1

Why is financial planning and control critical to the survival of a firm?

What are pro forma financial statements?

What are operating breakeven and financial leverage?

How can a firm use knowledge of leverage in the financial forecasting and control process?

Chapter Essentials—The Questions

FINANCIAL PLANNING AND CONTROL

The information derived from financial statement analysis can be used to establish future operating goals (financial planning) and to determine how to meet established goals (financial control).

Developing pro forma financial statements is an important part of the planning and control processes.

FINANCIAL PLANNING AND CONTROL

Pro Forma Financial Statements (Financial Planning)

Other Considerations in Forecasting Breakeven/Leverage Analysis

Operating Financial Total

Using of Breakeven/Leverage Analysis (Control)

FINANCIAL PLANNING—FORECASTING

Sales Forecast most important part of financial planning generally based on the trend in sales in recent periods inaccurate sales forecasts can have serious

repercussions—if the firm is too optimistic, such assets as inventory will be built up too much; if the firm is too conservative, it might miss valuable opportunities because existing production capabilities might not be sufficient to meet new demand

Trend in Sales for AgriCorp

0

100

200

300

400

500

600

2004 2005 2006 2007 2008 2009

Sales($ millions)

Average growth = 12%

Projected (Pro Forma) Financial Statements

Help the firm determine what is needed to finance expected future operating activities

Information from these statements indicates how much financing will be generated by the firm internally and how much needs to be generated externally (called additional funds needed) by borrowing or by selling stock

Projected (Pro Forma) Financial Statements

To construct a pro forma balance sheet and a pro forma income statement: Step 1: Forecast next period’s income

statement Step 2: Forecast next period’s balance sheet Step 3: Raising the additional funds needed Step 4: Financing feedbacks

Step 1: Construct a Pro Forma Income Statement

Estimate the percentage growth (increase or decrease) in sales, cost of goods sold, and other variable revenues and expenses

Change the current values by the estimates An easy way to approach this task is to apply a

single growth rate to all revenue and expense categories that change when production changes

To be more accurate, each category should be examined individually to determine what the effect of any forecasted change is

Step 1: Construct AgriCorp’s Pro Forma Income Statement for Next

Year

Assumptions AgriCorp operated at full capacity last year. Sales are expected to grow by 12 percent. The variable cost ratio remains at 80 percent

(same as last year) Next year’s dividend payout will be

maintained at 60 percent of net income.

AgriCorp’s Pro Forma Income Statement for Next Year ($ millions)

Last Year’s

Results

Sales $500.00Variable costs (80%) (400.00)Fixed Costs ( 55.00)EBIT = NOI 45.00Interest ( 10.00)Taxable income (EBT) 35.00Taxes @ 40% ( 14.00)Net Income 21.00

Dividends (60% of NI) 12.60Addition to RE 8.40

Next Year’sx (1 + g) Initial Forecastx 1.12 $560.00x 1.12 (448.00)x 1.12 ( 61.60)

50.40 ( 10.00)

40.40( 16.16)

24.24

14.549.70

Step 2: Construct AgriCorp’s Pro Forma Balance Sheet for Next

Year

Assumptions AgriCorp operated at full capacity last

year. Each type of asset grows proportionally

with sales. Payables and accruals (spontaneous

sources of financing) grow proportionally with sales.

AgriCorp’s Pro Forma Balance Sheet for Next Year($ millions)

Last Year’s Results

Current assets $155.00Fixed assets 120.00 Total assets $275.00

Payables & accruals 30.00Notes Payable 13.00Current liabilities 43.00Long-term debt 100.00 Total liabilities 143.00Common stock 44.00Retained earnings 88.00 Total equity 132.00 Total liabilities & equity $275.00

Next Year’s x (1 + g) Initial Forecastx 1.12 $176.60x 1.12 134.40

$308.00

x 1.12 $ 33.60 13.00

46.60 100.00146.60

44.00 97.70 141.70

$288.30

+9.70 Δ RE

Additional Funds Needed (AFN)

If AgriCorp does not raise additional capital by borrowing from the bank or issuing new stocks or bonds, then, based on the pro forma balance sheet, the following exists:

Total assets $308.00Total liabilities and equity 288.30 Additional funds needed (AFN) 19.70

19.70

Step 3: Raising the Additional Funds Needed (AFN)

AgriCorp plans to raise the additional funds needed (AFN) as follows:

ProportionNotes payable 15.0%New long-term debt 20.0New common stock 65.0

100.0

Amount$2.963.94

12.8019.70

Cost7.0%

10.0 dividend

Step 4: Financing Feedbacks If the AgriCorp issues new debt and common stock, the

total amount of interest and dividends paid will increase. Because interest and dividends must be paid with cash,

any increase in these costs will decrease the funds the firm has to invest—that is, the amount of income added to retained earnings will be less than originally forecasted.

