Chapter 4_Financial Planning

CHAPTER 4
LONG-TERM FINANCIAL PLANNING
MBA. DINH DO
The Faculty of Finance & Banking
University of Economics & Business, VNU
1
OBJECTIVES
v Understand the concept of financial planning
v Apply theoretical knowledge to:
Ø Prepare a sales forecast
Ø Prepare pro forma financial statements
Ø Determine the external financing needed to fund

potential growth
2
TOPICS
1. The definition of long-term financial planning

2. Financial planning models
o Sales forecasting method
o Pro forma income statement
o External financing needed and pro forma balance sheet
3. Growth and External financing needed
o Internal growth rate
o Sustainable growth rate
3
1. FINANCIAL PLANNING
The definition of Financial planning
¡ A financial plan is a pre-planned summary of the financial needs of a business's future

operations. To prepare a financial plan, a firm need to specify:
o Financial goals (quantitative and qualitative)
o Methods of using resources (internal and external) to achieve those goals
¡ Include:
o Short-term financial plan (within 01 year)
o Long-term financial plan (from 3 to 5 years or more)
4
Definition
¡ Long-term financial planning: Establishing guidelines for change and growth in a company,
helping to avoid future financial distress and bankruptcy
¡ In other words, it’s a mean of thinking critically and systematically about the future and
predicting possible problems.
5
Objectives
¡ Examining interactions: connections between investment proposals and funding options.
¡ Exploiting options: Develop, analyze, and compare different scenarios consistently, assess
their impact on shareholders, and then evaluate options.
¡ Identify possible future incidents and take action.
¡ Ensuring feasibility and internal consistency: linking different goals and objectives; Adjust
goals, set priorities.
6
Objectives
¡ Examining interactions: connections between investment proposals and funding options.
¡ Exploiting options: Develop, analyze, and compare different scenarios consistently, assess
their impact on shareholders, and then evaluate options.
¡ Identify possible future incidents and take action.
¡ Ensuring feasibility and internal consistency: linking different goals and objectives; Adjust
goals, set priorities.
7
The Process
7. Monitor
1.
the
Research
execution
1) Firm’s financial 2.
6. Execute Determine
policies financial the
2) Firm’s goals plan financing
need
5. Present 3. Collect
financial financial
plan data
4.
Prepare
financial
plan
8
Meaning
¡ What are your business goals? Implemented how? What is the roadmap like?
¡ The market and investors have a relative understanding of businesses, helping to build trust and
transparency in operations.
¡ Investors have a basis to evaluate the feasibility of business plans at enterprises, thereby creating
favorable conditions for enterprises to contact capital sources or find suitable partners.
¡ Enterprises and investors take the financial plan as the basis for evaluating business performance,
evaluating the operating capacity of the management team.
¡ Management levels in the enterprise deploy budgeting plans (Budgeting) to manage and control
expenditures in line with the outlined business strategies and orientations.
9
2. FINANCIAL PLANNING MODELS
Simplied financial planning models
Determine the
Sales Determine the level optimal sources
forecast of financing need of financing
Pro forma The

financial demand for
statements new capital
10
Sales forecast and Pro forma Income Statement
¡ Almost all financial plans require an externally supplied sales forecast. The user of the
planning model will supply this value, and most other values will be calculated based on it.
Frequently, the sales forecast will be given as the growth rate in sales
¡ Perfect sales forecasts are not possible, because sales depend on the uncertain future
state of the economy. Firms need know the forecast of the economy and the industry also.
¡ There are normally three state of the economy: Positive/ Normal/ Negative
11
Sales forecast and Pro forma Income Statement
Percentage of Sales Approach

A financial planning method in which accounts are varied depending
on a firm’s predicted sales level.
12
Asset requirement forecast and Pro Forma financial statements

