Chapter 15 Financial Planning 2000 SouthWestern College Publishing

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 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 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 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 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 = Industry 13. 5% Slowly Inc. 4. 8% (1 -d) x. 75. 40 ROS 6% 8% x T/A Turnover 1. 2 1. 0 Equity x Multip 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: 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 Accum Depr Net $12, 560 ($ 3, 620) $ 8, 940 Long Term Debt Equity Stock Accts Retained Earn Total Equity Total Assets $16, 653 Total L&E $ 4, 000 $ 6, 000 $ 5, 707 $11, 707 $16, 653 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. 1 M. 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 $5 M. 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: A/R = $3, 077 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 Gross Accumulated depreciation Net Additions Ending $12, 560 $5, 000 $17, 560 ($ 3, 620) $ 8, 940 ($ 760) $4, 240 ($ 4, 380) $13, 180 Accounts Payable: Accounts Payable Accruals: 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 1, 108 1, 484 $ 5, 830 19. 0 6. 5 8. 7 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 $ 485 $ 1, 694 $ 678 $ 1, 016 12. 8 10. 0 4. 0 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 A/P $ 716 $ 677 Accruals $ 230 $ 211 C/L $ 946 $ 888 Debt $4, 000 $5, 700 Equity Stock $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 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) $1, 700 ($ 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. 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