Chapter

Essentials

—The Questions

    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?

1

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 Planning) Financial Statements (Financial 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

Sales ($ millions) 600 500 400 300 200 100 0 2004 2005 2006 2007

Average growth = 12%

2008 2009

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 stock

internally

be generated and how much needs to

externally

(called additional funds needed) by borrowing or by selling

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: Step 3: Forecast next period’s balance sheet 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) Sales Variable costs (80%) Fixed Costs EBIT = NOI Interest Taxable income (EBT) Taxes @ 40% Net Income Last Year’s Results $500.00

(400.00) ( 55.00) 45.00

( 10.00) 35.00

( 14.00) 21.00

Dividends (60% of NI) Addition to RE 12.60

8.40

x (1 + g) x 1.12

x 1.12

x 1.12

Next Year’s

Initial

Forecast $560.00

(448.00) ( 61.60) 50.40

( 10.00) 40.40

( 16.16) 24.24

14.54

9.70

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) Current assets Fixed assets Total assets Last Year’s Results $155.00

120.00

$275.00

x (1 + g) x 1.12

x 1.12

Next Year’s

Initial

Forecast $176.60

134.40

$308.00

Payables & accruals Notes Payable Current liabilities Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities & equity 30.00

13.00

43.00

100.00

143.00

44.00

88.00

132.00

$275.00

x 1.12

+9.70 Δ RE $ 33.60

13.00

46.60

100.00

146.60

44.00

97.70

141.70

$288.30

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

288.30

Step 3: Raising the Additional Funds Needed (AFN)

AgriCorp plans to raise the additional funds needed (AFN) as follows: Notes payable New long-term debt New common stock Proportion 15.0% 20.0

65.0

100.0

Amount $2.96

3.94

12.80

19.70

Cost 7.0% 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)—2 nd Pass EBIT = NOI Interest Taxable income Taxes @ 40% Net Income Last Year’s Results $ 45.00

(10.00) 35.00

(14.00) 21.00

x (1+g) x 1.12

Next Year’s

Initial

Forecast $ 50.40

(10.00) 40.40

(16.16) 24.24

2 nd Pass Forecast $ 50.40

(10.60) 39.80

(15.92) 23.88

Dividends (60% of NI) 12.60

Addition to RE 8.40

14.54

9.70

14.33

9.55 New interest = 10.00 + (2.96 x 0.07) + (3.94 x 0.10) = 10.60  in addition to RE = 9.55 – 9.70 = –0.15

AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—2 nd Pass Total assets Last Year’s Results x (1+g) $275.00 x 1.12

Next Year’s

Initial

Forecast $308.00

2 nd Pass Forecast $308.00

Payables & accruals Notes payable Current liabilities Long-term debt Total liabilities Common stock Retained earnings 30.00 x 1.12

13.00

43.00

100.00

143.00

44.00

88.00

Total equity 132.00

Total liabilities & equity 275.00

+ 9.70

33.60

13.00

46.60

100.00

146.60

44.00

97.70

141.71

288.30

+ 2.96

+ 3.94

+12.80

- 0.15

AFN 1 AFN 2 = 2.96 + 3.94 + 12.80

= 308.00 – 307.85 = 19.70

= 0.15

33.60

15.96

49.56

103.94

153.50

56.80

97.55

154.35

307.85

AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—Final Pass Total assets Last Year’s Results x (1+g) $275.00 x 1.12

Next Year’s

Initial

Forecast $308.00

Final Forecast $308.00

Payables & accruals Notes payable Current liabilities Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities & equity 30.00 x 1.12

13.00

43.00

100.00

143.00

44.00

88.00

132.00

275.00

+ 9.70

33.60

13.00

+ 2.98

46.60

100.00

146.60

44.00

+12.90

97.70

141.71

+ 3.97

-0.15

288.30

33.60

15.98

49.58

103.97

153.55

56.90

97.55

154.45

308.00

Total AFN = 2.98 + 3.97 + 12.90 = 19.85 > 19.70 = AFN 1

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: Current sales level Full capacity sales = Percent of capacity used to generate current sales level Example —If AgriCorp currently operates at 80 percent capacity, then existing plant and equipment can produce sales equal to: Full capacity sales = $ 500 0 .

