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Chapter 4
Financial planning and corporate growth

MSC. NGUYEN HONG MINH

UNIVERSITY OF ECONOMICS AND BUSINESS- VIETNAM NATIONAL UNIVERSITY, HANOI

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4.1. What is Financial Planning?

 Financial planning formulates the way in which financial goals are

to be achieved.
 A financial plan is a statement of what is to be done in the future.
 Planning Horizon - divide decisions into short-run decisions
(usually next 12 months) and long-run decisions (usually 2 – 5
years)
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Why do we need
Financial planning?

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Basic Elements of Financial Planning

Many decisions have long lead times, which means they take a long time to implement. In an uncertain world,
this requires that decisions be made far in advance of their implementation.

 Investment in new assets – determined by capital budgeting decisions

 Degree of financial leverage – determined by capital structure decisions

 Cash paid to shareholders – dividend policy decisions The trade-off?

 Liquidity requirements – determined by net working capital decisions

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Role of Financial Planning

 Examine interactions – help management see the interactions between decisions

 Explore options – give management a systematic framework for exploring its opportunities

 Avoid surprises – help management identify possible outcomes and plan accordingly

 Ensure feasibility and internal consistency – help management determine if goals can be
accomplished and if the various stated (and unstated) goals of the firm are consistent with one
another
Committing a plan to paper

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 Percentage of Sales Approach

 A financial planning method in which accounts are varied depending on a firm’s

predicted sales level.
 Separate the income statement and balance sheet accounts into two groups: those
that vary directly with sales and those that do not.
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Percentage of Sales Approach
 Some items vary directly with sales, while others do not
Fixed vs variable cost
 Income Statement
▪ Costs may vary directly with sales - if this is the case, then the profit margin is constant
▪ Depreciation and interest expense may not vary directly with sales – if this is the case, then the profit margin is not constant
▪ Dividends are a management decision and generally do not vary directly with sales – this influences additions to retained earnings
 Balance Sheet
▪ Initially assume all assets, including fixed, vary directly with sales
▪ Accounts payable will also normally vary directly with sales
▪ Notes payable, long-term debt and equity generally do not vary directly with sales because they depend on management decisions
about capital structure
▪ The change in the retained earnings portion of equity will come from the dividend decision

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Financial Planning Model Ingredients

 Economic Assumptions – explicit assumptions about the coming economic environment

 Sales Forecast – many cash flows depend directly on the level of sales (often estimated using sales growth rate)

 Pro Forma Statements – setting up the plan using projected financial statements allows for consistency and ease of interpretation

 Asset Requirements – the additional assets that will be required to meet sales projections

 Financial Requirements – the amount of financing needed to pay for the required assets

 Plug Variable – determined by management deciding what type of financing will be used to make the balance sheet balance

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Example: Historical Financial Statements

Gourmet Coffee Inc. Gourmet Coffee Inc.

Balance Sheet Income Statement
December 31, 2012 For Year Ended December 31,
2012
Assets 1000 Debt 400
Revenues 2000
Equity 600 Less: costs (1600)

Total 1000 Total 1000 Net Income 400

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Example: Pro Forma Income Statement

Gourmet Coffee Inc.

• Initial Assumptions
▪ Revenues will Pro Forma Income Statement
grow at 15% (2,000*1.15) For Year Ended 2013
▪ All items are tied directly to sales,
and the current relationships are Revenues 2,300
optimal
▪ Consequently, all other items will Less: costs (1,840)
also grow at 15%
Net Income 460

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A simple financial planning model

❑ Historical Financial Statements

❑ Pro Forma Income Statement
❑ Pro Forma Balance Sheet

❑Pro Forma Financial Statement

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Example: Income Statement

Tasha’s Toy Emporium

Tasha’s Toy Emporium
Income Statement, 2012 Pro Forma Income Statement, 2013
% of Sales
Sales 5,500
Sales 5,000
Less: costs (3,300)
Less: costs (3,000) 60%
EBT 2,000 40% EBT 2,200
Less: taxes (800) 16% Less: taxes (880)
(40% of EBT)
Net Income 1,320
Net Income 1,200 24%
Dividends 600 Dividends 660

Add. To RE 600 Assume Sales grow at 10% Add. To RE 660

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Dividend Payout Rate = 50%
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Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current % of Sales Pro Current % of Pro Forma
Forma Sales

Assets Liabilities & Owners’ Equity

Current Assets Current Liabilities
Cash $500 10% $550 A/P $900 18% $990

A/R 2,000 40 2,200 N/P 2,500 n/a 2,500

Inventory 3,000 60 3,300 Total 3,400 n/a 3,490
Total 5,500 110 6,050 LT Debt 2,000 n/a 2,000
Fixed Assets Owners’ Equity
Net PP&E 4,000 80 4,400 CS & APIC 2,000 n/a 2,000
Total Assets 9,500 190 10,450 RE 2,100 n/a 2,760
Total 4,100 n/a 4,760

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Example: External Financing Needed

 The firm needs to come up with an additional $200 in debt or equity to make the
balance sheet balance
▪ TA – TL&OE = 10,450 – 10,250 = 200
 Choose plug variable ($200 EFN)
▪ Borrow more short-term (Notes Payable)
▪ Borrow more long-term (LT Debt)
▪ Sell more common stock (CS & APIC)
▪ Decrease dividend payout, which increases the Additions To Retained Earnings

