Ch17-ppt-financial Planning And Control

Financial Planning and Control

© 2007 Thomson/South-Western

1

Essentials of Chapter 17 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?

2

Financial Planning and Control Financial Planning: The projection of sales, income, and assets based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projections

3

Financial Planning and Control Financial Control The phase in which financial plans are implemented, control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes.

4

Financial Planning: The Sales Forecast A forecast of a firm’s unit and dollar sales for some future period, generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc.

5

Unilate Textiles: 2010 Sales Projection $1,500

$1,000

$500 $0 2005

2006

2007

2008

2009

2010

6

Projected (Pro Forma) Financial Statements A method of forecasting financial requirements based on forecasted financial statements AFN = additional funds needed to support the level of forecasted operations

7

Projected Financial Statements Determine how much money the firm will need in a given period. Determine how much money the firm will generate internally during the same period. Subtract the funds generated internally from the funds required to determine the external financial requirements.

8

Step 1. Forecast the 2010 Income Statement: Unilate Textiles Assumptions:

Unilate operated at full capacity in 2009. Sales are expected to grow by 10 percent. The variable cost ratio remains at 82 percent (same as 2009). 2010 dividend per share will be the same as in 2009.

9

Step 1. Forecast the 2010 Income Statement Unilate 2009 2010 Initial Textiles Results Forecast Basis Forecast Net Sales Cost of Goods Sold

$

1,500.0 (1,230.0)

x 1.10 x 1.10

$

1,650.0 (1,353.0)

Gross Profit Fixed operating Costs Depreciation

270.0 (90.0) (50.0)

297.0 (99.0) (55.0)

EBIT Less Interest

130.0 (40.0)

143.0 (40.0)

EBT Taxes (40%)

90.0 (36.0)

103.0 (41.2)

x 1.10 x 1.10

Net Income Common Dividends

$

54.0 (29.0)

$

61.8 (29.0)

Addition to Retained Earnings

$

25.0

$

32.8

Earnings per Share Dividends per Share Number Common Shares (millions)

$ $

2.16 1.16

$ $

2.47 1.16

25.0

25.0

10

Step 2. Forecast the 2010 Balance Sheet Unilate Textiles 2009

Cash Accounts Receivable Inventory

Balances $ 15.0 180.0 270.0

Total Current Assets Net Plant & Equipment Total Assets

465.5 380.0 $

Accounts Payable Accruals Notes Payable

$ x 1.10 x 1.10

$

Owner's Equity Total Liabilites & Equity

$ $

430.0 130.0 285.0 415.0 845.0

929.5 33.0 66.0 40.0

130.0 300.0

Total Liabilities Common Stock Retained Earnings

Additional Funds Needed

511.5 418.0

x 1.10

845.0 30.0 60.0 40.0

Total Current Liabilities Long-Term Bonds

Forecast Basis x 1.10 x 1.10 x 1.10

2010 Initial Forecast $ 16.5 198.0 297.0

139.0 300.0 $

439.0 130.0 317.8

$ $

447.8 886.8

$

42.7

+$32.8

11

Step 3. Raising the Additional Funds Needed Higher sales must be supported by higher assets. Asset increase can be financed by spontaneous increases in accounts payable and accruals and by retained earnings. Any short fall must be financed from external sources--by borrowing or by selling new stock.

12

Step 4. Financing Feedbacks The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets

13

2010 Adjusted Forecast of Balance Sheet Unilate Textiles

Cash Accounts Receivable Inventory

Initial Forecast $ 16.5 198.0 297.0

Adjusted Forecast $ 16.5 198.0 297.0

511.5 418.0

511.5 418.0

Total Current Assets Net Plant & Equipment Total Assets Accounts Payable Accruals Notes Payable

$ $

929.5 33.0 66.0 40.0

$ $

929.5 33.0 66.0 46.8

Financing Adjustment

$

6.8

Total Current Liabilities Long-Term Bonds

139.0 300.0

145.8 309.0

9.0

Total Liabilities Common Stock Retained Earnings

439.0 130.0 317.8

454.8 159.3 315.5

29.3 (2.3)

