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Strategic and Operational Financial Planning
Professor XXXXXCourse Name / Number
2
Overview of the Planning Process
Financial planning activities
• Setting long-run strategic goals• Preparing quarterly and annual
budgets• Managing day-to-day fluctuations in
cash balances
Long-term financial planning
• Invest in positive NPV projects• Added complexity: CFOs usually see
many more projects that appear to have positive NPV than they can effectively pursue, thus they must prioritize.
• Limits on capital, production capacity, human resources and other inputs add complexity as well.
3
Long-Term Financial Planning
Strategic plan
• Multiyear action plan for the major investment and competitive initiatives
Senior management develops strategic plan by answering questions like:
– In what emerging markets might we have a sustainable competitive advantage?
– How can we leverage our competitive strengths across existing markets in which we currently do not compete?
– What threats to our current businesses exist, and how can we meet those threats?
– Where in the world should we produce? Where should we sell?– Can we deploy resources more efficiently by exiting certain
markets and using those resources elsewhere?
4
Contribution of Finance to Strategic Planning
Financial managers draw on a broad set of skills to asses the likelihood that a given strategic objective
can be achieved.Financial tools are used to determine the feasibility of a strategic plan, given firm’s existing and prospective
sources of funding.
Finance contributes to strategic planning through risk management.
Finance has control in the implementing strategic plans.
• Financial analysts prepare cash budgets that help avoid liquidity problems.
5
Sustainable Growth• Growth can be measured by increases in firm’s market value, its
asset base, the number of people it employs, increase in sales.
Increase in assets Cash Receivables Inventories Fixed Assets
Increase in Liabilities Accounts Payable Short-term debt Long-term debt
Increases in Equity Retained Earnings
= +
Trade-offs a firm faces when chooses to grow:
6
Sustainable Growth Model
Models how rapidly a firm can grow
Assumption of the model:
1. The firm will issue no new shares of common stock next year.2. The firm’s total asset turnover ratio, S/A, remains constant.3. The firm pays out a constant fraction, d, of its earnings as
dividends.4. The firm maintains a constant asset-to-equity ratio, A/E.5. The firm’s net profit margin, m, is constant.
Firm wants to increase sales by g percent.
7
Sustainable Growth Model
The model is used to derive the sustainable growth rate g* that keeps the sources and uses of
funds in balance.
E
Adm
S
AE
Adm
g)1(
)1(*
Increase in profit margin or assets-to-equity increase sustainable growth rate.
Increase in total asset turnover ratio has the same effect: increase in sustainable growth rate.
8
Pro Forma Financial Statements
Forecasts of balance sheet and income statements
“Top-down” or “bottom-up” sales forecasts:
“Top-down” approach uses macroeconomic and industry forecast to establish sales goals.
“Bottom-up” approach forecasts sales on a customer by customer basis.
Percentage-of-sales method
• Models all items on the balance sheet and income statements to grow in proportion to sales
• One item, such as cash balance or short term liability account, is adjusted after all projections to preserve the equality of left and right hands of balance sheet.
9
Balance Sheet of Zinsmeister Shoes
$116,250Total liabilities and equity$116,250Total assets
$46,550Retained earnings$60,000Net fixed assets
$20,200Common stock20,000Less: Accumulated depreciation
$20,000Long-term debt$80,000Gross fixed assets
$29,500Current liabilities$56,250Current assets
5,000Current long-term debt25,000Inventory
5,000Credit line21,250Accounts receivable
$19,500Accounts payable$10,000Cash
Liabilities and EquityAssets
Zinsmeister Shoe Balance Sheet as of December 31, 2004
10
Income Statement of Zinsmeister Shoes
17,325Less: Taxes
$32,175Net income
$49,500Pretax Income
$10,000Less: Depreciation
$3,000Less: Interest Expense
$25,000Less: Operating expense
$87,500Gross Profit
162,500Less: Cost of goods sold
$250,000Sales
Zinsmeister Shoe Income Statement for the year ended December 31, 2004
11
Assumptions to Generate Pro Forma Financial StatementsAssumptions:
Zinsmeister plans to increase sales by 30% next year (in 2005).
