Chapter 5 Financial Planning
Financial Planning Introductory concepts the role of planning Specific-item forecasting Forecasts that relate to sales The percentage-of-sales method illustrated Interpreting the pro-forma statements 5-2
Financial Planning Introductory concepts the role of planning Specific-item forecasting Forecasts that relate to sales The percentage-of-sales method illustrated Interpreting the pro-forma statements 5-3
The Role of Planning Planning Step 1 MISSION STATEMENT: a broad statement of purpose Step 2 UNDERSTAND CUSTOMERS: what does it take to exceed their expectations? Step 3 STRATEGY: aligning the firm with its internal culture and strengths and its external environment Step 4 OPERATING PLANS: making them consistent with strategy 5-4
The Role of Planning Budgeting the translation of the organization s plan into dollar impacts Divides the plan into time units Guides resource use and tests results Can have unintended side effects Damaging the firm to meet budget Leading to internally competitive rather than cooperative behaviors Tampering overreacting to environmental changes 5-5
The Role of Planning Financial planning Six tasks Make assumptions explicit and shared Identify healthy actions Identify financial resources Guide financing choices Benchmark results Communicate with stakeholders 5-6
The Role of Planning Financial planning (continued) Three parts The long-run financial plan The capital budget The operating or cash budget Pro-forma financial statements Projected future statements Used to examine the financial implications of alternative decisions 5-7
Financial Planning Introductory concepts the role of planning Specific-item forecasting Forecasts that relate to sales The percentage-of-sales method illustrated Interpreting the pro-forma statements 5-8
Specific-Item Forecasting Defined projecting each financial statement account independent of the other accounts Advantage flexibility Disadvantage ignores relationships among variables that might improve forecasting accuracy 5-9
Financial Planning Introductory concepts the role of planning Specific-item forecasting Forecasts that relate to sales The percentage-of-sales method illustrated Interpreting the pro-forma statements 5-10
Forecasts That Relate to Sales Why? many accounts depend on sales Three requirements for success Start with a good sales forecast Correctly identify the accounts that relate to sales ask three questions: Why is the firm spending this money? What is the time horizon of the account? How will management respond? Accurately establish the relationship of those accounts to sales 5-11
Forecasts That Relate to Sales Income statement accounts Variable costs change with sales Fixed costs do not change with sales Balance sheet accounts Spontaneous accounts change with sales without the need for specific management action Discretionary accounts do not change with sales but rather are set by management decisions 5-12
Financial Planning Introductory concepts the role of planning Specific-item forecasting Forecasts that relate to sales The percentage-of-sales method illustrated Interpreting the pro-forma statements 5-13
The Percentage-of-Sales Method Seven steps Forecast sales Classify accounts Determine relationships Project new values Fill in the pro-forma income statement and balance sheet Force the pro-forma balance sheet to balance Produce the pro-forma cash flow statement 5-14
The Percentage-of-Sales Method 5-15
The Percentage-of-Sales Method THE JEFFERSON COMPANY Income Statement For the year ended December 31, 2011 Sales $ 2,500 Cost of Goods Sold 1,738 Gross profit 762 Operating expenses $ 550 Depreciation 40 590 EBIT 172 Interest expense 18 EBT 154 Tax expense 54 EAT $ 100 Dividends 33 Addition to retained earnings $ 67 5-16
The Percentage-of-Sales Method THE JEFFERSON COMPANY Balance Sheet December 31, 2011 Cash $ 100 Accounts payable $ 150 Marketable securities 50 Accrued payables 200 Accounts receivable 150 Bonds payable 200 Inventories 200 Common stock 150 Plant, net 500 Retained earnings 300 Total assets $ 1,000 Total liability and equity $ 1,000 5-17
The Percentage-of-Sales Method THE JEFFERSON COMPANY Pro-Forma Income Statement For the year ended December 31, 2012 Data obtained from: Sales $ 3,000 Step 1 - forecast -Cost of goods sold 2,086 Step 4a - projection Gross profit 914 -Operating expenses $ 625 Step 4a - projection -Depreciation 40 Step 2a - fixed cost 665 EBIT 249 -Interest expense 18 Step 4c - projection EBT 231 -Tax expense (35%) 81 Step 2f - calculation EAT $ 150 -Dividends 50 Step 2g - calculation Addition to retained earnings $ 100 5-18
The Percentage-of-Sales Method THE JEFFERSON COMPANY Pro-Forma Balance Sheet December 31, 2012 Data obtained from: Cash $ 120 Step 4b - projection Marketable securities 50 Step 2d - discretionary Accounts receivable 180 Step 4b - projection Inventories 240 Step 4b - projection Plant, net 600 Step 4b - projection Total Assets $ 1,190 Accounts Payable $ 180 Step 4b - projection Accrued Payable 240 Step 4b - projection Bonds payable 150 Step 4c - projection Common stock 150 Step 2d - discretionary Retained earnings 400 Step 5 - pro-forma income statement $ 1,120 External Financing Needed 70 Step 6 - force a balance Total liability and equity $ 1,190 5-19
The Percentage-of-Sales Method THE JEFFERSON COMPANY Pro-Forma Statement of Cash Flows For the year ended December 31, 2012 Data obtained from: CASH FLOW FROM OPERATIONS Received from customers $ 2,970 Pro-forma statements Paid to suppliers and employees (2,681) Pro-forma statements Interest Paid (18) New income statement Income taxes paid (81) New income statement Net cash provided by operating activities 190 CASH FLOW FROM INVESTMENTS Payment for purchase of property plant and equipment (140) Both balance sheets CASH FLOW FROM FINANCING External financing 70 New balance sheet Repayment of long-term debt (50) Both balance sheets Dividents paid (50) New income statement Net cash used by financing activities (30) 5-20
The Percentage-of-Sales Method NET INCREASE (DECREASE) IN CASH 20 Cash and equivalents, beginning of year 150 Cash and equivalents, end of year $ 170 RECONCILIATION OF NET INCOME TO CASH PROVIDED BY OPERATIONS Net income $ 150 New income statement Add back: Depreciation 40 New income statement Subtract increase in: Accounts receivable (30) Both balance sheets Inventories (40) Both balance sheets Add increase in: Accounts payable 30 Both balance sheets Accrued payables 40 Both balance sheets Net cash provided by operations $ 190 5-21
Financial Planning Introductory concepts the role of planning Specific-item forecasting Forecasts that relate to sales The percentage-of-sales method illustrated Interpreting the pro-forma statements 5-22
Interpreting the Pro-Forma Statements There are two reasons why firms need external funds Growth long-term trend Seasonality temporary fluctuations The cash flow statement gives additional clues to funding it identifies why funds are needed and whether the money will return to the firm in the short or long term 5-23
Interpreting the Pro-Forma Statements Financial (ratio) analysis can be used to examine the results Test for trends in the ratios not directly related to sales Test the choice of EFN source using the ratios sensitive to financing choice calculate the ratios for each financing alternative Relationships are changing the percentage relationships of most accounts to sales is changing as companies improve their business processes 5-24