Download 15 - Finance

Chapter 15
Financial Planning
© 2000 South-Western College Publishing
BUSINESS PLAN
A picture or model of what a business unit is expected to become.
Consists of Words and Numbers
Numbers Are Mostly Financial
COMPONENT PARTS OF A BUSINESS PLAN
A. Contents
B. Executive Summary
C. Mission and Strategy Statement
D. Market Analysis
E. Operations (of the business)
F. Management and Staffing
G. Financial Projections
H. Contingencies
TM 15-1
THE PURPOSE OF PLANNING AND
PLAN INFORMATION
Two major audiences: management and outside investors
THE MANAGERIAL VALUE OF PLANNING
The Planning Process
Creates a cohesive unit with common goals
Promotes an understanding of objectives and policies
Forces a thinking through of everything that has to be done
Makes people understand what they individually have to do
A Road Map for Running the Business
Comparing operating performance to plan
Investigate deviations
Propose Solutions
TM 15-2 Slide 1 of 2
Planned
Performance
Actual
Performance
Comparison
Same
Continue
as before
Deviation
Corrective
Action
Figure 15-1 Using a Plan to Guide Business Performance
A Statement of Goals and Targets
A measurement of success
A reward system - bonuses
Predicts Outside Financing Needs
TM 15-2 Slide 2 of 2
THE PLAN TO OUTSIDE INVESTORS
Communicates management's ideas about what the
company will be in the future
Tells: Equity investors their expected return
Debt investors the source of repayment
In small firms: Use the business plan document
In large firms: Information is conveyed to
securities analysts
TM 15-3 Slide 1 of 2
Business Planning in Divisions of Large Companies
Divisions produce their own plans which are consolidated
into a corporate plan
The planning and review process is a major vehicle for
communication between division and corporate managements
Success and failure at the division are defined
relative to the business plan
Credibility and Supporting Detail
A plan needs to contain enough detail to convince its audience
that it represents management's best thinking
TM 15-3 Slide 2 of 2
FOUR KINDS OF BUSINESS PLANNING
Strategic Planning
Budgeting
Operational Planning
Forecasting
...differ according to three attributes:
(1) Length of the planning horizon
(2) Kinds of issues addressed
(3) Level of detail projected
The Business Planning Spectrum
Strategic
Plan
Annual
Operating
Plan
Quarterly
Budgets
Short-Term
Forecasts
Long Term
General,
Conceptual
Short Term
Detailed,
Numerical
Figure 15-2 The Business Planning Spectrum
TM 15-4 Slide 1 of 2
BUSINESS PLANS FOR
SMALL BUSINESSES
The Business Planning Spectrum
Strategic
Plan
Annual
Operating
Plan
Quarterly
Budgets
Short-Term
Forecasts
The Small Business “BUSINESS PLAN”
Figure 15-3 Relating Business Planning in Large and Small Companies
TM 15-4 Slide 2 of 2
THE FINANCIAL PLAN
A firm's projected financial statements
Generally a part of a broader business plan
MAKING FINANCIAL PROJECTIONS
Translating physical and economic activity into dollars
Forecast sales first
Then forecast the support required by the implied activity
PLANNING FOR NEW AND EXISTING BUSINESSES
Harder to plan for a new or proposed business
No history - must make assumptions about everything
THE TYPICAL PLANNING TASK
Most financial planning is for existing businesses
Forecast changes to past history
The changes are planning assumptions
Anything about which an assumption isn't made is implicitly assumed to remain
unchanged. For a new business, everything has to be explicitly assumed.
TM 15-5
PLANNING ASSUMPTIONS
A physical or economic condition expected to exist
during the planning period
Can originate outside the company: interest rates, taxes
Can be internal: pricing, cost control
Can come from customer behavior: response to pricing
Each line on a projected set of financial statements is generally
forecast based on one or more assumptions
TM 15-6
THE PROCEDURAL APPROACH
Make a revenue projection
Then forecast the income statement and balance sheet line by line
until come to interest and debt
THE INTEREST/DEBT PLANNING PROBLEM
We need debt to forecast interest and interest to forecast debt.
EAT (less dividends) is added to Beginning Equity to arrive at
Ending Equity, which is required to compute Ending Debt.
Ending Debt is averaged with Beginning Debt and multiplied
by the interest rate to calculate Interest Expense.
