The Financial Planning

Process
Financial Planning
 Financial planning is an important aspect of the firm’s
operations because it provides road maps for guiding,
coordinating, and controlling the firm’s actions to
achieve its objectives.
 Two key aspects of the financial planning process are
cash planning and profit planning.
 Cash planning involves preparation of the firm’s cash
budget.
 Profit planning involves preparation of pro forma
statements.
 Both the cash budget and the pro forma statements are
useful for internal financial planning; they also are
routinely required by existing and prospective lenders.
Financial Planning
 The financial planning process begins with
long-term, or strategic, financial plans.
 These in turn guide the formulation of short-

term, or operating, plans and budgets.

 Generally, the short-term plans and budgets

implement the firm’s long term strategic

objectives.
Long-Term (Strategic) Financial
Plans
 Long-term (strategic) financial plans lay out a
company’s planned financial actions and the
anticipated impact of those actions over
periods ranging from 2 to 10 years.
 Five-year strategic plans, which are revised as
significant new information becomes available,
are common.
 Generally, firms that are subject to high
degrees of operating uncertainty, relatively
short production cycles, or both, tend to use
shorter planning horizons.
Long-Term (Strategic) Financial
Plans
 Long-term financial plans are part of an integrated
strategy that, along with production and marketing
plans, guides the firm toward strategic goals.
 Those long-term plans consider proposed outlays for
fixed assets, research and development activities,
marketing and product development actions, capital
structure, and major sources of financing.
 Also included would be termination of existing projects,
product lines, or lines of business; repayment or
retirement of outstanding debts; and any planned
acquisitions.
 Such plans tend to be supported by a series of annual
budgets and profit plans.
Short-Term (Operating) Financial
Plans
 Short-term (operating) financial plans specify
short-term financial actions and the
anticipated impact of those actions.
 These plans most often cover a 1- to 2-year

period.
 Key inputs include the sales forecast and

various forms of operating and financial data.

 Key outputs include a number of operating

budgets, the cash budget, and pro forma

financial statements.
Short-Term (Operating) Financial
Plans
 Short-term financial planning begins with the sales
forecast.
 From it, production plans are developed that take into
account lead (preparation) times and include estimates of
the required raw materials.
 Using the production plans, the firm can estimate direct
labor requirements, factory overhead outlays, and operating
expenses.
 Once these estimates have been made, the firm’s pro forma
income statement and cash budget can be prepared.
 With the basic inputs (pro forma income statement, cash
budget, fixed asset outlay plan, long-term financing plan,
and current-period balance sheet), the pro forma balance
sheet can finally be developed.
Cash Planning: Cash Budgets
 The cash budget, or cash forecast, is a statement of the firm’s
planned inflows and outflows of cash.
 It is used by the firm to estimate its short-term cash
requirements, with particular attention to planning for surplus
cash and for cash shortages.
 Typically, the cash budget is designed to cover a 1-year period,
divided into smaller time intervals.
 The number and type of intervals depend on the nature of the
business. The more seasonal and uncertain a firm’s cash flows,
the greater the number of intervals.
 Because many firms are confronted with a seasonal cash flow
pattern, the cash budget is quite often presented on a monthly
basis.
 Firms with stable patterns of cash flow may use quarterly or
annual time intervals.
Cash Planning: Cash Budgets
The Sales Forecast
 The key input to the short-term financial planning process is the

firm’s sales forecast.

 This prediction of the firm’s sales over a given period is ordinarily

prepared by the marketing department.

