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  1. 1. Financial Planning Chapter 16 © 2003 South-Western/Thomson Learning
  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. 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>
  11. 11. 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>
  12. 12. 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>
  13. 13. 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>
  14. 14. 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>
  15. 15. 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>
  16. 16. 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>
  17. 17. 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>
  18. 18. 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>
  19. 19. 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>Current 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>
  20. 20. 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>
  21. 21. 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>
  22. 22. 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>
  23. 23. 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>
  24. 24. 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>
  25. 25. 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>
  26. 26. 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>
  27. 27. 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>
  28. 28. 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>
  29. 29. 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>
  30. 30. 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>
  31. 31. 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>
  32. 32. 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>
  33. 33. 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>