Finance 3310
Lecture Notes
Lecture 4
Long-Term Financial Planning and Growth
The previous two lectures involved analyzing the financial standing and past performance of a company. Now we want to peer into the future a bit. This process is called financial planning. Financial planning is actually a byproduct of corporate strategic planning. Strategic plans could encompass as much as five years and as little as one year. Strategic planning can be a very complex process involving SWOT analysis and other such management tools. A strategic plan might consist of:
• Goals or objectives
• Action Plans
• Performance Measurement
While the overriding goal is to maximize shareholder value, such a goal is not operational. As an example, one goal or objective might be to increase market share. The action plan would then be a set of anticipated or planned steps to be taken to increase market share. Perhaps these would include changing the pricing policy or advertising, or acquiring another company. The final important part of a strategic plan is performance measurement. This is where success is measured. In the market share example the company would simply calculate its market share and compare it to its goal.
A strategic plan will imply a financial plan.
Why Do Financial Planning?
A financial plan attaches numbers to (rationalizes) the company's strategic plan. It sheds light on the feasibility and consistency of the strategic goals and indicates the financial implications of such goals. More directly, the financial plan:
• Is a tool for performance measurement; a benchmark for measuring success. How do our financial statements compare to what we projected based on our strategic plan? Suppose we did not forecast the financial implications of a strategic plan.
• Indicates the financing need implied by the strategic plan. This is critical. The strategic plan will involve a set of corporate resource allocation decisions. (A change in the `circle.') This in turn will imply a financing need. If the company knows in advance it will need significant financing to achieve its goals, then it can begin arranging for such financing. Many small, growing businesses do not prepare financial plans and recognize their significant financial needs too late.
• Enables `what if' analysis. The company can easily explore the implications of changing assumptions.
T4.2
FINANCIAL PLANNING MODEL COMPONENTS
On a conceptual basis, a planning model, like any model, consists of:
• a set of assumptions (economy for example)
• a set of behavioral or descriptive equations (acctg equations),
• a set of endogenous or choice variables (capital spending; dividends),
• a set of exogenous or `given' variables (debt schedule; asset needs).
The major components of a financial planning model are:
• Sales forecast - this drives the whole model. What factors should be considered in arriving at a sales forecast?
• Pro-forma financial statements - these are forecasts of a future balance sheet and income statement. These summarize the financial implications imbedded in the sales forecast and other strategic goals.
• Asset requirements - given an assumed relation between assets and sales, as well as capacity considerations, the sales forecast will imply asset needs.
• Financial requirements - simply reflect planned (or existing) debt and dividend policies.
• A plug number. This is the number needed to make the balance sheet `balance' and represents the external financing need (EFN) of the company.
• Cash budget. Cash budgets are discussed in chapter 17, but really are part of the financial planning process. Most companies will prepare cash budgets in conjunction with pro-forma financial statements. Practically, it provides a way to check the internal consistency of the pro-formas.
FINANCIAL PLANNING STEPS
The text begins with a `percentage of sales' approach to actually preparing the pro-forma financial statements. I think it is useful to take a slightly more general approach. Below is a set of steps I use: (Step 2 is applied to each account in the financial statements)
Step 1: Sales Forecast
Step 2: Is Other Information Available About Account?
YES ==> Use It
NO ==> Does Account Vary With Sales?
Step 3: Does Account Vary with Sales?
Yes ==> Percentage of Sales Method
No ==> Don't Change
T4.4 - T.47
PERCENTAGE OF SALES METHOD
The percentage of sales method is a method you use when you don't have other information about the account, but the account is expected to vary with sales. The percentage of sales method assumes the following about the account in question:
• The current balance in the account is optimal for the current level of sales.
• The account should be scaled linearly up and down with sales. Stated differently, the ratio of the account to sales should not change. If sales increase 20%, the account in question should increase 20%.
• For fixed assets this implies full capacity and a linear production process. This doesn't always accord with reality where fixed asset additions tend to be `lumpy.' Also, consider the effect of a decrease in sales. In addition, if the company is operating at less than full capacity, then the % should be calculated using full capacity sales, and should only be used when sales are forecast to exceed full capacity. (See T4.8)
Frequently other information is available. This includes things such as:
• Capital spending projections
• Dividend policy
• Notes payable schedule
• Financing plans
• A/R, A/P policies
Balance Sheet and Income Statement Relations
Recall that several accounts on the balance sheet are directly related to accounts on the income statement. For example, projected retained earnings depends on projected income. Also, interest expense is related to debt and depreciation expense is related to accumulated depreciation. In general, for any account:
Projected Account Balance =
Beg. Balance + Projected Additions - Projected Subtractions
We know specifically that:
Projected Retained Earnings = Beg. R/E + Projected NI - Projected Dividends
Also, accumulated depreciation should be consistent with depreciation expense, and interest expense should bear some relation to outstanding interest-bearing debt.
External Financing Needs (EFN)
After projecting the balance in each asset, liability and equity account, the balance sheet will not `balance.' The plug number needed to make the balance sheet balance is the external financing need, or EFN for short. Given the company's sales projections, the EFN represents the amount of external financing needed to support such sales. External financing would include interest-bearing debt and equity. Where the money is finally obtained would depend on the desired capital structure.