 On the basis of the sales forecast, the financial manager estimates

the monthly cash flows that will result from projected sales receipts
and from outlays related to production, inventory, and sales.
 The manager also determines the level of fixed assets required and

the amount of financing, if any, needed to support the forecast level

of sales and production.
 In practice, obtaining good data is the most difficult aspect of

forecasting.
 The sales forecast may be based on an analysis of external data,

internal data, or a combination of the two

Cash Planning: Cash Budgets
The Sales Forecast
 An external forecast is based

◦ on the relationships observed between the firm’s sales

and certain key external economic indicators such as
the gross domestic product (GDP), new housing starts,
consumer confidence, and disposable personal income.
◦ Forecasts containing these indicators are readily
available.
◦ Because the firm’s sales are often closely related to
some aspect of overall national economic activity, a
forecast of economic activity should provide insight
into future sales.
Cash Planning: Cash Budgets
 The Sales Forecast
 Internal forecasts are based on
◦ a buildup, or consensus, of sales forecasts through the
firm’s own sales channels.
◦ Typically, the firm’s salespeople in the field are asked to
estimate how many units of each type of product they
expect to sell in the coming year.
◦ These forecasts are collected and totaled by the sales
manager, who may adjust the figures using knowledge
of specific markets or of the salesperson’s forecasting
ability.
◦ Finally, adjustments may be made for additional internal
factors, such as production capabilities.
Cash Planning: Cash Budgets
 Firms generally use a combination of external
and internal forecast data to make the final
sales forecast.
 The internal data provide insight into sales

expectations, and the external data provide a

means of adjusting these expectations to
take into account general economic factors.
 The nature of the firm’s product also often

affects the mix and types of forecasting

methods used.
Preparing the Cash Budget
Preparing the Cash Budget
Cash Receipts
 Cash receipts include all of a firm’s inflows of cash in a given financial

period.
 The most common components of cash receipts are cash sales,

collections of accounts receivable, and other cash receipts.

EXAMPLE
 Coulson Industries, a defense contractor, is developing a cash budget

for October, November, and December. Coulson’s sales in August and

September were $100,000 and $200,000, respectively. Sales of
$400,000, $300,000, and $200,000 have been forecast for October,
November, and December, respectively. Historically, 20% of the firm’s
sales have been for cash, 50% have generated accounts receivable
collected after 1 month, and the remaining 30% have generated
accounts receivable collected after 2 months. Bad-debt expenses
(uncollectible accounts) have been negligible.5 In December, the firm
will receive a $30,000 dividend from stock in a subsidiary.
Preparing the Cash Budget
Preparing the Cash Budget
Cash Disbursements
 Cash disbursements include all outlays of cash by the firm during a

given financial period.

 The most common cash disbursements are

◦ Cash purchases
◦ Fixed-asset outlays
◦ Payments of accounts payable
◦ Interest payments Rent (and lease) payments
◦ Cash dividend payments
◦ Wages and salaries
◦ Principal payments (loans)
◦ Tax payments
◦ Repurchases or retirements of stock
 It is important to recognize that depreciation and other noncash charges
are NOT included in the cash budget, because they merely represent a
scheduled write-off of an earlier cash outflow. The impact of
depreciation is reflected in the reduced cash outflow for tax payments.
Preparing the Cash Budget
EXAMPLE
 Coulson Industries has gathered the following data needed for the preparation of a cash
disbursements schedule for October, November, and December.
◦ Purchases The firm’s purchases represent 70% of sales. Of this amount, 10% is
paid in cash, 70% is paid in the month immediately following the month of
purchase, and the remaining 20% is paid 2 months following the month of
purchase.
◦ Rent payments Rent of $5,000 will be paid each month.
◦ Wages and salaries Fixed salary cost for the year is $96,000, or $8,000 per
month.
◦ In addition, wages are estimated as 10% of monthly sales.
◦ Tax payments Taxes of $25,000 must be paid in December.
◦ Fixed-asset outlays
◦ New machinery costing $130,000 will be purchased and paid for in November.
◦ Interest payments An interest payment of $10,000 is due in December.
◦ Cash dividend payments Cash dividends of $20,000 will be paid in October.
◦ Principal payments (loans) A $20,000 principal payment is due in December.
◦ Repurchases or retirements of stock No repurchase or retirement of stock is
expected between October and December
Cash Planning: Cash Budgets
Preparing the Cash Budget
Net Cash Flow, Ending Cash, Financing, and Excess Cash
 We have inputs for the first two entries, and we now continue

calculating the firm’s cash needs.

