Financial Planning

24

Corporate Financial Management 3e Emery Finnerty Stowe

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Learning Objectives
Describe the financial planning process. Forecast the firms future financing needs on the basis of sales growth. Describe the usefulness of pro forma financial statements. Create short- and long-term financial planning models using spreadsheets. Construct a cash budget.
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Chapter Outline
24.1 24.2 24.3 24.4 The Financial Planning Process Cash Budgeting Pro Forma Financial Statements Automating Financial Forecasting

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Financial Planning and the Principles of Finance

Valuable Ideas
Use both bottom-up and top-down processes to find valuable ideas.

Behavioral
Use common industry practices as a good starting place for the planning process.

Self-Interested Behavior
Carefully evaluate the financial plans impact on the firm and its stakeholders.

Incremental Benefits
Forecast and analyze the incremental cash flows of alternative decisions.

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Financial Planning and the Principles of Finance

Time Value of Money
Compare the NPVs of alternative plans.

Two-Sided Transactions
Look for situations that are not zero-sum games and thus may be profitable to you and your supplier or customer, perhaps by reducing agency and transactions costs.

Comparative Advantage
Design plans to take advantage of any opportunities you can find to use the firms comparative advantage to create value.

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24.1 The Financial Planning Process A firms financial plan involves decisions about: Liquidity Working Capital Inventories Capital Budgeting Capital Structure Dividends

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The Financial Plan

Financial planning is the process of evaluating the impact of alternative investing and financing decisions of the firm. Every financial plan has three components:
A model Inputs Outputs
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The Financial Plan

The model is a set of mathematical relationships between the inputs and the outputs. Inputs to the model may include:
Projected sales Collections Costs Interest rates Exchange rates
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The Financial Plan

The outputs of the financial plan are:
Pro forma financial statements A set of budgets

Pro forma financial statements are projected financial statements. A budget is a detailed schedule of a financial activity:
Sales budget Advertising budget Cash budget

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The Financial Plan

The planning horizon is the length of time that the financial plan projects into the future. Short-term financial plans
Usually have a planning horizon of one year or less. Are detailed and very specific.

Long-term financial plans

Usually have a five- or ten-year planning horizon. Tend to be less detailed.

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Components of the Financial Plan

Clearly stated strategic, operating and financial objectives. Assumptions on which the plan is based. Description of underlying strategies. Contingency plans for emergencies. Budgets, classified by
time period division type
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Components of the Financial Plan

The financing program, classified by
time period source of funds types of funds

A set of period-by-period pro forma financial statements for the entire planning horizon.

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Planning Cycles
A planning cycle specifies how frequently plans are reviewed and updated. The planning horizon is also renewed with each update. Short-term plans are updated more frequently than long-term plans.

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Bottom-Up and Top-Down Planning

A bottom up planning process starts at the production level and proceeds upwards through the corporate hierarchy. A top-down planning process starts with top management making strategic decisions.
These decisions are then implemented by managers further down the corporate hierarchy.
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Phases of the Financial Planning Process

Formulating the plan Implementing the plan Evaluating performance

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Benefits of Financial Planning

Standardizing assumptions Future orientation Objectivity Employee development Lender requirements Better performance evaluation Preparing for contingencies

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24.2 Cash Budgets

Cash budgets
Project and summarize cash inflows and outflows. Show monthly cash balances. Show any short-term borrowing needed to cover cash shortfalls.

They are usually based on sales forecasts. They are usually constructed on a monthly basis.
More frequent planning may be warranted.

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Preparing a Cash Budget

As a cash manager of Tyler Paints, you are required to prepare a cash budget for April, May, and June. Sales in the first three months of the year were $400,000, $500,000, and $600,000, respectively. Projected sales for April through June are given below.
Month: Projected Sales: April May $1,200,000 $1,000,000 June $1,000,000

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Tyler Paints Cash Budget

Tyler collects 20% of its sales in the month of the sale. An additional 45% is collected in the month following the sale, and the remaining 35% is collected two months after the sale. Purchases amount to 60% of next months sales, and are paid for in the month prior to the sale. Wages equal 20% of the current months sales, while other fixed expenses (such as rent) are $120,000 per month. Tyler expects to pay taxes of $200,000 in June. Tylers policy is to have a monthly cash balance of $450,000 for liquidity reasons. Any shortages will be met by short-term borrowings. Surplus cash will be used to pay off such loans.

