Financial Planning Chapter 16
Business Planning  <ul><li>A business plan is a model of what management expects a business to become in the future </li><...
Component Parts of a Business Plan  <ul><li>Typical outline </li></ul><ul><ul><li>Contents </li></ul></ul><ul><ul><li>Exec...
Component Parts of a Business Plan <ul><ul><li>Management and staffing </li></ul></ul><ul><ul><ul><li>Firm’s projected per...
The Purpose of Planning and Plan Information <ul><li>Major audience of business plan include </li></ul><ul><ul><li>Firm’s ...
Credibility and Supporting Detail <ul><li>A good business plan shows enough supporting detail to indicate it is the produc...
Four Kinds of Business Plan <ul><li>Four variations on basic idea of business planning </li></ul><ul><ul><li>Strategic pla...
Four Kinds of Business Plan <ul><ul><li>Operational planning </li></ul></ul><ul><ul><ul><li>Translates business ideas (day...
Four Kinds of Business Plan <ul><li>The Business Planning Spectrum </li></ul><ul><ul><li>Most large companies produce all ...
Figure 16.2:  The Business Planning Spectrum
Financial Plan as a Component of a Business Plan <ul><li>Financial plan is a set of pro forma financial statements project...
Planning for New and Existing Businesses <ul><li>Harder to forecast an operation that is very new or not yet begun </li></...
The General Approach, Assumptions, and the Debt/Interest Problem <ul><li>What We Have and What We Need to Project </li></u...
Planning Assumptions—Example <ul><li>Q: This year Crumb Baking Corp. sold 1 million coffee cakes per month to grocery dist...
Planning Assumptions—Example A: There are three inter-related planning assumptions:  (1) a management action regarding pri...
The General Approach, Assumptions, and the Debt/Interest Problem <ul><li>The Procedural Approach </li></ul><ul><ul><li>Fin...
The General Approach, Assumptions, and the Debt/Interest Problem <ul><li>To complete the BS we need to know the amount of ...
Figure 16.5:  The Debt/Interest Planning Problem
An Iterative Numerical Approach <ul><li>Procedure works as follows </li></ul><ul><ul><li>Interest:  Guess a value of inter...
An Iterative Numerical Approach—Example  Q: The following partial financial forecast has been done for Graybarr Inc.  Comp...
An Iterative Numerical Approach—Example  A: The huge increase in assets will cause the company’s debt to increase at a dra...
An Iterative Numerical Approach—Example  A: Now we check to see if the the interest implied by our calculated debt (averag...
Plans with Simple Assumptions <ul><li>A rough plan can be generated with just a few assumptions </li></ul><ul><li>A detail...
Plans with Simple Assumptions—Example  Q: The Overland Manufacturing Company expects next year’s revenues to increase by 1...
Plans with Simple Assumptions—Example  Assume the firm pays state and federal income taxes at a combined flat rate of 42%,...
Plans with Simple Assumptions—Example  Taking the average debt at 12% yields a calculated interest of $86,000 which is con...
Plans with Simple Assumptions <ul><li>Forecasting Cash Needs </li></ul><ul><ul><li>A key reason for doing financial projec...
The Percentage of Sales Method—A Formula Approach <ul><li>If we assume that net fixed assets will rise in tandem with sale...
The Percentage of Sales Method—A Formula Approach <ul><li>Representing a firm’s growth rate in sales as g, then </li></ul>...
The Percentage of Sales Method—A Formula Approach—Example  Q: Forecast the external financing requirements of the Overland...
The Percentage of Sales Method—A Formula Approach—Example  <ul><li>A: Applying the EFR equation we have: </li></ul>Example...
The Sustainable Growth Rate <ul><li>A firm can grow at its sustainable growth rate without selling new stock if its financ...
The Sustainable Growth Rate <ul><li>Sustainable growth rate assumes that the debt/equity ratio is constant </li></ul><ul><...
The Sustainable Growth Rate <ul><li>Incorporating equations from the DuPont equations into the g s  equation we obtain </l...
Plans With More Complicated Assumptions <ul><li>The percentage of sales method is appropriate for quick estimates, but gen...
