Financial Planning 79

CHAPTER 4

FINANCIAL PLANNING

FOCUS
We begin by explaining the nature of business planning and placing financial forecasting within that
broader context. Once we get into financial planning we focus on exactly how to construct plans from
physical assumptions about a business and its environment. Finally we look at some of the problems
created when plans function as both goal statements and projections of what is most likely to happen in
the future.

PEDAGOGY
This chapter focuses on "how to do it." That is, how to really build a financial plan from a series of
physical and economic assumptions. This is an important distinction of this text. Most books talk about
planning, but actually teach only the overly simplified percentage of sales approach. After reading this
chapter, students are able to do real business financial plans.

TEACHING OBJECTIVES
Students should gain a broad appreciation of planning concepts and the managerial problems
associated with plans and planning. They should also emerge from this chapter able to construct real
plans based on fairly complex assumptions.

OUTLINE

I. BUSINESS PLANNING
A business plan is a model of what management expects a business to become in the future.
A. Component Parts of a Business Plan
A typical table of contents showing the important sections of a business plan.
B. The Purpose of Planning and Plan Information
Planning is valuable to management for the cohesive and goal setting benefits of the process. It
also provides vital information to outside investors.
C. Credibility and Supporting Detail
A credible plan must show enough detail to convince readers that a thorough analysis was done
in putting it together.
D. Four Kinds of Business Plan
Strategic and Operational planning, Budgeting and Forecasting. The characteristics and
significance of each. Relating planning for small and large businesses.
E. The Financial Plan as a Component of a Business Plan
Financial projections are a part of every business plan, but their importance varies with the type
of planning being done.

II. MAKING FINANCIAL PROJECTIONS

Techniques.
A. Planning for New and Existing Businesses
New businesses are more difficult because there's no history with which to start. Fresh
assumptions have to be made about everything.
B. The General Approach, Assumptions, and the Debt/Interest Problem
The procedural approach to financial planning.
Making physical assumptions which have to be turned into dollar forecasts. What we generally
have to start with (last year's results) and the statements we have to forecast. The debt/interest
problem.
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C. Plans with Simple Assumptions

Quick and dirty approaches - the percentage of sales method and modifications. The limitations
of such methods.
D. The Percentage of Sales Method - A Formula Approach
The percentage of sales method reduced to a formula for estimating external funding
requirements.
E. The Sustainable Growth Rate
The theoretical idea of sustainable growth and its application as a method of analyzing
performance.
F. Plans with More Complicated Assumptions
The technique of putting more complex assumptions into financial projections.
G. Comprehensive Example - A Complex Plan for an Existing Business
Building a plan with a relatively complex set of assumptions. Illustrated step by step.
H. Planning at the Department Level
The detail supporting expense projections at the departmental level.
I. The Cash Budget
Forecasting cash flow through receipts and disbursements.

III. MANAGEMENT ISSUES IN FINANCIAL PLANNING

A. The Financial Plan as a Set of Goals
Plans are simultaneously statements of goals and projections of what will happen. But goals are
often set to be a stretch and not likely to be fully achieved.
B. Risk in Financial Planning in General
Business plans are chronically optimistic. This creates problems if we need to rely on the
projections in them for very concrete things like bank borrowing.
C. Financial Planning and Computers
Computers have taken the number crunching out of financial planning, but they haven't made
the thinking behind the assumptions any easier.

QUESTIONS

1. A financial plan has to be either a prediction about the future or a statement of goals; it can't be
both. Explain this statement and comment on its validity.

ANSWER: On the surface, virtually all financial plans purport to be statements of what is likely to
happen in the future. However, plans are used as management tools in that they usually contain goals
toward which the organization is expected to strive. A problem exists if the goal, for motivational
purposes, is established somewhat beyond what the organization is likely to be able to achieve. In other
words, the plan may be more of a statement of what people would like to have happen than of what they
really expect to happen. A related problem is that unrealistically optimistic managers sometimes force
unachievable plans (goals) on organizations.
This is a major problem in planning. The fact is that companies rarely do two plans, one reflecting
goals and one reflecting expectations. As a result most business plans are something of a combination
of goals and what is most likely to occur. This obviously makes things difficult for users in that it
detracts from the reliability of published business plans.

