Document16

Financial Planning

Chapter 16

© 2003 South-Western/Thomson Learning

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Business Planning

A business plan is a model of what management expects a business to become in the future Expressed in words and financial projections

Financial statements are pro forma What the firm’s financial statements will look like if the

planning assumptions are true Good business plan should be comprehensive

Include projections concerning products, markets, employees, technology, facilities, capital, revenue, profitability, etc.

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Component Parts of a Business Plan

Typical outline Contents Executive summary Mission and strategy statement

• Basic charter and establishes long-term direction

Market analysis• Why the business will succeed against its competitors

Operations (of the business)• How the firm creates and distributes its product/service

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Component Parts of a Business Plan

Management and staffing• Firm’s projected personnel needs

Financial projections• Projects the firm’s financial statements into the

future• Main focus of this chapter

Contingencies• What the firm will do if things don’t go as planned

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The Purpose of Planning and Plan Information Major audience of business plan include

Firm’s 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

• Especially important for firms that use outside financing

Outside investors• Tells equity investors what returns they can expect• Tells debt investors where firm will get the money to repay

loans

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Credibility and Supporting Detail

A good business plan shows enough supporting detail to indicate it is the product of careful thinking

May display summarized financial projections but enough detail to explain the projections Important to match the level of detail to the

purpose of the plan

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Four Kinds of Business Plan

Four variations on basic idea of business planning Strategic planning

• Addresses broad, long-term issues; contains summarized, approximate financial projections

• Five-year horizon is common• Deals with concepts expressed mainly in words,

not numbers• Firm analyzes itself, the industry and the competitive

situation

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Operational planning• Translates business ideas (day-to-day operations) into

concrete, short-term projections• Even mix of words and numbers

Budgeting• Short-term updates of the annual plan when business

conditions change rapidly

Forecasting• Very short-term projections of profit and cash flow • Consist almost entirely of numbers• Most large firms perform monthly cash forecasts

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The Business Planning Spectrum Most large companies produce all the parts of a

business plan• May also perform quarterly budgets and numerous

forecasts

Relating Planning Processes of Small and Large Businesses Small businesses tend to develop a single business

plan when in need of funding• Contains both strategic and operating elements

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Financial Plan as a Component of a Business Plan

Financial plan 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, but not usually the center of the projection However, with annual plans the financial

projections are the centerpiece

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Planning for New and Existing Businesses Harder to forecast an operation that is very new

or not yet begun No history on which to base projections

The Typical Planning Task Most financial planning involves forecasting changes

in ongoing businesses based on planning assumptions

Pro forma statements must reflect the assumptions made such as

• Unit sales will rise by 10% annually• Overall labor costs will rise by 4%, etc.

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The General Approach, Assumptions, and the Debt/Interest Problem

What We Have and What We Need to Project Only need to project an income statement and

balance sheet• Statement of cash flows will be created from these

documents

Planning Assumptions An expected condition that dictates the size of one

or more financial statement items• Could be planned management actions such as cost

control• Could be items outside management control such as

interest rate levels or demand by consumers

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The Procedural Approach Financial plans are built line-by-line beginning with

revenues• First, all income statement (IS) items are projected, stopping just

before interest expense line• Then all balance sheet (BS) items are projected except long-term

debt and equity

Debt/Interest Planning Problem The next items needed are interest expense (IS) and debt

(BS) However, this causes a dilemma because

• Planned debt is required to forecast interest, but interest is required to forecast debt

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To complete the BS we need to know the amount of debt

However, this depends on the amount of retained earnings generated during the year But, retained earnings depend on net income and net income

depends on how much interest expense is paid on debt Results in a circular argument Every financial plan runs into this technical problem Can be resolved using a numerical approach

beginning with a guess at the solution

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An Iterative Numerical Approach Procedure works as follows

Interest: Guess a value of interest expense EAT: Complete the income statement Ending equity: Calculate ending equity as beginning equity plus

EAT (less dividends plus new stock to be sold if either of these exist) Ending debt: Calculate ending debt as total L&E (= total assets) less

current liabilities less ending equity Interest: Average beginning and ending debt then calculate interest

expense on that value Test the results: Compare the calculated interest from previous step

to the original guess• If the two are significantly different repeat the process replacing the

original interest expense guess with the interest expense just calculated• If the calculated value of interest is close to the guess, stop

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Plans with Simple Assumptions

A rough plan can be generated with just a few assumptions

A detailed financial plan can involve numerous assumptions

The Quick Estimate Based on Sales Growth The percentage of sales method assumes most

financial statement line items vary directly with revenues

• 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

• In practice modifications are made to the assumptions

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Plans with Simple Assumptions

Forecasting Cash Needs A key reason for doing financial projections

is to forecast the firm’s external financing needs

When a plan shows increasing debt, the implication is that additional external financing will be needed