Plans With More Complicated Assumptions <ul><li>Indirect planning assumptions are made about financial ratios, which in tu...
Planning at the Department Level <ul><li>Operational plans projections are much more detailed than the single numbers appe...
The Cash Budget <ul><li>Forecasting cash is an important part of financial planning </li></ul><ul><li>The cash budget is a...
Receivables and Payables—Forecasting with Time Lags <ul><li>Forecasting receivables collection is difficult because you ne...
Receivables and Payables—Forecasting with Time Lags—Example  Q: A firm has discerned that its collections exhibit the foll...
Debt and Interest <ul><li>Forecasting short-term debt and interest can be tricky if a company is funding current cash need...
The Cash Budget—Example  Q: The Pulmeri Company’s revenues tend to go through a quarterly cycle.  It’s now mid-March and m...
The Cash Budget—Example A:  First lay out revenue and lag in collections according to the historical pattern. $7,350 $6,30...
The Cash Budget—Example A:  Next, lag inventory purchases (half of sales dollars) back one month from the date of sale and...
The Cash Budget—Example A:  Finally, summarize these results along with payroll and other disbursement and work through th...
The Cash Budget—Example $(6,654) $(5,697) $(4,700) $(5,000) Cumulative cash flow (loan) $(957) $(997) $300 Net cash flow $...
Management Issues in Financial Planning <ul><li>The Financial Plan as a Set of Goals </li></ul><ul><ul><li>The financial p...
Risk in Financial Planning in General <ul><li>Stretch planning and aggressive optimism can lead to unrealistic plans that ...
Risk in Financial Planning in General <ul><li>Underforecasting—The Other Extreme </li></ul><ul><ul><li>Underforecasting se...
Risk in Financial Planning in General <ul><li>Scenario Analysis—”What If”ing </li></ul><ul><ul><li>Many companies produce ...
Financial Planning and Computers <ul><li>Virtually all planning is done with the aid of computers </li></ul><ul><li>Comput...
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Chapter 16 Financial Planning

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FINANCIAL MANAGEMENT PART 16

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  • Dear Alamgir Alwani,

    I am a undergraduate student and conducting my final year project on Financial Planning. Your presentation has helped me much because it's very structured and detailed. Thanks so much!
    Would you please recommend me some textbooks related to corporate financial planning?

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    Hai Yen
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Chapter 16 Financial Planning

  1. 1. Financial Planning Chapter 16
  2. 2. Business Planning <ul><li>A business plan is a model of what management expects a business to become in the future </li></ul><ul><ul><li>Expressed in words and financial projections </li></ul></ul><ul><li>Financial statements are pro forma </li></ul><ul><ul><li>What the firm’s financial statements will look like if the planning assumptions are true </li></ul></ul><ul><li>Good business plan should be comprehensive </li></ul><ul><ul><li>Include projections concerning products, markets, employees, technology, facilities, capital, revenue, profitability, etc . </li></ul></ul>
  3. 3. Component Parts of a Business Plan <ul><li>Typical outline </li></ul><ul><ul><li>Contents </li></ul></ul><ul><ul><li>Executive summary </li></ul></ul><ul><ul><li>Mission and strategy statement </li></ul></ul><ul><ul><ul><li>Basic charter and establishes long-term direction </li></ul></ul></ul><ul><ul><li>Market analysis </li></ul></ul><ul><ul><ul><li>Why the business will succeed against its competitors </li></ul></ul></ul><ul><ul><li>Operations (of the business) </li></ul></ul><ul><ul><ul><li>How the firm creates and distributes its product/service </li></ul></ul></ul>
  4. 4. Component Parts of a Business Plan <ul><ul><li>Management and staffing </li></ul></ul><ul><ul><ul><li>Firm’s projected personnel needs </li></ul></ul></ul><ul><ul><li>Financial projections </li></ul></ul><ul><ul><ul><li>Projects the firm’s financial statements into the future </li></ul></ul></ul><ul><ul><ul><ul><li>Main focus of this chapter </li></ul></ul></ul></ul><ul><ul><li>Contingencies </li></ul></ul><ul><ul><ul><li>What the firm will do if things don’t go as planned </li></ul></ul></ul>
