Revise Lecture 20 Profit Planning Planning basically involves

Revise Lecture 20

Profit Planning • Planning basically involves two major areas for analysis: 1. External Factors 2. Internal Factors

Profit Planning • • External Factors The planner evaluates the outlook for the economy as a whole. Will the firm be operating during a period of economic growth and expansion? Will the next one to three years be a period of recession and stagnation? Is the industry anticipating growth or decline?

Profit Planning External Factors • Does the firm have stable market for its products? • Is the firm’s competition gaining or losing strength?

Profit Planning Internal Factors Some factors are internal in the sense that they are under the control of the firm. Foe example, such items as cash levels, kind amount of inventories.

Profit Planning Benefits of planning 1. 2. 3. 4. 5. Anticipation of problems and opportunities Coordination of actions Assistance in control Providing standards of performance Time saving

Leverage • A general dictionary definition of the term leverage would refer to an increased means of accomplishing some purpose. • In some cases, as with lifting heavy objects, leverage allows us to accomplish things not otherwise possible at a given level of efforts. • This concept is valid in running a company.

Leverage • Ability to influence what people do: diplomatic/ political leverage • Leveraged buy-out: the act of a small company buying a larger company using money that is borrowed based on the value of this larger company

Leverage • The financial manager can identify many different types of leverage. • In most cases, the effects are reversible, so that the leverage may be favourable or unfavourable • We will bring together the different concepts of leverage in the planning process of the firm.

Leverage • Each concept will link a measure of profit, such as return on investment or earnings before taxes, with another area of the firm’s operating or financial situation. • Each type of leverage will be analyzed to determine what it measures and what it shows with respect to the firm’s operations or financing.

Types of Leverages ROI Leverage A) Asset turnover leverage B) Profit margin leverage C) Tighten management leverage

Types of Leverages Marginal Analysis Leverage A) Operating leverage B) Interest coverage leverage C) Combined leverage Financial Leverage

Leverage Return-on-Investment Leverage Return on investment (ROI) is the prime indicator of management’s efficiency in achieving profit from operations. ROI is the product of two factors: 1. Assets turnover 2. Profit margin If either of these ratios can be increased, ROI will be increases to a greater degree.

Return on Investment Leverage Asset-Turnover side of ROI Leverage The term asset leverage is frequently used to refer the asset-turnover aspects of ROI leverage. It is the tool that links the firm’s return on investment with its degree of efficiency in employing assets. It is important for two reasons: 1. Similar profit margins are common 2. Asset turnover reflects efficiency

Return on Investment Leverage Similar profit margins are common • When comparing firms producing similar products for similar markets, we might expect them to have the same approximate profit margins. This recognizes that their costs will be about the same and they will be forced by market factors to establish equal selling prices for the goods. • In this situation, it is difficult to increase ROI by increasing profit margin, thus the employment of assets becomes very important.

Return on Investment Leverage Assets turnover reflects efficiency The ability to generate a large volume of sales on a small asset base is a measure of a firm’s operating efficiency. Aggressive, profit-minded firms strive for a rapid turnover in order to gain the benefits of asset leverage on ROI

Return on Investment Leverage • Asset turnover is the tool that we use to monitor the employment of assets on a comparative basis. If a firm has a relatively high asset turnover compared to other firms, we say that is has a high degree of asset leverage. If low, it has a low degree of asset leverage. • Note that firm cannot have absolute high or low asset leverage, it has a relative high or low leverage.

Using asset turnover or profit margin to produce ROI Leverage (P 158)

Two examples of asset leverage

Return on Investment Leverage Profit-margin side of ROI Leverage Although similar firms tend to have a similar profit margins, careful cost control can increase profit margin with a levering effect on ROI. Some major areas where cost control is possible are the following; 1. Production 2. Selling expenses 3. Distribution 4. Administrative expenses

Return on Investment Leverage ROI through tighter management Small reductions in the size of operating assets combined with small decrease in operating costs can have significant effects. Careful planning can help the firm achieve the lower costs, which result in better use of assets and higher reported profits.

Leverage through tighter management – p 160

Marginal-Analysis Leverage Three kinds of leverage are identified with the marginal-analysis approach to profit planning. 1. Operating Leverage 2. Interest-Charge Leverage 3. Combined Leverage

Marginal-Analysis Leverage Operating Leverage • Operating leverage exists when changes in revenues produce greater changes in EBIT • The degree of operating leverage at any single sales volume can be calculated from a ratio of marginal contribution to EBIT. • If the marginal contribution is Rs 900000 and the EBIT is Rs 450000, the operating leverage is 900/450 or 2/1. Thus any % increase in sales results in twice that % increase in EBIT.

Operating Leverage • What does operating leverage tell the financial manager? • It tells the impact of changes in sales on operating income. If a firm has a high degree of operating leverage, small changes in sales have large effects on EBIT. If the change is a small rise in sales, profits will rise dramatically. But if the change is a small decline in forecast sales, EBIT may be wiped out and a loss may be reported

Draw p 161

Interest-Charges Leverage • Interest-charges leverage sometimes called financial leverage exists whenever a firm has debt that requires the payment of interest. • It gives us a measure of the degree to which changes in operating income will affect EBT • Interest-charge leverage = EBIT / EBT • This means that any % increase in EBIT would be accompanied by a % in increase in EBT

Combined Leverage • Combined leverage is used to compare changes in revenues with changes in EBT and also changes in net income. It combines the effects of operating and interest-charges leverage.

Financial Leverage The most widely accepted usage of financial leverage refers to a situation in which both of the following exit; 1. Limited cost securities. A firm must be financing a portion of its assets by using debt, preferred stock or some other security with a limited cost to the firm. 2. ROI is not equal to cost of the limited-cost securities. The firm’s ROI must not be equal to the % of interest or dividend being paid on the limitedcost security.

Financial Leverage Importance of Financial Leverage • Many financial managers would argue that financial leverage is the most important of the leverage concept. It finds particular application in capital-structure management. • A firm’s capital structure is the relation between the debt and equity securities that make up the firm’s financing of its assets.

Financial Leverage Importance of Financial Leverage A firm with no debt is said to have all-equity capital structure. Since most firms have capital structures with both debt and equity elements, the financial managers is highly concerned with the effects of borrowing. If a firm is making money on its borrowing (has favourable financial leverage).