TM 15-7 Slide 1 of 2
INSERT FIGURE
Figure 15-5 The Debt/Interest Planning Problem
TM 15-7 Slide 2 of 2
SOLUTION THROUGH AN ITERATIVE,
NUMERICAL APPROACH
1. Interest: Guess a value of interest expense.
2. EAT: Complete the income statement.
3. Ending Equity: Calculate ending equity as beginning equity plus EAT
(less dividends plus new stock to be sold if either exist).
4. Ending Debt: Calculate ending debt as total L&E (=Total Assets) less
current liabilities less ending equity.
5. Interest: Average beginning and ending debt. Calculate interest by
multiplying average debt by the interest rate.
6. Test Results: Compare the calculated interest from step 5 to the original
guess in step 1.
a. If the two are significantly different, return to step 1
replacing the guess at interest with the value just calculated and repeat
steps 2 through 6.
b. If the calculated value is close to the guess, stop.
TM 15-8
PLANS WITH SIMPLE ASSUMPTIONS
Quick Estimates Based on Sales Growth
Percentage of Sales Method
All line items grow by the same percentage as sales
(A very unrealistic assumption)
Modified Percentage of Sales Method
Most line items grow by the same percentage as sales
TM 15-11
ESTIMATING EXTERNAL FUNDING
REQUIREMENTS USING A FORMULA APPROACH
BASED ON THE PERCENTAGE OF SALES METHOD
Growth in Assets
- Growth in Current Liabilities
- Current earnings retained
= External Funding Requirement
EFR =
g(Assetsthis yr)
- g(Current Liabilitiesthis yr)
- [(1-d)ROS][(1+g)Salesthis yr]
The EFR gives a very rough estimate of external funding needs
TM 15-13
THE SUSTAINABLE GROWTH RATE
A theoretical measure of a business's strength
The rate at which the firm can grow without newly sold equity
if none of its financial ratios change
Equivalent to forecasting growth using the Unmodified
Percentage of Sales Method
Simply the Growth in Equity Created by Retained earnings
gs 
(1  d)EAT
 ROE(1  d)
Equiity
where d is the dividend payout ratio
TM 15-14 Slide 1 of 2
Using the Sustainable Growth Concept through
the extended Du Pont Equation:
ROE
g s  (1  d) 
EAT Sales Assets


Sales Assets Equity
A firm's ability to grow is dependent on
1. Earnings
2. Using assets to generate sales
3. Using leverage (borrowed money)
4. The percent of earnings retained
Use to analyze a firm's growth relative to others
gs =
(1-d)
Industry
13.5%
Slowly Inc. 4.8%
.75
.40
T/A
Equity
x ROS x Turnover x Multip
6%
8%
1.2
1.0
2.5
1.5
TM 15-14 Slide 2 of 2
Two Kinds of Planning Assumption
• DIRECT AND INDIRECT
• MANAGEMENT BY RATIOS
Example 15-6
Next year's revenue is forecast at $7,900,000. What receivables figure
should be included in a financial plan to reflect a 40 day ACP
assumption.
Solution:
ACP 
40 days 
A/R
 360
Sales
A/R
 360
$7,900,000
A/R = $877,777
TM 15-15
The Cash Budget
There are two ways to forecast cash.
1. Deriving a projected statement of cash flows
2. Cash Budgeting - forecasting cash receipts and
disbursements as they’re likely to occur.
TM 15-16 Slide 1 of 3
COMPREHENSIVE EXAMPLE (15-7)
A COMPLEX PLAN FOR AN EXISTING BUSINESS
MACADAM COMPANY - INCOME STATEMENTTHIS YEAR ($000)
$
%
Revenue
$14,200
100.0%
COGS
7,810
55.0
Gross Margin
$ 6,390
45.0
Expenses:
Marketing
Engineering
Fin & Admin
Total Expense
$ 2,556
1,065
1,349
$ 4,970
18.0
7.5
9.5
35.0
EBIT
Interest
EBT
Income Tax
EAT
$ 1,420
$ 568
$ 852
$ 341
$ 511
10.0
4.0
6.0
2.4
3.6
TM 15-16 Slide 2 of 3
MACADAM COMPANY BALANCE SHEET - THIS YEAR($000)
ASSETS
Cash
Accts Rec
Inventory
Curr Assets
$ 1,560
$ 3,550
$ 2,603
$ 7,713
LIABILITIES & EQUITY
Accts Payable
$ 716
Accruals
$ 230
Current Liab
$ 946
Fixed Assets
Gross
$12,560
Accum Depr ($ 3,620)
Net
$ 8,940
Long Term Debt
Equity
Stock Accts
Retained Earn
Total Equity
$ 6,000
$ 5,707
$11,707
Total Assets
Total L&E
$16,653
$16,653
$ 4,000
TM 15-16 Slide 3 of 3
FACTS
1. Virtually all payables are due to inventory purchases, and
the COGS is approximately 60% purchased material.
