Session 3:

Long-term financial planning and growth

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Learning Objectives

Financial Planning

Financial Planning Models

The percentage of Sales Approach

External Financing and Growth

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 1. Financial Planning

Formulating Avoid financial

Financial goals stumbling

Anticipating Establish
problems before guidelines for
they arrive change and growth 3
Elements of Financial Planning
Investment in new assets – determined by capital budgeting
decisions

Degree of financial leverage – determined by capital structure

decisions

Liquidity requirements – determined by net working capital

decisions

Cash paid to shareholders – determined by dividend policy

decisions

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2. Financial Planning Process
• Financial Planning: what should 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)

• Aggregation - combine capital budgeting decisions into one

large project

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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

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3. The Percentage of Sales approach
Financial Planning Model Ingredients

• Economic Assumptions –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 7
Example: Proforma Income statement

• Rosengarten Corporation has projected a 25% increase in sales

for the coming year.
• $1000 x 1.25=$1,250

• In order to generate a proforma income statement, we assume

that total costs will continue to run at 80% of sales.
• This is know as the percent of sales approach

• The effect of this approach imply that the profit margin remain
constant 13.2% (look at book RWJ 2nd edition page 100).
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Rosengarten Income Statement

Don’t forget to Add $110 to the balance

sheet in the retained earnings account
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Proforma balance sheet

• On the balance sheet, we assume that some items vary

directly with sales and others do not
• For those items that do vary with sales, we express each as a
percentage of sales
• When an item does not vary with sales, we write “n/a”

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 Rosengarten Balance sheet- Unbalanced
(table 4-4).

• Inspecting our pro forma balance sheet reveals a discrepancy: Assets and liabilities and equity not
balanced, which we know that it should be balance!!
• The shortfall is called external financing needed “EFN” or the plug variable
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Percentage 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 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 12
Example 2: Hoffman Company-table 4-8

• The Hoffman company is forecasting next year sales to be

$600 (increase 20%)
• Thus at a 20% growth rate, Hoffman needs $100 in new
assets as their first year assets total $500.

• (Look at book RWJ chapter 4 page 108)

Assets % of S Liab & Equities % of S
C/A $200 40% T. Debt $250 n/a
NFA $300 60% Equity $250 n/a
TA $500 100 Total $500 n/a 13
Hoffman Income Statement-table 4-8

• Projected additions to retained earnings are $52.8

• Projected dividends paid are $26.4

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Hoffman Balance sheet - unbalances

• After adding the $52.8 into retained earnings, the balance

sheet is not balance
• But it should be!
• Thus the plug variable is 47.2 (company should be borrowed)
or EFN (External Financing Needed) 15
Financing Policy and Growth, p-111.
• 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 assumes that the dividend
payout ratio is constant.
• Using the information from Tasha’s Toy Emporium
 ROA = 1200 / 9500 = .1263
 b = retention ratio = (1 – dividend payout ratio) = .5

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The Sustainable Growth Rate, p-112.
• 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-equity ratio.
• Assumptions:
• The sustainable growth rate also assumes that the dividend payout ratio is
constant
• No new external equity is issued, but debt increases with growth
• Using Tasha’s Toy Emporium
 ROE = 1200 / 4100 = .2927
 b = .5
ROE×b
Sustainable  Growth Rate =
1−ROE×b 17
Determinants of Growth, p-115.

• Profit margin–operating efficiency to generate funds internally

• Financial leverage – choice of optimal debt ratio, how to

utilized debt and maximize products

• Dividend policy – choice of how much to pay to shareholders

versus reinvesting in the firm

• Total asset turnover – asset use efficiency

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