4.2 Financial Planning Models: A First Look 4.3 The Percentage of Sales Approach

Chapter Four

Long-term Financial Planning

and Corporate Growth

4.1 What is Financial Planning?

4.2 Financial Planning Models: A First Look 4.3 The Percentage of Sales Approach

4.4 External Financing and Growth

4.5 Some Caveats of Financial Planning Models 4.6 Summary and Conclusions

Chapter Organisation

Chapter Objectives

• Understand what financial planning is and what it can accomplish.

• Outline the elements of a financial plan.

• Discuss and be able to apply the percentage of sales approach.

• Understand how capital structure policy and

dividend policy affect a firm’s ability to grow.

What is Financial Planning?

• Formulates the way financial goals are to be achieved.

• Requires that decisions be made about an uncertain future.

• Recall that the goal of the firm is to maximise the

market value of the owner’s equity—growth will

result from this goal being achieved.

Dimensions of Financial Planning

• The planning horizon is the long-range period that the process focuses on (usually two to five years).

• Aggregation is the process by which the smaller investment proposals of each of a firm’s

operational units are added up and treated as one big project.

• Financial planning usually requires three alternative plans: a worst case, a normal case and a best

case.

Accomplishments of Planning

• Interactions—linkages between investment proposals and financing choices.

• Options—firm can develop, analyse and compare different scenarios.

• Avoiding surprises—development of contingency plans.

• Feasibility and internal consistency—develops a structure for

reconciling different objectives.

Elements of a Financial Plan

• An externally supplied sales forecast (either an explicit sales figure or growth rate in sales).

• Projected financial statements (pro-formas).

• Projected capital spending.

• Necessary financing arrangements.

• Amount of new financing required (‘plug’ figure).

Example—A Simple Financial Planning Model

Recent Financial Statements

Financial performance Financial position

Sales $100 Assets $50 Debt $20

Costs 90 Equity 30

Net Income $ 10 Total $50 Total $50

Assume that:

1. Sales are projected to rise by 25 per cent 2. The debt/equity ratio stays at 2/3

3. Costs and assets grow at the same rate as sales

Example—A Simple Financial Planning Model

Pro-Forma Financial Statements

Financial performance Financial position

Sales $ 125 Assets $ 62.5 Debt $25

Costs 112.5 Equity 37.5

Net $ 12.5 Total $ 62.5 Total $ 62.5

What is the plug?

Notice that projected net income is $12.50, but equity only

increases by $7.50. The difference, $5.00 paid out in cash

dividends, is the plug.

Percentage of Sales Approach

• A financial planning method in which accounts are varied depending on a firm’s predicted sales level.

• Dividend payout ratio is the amount of cash paid out to shareholders.

• Retention ratio is the amount of cash retained within the firm and not paid out as a dividend.

• Capital intensity ratio is the amount of assets needed to

generate $1 in sales.

Example—Financial Performance Statement

Sales $1000

Costs 800

Taxable Income 200

Tax (30%) 60

Net profit $ 140

Retained earnings $112

Dividends $28

Sales (projected) $1 250 Costs (80% of sales) 1 000

Taxable Income 250

Tax (30%) 75

Net profit $ 175

Example—Pro-Forma Financial

Performance Statement

Example—Steps

• Use the original financial position statement to create a pro-forma; some items will vary directly with sales.

• Calculate the projected addition to retained earnings and the projected dividends paid to shareholders.

• Calculate the capital intensity ratio.

Example—Financial Position Statement

Assets

Current assets ($) (% of sales)

Cash 160 16

Accounts receivable 440 44

Inventory 600 60

Total 1 200 120

Non-current assets

Net plant and equipment 1 800 180

Total assets 3 000 300

Example—Financial Position Statement

Liabilities and owners’ equity

Current liabilities ($) (% of sales) Accounts payable 300 30

Notes payable 100 n/a Total 400 n/a

Long-term debt 800 n/a Shareholders’ equity

Issued capital 800 n/a

Retained earnings 1 000 n/a

Total 1 800 n/a

Example—Partial Pro-Forma Financial Position Statement

Assets

Current assets ($) Change

Cash 200 $ 40

Accounts receivable 550 110

Inventory 750 150

Total 1 500 $300

Non-current assets

Net plant and equipment 2 250 $450

Total assets 3 750 $750

Example—Partial Pro-Forma Financial Position Statement

Liabilities and owners’ equity

Current liabilities ($) Change Accounts payable 375 $ 75

Notes payable 100 0 Total 475 $ 75

Long-term debt 800 0 Shareholders’ equity

Issued capital 800 0 Retained earnings 1 140 $140 Total 1 940 $140

Total liabilities & s’holders’ equity 3 215 $215

Example—Results of Model

• The good news is that sales are projected to increase by 25 per cent.

• The bad news is that $535 of new financing is required.

• This can be achieved via short-term borrowing, long- term borrowing and new equity issues.

