Strategic and Operational Financial Planning Chapter 22 Strategic and Operational Financial Planning Professor John Zietlow MBA 621

Chapter 22: Overview 22.1 Overview of the Planning Process 22.2 Planning for Growth Sustainable Growth Pro Forma Financial Statements 22.3 Planning and Control Short – Term Financing Strategies The Cash Budget Cash Receipts Cash Disbursements 22.4 Summary

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 have many more projects that appear to have positive NPV than they can pursue Limits on capital, production capacity, human resources and other inputs add complexity as well Long-term financial planning – more an art than a science

Long-Term Financial Planning Strategic plan – multiyear action plan for the major investment and competitive initiatives Senior management develops strategic plan by answering questions such as: 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 business 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?

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 Finance involved in determining the feasibility of a strategic plan given firm’s existing and prospective sources of funding Determine if firm’s ability to generate cash internally and raise cash externally are sufficient to fund projects included in strategic plan Finance has a control function in the implementation of strategic plans Financial analysts prepare cash budgets that help avoid liquidity problems Finance contributes to strategic planning through risk management Developing risk scenarios and ways to deal with them

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 Next figure illustrates the trade-off a firm faces when chooses to grow Increase in Liabilities Accounts Payable Short-term debt Long-term debt Increase in assets Cash Receivables Inventories Fixed Assets = + Increases in Equity Retained Earnings

Sustainable Growth Model Sustainable growth model (Higgins, 1981) – 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 Asset turnover ratio constant => assets must increase by gA

Sustainable Growth Model (Continued) The model is used to derive the sustainable growth rate g* a) Asset turnover ratio remains constant (assumption 2) => assets must increase by gA (to 1 + gA) the next period b) Retained earnings for the next period will equal S(m)(1+g)(1-d) c) The ratio L/E must remain constant (from assumption 4, A/E ratio is constant): d) Increase in liabilities equals S(m)(1+g)(1-d)(L/E) (from a and b)

Sustainable Growth Model (Continued) e) Increase in assets must match increase in liabilities and equity The sustainable growth rate that keeps the sources and uses of funds in balance: Increase in profit margin or assets-to-equity increase sustainable growth rate Increase in total asset turnover ratio (A/S is reducing in this case) has the same effect - increase in sustainable growth rate

Pro Forma Financial Statements Forecasts of balance sheet and income statements Communicate to investors future plans Used for internal planning and control purposes Start with “top-down” or “bottom-up” sales forecast “Top-down” approach – use macroeconomic and industry forecast to establish sales goals “Bottom-up” approach – forecast sales on a customer by customer basis Many firms use combination of these two approaches 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 left as plug figure – adjusted after all projections to preserve the equality of left and right hands of balance sheet

Balance Sheet of Zinsmeister Shoes Zinsmeister Shoe Balance Sheet as of December 31, 2004 Assets Liabilities and Equity Cash $10,000 Accounts payable $19,500 Accounts receivable 21,250 Credit line 5,000 Inventory 25,000 Current long-term debt Current assets $56,250 Current liabilities $29,500 Gross fixed assets $80,000 Long-term debt $20,000 Less: Accumulated depreciation 20,000 Common stock $20,200 Net fixed assets $60,000 Retained earnings $46,550 Total assets $116,250 Total liabilities and equity

Income Statement of Zinsmeister Shoes Zinsmeister Shoe Income Statement for the year ended December 31, 2004 Sales $250,000 Less: Cost of goods sold 162,500 Gross Profit $87,500 Less: Operating expense $25,000 Less: Interest Expense $3,000 Less: Depreciation $10,000 Pretax Income $49,500 Less: Taxes 17,325 Net income $32,175

Assumptions to Generate Pro Forma Financial Statements Use following assumptions: 1. Zinsmeister plans to increase sales by 30% next year (in 2005) 2. Gross profit margin will remain 35% 3. Operating expenses will equal 10% of sales, as in 2004 4. Interest rate paid on all debt is 10% 5. Invest additional $20 mil in fixed assets in 2005. Depreciation expense will increase from $10 mil to $15 mil 6. Tax rate is 35% 7. Cash holdings will increase by $1 mil next year 8. Accounts receivables are 8.5% of sales 9. Inventories equal 10% of sales 10. Accounts payable are 12% of cost of goods sold 11. Repay additional $5 mil in long-term debt next year 12. Pay 50% of net income as dividend

Pro Forma Income Statement for Zinsmeister Shoes Using these assumptions, compute the income statement items All begin with forecasted sales in 2005 1. Zinsmeister plans to increase sales by 30% next year Sales = $250,000 X 1.3 = $325,000 2. Gross profit margin will remain 35% Gross profit is $325,000 X 0.35 = $113,750 Cost of goods sold is then $211,250 3. Operating expenses will equal 10% of sales, as in 2004 Operating expenses = $325,000 X 0.1 = $32,500 11. Repay additional $5 mil in long-term debt next year Interest expense = (Credit Line + Current long-term debt + Long-term debt) X Interest rate = ($5 mil + $5mil + $15mil) X 0.1 = $2.5mil (this assumption may change as other items are 4. Interest rate paid on all debt is 10%

