Chapter 3 Financial Planning and Control

Chapter 3
Financial
Planning and
Control
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Chapter 3 - Learning Objectives
 Construct simple pro forma financial statements that can be used
to forecast financing or investment needs.
 Discuss some of the complications that management should
consider when constructing pro forma financial statements.
 Describe and compute (a) operating breakeven and operating
leverage, (b) financial leverage, and (c) total leverage.
 Discuss how knowledge of leverage is used in the financial
forecasting and control process and why financial planning is
critical to firm survival.
 Discuss why it is important for a firm to construct a cash budget.
Describe the information that is provided by a cash budget.
International brands
Founded in 1937,
known for its
instant film and
cameras.
Polaroid neglected
the need to explore
new territory and
enhance their long-
term viability.
the largest sellers
of PCs in the entire
world in the 1980s
and 1990s.
Compaq ultimately
struggled to keep
up in the price wars
against Dell and
was acquired for
US$25 billion by HP
in 2002.
one time the world’s
biggest film
company.
(1889-2012)
could not keep up with
the digital revolution.
Competitors, such as
the Japanese firm
Canon, grasped this
opportunity and has
consequently outlived
the giant.
Filipino brands
Diana Margarine
popular between
1930’s and 1940’s
sold in cans no
refrigeration
required
manufactured in
Manila by
Dy Buncio & Co.,
Inc.
Filipino brands
Popular in 1960’s, Halili

Beer manufactured by
F.F. Halili Enterprises
Halili beer and

beverages fizzled out
either because of a
strategic acquisition or
lack of leadership.
Filipino brands
Established in 1954
by Anton Goquiolay,
Serg’s Products Inc.
Its operation was

temporarily halted by
the martial law era
Serg’s faced massive
debts which were
made even worse by
labor disputes within
the factory.
Filipino brands
1955, Radiowealth,
Inc., began
manufacturing its
own television sets
made from imported
electronic parts.
Theirs were more
affordable so many
Filipino families had
the chance to own
this appliance.
PLAN…
Gives us the directions for operating the
firm in the future.
CONTROL SYTEMS…
Ensures the plan is implemented and
modified to account to account for the
dynamic environment the company
faces.
Financial Planning
The projection of sales, income, and
assets based on alternative production
and marketing strategies, as well as the
determination of the resources needed
to achieve these projections
Financial Control
 The phase in which financial plans are
implemented
 Control deals with the feedback and
adjustment process required to ensure
adherence to plans and modification
of plans because of unforeseen changes
Sales Forecasts
A forecast of a firm’s unit and dollar
sales for some future period
 Starts with review of sales during the past 5
to 10 years
 Generally based on recent sales trends
plus forecasts of the economic prospects
for the nation, region, and industry
Argile Textiles: 2013 Sales Projection
Year Sales ($ million) 10% growth rate for sales

2008 $515 •Expected economic activity
2009 620 •Competitive conditions
•Product development and
2010 605
distribution
2011 700
2012 750
2013
Argile Textiles: 2013 Sales Projection
Projected (Pro Forma) Financial Statements
 Forecast of financial requirement involves

determining how much firm will
1) Need during a given period
2) Generate funds internally
3) By borrowing, issuing of new stocks, or both
to raise external funds.
Projected (Pro Forma) Financial
Statements
 Step 1: Begin with forecast of sales
- to obtain initial estimate of retained earning
- requires assumption of operating cost ratio,
tax rate, interest charges, and dividend
payment
this step determines how much income the

company will earn and retain
Statements
 Step 2: Forecast the balance sheet
- Higher sales will lead to higher receivables,
additional inventories, and new plant and
equipment to increase production.
- Accrued wages and accrued taxes will
increase.
- current liabilities that change naturally with
changes of sales provide spontaneous
generated funds- it increase at the same rate
as sales
Statements
 Step 3: Raise additional fund needed (AFN)
 Step 4: Adjust forecasts for financing

feedbacks
Statements
 Project the asset requirements for the coming
period
 Project the liabilities and equity that will be
generated under normal operations
 Subtract the projected liabilities and equity
from the required assets to estimate the
additional funds needed (AFN) to support the
level of forecasted operations
Projected Balance Sheet Method
 A method of forecasting financial
requirements based on forecasted
financial statements
Projected Balance Sheet Method
Financing feedbacks are the effects on
the income statement and balance sheet
of actions taken to finance forecasted
increases in assets
Statements
Analysis of the forecast