• The planning process points out problems and

Example—Results of Model (continued)

• Assume that $225 is borrowed via notes payable and $310 is borrowed via long-term debt.

• ‘Plug’ figure now distributed and recorded within the financial position statement.

• A new (complete) pro-forma financial position

statement can be derived.

Example—Pro-Forma Financial Position Statement

Assets

Current assets ($) Change

Cash 200 $ 40

Accounts receivable 550 110

Inventory 750 150

Total 1 500 $300

Non-current assets

Net plant and equipment 2 250 $450

Example—Pro-Forma Financial Position Statement

Liabilities and owners’ equity

Current liabilities ($) Change Accounts payable 375 $ 75 Notes payable 325 $225 Total 700 $300

Long-term debt 1 110 $310 Shareholders’ equity

Issued capital 800 0 Retained earnings 1 140 $140

Total 1 940 $140

External Financing and Growth

• The higher the rate of growth in sales/assets, the greater the external financing needed (EFN).

• Need to establish a relationship between EFN and

growth (g).

Example—Statement of Financial Performance

Sales $ 500

Costs 400

Taxable Income $ 100

Tax (30%) 30

Net profit $ 70

Retained earnings $ 25

Dividends $ 45

Example—Statement of Financial

Position

Ratios Calculated

p (profit margin) = 14%

R (retention ratio) = 36%

ROA (return on assets) = 7%

ROE (return on equity) = 12.7%

D/E (debt/equity ratio) = 0.818

Growth

• Next year’s sales forecasted to be $600.

• Percentage increase in sales:

• Percentage increase in assets also 20 per cent.

$500 20%

$100 



Increase in Assets

• What level of asset investment is needed to support a given level of sales growth?

• For simplicity, assume that the firm is at full capacity.

• The indicated increase in assets required equals:

A × g

where A = ending total assets from the previous period

• How will the increase in assets be financed?

Internal Financing

• Given a sales forecast and an estimated profit margin, what addition to retained earnings can be expected?

• This addition to retained earnings represents the level of internal financing the firm is expected to generate over the coming period.

• The expected addition to retained earnings is:

where: S = previous period’s sales g = projected increase in sales

p = profit margin

  ^{S R}  ^g 

p  

 1

External Financing Needed

• If the required increase in assets exceeds the internal funding available (that is, the increase in retained earnings), then the difference is the

external financing needed (EFN).

EFN = Increase in Total Assets –

Addition to Retained Earnings

= A(g) – p(S)R × (1 + g)

Example—External Financing Needed

Increase in total assets = $1000 × 20%

= $200

Addition to retained earnings = 0.14($500)(36%) × 1.20 = $30

• The firm needs an additional $200 in new financing.

• $30 can be raised internally.

• The remainder must be raised externally (external

financing needed).

Example—External Financing Needed (continued)

170

$

20 1

% 36 ) 500

$ ( 14 0 )

20 0

( 1000

$

) 1

( )

( )

(

RE o

Addition t assets

in total Increase

EFN

. .

.

g R

S p g

A





















Relationship

• To highlight the relationship between EFN and g:

• Setting EFN to zero, g can be calculated to be 2.56 per cent.

• This means that the firm can grow at 2.56 per cent with no external financing (debt or equity).

     

      

g

g .

% .

g R

S p A

R S p





























975 25

%) 36 ( 500

$ 14 0 1000

$ 36

500

$

14

0

EFN

Financial Policy and Growth

• The example so far sees equity increase (via

retained earnings), debt remain constant and D/E decline.

• If D/E declines, the firm has excess debt capacity.

• If the firm borrows up to its debt capacity, what

growth can be achieved?

Sustainable Growth Rate (SGR)

The sustainable growth rate is the growth rate a firm can maintain given its debt capacity, ROE and retention ratio.

 

 ^{   R R} 

 1 ROE

SGR ROE

Example—Sustainable Growth Rate

• Continuing from the previous example:

• The firm can increase sales and assets at a rate of 4.82 per cent per year without selling any additional equity and without changing its debt ratio or payout ratio.

 

 

4.82%

0.36 0.127

1

0.36) .127

0 SGR (





 

Sustainable Growth Rate (SGR)

• Growth rate depends on four factors:

– profitability (profit margin)

– dividend policy (dividend payout)

– financial policy (D/E ratio)

– asset utilisation (total asset turnover)

• Do you see any relationship between the SGR and

the Du Pont identity?

Summary of Growth Rates

1. Internal growth rate

This growth rate is the maximum growth rate that can be achieved with no external debt or equity financing.

2. Sustainable growth rate

The SGR is the maximum growth rate that can be

achieved with no external equity financing while

borrowing to maintain a constant D/E ratio.

Important Questions

• It is important to remember that we are working with accounting numbers and we should ask ourselves some important questions as we go through the planning process.

• How does our plan affect the timing and risk of our cash flows?

• Does the plan point out inconsistencies in our goals?

• If we follow this plan, will we maximise owners’

wealth?