Module 03: Financial Planning Tools and Concepts - Financial Planning Process

and Preparation of Budgets and Projected Financial Statements

I. LEARNING COMPETENCIES
1. Identify the steps in the financial planning process.
2. Illustrate the formula and format for the preparation of budgets and projected
financial statement.
3. Create a cash budget.

II. LESSON PRESENTATION

Motivation
How do you see yourself five years from now?

Your answers are the long-term goals that you have planned to achieve in the future. In
the activity, you have demonstrated that planning plays an important role in everyday life as
you already have in mind a set of plans for the next five years. Even those who said they are not
yet sure what they want five years from now will probably still have an idea of what kind of life
they want. They are still in the process of planning.
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 (Gitman &
Zutter,2012).
Management Planning - is about setting the goals of the organization and identifying ways on
how to achieve them (Borja& Cayanan, 2015).
In order to attain your long-term goals, you will need to accomplish several milestones
within it. These milestones are called short-term goals. Like for example your long-term goal of
earning your college degree in five years. To attain such, you will need to surpass a number of
short-term goals such as to pass the college entrance exam, to pass many midterm and final
exams and to accomplish school projects.

Two Phases of Financial Planning

Long-Term Financial Plans
- These are a set of goals that lay out the overall direction of the company.
- A long-term financial plan is an integrated strategy that takes into account various
departments such as sales, production, marketing, and operations for the purpose of guiding
these departments towards 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 (Gitman & Zutter,
2012).
Short-Term Financial Plans
- Specify short-term financial actions and the anticipated impact of those actions. Part of short
term financial plans include setting the sales forecast and other forms of operating and financial
data. This would then translate into operating budgets, the cash budget, and pro forma
financial statements (Gitman & Zutter, 2012).
- For the purpose of this topic, emphasis will be made on short-term financial planning.

Image 3.1. Comparison of Short-Term and Long-Term Planning (Gitman & Zutter, 2012) (Source: DepEd Business Finance
Teaching Guide)
Strategic vs. Tactical Planning
A strategic plan supports the organization's vision and mission statements by outlining
the high-level plan to achieve both. A tactical plan answers "how do we achieve our strategic
plan?" It outlines actions to achieve short-term goals, generally within a year or less.

The Financial Planning Process

1) Set goals or objectives.
For corporations, long term and short term objectives are usually identified. These can
be seen in the company’s vision and mission statements. The vision statement states where the
company wants to be while the mission statement states the plans on how to achieve the
vision. Examples of a company’s Vision-Mission statements are as follows:
Jollibee Foods Corporation (JFC)
Vision: To excel in providing great tasting food that meets local preferences better than
anyone; To become one of the three largest and most profitable restaurant companies in the
world by 2020.
Mission: To serve great tasting food, bringing the joy of eating to everyone.
McDonalds Philippines
Vision: First to respond to the fast changing needs of the Filipino family; First choice when it
comes to food and dining experience; First mention as the ideal employer and socially
responsible company; First to respond to the changing lifestyle of the Filipino family
Mission: To serve the Filipino community by providing great-tasting food and the most relevant
customer delight experience.
2) Identify Resources.
Resources include production capacity, human resources who will man the operations
and financial resources (Borja & Cayanan, 2015).
3) Identify goal-related tasks
4) Establish responsibility centers for accountability and timeline.
There must be a timeline for the activities, especially since they were allotted a specific
time to do the activity.
5) Establish the evaluation system for monitoring and controlling.
For corporations, the management must establish a mechanism which will allow plans
to be monitored. This can be done through quantified plans such as budgets and projected
financial statements. The management will then compare the actual results to the planned
budgets and projected financial statements. Any deviations from the budgets should be
investigated.
6) Determine contingency plans.
In planning, contingencies must be considered as well. Budgets and projected financial
statements are anchored on assumptions. If these assumptions do not become realities,
management must have alternative plans to minimize the adverse effects on the company
(Borja & Cayanan, 2015).

Characteristics of an Effective Plan

In planning, the goal of maximizing shareholders’ wealth must always be put in mind.
The following criteria may be used for effective planning:
- Specific – target a specific area for improvement.
- Measurable – quantify or at least suggest an indicator of progress.
- Assignable – specify who will do it.
- Realistic – state what results can realistically be achieved, given available resources.
- Time-related – specify when the result(s) can be achieved. (Doran, G. T. (1981). "There's a
S.M.A.R.T. way to write management's goals and objectives". Management Review (AMA
FORUM) 70 (11): 35–36.)

