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Financial Planning and Management

Financial Planning and Management. Professor XXXXX Course Name / Number. Setting long-run strategic goals Preparing quarterly and annual budgets Managing day-to-day fluctuations in cash balances. Financial planning activities. Invest in positive NPV projects

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Financial Planning and Management

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  1. Financial Planning and Management Professor XXXXX Course Name / Number

  2. Setting long-run strategic goals • Preparing quarterly and annual budgets • Managing day-to-day fluctuations in cash balances Financial planning activities • Invest in positive NPV projects • Added complexity: CFOs usually see many more projects that appear to have positive NPV than they can effectively pursue; thus, they must prioritize. • Limits on capital, production capacity, human resources and other inputs add complexity as well. Long-term financial planning Overview of the Planning Process

  3. Multiyear action plan for major investment and competitive initiatives Strategic plan Long-Term Financial Planning • In what emerging markets might we have a sustainable competitive advantage? • How can we leverage our competitive strengths across existing markets in which we currently do not compete? • What threats to our current businesses exist, and how can we best meet those threats? • Where in the world should we produce? Where should we sell? • Can we deploy resources more efficiently by exiting certain markets and using those resources elsewhere? Senior management develops strategic plan by answering questions like:

  4. Contribution of Finance to Strategic Planning Financial managers draw on a broad set of skills to asses the likelihood that the firm can achieve a given strategic objective. They determine the feasibility of a strategic plan, given firm’s existing and prospective sources of funding. Financial managers exercise control function in implementing strategic plans. Financial analysts prepare cash budgets to avoid or limit liquidity problems. Finance also contributes to strategic planning through risk management.

  5. A firm faces trade-offs when choosing to grow: uses of funds must equal sources of funds Liability Increases Accounts Payable Short-term debt Long-term debt Asset IncreasesCash Receivables InventoriesFixed Assets = + Equity Increases Retained Earnings Sustainable Growth • Growth can be measured by increases in firm’s market value, its asset base, the number of people it employs, or increases in its sales.

  6. Sustainable Growth Model • Models how rapidly a firm can grow 1. The firm will issue no new shares of common stock next year; 2. The firm’s total asset turnover ratio, S/A, remains constant; 3. The firm pays out a constant fraction, d, of its earnings as dividends; 4. The firm maintains a constant asset-to-equity ratio, A/E, and 5. The firm’s net profit margin, m, is constant. Model’s Assumptions: Firm wants to increase sales by g percent

  7. Sustainable Growth Model • The model can derive the sustainable growth rate g* that balances the sources and uses of funds. Increase in profit margin or assets-to-equity increase sustainable growth rate. Increase in total asset turnover ratio has the same effect: increase in sustainable growth rate.

  8. Models all items on the balance sheet and income statements to grow in proportion to sales • One item, such as cash balance or short term liability account, is adjusted after all projections to preserve the equality of left and right hands of balance sheet Percentage-of-sales method Pro Forma Financial Statements • Forecasts of balance sheet and income statements • “Top-down” approach uses macroeconomic and industry forecast to establish sales goals • “Bottom-up” approach forecasts sales on a customer by customer basis “Top-down” or “bottom-up” sales forecasts:

  9. Zinsmeister Shoe Balance Sheet as of December 31, 2006 Assets Liabilities and Equity Cash $10,000 Accounts payable $19,500 Accounts receivable 21,250 Credit line 5,000 Inventory 25,000 Current long-term debt 5,000 Current assets $56,250 Current liabilities $29,500 Gross fixed assets $80,000 Long-term debt $20,000 Less: Accumulated depreciation 20,000 Common stock $20,200 Net fixed assets $60,000 Retained earnings $46,550 Total assets $116,250 Total liabilities and equity $116,250 Balance Sheet of Zinsmeister Shoes

