Financial Planning

Component Parts of a Business Plan

 Typical outline
 Contents  Executive summary  Mission and strategy statement
   Basic charter and establishes long-term direction Why the business will succeed against its competitors How the firm creates and distributes its product/service

 Market analysis  Operations (of the business)

Component Parts of a Business Plan

 Typical outline - continued
 Management and staffing
 Firms projected personnel needs

 Financial projections
 Projects the firms financial statements into the future

 Contingencies
 What the firm will do if things dont go as planned

The Purpose of Planning and Plan Information

 Major audience of business plan include
 Firms 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

Four Kinds of Business Plan

Kinds of planning
1. 2. 3. 4. Strategic Planning Operational Planning Budgeting Forecasting

Four Kinds of Business Plan

 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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Four Kinds of Business Plan

 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

Four Kinds of Business Plan

 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

Four Kinds of Business Plan

 Forecasting
 Very short-term projections of profit and cash flow
 Where will the businesss financial momentum carry it in the next few weeks

 Consists almost entirely of numbers  Cash forecasts are projections of shortterm cash needs
 Most large firms do monthly cash forecasts
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Financial Plan as a Component of 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 Businesses

 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 Task What we have and what we need to project

Figure 4.4

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Planning Assumptions
Example 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. Crumbs operating assumptions with respect to sales and receivables for next year are:

Example

1. 2. 3.

Price will be decreased by 10% in order to sell more product. As a result of the price decrease, unit sales volume will increase to 15 million coffee cakes. Collection efforts will be increased so that only one month of sales will be in receivables at year end.

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

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Planning Assumptions
Example 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 z 12 = $1,125,000.

Example

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Plans with Simple Assumptions

 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 Assumptions

 Forecasting Cash Needs
 A key reason for financial projections is to forecast the firms 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 MethodA 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 MethodA Formula Approach

 If the firms 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 v current liabilitiesthis year) - [(1 d) ROS][(1+g)salesthis year]
 Where d=dividend payout ratio

EFR = Growth in assets growth in current liabilities planned years retained earnings

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The Percentage of Sales Method A 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.
Underhill Manufacturing Company This Year ($000) Income Statement Balance Sheet Revenue $ 13,580 ASSETS COGS $ 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 LIABILITIES EAT $ 1,488 Accounts payable $ 125 Accruals $ 45 Current Liabilities $ 170 Debt $ 1,330 Equity $ 4,500 Total L&E $ 6,000

The items needed to apply the EFR equation are highlighted. We also need the ROS figure of 11% (EAT z sales, or $1,488 z $13,580) and the expected dividend payout ratio of 25%. Revenues are expected to increase by 15%.
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Example

The Percentage of Sales Method A Formula Approach Example 4.4

EFR = g(assetsthis year) - (g v current liabilitiesthis year) - [(1-d)ROS][(1+g)salesthis year] Example EFR = .15($6,000) - .15($170) - [(1-.25)(.11)(1.15)($13,580)] EFR = - $413.9
A 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 Rate

 A theoretical measure of a firms 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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The Sustainable Growth Rate

 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 firms inherent growth capability

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The Sustainable Growth Rate

 Incorporating equations from the DuPont equations into the gs equation we obtain
EAT sales assets gs ! 1  d v v v sales assets equity

gs = (1-d)ROS x Total Asset Turnover x Equity Multiplier Firms 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 Plans Indirect 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: Mylars 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?

Example

A: ACP =

A/R x 360 Sales A/R 40 days = $7,900,000 A/R = $877,777 x 360

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

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Management Issues in Financial 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 in 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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Risk in Financial Planning in General

 UnderforecastingThe Other Extreme
 Sets a goal that is easy to meet, ensures success
 Doesnt motivate best possible performance

 Bottom-up plans are consolidated from lower managements 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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Risk in Financial Planning in General

 Scenario AnalysisWhat Ifing
 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

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