Preparing the financial section

of a business plan

by Michele Bertoni
 Financial planning
Financial planning is used by managers for translating strategies into
accounting numbers. Examples of financial planning are business plans
and budgets, also known as profit plans.
To build a profit plan, managers need to answer three questions:
1) Does the organization’s strategy create economic value?
2) Does the organization have enough cash to fund the strategy and
remain solvent?
3) Does the organization create enough value to attract and retain the
financial resources that it needs to fund long-term investments?

When planning, managers need to take into consideration all the three
aspects mentioned above. Understanding that cash, profit and
profitability are interlocking aspects of any business is the key for
successful financial planning.

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 The 3 wheels of financial planning

Source: R. Simons, Performance Measurement

and Control Systems for Implementing Strategy,
Pearson, 2014

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 The profit wheel: sales
It’s the starting point of financial planning. It summarizes the expected
revenues and expenses for a specified future accounting period.

The starting point of a profit plan are assumptions about the future, esp.
about the expected level of sales.
Managers usually employ a combination of the following two methods for
estimating future sales:
1) statistical methods based on general market conditions, business
perspectives, etc.
2) “educated guess”, gathering the opinions of commercial managers and
sales staff.
Sales plan include physical quantities, per-unit pricing, product mix and
new product introductions and product deletions.

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Michele Bertoni
 The profit wheel: operating expenses
It’s useful to classify operating expenses in variable and fixed costs.
Variable costs are typically estimated as a percentage of sales (examples:
raw materials, sales commissions, energy costs, etc.).
Fixed costs do not vary directly with the level of sales. Three categories:
1) Committed (or sunk) costs (e.g.: depreciation);
2) Discretionary costs (e.g.: advertising, training, research).
3) Activity-based indirect costs: costs that change with the level of specific
underlying activities (e.g.: material handling, billing costs, supervision).
Sometimes called “overhead”.

Fixed costs change whenever the firm’s productive capacity change: for
this reason the distinction between fixed and variable costs is only valid in
the “short term” (i.e., an undefined period of time in which the firms is
constrained by its past decisions about the productive capacity).

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 Parametric costs and discretionary costs
Parametric costs are those costs for which a standard can be applied.
For example, the standard cost of direct material depends on the
production volume and on the unit cost per component used. Direct
labor costs too are normally parametric.

For discretionary costs, on the other hand, no standards can be applied.

They only depend on the management’s decisions, not on the volume
of the output. There is no “right” amount for R&D expenses,
advertising, administrative costs, some indirect manufacturing costs
and for most selling costs.

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Michele Bertoni
 How to determine discretionary costs
Sometimes discretionary costs are determined applying the
following formulas:

the cost should be the same as the previous year;

the cost should be equal to x% of sales;
the cost should be equal to y plus x% of sales.

In the first case the cost has the same behavior of a fixes cost; in the
second case it behaves like a variable cost (with sales); in the third
case the cost is apparently semi-fixed.
These rules are not parametric and they can be modified anytime.
Discretionary costs sometimes generate misleading cost-volume
relations: for example, selling costs could appear to be positively
correlated with sales.

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Michele Bertoni
 Sunk costs
Sunk costs are the consequences of past commitments. For example,
depreciation of plant and property is the consequence of an
investment, and it is an unavoidable cost until the asset is held by the
firm.
In the short term, sunk costs are not controllable.
Sunk costs can be direct costs if, for example, the asset being
depreciated is used uniquely by a specific responsibility center.

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 Cost-volume-profit analysis (break-even point)

C, R TR TC
Relevant range

VC

FC

Q
Q*

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 The operating leverage

ΔEBIT ΔQ * ucm
EBIT. EBIT. Q * ucm
operating leverage   
ΔQ ΔQ EBIT
Q Q
Where:
EBIT = operating income (Earnings Before Interest and Tax)
Q = Quantity of products sold
ucm = unit contribution margin (unit price – unit variable cost)

As volume increases, average per-unit cost decreases, because the fixed

costs are spreaded over a higher volume. When fixed costs are prevalent,
unitary contribution margins are usually larger.