2. The following issues are related to the accuracy and reliability of financial plans. Explain the
processes/issues related to each.
Top-down vs. bottom-up planning
Plans as statements of goals vs. plans as predictions of what's going to happen.
Planning assumptions.
 Financial Planning 81

Aggressive optimism vs. underforecasting.

Scenario analysis

ANSWER:
Top-down vs. bottom-up planning: A top down plan forces top management's goals on the
organization, often when they're not realistic. It tends to create plans that are beyond what's achievable.
A bottom-up plan is built up from statements of capabilities and needs made by middle and lower level
managers. It tends to understate what the organization can be stretched to accomplish. A good plan is a
combination of the two in that a give and take process occurs in which an acceptable middle ground is
reached.
Plans as statements of goals vs. plans as predictions of what's going to happen: Most plans are a
little of each. A problem is created if the goal is a "stretch" that's not really expected to be achieved.
Then using the plan as a prediction of the future for administrative purposes, such as to predict
borrowing requirements, can lead to serious errors.
Planning assumptions: Financial plans are based on assumptions about what will happen in the
physical world. If the financial plan is to be accurate and reliable, the assumptions that underlie it have
to be realistically achievable. This means they have to be based on a practical knowledge of the
business environment in which the firm is working. They must also be neither overly aggressive nor too
timid. Further, assumptions have to be translated into dollar figures correctly. This is a technical issue
that isn't very difficult, but does require that the planner know basic finance and accounting.
Aggressive optimism vs. underforecasting: Aggressive optimism describes a condition in which
people force plans to reflect what they want to happen rather than what is likely to happen. It's often
part of the "top-down" phenomenon. Senior managers simply refuse to accept the real limitations of the
organization and the environment. Underforecasting is the opposite. People put together easy-to-
achieve plans so their performance will look good against plan. There's usually a compensation element
involved.
Scenario analysis: Scenarios can be a way around some of the reliability problems in planning.
It involves creating several plans based on a variety of assumptions. Inevitably one scenario becomes
"the" plan, but other scenarios can be used for different purposes. For example a more conservative
plan can be used to forecast bank borrowing requirements than the one used to set internal goals.

3. Why is it important that physical assumptions precede financial results in the planning process.
For example, what's wrong with assuming that you want a business that sells $50 million a year earning
a profit of $5 million, and then building a revenue and cost plan to fit those goals?

ANSWER: This approach tends to create a plan that isn't likely to happen. In a sense it reverses cause
and effect. The fundamental that has to underlie the business plan in this situation is that a market for
$50 million of product has to exist. Further, the competitive situation has to be such that the $50 million
can be sold at a high enough margin to make a business viable. Working backwards tends to force
acceptance of this assumption when it may not be realistic.

4. Why is planning for a new business harder than planning for an existing operation? In which do
you have to make more assumptions? Why? What implicit assumption provides a short cut in one
situation?

ANSWER: The new business is harder because you have to make explicit assumptions about
everything without the benefit of history on which to base those assumptions. With an existing
business, anything you don't make an assumption about is implicitly assumed to remain the same as last
year. That "shortcut" option doesn't exist for a new business.

5. Briefly describe the interest-debt planning problem and the approach that leads to its solution.
(Use a few brief sentences. Don't list the procedural steps or give a numerical example.)
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ANSWER: A forecast of profit requires an estimate of interest expense, which depends on a projection
of debt (because interest is debt times the interest rate). The amount of debt required, however, is
dependent on the year's profit. The more profit a firm earns, the less debt it needs to support its assets.
Hence we need debt to forecast interest but we need interest (and hence profit) to forecast debt. This
situation results in a computational impasse.

6. How are planning assumptions reflected in projected financial statements? Is there a standard
computational procedure for incorporating assumptions into planned numbers? What's the difference
between simple, estimated plans and more complex precise plans. Can a plan be precise, complex, and
inaccurate at the same time? How?

ANSWER: Planning assumptions imply financial statement numbers that are consistent with the
existence of the conditions assumed. They are put into plans by calculating the implied figures and
including them in the projected financial statements. There is no one computational method. The
appropriate calculation depends on the nature of the item as well as that of the assumption.
A simple plan has a small number of simple assumptions while a complex plan has a larger number
of more detailed assumptions. A complex plan can be inaccurate if the detailed assumptions are wrong
or unrealistic. It's important to realize that the extra work of putting together a detailed plan doesn't
make it a better plan if the assumptions are unrealistic.

