Chapter 12

Financial Planning and Control

© 2005 Thomson/South-Western

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Financial Planning and Control

Financial Planning:The projection of sales, income, and assets

based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projections

Financial ControlThe phase in which financial plans are

implemented, control deals with the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes.

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Financial Planning: The Sales Forecast

A forecast of a firm’s unit and dollar sales for some future period, generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, etc.

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Projected (Pro Forma) Financial Statements

A method of forecasting financial requirements based on forecasted financial statements

AFN = additional funds needed to support the level of forecasted operations

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Projected Financial Statements

Determine how much money the firm will need in a given period.

Determine how much money the firm will generate internally during the same period.

Subtract the funds generated internally from the funds required to determine the external financial requirements.

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Step 1. Forecast the 2010 Income Statement

Assumptions:Unilate operated at full capacity in 2009.Sales are expected to grow by 10%.Variable cost ratio is 82% (same as 2009).2010 dividend per share is the same as

2009.AFN is raised by 60% short-term debt with

10% cost and 40% long-term debts with 12% cost.

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Step 1. Forecast the 2010 Income Statement ($ millions)

Unilate Textiles2009 Forecast 2010 Initial

Results Basis ForecastNet Sales 1,500.0$ x 1.10 1,650.0$ Cost of Goods Sold (1,230.0) x 1.10 (1,353.0) Gross Profit 270.0 297.0 Fixed operating Costs (90.0) x 1.10 (99.0) Depreciation (50.0) x 1.10 (55.0) EBIT 130.0 143.0 Less Interest (40.0) (40.0) EBT 90.0 103.0 Taxes (40%) (36.0) (41.2) Net Income 54.0$ 61.8$ Common Dividends (29.0) (29.0) Addition to Retained Earnings 25.0$ 32.8$ Earnings per Share 2.16$ 2.47$ Dividends per Share 1.16$ 1.16$ Number Common Shares (millions) 25.0 25.0

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Step 2. Forecast the 2010 Balance Sheet ($ millions)

Unilate Textiles 2010

2009 Forecast Initial Balances Basis Forecast

Cash 15.0$ x 1.10 16.5$ Accounts Receivable 180.0 x 1.10 198.0 Inventory 270.0 x 1.10 297.0

Total Current Assets 465.5 511.5 Net Plant & Equipment 380.0 x 1.10 418.0 Total Assets 845.0$ 929.5$ Accounts Payable 30.0 x 1.10 33.0 Accruals 60.0 x 1.10 66.0 Notes Payable 40.0 40.0

Total Current Liabilities 130.0 139.0 Long-Term Bonds 300.0 300.0

Total Liabilities 430.0$ 439.0$ Common Stock 130.0 130.0 Retained Earnings 285.0 +$32.8 317.8

Owner's Equity 415.0$ 447.8$ Total Liabilites & Equity 845.0$ 886.8$ Additional Funds Needed 42.7$

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Unilate has decided that any additional funds needed to support future operations will be raised mainly by issuing new common stock.

Step 3. Raising the Additional Funds Needed

Higher sales must be supported by higher assets.

Asset increase can be financed by spontaneous increases in accounts payable and accruals and by retained earnings.

Any short fall must be financed from external sources--by borrowing or by selling new stock.

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The effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets

Step 4. Financing Feedbacks

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Full Capacity Sales Actual sal

es% of capacity

$1,

.$1, million.500

0 80875

Other Considerations in Forecasting: Excess CapacitySuppose in 2009 fixed assets had

been operated at only 80% of capacity:

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Changes in variable cost ratio affect the addition to retained earnings which affects the amount of AFN.

Other Considerations in Forecasting: Economies of Scale

Unilate’s variable cost ratio is 82% of sales.

Ratio might decrease to 80% if operations increase significantly.

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Other Considerations in Forecasting: Lumpy Assets

Assets that cannot be acquired in small increments, but must be obtained in large, discrete amounts

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Summary: How different factors affect the AFN forecast.