Planning and Controlling

A plan is useless if it is not quantified. A quantified plan is represented through budgets
and projected or pro-forma financial statements. These budgets and pro-forma financial
statements are useful for controlling. Budgeting is the most important activity in planning. They
serve as the bases for monitoring actual performance.
Meeting the plans is good. However, failing to meet the plans is not equivalent to failure
if the reasons for not meeting such plans can be justified especially when the reasons are
fortuitous in nature and are beyond the control of management. Measuring actual performance
vis a vis the plans even at the early start of the year allows the management to assess the
company’s performance and come up with remedial actions if (Cayanan, 2015).

I. Sales Budget
- The most important account in the financial statement in making a forecast is sales since most
of the expenses are correlated with sales.
- Recall from Lesson 2: Financial Statement analysis that cost of sales ratio, gross profit ratio,
and variable operating expenses ratio are based on the sales figure.
- Given the importance of the sales forecast, the financial manager must be able to support this
figure with reasonable assumptions. The following external and internal factors should be
considered in forecasting sales:

Image 3.2. Factors that Influence Sales

(Gitman & Zutter, 2012) (Source: DepEd
Business Finance Teaching Guide)
Macroeconomic Variables
(External)
Macroeconomic variables
such as the GDP rate, inflation rate,
and interest rates, among others play
an important role in
forecasting sales because it tells us
how much the consumers are willing
to spend. A low GDP rate coupled by a
high inflation rate means that consumers are spending less on their purchases of goods and
services. This means that we should not forecast high sales of the periods of low GDP.
Developments in the Industry (External)
Products and services which have more developments in its industry would likely have a higher
sales forecast than a product or service in slow moving industry. Consumer trends are always
changing, thus the industry should be competitive to be able to appeal to more customers and
stay in the market.
Competition (External)
Suppose you are selling bread and you know that each person in your community eats
an average of one loaf of bread a day. The population of your community is 500 people. If you
are the only person selling bread in your town, then your sales forecast is 500 units of bread.
However, you also have to take account your competition. What if there are 4 other sellers of
bread? You will need to have to divide the sales between the 5 of you. Does this mean your
new forecast should be 100 units of bread? Not necessary. You should also know the
preference of your consumers. If more of them would prefer to buy more bread from you, then
you should increase your sales forecast.
Production Capacity and man power (Internal)
Suppose that you have already evaluated the macroeconomic factors and identified that
there is a very strong market for your product and consumers are very likely to buy from you.
You forecasted that you will be able to sell 1,000 units of your product. However, you only have
20 employees who are able to produce 20 units each. Your capacity cannot cover your expected
demand hence, you are limited by it. To be able to increase capacity, you should be able to
expand your operations.

Implications if Sales Budget is Not Correct

If understated, there can be lost opportunities in the form of forgone sales. If it is too
optimistic, the management may decide to unnecessarily increase capacity or hire more
employees and end up with more inventories.
II. Production Budget
- A production budget provides information regarding the number of units that should be
produced over a given accounting period based on expected sales and targeted level of ending
inventories.
- It is computed as follows:
Required production in units = Expected Sales + Target Ending Inventories - Beginning
Inventories

To Note: Ending inventory of current period is beginning inventory of next period.

Example:
Company A forecasts sales in units for January to May as follows:

- Moreover, Company A would like to maintain 100 units in its ending inventory at the end of
each month.
- Beginning inventory at the start of January amounts to 50 units.
- How many units should [A] Company produce in order to fulfill the expected sales of the
company?
Answer Key:

III. Budgeting Cash

- Operations budget refers to the variable and fixed costs needed to run the operations of the
company but are not directly attributable tothe generation of sales.
Examples of this are the following:
• Rent payments
• Wages and Salaries of selling and administrative personnel
• Administrative Costs
• Travel and representation expenses
• Professional fees
• Interest Payments
• Tax Payments
IV. Cash Budget
- For a business enterprise, having the right amount of cash is important since cash is used to
make payments for purchases, for operational expenses, to creditors, and for other
transactions.
- The cash budget forecasts the timing of these cash outflows and matches them with cash
inflows from sales and other receipts. The cash budget is also a control tool to monitor the way
the company handles cash. It is used by the firm to estimate its short-term cash requirements,
with particular attention being paid to planning for surplus cash and for cash shortages (Gitman
& Zutter, 2012).
Below is the general form of the Cash Budget:

Steps in Formulating a Cash Budget:

Step A.
Form the sales forecast, identify how much would be collected in the cash budget
period. Sales may be made in cash or for credit. Cash sales are translated to cash at the point of
sale while credit sales are collected depending on the credit period. Credit periods may range
from 10 days to more than a month depending on the strategy of the company. Recall from
Lesson 2: Financial Statement Analysis the implications of the company’s credit policy.
Continuing from previous example, assume selling price is PHP100/unit. Sales for each
month are expected to be collected as follows:
‣ Month of sales : 20%
‣ A month after sales: 50%
‣ 2 months after sales: 30%
How much is total receipts from sales?
Step B.
Identify other receipts.
Examples:
‣ interest received
‣ return on principal investments
‣ proceeds from sale of non-operating assets
‣ issuance of capital stock
‣ proceeds from borrowings
- Add these receipts to the collections from sales to get to total receipts.
Step C.
From the Production Budget, identify how much of the purchases made will be paid by
the company on the cash budget period. Like sales, purchases may be made in cash or on credit
depending on the supplier’s credit terms.
Continuing from previous example:
‣ Assume that cost per unit is PHP50.
‣ All purchases this month are paid the following month. How much is total cash disbursements
for purchases?

Step D.
From the operations budget, identify which expenses will be paid in cash during the cash
budget period.
The following expense items will be paid based on the following periods:
‣ Rent payments: Rent of PHP5,000 will be paid each month.
‣ Wages and salaries: Fixed salaries for the year are PHP96,000, or PHP8,000 per month.
Wages are estimated as 10% of monthly sales.
‣ Tax payments: Taxes of PHP25,000 must be paid in April.
Step E.
Identify all other cash payments to be made.
Examples:
‣ Fixed-asset purchases in cash
‣ Cash dividend payments
‣ Principal Payments
‣ Repurchase of common stock
‣ Purchase of stock/bond investments
It is important to recognize that depreciation and other noncash charges are NOT
included in the cash budget. The following items will be paid based on the following periods:
‣ Fixed-asset outlays: New machinery costing PHP130,000 will be purchased and paid for in
April.
‣ Interest payments: An interest payment of PHP10,000 is due in May.
‣ Cash dividend payments: Cash dividends of PHP20,000 will be paid in January.
‣ Principal payments (loans): A PHP20,000 principal payment is due in February.

Step F.
Match the receipts and disbursements on the periods they become collectible and
payable, respectively.
Step G.
Set a minimum required cash balance. This balance is maintained in case contingencies
arise. Recall from the steps in planning that we should also plan for contingencies.
Step H.
If the net cash flow is above the minimum cash balance, the company is in excess cash
and may consider putting it in short term investments. If it is below, the company should make
a short term borrowing during that period.
Moreover, Company A has a beginning cash balance of PHP80,000 and would like to
maintain an ending cash balance of PHP100,000 per month. Prepare Company A’s Cash Budget
for January to May. Prepare a cash budget.
Evaluating the Cash Budget:
‣ If the ending cash balance after payment of all required disbursements is less than the
required ending balance, the company needs to borrow additional cash from short term
borrowings to meet its required ending balance. Should the ending cash balance exceed the
company’s minimum cash requirement the next period, the company may be able to repay the
loan plus accrued interest.
‣ Should the Company have excess cash above its required maintaining cash balance, the
company may invest this cash on short term investments so that it will have an opportunity to
earn additional profits. If the company’s cash balance would then fall below its minimum cash
requirement, the company may withdraw the investment to be able to meet the required cash
balance.

V. Projected Financial Statements

Projected financial statements is a tool of the company to set an overall goal of what the
company’s performance and position will be for and as of the end of the year. It sets targets to
control and monitor the activities of the company. The following reports may be forecasted:
‣ Projected Income Statement
‣ Projected Statement of Financial Position
‣ Projected Statement of Cash Flows
Refer to the following historical financial statements to be used for the succeeding
discussions:

Steps on Financial
Statement Projection
a. Forecast Sales.
Scenario: Sales are
expected to increase by
10% in 2015 from the
2014 sales level. This
growth assumption
is based on the assessment of the external and internal factors related to the Company and the
historical growth of the company. The company’s sales grew by 10.3% annually from 2010 to
2014.

