Chapter 12

Financial Planning and Control

2005 Thomson/South-Western

Financial Planning and Control

Financial Planning:
The projection of sales, income, and assets based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projections

Financial Control
The phase in which financial plans are implemented, control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes.
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Financial Planning: The Sales Forecast

A forecast of a firms unit and dollar sales for some future period, generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc.

Projected (Pro Forma) Financial Statements

A method of forecasting financial requirements based on forecasted financial statements AFN = additional funds needed to support the level of forecasted operations
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Projected Financial Statements

Determine how much money the firm will need in a given period. Determine how much money the firm will generate internally during the same period. Subtract the funds generated internally from the funds required to determine the external financial requirements.
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Step 1. Forecast the 2010 Income Statement

Assumptions: Unilate operated at full capacity in 2009. Sales are expected to grow by 10%. Variable cost ratio is 82% (same as 2009). 2010 dividend per share is the same as 2009. AFN is raised by 60% short-term debt with 10% cost and 40% long-term debts with 12% cost.
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Step 1. Forecast the 2010 Income Statement ($ millions)

Unilate Textiles
Net Sales Cost of Goods Sold Gross Profit Fixed operating Costs Depreciation EBIT Less Interest EBT Taxes (40%) Net Income Common Dividends Earnings per Share Dividends per Share Number Common Shares (millions) $ 2009 Results $ 1,500.0 (1,230.0) 270.0 (90.0) (50.0) 130.0 (40.0) 90.0 (36.0) 54.0 (29.0) 25.0 2.16 1.16 25.0 $ $ $ $ Forecast Basis x 1.10 x 1.10 x 1.10 x 1.10 2010 Initial Forecast $ 1,650.0 (1,353.0) 297.0 (99.0) (55.0) 143.0 (40.0) 103.0 (41.2) 61.8 (29.0) 32.8 2.47 1.16
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Addition to Retained Earnings $ $ $

25.0

Step 2. Forecast the 2010 Balance Sheet ($ millions)

Unilate Textiles
2009 Balances Cash $ 15.0 Accounts Receivable 180.0 Inventory 270.0 Total Current Assets 465.5 Net Plant & Equipment 380.0 Total Assets $ 845.0 Accounts Payable 30.0 Accruals 60.0 Notes Payable 40.0 Total Current Liabilities 130.0 Long-Term Bonds 300.0 Total Liabilities $ 430.0 Common Stock 130.0 Retained Earnings 285.0 Owner's Equity $ 415.0 Total Liabilites & Equity $ 845.0 Additional Funds Needed Forecast Basis x 1.10 x 1.10 x 1.10 x 1.10 x 1.10 x 1.10 2010 Initial Forecast $ 16.5 198.0 297.0 511.5 418.0 $ 929.5 33.0 66.0 40.0 139.0 300.0 $ 439.0 130.0 317.8 $ 447.8 $ 886.8 $ 42.7

+$32.8

Step 3. Raising the Additional Funds Needed

Higher sales must be supported by higher assets. Asset increase can be financed by spontaneous increases in accounts payable and accruals and by retained earnings. Any short fall must be financed from external sources--by borrowing or by selling new stock.

Unilate has decided that any additional funds needed to support future operations will be raised mainly by issuing new common stock.

Step 4. Financing Feedbacks

The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets

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Other Considerations in Forecasting: Excess Capacity

Suppose in 2009 fixed assets had been operated at only 80% of capacity:

Actual sal es Full Capacity Sales % of capacity

$1,500 $1,875 million. 0.80
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Other Considerations in Forecasting: Economies of Scale Unilates variable cost ratio is 82% of sales. Ratio might decrease to 80% if operations increase significantly.
Changes in variable cost ratio affect the addition to retained earnings which affects the amount of AFN.
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Other Considerations in Forecasting: Lumpy Assets

Assets that cannot be acquired in small increments, but must be obtained in large, discrete amounts

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Summary: How different factors affect the AFN forecast.

Dividend payout ratio changes.
If reduced, more RE, reduce AFN.

