Financial planning and management
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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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Financial planning and management

Financial Planning and Management

Professor XXXXX

Course Name / Number


Overview of the planning process

  • 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


Long term financial planning

  • 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:


Contribution of finance to strategic planning

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.


Sustainable growth

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.


Sustainable growth model

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


Sustainable growth model1

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.


Pro forma financial statements

  • 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:


Balance sheet of zinsmeister shoes

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


Income statement of zinsmeister shoes

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


Assumptions to generate pro forma financial statements

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.


Pro forma income statement for zinsmeister shoes

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


Pro forma balance sheet for zinsmeister shoes

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


Pro forma balance sheet for zinsmeister shoes1

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


External funds required efr for zinsmeister shoes

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.


Short term financing strategies

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:


Quarterly sales for hershey foods 1992 2003

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)


Financing strategies available to hershey

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)


Cash budget

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


Cash receipts

  • 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


Schedule of projected cash receipts for farrell industries

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


Cash disbursements

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


Cash disbursements1

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.


Projected cash disbursements for farrell industries

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


Net cash flow ending cash financing needs and excess cash

  • 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


Cash budget for farrell industries

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.


Financial planning and management1

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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