Gross profit margin will remain 35%. Operating expenses will equal 10% of sales, as in 2004. Interest rate paid on all debt is 10%. Invest additional $20 mil in fixed assets in 2005.
Depreciation expense will increase from $10 mil to $15 mil.
Tax rate is 35%. Cash holdings will increase by $1 mil next year. Accounts receivables are 8.5% of sales. Inventories equal 10% of sales. Accounts payable are 12% of cost of goods sold. Firm will repay additional $5 mil in long-term debt next
year. Firm will pay out 50% of net income as dividend.
12
Pro Forma Income Statement of Zinsmeister Shoes
$41,438Net income
22,312Less: Taxes
$20,719Dividends
$63,750Pretax Income
$15,000Less: Depreciation
$2,500Less: Interest Expense
$32,500Less: Operating expense
$113,750Gross Profit
211,250Less: Cost of goods sold
$325,000Sales
Pro forma income statement
13
Pro Forma Balance Sheet for Zinsmeister Shoes
Cash holdings will increase by $1 mil next year• Cash = $10 mil+ $1mil = $11 mil
Accounts receivables are 8.5% of sales• A/R = $325,000 X 0.085 = $27,625
Inventories equal 10% of sales• Inventory = $325,000 X 0.1 = $32,500
Invest additional $20 mil in fixed assets in 2005. Depreciation expense will increase from $10 mil to $15 mil• Gross fixed assets = $80 mil + $20 mil = $100 mil• Accumulated depreciation = $20 mil + $15 mil = $35 mil
Accounts payable are 12% of cost of goods sold• A/P = $211,250 X 0.12 = $25,350
14
Pro Forma Balance Sheet for Zinsmeister Shoes
$136,125Total liabilities and equity$136,125Total assets
$67,269Retained earnings$65,000Net fixed assets
$20,200Common stock35,000Less: Accumulated depreciation
$15,000Long-term debt$100,000Gross fixed assets
$33,656Current liabilities$71,125Current assets
5,000Current long-term debt32,500Inventory
3,306Credit line27,625Accounts receivable
$25,350Accounts payable$11,000Cash
Liabilities and EquityAssets
15
External Funds Required (EFR) for Zinsmeister Shoes
)1)(1( dgmSSS
APS
S
AEFR
Forecast of external funds required can be modeled with the following equation:
EFR for Zinsmeister is $8,111,000. In pro forma balance sheet external financing declined by $6.7 mil. Why the discrepancy?
Discrepancy arises because assets to sales ratio is actually not constant, as equation assumes.
16
Short-Term Financing Strategies
Conservative strategy
• Use long-term financing to cover both permanent assets and temporary assets.
Aggressive strategy
• Use short-term financing to fund both seasonal peaks and part of long-term growth in sales and assets.
Matching strategy
• Finance permanent assets with long-term funding sources and temporary asset requirement with short-term financing.
Companies can adopt the following strategies to fund long-term trend and seasonal fluctuations of sales:
17
Quarterly Sales for Hershey Foods (1992 – 2002)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
1,400
1,200
1,000
800
600
400
200
0
Year
Qu
arte
rly
Sa
les
($
in m
illi
on
s)
Quarterly Sales
18
Financing Strategies Available to Hershey
1,400
1,200
1,000
800
600
400
200
0
Quarters (1992-2002)
1,600
1,800
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
To
tal
As
sets
($ i
n m
illi
on
s)
Hershey’s Current Assets Matching Strategy Conservative Strategy Aggressive Strategy
19
Cash Budget
Cash budget shows firm’s planned cash inflows and outflows.
Firm’s sales forecastKey input
Cash receipts • All firm’s cash inflows in a given
financial period
Cash disbursemen
ts
• All outlays of cash by the firm during a given financial period
Estimate the monthly cash flows that will result from projected sales receipts and from production-related,
inventory-related, and sales-related outlays.
