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Questions and Answers
The degree of financial leverage a firm chooses to use is considered a fundamental element of its financial policy.
The degree of financial leverage a firm chooses to use is considered a fundamental element of its financial policy.
True (A)
Financial planning is limited to establishing guidelines for change in a firm without taking into consideration growth aspects.
Financial planning is limited to establishing guidelines for change in a firm without taking into consideration growth aspects.
False (B)
Pro forma statements, such as balance sheets and income statements, are essential components of a financial plan and offer a projected view of the firm's financial performance.
Pro forma statements, such as balance sheets and income statements, are essential components of a financial plan and offer a projected view of the firm's financial performance.
True (A)
The level of aggregation in financial planning is the process of breaking down a large investment project into smaller component projects.
The level of aggregation in financial planning is the process of breaking down a large investment project into smaller component projects.
Financial planning typically involves establishing a planning horizon of two to five years, encompassing a long-range time period for the financial planning process.
Financial planning typically involves establishing a planning horizon of two to five years, encompassing a long-range time period for the financial planning process.
The term 'operating leverage' refers to the extent to which a company's fixed operating costs impact its profitability.
The term 'operating leverage' refers to the extent to which a company's fixed operating costs impact its profitability.
Flexible budgets are prepared before the budget period begins, based on estimated sales and production volume.
Flexible budgets are prepared before the budget period begins, based on estimated sales and production volume.
A master budget is a static budget, prepared at the beginning of the period and remaining constant throughout.
A master budget is a static budget, prepared at the beginning of the period and remaining constant throughout.
A flexible budget takes into account changes in production volume when evaluating cost performance.
A flexible budget takes into account changes in production volume when evaluating cost performance.
Static budgets, unlike flexible budgets, are better suited for evaluating actual performance against planned performance.
Static budgets, unlike flexible budgets, are better suited for evaluating actual performance against planned performance.
A firm's ability to sustain growth is independent of its dividend policy, as dividends are simply a distribution of existing profits.
A firm's ability to sustain growth is independent of its dividend policy, as dividends are simply a distribution of existing profits.
If a company wants to maintain a constant debt-equity ratio and relies solely on internal financing, it can achieve a growth rate equivalent to its sustainable growth rate.
If a company wants to maintain a constant debt-equity ratio and relies solely on internal financing, it can achieve a growth rate equivalent to its sustainable growth rate.
A reduction in the total asset turnover ratio would increase the sustainable growth rate of a company.
A reduction in the total asset turnover ratio would increase the sustainable growth rate of a company.
A decline in profit margin necessitates an increase in financial leverage to maintain the same sustainable growth rate.
A decline in profit margin necessitates an increase in financial leverage to maintain the same sustainable growth rate.
Assuming a constant debt-equity ratio, if a firm's profit margin doubles, its sustainable growth rate will also double.
Assuming a constant debt-equity ratio, if a firm's profit margin doubles, its sustainable growth rate will also double.
The plug in financial planning represents the amount of external financing needed to balance the projected balance sheet, assuming all other variables are fixed.
The plug in financial planning represents the amount of external financing needed to balance the projected balance sheet, assuming all other variables are fixed.
The internal growth rate is calculated as the product of the profit margin, asset turnover, and the retention ratio.
The internal growth rate is calculated as the product of the profit margin, asset turnover, and the retention ratio.
A company's financial planning model only needs to project future asset requirements and financing arrangements.
A company's financial planning model only needs to project future asset requirements and financing arrangements.
The Degree of Operating Leverage (DOL) is a measure of how much a company's operating income changes in response to a change in sales.
The Degree of Operating Leverage (DOL) is a measure of how much a company's operating income changes in response to a change in sales.
The Degree of Financial Leverage (DFL) is 1.2, indicating that a 1% change in earnings before interest and taxes will result in a 1.2% change in net income.
The Degree of Financial Leverage (DFL) is 1.2, indicating that a 1% change in earnings before interest and taxes will result in a 1.2% change in net income.
If a company's contribution margin is $1,000,000 and its EBIT is $500,000, its Degree of Operating Leverage (DOL) is 2.
If a company's contribution margin is $1,000,000 and its EBIT is $500,000, its Degree of Operating Leverage (DOL) is 2.
A company with high operating leverage is more sensitive to changes in sales volume than a company with low operating leverage.
A company with high operating leverage is more sensitive to changes in sales volume than a company with low operating leverage.
If a company's variable costs are $100,000 and its fixed costs are $50,000, and its EBIT is $50,000, its DOL is 1.5.
If a company's variable costs are $100,000 and its fixed costs are $50,000, and its EBIT is $50,000, its DOL is 1.5.
A company with a higher DFL will have a higher combined leverage compared to a company with a lower DFL.
A company with a higher DFL will have a higher combined leverage compared to a company with a lower DFL.
The formula for Combined Leverage is (Contribution Margin/EBIT) * (EBIT/EBT).
The formula for Combined Leverage is (Contribution Margin/EBIT) * (EBIT/EBT).
A company with a DOL of 2 and a DFL of 1.5 will have a Combined Leverage of 3.
A company with a DOL of 2 and a DFL of 1.5 will have a Combined Leverage of 3.