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Example: Operating at Less than Full
Capacity
 Suppose that the company is currently operating at 80% capacity.
▪ Full Capacity sales = 5000 / .8 = 6,250
▪ Estimated sales = $5,500, so we would still only be operating at 88%
▪ Therefore, no additional fixed assets would be required.
▪ Pro forma Total Assets = 6,050 + 4,000 = 10,050
▪ Total Liabilities and Owners’ Equity = 10,250
 Choose plug variable (for $200 EXCESS financing)
▪ Repay some short-term debt (decrease Notes Payable)
▪ Repay some long-term debt (decrease LT Debt)
▪ Buy back stock (decrease CS & APIC)
▪ Pay more in dividends (reduce Additions To Retained Earnings)
▪ Increase cash account

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Example:

 The most recent financial statements for GPS, Inc., are shown here:

Assets and costs are proportional to sales. Debt and equity are not. A dividend of $1,400 was paid, and the
company wishes to maintain a constant payout ratio. Next year’s sales are projected to be $21,840. What is the
external financing needed?
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Growth and External Financing

 Dividend payout ratio: The amount of cash paid out to shareholders

divided by net income = Cash dividend/Net income
 Retention ratio: The addition to retained earnings divided by net income.
Also called the plowback ratio = 1- Dividend payout ratio

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Example:

Solution
An increase of sales to $21,840 is an increase of:

Sales increase = ($21,840 – 19,500) / $19,500

Sales increase = .12 or 12%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

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Example:
The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:

Dividends = ($1,400 / $2,700)($3,024)

Dividends = $1,568

The addition to retained earnings is:

Addition to retained earnings = $3,024 – 1,568

Addition to retained earnings = $1,456

And the new equity balance is:

Equity = $45,500 + 1,456

Equity = $46,956

So the EFN is:

EFN = Total assets – Total liabilities and equity
EFN = $109,760 – 99,456
EFN = $10,304

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Growth and External Financing

 At low growth levels, internal financing (retained earnings) may exceed the required
investment in assets
 As the growth rate increases, the internal financing will not be enough, and the firm
will have to go to the capital markets for money
 Examining the relationship between growth and external financing required is a useful
tool in long-range planning

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Growth and External Financing

 Dividend payout ratio: The amount of cash paid out to shareholders

divided by net income = Cash dividend/Net income
 Retention ratio: The addition to retained earnings divided by net income.
Also called the plowback ratio = 1- Dividend payout ratio

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The Internal Growth Rate

 The internal growth rate tells us how much the firm can grow assets using retained earnings as the
only source of financing.
 The internal growth rate of a firm is best described as the maximum growth rate achievable
excluding external financing of any kind.
 Using the information from Tasha’s Toy Emporium
▪ ROA = 1200 / 9500 = .1263 ROA b
InternalGrowthRate=
▪ b = .5 1 - ROA b
.1263.5
= = .0674
 b= retention ratio = 1- dividend payout ratio 1− .1263.5
= 6.74%

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The Sustainable Growth Rate

 The sustainable growth rate tells us how much the firm can grow by using internally
generated funds and issuing debt to maintain a constant debt ratio.
 The sustainable growth rate of a firm is best described as the maximum growth rate
achievable excluding any external equity financing while maintaining a constant debt-
equity ratio.
ROE b
 Using Tasha’s Toy Emporium Sustainable GrowthRate=
1- ROE b
▪ ROE = 1200 / 4100 = .2927
.2927.5
= = .1714
▪ b = .5 1− .2927.5
= 17.14%
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The Sustainable Growth Rate

There are various reasons why a firm might wish to avoid equity sales.
 New equity sales can be expensive.
 The current owners may not wish to bring in new owners or contribute additional
equity.
 A firm might view a particular debt–equity ratio as optimal

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Growth and External Financing
 Growth and External Financing

 Hoffman grows at exactly the sustainable growth rate of 21.36 percent. What will the pro forma
statements look like?
 At a 21.36 percent growth rate, sales will rise from $500 to $606.8. The pro forma income
statement will look like this:
4.4. Growth and External Financing

 EFN is $53.4. If Hoffman borrows this amount, then total debt will rise to
$303.4, and the debt–equity ratio will be exactly 1.0, which verifies our earlier
calculation. At any other growth rate, something would have to change.
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Example:

The Two Sisters has a 9 percent return on assets and a 75 percent retention ratio. What is the internal
growth rate?
A. 6.50 percent
B. 6.75 percent
C. 6.97 percent
D. 7.24 percent

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Determinants of Growth

 Profit margin – operating efficiency

 Total asset turnover – asset use efficiency

 Financial leverage – choice of optimal debt ratio

 Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

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Important Questions

 It is important to remember that we are working with accounting numbers;

therefore, we must ask ourselves some important questions as we go
through the planning process:
▪ How does our plan affect the timing and risk of our cash flows?

▪ Does the plan point out inconsistencies in our goals?

▪ If we follow this plan, will we maximize owners’ wealth?

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Case study

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Key Concepts and Skills

 Understand the financial planning process and how decisions are interrelated

 Be able to develop a financial plan using the percentage of sales approach

 Be able to compute external financing needed and identify the determinants of a firm’s growth

 Understand the Internal Growth Rate and Sustainable Growth Rate

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