¡ Pro Forma Financial statements
¡ Asset requirement: The plan will describe
o Financial statement templates used to
projected capital spending
summarize various events that are
expected in the future. o The projected balance sheet will contain
changes in total fixed assets (possibly) and
o At a minimum, the model will generate
net working capital. These changes are
reports based on forecasts for key metrics,
effectively the firm’s total capital budget.
such as revenue.
o Proposed capital spending in different
o Using revenue projections, the financial
areas must thus be reconciled with the
planning model generates the pro forma
overall increases contained in the long-
income statement and balance sheet. (The
range plan.
percentage of sales)
13
Asset requirement forecast and Pro Forma financial statements
¡ External Financing Need (EFN - The Plug)
¡ Financial requirement
o After the firm has a sales forecast and an
o The plan will include a section about the estimate of the required spending on assets,
necessary financing arrangements. This part some amount of new financing will often be
of the plan should discuss dividend policy necessary because projected total assets will
and debt policy. exceed projected total liabilities and equity. The
o Sometimes firms will expect to raise cash by balance sheet will no longer balance.
selling new shares of stock or by borrowing: o Need new capital, a financial “plug” variable
• What kinds of securities have to be sold must be selected. The plug is the designated
• What methods of issuance are most source or sources of external financing needed
appropriate to deal with any shortfall (or surplus) in
financing and thereby bring the balance sheet
into balance. 14
EX 4.1: The following is firm A’s financial statement in 2022:

Income Statement Balance Sheet
Sales $1,000 Assets $ 500 Liabilities $ 250
Expenses $ 800 Equity $ 250
Net income $ 200 Total asset $ 500 Liability + Equity $ 500
¡ Assumptions:
o All accounts vary directly with sales and all currrent relationships are optimal à All accounts
fluctuate at a rate equal to the rate of change in sales.
o Sales growth rate in 2023 is forecasted to be 20%à 2023 Forecast:
Sales = $ 1,000 x (1 + 20%) = $ 1,200
TA = TL + E = $ 500 x (1 + 20%) = $ 600 (Increase by $100) 15
EX 4.1: Forecasted financial statements of firm A in 2023:

Sales $1,200 Asset $ 600 Liabilities $ 110
Net income $ 240 Total asset $ 600 Liabilities + Equity $ 600
¡ Assumption 1: Firm A does not pay any dividend, $240 in net income will totally forward to
Retained earnings account à Change in capital forecast in 2023:
o Total asset = 600 ($100 higher than 2022)
o Equity = 250 + 240 = 490
o Debt = Total asset - Equity = 600 – 490 = 110 ($140 less than 2022)
16
EX 4.1: Forecasted financial statements of firm A in 2023:

Sales $1,200 Asset $ 600 Liabilities $ 300
Net income $ 240 Total asset $ 600 Liabilities + Equity $ 600
¡ Assumption 2: Firm A pays $190 in dividend, $50 in net income will forward to Retained earnings
account à Change in capital forecast in 2023:
o Total asset = 600 ($100 higher than 2022)
o Equity = 250 + 50 = 300
o Liabilities = 600 – 300 = 300 ($50 higher than 2022)
17
Conclusion: The relationship between sales growth and financial policy
¡ When sales go up à Total asset will also increase to sustain the growth (new investment in
fixed asset and NWC) à Total capital (Liability + Equity) increase as well.
¡ How Liability & Equity change depend on the financial policy and dividend policy of the firm.
Growth in total assets require new financing. The company can decide to, whether:
o Pay dividend: maintain the capital structure (300/300) or
o Not to pay any dividend: change the capital structure (110/490).
¡ In the example, the company did not need any external financing à Rarely happens.
18
EX 4.2: Firm B’s income statement in 20X1 is as follow:
¡ Assumptions:
Income Statement 20X1
o Sales growth is 25% in 20X2
Sales $ 1000
o Expenses grow at the same rate
Expenses $ 800
as sales
Taxable income $ 200
o Dividend payout ratio is fixed
Tax (20%) $ 40
Net income $ 160 ¡ Rquirement: Base on the sales
forecast, prepare a pro forma for
Dividend paid $ 54
firm B in 20X2
Retained earnings $ 106
19
EX 4.2: Answer