  10. Zinsmeister Shoe Income Statement for the year ended December 31, 2006 Sales $250,000 Less: Cost of goods sold 162,500 Gross Profit $87,500 Less: Operating expense $25,000 Less: Interest Expense $3,000 Less: Depreciation $10,000 Pretax Income $49,500 Less: Taxes 17,325 Net income $32,175 Income Statement of Zinsmeister Shoes

  11. Assumptions to Generate Pro Forma Financial Statements Assumptions: • Zinsmeister plans to increase sales by 30% next year(in 2007). • Gross profit margin will remain 35%. • Operating expenses will equal 10% of sales, as in 2006. • Interest rate paid on all debt is 10%. • Invest additional $20 mil in fixed assets in 2007. • Depreciation expense will increase from $10 mil to $15 mil. • Tax rate is 35%. • Cash holdings will increase by $1 mil next year. • Accounts receivables are 8.5% of sales. • Inventories equal 10% of sales. • Accounts payable are 12% of cost of goods sold. • Firm will repay additional $5 mil in long-term debt next year. • Firm will pay out 50% of net income as dividend.

  12. Pro forma income statement Sales $325,000 Less: Cost of goods sold 211,250 Gross Profit $113,750 Less: Operating expense $32,500 Less: Interest Expense $2,500 Less: Depreciation $15,000 Pretax Income $63,750 Less: Taxes 22,312 Net income $41,438 Dividends $20,719 Pro Forma Income Statement for Zinsmeister Shoes

  13. Pro Forma Balance Sheet for Zinsmeister Shoes Cash holdings will increase by $1 mil next year: • Cash = $10 mil+ $1mil = $11 mil Accounts receivables are 8.5% of sales: • A/R = $325,000 X 0.085 = $27,625 Inventories equal 10% of sales: • Inventory = $325,000 X 0.1 = $32,500 Invest additional $20 mil in fixed assets in 2007. Depreciation expense will increase from $10 mil to $15 mil: • Gross fixed assets = $80 mil + $20 mil = $100 mil • Accumulated depreciation = $20 mil + $15 mil = $35 mil Accounts payable are 12% of cost of goods sold: • A/P = $211,250 X 0.12 = $25,350

  14. Assets Liabilities and Equity Cash $11,000 Accounts payable $25,350 Accounts receivable 27,625 Credit line 3,306 Inventory 32,500 Current long-term debt 5,000 Current assets $71,125 Current liabilities $33,656 Gross fixed assets $100,000 Long-term debt $15,000 Less: Accumulated depreciation 35,000 Common stock $20,200 Net fixed assets $65,000 Retained earnings $67,269 Total assets $136,125 Total liabilities and equity $136,125 Pro Forma Balance Sheet for Zinsmeister Shoes

  15. External Funds Required (EFR) for Zinsmeister Shoes Model forecast of external funds required with the following equation: EFR for Zinsmeister is $8,111,000. In pro forma balance sheet external financing declined by $6.7 mil. Why the discrepancy? Discrepancy arises because assets to sales ratio is actually not constant, as equation assumes.

  16. Conservative strategy • Use long-term financing to cover both permanent assets and temporary assets Aggressive strategy • Use short-term financing to fund both seasonal peaks and part of long-term growth in sales and assets Matching strategy • Finance permanent assets with long-term funding sources and temporary asset requirement with short-term financing Short-Term Financing Strategies Companies can adopt following strategies to fund long-term trend and seasonal sales fluctuations of sales:

  17. 1,400 1,200 1,000 Quarterly Sales ($ in millions) 800 600 400 200 Quarterly Sales 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Year Quarterly Sales for Hershey Foods (1992 – 2003)

  18. Financing Strategies Available to Hershey 1,800 1,600 1,400 1,200 1,000 Total Assets($ in millions) 800 600 Hershey’s Current Assets Matching Strategy Conservative Strategy Aggressive Strategy 400 200 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Quarters (1992-2003)

  19. Key input • Firm’s sales forecast Cash receipts • All firm’s cash inflows in a given financial period Cash disbursements • All of firm’s cash outlays during a given financial period Cash Budget • Cash budget shows firm’s planned cash inflows and outflows Estimate the monthly cash flows