Pro Forma Income Statement of Zinsmeister Shoes (Continued) Sales $325,000 Less: Cost of goods sold 211,250 Gross Profit $113,750 Less: Operating expense $32,500 Less: Interest Expense $2,500 Less: Depreciation $15,000 Pretax Income $63,750 Less: Taxes 22,312 Net income $41,438 Dividends $20,719

Pro Forma Balance Sheet for Zinsmeister Shoes Using these assumptions, compute the balance sheet items 7. Cash holdings will increase by $1 mil next year Cash = $10 mil+ $1mil = $11 mil 8. Accounts receivables are 8.5% of sales A/R = $325,000 X 0.085 = $27,625 9. Inventories equal 10% of sales Inventory = $325,000 X 0.1 = $32,500 5. 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

Pro Forma Balance Sheet for Zinsmeister Shoes (Continued) 10. Accounts payable are 12% of cost of goods sold A/P = $211,250 X 0.12 = $25,350 Credit line used as plug figure Credit should be $3,306,000 to balance the balance sheet Initial estimate of $2.5 mil interest payment on the income statement too high Given a credit line of $3,306,000, interest payment would be only $2.33 mil The decline in interest expense increases the profit and retained earnings. Higher earnings – the credit line is reduced even more Credit line, interest expense and retained earnings linked through the balance sheet, income statement assumption 4 iterative process to compute these items

Pro Forma Balance Sheet for Zinsmeister Shoes Assets Liabilities and Equity Cash $11,000 Accounts payable $25,350 Accounts receivable 27,625 Credit line 3,306 Inventory 32,500 Current long-term debt 5,000 Current assets $71,125 Current liabilities $33,656 Gross fixed assets $100,000 Long-term debt $15,000 Less: Accumulated depreciation 35,000 Common stock $20,200 Net fixed assets $65,000 Retained earnings $67,269 Total assets $136,125 Total liabilities and equity

External Funds Required (EFR) for Zinsmeister Shoes Forecast of external funds required can be modeled with the following equation: - additional assets required to maintain a constant asset turnover ratio - additional accounts payable available assuming that the ratio of accounts payable to sales remains constant - additional financing source from increased retained earnings EFR for Zinsmeister is $8,111,000. In pro forma balance sheet external financing declined by $6.7 mil Discrepancy because assets to sales ratio is actually not constant as equation assumes

Short-Term Financing Strategies Growth is a very common long-term objective for many firms Sales volumes usually vary along a long-term upward trend Current assets tend to rise and fall with sales Fixed assets follow the long-term upward trend of sales, but do not vary short-term with sales Companies can adopt conservative, aggressive, or matching strategy to fund long-term trend and seasonal fluctuations Conservative strategy – use long-term financing to cover both long-term investments as well as short-term 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 (fixed assets plus permanent component of current assets) with long-term funding sources and temporary asset requirement with short-term financing

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 Year Quarterly Sales ($ in millions) Quarterly Sales

Financing Strategies Available to Hershey 1,400 1,200 1,000 800 600 400 200 Quarters (1992-2002) 1,600 1,800 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total Assets($ in millions) Hershey’s Current Assets Matching Strategy Conservative Strategy Aggressive Strategy

Cash Budget Cash budget shows firm’s planned cash inflows and outflows Used to estimate short-term cash requirements and provide the information needed to plan short-term investment (surplus cash) and short-term funding needs (cash shortages) Key input in building cash budget– firm’s sales forecast Estimate the monthly cash flows that will result from projected sales receipts and from production-related, inventory-related, and sales-related outlays Cash receipts – include all firm’s cash inflows in a given financial period Cash disbursements include all outlays of cash by the firm during a given financial period

Cash Receipts Most common components of cash receipts Cash sales, collections of accounts receivable, and other cash receipts 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 Table next slide shows schedule of cash receipts for Farrell

Schedule of Projected Cash Receipts for Farrell Industries August September October November December Forecast Sales $100 $200 $400 $300 Cash Sales (20%) $20 $40 $80 $60 Collection of accounts receivable Previous month (50%) 50 100 200 150 Two months prior (30%) 30 60 120 Other cash receipts Total cash receipts $210 $320 $340

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: not included in the cash budget; does have a cash outflow effect through its 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

Cash Disbursements (Continued) 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 Table on next slide shows schedule of cash disbursements for Farrell Industries

Schedule of Projected Cash Disbursements for Farrell Industries August September October November December Purchases (70% of sales) $70 $140 $280 $210 Cash Purchases (10%) $7 $14 $28 $21 Payments of accounts payable Previous month (70%) 49 98 196 147 Two months prior (20%) 14 28 56 Rent payments 5 Wages and salaries 48 38 Tax payments 25 Fixed asset outlays 130 Interest payments 10 Cash dividend payments 20 Principal payments Total cash disbursements $213 $418 $305

Net Cash Flow, Ending Cash, Financing Needs and Excess Cash The firm’s net cash flow: subtract cash disbursements from cash receipts for each period. Ending cash balance can be found by adding 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 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

Cash Budget for Farrell Industries -51 47 50 Add: Beginning cash -$16 -$51 $47 Ending cash balance 25 Less: Minimum cash balance $41 $76 Required total financing (notes payable) $22 Excess cash balance (marketable securities) $35 -$98 -$3 Net cash flow 305 418 213 Less: Total cash disbursements $340 $320 $210 Total cash receipts December November October