7. Comment on the value of the formula (EFR) approach to estimating funding requirements.
Could it create more problems than it solves?

ANSWER: The EFR estimates external funding requirements based on the assumption of a single
growth rate for the entire company. That is, it assumes all elements of the financial statements (income
statement and balance sheet) grow at the same rate. This is a very unrealistic assumption that is almost
never satisfied. That implies the estimate is virtually always wrong which can obviously cause
problems.

8. Contrast planning cash requirements, especially borrowing, using the statement of cash flows derived
from forecast financial statements with a cash budget. Which is likely to be more useful in running a
finance department?

ANSWER:
The statement of cash flows gives a rough summarized estimate of the cash inflows and
outflows during an accounting period. It tells us where cash will come from and what it is to be used for
in overall terms such as from operating results and from increases and decreases in various balance
sheet accounts. But it doesn’t give us any detail on exactly when cash will be collected or expended.
The cash budget, on the other hand is a detailed, time phased schedule of expected receipts and
disbursements. It shows when monthly sales are expected to be collected and when payments to
employees, vendors, and taxing authorities are scheduled to be made. Because of this detail, a cash
budget is likely to be more valuable for running the day to day operations of a finance department than a
forecast statement of cash flows.

9. Financial planning is no longer a problem in business because of the advent of personal

computers. Armed with a PC and the appropriate software, anyone can do a plan for even the largest
and most complicated company. Evaluate this statement.

ANSWER: The statement isn't true. Computers have enabled people to do the computations involved
in planning faster and easier, especially when they have to be redone several times. However,
computers don't help with making planning assumptions. And those remain the heart of planning.
 Financial Planning 83

Computers' greatest contribution is that they make it possible to evaluate the consequences of a variety
of assumptions quickly. That gives people a better feel for the probabilities involved in outcomes.

10. You're a new member of the planning staff within the finance department at Bertram
Enterprises, a large manufacturer of household goods. The firm does an annual operating plan and a
long-range plan every year. You've just received a note from the CFO asking you to help him prepare
for a meeting with the firm's investment bankers to discuss issuing new securities in the future. The
note asks you to prepare an estimate of the company's funding needs and suggests that you "start with"
the most recent annual and long-range plans. You're confused by the term start with, since the plans
clearly indicate future funding needs. What might the CFO be getting at, and how would you approach
the assignment?

ANSWER: The plan may have unrealistic assumptions, be aggressively optimistic, or be used as a set
of goals that aren't likely to be achieved. The CFO probably wants you to revisit the major assumptions
in the plan and make conservative alternate assumptions from which you'll recast the projected funding
requirements. You'll do this by visiting with key managers, especially functional area heads, to get their
candid inputs for a conservative forecast.

11. You are developing next year’s financial plan for Ajax Inc., a medium sized manufacturing company
that’s currently operating at 80% of factory’s capacity. The firm is launching a sales promotion that’s
expected to generate a sudden 20% increase in revenues starting at the beginning of the new year.
Unlike current sales which are virtually all on credit, approximately fifty percent of the new business
will be paid in cash. No changes are planned in the company’s operations other than acquiring the
resources necessary to support the sales growth. Develop some reasonable planning assumptions for the
following balance sheet line items and explain your reasoning for each. (Hint: Which balance sheet
items will be effected by an increase in sales proportionately or less than proportionately. Assume any
additional cash needed is borrowed.)

Cash Accounts Payable

Accounts Receivable Accruals (wage)
Inventory
Gross Fixed Assets Debt
Accumulated Depreciation Equity

ANSWER:
Cash: When revenue increases more money will be flowing in from cash sales and collections and out to
pay for labor and materials. So cash can be expected to increase roughly proportionately with sales.

Accounts Receivable: To the extent that the new business is on credit terms, receivables will increase
proportionately with sales. To the extent that sales are paid in cash there is no increase in receivables.
Hence we would expect about a 10% increase in receivables – one half the sales increase.

Inventory and Accounts Payable: A 20% increase in sales will require a 20% increase in production,
resulting in similar increases materials purchases and inventory.

Gross Fixed Assets: Since the factory is operating below capacity no new facilities or equipment will be
required to increase output Therefore, gross fixed assets won’t change except for minor replacements
of worn out equipment.