20
Cash ReceiptsCommon components of cash receipts: cash sales, collections of accounts receivable, and other cash
receipts
An example…• Farrell Industries develops cash receipts forecasts for
October, November, and December:– Sales in August and September: $100,000 and
$200,000– Forecasted sales for October, November, and
December: $400,000, $300,000, and $200,000– 80% of sales on credit, 20% cash sales– 50% of sales collected next month; remaining 30%
collected after two months– In December, $30,000 dividends from stock Farrell
holds in a subsidiary
21
Schedule of Projected Cash Receipts for Farrell Industries
$340$320$210Total cash receipts
30Other cash receipts
1206030Two months prior (30%)
15020010050Previous month (50%)
Collection of accounts receivable
$40$60$80$40$20Cash Sales (20%)
$200$300$400$200$100Forecast Sales
DecemberNovemberOctoberSeptemberAugust
22
Cash Disbursements
Cash disbursements items:
• Cash purchases, fixed asset outlays, payments of accounts payable, interest payments, and rent and lease payments
• Cash dividend payments, wages and salaries, loan principal payments, tax payments, and repurchase or retirement of stock
• Depreciation, though not included in the cash budget, does have a cash outflow effect through impact on tax payments.
• Farrell Industries uses the following assumptions to compute cash disbursements for October, November, and December:• Purchases equal 70% of sales. Paid 10% in cash; 70%
paid next month, and 20% two months after the purchase
• October purchases = 70% X $400,000 = $280,000• $28,000 paid in cash, $196,000 paid in November,
and $56,000 paid in December
23
Cash Disbursements
• Rent payments: $5,000 paid each months• Wages and salaries: 10% of monthly sales plus
$8,000• October wages = 10% X $400,000 + $8,000 =
$48,000• Tax payments: $25,000 taxes paid in December• Fixed assets outlays: $130,000 in new machinery
paid in November• Interest payments: $10,000 due in December• Cash dividends payments: $20,000 dividends will
be paid in November• Principal payments: $20,000 principal payment
due in December
24
Projected Cash Disbursements for Farrell Industries
555Rent payments
283848Wages and salaries
25Tax payments
130Fixed asset outlays
10Interest payments
20Cash dividend payments
$305$418$213Total cash disbursements
20Principal payments
562814Two months prior (20%)
1471969849Previous month (70%)
Payments of accounts payable
$14$21$28$14$7Cash Purchases (10%)
$140$210$280$140$70Purchases (70% of sales)
DecemberNovemberOctoberSeptemberAugust
25
Net Cash Flow, Ending Cash, Financing Needs and Excess Cash
Net cash flow
• Subtract cash disbursements from cash receipts for each period.
Ending cash balance
• Add the beginning cash balance to the firm’s net cash flow.
• Farrell constructs the cash budget using the cash receipts and disbursements and the following assumptions:• Cash balance at the end of September is $50,000.• Notes payable and marketable securities are $0 at the
end of September.• $25,000 is the desired minimum cash balance.
26
Cash Budget for Farrell Industries
-514750Add: Beginning cash-$16-$51$47Ending cash balance
252525Less: Minimum cash balance$41$76Required total financing (notes payable)
$22Excess cash balance (marketable securities)
$35-$98-$3Net cash flow305418213Less: Total cash disbursements
$340$320$210Total cash receipts
DecemberNovemberOctober
If cash balance is less than desired minimum cash balance, issue notes payable.
If cash balance above desired minimum cash balance, invest in short-term marketable securities.
Strategic financial plans act as a guide for preparing operating financial plans.
Sustainable growth model is a tool managers can use to determine the feasibility of a
target growth rate under certain conditions.Pro forma financial statements are projected
financial statements.Cash budgets forecast short-term cash inflows
and outflows of firm.
Strategic and Operational Financial Planning