The operating leverage is greater whenever fixed costs prevail over variable
costs.
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 A comparison of cost structures

A B C
price 500 500 500
unit variable cost 270 210 90
unit contribution margin 230 290 410
fixed costs 60,000 120,000 240,000
quantity 1,000 1,000 1,000

Total sales 500,000 500,000 500,000

Total variable costs 270,000 210,000 90,000
Total contribution margin 230,000 290,000 410,000
Fixed costs 60,000 120,000 240,000
Operating income (EBIT) 170,000 170,000 170,000
ROS 34.0% 34.0% 34.0%
Break-even point 261 414 585
operating leverage 1.35 1.71 2.41
% of variable costs 82% 64% 27%
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 Sales decrease

A B C
price 500 500 500
unit variable cost 270 210 90
unit contribution margin 230 290 410
fixed costs 60,000 120,000 240,000
quantity 600 600 600

Total sales 300,000 300,000 300,000

Total variable costs 162,000 126,000 54,000
Total contribution margin 138,000 174,000 246,000
Fixed costs 60,000 120,000 240,000
Operating income (EBIT) 78,000 54,000 6,000
ROS 26.0% 18.0% 2.0%
Break-even point 261 414 585
operating leverage 1.77 3.22 41.00
% of variable costs 73% 51% 18%
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 Sales increase

A B C
price 500 500 500
unit variable cost 270 210 90
unit contribution margin 230 290 410
fixed costs 60,000 120,000 240,000
quantity 1,400 1,400 1,400

Total sales 700,000 700,000 700,000

Total variable costs 378,000 294,000 126,000
Total contribution margin 322,000 406,000 574,000
Fixed costs 60,000 120,000 240,000
Operating income (EBIT) 262,000 286,000 334,000
ROS 37.4% 40.9% 47.7%
Break-even point 261 414 585
operating leverage 1.23 1.42 1.72
% of variable costs 86% 71% 34%
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 Gross margins: EBITDA
EBITDA is the profit before depreciation, amortization and provisions
for risks, all costs that do not imply any cash outflows.

EBITDA does not include some costs which are considered to be

“estimated”: it is then supposed to be less influenced by judgement;
There is a strong link between EBITDA and the cash flow from
operations.
A company with a negative EBITDA would face very difficul times. It
would imply problems in terms of financial performance and cash
equilibrium.

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Michele Bertoni
 Gross margins: EBIT

It’s the most common measure of financial performance, also known as

“operating profit”.
EBIT is the difference between operating revenues and operating expenses.
It therefore excludes:
Financial income and financial expenses;
Extraordinary items
Income taxes
Its importance resides in the fact that it provides a measure of performance
which is independent from the financial structure of the firm. It can be used
to make comparisons among different firms, operating in the same industry,
with different debt/equity ratios.

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 Gross margins: NOPAT

NOPAT (Net Operating Profit After Taxes) is the operating profit net of
income taxes that would be paid on that income, if it were taxable.
It is a good measure of performance, because it shows the capacity of
the company to produce wealth (economic efficiency) through its own
business, considering also the effect of taxation.
It is often compared to the WACC (Weighted Average cost of Capital) in
order to understand whether the company return on investments is
higher than the return requested requested (on average) by lenders and
shareholders.

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 The profit wheel: investments in new assets
The predicted level of sales is determined by the level of assets
available to generate those sales. An asset investment plan is another
essential tool in implementing strategy.
There are two types of investments: operating assets and long-term
(or fixed) assets.
The long term investment plan (capital investment plan) commits the
company for a long time in the future; it must be consistent with the
firm’s strategy.
The level of operating assets is related to the operating costs, and it
has a great importance in determining the firm’s cash flows.

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 Net working capital
It is defined as:
Current operating assets – current operating liabilities.
The profit plan allows to determine the expected change in net
working capital. For example:

Business growth generally requires an increase in net working capital.