2. Assets currently on the firm's books will generate
depreciation of $510,000 next year.
3. The only balance sheet accrual represents unpaid wages.
Preliminary estimates indicate that next year's payroll will
be about $6.1M. Next year's closing balance sheet date will
be nine working days after a payday.
4. The combined state and federal income tax rate is 40%.
5. Interest on current and future borrowing will be at a rate of
10%.
TM 15-17
PLANNING ASSUMPTIONS
Income, Cost, and Expense
1. During the coming year, the firm will mount a major program to expand
sales. The expected result is a 20% growth in revenue. Pricing and
product mix will remain unchanged.
2. The revenue growth will be accomplished by increasing efforts in the
marketing/sales department. The increased expenses generated will be
accommodated by planning Marketing Department expenses at 19% of
the expanded revenue rather than the current 18%.
3. A major cost reduction effort is underway in the Manufacturing
Department which is expected to reduce the Cost Ratio (COGS/Revenue)
to 53% from its current level of 55%.
4. The Engineering Department will be unaffected by the expansion in sales.
Its dollar expenses will increase by normal inflation at a 4% rate over
last year.
5. Finance and administration expenses will need to expand to support the
higher volume, but due to scale economies the expansion will be at a
lower rate than the growth in sales. A target growth of 10% is planned
for those expenses.
TM 15-18 Slide 1 of 2
Assets and Liabilities
6. A lock box system will reduce cash balances 20%.
7. The current 90 day collection period (ACP) is considered unacceptable.
Increased attention to credit and collections in both finance and sales is
expected to bring the ACP down to 65 days.
8. Top management feels that the firm is operating with more inventory that it
needs. Manufacturing management has been challenged to increase the
Inventory Turnover Ratio based on COGS to 5 from its present level of 3
.
9. The Capital Plan has been put together in preliminary form, and indicates
capital spending of $5M. The average depreciation life of the assets to be
acquired is 10 years. Straight line depreciation will be used, and a
convention of taking one half year's depreciation in the first year will be
followed.
10. Vendors are complaining because the firm pays its bills in 55 days even
though most terms call for payment within 30 days. Fearing that inventory
and supplies will be cut off, management has decided to shorten the
payment cycle to 45 days.
11. No dividends will be paid next year, and no new stock will be sold.
TM 15-18 Slide 2 of 2
Solution: Income Statement Items
Revenue:
Revenue = $14,200  1.20 = $17,040
Cost of Goods Sold (COGS):
COGS = $17,040  .53 = $9,031
Marketing Expense:
Marketing Expense = $17,040  .19 = $3,238
Engineering Expense:
Engineering Expense = $1,065  1.04 = $1,108
Finance and Administrative Expense:
Fin & Admin Expense = $1,349  1.10 = $1,484
TM 15-19
Balance Sheet Items
Cash:
Cash = $1,560  (1-.20) = $1,248
Accounts Receivable:
65 
AR
 360
$17,040
A/R = $3,077
Inventory:
5.0 
$9,031
 $1,806
Inventory
Fixed Assets:
Gross Fixed Asset Additions = $5,000
Depreciation
New Equipment = [$5,000/10]  1/2 = $250
Old Equipment
= $510
$760
TM 15-20 Slide 1 of 2
Balance Sheet Items
Ending balances are forecasted:
Beginning Additions Ending
Gross
Accumulated
depreciation
Net
$12,560
$5,000
$17,560
($ 3,620)
$ 8,940
($ 760)
$4,240
($ 4,380)
$13,180
Accounts Payable:
Accounts Payable  purchases 