When we consider the effects of the increased interest and dividend payments, we find that the AFN is actually greater than originally expected.

Financing feedbacks—that is, the effects on the financial statements of actions taken to finance forecasted increases in assets—must be considered to determine the exact amount of AFN.

AgriCorp’s Pro Forma Income Statement for Next Year ($ millions)

—2nd PassLast Year’s Next Year’s Results x (1+g) Initial Forecast

EBIT = NOI $ 45.00 x 1.12 $ 50.40Interest (10.00) (10.00)Taxable income 35.00 40.40Taxes @ 40% (14.00) (16.16)Net Income 21.00 24.24

Dividends (60% of NI) 12.60 14.54Addition to RE 8.40 9.70

$ 50.40(10.60)

New interest = 10.00 + (2.96 x 0.07) + (3.94 x 0.10) = 10.60

39.80(15.92)23.88

14.339.55

in addition to RE = 9.55 – 9.70 = –0.15

2nd PassForecast

AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—2nd Pass

Last Year’s Next Year’s Results x (1+g) Initial Forecast

Total assets $275.00 x 1.12 $308.00

Payables & accruals 30.00 x 1.12 33.60Notes payable 13.00 13.00 Current liabilities 43.00 46.60Long-term debt 100.00 100.00 Total liabilities 143.00 146.60Common stock 44.00 44.00Retained earnings 88.00 97.70 Total equity 132.00 141.71 Total liabilities & equity 275.00 288.30

$308.00

33.60 15.96

49.56103.94

2nd PassForecast

+ 9.70

+ 2.96

+ 3.94153.50

56.80+12.80 97.55- 0.15

154.35307.85

AFN1 = 2.96 + 3.94 + 12.80 = 19.70AFN2 = 308.00 – 307.85 = 0.15

AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—Final Pass

Last Year’s Next Year’s Results x (1+g) Initial Forecast

Total assets $275.00 x 1.12 $308.00

Payables & accruals 30.00 x 1.12 33.60Notes payable 13.00 13.00 Current liabilities 43.00 46.60Long-term debt 100.00 100.00 Total liabilities 143.00 146.60Common stock 44.00 44.00Retained earnings 88.00 97.70 Total equity 132.00 141.71 Total liabilities & equity 275.00 288.30

$308.00

33.60 15.9849.58

103.97

FinalForecast

+ 9.70

+ 2.98

+ 3.97153.55

56.90+12.90 97.55-0.15

154.45308.00

Total AFN = 2.98 + 3.97 + 12.90 = 19.85 > 19.70 = AFN1

Other Considerations in Forecasting

Excess capacity—If the firm has excess capacity, it will not have to increase plant and equipment at the same growth rate as sales. To determine the level of sales current plant capacity can handle, use the following equation:

level salescurrent generate tousedcapacity ofPercent

level salesCurrent = salescapacity Full

Example—If AgriCorp currently operates at 80 percent capacity, then existing plant and equipment can produce sales equal to:

625$80.0

500$ = salescapacity Full

In this case, sales can grow by 25 percent before AgriCorp needs to expand its plant and equipment.

Other Considerations in Forecasting

Excess capacity—If the firm has excess capacity, it will not have to increase plant and equipment at the same growth rate as sales. Economies of scale—If economies of scale exist, the variable cost ratio might change with changes in production activity.

Lumpy assets—Many assets are not completely divisible some assets might have to be purchased in larger

increments than the firm would prefer “lumpy assets” must be purchased in discrete

increments, say, $10 million per addition, which means we cannot simply increase assets by a growth rate like 12 percent

Financial Control—Budgeting and Leverage Analysis

Proper financial control helps to ensure the firm meets the expectations developed in the planning stage, and, when results fall short of expectations, helps management determine the reasons. Breakeven analysis—evaluation of the level

of operations to determine the ability of the firm to generate profits

Leverage analysis—examination as to how well the firm can cover its fixed costs, both operating and financial; gives an indication of risk

Operating Breakeven Analysis

Operating breakeven point is defined as the level of operations where the net operating income, NOI = EBIT, equals zero

Total operating costs (both fixed and variable) = sales revenues

Operating Breakeven Analysis—Example

Worldwide Widgets, Inc.’s operations have the following characteristics:

Selling price (P) $8.00Variable cost per unit (V) $6.00Variable cost ratio = V/P 0.75Fixed operating costs $12,000.00Existing sales 10,000 units