This represents the connection between the profit and the cash
wheels, because the managers must ensure the business can provide
enough cash to sustain the expected increase in net working capital.

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 The cash wheel
The cash cycle: there could be a considerable time between
disbursements to purchase inventory and pay operating expenses and
receipts of cash from customers. During this period of time the firm may
need borrowing in order to cover its ongoing cash outflows.
Fast growing companies use a lot of cash: it is essential to understand
whether the profit plan is feasible. In case it exceeds the firm’s borrowing
capacity, the profit plan must be revised.
Operating cash is the main variable that is needed to be determined:

Operating cash flow = Cash received from customers – Cash paid to

suppliers and for operating expenses.
Operating cash flows are usually determined using the indirect method
(i.e., starting from the profits).

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 Cash flows and the product lifecycle

Sales

time
Introduction Initial Advanced Maturity Decline
growth growth

ROI

Cash flows

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 The ROE wheel
Profits are both a constraint and a goal: a minimum level of profits is
necessary to survive, but more profit will lead to more resources for
future investments, higher dividends, higher stock price, and lower cost
of debt.
There are several measures of profitability, ROI, ROS and ROE being the
most common.
Net profit
 ROE (Return on Equity)
Equity

EBIT
 ROI (Return on Investments)
Operating assets

EBIT
 ROS (Return on Sales)
Sales
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 Ratios are not set in stone…

There is no generally accepted method for calculating ratios. For

example, ROI can be also calculated as:

Operating profit to total assets (ROA);

Operating profit to operating assets, therefore excluding financial assets
(shares, bonds and sometimes even cash…);
Operating profit to capital employed (owners’ equity + long-term
liabilities), or ROCE;
Operating profit to the difference of total assets and operating liabilities
(assets – acct. payable – provisions – other operating liabilities), see
previous point.

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 Analysis of operating profitability

Asset turnover ratio

EBIT EBIT Sales

ROI   *
Assets Sales Assets

ROS (Return on Sales)

ROI is determined by asset turnover (“how many times” assets are

renewed in a year) and profit margins on sales.

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 ROS, asset turnover and ROI

The same ROI level can be achieved

ROS with different combinations of ROS
and asset turnover ratio.

ROI = 14%

ROI = 12%

Asset turnover
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 What are the determinants of the ROS level?

ROS

Sales Total variable Fixed costs

costs

Sale prices

Variable
unitary
Volumes costs
Cost of
inputs

Efficiency
Source: Bubbio (2000) 25
Michele Bertoni
 What are the determinants of asset turnover?

Asset trnv.

Sales Current assets Fixed assets

Sale prices

Operating Other
Volumes fixed assets fixed
assets
Stock and accts.
receivable
management

Source: Bubbio (2000) 26

Michele Bertoni
 The ROE tree (Dupont analysis)

NP: net profit

A: assets
NP/E E: owners’ equity
EBIT: earnigs before interest
and tax
NP/A x A/E

NP/Sales x Sales/A x A/E

EBIT/Sales x NP/EBIT x Sales/A x A/E

Financial and tax Financial
ROS Asset turnover
items structure

Michele Bertoni
ROI 27
 ROI and ROE: the financial leverage effect

Gearing ratio

 Liab. Net profit

ROE  ROI  ROI  id  *  *
 OE  EBT

Sign of the leverage

id = cost of debt (interest/liabilities) = ROD

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 Financial risk

ROI, ROI – id > 0

ROE

ROI = id

ROI ROI – id < 0

L
OE

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 Gearing amplifies the risk of changes in ROE

ROE ROI = 8%

ROI = 6%
8%
30
6%
6
id = 5%
2%

0 4 L
ROI = 2% OE

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 An overview of ratios and flows
ROE

Financial ROI ROD Income taxes and

structure non-recurring
items
Asset turnover ROS
Source: Bubbio (2000)

Current ratio Current assets Operating

turnover flow of NWC
Acid ratio Stock turnover
period Operating
Creditors Debtors cash flow
turnover period turnover period

Balance sheet Income st.

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