T4.9
EXTERNAL FINANCING AND GROWTH
In the percentage of sales approach all assets increase by the percentage increase in sales. (Assume a simplified balance sheet where current assets are net of current liabilities.) On the right-hand side of the balance sheet, debt does not vary with sales, while the equity accounts increase because of an increase in retained earnings. If the increase in assets exceeds the growth in retained earnings, then external financing is needed. For low growth rates the increase in retained earnings may exceed the growth in assets, in which case there is a surplus in financing. The relation between sales growth and the financing need is shown in T4.9.
Two growth rates are of particular importance. These are the internal growth rate (IGR) and the sustainable growth rate (SGR).
Internal growth rate:
• maximum rate of growth without using external funds
• debt/equity ratio falls over time
IGR = (ROA x b) / (1 - ROA x b)
This formula uses end of period accounting numbers. If ROA were calculated using beginning of period assets, the formula would simplify to ROA x b, which many people use as a reasonable approximation.
Sustainable growth rate:
• maximum rate of growth without using equity financing
• keeps debt/equity ratio constant
SGR = (ROE x b) / (1 - ROE x b)
This would simplify to ROE x b if beginning of period equity were used to calculate ROE. Many people use this easier version as a reasonable approximation.
We can use the DuPont decomposition of ROE from Chapter 3 to examine the determinants of growth (see T4-12).
ROE x b = Profit margin x Asset turnover x Equity Multiplier x b
This indicates the sustainable growth rate depends on the company's profitability, efficiency of asset use, financial leverage and dividend policy. If a company wanted to grow faster than its SGR, then it would have to:
• squeeze more $'s of sales out of each $ of assets (increase asset turnover)
• for each $ of sales, get more to the bottom line (increase profitability)
• decrease dividends (increase b)
• be willing to accept more financial leverage (a higher equity multiplier)
It should not be surprising that many growing, profitable small businesses run into financing problems. Slide T4.13 summarizes these two growth rates.
Self-test problems 4.1, 4.2, & 4.3
Earlier we discussed how to prepare pro-forma financial statements as part of the corporate financial planning process. We also examined the relation between growth and external financing needs. Most companies, when forecasting financial statements, also forecast cash flow. Thus the contents of Chapter 18, Short-Term Finance and Planning is an integral part of corporate financial planning.
OPERATING CYCLE AND CASH CYLE
The operating cycle for a typical manufacturing firm measures the length of time between buying inputs for production to ultimately collecting cash from the sale of the product. This is easily measured using the ratios we have already calculated. As T18.2 indicates, there are three significant points in time:
• purchase inventory
• sell product (on credit)
• collect cash for sale
The time from inventory purchase until sale is the `inventory period' or what we called `days sales in inventory.' The time from sale until collection of the sale is `days sales outstanding' or the `collection period.'
The cash cycle recognizes that companies do not pay for inventory at the time of purchase. The cash cycle is calculated by subtracting the payables period from the operating cycle as follows:
Cash Cylce = Operating Cycle - Days Payable
Recall that financing needs are related to asset turnover. The larger the cash cycle, the higher are the financing needs of the company. This shows up in asset turnover, which will be lower the higher the cash cycle. T18.7 indicates two different management approaches with respect to the cash cyle, and ultimately the investment in current assets. With respect to `optimal working capital' policy, management must weigh the costs of holding more current assets (financing, economic) with the benefits (fewer lost sales, no illiquidity costs, etc.).
FINANCING STRATEGIES
There are several strategies with respect to short-term financing. T18.9 indicates an `ideal' policy whereby long-term assets are financed with long-term financing and current assets are financed with current liabilities. T18.10 (F) indicates a `flexible' policy where the company obtains enough long-term financing to finance maximum asset requirements. Excess financing is invested in marketable securities. T18.10 (R) indicates a `restrictive' policy whereby the company uses long-term financing to finance the minimum asset requirements. Short-term borrowing is used to cover seasonal variations. Finally, T18.11 indicates a `compromise' policy whereby the company keeps a reserve of liquidity, but not too much.
CASH BUDGET (Chpt 18 self-test problems 1&2)
A cash budget is an extremely useful tool which should be prepared in connection with pro-forma financial statements. As a practical matter, preparing both provides a way to check whether they have been prepared correctly. If the external financing number is not the same for each, then a mistake or inconsistency exists somewhere.
A cash budget is simply a projection or forecast of future cash inflows and outflows. Like pro-formas a cash budget is useful for planning and performance measurement. A cash budget typically provides more information about short-run (seasonal or interim) financing needs.
Cash Budget - Steps
STEP 1: Obtain a Sale Forecast
• By Month, week, quarter, etc.
STEP 2: Project the timing and amount of cash inflows
• Major cash inflow is collection of sales
• What are other possible sources of cash inflows?
• How do you estimate the timing?
STEP 3: Project the timing and amount of cash outflows
• Purchases • Labor (Sales; production)
• Capital expenditures
• Other expenses: interest, taxes & other administrative
• Financing: dividends; debt repayment (?)
STEP 4: Net Cash Flow
STEP 5: Financing Need/Surplus (Format)
Net Cash Flow
+ Beginning Cash
= `Ending' Cash (Can Stop Here)
- Desired Cash
= Financing Need (Should Equal B/S EFN)
STEP 6: Make sure financing need is same as EFN on pro-forma balance sheet