Financial Planning

Ram Babu Roy, RMSoEE

IIT Kharagpur

References:
1. Entrepreneurship: Successfully launching New ventures, Bruce R Barringer, R Duane
Ireland, 3rd Edition, Pearson (2010).

2. Technology Ventures: From Idea to Enterprise, 2nd Edition, Richard C Dorf and Thomas H
B (2008)

& Various web pages on internet

Note: This study material has been prepared for the purpose of classroom discussions
only.
 The Process of Financial Management

• Importance of Financial Statements

– To assess whether its financial objectives are being met, firms rely
heavily on analysis of financial statements.
• A financial statement is a written report that quantitatively describes a
firm’s financial health.
• Most common: The income statement, the balance sheet, and the
statement of cash flows
• Historical Financial Statements
– Reflect past performance and are usually prepared on a quarterly
and annual basis.
• Publicly traded firms are required to prepare financial statements and
make them available to the public.
• Pro Forma Financial Statements
– Are projections for future periods based on forecasts and are
typically completed for two to three years in the future.
• Pro forma financial statements are strictly planning tools and are not
required by any govt. agency.
 The Process of Financial Management

• Forecasts
– Are an estimate of a firm’s future income and expenses, based on
past performance, its current circumstances, and its future plans.
– New ventures typically base their forecasts on an estimate of sales
and then on industry averages or the experiences of similar start-
ups regarding the cost of goods sold and other expenses.
• Budgets
– Are itemized forecasts of a company’s income, expenses, and
capital needs and are also an important tool for financial planning
and control.
• Financial Ratios
– Depict relationships between items on a firm’s financial
statements.
– An analysis of its financial ratios helps a firm determine whether it
is meeting its financial objectives and how it stakes up against
industry peers.
 Pro Forma Financial Statements

• Pro Forma Financial Statements

– A firm’s pro forma financial statements are similar to its
historical financial statements except that they look forward
rather than track the past.
– The preparation of pro form financial statements helps a
firm rethink its strategies and make adjustments if
necessary.
– The preparation of pro forma financials is also necessary if
a firm is seeking funding or financing.
 Pro forma financial statements
• How much money will you need for your
business needs?
– Create the Vision
– Identify Income and Expenses items
– Estimate the cost
• Important Uses
– Forecast the amount of external financing that will
be required
– Evaluate the impact that changes in the operating
plan have on the value of the firm
– Set appropriate targets for compensation plans
 What You Need
• Clear ideas about the purpose and audience for your
projections.
• Understanding of the key drivers of financial results for
the business.
• Some knowledge of accounting & financial statement
analysis:
• Skill in using spreadsheet software -- such as Excel
• Creativity, attention to detail, and good judgment.
• A lot of time
 Revenue Model
• Product Sales
• Subscription (Membership) Fee
• Advertising revenue
• Transaction Fee
• Affiliate Revenue

• Profit = Revenue - Cost

 Sources of Revenue Growth
• Increasing brand recognition
• Intellectual Property Licensing
• International Expansion
• Acquisition of other firms
• Price increase
• New Product Offerings
 Types of Pro Forma Financial Statements

Financial Statement Purpose

Pro Forma Income Shows the projected results of the operations

Statement of a firm over a specific period.

Shows a projected snapshot of a

Pro Forma company’s assets, liabilities, and owner’s
Balance Sheet equity at a specific point in time.

Pro Forma Shows the projected flow of cash into and

Statement of Cash out of a company from operation, investing
flows and financing activities for a specific period
 Financial Projections
• You may use template for financial statement models
• May build your own income statement model - key
drivers often are unique to the particular situation
• Do monthly projections for the first two years, then
quarterly after that
• Add the periods up, and present the annual summaries
to potential financing sources
• Warnings
– Do not be too optimistic about future financial results
– Do not underestimate the time and cost it takes to get
things done
 Key Points
• Revenues & expenses are independent of cash payments. Recognize
them when a transaction happens, not when cash comes in or goes
out (maybe much later).
• Cost of Goods Sold are the direct costs in producing your service –
materials, installation costs, customer service, maintenance, etc.
• Revenue – Costs of Goods Sold = Gross Profit
• General & Administrative are support costs, like finance, HR, IT, top
management
• Gross Profit – Sales & Marketing – General & Admin = Operating
Income, also known as Operating Cash Flow
• Following these conventions allows for comparison of your
projections with other similar business’ results.
• Depreciation expense spreads out the cost of property, plant and
equipment – over its useful life.
• R&D costs?
Pro Forma Income Statements

8-12
 Compare your Income Statement
numbers to similar companies
Annual Projections Year As a % of Sales

Sales 800 100%

Cost of Goods Sold 350 44%

Gross Profit 450 56%

Sales & Marketing 195 24%

General & Admin 210 26%

Operating Income 45 6%
Pro Forma Balance Sheets
Pro Forma Balance Sheets
Liabilities and Shareholder’s Equity
 Pro Forma Statement of Cash Flow