 Determine if the forecast meets the firm’s
financial targets
 Planned management changes must be
incorporated into the forecasts
 Iterative process
Other Considerations in Forecasting
Excess Capacity
Current sales level
Full capacity sales =
æ Percent of capacity used ö
ç ÷
è to generate current sales level ø
• this is use too compute the sales capacity of the firm
if we know what percentage of assets is utilized to
produce a particular level of sales.
• Excess capacity means less external financing is
required to support increases in operations.
Full Capacity Sales

• Example: If Argile actually had only 75% of fixed
asset’s capacity to produce 2012 sales of ₱750M
2
𝑛𝑥 𝑛 𝑛 − 1 𝑥
₱750,000,000
1+𝑥 𝑛 =1+ + +⋯
= ₱1,000,000,000
1! 2!
.75
Economies of Scale
 Variable cost of goods sold ratio changes
with size of the firm
 This affects the addition to retained
earnings, and thus the AFN
Lumpy Assets
 Assets that cannot be acquired in small
increments, but must be obtained in large,
discrete amounts
 Small increase in sales can require
significant increase in plant and equipment
Financial Control –
Budgeting and Leverage
Relationship between sales volume and

profitability under different operating
conditions
Control phase and process
Operating Breakeven Analysis
An analytical technique for studying the
relationship among sales revenues,
operating costs, and profits
Only deals with the operating section of
the income statement
Operating Breakeven Analysis
Operating Breakeven Point
 Represents the level of production and
sales where operating income is zero
 The point where revenues from sales just
equal total operating costs
Breakeven Computation
Sales Total Total Total

revenues = operating
F = variable F + fixed
Q = =
(POpBE
x Q) Contribution P-V
costs margincosts costs
(P x Q) = TOC = (V x Q) + F
Breakeven Point for Argile Textiles
$93.5 mil $93.5 mil
QOpBE = = = 17 Million Units
$27.50 - 22.00 $5.50
Breakeven Graph - Argile Textiles
Breakeven Computation
F F
SOpBE = =
Gross profit margin 1- V
P
Breakeven based on dollar sales for Argile Textiles
$93.5 $93.5 $93.5

SBE = = = = $467.5 million
1- ( $22.00
$27.50 ) 1 - 0.80 0.20
Using Operating Breakeven Analysis
1. New product decisions

Required sales to achieve profitability
2. Expansion of operations
Increase fixed and variable costs
Increase sales
3. Modernization and automation
Increased fixed and reduced variable costs
4. Determine riskiness of operations
Operating Leverage
The existence of fixed operating costs,
such that a change in sales will produce
a larger change in operating income
(EBIT)
Operating Leverage
Degree of operating leverage (DOL)
 the percentage change in NOI associated
with a given percentage change in sales
Gross profit (Q´ P) - (Q´ V) S- VC

DOL = = =
NOI (Q´ P) - (Q´ V ) - F S- VC- F
Operating Leverage
Operating leverage and operating
breakeven
 Higher operating leverage increases
operating breakeven point
Using Leverage and Forecasting for Control
Changes in operations affect income,

which impact the balance sheet and the
financing needs of the firm
Forecasted results and their impact can
be adjusted ahead of time
Feedback needs evaluated
Problem
1. Following is information about the Super Shoe Store
(SSS)
Selling price per unit P50
Variable cost per unit P30
Fixed operating cost P120,000
1. What is SSS’ operating income (NOI) when sales are
10,000 units ( boxes of shoes)?
2. How many pairs of shoes does SSS have to sell to
break even with its operations?
3. What is the degree of operating leverage for 10,000
pairs of shoes
Cash Budgeting
Cash budget
 A schedule showing cash receipts, cash
disbursements, and cash balances for a
firm over a specified time period
Target (minimum) cash budget
 The minimum cash balance a firm desires
to maintain to conduct business
Cash Budgeting
Disbursements and receipts method
(scheduling)
 The net cash flow is determined by
estimating the cash disbursements and
the cash receipts expected to be generated
each period
The Cash Conversion Cycle
The length of time from the payment for
the purchase of raw materials to
manufacture a product until the
collection of accounts receivable
associated with the sale of the product
1. The inventory conversion period
 Length of time required to convert
materials into finished goods and then to
sell those goods
 The amount of time the product remains in
inventory in various stages of completion
2. The receivables collection period
 Average length of time required to convert
the firm’s receivables into cash
 Also called days sales outstanding (DSO)
3. The payables deferral period
 Average length of time between the
purchase of raw materials and labor and
the payment of cash for them
 The cash conversion cycle
 Net the three periods
 Average length of time a dollar is tied up
in current assets
Cash Inventory Receivables Payables

conversion = conversion + collection _ deferral
cycle period period period
Argiles Textiles: Cash Conversion Cycle
Inventory Conversion Receivables Collection

