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The components of a financial plan.


Inputs Planning Model Outputs
Projected financial statements
Current financial statements. Equations specifying key
(pro formas).
Forecasts of key variables relationships.
Financial ratios.
such as sales or interest
Sources and uses of cash.
rates.
88 SECTION ONE


TABLE 1.11
INCOME STATEMENT
Financial statements of
Executive Cheese Company Sales $ 1,200
for past year Costs 1,000
Net income $ 200

BALANCE SHEET, YEAR-END
Assets $2,000 Debt $ 800
Equity 1,200
Total $2,000 Total $ 2,000



Suppose that Executive Cheese has prepared the simple balance sheet and income
statement shown in Table 1.10. The firm™s financial planners forecast that total sales
next year will increase by 10 percent from this year™s level. They expect that costs will
be a fixed proportion of sales, so they too will increase by 10 percent. Almost all the
forecasts for Executive Cheese are proportional to the forecast of sales. Such models
are therefore called percentage of sales models. The result is the pro forma, or fore-
PERCENTAGE OF
cast, income statement in Table 1.12, which shows that next year™s income will be $200
SALES MODELS
— 1.10 = $220.
Planning model in which
Executive Cheese has no spare capacity, and in order to sustain this higher level of
sales forecasts are the
output, it must increase plant and equipment by 10 percent, or $200. Therefore, the left-
driving variables and most
hand side of the balance sheet, which lists total assets, must increase to $2,200. What
other variables are
about the right-hand side? The firm must decide how it intends to finance its new as-
proportional to sales.
sets. Suppose that it decides to maintain a fixed debt-equity ratio. Then both debt and
equity would grow by 10 percent, as shown in the pro forma balance sheet in Table 1.12.
Notice that this implies that the firm must issue $80 in additional debt. On the other
hand, no equity needs to be issued. The 10 percent increase in equity can be accom-
plished by retaining $120 of earnings.
This raises a question, however. If income is forecast at $220, why does equity in-
crease by only $120? The answer is that the firm must be planning to pay a dividend of
$220 “ $120 = $100. Notice that this dividend payment is not chosen independently but
is a consequence of the other decisions. Given the company™s need for funds and its de-
BALANCING ITEM
cision to maintain the debt-equity ratio, dividend policy is completely determined. Any
Variable that adjusts to
other dividend payment would be inconsistent with the two conditions that (1) the right-
maintain the consistency of a
hand side of the balance sheet increase by $200, and (2) both debt and equity increase
financial plan. Also called
by 10 percent. For this reason we call dividends the balancing item, or plug. The bal-
plug.
ancing item is the variable that adjusts to make the sources of funds equal to the uses.

TABLE 1.12
PRO FORMA INCOME STATEMENT
Pro forma financial
statements of Executive Sales $ 1,320
Cheese Costs 1,100
Net income $ 220

PRO FORMA BALANCE SHEET
Assets $2,200 Debt $ 880
Equity 1,320
Total $2,200 Total $ 2,200
Financial Planning 89


TABLE 1.13
Assets $2,200 Debt $ 960
Pro forma balance sheet with
Equity 1,240
dividends fixed at $180 and
Total $2,200 Total $ 2,200
debt used as the balancing
item

Of course, most firms would be reluctant to vary dividends simply because they have
a temporary need for cash; instead, they like to maintain a steady progression of divi-
dends. In this case Executive Cheese could commit to some other dividend payment and
allow the debt-equity ratio to vary. The amount of debt would therefore become the bal-
ancing item.
For example, suppose the firm commits to a dividend level of $180, and raises any
extra money it needs by an issue of debt. In this case the amount of debt becomes the
balancing item. With the dividend set at $180, retained earnings would be only $40, so
the firm would have to issue $160 in new debt to help pay for the additional $200 of as-
sets. Table 1.13 is the new balance sheet.
Is the second plan better than the first? It™s hard to give a simple answer. The choice
of dividend payment depends partly on how investors will interpret the decision. If last
year™s dividend was only $50, investors might regard a dividend payment of $100 as a
sign of a confident management; if last year™s dividend was $150, investors might not
be so content with a payment of $100. The alternative of paying $180 in dividends and
making up the shortfall by issuing more debt leaves the company with a debt-equity
ratio of 77 percent. That is unlikely to make your bankers edgy, but you may worry
about how long you can continue to finance expansion predominantly by borrowing.
Our example shows how experiments with a financial model, including changes in
the model™s balancing item, can raise important financial questions. But the model does
not answer these questions.

Financial models ensure consistency between growth assumptions and
financing plans, but they do not identify the best financing plan.



Suppose that the firm is prevented by bond covenants from issuing more debt. It is
Self-Test 1
committed to increasing assets by 10 percent to support the forecast increase in sales,
and it strongly believes that a dividend payment of $180 is in the best interests of the
firm. What must be the balancing item? What is the implication for the firm™s financ-
ing activities in the next year?