Operating Breakeven Analysis—Graph

0

20,000

40,000

60,000

80,000

100,000

120,000

2,000 4,000 6,000 8,000 10,000 12,000 14,000

Units Produced and Sold

Dollars

Fixed operating costs = $12,000

Total operating costs

Total salesOperating profit

Operating loss

48,000

Operating Breakeven Analysis—Computation

unitper cost operating Variable

unitper price Sales

costs operating fixed TotalQ

sold unitsin intpobreakeven Operating

OpBE

ratiocost Variable1

costs operating fixed TotalS

dollars salesin intpobreakeven Operating

OpBE

units 000,600.2$

000,12$

00.6$00.8$

$12,000

000,48$25.0

000,12$

0.751

$12,000

= 6,000 x $8

Operating Breakeven Analysis—Uses

Determine the level of sales a product must achieve to make a profit.

Indicate the impact of general growth on the cost structure of the firm.

Show how modernization to improve efficiency affects fixed and variable costs, thus profitability of operations

Operating Leverage Analysis

In business, leverage refers to the existence of fixed costs.

The presence of leverage means that a change in sales will result in a larger change in operating income (EBIT), net income, or both.

Operating leverage exists if fixed operating costs, such as depreciation, are present.

The degree of operating leverage (DOL) is defined as the percent change in net operating income, NOI, that results from a particular percent change in sales.

Operating Leverage

DOL is computed as follows:

EBIT

profit Gross =

costs operatingfixed Total - costs operating

variableTotal - Sales

costs variableTotal - Sales = DOL

Generally, a firm with a high DOL is considered to have high risk associated with its operations

Current Income Statement for Worldwide Widgets

Sales in units 10,000

Sales @ $8 per unit $80,000Variable costs @ $6 per unit (60,000)Gross Profit 20,000Fixed operating costs (12,000)NOI = EBIT $ 8,000

Operating Leverage

Does Worldwide Widgets have operating leverage?

Yes, because the firm has fixed operating costs equal to $12,000.

Worldwide’s degree of operating leverage is: 5.2

000,8$

000,20$

EBIT

profit Gross = DOL

DOL = 2.5x means that for every 1 percent deviation in sales from expectations, there will be a 2.5 percent deviation in EBIT (in the same direction) from expectations.

Effect of DOL for Worldwide Widgets

CurrentForecast

Sales ($8/unit)Variable costs ($6/unit)Gross ProfitFixed operating costsNOI = EBIT

$80,000(60,000)

20,000(12,000)$ 8,000

If Sales are Percent10% LowerDeviation$72,000 -10.0%(54,000) -10.0%18,000 -10.0%

(12,000) - 0.0%$ 6,000 -25.0%

DOL = 2.5; as a result, a 10 percent decrease in sales will result in a 25 percent (2.5 x 10%) decrease in EBIT

Operating Leverage and Operating Breakeven

Generally, a higher degree of operating leverage (DOL) implies that greater risk is associated with the firm’s operations.

Risk is variability. The closer the firm operates to its breakeven

point, the riskier its operations are considered.

Everything else equal, firms with higher DOLs operate closer to their operating breakeven points, and thus cannot cover fixed operating costs as easily as firms with lower DOLs.

Financial Breakeven Analysis

Financial breakeven point is defined as the level of operating income (NOI or EBIT) that covers all fixed financing charges.

At the financial breakeven point, EPS = 0. For the most part, fixed financial charges

include interest paid on debt and preferred stock dividends.

For firms that do not have preferred stock, the financial breakeven point, EBITFinBE, is simply interest on debt.

Most firms do not have preferred stock.

Financial Breakeven Analysis—Example

Worldwide Widgets, Inc. is financed with the following sources of long-term funds:

Bonds @ 8% interest $ 50,000Preferred stock 0Common stock (5,000 shares outstanding) 50,000

Total capital $100,000

Financial Breakeven Analysis—Graph

Financial breakeven point

-2.00

-1.50

-1.00

-0.50

0

0.50

1.00

1.50

2.00

-8,000 -4,000 0 4,000 8,000 12,000 16,000

EPS ($)

EBIT ($)

Financial Breakeven Analysis—Computation

The financial breakeven point is computed as follows:

rateTax - 1

payments dividend Preferred + costsInterest = EBITFinBE

If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is:

000,4$4.0 - 1

0$ + )08.0(000,50$ = EBITFinBE

Financial Breakeven Analysis—Uses

Financial breakeven analysis gives an indication as to how the firm’s mix of debt and preferred stock (fixed financing) affects EPS (net income).

Financial Leverage

Financial leverage exists if the firm has fixed financial charges: interest on debt preferred dividends

The degree of financial leverage (DFL) is the percent change in EPS that results from a particular percent change in net operating income.