Period (81.0 days) Period (43.2 days)
Payables
Deferral Cash Conversion Cycle
Period (81.0 days + 43.2 days – 9.0 days = 115.2 days)
(9.0 days)
Purchase Raw Pay for Raw Sell Finished Goods— Collect Accounts
Materials—Increase Materials Increase Accounts Receivable
Accounts Payable Receivable
(CASH OUT) (CASH IN)
Working Capital Investment and Financing
Policies
Two basic questions:

 1. What is the appropriate level for current
assets, both in total and by specific
accounts?
 2. How should current assets be financed?
Alternative Current Asset Investment
Policies
Relaxed current asset investment policy

 Relatively large amounts of cash and
marketable securities and inventories are
carried and sales are stimulated by a liberal
credit policy that results in a high level of
receivables
Policies
Restricted current asset investment

policy
 Holdings of cash and marketable securities
and inventories are minimized, and a
restrictive accounts receivable policy is
followed
Policies
Moderate current asset investment

policy
 A policy that is between the relaxed and
restricted policies
Policies
Current Assets
($)
Relaxed
40
Moderate
30
Restricted
20
Current Assets to Support 10

Policy Sales of $100
Relaxed $30
Moderate 23
Restricted 16 Sales ($)
0 50 100 150 200
Current Assets
Permanent current asset
 Current asset balances that do not change
due to seasonal or economic conditions
 These balances exist even at the trough of
a firm’s business cycle
Permanent current assets

Current Assets
Temporary current asset
 Current assets that fluctuate with seasonal
or economic variations in a firm’s business
Temporary current assets
Permanent current assets

Alternative Current Asset Financing
Policies
Maturity matching, or “self-liquidating”

approach
 A financing policy that matches asset and
liability maturities
 This would be considered a moderate
current asset financing policy
Policies
Conservative approach
 A policy where all of the fixed assets, all of
the permanent current assets, and some of
the temporary current assets of a firm are
financed with long-term capital
Policies
Aggressive approach
 A policy where all of the fixed assets of a
firm are financed with long-term capital, but
some of the firm’s permanent current
assets are financed with short-term
nonspontaneous sources of funds
Advantages and Disadvantages of Short-
Term Financing
 Speed
 A short-term loan can be obtained much more
quickly than long-term credit
 Flexibility
 For cyclical needs, avoid long-term debt
 Cost of issuing long-term debt is higher
 There might be penalties for payoff prior to maturity
 Long-term debt generally has restrictive covenants
Term Financing
Cost of long-term versus short-term debt

 Yield curve is generally upward sloping
 Short term interest rates are generally
lower than long-term rates
Term Financing
Risk of long-term versus short-term debt

 Short-term debt subjects the firm to more
risk than long-term debt
 Short-term interest expenses fluctuate
 Firm may not be able to repay short-term debt,
thus might be forced into bankruptcy
Short-Term Credit
Any liability originally scheduled for
repayment within one year
Sources of Short-Term Financing
 Accruals
 Continually recurring short-term liabilities
 Liabilities such as wages and taxes that increase
spontaneously with operations
 Accounts payable (trade credit)
 Credit created when one firm buys on credit from
another firm
Short-term bank loans
 Maturity typically 90 days
 Promissory note specifies terms and
conditions
 Amount, interest rate, repayment schedule,
collateral, and any other agreements
 Compensating balances of 10 to 20 percent
might be required to be maintained in a
checking account
 Line of credit can be arranged
 Specified maximum amount of funds
available
 Revolving credit agreement
 Line of credit where funds are committed,
or guaranteed by the lender
 Commitment fee
 Fee generally charged on the unused
balance of a revolving credit agreement
Commercial paper
 Unsecured short-term promissory notes
issued by large, financially sound firms to
raise funds
 Secured loans
 Loan backed by collateral
 For short-term loans, the collateral is often either
inventory or receivables
 Factoring is the sale of receivables
 Pledging is the use of receivables as collateral for
a loan
 The lender might seek recourse (payment) from
the borrowing firm for uncollectible receivables
used to secure a loan
Computing the Cost of Short-Term Credit
Dollar cost of borrowing

