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1© 2008 Thomson South-Western

Chapter 4

Financial Planning

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Component Parts of a Component Parts of a Business PlanBusiness Plan

Typical outline○ Contents○ Executive summary○ Mission and strategy statement

• Basic charter and establishes long-term direction

○ Market analysis• Why the business will succeed against its competitors

○ Operations (of the business)• How the firm creates and distributes its product/service

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Component Parts of a Component Parts of a Business PlanBusiness Plan

Typical outline - continued○ Management and staffing

• Firm’s projected personnel needs

○ Financial projections• Projects the firm’s financial statements into the

future

○ Contingencies• What the firm will do if things don’t go as

planned

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The Purpose of Planning and The Purpose of Planning and Plan InformationPlan Information

Major audience of business plan include○ Firm’s own management

• Planning process helps pull management team together

• Provides a road map for running the business• Provides a statement of goals• Helps predict financing needs

○ Outside investors• Tells equity investors what returns can be

expected• Tells debt investors how firm will repay loans

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Four Kinds of Business PlanFour Kinds of Business Plan

Kinds of planning1. Strategic Planning

2. Operational Planning

3. Budgeting

4. Forecasting

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Strategic Planning○ Addresses broad, long-term issues,

contains summarized, approximate financial projections

• Five-year horizon is common• Concepts expressed mainly in words, not

numbers• Firm analyzes itself, the industry and the

competitive situation

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

operations) into concrete, short-term projections

○ Specifies how much the firm will sell, to whom, and at what prices

○ An equal mix of words and numbers

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Budgeting○ Short-term updates of the annual plan

• Usually Covers a calendar quarter • Used in industries in which business

conditions change rapidly

○ Mostly financial detail with a few words

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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 needs

• Most large firms do monthly cash forecasts

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Financial Plan as a Component Financial Plan as a Component of a Business Planof a Business Plan

Financial plan is the financial portion of the business plan○ It is a set of pro forma financial

statements projected over the time period covered by the business plan

○ Financial statements are a piece of the projection, not the center of the projection

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Planning for New and Existing Planning for New and Existing BusinessesBusinesses

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

The Typical Planning Task○ Most financial planning involves forecasting

changes in ongoing businesses based on planning assumptions

○ Projected statements reflect assumptions such as:

• Unit sales will increase by 10% • Overall labor costs will rise by 4%, etc.

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The Planning TaskThe Planning Task What we have and what we need to project Figure 4.4

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Planning AssumptionsPlanning AssumptionsExample 4.1

Q: This year Crumb Baking Corp. sold 1 million coffee cakes per month to grocery distributors at $1 each for a total of $12 million. The firm had year-end receivables equal to two months of sales, or $2 million. Crumb’s operating assumptions with respect to sales and receivables for next year are:

1. Price will be decreased by 10% in order to sell more product.2. As a result of the price decrease, unit sales volume will

increase to 15 million coffee cakes.3. Collection efforts will be increased so that only one month of

sales will be in receivables at year end.

Forecast next year’s revenue and ending receivables balance on the basis of these assumptions. Assume sales are evenly distributed over the year.

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Planning AssumptionsPlanning AssumptionsExample 4.1

A: There are three inter-related planning assumptions: (1) a management action regarding pricing; (2) the expected customer response to the price change; and (3) and change in collection efforts.

The first two assumptions establish the revenue forecast. Next year, the firm expects to sell 15 million coffee cakes at $0.90 each,

revenue = 15,000,000 x $.90 = $13,500,000.

The third assumption regarding receivables requires the use of the total revenue forecast. Receivables are expected to decrease from two months of revenue to only one month; thus receivables are expected to be $13,500,000 12 = $1,125,000.

