BMSH2201

FINANCIAL PLANNING TOOLS AND CONCEPTS

The Financial Planning Process
Introduction to Financial Planning

 Financial planning is important for several reasons:

o Financial planning helps the business assess the impact of a particular strategy on its financial
position, cash flows, reported earnings, and need for external financing.
o When a business develops financial plans, the management is better able to react to any changes in
the market condition, such as when sales are slower than expected or a reduction in the supply of
raw materials.
o Creating a financial plan helps managers understand the trade-offs involved in investments and
financial plans. For example, by developing a financial plan, management can better understand the
trade-off between having sufficient inventory to satisfy customer demands and the need to finance
the investment in inventory.
Long-term Planning Process

 Forecast sales – Forecasting sales begins with understanding the industry the business belongs to,
knowing the target market, and ultimately forecasting the market share in sales from that segment.
Forecasted sales may increase based on the target increase in market share or the increase in the market
itself.
A fundamental truth in business is that a company acquires assets to generate sales. If the firm
wants to increase sales, it has to acquire more assets. If the business wants to increase sales by
25%, the assets need to increase by 25% as well. To increase the assets by 25%, the other side of
the balance sheet (liabilities and equity) needs to increase and keep the balance sheet equal.
 Compute the dividend pay-out ratio and plowback ratio – These ratios analyze the relationship
between net income and dividends.
o The pay-out ratio is computed by dividing the cash dividends by net income. It is expressed as a
percentage. For example, if the firm has a net income of P5M and a cash dividend of P3M, the pay-
out ratio is 60%. This means that 60% of the net income goes to the stockholders.
o The plowback ratio is the opposite of the pay-out ratio. It is the portion of income that does not get
paid out as dividends. It is also known as the retention ratio.
o If the business does not pay any dividends, the plowback ratio is 100%, and the pay-out ratio is
zero.
o These ratios indicate how much of the profits are retained for business growth. Younger businesses
tend to have higher plowback ratios; these fast-growing companies are more focused on business
development.
 Identify the sources of funds – The business must learn to identify the funds that can come from
normal business activities (sales).
 Use the percentage of sales approach to prepare the pro-forma financial statements – The
percentage of sales approach is based on the premise that most balance sheets and income statement
accounts vary with sales. If the forecasted sales growth is 25%, the income statement and balance sheet
accounts will also increase by 25%.
 Calculate the external financing need (EFN) – EFN, also known as Additional Funds Needed
(AFN) and Discretionary Financing Needs (DFN), is the required additional financing. It is acquired
through the sales of stocks and bonds.
Budgeting

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Budgeting

A budget estimates the amount of revenues and expenses a company may incur over a future period.
Budgeting represents a business’ financial position, cash flows, and goals. A company’s budget is usually re-
evaluated periodically, usually once per fiscal year, depending on how the management wants to update the
information. Budgeting creates a baseline to compare actual results to determine how the results vary from the
expected performance.
 It is also a financial plan expressed in quantitative terms, prepared by the management in advance for
the forthcoming period. It is the financial expression of a business plan or target.
 The budget sets the company's targets and is updated once a year. The budget is compared to actual
results to determine variances from expected performance.
Types of Budgets
 Capital Budget – This budget estimates all capital asset acquisitions and summarizes all expenses and
costs of major purchases for the next year. Capital assets include items that have useful lives of more
than 12 months, such as buildings, building improvements, land, furniture, fixtures, equipment, and
computers.
 Operating Budget - Operating budgets indicate the products and services a firm expects to use in a
budget period. It describes all the income-generating activities of a firm, including production, sales,
and inventories of finished goods. An operating budget typically has two (2) distinct parts: the expense
and revenue budgets. The expense budget indicates all expected expenses of a firm for the coming year,
while the revenue budget shows all projected revenues for the coming year.
 Cash Budget - A cash budget projects all cash inflows and outflows for the next year. A cash budget is
important because it allows administrators to timely identify periods with cash overages and shortages
so they can take necessary remedial action.
 Sales Budget - Sales budgets indicate the sales a firm expects to make in units and money for a budget
year. They detail the quantities of products or services a firm expects to sell, revenues incurred from
those sales, and all expenses accrued during selling. Sales budget forecasts determine sales potential or
the maximum number of sales a firm can make. This information is then used to plan resource
allocations to achieve those sales levels. Sales budgets serve as benchmarks or yardsticks against which
actual sales performance is measured, and variables such as sales volume, profitability, and selling
expenses are controlled.
 Personnel Budget – This budget is also known as the salary and wage budget. They are cost
estimations related to labor. They include the costs of recruitment, hiring, training, assignment, salaries,
overtime costs, additional benefits, and retirement.
Preparing the Cash Budget