Owner's Equity

447.8

474.8

Total Liabilites & Equity Additional Funds Needed

$

886.8 42.7

$

929.5 -

$

42.8

14

2010 Adjusted Forecast of Income Statement Unilate Initial Adjusted Financing Textiles Forecast Forecast Adjustment Net Sales C os t of Goods Sold Gros s P rofit

$

1,650.0 $ (1,353.0) 297.0

1,650.0 (1,353.0) 297.0

Fixed operating C os ts Depreciation

99.0 (55.0)

99.0 (55.0)

EBIT Les s Interes t

143.0 (40.0)

143.0 (41.4) $

(1.4)

EBT Taxes (40%)

103.0 (41.2)

101.6 (40.6)

(1.4) 0.6

61.8 $ (29.0)

61.0 (30.5)

(0.8) (1.5)

30.5 $ 2.32 1.16 26.3

(2.3)

Net Income C ommon Dividends

$

Addition to R etained Earnings $ Earnings per Share $ Dividends per Share $ Number C ommon Shares

32.8 $ 2.47 $ 1.16 $ 25.0

15

Unilate Textiles: Adjusted Key Ratios

Current R atio Inventory T urnover D ays Sales O utstanding T otal A ssets T urnover D ebt R atio T im es Interest E arned Profit M argin Return on A ssets Return on E quity

A djusted P relim inary 2009 2010 3.6x 3.5x 4.6x 5.6x 43.2 days 43.2 days 1.8x 1.8x 50.9% 48.9% 3.3x 3.5x 3.6% 3.7x 6.4% 6.6% 13.0% 12.8%

Industry A verage 4.1x 7.4x 32.1 days 2.1x 45.0% 6.5x 4.7% 12.6% 17.2% 16

Other Considerations in Forecasting: Excess Capacity Suppose in 2009 fixed assets had been operated at only 80% of capacity: Actual sales Full Capacity Sales = % of capacity $1,500 = = $1,875 million. 0.80

17

Other Considerations in Forecasting: Economies of Scale Unilate’s variable cost ratio is 82% of sales. Ratio might decrease to 80% if operations increase significantly. Changes in variable cost ratio affect the addition to retained earnings which affects the amount of AFN.

18

Other Considerations in Forecasting: Lumpy Assets Assets that cannot be acquired in small increments, but must be obtained in large, discrete amounts

19

How different factors affect the AFN forecast. Dividend payout ratio changes.  If reduced, more RE, reduce AFN.

Profit margin changes.  If increases, total and retained earnings increase, reduce AFN.

Plant capacity changes.  Less capacity used, less need for AFN.

Payment terms increased to 60 days.  Accounts payable would double, increasing liabilities, reduce AFN.

20

Financial Control Budgeting and Leverage The phase in which financial plans are implemented; control deals with the feedback and adjustment processes required to ensure the firm is following the right financial path to accomplish its goals, and, if not, to make necessary corrections. 

21

Operating Breakeven Analysis An analytical technique for studying the relationship between sales revenues, operating costs, and profits Operating breakeven analysis deals only with the upper portion of the income statement - the portion from sales to NOI

22

Unilate’s 2010 Forecasted Operating Income Sales (S)--(110 million units) Variable cost of goods sold (VC) Gross profit (GP) Fixed operating costs (F) Net operating income (NOI =EBIT)

$ 1,650.00 (1,353.00) 297.00 (154.00) $ 143.00

23

Operating Breakeven Chart Revenues & Costs

Total Sales Revenues (P x Q)

1,400 1,200 1,000

SOpBE =856 800 600 400 200 154 0 0

Operating Profit (EBIT > 0)

Operating Loss (EBIT < 0)

Total Operating Costs (F + Q x V)

Operating Breakeven Point (EBIT = 0)

