1 / 49

Chapter Essentials —The Questions

Chapter Essentials —The Questions. Why is financial planning and control critical to the survival of a firm? What are pro forma financial statements? What are operating breakeven and financial leverage? How can a firm use knowledge of leverage in the financial forecasting and control process?.

quasim
Download Presentation

Chapter Essentials —The Questions

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter Essentials—The Questions • Why is financial planning and control critical to the survival of a firm? • What are pro forma financial statements? • What are operating breakeven and financial leverage? • How can a firm use knowledge of leverage in the financial forecasting and control process?

  2. FINANCIAL PLANNING AND CONTROL • The information derived from financial statement analysis can be used to establish future operating goals (financial planning) and to determine how to meet established goals (financial control). • Developing pro forma financial statements is an important part of the planning and control processes.

  3. FINANCIAL PLANNING AND CONTROL • Pro Forma Financial Statements (Financial Planning) • Other Considerations in Forecasting • Breakeven/Leverage Analysis • Operating • Financial • Total • Using of Breakeven/Leverage Analysis (Control)

  4. FINANCIAL PLANNING—FORECASTING • Sales Forecast • most important part of financial planning • generally based on the trend in sales in recent periods • inaccurate sales forecasts can have serious repercussions—if the firm is too optimistic, such assets as inventory will be built up too much; if the firm is too conservative, it might miss valuable opportunities because existing production capabilities might not be sufficient to meet new demand

  5. Sales ($ millions) 600 500 400 300 200 100 0 2004 2005 2006 2007 2008 2009 Trend in Sales for AgriCorp Average growth = 12%

  6. Projected (Pro Forma) Financial Statements • Help the firm determine what is needed to finance expected future operating activities • Information from these statements indicates how much financing will be generated by the firm internally and how much needs to be generated externally (called additional funds needed) by borrowing or by selling stock

  7. Projected (Pro Forma) Financial Statements • To construct a pro forma balance sheet and a pro forma income statement: • Step 1: Forecast next period’s income statement • Step 2: Forecast next period’s balance sheet • Step 3: Raising the additional funds needed • Step 4: Financing feedbacks

  8. Step 1: Construct a Pro Forma Income Statement • Estimate the percentage growth (increase or decrease) in sales, cost of goods sold, and other variable revenues and expenses • Change the current values by the estimates • An easy way to approach this task is to apply a single growth rate to all revenue and expense categories that change when production changes • To be more accurate, each category should be examined individually to determine what the effect of any forecasted change is

  9. Step 1: Construct AgriCorp’s Pro Forma Income Statement for Next Year Assumptions • AgriCorp operated at full capacity last year. • Sales are expected to grow by 12 percent. • The variable cost ratio remains at 80 percent (same as last year) • Next year’s dividend payout will be maintained at 60 percent of net income.

  10. AgriCorp’s Pro Forma Income Statement for Next Year ($ millions) Next Year’s x (1 + g)Initial Forecast x 1.12 $560.00 x 1.12 (448.00) x 1.12( 61.60) 50.40 Last Year’s Results Sales $500.00 Variable costs (80%) (400.00) Fixed Costs ( 55.00) EBIT = NOI 45.00 Interest ( 10.00) Taxable income (EBT) 35.00 Taxes @ 40% ( 14.00) Net Income 21.00 Dividends (60% of NI) 12.60 Addition to RE 8.40 ( 10.00) 40.40 ( 16.16) 24.24 14.54 9.70

  11. Step 2: Construct AgriCorp’s Pro Forma Balance Sheet for Next Year Assumptions • AgriCorp operated at full capacity last year. • Each type of asset grows proportionally with sales. • Payables and accruals (spontaneous sources of financing) grow proportionally with sales.

  12. AgriCorp’s Pro Forma Balance Sheet for Next Year($ millions) Next Year’s x (1 + g)Initial Forecast x 1.12 $176.60 x 1.12 134.40 $308.00 x 1.12 $ 33.60 Last Year’s Results Current assets $155.00 Fixed assets 120.00 Total assets $275.00 Payables & accruals 30.00 Notes Payable 13.00 Current liabilities 43.00 Long-term debt 100.00 Total liabilities 143.00 Common stock 44.00 Retained earnings 88.00 Total equity 132.00 Total liabilities & equity $275.00 13.00 46.60 100.00 146.60 44.00 +9.70 Δ RE 97.70 141.70 $288.30

