CHAPTER THREE
Financial Planning
and Corporate Growth
Abdu Seid(PhD)
CHAPTER OUTLINE
1. What is Financial Planning?
2. Financial Planning Models: A First Look
3. The Percentage of Sales Approach
4. External Financing and Growth
5. Some Caveats of Financial Planning
Models
CHAPTER OBJECTIVES
Understand what financial planning is and what
it can accomplish.
Outline the elements of a financial plan.
Discuss and be able to apply the percentage of
sales approach.
Understand how capital structure policy and
dividend policy affect a firm’s ability to grow.
WHAT IS FINANCIAL PLANNING?
Formulates the way financial goals are to be
achieved.
Requires that decisions be made about an
uncertain future.
Recall that the goal of the firm is to maximise
the market value of the owner’s equity—
growth will result from this goal being achieved.
WHAT IS FINANCIAL PLANNING?
The basic policy elements of financial
planning are:
The firm’s needed investment in new assets.
The degree of financial leverage the firm
chooses to employ.
The amount of cash the firm thinks it is
necessary and appropriate to pay shareholders.
The amount of liquidity and working capital
the firm needs on an ongoing basis.
IMPORTANT QUESTIONS
Remember! we are working with accounting
numbers and we should ask ourselves some
important questions as we go through the
planning process. For example:
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 maximise
owners’ wealth?
DIMENSIONS OF FINANCIAL
PLANNING
The planning horizon is the long-range
period that the process focuses on (usually two
to five years).
Aggregation is the process by which the
smaller investment proposals of each of a
firm’s operational units are added up and
treated as one big project.
Financial planning usually requires three
alternative plans: a worst case, a normal
case, and a best case.
ACCOMPLISHMENTS OF
PLANNING
Interactions—linkages between investment
proposals and financing choices.
Options—firm can develop, analyse and
compare different scenarios.
Avoiding surprises—development of
contingency plans.
Feasibility and internal consistency—
develops a structure for reconciling different
objectives.
ELEMENTS OF A FINANCIAL PLAN
An externally supplied sales forecast
(either an explicit sales figure or growth rate
in sales).
Projected financial statements (pro-formas).
Projected capital spending.
Necessary financing arrangements.
Amount of new financing required (‘plug’
figure).
Assumptions about the economic
environment.
EXAMPLE—A SIMPLE FINANCIAL
PLANNING MODEL
Recent Financial Statements
Income Statement Balance Sheet
Sales $100 Assets $50 Debt
$20
Costs 90 Equity 30
Net Income $ 10 Total $50 Total $50
Assume that:
1. Sales are projected to rise by 25 per cent
2. The debt/equity ratio stays at 2/3
3. Costs and assets grow at the same rate as sales
EXAMPLE—A SIMPLE FINANCIAL
PLANNING MODEL
Pro-Forma Financial Statements
Income Statement Balance Sheet
Sales $ 125 Assets $ 62.50 Debt $25
Costs 112.50 Equity 37.50
Net $ 12.50 Total $ 62.50 Total $ 62.50
What is the plug?
Notice that projected net income is $12.50, but equity only
increases by $7.50. The difference, $5.00 paid out in cash
dividends, is the plug.
PERCENTAGE OF SALES
APPROACH
A financial planning method in which
accounts are varied depending on a firm’s
predicted sales level.
Dividend payout ratio is the amount of
cash paid out to shareholders.
Retention ratio is the amount of cash
retained within the firm and not paid out as
a dividend.
Capital intensity ratio is the amount of
assets needed to generate $1 in sales.
EXAMPLE—INCOME STATEMENT
Sales $1 000
Costs 800
Taxable Income 200
Tax (30%) 60
Net profit $140
Retained earnings $ 112
Dividends $ 28
EXAMPLE—PRO-FORMA INCOME
STATEMENT
Sales (projected) $1 250
Costs (80% of sales) 1 000
Taxable Income 250
Tax (30%) 75
Net profit $ 175
EXAMPLE—STEPS
Use the original Income Statement to create a
pro-forma; some items will vary directly with
sales.
Calculate the projected addition to retained
earnings and the projected dividends paid to
shareholders.
Calculate the capital intensity ratio.
EXAMPLE—BALANCE SHEET
Assets
Current assets ($) (% of sales)
Cash 160 16
Accounts receivable 440 44
Inventory 600 60
Total 1 200 120
Non-current assets
Net plant and equipment 1 800 180
Total assets 3 000 300
EXAMPLE—BALANCE SHEET
Liabilities and owners’ equity
Current liabilities ($) (% of sales)
Accounts payable 300 30
Notes payable 100 n/a
Total 400 n/a
Long-term debt 800 n/a
Shareholders’ equity
Issued capital 800 n/a
Retained earnings 1 000 n/a
Total 1 800 n/a
Total liabilities & owners’ equity 3 000 n/a
EXAMPLE—PARTIAL PRO-
FORMA BALANCE SHEET
Assets
Current assets ($) Change
Cash 200 $ 40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300
Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750
EXAMPLE—PARTIAL PRO-
FORMA BALANCE SHEET
Liabilities and owners’ equity
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 100 0
Total 475 $ 75
Long-term debt 800 0
Shareholders’ equity
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & owners’ equity 3 215 $215
External financing needed 535 $535(750-
75+140)
EXAMPLE—RESULTS OF
MODEL
The good news is that sales are projected to increase by
25 per cent.
The bad news is that $535 of new financing is required.
This can be achieved via short-term borrowing, long-
term borrowing, and new equity issues.
The planning process points out problems and potential
conflicts.
EXAMPLE—RESULTS OF
MODEL…
Assume that $225 is borrowed via notes payable
and $310 is borrowed via long-term debt.
‘Plug’ figure now distributed and recorded within
the Balance Sheet.
