Chapter

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

10•Short-Term Financial

Planning •Short-Term Financial

Planning

4-2

Key Concepts and Skills

• Understand the financial planning process and how decisions are interrelated

• Be able to develop a financial plan using the percentage of sales approach

• Be able to prepare a cash budget

• Understand the various options for short-term financing

4-3

Chapter Outline

• What is Financial Planning?

• Financial Planning Models: A First Look

• The Percentage of Sales Approach

• External Financing and Growth

• The Cash Budget

4-4

Elements of Financial Planning

• Investment in new assets – determined by capital budgeting decisions

• Degree of financial leverage – determined by capital structure decisions

• Cash paid to shareholders – determined by dividend policy decisions

• Liquidity requirements – determined by net working capital decisions

4-5

Financial Planning Process

• Planning Horizon - divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years)

• Aggregation - combine capital budgeting decisions into one big project

• Assumptions and Scenarios• Make realistic assumptions about important variables• Run several scenarios where you vary the

assumptions by reasonable amounts• Determine at least a worst case, normal case and best

case scenario

4-6

Role of Financial Planning

• Examine interactions – help management see the interactions between decisions

• Explore options – give management a systematic framework for exploring its opportunities

• Avoid surprises – help management identify possible outcomes and plan accordingly

• Ensure feasibility and internal consistency – help management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another

4-7

Financial Planning Model Ingredients

• Sales Forecast – many cash flows depend directly on the level of sales (often estimated sales growth rate)

• Pro Forma Statements – setting up the plan as projected financial statements allows for consistency and ease of interpretation

• Asset Requirements – the additional assets that will be required to meet sales projections

• Financial Requirements – the amount of financing needed to pay for the required assets

• Plug Variable – determined by management decisions about what type of financing will be used (makes the balance sheet balance)

• Economic Assumptions – explicit assumptions about the coming economic environment

4-8

Example: Historical Financial Statements

Gourmet Coffee Inc.Balance Sheet

December 31, 2004Assets 1000 Debt 400

Equity 600

Total 1000 Total 1000

Gourmet Coffee Inc.

Income Statement

For Year Ended December 31, 2004

Revenues 2000

Costs 1600

Net Income 400

4-9

Example: Pro Forma Income Statement

• Initial Assumptions• Revenues will grow at

15% (2000*1.15)• All items are tied

directly to sales and the current relationships are optimal

• Consequently, all other items will also grow at 15%

Gourmet Coffee Inc.

Pro Forma Income Statement

For Year Ended 2005

Revenues 2,300

Costs 1,840

Net Income 460

4-10

Example: Pro Forma Balance Sheet

• Case I• Dividends are the plug

variable, so equity increases at 15%

• Dividends = 460 NI – 90 increase in equity = 370

• Case II• Debt is the plug variable

and no dividends are paid• Debt = 1,150 – (600+460) =

90• Repay 400 – 90 = 310 in

debt

Gourmet Coffee Inc.

Pro Forma Balance Sheet

Case 1

Assets 1,150 Debt 460

Equity 690

Total 1,150 Total 1,150

Gourmet Coffee Inc.

Pro Forma Balance Sheet

Case 1Assets 1,150 Debt 90

Equity 1,060

Total 1,150 Total 1,150

4-11

Percent of Sales Approach

• Some items vary directly with sales, while others do not• Income Statement

• Costs may vary directly with sales - if this is the case, then the profit margin is constant

• Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant

• Dividends are a management decision and generally do not vary directly with sales – this affects additions to retained earnings

• Balance Sheet• Initially assume all assets, including fixed, vary directly with sales• Accounts payable will also normally vary directly with sales• Notes payable, long-term debt and equity generally do not because

they depend on management decisions about capital structure• The change in the retained earnings portion of equity will come

from the dividend decision

4-12

Example: Income StatementTasha’s Toy Emporium

Income Statement, 2004

% of Sales

Sales 5,000

Costs 3,000 60%

EBT 2,000 40%

Taxes (40%)

800 16%

Net Income 1,200 24%

Dividends 600

Add. To RE 600

Tasha’s Toy Emporium

Pro Forma Income Statement, 2005

Sales 5,500

Costs 3,300

EBT 2,200

Taxes 880

Net Income 1,320

Dividends 660

Add. To RE 660

Assume Sales grow at 10%

Dividend Payout Rate = 50%

4-13

Example: Balance SheetTasha’s Toy Emporium – Balance Sheet

Current % of Sales

Pro Forma

Current % of Sales

Pro Forma

ASSETS Liabilities & Owners’ Equity

Current Assets Current Liabilities

Cash $500 10% $550 A/P $900 18% $990

A/R 2,000 40 2,200 N/P 2,500 n/a 2,500

Inventory 3,000 60 3,300 Total 3,400 n/a 3,490

Total 5,500 110 6,050 LT Debt 2,000 n/a 2,000

Fixed Assets Owners’ Equity

Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000

Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760

Total 4,100 n/a 4,760

Total L & OE 9,500 10,250

4-14

Example: External Financing Needed

• The firm needs to come up with an additional $200 in debt or equity to make the balance sheet balance• TA – TL&OE = 10,450 – 10,250 = 200

• Choose plug variable• Borrow more short-term (Notes Payable)• Borrow more long-term (LT Debt)• Sell more common stock (CS & APIC)• Decrease dividend payout, which increases

the Additions To Retained Earnings

Cash Budget• Forecast of cash inflows and outflows over

the next short-term planning period

• Primary tool in short-term financial planning

• Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs

• Allows a company to plan ahead and begin the search for financing before the money is actually needed 4-15

Example: Cash Budget Information

• Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales

• Sales estimates (in millions)• Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550

• Accounts receivable• Beginning receivables = $250• Average collection period = 30 days

• Accounts payable• Purchases = 50% of next quarter’s sales• Beginning payables = 125• Accounts payable period is 45 days

• Other expenses• Wages, taxes and other expense are 30% of sales• Interest and dividend payments are $50• A major capital expenditure of $200 is expected in the second quarter

• The initial cash balance is $80 and the company maintains a minimum balance of $50

4-16

4-17

Example: Cash Budget – Cash Collections

• ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made and the remaining 1/3 are collected the following quarter

• Beginning receivables of $250 will be collected in the first quarter

• Q1 Q2 Q3 Q4

• Beginning Receivables 250 167 200 217• Sales 500 600 650 800• Cash Collection 583 567 633 750• Ending Receivables 167 200 217 367

4-18

Example: Cash Budget – Cash Disbursements

• Payables period is 45 days, so half of the purchases will be paid for each quarter and the remaining will be paid the following quarter

• Beginning payables = $125

• Q1 Q2 Q3 Q4

• Payment of accounts 275 313 362 338• Wages, taxes and other expenses 150 180 195 240• Capital expenditures 200• Interest and dividend payments 50 50 50 50• Total cash disbursements 475 743 607 628

4-19

Example: Cash Budget – Net Cash Flow and Cash Balance

Q1 Q2 Q3 Q4• Total cash collections 583 567 633 750• Total cash disbursements475 743 607 628• Net cash inflow 108- 176 26 122• Beginning Cash Balance 80 188 12 38• Net cash inflow 108 -176 26 122• Ending cash balance 188 12 38 160• Minimum cash balance -50 -50 -50 -50• Cumulative surplus • (deficit) 138 -39 -14 107

4-20

4-21

Example: Cash Budget – Cash Collections

• ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made and the remaining 1/3 are collected the following quarter

• Beginning receivables of $250 will be collected in the first quarter

4-22

Chapter

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

4•End of Chapter•End of Chapter