  5. 5. The Purpose of Planning and Plan Information <ul><li>Major audience of business plan include </li></ul><ul><ul><li>Firm’s own management </li></ul></ul><ul><ul><ul><li>Planning process helps pull management team together </li></ul></ul></ul><ul><ul><ul><li>Provides a road map for running the business </li></ul></ul></ul><ul><ul><ul><li>Provides a statement of goals </li></ul></ul></ul><ul><ul><ul><li>Helps predict financing needs </li></ul></ul></ul><ul><ul><ul><ul><li>Especially important for firms that use outside financing </li></ul></ul></ul></ul><ul><ul><li>Outside investors </li></ul></ul><ul><ul><ul><li>Tells equity investors what returns they can expect </li></ul></ul></ul><ul><ul><ul><li>Tells debt investors where firm will get the money to repay loans </li></ul></ul></ul>
  6. 6. Credibility and Supporting Detail <ul><li>A good business plan shows enough supporting detail to indicate it is the product of careful thinking </li></ul><ul><li>May display summarized financial projections but enough detail to explain the projections </li></ul><ul><ul><li>Important to match the level of detail to the purpose of the plan </li></ul></ul>
  7. 7. Four Kinds of Business Plan <ul><li>Four variations on basic idea of business planning </li></ul><ul><ul><li>Strategic planning </li></ul></ul><ul><ul><ul><li>Addresses broad, long-term issues; contains summarized, approximate financial projections </li></ul></ul></ul><ul><ul><ul><li>Five-year horizon is common </li></ul></ul></ul><ul><ul><ul><li>Deals with concepts expressed mainly in words, not numbers </li></ul></ul></ul><ul><ul><ul><ul><li>Firm analyzes itself, the industry and the competitive situation </li></ul></ul></ul></ul>
  8. 8. Four Kinds of Business Plan <ul><ul><li>Operational planning </li></ul></ul><ul><ul><ul><li>Translates business ideas (day-to-day operations) into concrete, short-term projections </li></ul></ul></ul><ul><ul><ul><li>Even mix of words and numbers </li></ul></ul></ul><ul><ul><li>Budgeting </li></ul></ul><ul><ul><ul><li>Short-term updates of the annual plan when business conditions change rapidly </li></ul></ul></ul><ul><ul><li>Forecasting </li></ul></ul><ul><ul><ul><li>Very short-term projections of profit and cash flow </li></ul></ul></ul><ul><ul><ul><li>Consist almost entirely of numbers </li></ul></ul></ul><ul><ul><ul><li>Most large firms perform monthly cash forecasts </li></ul></ul></ul>
  9. 9. Four Kinds of Business Plan <ul><li>The Business Planning Spectrum </li></ul><ul><ul><li>Most large companies produce all the parts of a business plan </li></ul></ul><ul><ul><ul><li>May also perform quarterly budgets and numerous forecasts </li></ul></ul></ul><ul><li>Relating Planning Processes of Small and Large Businesses </li></ul><ul><ul><li>Small businesses tend to develop a single business plan when in need of funding </li></ul></ul><ul><ul><ul><li>Contains both strategic and operating elements </li></ul></ul></ul>
  10. 10. Figure 16.2: The Business Planning Spectrum
  11. 11. Financial Plan as a Component of a Business Plan <ul><li>Financial plan is a set of pro forma financial statements projected over the time period covered by the business plan </li></ul><ul><li>Financial statements are a piece of the projection, but not usually the center of the projection </li></ul><ul><ul><li>However, with annual plans the financial projections are the centerpiece </li></ul></ul>
  12. 12. Planning for New and Existing Businesses <ul><li>Harder to forecast an operation that is very new or not yet begun </li></ul><ul><ul><li>No history on which to base projections </li></ul></ul><ul><li>The Typical Planning Task </li></ul><ul><ul><li>Most financial planning involves forecasting changes in ongoing businesses based on planning assumptions </li></ul></ul><ul><ul><li>Pro forma statements must reflect the assumptions made such as </li></ul></ul><ul><ul><ul><li>Unit sales will rise by 10% annually </li></ul></ul></ul><ul><ul><ul><li>Overall labor costs will rise by 4%, etc . </li></ul></ul></ul>
  13. 13. The General Approach, Assumptions, and the Debt/Interest Problem <ul><li>What We Have and What We Need to Project </li></ul><ul><ul><li>Only need to project an income statement and balance sheet </li></ul></ul><ul><ul><ul><li>Statement of cash flows will be created from these documents </li></ul></ul></ul><ul><li>Planning Assumptions </li></ul><ul><ul><li>An expected condition that dictates the size of one or more financial statement items </li></ul></ul><ul><ul><ul><li>Could be planned management actions such as cost control </li></ul></ul></ul><ul><ul><ul><li>Could be items outside management control such as interest rate levels or demand by consumers </li></ul></ul></ul>
