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  1. 1. Chapter 4 Financial Planning
  2. 2. 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>
  3. 3. Component Parts of a Business Plan <ul><li>Typical outline - continued </li></ul><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><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>
  4. 4. 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><li>Outside investors </li></ul></ul><ul><ul><ul><li>Tells equity investors what returns can be expected </li></ul></ul></ul><ul><ul><ul><li>Tells debt investors how firm will repay loans </li></ul></ul></ul>
  5. 5. Four Kinds of Business Plan <ul><li>Kinds of planning </li></ul><ul><ul><li>Strategic Planning </li></ul></ul><ul><ul><li>Operational Planning </li></ul></ul><ul><ul><li>Budgeting </li></ul></ul><ul><ul><li>Forecasting </li></ul></ul>
  6. 6. Four Kinds of Business Plan <ul><li>Strategic Planning </li></ul><ul><ul><li>Addresses broad, long-term issues, contains summarized, approximate financial projections </li></ul></ul><ul><ul><ul><li>Five-year horizon is common </li></ul></ul></ul><ul><ul><ul><li>Concepts expressed mainly in words, not numbers </li></ul></ul></ul><ul><ul><ul><li>Firm analyzes itself, the industry and the competitive situation </li></ul></ul></ul>
  7. 7. Four Kinds of Business Plan <ul><li>Operational Planning </li></ul><ul><ul><li>Translates business ideas (day-to-day operations) into concrete, short-term projections </li></ul></ul><ul><ul><li>Specifies how much the firm will sell, to whom, and at what prices </li></ul></ul><ul><ul><li>An equal mix of words and numbers </li></ul></ul>
  8. 8. Four Kinds of Business Plan <ul><li>Budgeting </li></ul><ul><ul><li>Short-term updates of the annual plan </li></ul></ul><ul><ul><ul><li>Usually Covers a calendar quarter </li></ul></ul></ul><ul><ul><ul><li>Used in industries in which business conditions change rapidly </li></ul></ul></ul><ul><ul><li>Mostly financial detail with a few words </li></ul></ul>
  9. 9. Four Kinds of Business Plan <ul><li>Forecasting </li></ul><ul><ul><li>Very short-term projections of profit and cash flow </li></ul></ul><ul><ul><ul><li>Where will the business’s financial momentum carry it in the next few weeks </li></ul></ul></ul><ul><ul><li>Consists almost entirely of numbers </li></ul></ul><ul><ul><li>Cash forecasts are projections of short-term cash needs </li></ul></ul><ul><ul><ul><li>Most large firms do monthly cash forecasts </li></ul></ul></ul>
  10. 10. Financial Plan as a Component of a Business Plan <ul><li>Financial plan is the financial portion of the business plan </li></ul><ul><ul><li>It is a set of pro forma financial statements projected over the time period covered by the business plan </li></ul></ul><ul><ul><li>Financial statements are a piece of the projection, not the center of the projection </li></ul></ul>
  11. 11. Planning for New and Existing Businesses <ul><li>Hard to forecast a new operation </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>Projected statements reflect assumptions such as: </li></ul></ul><ul><ul><ul><li>Unit sales will increase by 10% </li></ul></ul></ul><ul><ul><ul><li>Overall labor costs will rise by 4%, etc . </li></ul></ul></ul>
  12. 12. The Planning Task What we have and what we need to project Figure 4.4
  13. 13. Planning Assumptions Example 4.1 <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
  14. 14. 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  12 = $1,125,000. Example
  15. 15. Plans with Simple Assumptions <ul><li>The Quick Estimate Based on Sales Growth </li></ul><ul><ul><li>The percentage of sales method assumes all financial statement line items vary directly with sales revenue </li></ul></ul><ul><ul><ul><li>This is an unrealistic assumption </li></ul></ul></ul><ul><ul><ul><li>Management virtually always has more insight </li></ul></ul></ul><ul><ul><li>The modified percentage of sales method assumes most but not all line items vary with sales </li></ul></ul>
  16. 16. Plans with Simple Assumptions <ul><li>Forecasting Cash Needs </li></ul><ul><ul><li>A key reason for financial projections is to forecast the firm’s external financing needs </li></ul></ul><ul><ul><li>When a plan shows increasing debt, additional external financing will be needed </li></ul></ul><ul><ul><ul><li>Can be obtained by issuing new stock or borrowing </li></ul></ul></ul>
  17. 17. The Percentage of Sales Method—A Formula Approach <ul><li>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 </li></ul><ul><ul><li>Purpose – to estimate external financing requirements approximately and quickly </li></ul></ul>
  18. 18. The Percentage of Sales Method—A Formula Approach <ul><li>If the firm’s growth rate in sales is g, it can be shown (see text) that external funds required (EFR) in the planned (next) year will be </li></ul><ul><li>EFR = g(assets this year ) </li></ul><ul><ul><li> - (g  current liabilities this year ) </li></ul></ul><ul><ul><li> - [(1 – d) ROS][(1+g)sales this year ] </li></ul></ul><ul><ul><ul><li>Where d=dividend payout ratio </li></ul></ul></ul><ul><li>EFR = Growth in assets </li></ul><ul><li>– growth in current liabilities </li></ul><ul><li>– planned year’s retained earnings </li></ul>
  19. 19. 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. 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%.