• Can be obtained by• Issuing debt or bank financing• Issuing new stock

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The Percentage of Sales Method—A Formula Approach 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 Purpose is to estimate external financing

requirements (EFR) A growing firm must buy assets to support

growth Some funds will be generated internally via

• Current liabilities• Retained earnings

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The Percentage of Sales Method—A Formula Approach Representing a firm’s growth rate in sales as g,

then Growth in assets = g assetsthis year and Growth in current liabilities = g x current liabilitiesthis

year

EATnext year = ROS (1 + g)salesthis year

Current earnings retained = (1 – dividend payout ratio) EATnext year

EFR = g(assetsthis year) - g current liabilitiesthis year - (1 – dividend payout ratio) EATnext year

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The Sustainable Growth Rate

A firm can grow at its sustainable growth rate without selling new stock if its financial ratios remain constant The growth in equity created by profits

Business operations create new equity equal to the amount of current retained earnings, or (1 – DPR)EAT This implies a sustainable growth rate in equity, gs, of

• gs = EAT(1 – d) equity• Since ROE = EAT equity, gs = ROE(1 – d)

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Sustainable growth rate assumes that the debt/equity ratio is constant Equity growth occurs via retained earnings

so no new stock needs to be issued However, new debt will need to be raised to

keep the debt/equity ratio constant Sustainable growth concept gives an

indication of the determinants of a firm’s inherent growth capability

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Incorporating equations from the DuPont equations into the gs equation we obtain

s

EAT sales assetsg 1 d

sales assets equity

Thus, a firm’s ability to grow depends on the following:Its ability to earn profits on sales (ROS)Its talent at using assets to generate sales (total asset turnover)Its use of leverage (equity multiplier)The percentage of earnings retained (1 – d)

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Plans With More Complicated Assumptions

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

Real plans general incorporate complex assumptions about important financial items Specific accounts can be forecast separately

• Fixed assets are forecast by projecting the gross amount using the capital plan and handling depreciation separately

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Plans With More Complicated Assumptions

Indirect planning assumptions are made about financial ratios, which in turn lead to line item values Accounts receivable are generally forecast

by making an assumption about the Average Collection Period and calculating the implied balance

Inventory is generally forecast indirectly thru the Inventory Turnover ratio

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Planning at the Department Level Operational plans projections are much more

detailed than the single numbers appearing on the income statement Departmental detail supports the expense entries on the

planned income statement Manufacturing Departments

Spending in manufacturing departments is incorporated in the product’s cost through cost accounting procedures

• Money spent is absorbed into inventory and becomes COGS on the income statement when the product is sold

• The cost ratio assumption summarizes enormous detail in manufacturing departments

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The Cash Budget

Forecasting cash is an important part of financial planning

The cash budget is a detailed projection of receipts and disbursements of cash Receipts generally come from cash sales, collecting

receivables, borrowing and selling stock Disbursements include paying for purchases,

wages, taxes and other expenses including rent, utilities, supplies, etc.

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Receivables and Payables— Forecasting with Time Lags Forecasting receivables collection is difficult

because you never know exactly when a customer will pay his bill Some pay by the due date (terms of trade, usually

30 days), while others lean on the trade and others may never pay

However, a firm generally knows the trend in receivables collection, such as what percentage of customers pay over time from the day of sale

If a prompt payment discount is offered that can complicate matters

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Debt and Interest

Forecasting short-term debt and interest can be tricky if a company is funding current cash needs directly by borrowing Not unusual

The current month’s interest payment is based on the preceding month’s loan balance But that balance depends on whether the month’s cash flow is

positive or negative Other Items

Forecasting most other items is relatively straightforward• Payroll dates are known in advance so wages are easy to

forecast, as are dates for interest payments on bonds and taxes, etc.

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Management Issues in Financial Planning

The Financial Plan as a Set of Goals The financial plan can be a tool with which to

manage the company and motivate desirable performance

Problems arise when top management puts in stretch goals

• A target for which the organization strives, but is unlikely to achieve

• People may give up if they consider the goal impossible

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Risk in Financial Planning in General Stretch planning and aggressive optimism can

lead to unrealistic plans that have little chance of coming true

Top-down plans are forced on the organization by management and are often unrealistically optimistic Middle and lower level managers often feel that such

plans are unrealistic The risk in financial planning is that the plan

overstates achievable performance

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Risk in Financial Planning in General Underforecasting—The Other Extreme

Underforecasting sets up a goal that is easy to meet and ensures future success

Bottom-up plans are consolidated from lower management’s inputs and tend to understate what the firm can do

The Ideal Process Ideally the process is a combination of the top-down

and bottom-up approaches The end result is a realistic compromise that is

achievable

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Risk in Financial Planning in General Scenario Analysis—”What If”ing

Many companies produce a number of plans reflecting different scenarios—”what if”

Gives planners a feel for the impact of their 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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Financial Planning and Computers Virtually all planning is done with the aid of

computers Computers make planning quicker and more

thorough, but don’t improve the judgments at the heart of the plan

Repetitive Calculations Before computers, recomputing a plan was time

consuming and labor-intensive However, with computers repetitive calculations can

be done quickly and easily