  14. 14. Planning Assumptions—Example <ul><li>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. Crumb’s operating assumptions with respect to sales and receivables for next year are: </li></ul><ul><ul><li>Price will be decreased by 10% in order to sell more product. </li></ul></ul><ul><ul><li>As a result of the price decrease, unit sales volume will increase to 15 million coffee cakes. </li></ul></ul><ul><ul><li>Collection efforts will be increased so that only one month of sales will be in receivables at year end. </li></ul></ul><ul><li>Forecast next year’s revenue and ending receivables balance on the basis of these assumptions. Assume sales are evenly distributed over the year. </li></ul>Example
  15. 15. Planning Assumptions—Example 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, for total revenue of $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  12, or $1,125,000. Example
  16. 16. The General Approach, Assumptions, and the Debt/Interest Problem <ul><li>The Procedural Approach </li></ul><ul><ul><li>Financial plans are built line-by-line beginning with revenues </li></ul></ul><ul><ul><ul><li>First, all income statement (IS) items are projected, stopping just before interest expense line </li></ul></ul></ul><ul><ul><ul><li>Then all balance sheet (BS) items are projected except long-term debt and equity </li></ul></ul></ul><ul><li>Debt/Interest Planning Problem </li></ul><ul><ul><li>The next items needed are interest expense (IS) and debt (BS) </li></ul></ul><ul><ul><li>However, this causes a dilemma because </li></ul></ul><ul><ul><ul><li>Planned debt is required to forecast interest, but interest is required to forecast debt </li></ul></ul></ul>
  17. 17. The General Approach, Assumptions, and the Debt/Interest Problem <ul><li>To complete the BS we need to know the amount of debt </li></ul><ul><li>However, this depends on the amount of retained earnings generated during the year </li></ul><ul><ul><li>But, retained earnings depend on net income and net income depends on how much interest expense is paid on debt </li></ul></ul><ul><li>Results in a circular argument </li></ul><ul><li>Every financial plan runs into this technical problem </li></ul><ul><li>Can be resolved using a numerical approach beginning with a guess at the solution </li></ul>
  18. 18. Figure 16.5: The Debt/Interest Planning Problem
  19. 19. An Iterative Numerical Approach <ul><li>Procedure works as follows </li></ul><ul><ul><li>Interest: Guess a value of interest expense </li></ul></ul><ul><ul><li>EAT: Complete the income statement </li></ul></ul><ul><ul><li>Ending equity: Calculate ending equity as beginning equity plus EAT (less dividends plus new stock to be sold if either of these exist) </li></ul></ul><ul><ul><li>Ending debt: Calculate ending debt as total L&E (= total assets) less current liabilities less ending equity </li></ul></ul><ul><ul><li>Interest: Average beginning and ending debt then calculate interest expense on that value </li></ul></ul><ul><ul><li>Test the results: Compare the calculated interest from previous step to the original guess </li></ul></ul><ul><ul><ul><li>If the two are significantly different repeat the process replacing the original interest expense guess with the interest expense just calculated </li></ul></ul></ul><ul><ul><ul><li>If the calculated value of interest is close to the guess, stop </li></ul></ul></ul>
  20. 20. An Iterative Numerical Approach—Example Q: The following partial financial forecast has been done for Graybarr Inc. Complete the financial plan, assuming that Graybarr pays interest at 10% and has a flat income tax rate of 40% including federal and state taxes. Also assume no dividends are to be paid and no new stock is to be sold. Example
  21. 21. An Iterative Numerical Approach—Example A: The huge increase in assets will cause the company’s debt to increase at a dramatic rate. The first iteration is represented below, with the steps enumerated. Example 1: Guess at the firm’s interest expense. Most firms use last year’s value as a guess. 2: Compute EAT. 3: Calculate Ending equity as beginning equity plus EAT less dividends. 4: Calculate Ending debt as total L&E less ending equity less ending current liabilities.