80  $ 625 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 generate profits —evaluation of the level of operations to determine the ability of the firm to  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) Variable cost per unit (V) Variable cost ratio = V/P Fixed operating costs Existing sales $8.00

$6.00

0.75

$12,000.00

10,000 units

Operating Breakeven Analysis— Graph

Dollars 120,000 100,000 Total sales 80,000 60,000 48,000 40,000 Total operating costs 20,000 Fixed operating costs = $12,000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Units Produced and Sold

Operating Breakeven Analysis— Computation

Operating breakeven po int in units sold  Q OpBE  Total fixed operating costs Sales price per unit  Variable cost operating per unit  $12,000 $ 8 .

00  $ 6 .

00  $ 12 , 000 $ 2 .

00  6 , 000 units Operating breakeven po int in sales dollars  S OpBE  Total fixed 1  operating Variable costs cost ratio  $12,000 1  0.75

 $ 12 , 000 0 .

25  $ 48 , 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: DOL = Sales Sales Total variable costs Total variable operating costs   Total fixed operating costs = Gross profit EBIT 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 Sales @ $8 per unit Variable costs @ $6 per unit Gross Profit Fixed operating costs NOI = EBIT 10,000 $80,000 (60,000) 20,000 (12,000) $ 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: DOL = Gross profit EBIT  $ 20 , 000  2 .

5  $ 8 , 000 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

Sales ($8/unit) Variable costs ($6/unit) Gross Profit Fixed operating costs NOI = EBIT Current Forecast $80,000 (60,000) 20,000 (12,000) $ 8,000 If Sales are Percent 10% Lower Deviation $72,000 -10.0% (54,000) -10.0% 18,000 -10.0% (12,000) $ 6,000 - 0.0% -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 operating income (NOI or EBIT) that covers all fixed financing charges.

is defined as the level of 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, EBIT FinBE , 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 Preferred stock Common stock (5,000 shares outstanding) Total capital $ 50,000 0 50,000 $100,000

Financial Breakeven Analysis—Graph

EPS ($) 2.00

1.50

1.00

0.50

0 -0.50

-1.00

-1.50

-2.00

-8,000 -4,000 Financial breakeven point 0 4,000 8,000 12,000 16,000 EBIT ($)

Financial Breakeven Analysis— Computation

  The financial breakeven point is computed as follows: Preferred dividend payments EBIT FinBE = Interest costs + 1 Tax rate If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is: EBIT FinBE = $ 50 , 000 ( 0 .

08 ) $ 0 + 1 0 .

4  $ 4 , 000

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: DFL = EBIT EBIT Financial BEP = EBIT EBIT Interest  Preferred dividends 1 Tax rate If a firm has no preferred stock, the DFL simplifies to: EBIT DFL = EBIT Interest Generally, a firm with a high DFL is considered to have high risk associated with its financing.

Current Income Statement for Worldwide Widgets

Sales Variable costs (75% of sales) Gross Profit Fixed operating costs NOI = EBIT Interest = $50,000 x 0.08

Taxable income (EBT) Taxes (40%) Net income $80,000 (60,000) 20,000 (12,000) $ 8,000 ( 4,000) 4,000 ( 1,600) $ 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: D F EBIT L = EBIT  I  $ 8 , $ 8 , 000 000  $ 4 , 000  2 .

0  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

EBIT Interest Taxable income (EBT) Taxes (40%) Net income = EAC Current Forecast $8,000 (4,000) 4,000 (1,600) $ 2,400 If EBIT is 25% Lower $6,000 (4,000) 2,000 ( 800) $ 1,200 Percent Deviation -25.0% 0.0% -50.0% -50.0% -50.0% EPS = EAC/5,000 $0.48

$0.24

-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

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 DTL  DOL  DFL  Gross profit EBIT  EBIT EBIT  Financial BEP  Gross profit EBIT  Financial BEP  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: D T L = DOL  DFL  2 .

5  2 .

0  5 .

0  = Gross profit EBIT  I  $ 20 , 000 $ 8 , 000  $ 4 , 000  5 .

0  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.

Effect of DTL for Worldwide Widgets

Sales Variable operating costs Gross profit Fixed operating costs EBIT Interest Taxable income (EBT) Taxes (40%) Net income = EAC Current Forecast $80,000 (60,000) 20,000 (12,000) 8,000 ( 4,000) 4,000 ( 1,600) 2,400 If Sales are 10% Lower Deviation $72,000 Percent -10.0% (54,000) 18,000 (12,000) 6,000 -10.0% -10.0% 0.0% -25.0% ( 4,000) 2,000 ( 800) 1,200 0.0% -50.0% -50.0% -50.0% EPS = EAC/5,000 $0.48

50 percent (5.0 x 10%) decrease in EPS $0.24

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

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.

Chapter

Essentials

—The Answers

  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 48

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 49