  20. An example… • Farrell Industries develops cash receipts forecasts for October, November, and December: • Sales in August and September: $300,000 and $600,000 • Forecasted sales for October, November, and December: $1,200,000, $900,000, and $600,000 • 90% of sales on credit, 10% cash sales • 60% of sales collected next month; remaining 30% collected after two months • In December, $90,000 dividends from stock Farrell holds in a subsidiary Cash Receipts Common components of cash receipts: cash sales, collections of accounts receivable, and other cash receipts

  21. August September October November December Forecast Sales $300 $600 $1,200 $900 $600 Cash Sales (10%) $30 $60 $120 $90 $60 Collection of accounts receivable Previous month (60%) 180 360 720 540 Two months prior (30%) 90 180 360 Other cash receipts 90 Total cash receipts $570 $990 $1,050 Schedule of Projected Cash Receipts for Farrell Industries

  22. Cash disbursements items: • Cash purchases, fixed asset outlays, payments of accounts payable, interest payments, and rent and lease payments • Cash dividend payments, wages and salaries, loan principal payments, tax payments, and repurchase or retirement of stock • Depreciation, though not included in the cash budget, does have a cash outflow effect through impact on tax payments. • Farrell Industries uses the following assumptions to compute cash disbursements for October, November, and December: • Purchases equal 70% of sales. Paid 20% in cash; 60% paid next month, and 20% two months after the purchase: • October purchases = 70% X $1,200,000 = $840,000 • $168,000 paid in cash, $504,000 paid in November, and $168,000 paid in December. Cash Disbursements

  23. Cash Disbursements • Rent payments: $20,000 paid each months. • Wages and salaries: 10% of monthly sales plus $30,000. • October wages = 10% X $1,200,000 + $30,000 = $150,000. • Tax payments: $75,000 taxes paid in December. • Fixed assets outlays: $390,000 in new machinery paid in November. • Interest payments: $30,000 due in December. • Cash dividends payments: $60,000 dividends will be paid in October. • Principal payments: $60,000 principal payment due in December.

  24. August September October November December Purchases (70% of sales) $210 $420 $840 $630 $420 Cash Purchases (20%) $42 $84 $68 $126 $4 Payments of accounts payable Previous month (60%) 126 252 504 378 Two months prior (20%) 42 84 168 Rent payments 20 20 20 Wages and salaries 150 120 90 Tax payments 75 Fixed asset outlays 390 Interest payments 30 Cash dividend payments 60 Principal payments 60 Total cash disbursements $692 $1,244 $905 Projected Cash Disbursements for Farrell Industries

  25. Subtract cash disbursements from cash receipts for each period Net cash flow Ending cash balance • Add the beginning cash balance to the firm’s net cash flow • Farrell constructs the cash budget using the cash receipts and disbursements and the following assumptions: • Cash balance at the end of September is $200,000; • Notes payable and marketable securities are $0 at the end of September, and • $50,000 is the desired minimum cash balance. Net Cash Flow, Ending Cash, Financing Needs and Excess Cash

  26. October November December Total cash receipts $570 $990 $1,050 Less: Total cash disbursements 692 1,244 905 Net cash flow -$122 -$254 $145 Add: Beginning cash 200 78 -176 Ending cash balance $78 -$176 -$31 Less: Minimum cash balance 50 50 50 Required total financing (notes payable) $226 $81 Excess cash balance (marketable securities) $28 Cash Budget for Farrell Industries If cash balance is less than desired minimum cash balance, issue notes payable. If cash balance above desired minimum cash balance, invest in short-term marketable securities.

  27. Strategic financial plans act as guides for preparing operating financial plans. Sustainable growth model is a tool that managers can use to determine the feasibility of a target growth rate under certain conditions. Pro forma financial statements are projected financial statements. Cash budgets forecast firm’s short-term cash inflows and outflows. Financial Planning and Management

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