  13. Additional Funds Needed (AFN) If AgriCorp does not raise additional capital by borrowing from the bank or issuing new stocks or bonds, then, based on the pro forma balance sheet, the following exists: Total assets $308.00 Total liabilities and equity 288.30 Additional funds needed (AFN) 19.70 19.70

  14. Step 3: Raising the Additional Funds Needed (AFN) AgriCorp plans to raise the additional funds needed (AFN) as follows: Proportion Notes payable 15.0% New long-term debt 20.0 New common stock 65.0 100.0 Amount $2.96 3.94 12.80 19.70 • Cost • 7.0% • 10.0 • dividend

  15. Step 4: Financing Feedbacks • If the AgriCorp issues new debt and common stock, the total amount of interest and dividends paid will increase. • Because interest and dividends must be paid with cash, any increase in these costs will decrease the funds the firm has to invest—that is, the amount of income added to retained earnings will be less than originally forecasted. • When we consider the effects of the increased interest and dividend payments, we find that the AFN is actually greater than originally expected. • Financing feedbacks—that is, the effects on the financial statements of actions taken to finance forecasted increases in assets—must be considered to determine the exact amount of AFN.

  16. AgriCorp’s Pro Forma Income Statement for Next Year ($ millions)—2nd Pass 2nd Pass Forecast $ 50.40 (10.60) Last Year’s Next Year’s Results x (1+g)Initial Forecast EBIT = NOI $ 45.00 x 1.12 $ 50.40 Interest (10.00)(10.00) Taxable income 35.00 40.40 Taxes @ 40% (14.00)(16.16) Net Income 21.00 24.24 Dividends (60% of NI) 12.60 14.54 Addition to RE 8.40 9.70 39.80 (15.92) 23.88 14.33 9.55 New interest = 10.00 + (2.96 x 0.07) + (3.94 x 0.10) = 10.60 • in addition to RE = 9.55 – 9.70 = –0.15

  17. AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—2nd Pass 2nd Pass Forecast $308.00 33.60 15.96 Last Year’s Next Year’s Results x (1+g)Initial Forecast Total assets $275.00 x 1.12 $308.00 Payables & accruals 30.00 x 1.12 33.60 Notes payable 13.00 13.00 Current liabilities 43.00 46.60 Long-term debt 100.00100.00 Total liabilities 143.00 146.60 Common stock 44.00 44.00 Retained earnings 88.00 97.70 Total equity 132.00 141.71 Total liabilities & equity 275.00 288.30 + 2.96 49.56 103.94 + 3.94 153.50 56.80 +12.80 + 9.70 - 0.15 97.55 154.35 307.85 AFN1 = 2.96 + 3.94 + 12.80 = 19.70 AFN2 = 308.00 – 307.85 = 0.15

  18. AgriCorp’s Pro Forma Balance Sheet for Next Year ($ millions)—Final Pass Final Forecast $308.00 33.60 15.98 Last Year’s Next Year’s Results x (1+g)Initial Forecast Total assets $275.00 x 1.12 $308.00 Payables & accruals 30.00 x 1.12 33.60 Notes payable 13.00 13.00 Current liabilities 43.00 46.60 Long-term debt 100.00100.00 Total liabilities 143.00 146.60 Common stock 44.00 44.00 Retained earnings 88.00 97.70 Total equity 132.00 141.71 Total liabilities & equity 275.00 288.30 + 2.98 49.58 103.97 + 3.97 153.55 56.90 +12.90 + 9.70 -0.15 97.55 154.45 308.00 Total AFN = 2.98 + 3.97 + 12.90 = 19.85 > 19.70 = AFN1

  19. Other Considerations in Forecasting • Excess capacity—If the firm has excess capacity, it will not have to increase plant and equipment at the same growth rate as sales. To determine the level of sales current plant capacity can handle, use the following equation: • Example—If AgriCorp currently operates at 80 percent capacity, then existing plant and equipment can produce sales equal to: In this case, sales can grow by 25 percent before AgriCorp needs to expand its plant and equipment.

  20. Other Considerations in Forecasting • Excess capacity—If the firm has excess capacity, it will not have to increase plant and equipment at the same growth rate as sales. • Economies of scale—If economies of scale exist, the variable cost ratio might change with changes in production activity. • Lumpy assets—Many assets are not completely divisible • some assets might have to be purchased in larger increments than the firm would prefer • “lumpy assets” must be purchased in discrete increments, say, $10 million per addition, which means we cannot simply increase assets by a growth rate like 12 percent

  21. Financial Control—Budgeting and Leverage Analysis Proper financial control helps to ensure the firm meets the expectations developed in the planning stage, and, when results fall short of expectations, helps management determine the reasons. • Breakeven analysis—evaluation of the level of operations to determine the ability of the firm to generate profits • Leverage analysis—examination as to how well the firm can cover its fixed costs, both operating and financial; gives an indication of risk

  22. Operating Breakeven Analysis • Operating breakeven point is defined as the level of operations where the net operating income, NOI = EBIT, equals zero • Total operating costs (both fixed and variable) = sales revenues

  23. Operating Breakeven Analysis—Example Worldwide Widgets, Inc.’s operations have the following characteristics: Selling price (P) $8.00 Variable cost per unit (V) $6.00 Variable cost ratio = V/P 0.75 Fixed operating costs $12,000.00 Existing sales 10,000 units

  24. Dollars 120,000 100,000 80,000 60,000 40,000 20,000 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Units Produced and Sold Operating Breakeven Analysis—Graph Operating profit Total sales Total operating costs 48,000 Fixed operating costs = $12,000 Operating loss

  25. Operating Breakeven Analysis—Computation = 6,000 x $8

  26. Operating Breakeven Analysis—Uses • Determine the level of sales a product must achieve to make a profit. • Indicate the impact of general growth on the cost structure of the firm. • Show how modernization to improve efficiency affects fixed and variable costs, thus profitability of operations

  27. Operating Leverage Analysis • In business, leverage refers to the existence of fixed costs. • The presence of leverage means that a change in sales will result in a larger change in operating income (EBIT), net income, or both. • Operating leverage exists if fixed operating costs, such as depreciation, are present. • The degree of operating leverage (DOL) is defined as the percent change in net operating income, NOI, that results from a particular percent change in sales.

  28. Operating Leverage DOL is computed as follows: Generally, a firm with a high DOL is considered to have high risk associated with its operations

  29. Current Income Statement for Worldwide Widgets Sales in units 10,000 Sales @ $8 per unit $80,000 Variable costs @ $6 per unit (60,000) Gross Profit 20,000 Fixed operating costs (12,000) NOI = EBIT $ 8,000

  30. Operating Leverage • Does Worldwide Widgets have operating leverage? • Yes, because the firm has fixed operating costs equal to $12,000. • Worldwide’s degree of operating leverage is: DOL = 2.5x means that for every 1 percent deviation in sales from expectations, there will be a 2.5 percent deviation in EBIT (in the same direction) from expectations.

  31. Effect of DOL for Worldwide Widgets If Sales are Percent 10% LowerDeviation Current Forecast Sales ($8/unit) Variable costs ($6/unit) Gross Profit Fixed operating costs NOI = EBIT $80,000 (60,000) 20,000 (12,000) $ 8,000 $72,000 -10.0% (54,000) -10.0% 18,000 -10.0% (12,000) - 0.0% $ 6,000 -25.0% DOL = 2.5; as a result, a 10 percent decrease in sales will result in a 25 percent (2.5 x 10%) decrease in EBIT

  32. Operating Leverage and Operating Breakeven • Generally, a higher degree of operating leverage (DOL) implies that greater risk is associated with the firm’s operations. • Risk is variability. • The closer the firm operates to its breakeven point, the riskier its operations are considered. • Everything else equal, firms with higher DOLs operate closer to their operating breakeven points, and thus cannot cover fixed operating costs as easily as firms with lower DOLs.

  33. Financial Breakeven Analysis • Financial breakeven point is defined as the level of operating income (NOI or EBIT) that covers all fixed financing charges. • At the financial breakeven point, EPS = 0. • For the most part, fixed financial charges include interest paid on debt and preferred stock dividends. • For firms that do not have preferred stock, the financial breakeven point, EBITFinBE, is simply interest on debt. • Most firms do not have preferred stock.

  34. Financial Breakeven Analysis—Example Worldwide Widgets, Inc. is financed with the following sources of long-term funds: Bonds @ 8% interest $ 50,000 Preferred stock 0 Common stock (5,000 shares outstanding) 50,000 Total capital $100,000

  35. EPS ($) 2.00 1.50 1.00 0.50 0 -8,000 -4,000 0 4,000 8,000 12,000 16,000 -0.50 EBIT ($) -1.00 -1.50 -2.00 Financial Breakeven Analysis—Graph Financial breakeven point

  36. Financial Breakeven Analysis—Computation • The financial breakeven point is computed as follows: • If Worldwide Widgets’ marginal tax rate is 40 percent, its financial breakeven point is:

  37. Financial Breakeven Analysis—Uses • Financial breakeven analysis gives an indication as to how the firm’s mix of debt and preferred stock (fixed financing) affects EPS (net income).