  20. 20. The Percentage of Sales Method— A Formula Approach Example 4.4 <ul><li>Example </li></ul><ul><li>EFR = g(assets this year ) </li></ul><ul><li>- (g  current liabilities this year ) </li></ul><ul><ul><li>- [(1-d)ROS][(1+g)sales this year ] </li></ul></ul><ul><ul><li>EFR = .15($6,000) - .15($170) </li></ul></ul><ul><ul><li> - [(1-.25)(.11)(1.15)($13,580)] </li></ul></ul><ul><ul><li>EFR = - $413.9 </li></ul></ul><ul><ul><li>A negative result implies the firm will generate cash </li></ul></ul><ul><ul><li>Note that the EFR technique is of limited value because it forces the unrealistic assumption that all financial statement items vary exactly with sales </li></ul></ul>
  21. 21. The Sustainable Growth Rate <ul><li>A theoretical measure of a firm’s strength </li></ul><ul><li>A firm can grow at its sustainable growth rate without selling new stock if its financial ratios remain constant </li></ul><ul><li>Business operations create new equity equal to the amount of current retained earnings, or (1 – d)EAT </li></ul><ul><li>Implies sustainable growth rate in equity, g s g s = EAT(1 – d) / equity </li></ul><ul><li>Since ROE = EAT / equity </li></ul><ul><li>g s = ROE(1 – d) </li></ul>
  22. 22. The Sustainable Growth Rate <ul><li>Assumes the debt/equity ratio is constant </li></ul><ul><ul><li>Equity growth occurs via retained earnings </li></ul></ul><ul><ul><li>New debt will need to be raised to keep the debt/equity ratio constant </li></ul></ul><ul><li>Gives an indication of the determinants of a firm’s inherent growth capability </li></ul>
  23. 23. The Sustainable Growth Rate <ul><li>Incorporating equations from the DuPont equations into the g s equation we obtain </li></ul><ul><li>g s = (1-d)ROS x Total Asset Turnover </li></ul><ul><li>x Equity Multiplier </li></ul><ul><li>Firm’s ability to grow depends on 4 abilities: </li></ul><ul><ul><li>Ability to earn profits on sales (ROS) </li></ul></ul><ul><ul><li>Use of assets to generate sales (T/A Turnover) </li></ul></ul><ul><ul><li>Use of borrowed money - leverage (equity mult) </li></ul></ul><ul><ul><li>Percentage of earnings retained (1 – d) </li></ul></ul>
  24. 24. More Complicated Plans Indirect Planning Assumptions <ul><li>Financial planning assumptions can be made: </li></ul><ul><ul><li>directly about the financial items </li></ul></ul><ul><ul><li>indirectly about a derivative of the item </li></ul></ul><ul><li>Indirect planning assumptions are usually based on financial ratios </li></ul><ul><ul><li>Receivables are usually managed through the Average Collection Period (ACP) </li></ul></ul>
  25. 25. Forecasting Accounts Receivable Example 4.6 <ul><li>Q: Mylar’s 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? </li></ul><ul><li>A: A/R </li></ul><ul><li>ACP = x 360 </li></ul><ul><li> Sales </li></ul><ul><li> A/R </li></ul><ul><li>40 days = x 360 </li></ul><ul><li> $7,900,000 </li></ul><ul><li>A/R = $877,777 </li></ul>Example An average balance would generally be used. See footnote in text.
  26. 26. 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 to manage the company and motivate 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 fully achieve </li></ul></ul></ul><ul><ul><ul><li>Want employees to stretch toward max performance </li></ul></ul></ul><ul><ul><ul><li>But people will give up if the goal seems impossible </li></ul></ul></ul>
  27. 27. Risk in Financial Planning in General <ul><li>Stretch planning and aggressive optimism can lead to unrealistic plans with little chance of coming true </li></ul><ul><li>Top-down plans forced on the organization by management are often unrealistically optimistic </li></ul><ul><ul><li>The risk in financial planning is that the plan overstates achievable performance </li></ul></ul>
  28. 28. Risk in Financial Planning in General <ul><li>Underforecasting—The Other Extreme </li></ul><ul><ul><li>Sets a goal that is easy to meet, ensures success </li></ul></ul><ul><ul><ul><li>Doesn’t motivate best possible performance </li></ul></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>A combination of the top-down and bottom-up approaches to planning </li></ul></ul><ul><ul><li>End result is a realistic, achievable compromise </li></ul></ul>
  29. 29. Risk in Financial Planning in General <ul><li>Scenario Analysis—”What If”ing </li></ul><ul><ul><li>Many companies produce plans reflecting different scenarios — “what if” </li></ul></ul><ul><ul><li>Gives planners a feel for the impact of 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>