Total Fixed Costs (F) 20

40

57 60 80 Units QOpBE

100

120 24

Breakeven Computation Sales = Total operating Total = + Total revenues costs variable costs (P x Q) = TOC = (V x Q) + costs F F QOpBE = P-V = Contribution margin QOpBE

=

$154.0 million $15.00 - $12.30

= 57.04 million units

fixed F

=

$154.0 million $2.70

≈

57.0 million units

25

Operating Breakeven Point F

SOpBE

=

SOpBE

= $154.0 = $12.30 1- $15.00

1-

(

V = P

( )

)

F Gross profit margin

$154.0 = $154.0 = 855.6 million 1 - 0.82 0.18

For the proposal to break even, Unilate must sell 57 million units or $855,600,000 of product.

26

Operating Leverage The existence of fixed operating costs, such that a change in sales will produce a larger change in operating income (EBIT)

27

Degree of Operating Leverage The percentage change in NOI (or EBIT) associated with a given percentage change in sales

28

Calculating the Degree of Operating Leverage Gross Profit DOL S = EBIT =

$297 $143

=

2.08x

Each 1 percent change in sales, will result in a 2.08 percent change in operating income.

29

Operating Income at Sales Levels of 110 and 99 Million Units 2010 F o r c a s t e d S a le s U n it P e rce n t O p e r a t io n sD e c r e a s e C h a n g e Change S a le s in u n its 110 99 (1 1 ) -1 0 .0 % S a le s r e v e n u e s $ 1 ,6 5 0 .0 $ 1 ,4 8 5 .0 $ (1 6 5 .0 ) -1 0 .0 % V a r ia b le c o s t o f g o o d s s o ld(1 ,3 5 3 .0 ) (1 ,2 1 7 .7 ) 1 3 5 .3 -1 0 .0 % G ro s s p ro f it F ix e d o p e r a tin g c o s ts

2 9 7 .0 (1 5 4 .0 )

N e t o p e r a tin g in c o m e ( E$B IT ) 1 4 3 .0 $

2 6 7 .3 (1 5 4 .0 ) 1 1 3 .3 $

( 2 9 .7 ) -

-1 0 .0 % 0 .0 %

( 2 9 .7 )

-2 0 .8 %

30

Financial Breakeven Analysis Determining the operating income (EBIT) the firm needs to just cover all of its fixed financing costs and produce earnings per share equal to zero

31

Financial Breakeven Computation Earnings available to common stockholders EPS = =0 Number of common shares outstanding =

(EBIT - I)(1 - T) - Dps Shrsc

EBITFinBE = I +

Dps (1 - T)

=0

= $41.4 + 0 = $41.4

32

Financial Leverage The existence of fixed financial costs such as interest and preferred dividends when a change in EBIT results in a larger change in EPS

33

Unilate Textiles: Degree of Financial Leverage DFL

EBIT = EBIT - I

DFL110

$143.0 = = $143.0 - $41.4

EBIT = EBIT - [financial BEP] $143.0 = $101.6

1.41x

34

Degree of Total Leverage Gross profit DTL = EBIT- [Financial BEP] S - VC = EBIT- I

Q(P - V) [Q (P - V) - F] - I

=

$297.0 = $101.6

= 2.92x

= DOL x DFL = 2.08 x 1.41 = 2.92x

35

Importance of Forecasting and Control Functions If projected operating results are not satisfactory, management can reformulate its plans. If funds required to meet sales forecast cannot be obtained, management can sale back projected levels of operations. If required funds can be raised, it is best to plan for their acquisition in advance. Any deviation from projections needs to be handled to improve future forecasts.