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Collections on Sales
Collections in the Month of April are:
20% of April Sales 45% of March Sales 35% of February Sales

Collections in April = $685,000

20%$1,200,000 = $240,000 45%$600,000 = $270,000 35%$500,000 = $175,000 $685,000

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Collections on Sales
April Sales t: 20% t1: 45% t2: 35% Total $1,200,000 $240,000 $270,000 $175,000 $685,000 May $1,000,000 $200,000 $540,000 $210,000 $950,000 June $1,000,000 $200,000 $450,000 $420,000 $1,070,000

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Collections on Sales
Uncollected sales at the end of June (Accounts Receivable) =
= 35% of May Sales + 80% of June Sales) = 35%$1,000,000 + 80% $1,000,000 = $1,150,000

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Cash Disbursements
Cash Disbursements in April =
Purchases of 60%(May Sales) + Wages of 20%(April Sales) + Other Fixed Expenses of $120,000

Cash Disbursements in April =

60%$1,000,000 + 20%$1,200,000 + $120,000 $960,000

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Cash Disbursements
April
Sales Purchases Wages Other Taxes Total
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May

June
$1,000,000 $300,000 $200,000 $120,000 $200,000 $820,000

$1,200,000 $1,000,000 $600,000 $240,000 $120,000 $0 $960,000 $600,000 $200,000 $120,000 $0 $920,000

Cash Budget
April Collections Disbursements $685,000 $960,000 May $950,000 $920,000 June $1,070,000 $820,000

Net Cash Flow Begin Balance Available Balance Borrowings Ending Balance
Cumulative Loans

($275,000) $450,000 $175,000 $275,000 $450,000

$275,000

$30,000 $450,000 $480,000 ($30,000) $450,000

$245,000

$250,000 $450,000 $700,000 ($245,000) $455,000

$0

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Cash Budget
Tyler will have to borrow $275,000 in April. Tyler can repay $30,000 in May, leaving an outstanding loan balance of $245,000. The short-term loan can be fully repaid in June.

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24.3 Pro Forma Financial Statements They show the effect of the firms decisions on its future financial statements. Effect of alternative decisions can be examined:
Effect of sales variations. Effect of interest rate changes. Effect of financing decisions. Effect of dividend decisions.
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Percent of Sales Forecasting Method

Allows firm to estimate funds required to finance growth. Sales growth results in:
increase in current and fixed assets. increase in spontaneous short-term financing. increase in profitability.

The increase in current assets must be financed from internally generated funds or external funds.
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Percent of Sales Forecasting Method

If internally generated funds are insufficient to finance the growth, the firm may:
Reduce the growth rate. Sell assets not required to run the firm. Obtain new external financing. Reduce or stop paying cash dividends.

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Additional Financing Needed (AFN)

Let
A/S = the increase in assets per dollar increase in sales. L/S = the increase in spontaneous liabilities per dollar increase in sales. S0 = current level of sales. g = projected growth rate in sales. M = net profit margin on sales. D = cash dividends planned for common stock.
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Additional Financing Needed (AFN)

Additional Financing Needed
Required increase Increase in Increase in AFN in assets liabilitie s retained earnings

AFN = (A/S)gS0 (L/S)gS0 [M(1+g)S0D]

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Additional Financing Needed

Peak Plastics expects 20% sales growth next year. Sales for the current year were $4 million. Several balance sheet items vary directly with sales: cash, 3%; A/R, 17%; Inv., 22%; and FA, 8%. A/P will increase by 18% of sales. The net profit margin is 6% and Peak expects to pay $84,000 in dividends to its common stockholders. Estimate the external capital Peak will be required to finance this growth. Use shortterm loan for the needed financing, and project the balance sheet.
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Additional Financing Needed

Required increase Increase in Increase in AFN in assets liabilitie s retained earnings

A L AFN gS0 gS0 [ M( 1 g)S 0 D] S S

AFN = (.50)(.2)4m (.18)(.2)4m [.06(1.20)4m $84,000]

AFN = 0.4m 0.144m [0.288m 0.084] = $52,000

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Additional Financing Needed

Current Pro forma Cash 220,000 A/R 700,000 Inventory 940,000 C. Assets 1,860,000 Net F. A. 1,100,000 Total assets 2,960,000 A/P 650,000 S-T Loan 310,000 C. Liabs 960,000 1,156,000 LTD 1,100,000 O.E. 900,000 + 0.03(800,000) = + 0.17(800,000) = + 0.22(800,000) = + 0.08(800,000) = 244,000 836,000 1,116,000 2,196,000 1,164,000 3,360,000 794,000 362,000 1,100,000 1,104,000

+ 0.18(800,000) = + 52,000 (AFN) =

+ 204,000 (+RE)=

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24.4 Using Spreadsheet Software to Prepare Financial Plans

Allows evaluation of changes in assumptions. Allows evaluation of alternative scenarios. Automates preparation of standardized budgets and financial statements.
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Summary
Financial planning is an organized process of gathering information, analyzing alternative decisions, developing goals and plans, implementing the plans, and evaluating performance against those plans. Good financial planning uses both top-down and bottom up processes. It involves all units in the process.
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Summary
A complete financial plan includes:
1. 2. 3. 4. Clearly stated objectives Assumptions Description of strategies Contingency plans for emergencies 5. Budgets (by unit, period, and type) 6. The financing program 7. A complete set of pro forma financial statements.

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Summary
Computer technology has greatly enhanced budgeting and the entire planning process.

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