Dividend payout ratio changes.If reduced, more RE, reduce AFN.

Profit margin changes.If increases, total and retained earnings increase, reduce

AFN.Plant capacity changes.

Less capacity used, less need for AFN.Payment terms increased to 60 days.

Accts. payable would double, increasing liabilities, reduce AFN.

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Financial Control - Budgeting and Leverage

The phase in which financial plans are implemented; control deals with the feedback and adjustment processes required to ensure the firm is following the right financial path to accomplish its goals, and, if not, to make necessary corrections. 

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Operating Breakeven Analysis

An analytical technique for studying the relationship between sales revenues, operating costs, and profits

Operating breakeven analysis deals only with the upper portion of the income statement - the portion from sales to NOI

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Unilate’s 2010 Forecasted Operating Income ($ millions)

Sales (S)--(110 million units) 1,650.00$ Variable cost of goods sold (VC) (1,353.00) Gross profit (GP) 297.00 Fixed operating costs (F) (154.00) Net operating income (NOI = EBIT) 143.00$

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Operating Breakeven Chart

0 20 40 57 60 80 100 120

1,400

1,200

1,000

600

400

0Units QOpBE

Revenues & Costs

Total Fixed Costs (F)

Total OperatingCosts (F + Q x V)

Total Sales Revenues (P x Q)

SOpBE =

200154

856800 Operating BreakevenPoint (EBIT = 0)

Operating Profit(EBIT > 0)

Operating Loss

(EBIT < 0)

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Breakeven Computation Sales Total operating Total Totalrevenues costs variable costs fixed costs

= = +

(P x Q) = TOC = (V x Q) + F

QOpBE F

P-VF

Contribution margin= =

QOpBE $154.0 million$15.00 - $12.30= =

$154.0 million$2.70

57.04 million units 57.0 million units

=

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Operating Breakeven Point

For the proposal to break even, Unilate must sell 57 million units or $855,600,000 of product.

SOpBE F F

Gross profit margin= =1- V

P( )SOpBE $154.0

$12.30$15.00

= = $154.0 1 - 0.82

1-= $154.0

0.18( )= 855.6 million

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Operating Leverage

The existence of fixed operating costs, such that a change in sales will produce a larger change in operating income (EBIT)

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Degree of Operating Leverage

The percentage change in NOI (or EBIT) associated with a given percentage change in sales

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DOLS Gross Profit

EBIT

Each 1 percent change in sales, will result in a 2.08 percent change in operating income.

Calculating the Degree of Operating Leverage

$297$143 2.08x= =

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Operating Income at Sales Levels of 110 and 99 Million Units 2010

Forcasted Sales Unit PercentOperations Decrease Change Change

Sales in units 110 99 (11) -10.0%Sales revenues 1,650.0$ 1,485.0$ (165.0)$ -10.0%Variable cost of goods sold (1,353.0) (1,217.7) 135.3 -10.0%Gross profit 297.0 267.3 (29.7) -10.0%Fixed operating costs (154.0) (154.0) - 0.0%Net operating income (EBIT) 143.0$ 113.3$ (29.7)$ -20.8%

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Financial Leverage

The existence of fixed financial costs such as interest and preferred dividends when a change in EBIT results in a larger change in EPS

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Unilate Textiles:Degree of Financial Leverage

DFL EBITEBIT I

EBITEBIT [financial BEP]

DFL110$143.0

$143.0 - $41.4 $143.0$101.6 1.41x

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DTL Gross profit- [Financial BEP] EBIT

Degree of Total Leverage

S - VC- IEBIT

Q(P - V) [Q (P - V) - F] - I

$297.0$101.6 2.92x

= DOL x DFL = 2.08 x 1.41 = 2.92x

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Importance of Forecasting and Control Functions

If projected operating results are not satisfactory, management can reformulate its plans.

If funds required to meet sales forecast cannot be obtained, management can sale back projected levels of operations.

If required funds can be raised, it is best to plan for their acquisition in advance.

Any deviation from projections needs to be handled to improve future forecasts.