 The firm’s net cash flow is found by subtracting the cash

disbursements from cash receipts in each period. Then we add

beginning cash to the firm’s net cash flow to determine the ending
cash for each period.
 Finally, we subtract the desired minimum cash balance from ending

cash to find the required total financing or the excess cash balance.
 If the ending cash is less than the minimum cash balance, financing

is required. Such financing is typically viewed as short-term and is

therefore represented by notes payable.
 If the ending cash is greater than the minimum cash balance,

excess cash exists. Any excess cash is assumed to be invested in a

liquid, short-term, interest-paying vehicle—that is, in marketable
securities
Preparing the Cash Budget
Preparing the Cash Budget
Evaluating the Cash Budget
The cash budget indicates whether a cash shortage or surplus is
expected in each of the months covered by the forecast.
Each month’s figure is based on the internally imposed
requirement of a minimum cash balance and represents the total
balance at the end of the month. At the end of each of the 3
months, Coulson expects the following balances in cash,
marketable securities, and notes payable:
Preparing the Cash Budget
 Note that the firm is assumed first to liquidate
its marketable securities to meet deficits and
then to borrow with notes payable if additional
financing is needed.
 As a result, it will not have marketable securities
and notes payable on its books at the same time.
 Because it may be necessary to borrow up to
$76,000 for the 3-month period, the financial
manager should be certain that some
arrangement is made to ensure the availability of
these funds.
Preparing the Cash Budget
Coping with Uncertainty in the Cash Budget

 Aside from careful estimation of cash budget inputs, there are

two ways of coping with the uncertainty of the cash budget.
 One is to prepare several cash budgets—based on pessimistic,
most likely, and optimistic forecasts. From this range of cash
flows, the financial manager can determine the amount of
financing necessary to cover the most adverse situation.
 The use of several cash budgets, based on differing
assumptions, also should give the financial manager a sense of
the riskiness of various alternatives.
 This sensitivity analysis, or “what if” approach, is often used to
analyze cash flows under a variety of circumstances.
Preparing the Cash Budget
EXAMPLE
 Table 3.11 presents the summary of Coulson Industries’ cash budget

prepared for each month of concern using pessimistic, most likely, and
optimistic estimates of total cash receipts and disbursements.
 The most likely estimate is based on the expected outcomes presented

earlier.
 During October, Coulson will, at worst, need a maximum of $15,000 of

financing and, at best, will have a $62,000 excess cash balance.

 During November, its financing requirement will be between $0 and

$185,000, or it could experience an excess cash balance of $5,000.

 The December projections show maximum borrowing of $190,000 with a

possible excess cash balance of $107,000.

 By considering the extreme values in the pessimistic and optimistic

outcomes, Coulson Industries should be better able to plan its cash

requirements.
 For the 3-month period, the peak borrowing requirement under the worst

circumstances would be $190,000, which happens to be considerably greater

than the most likely estimate of $76,000 for this period.
Preparing the Cash Budget
Profit Planning: Pro Forma
Statements
 Profit planning relies on accrual concepts to project
the firm’s profit and overall financial position.
 Shareholders, creditors, and the firm’s management
pay close attention to the pro forma statements,
which are projected, or forecast, income statements
and balance sheets.
 Various approaches for estimating the pro forma
statements are based on the belief that the financial
relationships reflected in the firm’s past financial
statements will not change in the coming period.
 The commonly used simplified approaches are
presented in subsequent discussions
Profit Planning: Pro Forma
Statements
 Two inputs are required for preparing pro forma
statements:
◦ (1) financial statements for the preceding year and
◦ (2) the sales forecast for the coming year.
 A variety of assumptions must also be made. The
company that we will use to illustrate the
simplified approaches to pro forma preparation is
Vectra Manufacturing, which manufactures and
sells one product.
 It has two basic product models—X and Y—which
are produced by the same process but require
different amounts of raw material and labor.
Profit Planning: Pro Forma
Statements
Preceding Year’s Financial Statements