Accumulated Depreciation: Accumulated depreciation will increase by the amount of scheduled

depreciation on assets already owned. As a result Net Fixed Assets can be expected to decrease
somewhat.
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Accruals: Direct labor wages will increase proportionately with sales which will cause a less than
proportionate increase in total payroll because there won’t be any increase in administrative salaries and
supervision. However, wage accruals at year end also depend on the number of days since the last
payday which needs to be checked before a planning figure can be developed.

Debt: The sales growth will result in an increase in net working capital which will require funding to
the extent it isn’t supplied by retained earnings. We’ve assumed that new funding will be borrowed, so
debt will increase by the difference between the increases in current assets and current liabilities less
retained earnings.

Equity: Equity will increase by the amount of net income less dividends plus any new stock sold.

Note the Debt and Equity balances will be determined by the iterative method discussed on page xxx.

BUSINESS ANALYSIS

1. Ed Perez has always wanted to run his own restaurant. He worked part-time in the food service
business during high school and college and has worked for a large restaurant chain since graduating
from college four years ago. He's now ready to open a franchised family style restaurant. However, to
get started, a large investment is required. Ed has saved some money, but will also have to secure a
substantial loan.
Fortunately, Ed's old college roommate, Joe Dixon, is now a loan officer with the local bank.
Besides being a good friend, Joe knows that Ed is a stable, hard-working businessman and an excellent
credit risk.
Ed is now meeting with Joe to apply for the loan. After exchanging pleasantries, Joe asks to see Ed's
business plan. In response Ed tells him all about the idea and shows him the written information from
the franchisor, which Joe glances at briefly.
Joe listens politely, leans back in his chair, and says, "Ed, I've known you for years. I'm sure this is a
great idea, and that you'll make a terrific restaurateur, but we can't even begin to consider a loan until we
see a fully developed business plan that looks at least five years into the future."
a. Why is Joe (the bank) insisting that Ed prepare a business plan?
1. What will it show the bank?
i. List some specific concerns that the bank might have that a plan would answer outside of
the financial section.
ii. List several concerns that the financial plan might answer for the bank.
iii. Why is the bank insisting on such a long planning horizon? Does that imply the bank is
looking for a strategic plan?
2. What will preparing a business plan do for Ed?
i. Before he gets started.
ii. After he gets started.
iii. What will he learn by doing the financial plan?
b. What kind of thinking is the bank looking for in Ed's plan? That is, should the plan be strategic or
operational or very short term?

ANSWER: a. Basically, the bank requires a business plan to increase its level of assurance that the
proposal represents a viable business. It wants to be able to check all of Ed's assumptions for
reasonability, and see if they come together into something that will work.
In the non-financial area they're looking for an analysis to see if the market will support another
restaurant. That means the plan should discuss things like population density and demographics,
location analysis and the competition.
 Financial Planning 85

In the operating area they're looking for a reasonable assurance that the entrepreneur knows how to
run a restaurant and that he hasn't left something important out. That should be easy to prove given Ed's
background and the franchisor's information. The bank also wants to know what Ed plans to spend the
borrowed money on, and when he'll need it.
The financial plan tells the bank that there's enough profit and cash flow in the business to support
Ed and pay back the loan. That's key. The bank wants to know when it will be repaid and where the
money's coming from. That's also why the time horizon is so long. Bank officers know the business
probably won't be able to repay the loan in much less than that time frame.
Doing the plan will force Ed to think carefully through the whole start-up phase of his business. He
may not have done that in spite of his experience. He'll have to lay out exactly what he'll need to do,
when he'll have to do it, and what resources he'll need to get it done. This is the best possible insurance
against leaving out something important. After the business is started he'll be able to use the plan as a
guide against which both he and the bank can measure his progress.
b. In the context of a small business plan, the bank is looking for a combination of strategic,
operational, and short term planning.