Profit margin changes.

If increases, total and retained earnings increase, reduce AFN.

Plant capacity changes.

Less capacity used, less need for AFN.

Payment terms increased to 60 days.

Accts. payable would double, increasing liabilities, 14 reduce AFN.

Financial Control Budgeting and Leverage

The phase in which financial plans are implemented; control deals with the feedback and adjustment processes required to ensure the firm is following the right financial path to accomplish its goals, and, if not, to make necessary corrections.
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Operating Breakeven Analysis

An analytical technique for studying the relationship between sales revenues, operating costs, and profits Operating breakeven analysis deals only with the upper portion of the income statement the portion from sales to NOI
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Unilates 2010 Forecasted Operating Income ($ millions)

Sales (S)--(110 million units) Variable cost of goods sold (VC) Gross profit (GP) Fixed operating costs (F) Net operating income (NOI = EBIT) $ 1,650.00 (1,353.00) 297.00 (154.00) $ 143.00
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Operating Breakeven Chart

Revenues & Costs 1,400 1,200 1,000
Total Sales Revenues (P x Q) Total Operating Costs (F + Q x V)

Operating Profit (EBIT > 0)

SOpBE = 856
800 600 400 200 154 0

Operating Loss (EBIT < 0)

Operating Breakeven Point (EBIT = 0)

Total Fixed Costs (F) 0 20 40 57 60 80 Units QOpBE 100 120

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Breakeven Computation
Sales = Total operating = Total + Total revenues costs variable costs fixed costs

(P x Q) = TOC
QOpBE QOpBE =

= (V x Q) + F F P-V = Contribution margin $154.0 million $15.00 - $12.30

=

$154.0 million $2.70 57.0 million units

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= 57.04 million units

Operating Breakeven Point

SOpBE F = 1-

( )

V = P

F Gross profit margin

SOpBE

= 1-

$154.0 = $12.30 $15.00

$154.0 = $154.0 = 855.6 million 1 - 0.82 0.18

For the proposal to break even, Unilate must sell 57 million units or $855,600,000 of product. 20

Operating Leverage
The existence of fixed operating costs, such that a change in sales will produce a larger change in operating income (EBIT)

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Degree of Operating Leverage

The percentage change in NOI (or EBIT) associated with a given percentage change in sales

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Calculating the Degree of Operating Leverage

Gross Profit DOL S EBIT
= $297 $143 = 2.08x

Each 1 percent change in sales, will result in a 2.08 percent change in operating income.

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Operating Income at Sales Levels of 110 and 99 Million Units

2010 Forcasted Sales Unit Operations Decrease Change Sales in units 110 99 (11) Sales revenues $ 1,650.0 $ 1,485.0 $ (165.0) Variable cost of goods sold (1,353.0) (1,217.7) 135.3 Gross profit 297.0 267.3 (29.7) Fixed operating costs (154.0) (154.0) Net operating income (EBIT) $ 143.0 $ 113.3 $ (29.7) Percent Change -10.0% -10.0% -10.0% -10.0% 0.0% -20.8%
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Financial Leverage
The existence of fixed financial costs such as interest and preferred dividends when a change in EBIT results in a larger change in EPS

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Unilate Textiles: Degree of Financial Leverage

DFL
EBIT EBIT - I EBIT EBIT - [financial BEP] $143.0 $101.6

DFL110

$143.0 $143.0 - $41.4

1.41x

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Degree of Total Leverage

Gross profit DTL EBIT- [Financial BEP] S - VC EBIT- I Q(P - V) [Q (P - V) - F] - I

$297.0 $101.6

2.92x

= DOL x DFL = 2.08 x 1.41 = 2.92x27

Importance of Forecasting and Control Functions

If projected operating results are not satisfactory, management can reformulate its plans. If funds required to meet sales forecast cannot be obtained, management can sale back projected levels of operations. If required funds can be raised, it is best to plan for their acquisition in advance. Any deviation from projections needs to be handled to improve future forecasts.
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