Compute for projected sales:

Projected Sales in 2015 = 5,250,000 x (1 + 10%) = 5,775,000
b. Forecast Cost of Sales and Operating Expenses
- In determining the cost of sales and operating expenses, variable and fixed costs should be
identified.
- Cost of sales are direct costs associated in the generation of sales. One way of projecting cost
of sales is using the cost of sales ratio.
Companies would generally have a consistent historical cost of sales ratio. The company may
use this as a starting point.
- Suppose that the company has an average of 60% cost of sales ratio. In doing projections, the
financial manager may use the same average ratio or, if the company is pushing for efficiency,
the financial manager may reduce this ratio to say 57% depending on his judgment.
- Operation costs are a mix of variable and fixed costs. Variable costs usually vary with sales. To
project these costs, the percentage of sales method may be used. On the other hand, fixed
costs remain the same no matter how the volume of sales has changed.
Scenario:
a. The Company wants to maintain the same gross profit per year as 2014.
b. Variable operating expense is 5% of sales.
c. Depreciation expense is 5% of the gross beginning balance of property, plant and equipment.
As of December 31, 2014, the gross balance of PPE is PHP5,200,000. For January 2015,
PHP1,000,000 new PPE will be acquired. It is the policy of the company that PPE acquired in the
first half of the year will be depreciated for one full year.

Compute for Cost of Sales, Variable Operating Expense, and Depreciation Expense:
Cost of sales percentage in 2014 = 4,305,000 ÷ 5,250,000) x 100%
Cost of sales percentage in 2014 = 82%
Projected cost of sales in 2015 = 82% x 5,775,000
Projected cost of sales in 2015 = 4,735,500
Variable (5% x Sales of 5,775,000) = 288,750
Fixed (depreciation expense)
(5,200,000 + 1,000,000) x 5% = 310,000
Total operating expenses 598,750

Compute for net PPE:

PPE net, beginning 2,440,000
Additions 1,000,000
Less: Depreciation (310,000)
PPE net, end 3,130,000
c. Forecast Net Income and Retained Earnings.
- To forecast net income, interest expense and income tax expense should also be considered
using the relevant interest and tax rates. Retained earnings is arrived at by adding projected net
income to beginning retained earnings then deducting dividends to be declared during the year.
- Just note this information. Return to this when all income statement items are complete.
Scenario: Income tax rate is 30% of the income before taxes. 75% of the income tax expense
will be paid in 2015 while the balance will be paid in 2016.
d. Determine balance sheet items that will vary with sales or whose balances will be highly
correlated to sales.
- Balance sheet items that may vary with sales or will be highly correlated with sales are cash,
accounts receivable, inventories, accounts payable, and accrues expenses payable.
Compute as follows:
The following financial statement accounts are expected to vary with sales based on the 2014
financial statements:
A. Cash
B. Trade accounts receivable
C. Inventories
D. Other current assets
E. Trade accounts payable
Cash
Cash as a percentage of sales in 2014 = (1,060,000 ÷ 5,200,000) x 100%
Cash as a percentage of sales in 2014 = 20.19%
Projected cash in 2015 = 20.19 % x 5,775,000
Projected cash in 2015 = 1,165,973
Accounts Receivable
Accounts receivable as a % of sales in 2014 = (2,300,500 ÷ 5,200,000) x 100%
Accounts receivable as a % of sales in 2014 = 43.82%
Projected accounts receivable in 2015 = 43.82% x 5,775,000
Projected accounts receivable in 2015 = 2,530,605
Inventories
Inventories as a % of sales in 2014 = (4,850,000 ÷ 5,200,000) x 100%
Inventories as a % of sales in 2014 = 92.38%
Projected inventories in 2015 = 92.38% x 5,775,000
Projected inventories in 2015 = 5,334,945
Other Current Assets
Other current assets as a % of sales in 2014 = (1,050,000 ÷ 5,200,000) x 100%
Other current assets as a % of sales in 2014 = 20%
Projected other current assets in 2015 = 20% x 5,775,000
Projected other current assets in 2015 = 1,155,000
Accounts payable
Accounts payable as a % of sales in 2014 = (5,050,000.00 ÷ 5,200,000) x 100%
Accounts payable as a % of sales in 2014 = 96.19%
Projected accounts payable in 2015 = 96.19% x 5,775,000
Projected accounts payable in 2015 = 5,554,973
e. Determine payment schedule for loans.
Scenario:
As of December 31, 2014, there are two long-term loans. Both have an annual interest rate of
8%.
a. The first loan will mature on June 30, 2015 and the remaining principal balance to be paid on
June 30, 2015 is
PHP1,250,000.
b. The second loan which was incurred on December 31, 2014 is paid at the rate of PHP500,000
principal balance every June 30 and December 31.
New loans of PHP3,500,000 will be incurred on December 31, 2015 payable at the rate of
PHP500,000 every June 30 and December 31. Annual interest rate is expected at 8%.
Compute for interest expense:

