Financial Planning 27 January 2010

1. Humphry Hung, PhD 洪興立博士 Faculty of Business Hong Kong Polytechnic University Financial Planning 27 January 2010

2. Financial Planning How wealth is created?

3. BUSINESS PLAN (Common Version) The Business Plan is the result of a PLANNING PROCESS. ELEMENTS OF A BUSINESS PLAN • Executive Summary • The Opportunity and the Company’s Services/Products • Market Research/Analysis • Economics of the Business • Marketing Plan • Design and Development Plan • Manufacturing and Operations Plan • Management Team • Overall Schedule • Critical Risks, Problems and Assumptions • The Financial Plan • Appendices

4. BUSINESS PLAN (Competition) ELEMENTS OF A BUSINESS PLAN FOR COMPEITITON • Executive Summary • Mission statement • The team • Market summary • Opportunities • Business concept • Competition • Goals and objectives • Financial plan • Resource requirements • Risks and rewards • Key Issues

5. Financial Planning: Purposes Three important uses: • Forecast the financial viability of the new business • Forecast the amount of external financing that will be required • Set appropriate targets for future plans

6. THE PURPOSE OF PLANNING 2 major audiences: management and outside investors (and the judges) THE MANAGERIAL VALUE OF PLANNING The Planning Process • Creates a cohesive unit with common goals • Promotes an understanding of objectives and policies • Forces a thinking through of everything that has to be done • Makes people understand what they individually have to do A Road Map for Running the Business • Comparing operating performance to plan • Investigate deviations • Propose Solutions

7. TO COMMUNICATE AND CONVINCE Communicates management's ideas about what the company will be in the future Shows: the economic viability of the project Tells: Potential investors their expected return Debt investors the source of repayment

8. WHY NEED FINANCIAL PLANS? • Profitability • Years of payback • Initial investment • We need….. • Income statement • Balance Sheet • Cash flow statement

9. INCOME STATEMENT ITEMS Sales - RevenueProceeds from sale of product or service (only) COGSSpending on things closely related to production Material, labor, production overheadGross MarginProfitability of production operations Often expressed as a percent of sales ExpensesOther spending - Marketing, finance, personnel

10. INCOME STATEMENT Total Sales Less Cost of Goods Sold = Gross Margin Operating expenses: salaries space costs (rent, utilities) advertising/PR Other expenses =Total Expenses Net Profit (Loss) pre-tax

11. INCOME STATEMENT : An Example Sales $1,000Cost of Goods Sold 600 Gross Margin $400 Expenses 230 Earnings Before Interest & Taxes $170 Interest Expense 20 Earnings Before Tax $150Tax 24 Net Income $126

12. INCOME STATEMENT

13. BALANCE SHEET ITEMS : ASSETS ASSETS Cash Checking accounts +Currency Accounts Receivable Due from sales on credit Offset-Allowance for doubtful accounts(bad debt reserve) Writing off of uncollectibles Overstatement of receivables Inventory Raw Material, WIP, Finished Goods Offset - Inventory reserve Writing off bad inventory Overstatement of inventory

14. BALANCE SHEET ITEMS : LIABILITIES Current Liabilities Due within a year Accounts Payable Due from purchases on credit Terms of sale Working Capital Current Assets - Current Liabilities Supports routine operations

15. BALANCE SHEET ITEMS : CAPITAL LONG TERM DEBT Bonds and Loans Debt generates interest expense - Increases risk of failure EQUITY Investment by Sheareholders

16. BALANCE SHEET ASSETSLIABILITIES Cash $1,000 Accounts Accounts Payable $1,500 Receivable 3,000 Others 500 Inventory 2,000 CURRENTCURRENT ASSETS $6,000 LIABILITIES $2,000 Fixed Assets Long Term Debt $5,000 Gross $4,000 Equity 2,000 Accum Depr (1,000) Net $3,000 TOTAL CAPITAL $7,000 TOTAL LIABILITIES TOTAL ASSETS $9,000 AND EQUITY $9,000 ASSETS = LIABILITIES + EQUITY Arrangement in order of decreasing liquidity

17. Cash comes in: net from operations new debt sale of fixed asset new investment Cash goes out: debt retired new fixed assets dividends stock redemption MANAGING CASH FLOWS

18. CASH FLOWS

19. THE FINANCIAL PLAN A firm's projected financial statements, generally a part of a broader business plan MAKING FINANCIAL PROJECTIONS • Translating physical and economic activity into dollars • Forecast sales first, then forecast the support required by the implied activity PLANNING FOR NEW AND EXISTING BUSINESSES • Harder to plan for a new or proposed business • No history - must make assumptions about everything THE TYPICAL PLANNING TASK • Most financial planning is for existing businesses • Forecast changes to past history • The changes are planning assumptions Anything about which an assumption isn't made is implicitly assumed to remain unchanged. For a new business, everything has to be explicitly assumed.