Decrease -> {

Decrease -> {

Principal ->
 Ratio Analysis

• Ratio Analysis
– The most practical way to interpret or make sense of a firm’s
historical financial statements
• Comparing a Firm’s Financial Results to Industry Norms
– helps a firm determine how it stakes up against its competitors and
if there are any financial “red flags” requiring attention.
– The same financial ratios used to evaluate a firm’s historical
financial statements should be used to evaluate the pro forma
financial statements.
– This work is completed so the firm can get a sense of how its
projected financial performance compares to its past performance
and how its projected activities will affect its cash position and its
overall financial soundness.
 Financial Ratios Are Used By
• Management:
– Planning and evaluating
– Identifying and assessing merger candidates

• Credit Managers
– Estimate the riskiness of potential borrowers

• Investors
– Evaluate corporate securities

18
 Financial Ratios
LIQUIDITY RATIOS
Current Ratio (Working capital ratio) Current Assets/ Current Liabilities
Quick Ratio (Acid test ratio) (Current Assets-Inv)/ Current Liabilities

MANAGEMENT RATIOS (EFFICIENCY)

Inventory Utilization(Turnover) Sales/Inv
Receivables Turnover Sales/Accounts Receivable
Average Collection Period Accounts Receivable/(Sales/365)
Fixed Asset Utilization Sales/Fixed Assets
Total Asset Utilization(Turnover) Sales/Total Assets
DEBT RATIOS (Safety)

Debt Ratio Total Liabilities/Total Assets

Interest coverage ratio (Times Interest
Earned) Earnings before Interest & Taxes(EBIT)/ Interest
Debt to equity Ratio Total Debt/Total Equity
PROFITABILITY RATIOS
Profit Margin Earnings after Taxes/Sales
Return on Assets Earnings after Taxes/Total Assets
Return on Total Equity Earnings after Taxes/Total Equity
Ratio Analysis Based on Historical and Pro-
Forma Financial Statements
 Forecasts
• Forecasts
– Forecasts are predictions of a firm’s future sales, expenses, income,
and capital expenditures.
• A firm’s forecasts provide the basis for its pro forma financial statements.
• A well-developed set of pro forma financial statements helps a firm create
accurate budgets, build financial plans, and manage its finances in a
proactive rather than a reactive manner.
• Sales Forecast
– A projection of a firm’s sales for a specified period (such as a year).
– Use suitable forecasting techniques: regression analysis, winter’s
method
– It is the first forecast developed and basis for most of the other
forecasts.
• A sales forecast for a new firm is based on a good-faith estimate of sales
and on industry averages or the experiences of similar start-ups.
• A sales forecast for an existing firm is based on (1) its record of past sales,
(2) its current production capacity and product demand, and (3) any factors
that will affect its future product capacity and product demand.
 Steps in Financial Forecasting
• Forecast sales
• Project the assets needed to support sales
• Project internally generated funds
• Project outside funds needed
• Decide how to raise funds
• See effects of plan on ratios
 Percent of Sales Forecasting
• Used to forecast amount of additional
financing required, due to increased sales
Total Forecasted Forecasted
Financing = Increase in – Increase in
Needed Assets Current Liabilities

• Some portion of the financing will be generated

internally, as shown below:

Increase in Forecasted
Retained = Earnings – Dividends
Earnings after Tax
 Additional Financing Needed
• Difference between total financing needed
and internal financing provided is equal to:
Additional (external) Financing Needed =

 Assets ( ∆Sales ) Current Liabilities ( ∆Sales ) 

 − 
 Sales Sales 
− Earnings After Taxes - Dividends 
 2012 Balance Sheet
(Millions of $)

Cash & sec. $ 20 Accts. pay. &

accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000
 2012 Income Statement
(Millions of $)
Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA costs 700.00
EBIT $ 100.00
Interest 10.00
EBT $ 90.00
Taxes (40%) 36.00
Net income $ 54.00
Dividends (40%) $21.60
Add’n to RE $32.40
 AFN (Additional Funds Needed):
Key Assumptions
• Operating at full capacity in 2012.
• Each type of asset grows proportionally with sales.
• Payables and accruals grow proportionally with
sales.
• 2012 profit margin ($54/$2,000 = 2.70%) and
payout (40%) will be maintained.
• Sales are expected to increase by $500 million.
• Then, assets must increase by $250 million.
 Definitions of Variables in AFN
• A*/S0: assets required to support sales;
called capital intensity ratio.
• ∆S: increase in sales.
• L*/S0: spontaneous liabilities ratio
• M: profit margin (Net income/sales)
• RR: retention ratio; percent of net income
not paid as dividend.
 What is the AFN?
AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0270($2,500)(1 - 0.4) = $184.5 million.