Sales $ 1250
Expenses $ 1000
Tax (20%) $ 50
Net income $ 200
Dividend paid $ 67
20
EX 4.3: Firm B’s balance sheet in 20X1 is as follow:
Total Assets Total Liabilities & Equity
Value Vary with Value Vary with
Sales Sales
Current asset Current liabilities
Cash & cash equivalent $ 160 Yes Account payables $ 300 Yes
Account receivables $ 440 Yes Current debt $ 100 n/a
Inventory $ 600 Yes Total CL $ 400 n/a
Total CA $ 1200 Yes Long-term liabilities $ 800 n/a
Fixed asset Equity
PPE net $ 1800 Perhaps Common stock + capital surplus $ 800 n/a
Retained earnings $ 1000 n/a
Total Equity $ 1800
Total asset $ 3000 Total Liabilities & Equity $ 3000
21
Ex 4.3: The balance sheet of Company B is as follow:

¡ Some items change directly to sales, expressed as a percentage of revenue, assuming the
ratio stays the same next year. Items in assets, Note: In the case of fixed assets, the
enterprise will consider calculating the total value of newly purchased fixed assets based on
current operating capacity => From there, there will be an exact increase in fixed assets
Retained earnings often vary with sales, but how much depends on expected net income
and dividends. (Enterprise has a certain dividend payout ratio) Some other items do not
change with revenue, Symbol: “n/a”: Other liabilities and equity do not change automatically
with revenue but depend on administrative action.
22
EX4.3: Result

Value Change Value Change
Cash & cash equivalent $ 200 $ 40 Account payables $ 375 $ 75
Situation 1: Fixed asset$of

Account receivables 550
Firm $B110is almost at its full capacity and$ 100
Current debt
the Firm$ 0
Inventory $ 750 $ 150 Total CL $ 475 $ 75
expect to invest in a$new
Total CA 1500
production line to support the forecast
$ 300 Long-term liabilities $ 800
sales $ 0
growth.
Fixed asset This new production line would Equity cost the firm $450 (25% increase).
$ 1933 $ 133
PPE net $ 2250 $ 450 Common stock + capital surplus $ 800 $0
Retained earnings $ 1133 $ 133
Total Equity $ 1933 $ 133
Total asset $ 3750 $ 750 Total Liabilities & Equity $ 3208 $ 208
EX4.3: Result à External Financing Need: $ 750 - $ 208 = $ 542

Account receivables $ 550 $ 110 Current debt $ 100 $0
Total CA $ 1500 $ 300 Long-term liabilities $ 800 $0
Fixed asset Equity $ 1933 $ 133
EX4.3: Result

Situation
Inventory II: Fixed asset $of750Firm $B150
is only
Totalat
CL70% of its capacity and still able
$ 475 $ 75
Total CA to support
$ 1500the forecast levelliabilities
$ 300 Long-term of sales growth. $ 800 $0
EX4.3: Result à External Financing Need: $ 300 - $ 208 = $ 92

Total CA $ 1500 $ 300 Long-term liabilities $ 800 $0
PPE net $1800 $0 Common stock + capital surplus $ 800 $0
NOTES
¡ The assumption that assets are a fixed percentage of sales is not appropriate. The
assumption only occurs if any increase in revenue leads to an increase in fixed assets => It
means capacity is being used up to 100%.
¡ In fact, many companies are not operating its fixed asset at full capacity.
¡ For example: Company X is operating at 70% capacity, revenue reaches $1,000.
o Revenue at full capacity = $1,000/0.7 = $1,429.
o Meaning: Revenue can grow up to $1,429 (42.9%) without increasing fixed assets.
27
3. GROWTH & EXTERNAL FINANCING NEEDED
¡ All other things staying the same, the higher the rate of growth in sales or assets, the
greater will be the need for external financing
¡ 2 approaches:
o Take growth rate as given, then determined the amount of external financing needed to support
that growth
o Take firm’ financial policy as given, then examine the relationship between that financial policy
and the firm’s ability to finance new investments and thereby grow.
28
EX 4.4: Firm C’s Income Statement and Balance Sheet in 20X1 are as follow:

Sales $ 500 Balance Sheet ending 20X1
Expenses $ 400 Asset Liabilities & Equity
Taxable income $ 100 Current asset $ 200 Liabilities $ 250
Tax (34%) $ 34 Fixed asset, net $ 300 Equity $ 250
Net income $ 66 Total asset $ 500 Liabilities & $ 500
Dividend paid $ 22 Equity
29
EX 4.4:
¡ Assumptions:
o Firm C uses no short-term debt: Only long-term debt
o The firm does not want to issue new shares à Demand for long-term debt (As the
source for EFN)
o Financial policy is given: Fixed Dividend payout ratio