36

Chapter 17 Essentials 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

37

Chapter 17 Essentials 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

38

Example 4-13 Page 173 SUE WILSON IS THE NEW FINANCIAL MANAGER OF NORTHWEST CHEMICALS (NWC), AN OREGON PRODUCER OF SPECIALIZED CHEMICALS SOLD TO FARMERS FOR USE IN FRUIT ORCHARDS. SHE IS RESPONSIBLE FOR CONSTRUCTING FINANCIAL FORECASTS AND FOR EVALUATING THE FINANCIAL FEASIBILITY OF NEW PRODUCTS.   PART I. FINANCIAL FORECASTING   SUE MUST PREPARE A FINANCIAL FORECAST FOR 2010 FOR NORTHWEST. NWC’S 2009 SALES WERE $2 BILLION, AND THE MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT INCREASE FOR 2010. SUE THINKS THE COMPANY WAS OPERATING AT FULL CAPACITY IN 2009, BUT SHE IS NOT SURE ABOUT THIS. THE 2009 FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE GIVEN IN TABLE IP 4-1.

  39

Example Continue Page 2 TABLE IP4-1.

FINANCIAL STATEMENTS AND OTHER DATA ON NWC ($ MILLIONS)

A. 2000 BALANCE SHEET CASH & SECURITIES ACCOUNTS RECEIVABLE INVENTORIES TOTAL CURRENT ASSETS

$ 20 240 240 $ 500

NET FIXED ASSETS TOTAL ASSETS

500 $1,000

ACCOUNTS PAYABLE AND ACCRUALS NOTES PAYABLE TOTAL CURRENT LIABILITIES LONG-TERM DEBT COMMON STOCK RETAINED EARNINGS TOTAL LIABILITIES AND EQUITY

B. 2000 INCOME STATEMENT SALES LESS: VARIABLE COSTS FIXED COSTS EARNINGS BEFORE INTEREST AND TAXES INTEREST EARNINGS BEFORE TAXES TAXES (40%) NET INCOME DIVIDENDS (30%) ADDITION TO RETAINED EARNINGS

$2,000.00 (1,200.00) ( 700.00) $ 100.00 ( 16.00) $ 84.00 ( 33.60) $ 50.40 $ 15.12 $ 35.28

$

100 100 $ 200 100 500 200 $1,000

Example 4-13 Page 173 C. 2009 KEY RATIOS NWC

INDUSTRY PROFIT MARGIN 2.52% 4.00% RETURN ON EQUITY 7.20% 15.60% DAYS SALES OUTSTANDING (360 DAYS) 43.20 DAYS 32.00 DAYS INVENTORY TURNOVER 5.00x 8.00x FIXED ASSETS TURNOVER 4.00x 5.00x TOTAL ASSETS TURNOVER 2.00x 2.50x TOTAL DEBT RATIO 30.00% 36.00% TIMES INTEREST EARNED 6.25x 9.40x CURRENT RATIO 2.50x 3.00x PAYOUT RATIO 30.00% 30.00% ASSUME THAT YOU WERE RECENTLY HIRED AS SUE’S ASSISTANT, AND YOUR FIRST MAJOR TASK IS TO HELP HER DEVELOP THE FORECAST. SHE ASKED YOU TO BEGIN BY ANSWERING THE FOLLOWING SET OF QUESTIONS:

Example 4-13 Page 173 A. ASSUME THAT NWC WAS OPERATING AT FULL CAPACITY IN 2009 WITH RESPECT TO ALL ASSETS. ESTIMATE THE 2010 FINANCIAL REQUIREMENT USING THE PROJECTED FINANCIAL STATEMENT APPROACH, MAKING AN INITIAL FORECAST PLUS ONE ADDITIONAL “PASS” TO DETERMINE THE EFFECTS OF “FINANCING FEEDBACKS.” ASSUME THAT (1) EACH TYPE OF ASSET AS WELL AS PAYABLES, ACCRUALS, AND FIXED AND VARIABLE COSTS GROW AT THE SAME RATE AS SALES; (2) THE PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT; (3) EXTERNAL FUNDS NEEDED ARE FINANCED 50 PERCENT BY NOTES PAYABLE AND 50 PERCENT BY LONG-TERM DEBT (NO NEW COMMON STOCK WILL BE ISSUED); AND (4) ALL DEBT CARRIES AN INTEREST RATE OF 8 PERCENT.