 The primary tool in short-term financial planning is the cash budget. It plots the business’ cash inflow
and outflow. It is typically done monthly and covers a year.
 It is divided into three (3) parts: cash receipts, cash disbursements, and excess cash balance (or required
total financing). An example of a cash budget is shown below:

Cash Budget
Jan Feb Mar
Cash Receipts
Less: Cash Disbursements
Net Cash Flow

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Add: Beginning Cash

Ending Cash
Less: Minimum Cash Balance
Required Total Financing
Excess Cash Balance

Preparing the cash budget can be summarized in these steps:

1. Forecast the business’ monthly sales. This can be done using historical figures.
2. Forecast the sales and the credit sales from the projected monthly sales. Cash sales are preferable to
credit sales. If sales are made on credit, estimate when the receivables would be collected.
3. Consider all the other cash receipts. Other cash receipts are sources of cash other than sales, such as
interest payment received.
4. Sum up the total cash receipts.
5. Forecast the business’ monthly purchases.
6. Forecast the business’ cash purchases and the credit purchases from the projected monthly purchases.
If purchases are made on credit, forecast when those debts will be paid.
7. Consider other cash disbursements. These include wages and salaries, taxes, capital expenditures,
rent, and interest payments.
8. Sum up the total cash disbursements.
9. Subtract the total cash disbursements from the total cash receipts to get the net cash flow.
10. Add the beginning cash balance to the net cash flow to get the ending cash balance. The ending cash
balance of the previous month will be the beginning cash balance of the next month.
11. Subtract the minimum cash balance from the ending cash balance. The minimum cash balance, also
known as the target cash balance, is the minimum cash balance the business needs to have on hand to
conduct its day-to-day operations. Short-term financing is required if the minimum cash balance is
greater than the ending cash balance. If the minimum cash balance is less than the ending cash balance,
the business has excess cash.
Part 1 of the Cash Budget: Cash Receipts (Steps 1-4)

Sales Forecast JAN FEB MAR APR MAY

150,000 220,000 380,000 340,000 295,000
Cash Sales (15%) 22,500 33,000
Accounts Receivable Collections
1-month debt 82,500
2-month debt
Other Cash Receipts 150,000 150,000 150,000 150,000 150,000
Total Cash Receipts 172,500 265,500

Part 2 of the Cash Budget: Cash Disbursements (Steps 5-8)

Sales Forecast JAN FEB MAR APR MAY

Purchases 120,000 176,000
Cash purchases 6,000 8,800
Accounts payable payment

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1-month debt 96,000

2-month debt
Rent payments 15,000 15,000 15,000 15,000 15,000
Wages and salaries 19,500 23,000
Tax payments 40,000
Fixed asset outlay 200,000
Interest payment 110,000 110,000 110,000 110,000 110,000
Principal payments 150,000
Total cash disbursements 150,500 252,800

Part 3 of the Cash Budget: Excess Cash Balance / Required Total Financing (Steps 9-11)

Sales Forecast JAN FEB MAR APR MAY

Cash Receipts 172,500 265,500
Less: Cash Disbursements 150,500 252,800
Net Cash Flow 22,000 12,700
Add: Beginning Cash
Ending Cash 70,000
Less: Minimum Cash
Balance
Required Total Financing
Excess Cash Balance

Forecasting

 A forecast estimates future trends and outcomes based on past and present data. It is a prediction of the
upcoming events or trends in business on the basis of present business conditions. There is no target
included in a forecast.
 Forecasting estimates a company’s future financial outcomes by examining historical data. Companies
use financial forecasting to determine how to allocate their budgets for a future period. Unlike
budgeting, financial forecasting does not analyze the variances between financial forecasts and actual
performance. Financial forecasts are updated regularly when there is a change in operations, inventory,
and business plan.
 The forecast is typically limited to major revenue and expense line items. There is usually no forecast
for a financial position, though cash flows may be forecasted.
 The forecast may be used for short-term operational considerations, such as adjustments to staffing,
inventory levels, and the production plan.

Types of forecasts
 Financial Forecast - A financial plan that projects income and expenses, future sales, future
demand for a product, or anything that is expected to happen in the future.
 Cash Flow Forecast – Projects cash inflow (sources of cash) and cash outflow (uses of cash).
 Investment Forecast – This forecast detail where to put investments to get maximum return.

