives an indication of the determinants of a firm’s inherent growth capability

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The Sustainable Growth Rate

Business operations create new equity equal to the amount of current retained earnings,

or (1 – d)Net Income

Implies sustainable growth rate in equity, gs gs = Net Income(1 – d) / equity

Because ROE = Net Income/equity gs = ROE(1 – d)

The Sustainable Growth Rate

Incorporating equations from the DuPont equations into the gs equation we obtain

sEAT sales assetsg 1 dsales assets equity

gs = (1-d)ROS x Total Asset Turnover x Equity Multiplier Firm’s ability to grow depends on 4 abilities:Ability to earn profits on sales (ROS)Use of assets to generate sales (T/A Turnover) Use of borrowed money - leverage (equity multiplier)Percentage of earnings retained (1 – d)

Concept Connection Example 4-5 Sustainable Growth Rate

After several years of lower-than-average growth, Slowly, Inc. compared its sustainable growth rate with an industry average:

Notice that Slowly’s sustainable growth rate is much lower than the average. Why?

Plans With More Complicated Assumptions

The percentage of sales method – Appropriate for quick estimates – Rarely used in formal plans due to lack of

detailReal plans generally incorporate complex assumptions about important financial items– Specific accounts can be forecast

separately

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More Complicated PlansIndirect Planning Assumptions

Financial planning assumptions can be made:– directly about the financial items– indirectly about a derivative of the item

Indirect planning assumptions are usually based on financial ratios– Receivables are usually managed through the

Average Collection Period (ACP)

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Concept Connection Example 4-8 Complex Plans

The Macadam Co. is developing its annual plan for next year. It expects to finish this year with the following financial results:

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Concept Connection Example 4-8 Complex Plans

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Concept Connection Example 4-8 Complex Plans

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Concept Connection Example 4-8 Complex Plans

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Concept Connection Example 4-8 Complex Plans

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Concept Connection Example 4-8 Complex Plans

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Figure 4-6 Supporting Detail for Annual Planning at the Department Level

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The Cash Budget

The cash budget is a detailed projection of receipts and disbursements of cash– A fundamentally different approach than

projecting financial statementsIn large part based on time lags between events and receipt or disbursement of related cash

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Receivables and Payables—Forecasting with Time Lags

Forecasting receivables collection is difficult because a company never knows when customers will pay their bills

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Debt and Interest

Forecasting short-term debt and interest is difficult if current cash needs are funded directly by borrowing– The current month’s interest payment is

based on the preceding month’s loan balanceOther Items– Forecasting most other items is

relatively straightforward

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Concept Connection Example 4-9 Cash Budgeting

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Concept Connection Example 4-9 Cash Budgeting

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Concept Connection Example 4-9 Cash Budgeting

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Concept Connection Example 4-9 Cash Budgeting

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Management Issues in Financial Planning

The Financial Plan as a Set of Goals– The financial plan can be a tool to

manage the company and motivate performance

– Problems arise when top management puts in stretch goals

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Inherent Conflicts

Stretch planning and aggressive optimism can lead to unrealistic plans with little chance of coming true

Top-down plans forced on the organization by management are often unrealistically optimistic

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Risk in Financial Planning in General

Top-down plans forced on the organization by management are often unrealistically optimisticUnder forecastingBottom-up Planning

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Risk in Financial Planning in General

Scenario Analysis—“What If”ing– Different scenarios — “what if”– Gives planners a feel for the impact of

assumptions not coming true

Communication– A single plan tends to be published

along with its attendant risks

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Financial Planning and Computers

Computers make planning quicker but don’t improve the judgments that are the heart of good planningRepetitive CalculationsChanging Assumptions

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