Financial Planning

FINANCIAL PLANNING •

What is financial Planning? It provides a roadmap for guiding, coordinating, and controlling firms actions to achieve goals. Two Key aspects of financial planning:1) Cash Planning 2) Profit Planning

Financial Planning Process • Long Term or Strategic financial Plan Lays out a company’s action plan ranging over a period of 2 to 10 years. • Short Term or Operating financial Plan Specify plan that covers financial actions to be taken over a 1to 2 years time period.

Long term or Strategic Plan •Proposed outlays for purchase of Fixed Asset •Research & Development Activities •Making a Product development action •Major sources of financing •Termination of existing projects products or line of business •Repayment or retirement of debts •Any planned acquisition

Operating Plan

Sales Forecast

Production Plan

Long term financial plan

Pro Forma income statement

Cash Budget

Current period Balance sheet Pro Forma Balance Sheet

Fixed asset outlay plan

Proforma or Projected Financial Statements 1.For assessing whether the firm’s anticipated performance is in line with the firm’s own target or investor expectations. 2.To estimate the effect of proposed operating changes. Doing “what if” analysis. 3.To anticipate the firm’s future financing needs 4.To estimate future free cash flows

Sales Forecasts •Monthly cash flows resulting from projected sales receipts •Outlays related to production , inventory and sales It can be derived from external forecast or Internal Forecast or both.

Financial Statement Forecasting • The Percent of Sales Method Many items on the income statement and balance sheets are assumed to increase proportionally with sales. Constant Ratio Method

2004 Forecasted Income Statement Sales Less: COGS SGA EBIT Interest EBT Taxes (40%) Net. income Div. (40%) Add. to RE

2004 1st Pass Factor 2003 $2,000 g=1.25 $2,500.0 Pct=60% 1,500.0 Pct=35% 875.0 $125.0 0.1(Debt03 ) 20.0 $105.0 42.0 $63.0 $25.2 $37.8

2004 Balance Sheet (Assets) Forecasted assets are a percent of forecasted sales. 2004 Sales = $2,500

Factor Cash Accts. rec. Inventories Total CA Net FA Total assets

Pct= 1% Pct=12% Pct=12% Pct=25%

2004 $25.0 300.0 300.0 $625.0 625.0 $1,250.0

2004 Preliminary Balance Sheet (Claims) 2004 Sales = $2,500

2003 AP/accruals Notes payable Total CL L-T debt Common stk. Ret. earnings Total claims

Factor Pct=5%

100 100 500 200

+37.8*

2004

Without AFN $125.0 100.0 $225.0 100.0 500.0 237.8 $1,062.8

*From forecasted income statement.

What are the additional funds needed (AFN)? • Required assets = $1,250.0 • Specified sources of fin. = $1,062.8 • Forecast AFN = $ 187.2

Implications of AFN • If AFN is positive, then you must secure additional financing. • If AFN is negative, then you have more financing than is needed. – Pay off debt. – Buy back stock. – Buy short-term investments.

Assumptions about How AFN Will Be Raised • No new common stock will be issued. • Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt.

How will the AFN be financed? Additional notes payable = 0.5 ($187.2) = $93.6. Additional L-T debt = 0.5 ($187.2)= $93.6.

2004 Balance Sheet (Claims) w/o AFN AFN With AFN AP/accruals $ 125.0 $ 125.0 Notes payable 100.0 +93.6 193.6 Total CL $ 225.0 $ 318.6 L-T debt 100.0 +93.6 193.6 Common stk. 500.0 500.0 Ret. earnings 237.8 237.8 Total claims $1,071.0 $1,250.0

2002 2nd Pass Income Statement 1st Pass Feedback 2nd Pass Sales $2,500 $2,500 Less: COGS 1,500 1,500 SGA 875 875 EBIT $ 125 $ 125 Interest 20 +18.72 38.72 EBT $ 105 $ 86.28 Taxes (40%) 42 34.5 Net income $ 63 $ 54.78 Div. (40%) $ 21.91 Add. to RE $ 32.87

2002 2nd Pass Balance Sheet (Assets) 1st Pass

AFN

2nd Pass

Cash

$25

$25

Accts. rec.

300

300

Inventories

300

300

Total CA

$625

$625

625

625

$1,250

$1,250

Net FA Total assets

No change in asset requirements.

2002 2nd Pass Balance Sheet (Claims) 1st Pass Feedback 2nd Pass AP/accruals $ 125 $ 125 Notes payable 193.6 193.6 Total CL $ 318.6 $ 318.6 L-T debt 193.6 193.6 Common stk. 500 500 Ret. earnings 237.8 232.82 Total claims $1,250 $ 1,245

Results After the Second Pass  Forecasted assets  Forecasted claims  2nd pass AFN

= $1,250 (no change) = $1,245 (higher) =$ 5 (short)

The $5 shortfall came from the $5 reduction in retained earnings. Additional passes could be made until assets exactly equal claims. $5(0.10) = $0.50 interest on 3rd pass.

AFN Equation Additional= Required - Spontaneous - Inc Funds Inc in assets Liabilities in RE Needed AFN

= (A*/S0)∆ S - (L*/S0)∆ S - M(S1)(RR)

Definitions of Variables in AFN • A*/S0: assets required to support sales; called capital intensity ratio. ∀ ∆ S: increase in sales. • L*/S0: spontaneous liabilities ratio • M: profit margin (Net income/sales) • RR: retention ratio; percent of net income not paid as dividend.

Assets must increase by $250 million. What is the AFN, based on the AFN equation? AFN = (A*/S0)∆ S - (L*/S0)∆ S - M(S1)(RR) = ($1,000/$2,000)($500) - ($100/$2,000)($500) - 0.0270($2,500)(1 - 0.4) = $184.5 million.

Equation AFN = $184.5 vs. Pro Forma AFN = $187.2 Why are they different?  Equation method assumes a constant profit margin.  Pro forma method is more flexible. More important, it allows different items to grow at different rates.

Factors that affect External Financial Requirements • Sales Growth ( increase in sales) • Capital intensity ( A*/ S0) • Spontaneous liabilities to sales ratio (L*/S0) • Profit Margin (M) • Retention Ratio (RR)

How would increases in these items affect the AFN? Higher sales: Increases asset requirements, increases AFN. Higher capital intensity ratio, A*/S0? Increases AFN: Need more assets for given sales increase.

Higher dividend payout ratio? • Increase AFN: Less retained earnings. Higher profit margin? • Decrease AFN: Higher profits, more retained earnings.

Pay suppliers in 60 days rather than 30 days? Decrease AFN: Trade creditors supply more capital, i.e., L*/S0 increases. Higher profit margin: Increases funds available internally, decreases AFN Higher Retention Ratio: Decreases AFN: Due to increase in retained earnings.

Relationship between Sales Growth and Financial Requirements 1. Financial Feasibility 2. Effect of Dividend Policy on financing needs 3. Capital Intensity 4. Profit Margin

When Balance Sheet Ratios are subject to change Three such conditions are:1.Economies of Scale 2.Lumpy Assets 3.Excess assets due to forecasting errors