2. You're the CFO of the Ramkin Company, which makes and sells electronic equipment. The
firm was originally an independent business, but was acquired by the larger BigTech Inc. ten years ago,
and is now operated as a division. BigTech has an elaborate planning system requiring all divisions to
produce a strategic plan and an annual operating once a year, a budget each quarter, monthly cash
forecasts and several quick forecasts near the end of each quarter.
The forecasts are done primarily by the finance department and don't require much of anyone else's
time. However, the strategic plan takes a good deal of executive effort, while budgets and the annual
operating plan demand a great deal of management effort at all levels.
It's eight AM on a morning in mid-October, and the executive team is about to start a meeting to kick
off the preparation of the annual operating plan for the next calendar year. As the meeting convenes,
Charlie Gogetter, the VP of Marketing, is clearly upset. He takes the floor and makes the following
statement.
"I'm tired of spending all this time on these silly plans! We just finished a Strategic Plan in June that
must've taken a month of my time while the western sales region got itself into big trouble. We also did
a third quarter budget in June, and a fourth quarter budget in September. Now we're starting another
plan that will probably tie up half of my sales managers' time until Christmas.
"On top of that it seems whenever we're not planning, we're putting together reviews comparing
actual performance to plan. Before we were acquired by BigTech, we hardly ever planned and we did
just fine! It's true we're a lot larger and more complex now, but I don't think we can spend this
much time planning rather than doing!
"I suggest that the CFO (he gestures toward you) be assigned to throw together something we can
submit to BigTech, and that the rest of us get on with our work."
Other members of the group to some extent share Charlie's feelings, and his comments have created
some unrest among the executive team about the company's management style. Prepare a response to
his statement and proposal. Don't rule out the possibility that BigTech is overdoing planning.

ANSWER: Staff: Systematic business planning along with evaluating results against plan is arguably
the most important thing senior management does. The process pulls the management team together
and identifies the firm's goals as well as those of the individuals' and departments within it. At the same
time a plan provides a road map for running the business after it's created and approved. In the context
of a division, the planning and review process is usually the primary vehicle for communication
between division management and the parent company.
A plan that the finance department throws together will create more problems than it solves. It won't
be "owned" by managers in other departments, and they'll resent being held to it when it comes time to
measure results and performance. We'd also lose the cohesive benefit of the process if we planned that
way.
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The biggest risk, however, lies in what will happen if we have some serious managerial problems
next year. Without a true consensus plan, we'd have a tough time trying to figure out where the
organization has gone off course and what to do about it.
Another problem we'd run into with a one-department plan relates to our image with our bosses at
BigTech. When we go through a review with them, they'll know immediately that the plan hasn't been
developed by the operating departments. Once they figure that out they won't be happy, and will just
send us back to the drawing board to do our homework. We're not likely to change BigTech's planning
requirements either. They aren't unusual for big companies, and in general are a good idea.
Notwithstanding all these issues, large corporations sometimes overdo planning. The problem
usually isn't that headquarters requires too many plans. Rather it's that senior managers at the division
level redo the plans too many times. There's often a feeling that a plan that's reworked five times is
better than one that's built and then reviewed once or twice. This isn't necessarily true. In other words,
operating divisions often spend too much time cycling and arguing over plans. They also do them in too
much detail.
The solution is to learn to "run smarter and not harder." That is to learn to plan more efficiently. A
good start might be to establish a small planning group to handle a lot of the preparation and research.
That will take some pressure off of management. A person experienced in the techniques of planning
can do a lot to make our processes more efficient.

3. You've just been hired as CFO of the Gatsby Corp., a new company in the hi-tech computer
business. Shortly after your arrival you were amazed to find that the firm does virtually no planning.
An extensive business plan was put together when it was started with venture capital eight years ago,
and revised when another round of funding was needed four years later. Other than on those occasions,
no planning seems to have been done at all.
The firm was founded by its entrepreneur president, Harvey Gatsby, and was based on a new
technical product he'd invented. Initial demand for the gadget was overwhelming, and the firm grew
rapidly if chaotically until about a year ago when competitive force started to impact its business. The
following conditions exist today.
 Sales of the original product are beginning to decline.
 The organization seems to have a number of people and departments whose function and value
aren't clear.
 The engineering department is pursuing several new developments that have commercial
possibilities, but progress has been haphazard, and no one seems to have thought through how any
money will be made from the ideas.
 Additional funding is required to get any new products that might be developed to market. Harvey
has suggested that you dust off the old business plan for another run at investors.
You feel that the company is in real danger, and that the source of the problem is that management
hasn't done any real forward planning in years. In your opinion the first step toward recovery is to
install a competent planning system. Write a memo to Harvey outlining your concerns and suggestions.
Include
1. The problem - why the happy chaos of the past may be about to come to an end, and what
that may mean.
2. How management's approach has to change if the firm is to survive. That is, it will have to
do a good deal of forward thinking and structured planning.
3. A statement of how planning systems differ between small and larger companies.
4. The benefits Gatsby can expect to realize by planning in a careful, structured way.
5. The need for a well-defined financial plan.