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 Projected Financial Statements – These show a summary of revenue and expense projections for the
budget period. They are prepared to guide managers on how to attain their objectives.
Working Capital Management
Holding on to cash

 Why People Hold on to Cash

o Speculation – Firms hold on to cash if there are special opportunities for the firm that must be acted
on quickly.
o Precaution – Holding cash can serve as an emergency fund for the firm. If expected cash inflows
are not received, the cash held on a precautionary basis could be used to satisfy short-term
obligations.
o Transaction – Firms exist to produce goods and services. This activity results in the need for cash to
buy raw materials and pay off debts.
 Liquidity
o Liquidity is the ability of the company to satisfy its short-term obligations using assets that are
readily converted to cash. Liquidity management is the ability of the company to generate cash when
and where needed.
o Liquidity management requires addressing the drags and pulls on liquidity.
 Drags on liquidity are the forces that delay cash collection, such as slow payments from
customers or obsolete inventory.
 Pulls on liquidity are decisions that result in paying cash too soon, such as paying cash credit or a
bank reducing its line of credit.
o Primary sources of liquidity
 Cash and cash equivalents
 Cash received from sales
 Accounts payables
 Short-term funds
 Trade credit from suppliers
 Working capital loans from banks
 Cash flow management
 The firm can also generate working capital by effectively managing its cash.

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Managing Cash, Receivables, and Inventory

A. The Operating Cycle
 A business purchases raw materials to manufacture the products they sell. Sometimes, those raw
materials are bought on credit. Once the products are sold, the business can choose to pay
immediately or at a later date.
 Ideally, businesses want to receive payment for sales right away and then use the payment to clear
the debts. However, there is often a mismatch in the timing of cash receipts and the cash payment for
the raw materials. Therefore, it is necessary to know how long, on average, it takes for the business
to pay its suppliers and collect its sales.
 The operating period refers to the period between the sale of the product and receiving the cash
payment. The cycle comprises two (2) periods: the inventory period and the accounts receivable
period. The inventory period is the time it takes for the business to sell its product after it has
purchased the raw materials. In contrast, the accounts receivable period is when it takes for the
business to collect the sale of the finished product. A shorter operating period is preferable for
business.
Accounts Receivable Period

Receivables Turnover 𝑁𝑒𝑡 𝐶𝑟𝑒𝑑𝐶𝐶𝑡 𝑆𝑎𝑙𝑒𝑠

Ratio: (𝐵𝑒𝑔𝐶𝐶𝑛𝑛𝐶𝐶𝑛𝑔 𝑅𝑒𝑐𝑒𝐶𝐶𝑣𝑎𝑏𝑙𝑒𝑠 + 𝐸𝑛𝑑𝐶𝐶𝑛𝑔 𝑅𝑒𝑐𝑒𝐶𝐶𝑣𝑎𝑏𝑙𝑒𝑠)⁄2

365
Age of Receivables
𝑅𝑒𝑐𝑒𝐶𝐶𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Inventory Period

Inventory Turnover Ratio 𝐶𝑜𝑠𝑡 𝑜𝑜𝑜 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

(𝐵𝑒𝑔𝐶𝐶𝑛𝑛𝐶𝐶𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐸𝑛𝑑𝐶𝐶𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)⁄2

365
Age of Inventory
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Operating Cycle
𝐴𝑔𝑒 𝑜𝑜𝑜 𝑅𝑒𝑐𝑒𝐶𝐶𝑣𝑎𝑏𝑙𝑒𝑠 + 𝐴𝑔𝑒 𝑜𝑜𝑜 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

B. The Cash Conversion Cycle

 The cash conversion cycle, also known as the cash cycle, is the time it takes for the business to
collect its account receivables after paying for its raw materials. It is calculated by subtracting the
accounts payable period from the operating cycle.
 The cash conversion period may be obtained by computing the accounts payable period turnover. It
is the time it takes for the business to pay for its raw materials from when they are acquired. Just like
the operating cycle, a shorter cycle is preferred.

𝐶𝑜𝑠𝑡 𝑜𝑜𝑜 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

Accounts Payable Turnover 𝐵𝑒𝑔𝐶𝐶𝑛𝑛𝐶𝐶𝑛𝑔 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 + 𝐸𝑛𝑑𝐶𝐶𝑛𝑔 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
� 2 �

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365
Accounts Payable Period
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

Cash Conversion Cycle 𝑂𝑝𝑒𝑟𝑎𝑡𝐶𝐶𝑛𝑔 𝑐𝑦𝑐𝑙𝑒 − 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑃𝑒𝑟𝐶𝐶𝑜𝑑

References
Mayo, H. B. (2017). Business Finance: Theory and Practice. Quezon City: Abiva Publishing House, Inc. Titman, S.,
Keown, A. J., & Martin, J. D. (2018). Financial Management: Principles and Applications (13th ed.).
New York: Pearson Education, Inc.

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