ACYFMG1 - II. Financial Planning PDF

Financial Planning  Financial planning establishes guidelines for change and growth in a firm. Financial planning formulates the way in which financial goals are to be achieved. To develop an explicit financial plan, managers must...

Financial Planning  Financial planning establishes guidelines for change and growth in a firm. Financial planning formulates the way in which financial goals are to be achieved. To develop an explicit financial plan, managers must Financial establish certain basic elements of the firm’s financial policy: Planning The firm’s needed investment in new assets The degree of financial leverage the firm chooses to employ The amount of cash the firm thinks is necessary and appropriate to pay shareholders The amount of liquidity and working capital the firm needs on an ongoing basis  Establishing the planning horizon, the long-range time period on which the financial planning process focuses (usually the next two to five years) Dimension s of Determine the level of aggregation, a process by which small investment proposals of each of a firm’s financial operational units are added up and treated as one planning big project Derive inputs in the form of alternative sets of assumptions about important variables (e.g., worst, normal, and best case) Elements of financial planning models: Sales forecast – Nearly all financial plans require an externally supplied sales forecast; often, the sales forecast will be given as the growth rate in sales. Pro forma statements – Financial plan will have a forecast balance sheet, income statement, and statement of cash flows; these are called pro forma statements, or pro formas. Asset requirements – Plan will describe projected capital spending and, at a minimum, the projected balance sheet will contain changes in total fixed assets and net working capital Financial requirements – Plan will include a section about the necessary financing arrangements (e.g., dividend and debt policy) The plug – The plug is the designated source(s) of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance Economic assumptions – Plan will explicitly state the economic environment in which the firm expects to reside over plan’s life  Simple Financial Planning Model ABC Corporation’s financial statements from the most recent year are as follows: Suppose sales increase by 20% (percentage of sales method), rising from $1,000 to $1,200: Planners would then forecast a 20% increase in costs, from $800 to $960, and assume that all variables will grow by 20%.  Growth Rates Internal growth rate is the maximum growth rate a firm can achieve without external financing of any kind. * We will use the derived equation for ACYFMG1 unless the question explicitly stated to use the simplified equation.  Growth Rates Sustainable growth rate is the maximum growth rate a firm can achieve without external equity financing while maintaining a constant debt-equity ratio. * We will use the derived equation for ACYFMG1 unless the question explicitly stated to use the simplified equation.  Growth Rates A firm’s ability to sustain growth depends on the following factors: 1.Profit margin: An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth. 2.Dividend policy: A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth. 3.Financial policy: An increase in the debt-equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate. 4.Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate.  Process of preparing budgets, plans, schedules and forecasts, and linking activities and how they fit together and affect costs. Purposes of budgeting: Develops a plan of action. Budgeting Facilitates communication of the plan within the organization. Allocates limited resources effectively. Sets benchmark to control profit and operations. Evaluates performance and provide incentives to managers. Provides resource information for decision-making.  Static budgets are set at the beginning of the period and remain constant. It is prepared based on a single level of output for a given period (usually a one-year period often coinciding with the fiscal year). The master budget is based on estimated sales and Master/Static production volume and is prepared before the budget period begins. Budget Flexible budgets take differences in cost due to vs. Flexible volume differences out of the analysis by budgeting based on actual production. They can be accurately Budget used for control purposes because any differences in cost caused by differences in volume of production have been removed. The flexible budget is based on actual sales and production volume and is prepared after the budget period ends. Budgeting Methodologies: Annual/Master Budgets II. LEVERAGE OPERATING LEVERAGE refers to the existence of fixed operating costs. Business risk is often measured by the degree of operating leverage (DOL). %△ Earnings before Interest and Taxes DOL = %△ Sales Contribution Margin DOL = Earnings Before Interest and Taxes (EBIT) Sales (1,000 units) 200,000 DOL = Contribution Margin Variable costs 110,000 Earnings Before Interest and Contribution margin 90,000 Taxes (EBIT) Fixed manufacturing costs 40,000 90,000 DOL = Earnings before interest and 50,000 taxes 50,000 Interest 10,000 Earnings before taxes 40,000 DOL = 1.8 Taxes (30%) 12,000 Net income 28,000 LEVERAGE FINANCIAL LEVERAGE refers to the amount of debt a business has acquired (raising capital through debt rather than equity). Financial risk is often measured by the degree of financial leverage (DFL). %△ Net Income / Earnings per Share DFL = %△ Earnings before Interest and Taxes Earnings Before Interest and Taxes (EBIT) DFL = Earnings Before Taxes (EBT) Sales (1,000 units) 200,000 DFL = Earnings Before Interest and Taxes (EBIT) Variable costs 110,000 Earnings Before Taxes (EBT) Contribution margin 90,000 Fixed manufacturing costs 40,000 50,000 DFL = Earnings before interest and 40,000 taxes 50,000 Interest 10,000 Earnings before taxes 40,000 DFL = 1.25 Taxes (30%) 12,000 Net income 28,000 LEVERAGE COMBINED LEVERAGE refers to the total or combined impact of operating and financial leverage. %△ Net Income / EPS DCL = %△ Sales Contribution Margin DCL = Earnings Before Taxes (EBT) LEVERAGE Sales (1,000 units) 200,000 DCL = Contribution Margin Variable costs 110,000 Earnings Before Taxes (EBT) Contribution margin 90,000 Fixed manufacturing costs 40,000 90,000 DCL = Earnings before interest and 40,000 taxes 50,000 Interest 10,000 Earnings before taxes 40,000 DCL = 2.25 Taxes (30%) 12,000 Net income 28,000