ANSWER: Harvey: I've been reviewing our organization and the current market situation, and frankly,
I'm concerned that we've got some problems brewing.
When you started the company eight years ago, you hit the market with a fresh new idea that caught
on immediately. That led to tremendous growth and excellent profitability, which allowed the company
 Financial Planning 87

to operate in a loosely organized manner giving people a great deal of latitude in what they did. The
style allowed managers and employees to operate in creative ways without thinking too much about
exactly where the firm was going. That creativity enhanced the firm's success at the time. The scenario
isn't unusual. A number of famous and successful companies started out that way.
Unfortunately, the passage of time inevitably brings two things to very successful small businesses,
size and competition. Competition makes it much harder to make money on the company's good ideas.
And size makes it very expensive to run the organization at less than peak efficiency.
A small firm that's earning lots of money can afford to do things that don't lead to profits like
exploring product ideas that don't have a market. Unfortunately, those functions become part of the
organization as it grows. Then when competition starts to squeeze margins, profits fall rapidly because
too many unnecessary things are going on.
I think we're in that position now. Sales of the standard product are slipping, and it isn't clear how
we'll replace those sales with new products currently under development. I'm afraid some very tough
times are ahead.
Getting out of this kind of dilemma involves changing the way we run the business. We can no
longer afford the "creative chaos" we've enjoyed in the past. From now on we need to be precise,
analytical and frugal. In particular we have to decide where we want the company to go and limit our
activities to those things that will get us there. We can do that by devoting ourselves to careful planning
done in a structured manner over the next few months.
I suggest that we go through a rigorous planning exercise. It should begin with a thorough
examination of everything we're doing today. In particular, we'd look at how much more life we can
expect out of the old product line, and what it will take to bring anything currently under development
to market. We should also go through every activity the firm is currently doing with an eye toward
justifying whether or not it should continue. As a result of that analysis we should eliminate functions
and activities we can do without.
Smaller companies generally put together a single business plan that says all that needs to be said
about their future. That's what we've done in the past. Larger firms, however, need to separate their
thinking into two components, strategic and operational. They generally do that by producing two
separate plans. One deals with long term issues like which new products and markets we should pursue.
The other addresses more immediate issues like how we'll handle the competition and get the most out
of the last days of the old product line. We can do the two plans together the first time. Later they
should be revised and updated annually, six months apart.
If we go through an exercise like this, I think you'll find the management team will work better
together. We'll all have a better understanding of more focused goals, and each of us will know what he
or she has to do to achieve them. We'll also produce a "road map" for running the business. The best
companies manage using their plans continuously. They compare results to plan, and when deviations
occur, they know exactly how to react to get the business back on course.
The backbone of all this is a well defined and documented financial plan. That's a set of projected
financial statements that tells us what we can expect to do in the future. It forms the basic road map,
and lets us make precise comparisons of actual performance with our expectations.
I'm sure we have to do this kind of thing if we expect to raise any more outside money. Backers will
be looking at us differently now that we're a larger company. They understand the pitfalls of getting big
rapidly and will expect a statement from us regarding how we'll manage the future from where we are
now. The planning process I've described will give us that. I don't think we'll be able to get by with
another revision of the old "small business" plan we used years ago.
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PROBLEMS

Planning Assumptions – Example 4.1 (page 135)

1. The Lineberry Golf Cart Co. sold 7,400 carts this year at an average unit price of $3,000. 50 days of
sales remained uncollected in accounts receivable at the end of the year. The firm produced the carts at
a 42% cost ratio (COGS/Revenue) and had three months of inventory on hand at year end (3/12 of the
year’s COGS).
The golf business is booming and management plans a 10% increase in unit sales despite a 5%
price increase. The firm has programs in place to improve production efficiency, inventory
management, and the effectiveness of collections efforts. It is assumed that these programs will
decrease the cost ratio to 40%, lower year end inventory to 2 months, and lower year end receivables to
40 days of sales.
Compute Lineberry’s revenue, COGS (cost of goods sold) and gross margin as well as ending
receivables and inventory for this year and next year’s plan. Calculate using a 360 day year and
assume sales are evenly distributed over the year.