A new (complete) pro-forma Balance Sheet can now
be derived.
EXAMPLE—PRO-FORMA
BALANCE SHEET
Assets
Current assets ($) Change
Cash 200 $ 40
Accounts receivable 550 110
Inventory 750 150
Total 1 500 $300
Non-current assets
Net plant and equipment 2 250 $450
Total assets 3 750 $750
EXAMPLE—PRO-FORMA
BALANCE SHEET
Liabilities and owners’ equity
Current liabilities ($) Change
Accounts payable 375 $ 75
Notes payable 325 $225
Total 700 $300
Long-term debt 1 110 $310
Shareholders’ equity
Issued capital 800 0
Retained earnings 1 140 $140
Total 1 940 $140
Total liabilities & owners’ equity 3 750 $750
EXTERNAL FINANCING AND
GROWTH
The higher the rate of growth in sales or
assets, the greater the external financing
needed (EFN).
Growth is simply a convenient means of
examining the interactions between investment
and financing decisions.
In effect, the use of growth as a basis for
planning is just a reflection of the high level of
aggregation used in the planning process.
Need to establish a relationship between EFN and
growth (g).
EXAMPLE—INCOME STATEMENT
Sales $ 500
Costs 400
Taxable Income $ 100
Tax (30%) 30
Net profit $ 70
Retained earnings $ 25
Dividends $ 45
EXAMPLE—BALANCE SHEET
RATIOS CALCULATED
p (profit margin) = 14%
R (retention ratio) = 36%
ROA (return on assets) = 7%
ROE (return on equity) = 12.7%
D/E (debt/equity ratio) = 0.818
GROWTH
Next year’s sales forecasted to be $600.
Percentage increase in sales:
$100
20%
$500
Percentage increase in assets also 20 per
cent.
INCREASE IN ASSETS
What level of asset investment is needed to support a
given level of sales growth?
For simplicity, assume that the firm is at full capacity.
The indicated increase in assets required equals:
A×g
where A = ending total assets from the previous period
How will the increase in assets be financed?
INTERNAL FINANCING
Given a sales forecast and an estimated profit margin, what
addition to retained earnings can be expected?
This addition to retained earnings represents the level of
internal financing the firm is expected to generate over
the coming period.
The expected addition to retained earnings is:
p S R 1 g
where: S = previous period’s sales
g = projected increase in sales
p = profit margin
R = retention ratio
EXTERNAL FINANCING
NEEDED
If the required increase in assets exceeds the
internal funding available (that is, the
increase in retained earnings), then the
difference is the external financing needed
(EFN).
EFN = Increase in Total Assets – Addition to Retained
Earnings
= A(g) – p(S)R × (1 + g)
EXAMPLE—EXTERNAL
FINANCING NEEDED
Increase in total assets = $1000 × 20%
= $200
Addition to retained earnings = 0.14($500)(36%) × 1.20
= $30
• The firm needs an additional $200 in new financing.
• $30 can be raised internally.
• The remainder must be raised externally (external
financing needed).
EXAMPLE—EXTERNAL
FINANCING NEEDED…
EFN Increase in total assets Addition t o RE
A( g ) p ( S ) R (1 g )
$1000 (0.20) 0.14($500)36% 1.20
$170
RELATIONSHIP
To highlight the relationship between EFN and g:
EFN pS R A pS R g
0.14$500 36% $1000 0.14$500 (36%)g
25 975 g
Setting EFN to zero, g can be calculated to be 2.56
per cent.
This means that the firm can grow at 2.56 per
cent with no external financing (debt or equity).
EXTERNAL FINANCING NEEDED AND GROWTH
IN SALES FOR THE PLANNING COMPANY
FINANCIAL POLICY AND
GROWTH
The example so far sees equity increase (via
retained earnings), debt remain constant and
D/E decline.
If D/E declines, the firm has excess debt
capacity.
If the firm borrows up to its debt capacity,
what growth can be achieved?
SUSTAINABLE GROWTH RATE
(SGR)
The Sustainable Growth Rate is the
growth rate a firm can maintain given its
debt capacity, ROE and retention ratio.
SGR
ROE R
1 ROE R
EXAMPLE—SUSTAINABLE
GROWTH RATE
Continuing from the previous example:
(0.127 0.36)
SGR
1 0.127 0.36
4.82%
The firm can increase sales and assets at a
rate of 4.82 per cent per year without
selling any additional equity and without
changing its debt ratio or payout ratio .
DETERMINANTS OF GROWTH
Growth rate depends on four factors:
Profitability (profit margin)
Dividend policy (dividend payout)
Financial policy (D/E ratio)
Asset utilization (total asset turnover)
If a firm does not wish to sell new equity, and its
profit margin, dividend policy, financial policy and
total asset turnover (or capital intensity) are all fixed,
then there is only one possible growth rate.
Do you see any relationship between the SGR and
SOME CAVEATS OF FINANCIAL
PLANNING MODELS
Financial planning models tend to rely on accounting
relationships and not financial relationships.
Because of this, they sometimes do not produce output
that gives the user meaningful clues about what
strategies will lead to increases in value.
Financial planning is an iterative process, whereby the
final plan—which is the result of negotiation—will
implicitly contain different goals in different areas and
also satisfy many constraints.
SUMMARY AND CONCLUSIONS
Long-term financial planning forces the firm to think
about the future and anticipate problems before they
arrive.
Financial planning establishes guidelines for change and
growth in a firm, and is concerned with the major
elements of a firm’s financial and investment policies.
However, corporate financial planning should not
become a purely mechanical activity. In particular, plans
are often formulated in terms of a growth target with no
explicit link to value creation.
Nevertheless, the alternative to financial planning is
‘stumbling into the future’.
THANKS!