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Plans with Simple Plans with Simple AssumptionsAssumptions

The Quick Estimate Based on Sales Growth

○ The percentage of sales method assumes all financial statement line items vary directly with sales revenue

• This is an unrealistic assumption• Management 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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Plans with Simple Plans with Simple AssumptionsAssumptions

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

• Can be obtained by issuing new stock or borrowing

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The Percentage of Sales Method—The Percentage of Sales Method—A Formula ApproachA Formula Approach

Assuming net fixed assets as well as other assets and liabilities vary with sales, the percentage of sales method can be condensed into a single formula○ Purpose – to estimate external financing

requirements approximately and quickly

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The Percentage of Sales Method—The Percentage of Sales Method—A Formula ApproachA 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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The Percentage of Sales Method—The Percentage of Sales Method—A Formula ApproachA Formula Approach Example 4.4

Q: Forecast the external financing requirements of the Underhill Manufacturing Company assuming net fixed assets and EAT grow at the same rate as sales. However, also assume the firm plans to pay a dividend equal to 25% of earnings next year.

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The items needed to apply the EFR

equation are highlighted. We

also need the ROS figure of 11% (EAT sales, or $1,488

$13,580) and the expected dividend

payout ratio of 25%. Revenues are

expected to increase by 15%.

Revenue 13,580$ ASSETSCOGS 7,470$ Cash 348$ Gross Margin 6,110$ Accounts receivable 1,698$ Expense 3,395$ Inventory 1,494$ EBIT 2,715$ Current assets 3,540$ Interest 150$ Net fixed assets 2,460$ EBT 2,565$ Total Assets 6,000$ Tax 1,077$ LIABILITIESEAT 1,488$ Accounts payable 125$

Accruals 45$ Current Liabilities 170$ Debt 1,330$ Equity 4,500$ Total L&E 6,000$

Income StatementUnderhill Manufacturing Company This Year ($000)

Balance Sheet

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The Percentage of Sales Method—The Percentage of Sales Method—A Formula ApproachA Formula Approach Example 4.4

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EFR = g(assetsthis year) - (g current liabilitiesthis year)

- [(1-d)ROS][(1+g)salesthis year]

EFR = .15($6,000) - .15($170) - [(1-.25)(.11)(1.15)($13,580)]

EFR = - $413.9A negative result implies the firm will generate cash

Note that the EFR technique is of limited value because it forces the unrealistic assumption that all

financial statement items vary exactly with sales

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The Sustainable Growth RateThe Sustainable Growth Rate

A theoretical measure of a firm’s strength

A firm can grow at its sustainable growth rate without selling new stock if its financial ratios remain constant

Business operations create new equity equal to the amount of current retained earnings, or (1 – d)EAT

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

Since ROE = EAT / equity

gs = ROE(1 – d)

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

s

EAT sales assetsg 1 d

sales 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 mult) Percentage of earnings retained (1 – d)

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More Complicated PlansMore Complicated PlansIndirect Planning AssumptionsIndirect 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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Forecasting Accounts Receivable

Example 4.6

Q: Mylar’s ACP is 60 days and management wants to forecast an improvement to 40 days. What is the ending A/R balance if revenue is forecast at $7.2 million?

A: A/R

ACP = x 360

Sales

A/R

40 days = x 360

$7,900,000

A/R = $877,777

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An average balance would generally be used. See footnote in text.

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Management Issues in Management Issues in Financial PlanningFinancial 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• A target for which the organization strives, but is unlikely

to fully achieve• Want employees to stretch toward max performance• But people will give up if the goal seems impossible

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Risk in Financial Planning Risk in Financial Planning in Generalin General

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○ The risk in financial planning is that the plan

overstates achievable performance

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Underforecasting—The Other Extreme○ Sets a goal that is easy to meet, ensures success

• Doesn’t motivate best possible performance

○ Bottom-up plans are consolidated from lower management’s inputs and tend to understate what the firm can do

The Ideal Process○ A combination of the top-down and bottom-up

approaches to planning○ End result is a realistic, achievable compromise

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Scenario Analysis—”What If”ing○ Many companies produce plans

reflecting different scenarios — “what if”○ Gives planners a feel for the impact of

assumptions not coming true

Communication○ A business unit is expected to have confidence in

its plan○ A single plan tends to be published along with its

attendant risks

slide 1

Business

business plan financial

financial planning

planning assumptions

sales revenue

purpose of planning

annual plan

month of sales

months of sales