Flashcards
Financial Planning
Financial Planning
A process to establish guidelines for financial goals and their achievement.
Planning Horizon
Planning Horizon
The long-range time period for which the financial plan is developed, usually 2 to 5 years.
Sales Forecast
Sales Forecast
An estimate of future sales, often expressed as a growth rate, necessary for financial planning.
Pro Forma Statements
Pro Forma Statements
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Financial Leverage
Financial Leverage
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Asset Requirements
Asset Requirements
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Financial Requirements
Financial Requirements
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The Plug
The Plug
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Economic Assumptions
Economic Assumptions
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Internal Growth Rate
Internal Growth Rate
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Sustainable Growth Rate
Sustainable Growth Rate
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Profit Margin
Profit Margin
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Dividend Policy
Dividend Policy
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Purpose of Budgeting
Purpose of Budgeting
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Static Budget
Static Budget
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Flexible Budget
Flexible Budget
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Master Budget
Master Budget
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Operating Leverage
Operating Leverage
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Degree of Operating Leverage (DOL)
Degree of Operating Leverage (DOL)
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Contribution Margin
Contribution Margin
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Earnings Before Interest and Taxes (EBIT)
Earnings Before Interest and Taxes (EBIT)
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Degree of Financial Leverage (DFL)
Degree of Financial Leverage (DFL)
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Earnings Before Taxes (EBT)
Earnings Before Taxes (EBT)
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Combined Leverage
Combined Leverage
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Net Income
Net Income
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Study Notes
Financial Planning
- Financial planning sets guidelines for a firm's growth and change.
- It outlines the way financial goals will be achieved.
- Managers need to establish basic financial policies for planning, including:
- Investment in new assets
- Financial leverage strategy
- Cash needs for shareholders
- Liquidity and working capital requirements
Dimensions of Financial Planning
- Planning horizon focuses on a long-term period, usually two to five years.
- Level of aggregation involves grouping smaller investment proposals into one large project.
- Input derivation involves using different scenarios (worst, normal, best case) for important variables.
Elements of Financial Planning Models
- Sales forecast is usually an external supply, often presented as a sales growth rate.
- Pro forma statements include balance sheets, income statements, and cash flow statements; also known as pro formas.
- Asset requirements show projected capital spending and changes in fixed assets and working capital.
- Financial requirements cover necessary financing arrangements, such as dividend and debt policies.
- The "plug" represents the external financing needed to balance the balance sheet, addressing any shortfalls or surpluses.
- Economic assumptions state the expected economic climate during the planning period.
Simple Financial Planning Model
- ABC Corporation's recent financial statements show sales of $1,000, costs of $800, and net income of $200.
- A 20% sales increase leads to increased costs and other factors also increasing by 20%, reflecting in new pro forma statements.
- Pro forma income statement reflects the expected change in sales and costs.
- Pro forma balance sheet expects similar increases across all items.
Growth Rates
- Internal growth rate (IGR) is the maximum achievable growth rate without external financing.
- The formula for IGR is based on net income (NI), return rate (RR), total assets (A), and liabilities (L). A simplified equation for IGR is ROA x RR
- Sustainable growth rate (SGR) is the maximum growth without external equity financing while maintaining a consistent debt-equity ratio.
- The formula for SGR is ROE x RR / 1 - (ROE x RR). A simplified equation is ROE x RR
Growth Rates (Factors)
- Profit margin increase leads to more internal funding and thus higher sustainable growth.
- Lower dividend payout (higher retention ratio) increases internally generated equity, leading to more sustainable growth.
- Higher debt-equity ratio (financial leverage) often leads to more available debt financing and higher sustainable growth rates.
- Higher asset turnover increases sales per dollar of assets, lowering the need for new assets, thus increasing sustainable growth.
Budgeting
- Budgeting is a process of creating budgets, plans, schedules, and forecasts to link activities in relation to costs.
- Budgeting goals include creating a plan, facilitating communication, allocating resources effectively, controlling profit, evaluating performance, and providing decision-making information.
Master/Static vs. Flexible Budgets
- Static budgets are fixed at the start of the period, based on a single output level over a period (often one year).
- Flexible budgets reflect changes in volume and costs, prepared after the budget period.
Budgeting Methodologies (Annual/Master Budgets)
- Budgets, such as capital, sales, production, direct materials, direct labor, factory overhead, selling and administrative expense, cost of goods sold, cash, and pro forma financial statements form part of the master budget.
Operating Leverage
- Operating leverage refers to fixed operating costs.
- Degree of operating leverage (DOL) measures the sensitivity of operating income to sales changes. It is calculated as Contribution Margin / Earnings Before Interest and Taxes (EBIT).
Financial Leverage
- Financial leverage refers to debt financing rather than equity.
- Degree of financial leverage (DFL) measures the sensitivity of earnings per share to changes in EBIT. It is calculated as Earnings Before Interest and Taxes (EBIT) / Earnings Before Taxes (EBT).
Combined Leverage
- Combined leverage (DCL) assesses the total impact of operating and financial leverage on earnings per share.
- It is calculated as Contribution Margin / Earnings Before Taxes.
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