What would be the
o Debt-Equity ratio = 250$/250$ = 1
firm’s EFN in 20X2?
o The fixed asset is currently operated at full capacity
o The target sales in 20X2 is $600 à Growth rate = 20%

30
EX 4.4: Result

Balance Sheet – Ending 20X2
Sales $ 600
Asset Liabilities & Equity
Expenses $ 480
Current asset $ 240 Liabilities $ 250
Fixed asset, $ 360 Equity $ 302.8
Tax (34%) $ 40.8
net
Net income $ 79.2
Total asset $ 600 Liabilities & $ 552.8
Dividend paid $ 26.4 Equity
Retained earnings $ 52.8
à EFN: $ 600 - $ 552.8 = $ 47.2

31
EX 4.4:
§ The firm does not want to issue new shares à Firm C would need to use long-term debt in
order to finance the EFN
§ New long-term debt = $42.7 à Total Liabilities = $250 + $42.7 = $29 7.2
Debt-Equity ratio = Total debt/ Equity = 297.2/302/8
= 0.98 ~ 1 (If compare to 20X1)
32
Growth and External Financing Needed

¡ We have the following table for Firm C in the previous example:
Forecast Sales Additional Asset Additional EFN Forecast Debt-

Growth Requirement Retained Earnings Equity Ratio
0% $0 $ 44,0 - $ 44,0 0,70
5% $ 25 $ 46,2 - $ 21,2 0,77
10% $ 50 $ 48,4 $ 1,6 0,84
15% $ 75 $ 50,6 $ 24,4 0,91
20% $ 100 $ 52,8 $ 47,2 0,98
25% $ 125 $ 55,0 $ 70,0 1,05
¡ Assumptions:
o Assets and Retained earnings vary according to change in sales
o EFN will be financed through debt
o Surplus fund will be used to pay off debt 33
Growth and External Financing Needed se

t
A s
125 in ent
a se em
Asset needs and retained earnings ($)

¡ At low growth rate (g): surplus fund, decreasing cre uir
In req
Debt-Equity; g > 10%: deficit fund, EFN > 0. 100
¡ g > 20% → Debt-Equity ratio >1 75 EFN > 0
¡ The need for new assets grows at a much faster

50
rate than the addition to retained earnings, so R Es
44 Additional
EFN < 0
the internal financing provided by the addition to 25
retained earnings rapidly disappears.
There exists a direct link between growth and 5 10 15 20 25

external financing Forecast Sales Growth(%) 34
Internal Growth Rate
§ The maximum growth rate that can be achieved with no external financing of any kind.
§ Formula:
§ Where:
o ROA: Return on asset
o b: plowback or retention ratio (Retained earnings/Net income)
35
Internal Growth Rate
§ EX 4.5: Firm A has the following information:

o Net income = $66
o Total asset = $500
o Retained earnings = $44
Calculate the internal growth rate for Firm A?
36
Sustainable Growth Rate
§ The maximum growth rate a firm can achieve without external equity financing while
maintaining a constant debt–equity ratio.
§ Formula:
§ Where:
o ROE: Return on equity
o b: plowback or retention ratio (Retained earnings/Net income)
37
¡ Companies normally try to avoid raising new equity capital, because:
?
38
¡ Companies normally try to avoid raising new equity capital, because:
o Higher costs
o The current shareholders do not want to share their profit/earnings with others
o Try to maintain the optimal level of capital structure
39
§ EX 4.6: Firm A has the following information:

o Net income = $66
o Total asset = $500
o Equity = $250
o Retained earnings = $44
Calculate the sustainable growth rate for Firm A?
40
Determinants of Growth
A firm’s ability to sustain growth depends explicitly on the following four factors:
1. Profit margin: An increase in profit margin will increase the firm’s ability to generate funds internally and
thereby increase its sustainable growth.
2. Dividend policy: A decrease in the percentage of net income paid out as dividends will increase the
retention ratio. This increases internally generated equity and thus increases sustainable growth.
3. Financial policy: An increase in the debt–equity ratio increases the firm’s financial leverage. Because
this makes additional debt financing available, it increases the sustainable growth rate.
4. Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for
each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby
increases the sustainable growth rate. Notice that increasing total asset turnover is the same thing as
decreasing capital intensity.
41
§ Given values for all four of these, there is only one growth rate that can be achieved. This is an
important point, so it bears restating:
42
Notes regarding the calculation method for sustainable growth rate:

Example: A company has the following information
Net income = $20 § Using beginning data
Plowback ratio (b) = 0.6
Sustainable Growth rate
Beginning Total asset = $100
Beginning Equity = $80 § Using ending data
Ending Equity = Beginning Equity + Additional retained earnings
Debt-Equity ratio = 0.25
= $80 + $20 x 0.6 = $92
Sustainable Growth rate
43
Excercise 1
¡ Assume the following company has a sustainable growth rate of 21.36%. Prepare the company's pro
forma income statement and balance sheet. Given the company's income statement and balance
sheet for the previous year are as follows. Dividend payout ration is fixed.
Income Statement
Sales $ 500
Balance Sheet
Expenses $ 400
Asset Liabilities & Equity
Current asset $ 200 Liabilities $ 250
Tax (34%) $ 34
Fixed asset $ 300 Equity $ 250
Net income $ 66
Total asset $ 500 Total Liabilities $ 500
Dividend $ 22 & Equity
44
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CHAPTER 4

LONG-TERM FINANCIAL PLANNING

University of Economics & Business, VNU

v Understand the concept of financial planning

v Apply theoretical knowledge to:

Ø Prepare a sales forecast

Ø Prepare pro forma financial statements

Ø Determine the external financing needed to fund

1. The definition of long-term financial planning

The definition of Financial planning

¡ A financial plan is a pre-planned summary of the financial needs of a business's future

o Financial goals (quantitative and qualitative)

o Methods of using resources (internal and external) to achieve those goals

o Short-term financial plan (within 01 year)

o Long-term financial plan (from 3 to 5 years or more)

¡ Examining interactions: connections between investment proposals and funding options.

¡ Identify possible future incidents and take action.

¡ Examining interactions: connections between investment proposals and funding options.

¡ Identify possible future incidents and take action.

Simplied financial planning models

Pro forma The

Sales forecast and Pro forma Income Statement

Sales forecast and Pro forma Income Statement

Percentage of Sales Approach

Asset requirement forecast and Pro Forma financial statements

EX 4.1: The following is firm A’s financial statement in 2022:

EX 4.1: Forecasted financial statements of firm A in 2023:

EX 4.1: Forecasted financial statements of firm A in 2023:

Conclusion: The relationship between sales growth and financial policy

EX 4.2: Firm B’s income statement in 20X1 is as follow:

Income Statement 20X2

Ex 4.3: The balance sheet of Company B is as follow:

Total Assets Total Liabilities & Equity

Situation 1: Fixed asset$of

EX4.3: Result à External Financing Need: $ 750 - $ 208 = $ 542

Total Assets Total Liabilities & Equity

Total Assets Total Liabilities & Equity

EX4.3: Result à External Financing Need: $ 300 - $ 208 = $ 92

Total Assets Total Liabilities & Equity

Income Statement 20X1

o Firm C uses no short-term debt: Only long-term debt

o Financial policy is given: Fixed Dividend payout ratio

o The target sales in 20X2 is $600 à Growth rate = 20%

Income Statement 20X2

à EFN: $ 600 - $ 552.8 = $ 47.2

Debt-Equity ratio = Total debt/ Equity = 297.2/302/8

= 0.98 ~ 1 (If compare to 20X1)

Growth and External Financing Needed

Forecast Sales Additional Asset Additional EFN Forecast Debt-

Growth and External Financing Needed se

Asset needs and retained earnings ($)

¡ g > 20% → Debt-Equity ratio >1 75 EFN > 0

¡ The need for new assets grows at a much faster

There exists a direct link between growth and 5 10 15 20 25

Internal Growth Rate

Internal Growth Rate

§ EX 4.5: Firm A has the following information:

Sustainable Growth Rate

Sustainable Growth Rate

¡ Companies normally try to avoid raising new equity capital, because: