FINANCIAL PLANNING AND CONTROL

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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.

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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)

3
FINANCIAL PLANNINGFORECASTING

• Sales Forecast
• most important part of financial planning
• generally based on the trend in sales in recent
  periods
• inaccurate sales forecasts can have serious
  repercussionsif 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

4
Trend in Sales for AgriCorp
Average growth 12

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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

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Projected (Pro Forma) Financial Statements

• To construct a pro forma balance sheet and a pro
  forma income statement
• Step 1 Forecast next periods income statement
• Step 2 Forecast next periods balance sheet
• Step 3 Raising the additional funds needed
• Step 4 Financing feedbacks

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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

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Step 1 Construct AgriCorps 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 years dividend payout will be maintained at
  60 percent of net income.

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AgriCorps Pro Forma Income Statement for Next
Year ( millions)

• Last Years
• 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 _at_ 40 ( 14.00)
• Net Income 21.00
• Dividends (60 of NI) 12.60
• Addition to RE 8.40

Next Years x (1 g) Initial
Forecast x 1.12 560.00 x
1.12 (448.00) x 1.12 ( 61.60) 50.40
( 10.00) 40.40 (
16.16) 24.24 14.54 9.70
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Step 2 Construct AgriCorps 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.

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AgriCorps Pro Forma Balance Sheet for Next
Year( millions)

• Last Years
• 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

Next Years x (1 g) Initial Forecast x
1.12 176.60 x 1.12 134.40 308.00
x 1.12 33.60
13.00 46.60
100.00 146.60
44.00
97.70 141.70 288.30
9.70 ? RE
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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

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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

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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 investthat 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 feedbacksthat is, the effects on the
  financial statements of actions taken to finance
  forecasted increases in assetsmust be considered
  to determine the exact amount of AFN.

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AgriCorps Pro Forma Income Statement for Next
Year ( millions)2nd Pass

• Last Years Next Years
• Results x (1g) Initial Forecast
• EBIT NOI 45.00 x 1.12 50.40
• Interest (10.00) (10.00)
• Taxable income 35.00 40.40
• Taxes _at_ 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

2nd Pass Forecast
50.40 (10.60)
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

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AgriCorps Pro Forma Balance Sheet for Next Year
( millions)2nd Pass

• Last Years Next Years
• Results x (1g) 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 100.00 100.00
• 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

2nd Pass Forecast
308.00 33.60 15.96
2.96
49.56 103.94
3.94
153.50 56.80
12.80
9.70
97.55
- 0.15
154.35 307.85
AFN1 2.96 3.94 12.80 19.70 AFN2 308.00
307.85 0.15
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AgriCorps Pro Forma Balance Sheet for Next Year
( millions)Final Pass

• Last Years Next Years
• Results x (1g) 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 100.00 100.00
• 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

Final Forecast
308.00 33.60 15.98
49.58 103.97
2.98
3.97
153.55 56.90
12.90
9.70
97.55
-0.15
154.45 308.00
Total AFN 2.98 3.97 12.90 19.85 gt 19.70
AFN1
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Other Considerations in Forecasting

• Excess capacityIf 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

• ExampleIf 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.
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Other Considerations in Forecasting

• Excess capacityIf the firm has excess capacity,
  it will not have to increase plant and equipment
  at the same growth rate as sales.

• Economies of scaleIf economies of scale exist,
  the variable cost ratio might change with changes
  in production activity.
• Lumpy assetsMany 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

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Financial ControlBudgeting 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 analysisevaluation of the level of
  operations to determine the ability of the firm
  to generate profits
• Leverage analysisexamination as to how well the
  firm can cover its fixed costs, both operating
  and financial gives an indication of risk

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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

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Operating Breakeven AnalysisExample

• 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

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Operating Breakeven AnalysisGraph
Operating profit
Total sales
Total operating costs
48,000
Fixed operating costs 12,000
Operating loss

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Operating Breakeven AnalysisComputation
6,000 x 8
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Operating Breakeven AnalysisUses

• 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

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Operating Leverage Analysis

• In business, leverage refers to the existence of
  fixed costs.
• The presence of leverage in general 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.

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Operating Leverage

• DOL is computed as follows

Generally, a firm with a high DOL is considered
to have high risk associated with its operations

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Current Income Statement for Worldwide Widgets

• Sales in units 10,000
• Sales _at_ 8 per unit 80,000
• Variable costs _at_ 6 per unit (60,000)
• Gross Profit 20,000
• Fixed operating costs (12,000)
• NOI EBIT 8,000

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Operating Leverage

• Does Worldwide Widgets have operating leverage?
• Yes, because the firm has fixed operating costs
  equal to 12,000.
• Worldwides 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.
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Effect of DOL for Worldwide Widgets

• Current
• Forecast
• Sales (8/unit)
• Variable costs (6/unit)
• Gross Profit
• Fixed operating costs
• NOI EBIT

If Sales are Percent 10 Lower Deviation
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
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Operating Leverage and Operating Breakeven

• Generally, a higher degree of operating leverage
  (DOL) implies that greater risk is associated
  with the firms 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.

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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.

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Financial Breakeven AnalysisExample

• Worldwide Widgets, Inc. is financed with the
  following sources of long-term funds
• Bonds _at_ 8 interest 50,000
• Preferred stock 0

Common stock (5,000 shares outstanding)
50,000
Total capital 100,000
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Financial Breakeven AnalysisGraph
Financial breakeven point
Positive EPS
Negative EPS

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Financial Breakeven AnalysisComputation

• The financial breakeven point is computed as
  follows

• If Worldwide Widgets marginal tax rate is 40
  percent, its financial breakeven point is

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Financial Breakeven AnalysisUses

• Financial breakeven analysis gives an indication
  as to how the firms mix of debt and preferred
  stock (fixed financing) affects EPS (net income).

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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.

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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.

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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
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Financial Leverage

• Does Worldwide Widgets have financial leverage?
• Yes, because the firm has a fixed financing
  costthat is, interestequal to 4,000.
• Worldwides 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.
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Effect of DFL for Worldwide Widgets

• Current
• Forecast
• EBIT
• Interest
• Taxable income (EBT)
• Taxes (40)
• Net income EAC
• EPS EAC/5,000

If EBIT is Percent 25 Lower Deviation
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

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Financial Leverage and Financial Breakeven

• Generally, a higher degree of financial leverage
  (DFL) implies greater risk is associated with the
  firms 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.

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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
  riskboth operating risk and financial risk.

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Total Leverage

• Worldwides 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.
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Effect of DTL for Worldwide Widgets

• 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

If Sales are Percent 10 Lower Deviation 72,000
-10.0 (54,000) -10.0 18,000 -10.0 (12,00
0) 0.0 6,000 -25.0
( 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

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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
  incomeoperating 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.