  22. 22. An Iterative Numerical Approach—Example A: Now we check to see if the the interest implied by our calculated debt (average debt x interest rate) [which is (($100,000 + $1,220,000)  2)  10% = $66,000] is significantly different from the initial guess. Our original guess of $200,000 is much higher than the calculated interest of $66,000. Thus, a second iteration is performed. Example Given these results the average debt is $620,000 and interest is $62,000. The second iteration and the calculated result differ by only $4,000.
  23. 23. Plans with Simple Assumptions <ul><li>A rough plan can be generated with just a few assumptions </li></ul><ul><li>A detailed financial plan can involve numerous assumptions </li></ul><ul><li>The Quick Estimate Based on Sales Growth </li></ul><ul><ul><li>The percentage of sales method assumes most financial statement line items vary directly with revenues </li></ul></ul><ul><ul><ul><li>Involves estimating only the company’s sales growth rate and assuming the firm’s efficiency and all its operating ratios remain constant throughout the growth period </li></ul></ul></ul><ul><ul><ul><li>In practice modifications are made to the assumptions </li></ul></ul></ul>
  24. 24. Plans with Simple Assumptions—Example Q: The Overland Manufacturing Company expects next year’s revenues to increase by 15% over this year’s. The firm has some excess factory capacity, so no new fixed assets beyond normal replacements will be needed to support the growth. This year’s income statement and ending balance sheet are estimated as follows: Example
  25. 25. Plans with Simple Assumptions—Example Assume the firm pays state and federal income taxes at a combined flat rate of 42%, borrows at 12% interest, and expects to pay no dividends. Project next year’s income statement and balance sheet by using the modified percentage of sales method. A: We’ll increase everything except net fixed assets by 15%. Example All highlighted items were increased by 15%. At this point we are at the debt/interest impasse. We’ll guess at interest (using last year’s interest of $150,000 as a starting point) and work through the procedure.
  26. 26. Plans with Simple Assumptions—Example Taking the average debt at 12% yields a calculated interest of $86,000 which is considerably less than the $150,000 assumed. Additional iterations should yield a more accurate projection. Example EAT was computed using an Interest of $150,000. The resulting EAT was added to Equity and the Debt figure was a plug, calculated by subtracting Equity and Current Liabilities from Total L&E.
  27. 27. Plans with Simple Assumptions <ul><li>Forecasting Cash Needs </li></ul><ul><ul><li>A key reason for doing financial projections is to forecast the firm’s external financing needs </li></ul></ul><ul><ul><li>When a plan shows increasing debt, the implication is that additional external financing will be needed </li></ul></ul><ul><ul><ul><li>Can be obtained by </li></ul></ul></ul><ul><ul><ul><ul><li>Issuing debt or bank financing </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Issuing new stock </li></ul></ul></ul></ul>
  28. 28. The Percentage of Sales Method—A Formula Approach <ul><li>If we assume that net fixed assets will rise in tandem with sales, the percentage of sales method can be condensed into a single formula </li></ul><ul><ul><li>Purpose is to estimate external financing requirements (EFR) </li></ul></ul><ul><li>A growing firm must buy assets to support growth </li></ul><ul><ul><li>Some funds will be generated internally via </li></ul></ul><ul><ul><ul><li>Current liabilities </li></ul></ul></ul><ul><ul><ul><li>Retained earnings </li></ul></ul></ul>
  29. 29. The Percentage of Sales Method—A Formula Approach <ul><li>Representing a firm’s growth rate in sales as g, then </li></ul><ul><ul><li>Growth in assets = g  assets this year and </li></ul></ul><ul><ul><li>Growth in current liabilities = g x current liabilities this year </li></ul></ul><ul><ul><li>EAT next year = ROS  (1 + g)sales this year </li></ul></ul><ul><ul><li>Earnings retained = (1 – dividend payout ratio) EAT next year </li></ul></ul><ul><ul><li>EFR = g(assets this year ) - g  current liabilities this year - (1 – dividend payout ratio) EAT next year </li></ul></ul>
  30. 30. The Percentage of Sales Method—A Formula Approach—Example Q: Forecast the external financing requirements of the Overland 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. Example The items needed to apply the EFR equation are highlighted. We also need the ROS figure of 11% (EAT  sales, or $1,488  $13,580) and the expected dividend payout ratio of 25%. Revenues are expected to increase by 15%.
