3-1 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter # 2 Financial Planning

3-2 Copyright © 2009 Pearson Prentice Hall. All rights reserved. The Financial Planning Process Financial planning involves guiding, coordinating, and controlling the firm’s actions to achieve its objectives. – cash planning and profit planning. Cash planning involves the preparation of the firm’s cash budget. Profit planning involves the preparation of both cash budgets and pro forma financial statements.

3-3 Copyright © 2009 Pearson Prentice Hall. All rights reserved. The Financial Planning Process: Long-Term (Strategic) Financial Plans Long-term strategic financial plans lay out a company’s planned financial actions and the anticipated impact of those actions over periods ranging from 2 to 10 years.

3-4 Copyright © 2009 Pearson Prentice Hall. All rights reserved. The Financial Planning Process: Long-Term (Strategic) Financial Plans (cont.) Long-term financial plans consider a number of financial activities including: –Proposed fixed asset investments –Research and development activities –Marketing and product development –Capital structure –Sources of financing These plans are generally supported by a series of annual budgets and profit plans.

3-5 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets The cash budget or cash forecast is a statement of the firm’s planned inflows and outflows of cash. It is used to estimate short-term cash requirements with particular attention to anticipated cash surpluses and shortfalls. Surpluses must be invested and deficits must be funded.

3-6 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets (cont.) The cash budget begins with a sales forecast, which is simply a prediction of the sales activity during a given period.

3-7 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets An Example: ABC Industries ABC contractor, is developing a cash budget for October, November, and December. In August and September were $100,000 and $200,000 respectively. Sales of $400,000, $300,000 and $200,000 have been forecast for October, November, and December. Historically, 20% of the firm’s sales have been for cash, 50% have been collected after 1 month, and the remaining 30% after 2 months. In December, ABC will receive a $30,000 dividend from stock in a subsidiary.

3-8 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets An Example: ABC Industries (cont.) Based on this information, we are able to develop the following schedule of cash receipts for ABC Industries. Table 3.8 A Schedule of Projected Cash Receipts for ABC Industries ($000)

3-9 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets An Example: ABC Industries (cont.) ABC Company has also gathered the relevant information for the development of a cash disbursement schedule. Purchases will represent 70% of sales—10% will be paid immediately in cash, 70% is paid the month following the purchase, and the remaining 20% is paid two months following the purchase. The firm will also expend cash on rent, wages and salaries, taxes, capital assets, interest, dividends, and a portion of the principal amount. The resulting disbursement schedule thus follows.

3-10 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Table 3.9 A Schedule of Projected Cash Disbursements for ABC Industries ($000)

3-11 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Cash Planning: Cash Budgets An Example: ABC Industries (cont.) The Cash Budget for ABC Industries can be derived by combining the receipts budget with the disbursements budget. At the end of September, ABC’s cash balance was $50,000, notes payable was $0, and marketable securities balance was $0. ABC also wishes to maintain a minimum cash balance of $25,000. As a result, it will have excess cash in October, and a deficit of cash in November and December. The resulting cash budget follows.

3-12 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Table 3.10 A Cash Budget for ABC Industries ($000)

3-13 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Statements Pro forma financial statements are projected, or forecast, financial statements – income statements and balance sheets.

3-14 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements ABC Manufacturing’s Income Statement for

3-15 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements (cont.) Balance Sheet, December 31, 2009

3-16 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements (cont.) Step 1: Start with a Sales Forecast –The first and key input for developing pro forma financial statements is the sales forecast for ABC Manufacturing Sales Forecast for ABC Manufacturing

3-17 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 1: Start with a Sales Forecast (cont.) –The previous sales forecast is based on an increase in price from $20 to $25 per unit for Model X and from $40 to $50 per unit for Model Y. –These increases are required to cover anticipated increases in various costs, including labor, materials, & overhead. Profit Planning: Pro Forma Financial Statements (cont.)

3-18 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 2: Preparing the Pro Forma Income Statement –A simple method for developing a pro forma income statement is the “percent-of-sales” method. Profit Planning: Pro Forma Financial Statements (cont.)

3-19 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements (cont.) Table 3.15 A Pro Forma Income Statement, Using the Percent-of-Sales Method, for ABC Manufacturing for the Year Ended December 31, 2010

3-20 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 2: Preparing the Pro Forma Income Statement (cont.) –Clearly, some of the firm’s expenses will increase with the level of sales while others will not. –The best way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components. –This may be demonstrated as follows. Profit Planning: Pro Forma Financial Statements (cont.)

3-21 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements (cont.)

3-22 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 3: Preparing the Pro Forma Balance Sheet –Probably the best approach to use in developing the pro forma balance sheet is the judgmental approach. –Under this simple method, the values of some balance sheet accounts are estimated and the company’s external financing requirement is used as the balancing account. Profit Planning: Pro Forma Financial Statements (cont.)

3-23 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 3: Preparing the Pro Forma Balance Sheet (cont.) 1.A minimum cash balance of $6,000 is desired. 2.Marketable securities will remain at their current level of $4, Accounts receivable will be approximately $16,875 which represents 45 days of sales on average [(45/365) x $135,000]. 4.Ending inventory will remain at about $16, % ($4,000) represents raw materials and 75% ($12,000) is finished goods. 5.A new machine costing $20,000 will be purchased. Total depreciation will be $8,000. Adding $20,000 to existing net fixed assets of $51,000 and subtracting the $8,000 depreciation yields a net fixed assets figure of $63,000. Profit Planning: Pro Forma Financial Statements (cont.)

3-24 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Step 3: Preparing the Pro Forma Balance Sheet (cont.) 6.Purchases will be $40,500 which represents 30% of annual sales (30% x $135,000). ABC takes about 73 days to pay on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) x $40,500]. 7.Taxes payable will be $455 which represents one-fourth of the 2010 tax liability. 8.Notes payable will remain unchanged at $8, There will be no change in other current liabilities, long-term debt, and common stock. 10.Retained earnings will change in accordance with the pro forma income statement. Profit Planning: Pro Forma Financial Statements (cont.)

3-25 Copyright © 2009 Pearson Prentice Hall. All rights reserved. Profit Planning: Pro Forma Financial Statements (cont.) A Pro Forma Balance Sheet, Using the Judgmental Approach, for ABC Manufacturing (December 31, 2010) Note: RE =