20. PLANNING ASSUMPTIONS THE PROCEDURAL APPROACH Make a revenue projection Then forecast the income statement and balance sheet line by line until come to interest and debt THE INTEREST/DEBT PLANNING PROBLEM We need debt to forecast interest and interest to forecast debt. EAT (less dividends) is added to Beginning Equity to arrive at Ending Equity. Ending Debt is averaged with Beginning Debt and multiplied by the interest rate to calculate Interest Expense.

21. PLANS WITH SIMPLE ASSUMPTIONS Quick Estimates Based on Sales Growth Percentage of Sales Method All line items grow by the same percentage as sales (A very unrealistic assumption) Modified Percentage of Sales Method Most line items grow by the same percentage as sales

22. 7 STEPS IN FINANCIAL PLANNING • Determine Purpose/Use of Forecast • Set Forecast Time Frame (matches Use) • Project Revenue (history & expectations) • Project Expenses (ratios & one time events) • Project Balance Sheet: • Investment Needs (Uses of funds) • Spontaneous Sources of funds • Calculate External Financing Need • SENSITIVITY TEST ASSUMPTIONS

23. Step 1:Determine Purpose of Forecast • Sample Purposes: • When to convert Investments to Cash • When Debt can be paid down • Estimating Sales Commissions • Setting Marketing Expense Budget • Typical Audiences • Your Bank • Your Management • All Employees • Investors

24. Step 2:Set Forecast Timeframe Examples: • 12 week Cash Budget • One Year Operating Plan • 3 Year Rolling Long Range Plan • 5-10 Year Strategic Plan

25. Step 3:Project Revenue • How • Trends • Expected Change Factors • Components of Revenue • Units x Price • Ratio of Products to Services • Importance of getting it Right • Validation & Updating

26. Step 4:Project Expenses • % of Sales (Top Down) Method • Bottom-Up (Zero Based) Method • FTE (Full Time Employee) or Headcount- Based Method • Must develop Assumption for each Expense Line… Walk Through P&L

27. Sample Expense Assumptions • Cost of goods sold • % of Sales • Headcount, Inflation • R & D. • Inflation, Competition • Sales & Marketing • Inflation • General & Adm. • % of Fixed Assets • Depreciation • % of Intangible Assets • Amortization • % of Debt • Interest Expense

28. Step 5:Project Balance Sheet • Normally 5 years • Develop Assumption for each line on Balance Sheet

29. Sample Balance Sheet Assumptions • Inventory • % of Sales • % of Sales • Accountable receivables • Replacement, Events • Fixed Assets • % of Expenses • Accounts Payable • Use to Balance • Notes Payable • Usually No Change • Long term Debt • Add Net Income less Dividends • Equity

30. Step 6:Calculate External Financing Need • Investment for the new business • Investment for further expansion • Credit control effectiveness

31. Step 7:Sensitivity Test for each Assumption Optional Assumptions: • Best Case Scenario • Worst Case Scenario • Competitive Ratios • Calculate & consider the impact

32. Sales Channel 3D body scanning Virtual fitting Information kiosk Cross-selling Collect market data Online assistance La Tailleur Example La TailleurKiosk Finalist of Asia Moot Business Plan Competition

33. Example Business Startup Kiosk Components Processing Unit Telecom Device Body Scanning La Tailleur kiosk Information Window Virtual Fitting Room

34. Example Marketing Plan Year 1 – 2 3 – 4 5 Phase 1 Phase 2 Phase 3 Sportswear Overseas Market Business Wear More than 40 retailers

35. Example Promotion Plan • Loyalty discount • Intensive personal selling • TV and radio • Sports event sponsorship • Web banner ads • Personal selling • Trade show • Road show • Publication • Official web site • Intensive personal selling • International trade show • Overseas publication Introductory Growth Maturity Total Market Sales Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

36. Example Financial Plan Assumptions: • No bad debt provision • No prepayment or accrual • Corporate profit tax is 16% • Our contribution 30% • Sales volume figures are calculated based on information projected by the Hong Kong Retailer Management Association

37. Example Sales Forecast

38. Example Financial Performance

39. Example The Deal • HK$10 million • 60% Equity Position • Class ‘A’ shares

40. Example Return On Investment • ROI = 103.63% • Payback = 3 Year

41. Example Exit Options • Public Listing • Buy Out • 50 million at 5th year • Sales below 113 million in 5th year • Merger and acquisition

42. SUMMARY We have covered…. • What is financial planning • Importance of forecasting • Financial statements • An Example of Financial Plan