Example 4-13 Page 173 I. INCOME STATEMENT: 2009 Actual

2010 Forecast Forecast FeedBasis 1st Pass Back

2nd

Pass Sales $2,000.00 x 1.25 $2,500.00 $2,500.00 Less: Var. costs (60%) (1,200.00) x 1.25 (1,500.00) 1,500.00 Fixed costs (700.00) x 1.25 (875.00) (875.00) EBIT $ 100.00 $ 125.00 $ 125.00 Interest (8%) (16.00) (16.00) +14.34a (30.34) EBT $ 84.00 $ 109.00 $ 94.66 Taxes (40%) (33.60) (43.60) (37.86) Net income $ 50.40 $ 65.40 $ 56.80 Dividends (30%) $ 15.12 $ 19.62 $ 17.04 RE addition $ 35.28 $ 45.78 $ 39.76 a External funds are financed with 50 percent notes payables and 50percent longterm debt, so the change in interest expense equals 0.08($89.61) + 0.08($89.61) = $7.17 + $7.17 = $14.34.

Example 4-13 Page 173 II. BALANCE SHEET: 2009 Actual

Forecast Basis $ 20.00

2010 Forecast Feed1st Pass Back x 1.25 $ 25.00

Cash & securities 25.00 Accounts receivable 240.00 x 1.25 300.00 Inventories 240.00 x 1.25 300.00 Tot. current assets $ 500.00 625.00 Net fixed assets 500.00 x 1.25 625.00 Total assets $1,000.00 $1,250.00 A/P and accruals $ 100.00 $ 125.00 Notes payable 100.00 100.00 Total current liab. $ 200.00 314.61 Long-term debt 100.00 189.61 Common stock 500.00 500.00 Retained earnings 200.00 +45.78 239.76 Total liab & equity $1,000.00 $1,243.98 AFN $ 179.22 $ 6.02 Cumulative AFN $ 185.24 aΔ in notes payable = $179.22(0.5) = $89.61. bΔ in long-term debt = $179.22(0.5) = $89.61. cΔ in RE = $39.76 - $45.78 = -$6.02. Process would continue until

2nd Pass $ 300.00 300.00

$ 625.00

x 1.25

$ 625.00 $1,250.00 $ 125.00

+89.61a 225.00 100.00

245.78

189.61 $ +89.61b 500.00 -6.02c

$1,070.78

AFN = $0.

Example 4-13 Page 173 CALCULATE NWC’S FORECASTED RATIOS, AND COMPARE THEM WITH THE COMPANY’S 2009 RATIOS AND WITH THE INDUSTRY AVERAGES. HOW DOES NWC COMPARE WITH THE AVERAGE FIRM IN ITS INDUSTRY, AND IS THE COMPANY EXPECTED TO IMPROVE DURING THE COMING YEAR B.

Key ratios

NWC 2009 2010 Industry Actual 2nd pass 2009 Profit margin 2.52% 2.27% 4.00% ROE 7.20% 7.68% 15.60% Days sales outstanding (DSO) 43.20 days 43.20 days 32.00 days Inventory turnover 5.00x 5.00x 8.00x Fixed assets turnover 4.00x 4.00x 5.00x Total assets turnover 2.00x 2.00x 2.50x Debt/assets 30.00% 40.34% 36.00% Times interest earned 6.25x 4.12x 9.40x Current ratio 2.50x 1.99x 3.00x Payout ratio 30.00% 30.00% 30.00% NWC’s profit margin and ROE are only about half as high as the industry average—NWC is not very profitable relative to other firms in its industry. Further, its DSO is too high, and its inventory turnover ratio is too low, which indicates that the company is carrying excess inventory and receivables. In addition, its debt ratio is forecasted to move above the industry average, and its coverage ratio is low and forecasted to decline even more. The company is not in good shape, and things do not appear to be improving.