Strategic and Operational Financial Planning Professor XXXXX Course 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. 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 Statements Assumptions:  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  Interest rate paid on all debt is 10%.  Invest additional $20 mil in fixed assets in 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 = $27,625 Inventories equal 10% of sales Inventory = $325,000 X 0.1 = $32,500 Invest additional $20 mil in fixed assets in 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 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) ,400 1,200 1, Year Quarterly Sales ($ in millions) Quarterly Sales

18 Financing Strategies Available to Hershey 1,400 1,200 1, Quarters ( ) 1,600 1, Total Assets($ in millions) 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 forecast Key input Cash receipts All firm’s cash inflows in a given financial period Cash disbursements 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 Receipts Common 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 Two months prior (30%) Previous 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

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 Add: Beginning cash -$16-$51$47Ending cash balance 25 Less: Minimum cash balance $41$76Required total financing (notes payable) $22Excess cash balance (marketable securities) $35-$98-$3Net cash flow Less: 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