  31. 31. The Percentage of Sales Method—A Formula Approach—Example <ul><li>A: Applying the EFR equation we have: </li></ul>Example A negative EFR figure means no additional outside funds are needed. A negative result says that Overland will generate enough funds during the period to reduce its debt by about $414,000.
  32. 32. The Sustainable Growth Rate <ul><li>A firm can grow at its sustainable growth rate without selling new stock if its financial ratios remain constant </li></ul><ul><ul><li>The growth in equity created by profits </li></ul></ul><ul><li>Business operations create new equity equal to the amount of current retained earnings, or (1 – DPR)EAT </li></ul><ul><ul><li>This implies a sustainable growth rate in equity, g s , of </li></ul></ul><ul><ul><ul><li>g s = EAT(1 – d)  equity </li></ul></ul></ul><ul><ul><ul><ul><li>Since ROE = EAT  equity, g s = ROE(1 – d) </li></ul></ul></ul></ul>
  33. 33. The Sustainable Growth Rate <ul><li>Sustainable growth rate assumes that the debt/equity ratio is constant </li></ul><ul><ul><li>Equity growth occurs via retained earnings so no new stock needs to be issued </li></ul></ul><ul><ul><li>However, new debt will need to be raised to keep the debt/equity ratio constant </li></ul></ul><ul><li>Sustainable growth concept gives an indication of the determinants of a firm’s inherent growth capability </li></ul>
  34. 34. The Sustainable Growth Rate <ul><li>Incorporating equations from the DuPont equations into the g s equation we obtain </li></ul><ul><li>Thus, a firm’s ability to grow depends on the following </li></ul><ul><ul><li>Its ability to earn profits on sales (ROS) </li></ul></ul><ul><ul><li>Its talent at using assets to generate sales (total asset turnover) </li></ul></ul><ul><ul><li>Its use of leverage (equity multiplier) </li></ul></ul><ul><ul><li>The percentage of earnings retained (1 – d) </li></ul></ul>
  35. 35. Plans With More Complicated Assumptions <ul><li>The percentage of sales method is appropriate for quick estimates, but generally aren’t used in formal plans because they gross over too much detail </li></ul><ul><li>Real plans general incorporate complex assumptions about important financial items </li></ul><ul><ul><li>Specific accounts can be forecast separately </li></ul></ul><ul><ul><ul><li>Fixed assets are forecast by projecting the gross amount using the capital plan and handling depreciation separately </li></ul></ul></ul>
  36. 36. Plans With More Complicated Assumptions <ul><li>Indirect planning assumptions are made about financial ratios, which in turn lead to line item values </li></ul><ul><ul><li>Accounts receivable are generally forecast by making an assumption about the Average Collection Period and calculating the implied balance </li></ul></ul><ul><ul><li>Inventory is generally forecast indirectly thru the Inventory Turnover ratio </li></ul></ul>
  37. 37. Planning at the Department Level <ul><li>Operational plans projections are much more detailed than the single numbers appearing on the income statement </li></ul><ul><ul><li>Departmental detail supports the expense entries on the planned income statement </li></ul></ul><ul><li>Manufacturing Departments </li></ul><ul><ul><li>Spending in manufacturing departments is incorporated in the product’s cost through cost accounting procedures </li></ul></ul><ul><ul><ul><li>Money spent is absorbed into inventory and becomes COGS on the income statement when the product is sold </li></ul></ul></ul><ul><ul><ul><li>The cost ratio assumption summarizes enormous detail in manufacturing departments </li></ul></ul></ul>
