Chapter 4

4.1.What is Financial Planning?

4.2.Pro Forma Income Statement
4.3.Pro Forma Balance Sheet
4.4.The Percentage of Sale Approach
Main Points
 Understand the financial planning process
and how decisions are interrelated
 Be able to develop a financial plan using the
percentage of sales approach
 Understand the four major decision areas
involved in long-term financial planning
 Understand how capital structure policy and
dividend policy affect a firm’s ability to grow

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Financial Plan
 A financial plan is a statement of what is to be
done in the future
 Financial planning is a process of systematically
thinking about the future
 Financial planning establishes guidelines for
change and growth in a firm

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Financial Planning Process -1
Financial Planning Process-2
Financial Planning Process-3
Principles for F. Planning
 Simplicity
 Flexibility
 Profitability
 Objectivity
 Practical
 Liquidity……
Example: Historical Financial
Statements
Gourmet Coffee Inc.
Gourmet Coffee Inc.
Balance Sheet Income Statement
December 31, 2004 For Year Ended
Assets 1000 Debt 400 December 31, 2004
Revenues 2000
Equity 600
Costs 1600
Total 1000 Total 1000 Net Income 400

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Example: Pro Forma Income
Statement
 Initial Assumptions
Gourmet Coffee Inc.
 Revenues will grow at
15% (2000*1.15) Pro Forma Income
 All items are tied Statement
directly to sales and the For Year End 2005
current relationships
Revenues 2,300
are optimal
 Consequently, all other
items will also grow at Costs 1,840
15%
Net Income 460
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Example: Pro Forma Balance Sheet
Gourmet Coffee Inc.
 Case I
Pro Forma Balance Sheet
 Debt & equity increase at
15% Case 1
 Dividends are the plug Assets 1,150 Debt 460
variable Equity 690
 Dividends = 460 – 90 Total 1,150 Total 1,150
Dividends = 370 Gourmet Coffee Inc.
 Case II
Pro Forma Balance Sheet
 No dividends are paid
Case 2
 Debt is the plug variable Assets 1,150 Debt 90
 Debt = 1,150 – (600+460) =
90 Equity 1,060
 Repay 400 – 90 = 310 in Total 1,150 Total 1,150
debt
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Percent of Sales Approach
 Some items vary directly with sales, while others
do not
 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 affects additions
to retained earnings

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Percent of Sales Approach
 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 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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Example: Income Statement
Tasha’s Toy Emporium Tasha’s Toy Emporium
Income Statement, 2004 Pro Forma Income Statement,
2005
% of
Sales 5,500
Sales
Sales 5,000 Costs 3,300

Costs 3,000 60% EBT 2,200

Taxes 880
EBT 2,000 40%
Net Income 1,320
Taxes 800 16%
(40%)
Dividends 660
Net Income 1,200 24%
Add. To RE 660
Dividends 600
Assume Sales grow at 10%
Add.
4-15 To RE 600 Dividend Payout Rate = 50%
Example: Balance Sheet
Tasha’s Toy Emporium – Balance Sheet
Current % of Pro Current % of Pro
Sales Forma Sales Forma
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 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
Total L & OE 9,500 10,250
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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
 Borrow more short-term (Notes Payable)
 Borrow more long-term (LT Debt)
 Sell more common stock (CS)
 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 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)
 Pay more in dividends (reduce Additions To Retained Earnings)
 Increase cash account
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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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FIGURE 4.1

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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.
 Using the information from Tasha’s Toy
Emporium
 ROA = 1200 / 9500 = .1263
 B = .5

ROA  b
Internal Growth Rate 
1 - ROA  b
.1263  .5
  .0674
1  .1263  .5
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 6.74%
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.
 Using Tasha’s Toy Emporium
 ROE = 1200 / 4100 = .2927
 b = .5
ROE  b
Sustainabl e Growth Rate 
1 - ROE  b
.2927  .5
  .1714
1  .2927  .5
 17.14%
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Example: Sustainable Growth
Tasha’s Toy Emporium
Tasha’s Toy Emporium
Income Statement, 2004 Pro Forma Income Statement,
% of Sales 2005
Sales 5,855
Sales 5,000
Costs 3,513
Costs 3,000 60%
EBT 2,342
EBT 2,000 40% Taxes 937
Taxes 800 16% Net Income 1,405
(40%)
Dividends 703
Net Income 1,200 24%
Add. To RE 702

Dividends Assume Sales grow at 17.1%,

4-23 600 sustainable growth rate
 Example contn’d
Current % of Pro Current % of Pro
Sales Forma Sales Forma
ASSETS Liabilities & Owners’ Equity
Current Assets Current Liabilities
Cash $500 10% $586 A/P $900 18% 1054
A/R 2,000 40 2,342 N/P 2,500 n/a 2,927
Inventory 3,000 60 3,513 CL 3,400 n/a 3,981
Total 5,500 110 6,441 LT Debt 2,000 1.17 2,342
Fixed Assets N/P + LTD 4500 1.17 5270

Net PP&E 4,000 80 4,684 CS 2,000 n/a 2,000

Total Assets 9,500 190 11,125 RE 2,100 n/a 2,802
Net Worth 4,100 1.17 4,802
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D/E= Total L & OE 9,500 11,125
Determinants of Growth
 Profitmargin – 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
– low dividend payout increases the
sustainable growth.

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Important Questions
 It is important to remember that we are
working with accounting numbers and 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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Deriving the Internal Growth
Rate
 Assuming no CL account varies spontaneously with
sales, and full capacity;
 EFN = increase in assets – addition to retained earnings
 Increase in assets = A  g
 Addition to retained earnings = NI(1 + g)b
 NI = PM(S)
 Thus,
 EFN = A(g) – PM(S)(1 + g)b
 = A(g) – PM(S)b – [PM(S)b]g
 = – PM(S)b + [A – PM(S)b]g

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Deriving Internal growth rate
(contn’d)
 ..where EFN is zero:
 EFN= 0 = – PM(S)b + [A – PM(S)b]g
 g = [PM(S)b ] / [A – PM(S)b]
 Since ROA = NI / A = PM(S) / A
 dividing numerator and denominator by A gives
 g = {[PM(S)b] / A} / {[A – PM(S)b] / A}
 g = b(ROA) / [1 – b(ROA)]
 This is internal growth rate.Growing with RE only.

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Deriving Sustainable growth
rate
 To maintain a constant D/E ratio with no external
equity financing, EFN must equal the addition to
retained earnings times the D/E ratio:
 EFN= (D/E)[ PM(S)b(1 + g)] = A(g) – PM(S)b(1 + g)
 Solving for g and then dividing numerator and
denominator by A:
 g = PM(S)b(1 + D/E) / [A – PM(S)b(1 + D/E )]
 = [ROA(1 + D/E )b] / [1 – ROA(1 + D/E )b]
 = b(ROE) / [1 – b(ROE)]

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