Transcript Slide 1

Chapter 4 Financial Planning
Business Plan
A business plan is a model of what
management expects a business
to become in the future
Financial statements are pro
forma
Good business plans are
comprehensive
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Component Parts of a
Business Plan
Typical outline
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Contents
Executive summary
Mission and strategy statement
Market analysis
Operations (of the business)
Management and staffing
Financial projections
Contingencies
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The Purpose of Planning and
Plan Information
Major audiences of business plan
– 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
– Outside investors
Tells equity investors what returns can be
expected
Tells debt investors how firm will repay loans
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The Purpose of Planning and
Plan Information
Planning process
Roadmap for running the business
Statement of goals
Predicting financing needs
Investor communication
Figure 4-1 Using a Plan to Guide
Business Performance
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Credibility and Supporting Detail
Shows enough supporting detail
to indicate it is the product of
careful thinking
Displays summarized financial
projections
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Four Kinds of Business Plan
Kinds of planning
– Strategic Planning
– Operational Planning
– Budgeting
– Forecasting
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Four Kinds of Business Plan
Strategic Planning
– Addresses broad, long-term issues,
contains summarized, approximate
financial projections
Five-year horizon is common
Concepts expressed mainly in words, not
numbers
Firm analyzes itself, the industry and the
competitive situation
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Four Kinds of Business Plan
Operational Planning
– Translates business ideas (day-to-day
operations) into concrete, short-term
projections
– Usually one year or less
– Specifies how much the firm will sell, to
whom, and at what prices
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Four Kinds of Business Plan
Budgeting
– Short-term updates of the annual plan
Usually Covers a three month quarter
Attempts a precise estimate of company
expenses
Mostly financial detail with a few words
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Four Kinds of Business Plan
Forecasting
– Very short-term projections of profit and
cash flow
Where will the business’s financial momentum carry it
in the next few weeks
– Consists almost entirely of numbers
– Cash forecasts are projections of shortterm cash needs
Most large firms do monthly cash forecasts
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Four Kinds of Business Plan
The Business Planning Spectrum
– Broad, long-term planning on one end and
numerical short-term forecasting on other
Relating Planning Processes of Small
and Large Businesses
– Small businesses tend to develop a single
business plan containing both strategic and
operating elements
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Figure 4-2
The Business Planning Spectrum
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Figure 4-3 Relating Business Planning
in Large and Small Firms
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Financial Plan as a Component of a
Business Plan
Financial plan is the financial portion of
the business plan
– A set of pro forma financial statements
projected over a time period
– Financials are only pieces of the
projection
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Planning for New and
Existing Businesses
Hard to forecast a new operation
– No history on which to base projections
The typical planning task
– In ongoing businesses, based on
planning assumptions such as
Unit sales will increase by 10%
Overall labor costs will rise by 4%, etc.
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Figure 4-4 The Planning Task
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Planning Assumptions
Planning Assumptions: expected
physical or economic condition that
dictates the size of one or more
financial statement items
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Concept Connection Example 4-1
Planning Assumptions
This year Crumb Baking Corp. sold
1 million coffee cakes per month at
$1 each for a total of $12 million.
Year-end receivables equal to two
months of sales or $2 million.
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Concept Connection Example 4-1
Planning Assumptions
Crumb’s operating assumptions for sales
and receivables are:
1. Price will be decreased by 10%.
2. As a result unit sales volume will increase to
15 million coffee cakes.
3. Collection efforts increased - only one month
of sales in receivables at year end.
Forecast next year’s revenue and ending
receivables balance.
Concept Connection Example 4-1
Planning Assumptions
Three interrelated planning assumptions
– a management action with respect to pricing,
– the expected customer response to that action
– 15 million coffee cakes will be sold at $.90
– Rev = 15,000,000 x $.90 = $13,500,000
Collection activities will be more effective
– one months of revenue in accounts receivable
at year end.
A/R = $13,500,000/12 = $1,125,000
The General Approach, Assumptions,
and the Debt/Interest Problem
The Procedural Approach
– Financial plans are built line-by-line
beginning with revenues
Debt/Interest Planning Problem
– The next items needed are interest
expense and debt
– Planned debt is required to forecast
interest, but interest is required to
forecast debt
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An Iterative Numerical Approach
Solves the debt/interest problem
– Interest: Guess a value of interest expense
– Net Income: Complete the income statement
– Ending equity: Calculate as beginning equity plus
net income
– Ending debt: Calculate 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 calculated interest to the
original guess
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Figure 4-5 The Debt/Interest
Planning Problem
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Plans with Simple Assumptions
The Quick Estimate Based on Sales
Growth
The percentage of sales method assumes all
financial statement line items vary directly with
sales revenue
This is an unrealistic assumption
Management virtually always has more insight
– The modified percentage of sales method
assumes most but not all line items vary with
sales
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Example 4.3 Plans with Simple Assumptions
Q: The Underhill Manufacturing Company expects next year’s
revenues to increase by 15% over this year’s. The firm has some
excess factory capacity, so no new fixed assets beyond normal
replacements will be needed to support the growth. This year’s
income statement and ending balance sheet are estimated as
follows:
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Example 4.3 Plans with Simple Assumptions
Assume the firm pays state and federal income taxes at a combined
flat rate of 42%, borrows at 12% interest, and expects to pay no
dividends. Project next year’s income statement and balance sheet
by using the modified percentage of sales method.
A:
We’ll increase everything except net fixed assets by 15%.