  38. 38. The Cash Budget <ul><li>Forecasting cash is an important part of financial planning </li></ul><ul><li>The cash budget is a detailed projection of receipts and disbursements of cash </li></ul><ul><ul><li>Receipts generally come from cash sales, collecting receivables, borrowing and selling stock </li></ul></ul><ul><ul><li>Disbursements include paying for purchases, wages, taxes and other expenses including rent, utilities, supplies, etc . </li></ul></ul>
  39. 39. Receivables and Payables—Forecasting with Time Lags <ul><li>Forecasting receivables collection is difficult because you never know exactly when a customer will pay his bill </li></ul><ul><ul><li>Some pay by the due date (terms of trade, usually 30 days), while others lean on the trade and others may never pay </li></ul></ul><ul><ul><li>However, a firm generally knows the trend in receivables collection, such as what percentage of customers pay over time from the day of sale </li></ul></ul><ul><ul><li>If a prompt payment discount is offered that can complicate matters </li></ul></ul>
  40. 40. Receivables and Payables—Forecasting with Time Lags—Example Q: A firm has discerned that its collections exhibit the following pattern: The firm expects its credit sales from January through March to be: Determine the company’s expected cash collections from receivables. A: Example 8% 30% 60% % collected 3 2 1 Months after sale $700 $600 $500 Credit sales Mar Feb Jan $56 $258 $640 $510 $300 Total collections $56 $210 $420 Mar $48 $180 $360 Feb $40 $150 $300 Jan Collections from sales made in May Apr Jun $700 Mar $600 $500 Credit sales Feb Jan
  41. 41. Debt and Interest <ul><li>Forecasting short-term debt and interest can be tricky if a company is funding current cash needs directly by borrowing </li></ul><ul><ul><li>Not unusual </li></ul></ul><ul><li>The current month’s interest payment is based on the preceding month’s loan balance </li></ul><ul><ul><li>But that balance depends on whether the month’s cash flow is positive or negative </li></ul></ul><ul><li>Other Items </li></ul><ul><ul><li>Forecasting most other items is relatively straightforward </li></ul></ul><ul><ul><ul><li>Payroll dates are known in advance so wages are easy to forecast, as are dates for interest payments on bonds and taxes, etc . </li></ul></ul></ul>
  42. 42. The Cash Budget—Example Q: The Pulmeri Company’s revenues tend to go through a quarterly cycle. It’s now mid-March and management expects the first quarter’s pattern to be repeated in the second quarter. The six-month period is as follows ($000). Historically, Pulmeri collects its receivables according to the following pattern. No prompt payment discount is offered, and there are virtually no bad debts. The firm purchases and receives inventory one month in advance of sales. Materials cost about half of sales revenue. Invoices for inventory purchases are paid 45 days after receipt of material. Payroll runs a constant $2.5M per month, and other expenses such as rent, utilities, and supplies are a fairly steady $1.5M per month. A $0.5M tax payment is scheduled for mid-April. Pulmeri has a short-term loan outstanding that is expected to stand at $5M at the end of March. Monthly interest is 1% of the previous month end balance. Prepare Pulmeri’s cash budget for the second quarter. Example $9,000 Mar $8,000 Feb $5,000 Jan $9,000 $8,000 $5,000 Revenue Jun May Apr 10% 25% 65% % collected 3 2 1 Months after sale
  43. 43. The Cash Budget—Example A: First lay out revenue and lag in collections according to the historical pattern. $7,350 $6,300 $8,350 Second quarter collections $5,200 May $1,250 $3,250 Apr $900 $2,250 $5,850 Mar $800 $2,000 $5,200 Feb $500 $1,250 $3,250 Jan Collections from sales made in $8,000 May $5,000 Apr $9,000 Jun $9,000 Mar $8,000 $5,000 Revenue Feb Jan Example