  38. Financial Leverage • Financial leverage exists if the firm has fixed financial charges: • interest on debt • preferred dividends • The degree of financial leverage (DFL) is the percent change in EPS that results from a particular percent change in net operating income.

  39. Financial Leverage DFL is computed as follows: If a firm has no preferred stock, the DFL simplifies to: Generally, a firm with a high DFL is considered to have high risk associated with its financing.

  40. Current Income Statement for Worldwide Widgets Sales $80,000 Variable costs (75% of sales) (60,000) Gross Profit 20,000 Fixed operating costs (12,000) NOI = EBIT $ 8,000 Interest = $50,000 x 0.08 ( 4,000) Taxable income (EBT) 4,000 Taxes (40%) ( 1,600) Net income $ 2,400

  41. Financial Leverage • Does Worldwide Widgets have financial leverage? • Yes, because the firm has a fixed financing cost—that is, interest—equal to $4,000. • Worldwide’s degree of financial leverage is: DFL = 2.0x means that for every 1 percent deviation in EBIT from expectations, there will be a 2.0 percent deviation in EPS (in the same direction) from expectations.

  42. Effect of DFL for Worldwide Widgets If EBIT is Percent 25% LowerDeviation Current Forecast EBIT Interest Taxable income (EBT) Taxes (40%) Net income = EAC EPS = EAC/5,000 $8,000 (4,000) 4,000 (1,600) $ 2,400 $6,000 -25.0% 0.0% (4,000) 2,000 -50.0% ( 800) -50.0% $ 1,200 -50.0% $0.48 $0.24 -50.0% DFL = 2.0; as a result, a 25 percent decrease in EBIT will result in a 50 percent (2.0 x 25%) decrease in EPS

  43. Financial Leverage and Financial Breakeven • Generally, a higher degree of financial leverage (DFL) implies greater risk is associated with the firm’s financial mix. • Risk is variability. • The closer the firms operates to its financial breakeven point, the riskier its financial position is. • Everything else equal, firms with higher DFLs operate closer to their financial breakeven points, and thus cannot as easily cover fixed financial costs as firms with lower DFLs.

  44. Combining Operating and Financial Leverage (DTL) • The degree of total leverage (DTL) is the combination of DOL and DFL. • DTL is the percent change in EPS associated with a particular percent change in sales • DTL = DOL x DFL • Everything else equal, a higher degree of total leverage, DTL, is associated with greater total risk—both operating risk and financial risk.

  45. Total Leverage Worldwide’s degree of total leverage is: DTL = 5.0x means that for every 1 percent deviation in sales from expectations, there will be a 5.0 percent deviation in EPS (in the same direction) from expectations.

  46. Effect of DTL for Worldwide Widgets If Sales are Percent 10% LowerDeviation $72,000 -10.0% (54,000) -10.0% 18,000 -10.0% (12,000) 0.0% 6,000 -25.0% Current Forecast Sales $80,000 Variable operating costs (60,000) Gross profit 20,000 Fixed operating costs (12,000) EBIT 8,000 Interest ( 4,000) Taxable income (EBT) 4,000 Taxes (40%) ( 1,600) Net income = EAC 2,400 EPS = EAC/5,000 $0.48 ( 4,000) 0.0% 2,000 -50.0% ( 800) -50.0% 1,200 -50.0% $0.24 -50.0% DTL = 5.0; as a result, a 10 percent decrease in sales will result in a 50 percent (5.0 x 10%) decrease in EPS

  47. Using Leverage Analysis for Financial Control • Knowledge of the degree of leverage, whether operating, financial, or both, helps determine how a change in sales will affect income—operating income, net income, or both. • Greater leverage indicates that greater changes in income (either NOI or net income) will result from changes in sales. • The greater variability that is associated with greater leverage suggests greater risk.

  48. Chapter Essentials—The Answers • Why is financial planning and control critical to the survival of a firm? • Forecasts of future operations are needed so that the firm can make arrangements for expected changes in production and future financing needs • What are pro forma financial statements? • The firm projects what it thinks the balance sheet and income statement will look like if future expectations come true

  49. Chapter Essentials—The Answers • What are operating breakeven and financial leverage? • The financial breakeven point is the level of EBIT that a firm must generate so that EPS equals zero • Financial leverage represents the fixed financial costs of the firm • How can a firm use knowledge of leverage in the financial forecasting and control process? • A firm uses the concept of leverage to estimate how fixed costs (operating and financial) affect its bottom line

More Related