All highlighted
items were
increased by 15%.
At this point we are at the
debt/interest impasse. We’ll
guess at interest (using last
year’s interest of $150,000
as a starting point) and
work through the
procedure.
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Example 4.3 Plans with Simple Assumptions
Net Income was
computed using an
Interest of $150,000.
The resulting Net
Income was added to
Equity and the Debt
figure was a plug,
calculated by
subtracting Equity and
Current Liabilities from
Total L&E.
Taking the average debt at 12% yields a calculated interest of
$86,000 which is considerably less than the $150,000 assumed.
Two additional iterations yield the following result.
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Example 4.3 Plans with Simple Assumptions
Forecasting Cash Needs
Forecasting Cash Needs
– A key reason for financial projections is
to forecast the firm’s external financing
needs
– When a plan shows increasing debt,
additional external financing will be
needed
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The Percentage of Sales Method
A Formula Approach
Purpose – to estimate external financing
requirements approximately and quickly
growth in assets
-growth in current liabilities
-earnings retained
_________________________________________________________________
=external funding requirements
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The Percentage of Sales Method
A Formula Approach
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
EFR = g(assetsthis year)
- (g  current liabilitiesthis year)
- [(1 – d) ROS][(1+g)salesthis year]
Where d=dividend payout ratio
EFR = Growth in assets
– growth in current liabilities
– planned year’s retained earnings
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Concept Connection Example 4-4
Concept Connection Example 4-4
The Sustainable Growth Rate
Assumes the debt/equity ratio is constant
– Equity growth occurs via retained
earnings
– New debt will need to be raised to
keep the debt/equity ratio constant
Gives an indication of the determinants of
a firm’s inherent growth capability
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The Sustainable Growth Rate
Business operations create new equity equal
to the amount of current retained earnings,
or (1 – d)Net Income
Implies sustainable growth rate in equity, gs
gs = Net Income(1 – d) / equity
Because
ROE = Net Income/equity
gs = ROE(1 – d)
The Sustainable Growth Rate
Incorporating equations from the DuPont equations
into the gs equation we obtain
EAT sales assets
gs  1  d 


sales assets equity
gs = (1-d)ROS x Total Asset Turnover x Equity Multiplier
Firm’s ability to grow depends on 4 abilities:
Ability to earn profits on sales (ROS)
Use of assets to generate sales (T/A Turnover)
Use of borrowed money - leverage (equity multiplier)
Percentage of earnings retained (1 – d)
Concept Connection Example 4-5
Sustainable Growth Rate
After several years of lower-than-average growth, Slowly,
Inc. compared its sustainable growth rate with an industry
average:
Notice that Slowly’s sustainable growth rate is much
lower than the average. Why?
Plans With More Complicated
Assumptions
The percentage of sales method
– Appropriate for quick estimates
– Rarely used in formal plans due to lack
of detail
Real plans generally incorporate
complex assumptions about important
financial items
– Specific accounts can be forecast
separately
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More Complicated Plans
Indirect Planning Assumptions
Financial planning assumptions can be
made:
– directly about the financial items
– indirectly about a derivative of the item
Indirect planning assumptions are
usually based on financial ratios
– Receivables are usually managed through
the Average Collection Period (ACP)
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Concept Connection Example 4-8
Complex Plans
The Macadam Co. is developing its annual plan for
next year. It expects to finish this year with the
following financial results:
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Concept Connection Example 4-8
Complex Plans
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Concept Connection Example 4-8
Complex Plans
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Concept Connection Example 4-8
Complex Plans
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Concept Connection Example 4-8
Complex Plans
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Concept Connection Example 4-8
Complex Plans
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Figure 4-6 Supporting Detail for Annual
Planning at the Department Level
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The Cash Budget
The cash budget is a detailed projection of
receipts and disbursements of cash
– A fundamentally different approach than
projecting financial statements
In large part based on time lags between
events and receipt or disbursement of
related cash
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Receivables and Payables—
Forecasting with Time Lags
Forecasting receivables collection is
difficult because a company never
knows when customers will pay their
bills
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Debt and Interest
Forecasting short-term debt and interest
is difficult if current cash needs are
funded directly by borrowing
– The current month’s interest payment is
based on the preceding month’s loan balance
Other Items
– Forecasting most other items is
relatively straightforward
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Concept Connection Example 4-9
Cash Budgeting
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Concept Connection Example 4-9
Cash Budgeting
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Concept Connection Example 4-9
Cash Budgeting
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Concept Connection Example 4-9
Cash Budgeting
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Management Issues in
Financial Planning
The Financial Plan as a Set of Goals
– The financial plan can be a tool to
manage the company and motivate
performance
– Problems arise when top management
puts in stretch goals
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Inherent Conflicts
Stretch planning and aggressive
optimism can lead to unrealistic
plans with little chance of coming true
Top-down plans forced on the
organization by management are often
unrealistically optimistic
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Risk in Financial Planning
in General
Top-down plans forced on the
organization by management are often
unrealistically optimistic
Under forecasting
Bottom-up Planning
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Risk in Financial Planning
in General
Scenario Analysis—“What If”ing
– Different scenarios — “what if”
– Gives planners a feel for the impact of
assumptions not coming true
Communication
– A single plan tends to be published
along with its attendant risks
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Financial Planning and Computers
Computers make planning quicker but
don’t improve the judgments that are
the heart of good planning
Repetitive Calculations
Changing Assumptions
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