•Higher sales:
•Increases asset requirements, increases AFN.
•Higher dividend payout ratio:
•Reduces funds available internally, increases AFN.
•Higher profit margin:
•Increases funds available internally, decreases AFN.
•Higher capital intensity ratio, A*/S0:
•Increases asset requirements, increases AFN.
•Pay suppliers sooner:
•Decreases spontaneous liabilities, increases AFN.
 Pro Forma Statements with the
Percent of Sales Method
• Project sales based on forecasted growth rate in sales
• Forecast some items as a percent of the forecasted sales
– Costs
– Cash
– Accounts receivable
– Inventories
– Net fixed assets
– Accounts payable and accruals
• Choose other items
– Debt
– Dividend policy (which determines retained earnings)
– Common stock
 Sources of Financing Needed to
Support Asset Requirements
• Based on the previous assumptions and choices,
we can estimate:
– Required assets to support sales
– Specified sources of financing
• Additional funds needed (AFN) is:
– Required assets minus specified sources of financing
• If AFN is positive, then you must secure
additional financing.
• If AFN is negative, then you have more financing
than is needed.
– Pay off debt.
– Buy back stock.
– Buy short-term investments.
How to Forecast Interest Expense
• Interest expense is actually based on the
daily balance of debt during the year.
• There are three ways to approximate
interest expense. Base it on:
– Debt at end of year
– Debt at beginning of year
– Average of beginning and ending debt
• Base interest expense on beginning debt,
but use a slightly higher interest rate.
– Easy to implement
– Reasonably accurate
 Percent of Sales: Inputs
2012 2013
Actual Proj.
COGS/Sales 60% 60%
SGA/Sales 35% 35%
Cash/Sales 1% 1%
Acct. rec./Sales 12% 12%
Inv./Sales 12% 12%
Net FA/Sales 25% 25%
AP & accr./Sales 5% 5%
 Other Inputs

Percent growth in sales 25%

Growth factor in sales (g) 1.25
Interest rate on debt 10%
Tax rate 40%
Dividend payout rate 40%
2013 Forecasted Income Statement
2013
2012 Factor 1st Pass
Sales $2,000 g=1.25 $2,500.0
Less: COGS Pct=60% 1,500.0
SGA Pct=35% 875.0
EBIT $125.0
Interest 0.1(Debt12) 20.0
EBT $105.0
Taxes (40%) 42.0
Net. income $63.0
Div. (40%) $25.2
Add. to RE $37.8
 2013 Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.

2013 Sales = $2,500

Factor 2013
Cash Pct= 1% $25.0
Accts. rec. Pct=12% 300.0
Inventories Pct=12% 300.0
Total CA $625.0
Net FA Pct=25% 625.0
Total assets $1,250.0
2013 Preliminary Balance Sheet (Claims)
2013 Sales = $2,500 2013
2012 Factor Without AFN
AP/accruals Pct=5% $125.0
Notes payable 100 100.0
Total CL $225.0
L-T debt 100 100.0
Common stk. 500 500.0
Ret. earnings 200 +37.8* 237.8
Total claims $1,062.8

*From forecasted income statement.

 Additional fund needed (AFN)?
• Required assets = $1,250.0
• Specified sources of fin. = $1,062.8
• Forecast AFN = $ 187.2

• We must have the assets to make forecasted sales, and so we

need to secure another $187.2 of financing.
• Equation AFN = $184.5 vs. Pro Forma AFN = $187.2.
• Why are they different?
• Equation method assumes a constant profit margin.
• Pro forma method is more flexible.
• It allows different items to grow at different rates.
 How Will AFN Be Raised?
• Assumptions
– No new common stock will be issued.
– Any external funds needed will be raised as debt, 50%
notes payable, and 50% L-T debt.
• Additional notes payable =
0.5 ($187.2) = $93.6.

• Additional L-T debt =

0.5 ($187.2) = $93.6.
 2013 Balance Sheet (Claims)
w/o AFN AFN With AFN
AP/accruals $ 125.0 $ 125.0
Notes payable 100.0 +93.6 193.6
Total CL $ 225.0 $ 318.6
L-T debt 100.0 +93.6 193.6
Common stk. 500.0 500.0
Ret. earnings 237.8 237.8
Total claims $1,071.0 $1,250.0
 Forecasted Ratios
2012 2013(E) Industry
• Profit Margin 2.70% 2.52% 4.00%
• ROE 7.71% 8.54% 15.60%
• DSO (days) 43.80 43.80 32.00
• Inv. turnover 8.33x 8.33x 11.00x
• FA turnover 4.00x 4.00x 5.00x
• Debt ratio 30.00% 40.98% 36.00%
• TIE 10.00x 6.25x 9.40x
• Current ratio 2.50x 1.96x 3.00x
Forecasted free cash flow and ROIC?
2012 2013(E)
Net operating WC $400 $500
(CA - AP & accruals)
Total operating capital $900 $1,125
(Net op. WC + net FA)
NOPAT (EBITx(1-T)) $60 $75
Less Inv. in op. capital $225
Free cash flow -$150
ROIC (NOPAT/Capital) 6.7%
Suppose in 2012 fixed assets had been
operated at only 75% of capacity.
• Capacity sales = Actual sales
= $2,000 = $2,667.
% of capacity 0.75
• With the existing fixed assets, sales could be
$2,667. Since sales are forecasted at only $2,500,
no new fixed assets are needed.
• Impact of excess capacity situation on the 2013
AFN
– The previously projected increase in fixed assets was
$125.
– Since no new fixed assets will be needed, AFN will fall
by $125, to
$187.2 - $125 = $62.2.