Strategic and Operational Financial Planning

1. Strategic and Operational Financial Planning Professor XXXXX Course Name / Number

2. Financial planning activities • Setting long-run strategic goals • Preparing quarterly and annual budgets • Managing day-to-day fluctuations in cash balances • 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. Long-term financial planning Overview of the Planning Process

3. Strategic plan • Multiyear action plan for the major investment and competitive initiatives Long-Term Financial Planning • 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? Senior management develops strategic plan by answering questions like:

4. Finance has control in the implementing strategic plans. • Financial analysts prepare cash budgets that help avoid liquidity problems. 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.

5. Trade-offs 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 • Growth can be measured by increases in firm’s market value, its asset base, the number of people it employs, increase in sales.

6. Sustainable Growth Model • Models how rapidly a firm can grow 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. Assumption of the model: 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. 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. Percentage-of-sales method Pro Forma Financial Statements • Forecasts of balance sheet and income statements “Top-down” approach uses macroeconomic and industry forecast to establish sales goals. “Bottom-up” approach forecasts sales on a customer by customer basis. “Top-down” or “bottom-up” sales forecasts:

9. 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 5,000 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 $116,250 Balance Sheet of Zinsmeister Shoes

10. 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 Income Statement of Zinsmeister Shoes

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 2004. • Interest rate paid on all debt is 10%. • Invest additional $20 mil in fixed assets in 2005. 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 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 Income Statement of Zinsmeister Shoes

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 0.085 = $27,625 Inventories equal 10% of sales • Inventory = $325,000 X 0.1 = $32,500 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 Accounts payable are 12% of cost of goods sold • A/P = $211,250 X 0.12 = $25,350

14. 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 $136,125 Pro Forma Balance Sheet for Zinsmeister Shoes

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. 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. Short-Term Financing Strategies Companies can adopt the following strategies to fund long-term trend and seasonal fluctuations of sales:

17. 1,400 1,200 1,000 Quarterly Sales ($ in millions) 800 600 400 200 Quarterly Sales 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year Quarterly Sales for Hershey Foods (1992 – 2002)

18. 1,800 1,600 1,400 1,200 1,000 Total Assets($ in millions) 800 600 Hershey’s Current Assets Matching Strategy Conservative Strategy Aggressive Strategy 400 200 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Quarters (1992-2002) Financing Strategies Available to Hershey

19. Key input • Firm’s sales forecast 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 Cash Budget • Cash budget shows firm’s planned cash inflows and outflows. Estimate the monthly cash flows that will result from projected sales receipts and from production-related, inventory-related, and sales-related outlays.

20. 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 Cash Receipts Common components of cash receipts: cash sales, collections of accounts receivable, and other cash receipts

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

22. 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 Cash Disbursements

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

25. 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. Net Cash Flow, Ending Cash, Financing Needs and Excess Cash

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

27. Strategic and Operational Financial Planning 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.