 .60  $9,031
45
45
 .60  COGS 
360
360
45
 $677
360
Accruals:
1.8
Accruals  $6,100 
 $211
52
TM 15-20 Slide 2 of 2
MACADAM COMPANY
PROJECTED INCOME STATEMENT ($000)
Revenue
COGS
Gross Margin
THIS YEAR
$
%
$14,200 100.0
7,810 55.0
$ 6,390 45.0
NEXT YEAR
$
%
$17,040 100.0
9,031 53.0
$ 8,009 47.0
Expenses
Marketing
Engineering
Fin & Admin
Total Expenses
$ 2,556
1,065
1,349
$ 4,970
18.0
7.5
9.5
35.0
$ 3,238 19.0
1,108 6.5
1,484
8.7
$ 5,830 34.2
EBIT
Interest
EBT
Income Tax
EAT
$ 1,420
$ 568
$ 852
$ 341
$ 511
10.0
4.0
6.0
2.4
3.6
$ 2,179 12.8
$ 485
2.8
$ 1,694 10.0
$ 678
4.0
$ 1,016 6.0
TM 15-21 Slide 1 of 2
MACADAM COMPANY
PROJECTED BALANCE SHEET ($000)
ASSETS
Cash
A/R
Inv
C/A
Fixed Assets
Gross
$12,560 $17,560
A/D
($ 3,620) ($ 4,380)
Net
$ 8,940 $13,180
LIABILITIES & EQUITY
THIS NEXT
YEAR YEAR
A/P
$ 716 $ 677
Accruals
$ 230 $ 211
C/L
$ 946 $ 888
Debt
$4,000 $5,700
Equity
Stock
$6,000 $6,000
R/E
$5,707 $6,723
Tot Equity
$11,707 $12,723
Total
Assets
Total
L&E
THIS
YEAR
$ 1,560
$ 3,550
$ 2,603
$ 7,713
NEXT
YEAR
$ 1,248
$ 3,077
$ 1,806
$ 6,131
$16,653 $19,311
$16,653 $19,311
TM 15-21 Slide 2 of 2
MACADAM COMPANY
PROJECTED CHANGES IN WORKING CAPITAL
NEXT YEAR (000)
Accts Rec
Inventory
Accts Pay
Accruals
Decr/(Incr)
in W/C
Beginning
$3,550
$2,603
$ 716
$ 230
Ending
$3,077
$1,806
$ 677
$ 211
Change
$ 473
$ 797
($ 39)
($ 19)
$5,207
$3,995
$1,212
TM 15-22 Slide 1 of 2
MACADAM COMPANY
PROJECTED STATEMENT OF CASH FLOWS - NEXT YEAR (000)
OPERATING ACTIVITIES
EAT
Depreciation
Decrease in W/C
Cash From Operating Activities
INVESTING ACTIVITIES
Increase in Gross
Fixed Assets
Cash From Investing Activities
FINANCING ACTIVITIES
Increase in Debt
Cash From Investing Activities.
NET CASH FLOW
RECONCILIATION
Beginning Cash
Net cash flow
Ending Cash
$1,016
$ 760
$1,212
$2,988
($5,000)
($5,000)
$1,700
$1,700
($ 312)
$1,560
($ 312)
$1,248
TM 15-22 Slide 2 of 2
Receivables and payables: Forecasting with Time Lags - Forecast
collections based on historical information pattern collected each month
following sales.
Months after
sale
% collected
Sales
Collections from sales
made in Jan
Feb
Mar
Total Collections
1
2
3
60%
30%
8%
Jan Feb Mar Apr
$500 $600 $700
$300
$300
$150
360
$510
$40
180
420
$640
May
Jun
$48
210
$258
$56
$56
FORECAST OTHER ITEMS SIMILARLY AND ADD ALL INS
AND OUTS EACH MONTH
TM 15-23
MANAGEMENT ISSUES IN FINANCIAL PLANNING
THE FINANCIAL PLAN AS A SET OF GOALS
Performance Measures
Bonuses
Stretch goals
RISK IN FINANCIAL PLANNING IN GENERAL
Reexamine Macadam's overall plan for achievability
Assumptions are all marvelously positive:
Revenue up 20%,
Cost of production decreases by 2% (a lot)
Asset management is totally successful
Will all of these positive things come true
without any offsetting negatives?
Probably not
TM 15-24 Slide 1 of 2
Typical of corporate business plans, everything is
routinely forecast to improve in the future.
Comes from:
- stretch planning
- aggressive optimism
- top down planning
It's never quite clear whether a company's plan is a candid statement of
what's likely to happen or a set of desirable goals.
Underforecasting - The Other Extreme
Bottom up planning
The Ideal Process
A give and take to arrive in the middle
Scenario Analysis
Producing more than one plan
TM 15-24 Slide 2 of 2
FINANCIAL PLANNING AND
COMPUTERS
Virtually all financial planning is done with computers.
Computers make repetitive calculations easy,
but
they don't do our thinking for us.
They don't help much in making planning assumptions,
which is the heart of the process.
TM 15-25