Practical financial managment 7e LASHER chapter 4

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 2... Conce

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

The Purpose of Planning and

Plan Information

Major audiences of business plan

Planning process helps pull management team together

Provides a road map for running the business

Provides a statement of goals

Helps predict financing needs

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

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

Four Kinds of Business Plan

Four Kinds of Business Plan

Strategic Planning

approximate financial projections

Five-year horizon is common

Concepts expressed mainly in words, not numbers

Firm analyzes itself, the industry and the competitive situation

Four Kinds of Business Plan

Operational Planning

short-term projections

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Four Kinds of Business Plan

Budgeting

Usually Covers a three month quarter

Attempts a precise estimate of company expenses

Mostly financial detail with a few words

Four Kinds of Business Plan

Forecasting

Where will the business’s financial momentum carry it in the next few weeks

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

Figure 4-2 The Business Planning Spectrum

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Figure 4-3 Relating Business Planning in Large and Small Fir ms

Financial Plan as a Component of a Business Plan

Financial plan is the financial portion of the business plan

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Planning for New and Existing Businesses

Hard to forecast a new operation

The typical planning task

Unit sales will increase by 10%

Overall labor costs will rise by 4%, etc.

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

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

Collection activities will be more effective

A/R = $13,500,000/12 = $1,125,000

The General Approach, Assumptions, and the Debt/Interest

Problem

The Procedural Approach

Debt/Interest Planning Problem

required to forecast debt

An Iterative Numerical Approach

liabilities less ending equity

expense on that value

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Solves the debt/interest problem

Figure 4-5 The Debt/Interest

Planning Problem

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:

Example 4.3 Plans with Simple Assumptions

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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.

Example 4.3 Plans with Simple Assu mptions

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.

Example 4.3 Plans with Simple Assumptions

Forecasting Cash Needs

Forecasting Cash Needs

financing needs

be needed

The Percentage of Sales Method

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

Concept Connection Examp le 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

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

Real plans generally incorporate complex assumptions about important financial items

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More Complicated Plans Indirect Planning Assumptions

Financial planning assumptions can be made:

Indirect planning assumptions are usually based on financial

ratios

Period (ACP)

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

Concept Connection Example 4-8 Complex Plans

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Concept Connection Example 4-8

Complex Plans

Concept Connection Example 4-8 Complex Plans

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Concept Connection Example 4-8 Complex Plans

Figure 4-6 Supporting Detail for Annual Planning at the Department Level

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The Cash Budget

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

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

Concept Connection Example 4-9

Cash Budgeting

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Concept Connection Example 4-9

Cash Budgeting

Concept Connection Example 4-9

Cash Budgeting

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Concept Connection Example 4-9

Cash Budgeting

Management Issues in Financial Planning

The Financial Plan as a Set of Goals

motivate performance

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Risk in Financial Planning

Risk in Financial Planning

in General

Scenario Analysis—“What If”ing

not coming true

Communication

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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