Percentage cost per period = rPER =
Amount of usable funds
rPER = Dollar
Effective
= EAR
cost of borrowing
= [1 + r
Amount of usable ] m - 1.0
PER funds
annual rate
Annual
= APR = rPER x m = rSIMPLE
percentage rate
Computing the Cost of Short-Term Credit
Discount interest loan

 A loan in which the interest, which is
calculated on the amount borrowed
(principal), is paid at the beginning of the
loan period
 Interest is paid in advance
Managing Cash and Marketable Securities
Cash management
 Goal of minimizing the amount of cash the
firm must hold for use in conducting its
normal business activities; must consider
the ability to:
 Pay suppliers
 Maintain its credit rating
 Meet unexpected cash needs
Firms Hold Cash For:
1. Transaction balance
 Cash balance necessary for day-to-day
operations
 The balance associated with routine payments
and collections
2. Compensating balance
 Deposit to meet bank loan requirements
Firms Hold Cash For:
3. Precautionary balance
 Cash balance held in reserve for unforeseen
fluctuations in cash flows
 Access to line of credit can reduce the need
for precautionary balances
4. Speculative balance
 Cash balance that is held to enable the firm to
take advantage of any bargain purchases that
might arise
 Easy access to borrowed funds can reduce the
need for speculative balances
Cash Management Techniques
Cash forecasts
Predict the timing of cash flows
Cash flow synchronization
Cash inflows coincide with cash
outflows, permitting a firm to hold low
transaction balances
Float
 The difference between the balance shown
in a checkbook and the balance on the
bank’s records
 Disbursement float
 The value of checks that have been written and
disbursed but have not fully cleared through
the banking system and thus have not been
deducted from the account on which they were
written
 Collection float
 The amount of checks that have been received
and deposited but have not yet been credited
to the account in which they were deposited,
because they have not cleared through the
banking system
Net float
 The difference between disbursement
float and collection float
 The difference between the balance
shown in the checkbook and the balance
shown on the bank’s books
Acceleration of receipts
 Lockbox arrangement
 Reduce float by having payments sent to
post office boxes located near customers
 Faster mail delivery
 Faster check clearing within the same
Federal Reserve district
Acceleration of receipts
 Preauthorized debit system
 Allows a customer’s bank to periodically
transfer funds from a customer’s account to a
selling firm’s bank account for the payment of
bills
 Concentration banking
 A technique used to move funds from many
bank accounts to a more central cash pool to
more effectively manage cash
Disbursement control
 Centralized disbursement system
 More control, but can delay payments
 Zero-balance account (ZBA)
 Special account used for disbursements that has a
balance of zero when there is no disbursement
activity
 Controlled disbursement accounts (CDA)
 Checking accounts in which funds are not
deposited until checks are presented for
payment, usually on a daily basis
Marketable securities
 Securities that can be sold on short notice
without loss of principal or original
investment
 Substitute for cash balances
 Temporary investment
 Finance seasonal or cyclical operations
 Amass funds to meet financial requirements in the
near future
Credit Management
Credit policy
 A set of decisions that include a firm’s
credit standards, credit terms, methods
used to collect credit accounts, and credit
monitoring procedures
Credit Management
Credit policy factors
 Credit standards
 Standards that indicate the minimum financial
strength a customer must have to be granted
credit
 Terms of credit
 Credit period
 The length of time for which credit is granted
 Length of credit period and any cash discounts
offered
Credit Management
Credit policy factors
 Collection policy
 The procedures followed by a firm to collect its
accounts receivables
Credit Management
Receivables monitoring
 The process of evaluating the credit policy
to determine if shifts in the customers’
payment patterns occur
Credit Management
 Receivables monitoring
 Days sales outstanding (DSO)
 The average length of time required to collect accounts
receivable
 Also called the average collection period
 Aging schedule
 Report showing how long accounts receivable have been
outstanding
 The report divides receivables into specified periods;
provides information about the proportion of receivables
that is current and the proportion that is past due for
given lengths of time
Argiles Textiles:
Receivables Aging Schedule, 2012
Net Amount Fraction of