AN IMPROVED MODEL
Now that you have grasped the idea behind financial planning models, we can move on
to a more sophisticated example.
Table 1.14 shows current (year-end 1999) financial statements for Executive Fruit
Company. Judging by these figures, the company is ordinary in almost all respects. Its
earnings before interest and taxes were 10 percent of sales revenue. Net income was
$96,000 after payment of taxes and 10 percent interest on $400,000 of long-term debt.
The company paid out two-thirds of its net income as dividends.
90 SECTION ONE


TABLE 1.14
INCOME STATEMENT
Financial statements for
Executive Fruit Co., 1999 Comment
(figures in thousands) Revenue $2,000
Cost of goods sold 1,800 90% of sales
EBIT 200 Difference = 10% of sales
Interest 40 10% of debt at start of year
Earnings before taxes 160 EBIT “ interest
State and federal tax 64 40% of (EBIT “ interest)
Net income $ 96 EBIT “ interest “ taxes
Dividends $ 64 Payout ratio = 2„3
Retained earnings $ 32 Net income “ dividends

BALANCE SHEET
Assets
Net working capital $ 200 10% of sales
Fixed assets 800 40% of sales
Total assets $1,000 50% of sales
Liabilities and shareholders™ equity
Long-term debt $ 400
Shareholders™ equity 600
Total liabilities and
shareholders™ equity $1,000 Equals total assets


Next to each item on the financial statements in Table 1.14 we have entered a com-
ment about the relationship between that variable and sales. In most cases, the comment
gives the value of each item as a percentage of sales. This may be useful for forecast-
ing purposes. For example, it would be reasonable to assume that cost of goods sold will
remain at 90 percent of sales even if sales grow by 10 percent next year. Similarly, it is
reasonable to assume that net working capital will remain at 10 percent of sales.
On the other hand, the fact that long-term debt currently is 20 percent of sales does
not mean that we should assume that this ratio will continue to hold next period. Many
alternative financing plans with varying combinations of debt issues, equity issues, and
dividend payouts may be considered without affecting the firm™s operations.
Now suppose that you are asked to prepare pro forma financial statements for Exec-
utive Fruit for 2000. You are told to assume that (1) sales and operating costs are ex-
pected to be up 10 percent over 1999, (2) interest rates will remain at their current level,
(3) the firm will stick to its traditional dividend policy of paying out two-thirds of earn-
ings, and (4) fixed assets and net working capital will need to increase by 10 percent to
support the larger sales volume.
In Table 1.15 we present the resulting first-stage pro forma calculations for Execu-
tive Fruit. These calculations show what would happen if the size of the firm increases
along with sales, but at this preliminary stage, the plan does not specify a particular mix
of new security issues.
Without any security issues, the balance sheet will not balance: assets will increase
to $1,100,000 while debt plus shareholders™ equity will amount to only $1,036,000.
Somehow the firm will need to raise an extra $64,000 to help pay for the increase in as-
sets. In this first pass, external financing is the balancing item. Given the firm™s growth
forecasts and its dividend policy, the financial plan calculates how much money the
firm needs to raise.
Financial Planning 91


TABLE 1.15
PRO FORMA INCOME STATEMENT
First-stage pro forma
statements for Executive Comment
Fruit Co., 2000 (figures in Revenue $ 2,200 10% higher
thousands) Cost of goods sold 1,980 10% higher
EBIT 220 10% higher
Interest 40 Unchanged
Earnings before taxes 180 EBIT “ interest
State and federal tax 72 40% of (EBIT “ interest)
Net income $ 108 EBIT “ interest “ taxes
Dividends $ 72 2„3 of net income

Retained earnings $ 36 Net income “ dividends

PRO FORMA BALANCE SHEET
Assets
Net working capital $ 220 10% higher
Fixed assets 880 10% higher
Total assets $ 1,100 10% higher
Liabilities and shareholders™ equity
Long-term debt $ 400 Temporarily held fixed
Shareholders™ equity 636 Increased by retained
earnings
Total liabilities and
shareholders™ equity $ 1,036 Sum of debt plus equity
Required external financing $ 64 Balancing item or plug
(= $1,100 “ $1,036)




In the second-stage pro forma, the firm must decide on the financing mix that best
meets its needs for additional funds. It must choose some combination of new debt or
new equity that supports the contemplated acquisition of additional assets. For exam-
ple, it could issue $64,000 of equity or debt, or it could choose to maintain its long-term
debt-equity ratio at two-thirds by issuing both debt and equity.
Table 1.16 shows the second-stage pro forma balance sheet if the required funds are
raised by issuing $64,000 of debt. Therefore, in Table 1.16, debt is treated as the bal-
ancing item. Notice that while the plan requires the firm to specify a financing plan
consistent with its growth projections, it does not provide guidance as to the best fi-
nancing mix.
Table 1.17 sets out the firm™s sources and uses of funds. It shows that the firm re-
quires an extra investment of $20,000 in working capital and $80,000 in fixed assets.
Therefore, it needs $100,000 from retained earnings and new security issues. Retained
earnings are $36,000, so $64,000 must be raised from the capital markets. Under the fi-
nancing plan presented in Table 1.16, the firm borrows the entire $64,000.
We have spared you the trouble of actually calculating the figures necessary for Ta-
bles 1.15 and 1.17. The calculations do not take more than a few minutes for this sim-
ple example, provided you set up the calculations correctly and make no arithmetic mis-
takes. If that time requirement seems trivial, remember that in reality you probably
would be asked for four similar sets of statements covering each year from 2000 to
2003. Probably you would be asked for alternative projections under different assump-
tions (for example, 5 percent instead of 10 percent growth rate of revenue) or different
92 SECTION ONE


TABLE 1.16
Comment
Second-stage pro forma
balance sheet for Executive Assets
Fruit Co., 2000 (figures in Net working capital $ 220 10% higher
thousands) Fixed assets 880 10% higher
Total assets $ 1,100 10% higher
Liabilities and shareholders™ equity
Long-term debt $ 464 16% higher (new borrowing = $64;
this is the balancing item)
Shareholders™ equity $ 636 Increased by retained earnings
Total liabilities and
shareholders™ equity $ 1,100 Again equals total assets




financial strategies (for example, freezing dividends at their 1999 level of $64,000).
This would be far more time-consuming. Moreover, actual plans will have many more
line items than this simple one. Building a model and letting the computer toil in your

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