 The income statement for the firm’s 2006

operations is given in Table 3.12.
 It indicates that Vectra had sales of $100,000, total
cost of goods sold of $80,000, net profits before
taxes of $9,000, and net profits after taxes of
$7,650. The firm paid $4,000 in cash dividends,
leaving $3,650 to be transferred to retained
earnings.
 The firm’s balance sheet for 2006 is given in Table
3.13.
Profit Planning: Pro Forma
Statements
 Preceding year income statement
Profit Planning: Pro Forma
Statements
Profit Planning: Pro Forma
Statements
Sales Forecast
 Just as for the cash budget, the key input for

pro forma statements is the sales forecast.

 Vectra Manufacturing’s sales forecast for the

coming year, based on both external and

internal data, is presented in Table 3.14.
 The unit sale prices of the products reflect an

increase from $20 to $25 for model X and from

$40 to $50 for model Y.
 These increases are necessary to cover

anticipated increases in costs.

Profit Planning: Pro Forma
Statements
Preparing the Pro Forma Income
Statement
 A simple method for developing a pro forma
income statement is the percent-ofsales
method.
 It forecasts sales and then expresses the

various income statement items as

percentages of projected sales.
 The percentages used are likely to be the

percentages of sales for those items in the

previous year.
Preparing the Pro Forma Income
Statement
 The technique that is used to prepare the pro forma
income statement in Table 3.15 assumes that all the firm’s
costs and expenses are variable.
 That is, we assumed that for a given percentage increase in
sales, the same percentage increase in cost of goods sold,
operating expenses, and interest expense would result.
 For example, as Vectra’s sales increased by 35 percent
(from $100,000 in 200 6to $135,000 projected for 2007),
we assumed that its costs of goods sold also increased by
35 percent (from $80,000 in 2006 to $108,000 in 2007).
 On the basis of this assumption, the firm’s net profits
before taxes also increased by 35 percent (from $9,000 in
2006 to $12,150 projected for 2007).
Preparing the Pro Forma Income
Statement
Preparing the Pro Forma Balance
Sheet
 A number of simplified approaches are
available for preparing the pro forma balance
sheet.
 Probably the best and most popular is the

