Financial Planning and Models

Financial Planning

• Financial planning analyzes investment and financing choices.
• It projects future consequences of current decisions and decides on alternatives.
• The financial planning process includes measuring performance against financial plan goals.
• The time horizon for a financial plan is known as the planning horizon.
• Optimistic, expected, and pessimistic cases are often used to model different possible outcomes.
• Financial plans ensure consistency with capital budgets and highlight decisions that support production/investment goals.
• Contingency planning involves formulating responses to potential surprises.
• Considering Options involves determining opportunities to leverage strengths in new areas.
• Financial plans draw connections between growth plans and financing requirements.

Financial Planning Models

• Financial planners use models to explore consequences of different strategies
• Inputs include current financial statements and forecasts of key variables, like sales and interest rates
• Planning Model uses equations, such as cost of producing sales and asset investment
• Outputs are pro forma financial statements, ratios, and sources/uses of cash
• Percentage of Sales Models use sales forecasts as the primary variable

Executive Cheese Financial Model

• This model uses a percentage of sales approach to build pro forma statements
• Sales are projected to increase by ten percent
• Costs are a fixed proportion of sales, increasing by ten percent also
• With no spare capacity, assets must also increase by ten percent
• A constant debt-equity ratio means both debt and equity increase by ten percent to finance assets
• To maintain debt-to-equity, the firm must issue $80 additional debt
• The firm's equity increases by 10%, from $1,200 to $1,320, in other words a $120 increase
• Executive Cheese net income is now $220, indicating a dividend payment of $100
• The dividend payment is a consequence of decisions made, not an independent choice

Alternative Executive Cheese Financial Model

• Management may commit to a dividend of, say, $180 instead
• In this scenario, the dividend is no longer the plug, but rather debt
• An $180 dividend results in only $40 added to retained earnings
• The firm would need to issue $160 in new debt to cover the $200 in assets

Improving Financial Planning

• Net Operating Working Capital (NOWC) is operating current assets minus operating current liabilities, excluding interest-bearing debt.
• Operating current assets needed to operate the business including trade receivables,prepaid expenses, inventory and other cash.
• Operating current liabilities includes trade payables, accruals, and any other liabilities spontaneously generated by the operation of the firm
• The pro forma for 2023 is based on sales and operating costs growth of ten percent from 2022
• Yummy Food Company's interest rates will remain at current level
• Yummy Food Company will maintains dividend policy of paying out two-thirds of earnings
• Property, Plant and Equipment (PPE) and Net Operating Working Capital (NOWC) is 10% to support higher sales volume

Tips for Planners

• Pitfalls include ignoring realities like depreciation and taxes
• Percent of sales methods are unrealistic due to fixed costs
• Accounting numbers generated, are not financial cash flows
• Adjustments must be made to these factors
• Sales can increase without investment in fixed assets if factories operate below capacity
• Once sales surpass a certain level, new capacity must be added

External Financing and Growth

• Rules of thumb can draw out the relationship between a firm's growth objectives and its requirement
• Formula: Required External Financing = (Total Assets x Increase in Sales) - Reinvested Earnings
• Internal growth rate: the maximum rate of growth without external financing
• Sustainable Growth is a steady rate at which a firm can grow without changing leverage
• Formula: Sustainable growth rate = plowback ratio x return on equity.
• A higher proportion of earnings allows the firm to issue more debt without increasing its leverage
• More reinvested profits and/or debt issues would allow it to grow more rapidly

Summary

• Financial planning produces a description of financial strategy, projecting future consequences via pro forma statements
• Financial plans establish financial goals and benchmarks for performance evaluation Aggregate decisions include capital investment, debt policy, and target dividend payout ratio.
• Understanding external financing needs as they relate to growth is one output of financial modeling.
• The internal growth rate is the maximum rate a firm can do if it relies entirely on invested profits
• The sustainable growth rate is the pace at which a firm can expand without changing its leverage ratio.