Age of Account Average
Outstanding Total
(days) Days
($ million) Receivables
0–30 $36.0 40% 18
31–60 45.0 50 55
61–90 5.4 6 77
Over 90 3.6 4 97
$90.0 100%
DSO = 0.40(18 days) + 0.50(55 days) + 0.06(77 days) + 0.04(97 days) = 43.2 days
Credit Management
Analyzing proposed changes in credit
policy
 Use NPV analysis the same as for capital
budgeting analysis
 Timings of the cash inflows and cash
outflows are important to the analysis
Inventory Management
 Raw materials
 Inventories purchased from suppliers that will
ultimately be transformed into finished goods
 Work in-process
 Inventory in various stages of completion
 Finished goods
 Inventories that have completed the production
process and are ready for sale
Optimal inventory level
Sustain operations at the lowest
possible cost
Stockout
 When a firm runs out of inventory and
customers arrive to purchase the product
Inventory costs
 Carrying costs
 Storage, insurance, use of funds, depreciation,
etc…
 Ordering costs
 Costs of placing an order
 The cost of each order is generally fixed
regardless of the average size of inventory
Total inventory costs (TIC)
= Total carrying costs + Total ordering costs
æCarrying costö æ Average unitsö æCost per ö æ Number of ö
= ç ÷ ´ ç ÷ +ç ÷ ´ ç ÷
è per unit ø è in inventory ø è order ø è orders ø
æQö æ Tö
= (C ´ PP) ´ ç ÷ + O ´ ç ÷
è2ø èQø
C = carrying cost as a percent of PP
PP = purchase price of product
Q = quantity ordered
T = total demand for product
O = fixed cost per order
Economic order quantity (EOQ)
 The optimal quantity that should be ordered
 It is the quantity that will minimize the total
inventory costs
Economic Ordering Quantity Model
EOQ model
 Formula for determining the order quantity
that will minimize total inventory costs
2´O´T
EOQ =
C ´ PP
EOQ model extensions
 Reorder point
 The level of inventory at which an order
should be placed
 Safety stocks
 Additional inventory carried to guard
against changes in sales rates or
production/shipping delays
EOQ model extensions
 Quantity discount
 A discount from the purchase price offered
for inventory ordered in large quantities
 Seasonal adjustments
 EOQ computed separately for each season
to account for sales variations
Chapter Principles
Key Financial Planning/Control Concepts
 Why is financial planning and control critical to the
survival of a firm?
 Financial planning requires the firm to forecast future
operations so that arrangements can be made for
expected changes in production
 What are the complications that management must
consider when constructing pro forma financial
statements?
 Excess Capacity
 Economies of Scale
 Lumpy Assets
Chapter Principles
Key Financial Planning Concepts
 What is operating breakeven and how is
breakeven analysis used in financial decision
making?
 The level of production and sales needed so that
operating income (EBIT = NOI) equals zero
 What is leverage and what types are used in
financial analysis?
 Leverage consists of fixed costs, whether they are
operating, financial, or both
Chapter Principles
 How can a firm use knowledge of leverage in
financial forecasting and control?
 A firm uses the concept of leverage to estimate
how fixed costs affect its “bottom line” net income
 Why is financial planning critical to firm
survival?
 Inadequate financial planning is the principal
reason businesses fail.
 Well-run companies generally base their operating
plans on a set of well-designed forecasted
financial statements.
Chapter Principles
 Why is it important for a firm to construct a cash
budget and what information does it provide?
 It helps management plan investment and borrowing
strategies
 It provides feedback and control to improve the
efficiency of the management of the firm’s finances
 It indicates both when external funds are needed and
the amounts that are needed
 It indicates when the firm can invest funds that are not
needed to support operations

Chapter 3 Financial Planning and Control

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Chapter 3 Financial Planning and Control

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Chapter 3

Popular in 1960’s, Halili

Halili beer and

Its operation was

Year Sales ($ million) 10% growth rate for sales

 Forecast of financial requirement involves

this step determines how much income the

 Step 4: Adjust forecasts for financing

Analysis of the forecast

Full Capacity Sales

Relationship between sales volume and

Sales Total Total Total

Breakeven based on dollar sales for Argile Textiles

$93.5 $93.5 $93.5

1. New product decisions

Gross profit (Q´ P) - (Q´ V) S- VC

Changes in operations affect income,

Cash Inventory Receivables Payables

Inventory Conversion Receivables Collection

Two basic questions:

Relaxed current asset investment policy

Restricted current asset investment

Moderate current asset investment

Current Assets to Support 10

Permanent current assets

Temporary current assets

Permanent current assets

Maturity matching, or “self-liquidating”

Cost of long-term versus short-term debt

Risk of long-term versus short-term debt

Dollar cost of borrowing

Discount interest loan

Net Amount Fraction of

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