judgmental approach, under which the values

of certain balance sheet accounts are
estimated and the firm’s external financing is
used as a balancing, or “plug,” figure.
Preparing the Pro Forma Balance
Sheet
 To apply the judgmental approach to prepare Vectra
Manufacturing’s 2007 pro forma balance sheet, a number of
assumptions must be made about levels of various balance sheet
accounts:
◦ A minimum cash balance of $6,000 is desired.
◦ Marketable securities are assumed to remain unchanged from their current
level of $4,000.
◦ Accounts receivable on average represent 45 days of sales. Because Vectra’s
annual sales are projected to be $135,000, accounts receivable should
average $16,875 (1/8 $135,000). (Forty-five days expressed fractionally is
one eighth of a year: 45/360 1/8.)
◦ The ending inventory should remain at a level of about $16,000, of which 25
percent (approximately $4,000) should be raw materials and the remaining
75 percent (approximately $12,000) should consist of finished goods.
◦ A new machine costing $20,000 will be purchased. Total depreciation for the
year is $8,000. Adding the $20,000 acquisition to the existing net fixed
assets of $51,000 and subtracting the depreciation of $8,000 yield net fixed
assets of $63,000.
Preparing the Pro Forma Balance
Sheet
◦ Purchases are expected to represent approximately 30% of annual sales, which in
this case is approximately $40,500 (0.30* $135,000). The firm estimates that it
can take 72 days on average to satisfy its accounts payable. Thus accounts
payable should equal one-fifth (72 days360 days) of the firm’s purchases, or
$8,100 (1/5* $40,500).
◦ Taxes payable are expected to equal one-fourth of the current year’s tax liability,
which equals $455 (one-fourth of the tax liability of $1,823 shown in the pro
forma income statement in Table 3.15).
◦ Notes payable are assumed to remain unchanged from their current level of
$8,300.
◦ No change in other current liabilities is expected. They remain at the level of the
previous year: $3,400.
◦ The firm’s long-term debt and its common stock are expected to remain
unchanged at $18,000 and $30,000, respectively; no issues, retirements, or
repurchases of bonds or stocks are planned.
◦ Retained earnings will increase from the beginning level of $23,000 (from the
balance sheet dated December 31, 2003, in Table 3.13) to $29,327. The increase
of $6,327 represents the amount of retained earnings calculated in the year-end
2004 pro forma income statement in Table 3.15.
Preparing the Pro Forma Balance
Sheet
 A 2007 pro forma balance sheet for Vectra Manufacturing based on these assumptions
is presented in Table 3.16.
 A “plug” figure—called the external financing required—of $8,293 is needed to bring
the statement into balance.
 This means that the firm will have to obtain about $8,293 of additional external
financing to support the increased sales level of $135,000 for 2007.
 A positive value for “external financing required,” like that shown in Table 3.16, means
that to support the forecast level of operation, the firm must raise funds externally
using debt and/or equity financing or by reducing dividends.
 Once the form of financing is determined, the pro forma balance sheet is modified to
replace “external financing required” with the planned increases in the debt and/or
equity accounts.
 A negative value for “external financing required” indicates that the firm’s forecast
financing is in excess of its needs.
 In this case, funds are available for use in repaying debt, repurchasing stock, or
increasing dividends.
 Once the specific actions are determined, “external financing required” is replaced in
the pro forma balance sheet with the planned reductions in the debt and/or equity
accounts.
 Obviously, besides being used to prepare the pro forma balance sheet, the judgmental
approach is also frequently used specifically to estimate the firm’s financing
requirements
Preparing the Pro Forma Balance
Sheet
Evaluation of Pro Forma Statements
 It is difficult to forecast the many variables involved in preparing pro
forma statements.
 As a result, investors, lenders, and managers frequently use the
techniques presented in this chapter to make rough estimates of
pro forma financial statements.
 However, it is important to recognize the basic weaknesses of these
simplified approaches.
 The weaknesses lie in two assumptions: (1) that the firm’s past
financial condition is an accurate indicator of its future, and (2) that
certain variables (such as cash, accounts receivable, and inventories)
can be forced to take on certain “desired” values.
 These assumptions cannot be justified solely on the basis of their
ability to simplify the calculations involved.
 However, despite their weaknesses, the simplified approaches to pro
forma statement preparation are likely to remain popular because of
their relative simplicity.
Evaluation of Pro Forma Statements
 However pro forma statements are prepared, analysts must understand
how to use them to make financial decisions.
 Both financial managers and lenders can use pro forma statements to
analyze the firm’s inflows and outflows of cash, as well as its liquidity,
activity, debt, profitability, and market value.
 Various ratios can be calculated from the pro forma income statement and
balance sheet to evaluate performance.
 Cash inflows and outflows can be evaluated by preparing a pro forma
statement of cash flows.
 After analyzing the pro forma statements, the financial manager can take
steps to adjust planned operations to achieve shorterm financial goals.
 For example, if projected profits on the pro forma income statement are
too low, a variety of pricing and/or cost-cutting actions might be initiated.
 If the projected level of accounts receivable on the pro forma balance sheet
is too high, changes in credit or collection policy may be called for.
 Pro forma statements are therefore of great importance in solidifying the
firm’s financial plans for the coming year.