  44. 44. The Cash Budget—Example A: Next, lag inventory purchases (half of sales dollars) back one month from the date of sale and then lag the payment two months forward in two equal parts. $4,250 $3,250 $3,500 Payment for materials $2,250 May $2,000 $2,000 Apr $1,250 $1,250 Mar $2,250 $2,250 Feb Payment $4,500 May $4,000 Apr Jun $2,500 Mar $4,500 Purchases Feb Jan Example
  45. 45. The Cash Budget—Example A: Finally, summarize these results along with payroll and other disbursement and work through the interest charges. Pulmeri Company Cash Budget Second Quarter 20x1 ($000) $500 Tax payment $1,500 $1,500 $1,500 General expenses $2,500 $2,500 $2,500 Payroll $4,250 $3,250 $3,500 Materials purchases Disbursements $7,350 $6,300 $8,350 Collections $8,000 May $5,000 Apr $9,000 Jun $9,000 Mar $8,000 $5,000 Revenue Feb Jan Example
  46. 46. The Cash Budget—Example $(6,654) $(5,697) $(4,700) $(5,000) Cumulative cash flow (loan) $(957) $(997) $300 Net cash flow $(57) $(47) $(50) Interest $(900) $(950) $350 Cash flows before interest $8,250 $7,250 $8,000 Disbursements before interest Pulmeri Company Cash Budget Second Quarter 20x1 ($000) May Apr Jun Mar Feb Jan Example
  47. 47. Management Issues in Financial Planning <ul><li>The Financial Plan as a Set of Goals </li></ul><ul><ul><li>The financial plan can be a tool with which to manage the company and motivate desirable performance </li></ul></ul><ul><ul><li>Problems arise when top management puts in stretch goals </li></ul></ul><ul><ul><ul><li>A target for which the organization strives, but is unlikely to achieve </li></ul></ul></ul><ul><ul><ul><ul><li>People may give up if they consider the goal impossible </li></ul></ul></ul></ul>
  48. 48. Risk in Financial Planning in General <ul><li>Stretch planning and aggressive optimism can lead to unrealistic plans that have little chance of coming true </li></ul><ul><li>Top-down plans are forced on the organization by management and are often unrealistically optimistic </li></ul><ul><ul><li>Middle and lower level managers often feel that such plans are unrealistic </li></ul></ul><ul><ul><li>The risk in financial planning is that the plan overstates achievable performance </li></ul></ul>
  49. 49. Risk in Financial Planning in General <ul><li>Underforecasting—The Other Extreme </li></ul><ul><ul><li>Underforecasting sets up a goal that is easy to meet and ensures future success </li></ul></ul><ul><ul><li>Bottom-up plans are consolidated from lower management’s inputs and tend to understate what the firm can do </li></ul></ul><ul><li>The Ideal Process </li></ul><ul><ul><li>Ideally the process is a combination of the top-down and bottom-up approaches </li></ul></ul><ul><ul><li>The end result is a realistic compromise that is achievable </li></ul></ul>
  50. 50. Risk in Financial Planning in General <ul><li>Scenario Analysis—”What If”ing </li></ul><ul><ul><li>Many companies produce a number of plans reflecting different scenarios—”what if” </li></ul></ul><ul><ul><li>Gives planners a feel for the impact of their assumptions not coming true </li></ul></ul><ul><li>Communication </li></ul><ul><ul><li>A business unit is expected to have confidence in its plan </li></ul></ul><ul><ul><li>A single plan tends to be published along with its attendant risks </li></ul></ul>
  51. 51. Financial Planning and Computers <ul><li>Virtually all planning is done with the aid of computers </li></ul><ul><li>Computers make planning quicker and more thorough, but don’t improve the judgments at the heart of the plan </li></ul><ul><li>Repetitive Calculations </li></ul><ul><ul><li>Before computers, recomputing a plan was time consuming and labor-intensive </li></ul></ul><ul><ul><li>However, with computers repetitive calculations can be done quickly and easily </li></ul></ul>

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