Financial Leverage

DFL is computed as follows:

rateTax - 1

dividends Preferred Interest - EBIT

EBIT =

BEP Financial - EBIT

EBIT = DFL

If a firm has no preferred stock, the DFL simplifies to:

Generally, a firm with a high DFL is considered to have high risk associated with its financing.

Interest - EBIT

EBIT = DFL

Current Income Statement for Worldwide Widgets

Sales $80,000Variable costs (75% of sales) (60,000)Gross Profit 20,000Fixed operating costs (12,000)NOI = EBIT $ 8,000Interest = $50,000 x 0.08 ( 4,000)Taxable income (EBT) 4,000Taxes (40%) ( 1,600)Net income $ 2,400

Financial Leverage

Does Worldwide Widgets have financial leverage?

Yes, because the firm has a fixed financing cost—that is, interest—equal to $4,000.

Worldwide’s degree of financial leverage is:

0.2

000,4$000,8$

000,8$

IEBIT

EBIT = LFD

DFL = 2.0x means that for every 1 percent deviation in EBIT from expectations, there will be a 2.0 percent deviation in EPS (in the same direction) from expectations.

Effect of DFL for Worldwide Widgets

CurrentForecast

EBITInterestTaxable income (EBT)Taxes (40%)Net income = EAC

EPS = EAC/5,000

$8,000(4,000)

4,000(1,600)$ 2,400

If EBIT is Percent25% LowerDeviation$6,000 -25.0%(4,000) 0.0%2,000 -50.0%

( 800) -50.0%

$ 1,200 -50.0%

DFL = 2.0; as a result, a 25 percent decrease in EBIT will result in a 50 percent (2.0 x 25%) decrease in EPS

$0.48 $0.24 -50.0%

Financial Leverage and Financial Breakeven

Generally, a higher degree of financial leverage (DFL) implies greater risk is associated with the firm’s financial mix.

Risk is variability. The closer the firms operates to its financial

breakeven point, the riskier its financial position is.

Everything else equal, firms with higher DFLs operate closer to their financial breakeven points, and thus cannot as easily cover fixed financial costs as firms with lower DFLs.

Combining Operating and Financial Leverage (DTL)

The degree of total leverage (DTL) is the combination of DOL and DFL.

DTL is the percent change in EPS associated with a particular percent change in sales

DTL = DOL x DFL

BEP FinancialEBIT

profit Gross

BEP FinancialEBIT

EBIT

EBIT

profit GrossDFLDOLDTL

Everything else equal, a higher degree of total leverage, DTL, is associated with greater total risk—both operating risk and financial risk.

Total Leverage

Worldwide’s degree of total leverage is:

0.50.25.2DFLDOL = LTD

DTL = 5.0x means that for every 1 percent deviation in sales from expectations, there will be a 5.0 percent deviation in EPS (in the same direction) from expectations.

0.5000,4$000,8$

000,20$

IEBIT

profit Gross =

Effect of DTL for Worldwide Widgets

CurrentForecast

Sales $80,000Variable operating costs (60,000)Gross profit 20,000Fixed operating costs (12,000)EBIT 8,000Interest ( 4,000)Taxable income (EBT) 4,000Taxes (40%) ( 1,600)Net income = EAC 2,400

EPS = EAC/5,000 $0.48

If Sales are Percent10% Lower Deviation$72,000 -10.0%(54,000) -10.0%

18,000 -10.0%(12,000) 0.0%

6,000 -25.0%( 4,000) 0.0%

2,000 -50.0%( 800) -50.0%

1,200 -50.0%

$0.24 -50.0%DTL = 5.0; as a result, a 10 percent decrease in sales will

result in a 50 percent (5.0 x 10%) decrease in EPS

Using Leverage Analysis for Financial Control

Knowledge of the degree of leverage, whether operating, financial, or both, helps determine how a change in sales will affect income—operating income, net income, or both.

Greater leverage indicates that greater changes in income (either NOI or net income) will result from changes in sales.

The greater variability that is associated with greater leverage suggests greater risk.

48

Why is financial planning and control critical to the survival of a firm? Forecasts of future operations are needed so

that the firm can make arrangements for expected changes in production and future financing needs

What are pro forma financial statements? The firm projects what it thinks the balance

sheet and income statement will look like if future expectations come true

Chapter Essentials—The Answers

49

Chapter Essentials—The Answers

What are operating breakeven and financial leverage? The financial breakeven point is the level of EBIT that

a firm must generate so that EPS equals zero Financial leverage represents the fixed financial costs

of the firm

How can a firm use knowledge of leverage in the financial forecasting and control process? A firm uses the concept of leverage to estimate how

fixed costs (operating and financial) affect its bottom line