Complete projected income statement as follows:

Compute for Income Tax Payable:

Projected Income Tax Payable in 2015: 51,225 x (1 – 75%) = 12,806

Compute for current and non-current portion of long term assets:

f. Check for other information
Scenario:
a. Cash dividends of PHP300,000 will be paid for 2015.
b. Other non-current assets and other current liabilities will remain unchanged.
Compute for retained earnings:

g. Determine external funds needed (EFN).

h. Determine how external funds needed may be financed.
- External Funds Needed is a plug figure to make projected assets equal projected liabilities and
shareholders’ equity.
EFN = change in total assets – (change in total liabilities + total change in stockholders’ equity)
Or
EFN = Squeeze figure to balance assets to Liabilities and equity

‣ A positive value for EFN, means that the company needs more funds equivalent to the
positive value of EFN. As to how this will be raised depends on the management and the
company’s ability to access funds. This EFN can be raised in the form of short term borrowing,
long term borrowing or equity, or a combination of all sources. The projected balance sheet
which generated this EFN is just the first iteration in preparing a pro-forma balance sheet.
‣ A negative value for EFN, means that the company has excess cash. As to how this excess cash
will be distributed will be the subject of the next iteration for the pro-forma balance sheet. This
can be disposed by adding it to the projected cash balance or it can be used to retire some of
the debt if pre-termination is allowed.

Complete FS as follows:
Prepare the projected statement of cash flows:

III. SUMMARY OF LESSON

 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.
 Management Planning is about setting the goals of the organization and identifying ways on
how to achieve them.
 Long-Term Financial Plans are a set of goals that lay out the overall direction of the
company.
 Short-Term Financial Plans include setting the sales forecast and other forms of operating
and financial data.
 A strategic plan supports the organization's vision and mission statements by outlining the
high-level plan to achieve both. A tactical plan answers "how do we achieve our strategic
plan?" It outlines actions to achieve short-term goals, generally within a year or less.
 The Financial Planning Process is: 1) Set goals or objectives 2) Identify Resources 3) Identify
goal-related tasks 4) Establish responsibility centers for accountability and timeline 5)
Establish the evaluation system for monitoring and controlling and 6) Determine
contingency plans.
 Budgeting is the most important activity in planning.

IV. ENRICHMENT
Planning
Direction: Answer the following question in 5-10 sentences. Write your answers on the spaces
provided. (10 pts. each; Correctness of Ideas - 7, Organization of Ideas - 3)
What should the management do if the actual performance of the company fell short of the
plans as early as in the first quarter?

V. EVALUATION
Cash Budget Preparation
Gerry Jacobs, a financial analyst for Best Value Supermarkets, has prepared the following sales
and cash disbursement estimates for the period of August through December of the current
year.
90% of sales are for cash, the remaining 10% are collected one month later. All disbursements
are on a cash basis. The firm wishes to maintain a minimum cash balance of $50. The beginning
cash balance in September is $25. Prepare a cash budget for the months of October, November,
and December, noting any needed financing or excess cash available. Write your answers ona
separate sheet. (20 pts.)

VI. RESOURCES
DepEd Business Finance Teaching Guide
https://www.shrm.org/resourcesandtools/tools-and-samples/hr-
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%20answers%20%22how,within%20a%20year%20or%20less.