SOLUTION:
This Year Next Year’s Plan
Units 7,400 7,400 x 1.1 = 8,140
Price x $3,000 $3,000 x 1.05 = x $3,150

Units x Price = Revenue

Revenue = $22,200,000 $25,641,000

Revenue x Cost Ratio = COGS

Cost ratio x.42 x .40
COGS $9,324,000 $10,256,400

Revenue – COGS = Gross Margin

Gross Margin $12,876,000 $15,384,600

(Days sales in A/R ÷ 360) x Revenue = A/R

A/R (50/360) x $22,200,000 = $3,083,333 (40/360) x $25,641,000 = $2,849,000

(Months Cost in INV / 12) x COGS = Inventory

COGS (3/12) x $9,324,000 = $2,331,000 (2/12) x $10,256,400 = $1,709,400

The Debt/Interest Planning Problem – Example 4.2 (page 137)

2. The Cambridge Cartage Company has partially completed its forecast of next year's financial
statements as follows.

FINANCIAL PLAN
CAMBRIDGE CARTAGE COMPANY
($000)

INCOME STATEMENT BALANCE SHEET

NEXT YEAR
NEXT YEAR Beginning Ending
Rev $17,220 ASSETS
Cost/Exp 14,120 Total Assets $12,540 $18,330
EBIT $ 3,100 LIABILITIES & EQUITY
 Financial Planning 89

Interest ? Current Liabs $ 410 $ 680

EBT ? Debt $ 5,630 ?
Tax ? Equity $ 6,500 ?__
EAT ? Total L&E $12,540 $18,330
The firm pays interest at 10% on all borrowings and pays a combined state and federal tax rate of 40%.
Complete the forecasted income statement and balance sheet. Begin by guessing at interest expense as
10% of beginning debt.

SOLUTION: The iterative procedure results in the following:

EBIT $ 3,100 LIABILITIES & EQUITY

Interest $ 769 Current Liabs $ 410 $ 680
EBT $ 2,331 Debt $ 5,630 $ 9,751
Tax $ 932 Equity $ 6,500 $ 7,899
EAT $ 1,399 Total L&E $12,540 $18,330

3. Lap Dogs Inc. is planning for next year and has the following summarized results so far ($000):

Income Statement
EBIT 236
Interest ?
EBT ?
Income Tax ?
EAT ?

Balance Sheet
This Year Next Year
Assets 582 745

Current Liabilities 63 80
Debt 275 ?
Equity 244 ?
Total Liab & Equity 582 745

The firm pays interest of 12% on all borrowing and is subject to an overall tax rate of 38%. It
paid interest of $20,000 this year and plans a $75,000 dividend next year. Complete Lap Dog’s forecast
of next year’s financial statements. Round all calculations to the nearest $1,000.

Solution:
Using this year’s interest as a first guess at next year’s and completing the financial statements
yields the following:

Income Statement
EBIT 236
Interest 20
EBT 216
Income Tax 82
EAT 134
90 Chapter 4

Balance Sheet
This Year Next Year
Assets 582 745

Current Liabilities 63 80
Debt 275 362
Equity 244 303
Total Liab & Equity 582 745

Check to see if the calculated average debt implies the interest guess

[(275 + 362) / 2] × .12 = 38

Since $38,000 is not close to the $20,000 guess, substitute $38,000 and iterate again as follows:

Income Statement
EBIT 236
Interest 38
EBT 198
Income Tax 75
EAT 123

Balance Sheet
This Year Next Year
Assets 582 745

Current Liabilities 63 80
Debt 275 373
Equity 244 292
Total Liab & Equity 582 745

Check the new debt figures against the second guess at interest:

[(275 + 373) / 2] × .12 = 39

The result is within $1,000 of the $38,000 second guess which is satisfactory for planning purposes.

4. The Libris Publishing Company had revenues of $200 million this year and expects a 50%
growth to $300 million next year. Costs and expenses other than interest are forecast at $250 million.
The firm currently has assets of $280 million and current liabilities of $40 million. Its debt to equity
ratio is 3:1. (I.e., capital is 75% debt and 25% equity.) It pays 12% interest on all of its debt, and is
subject to federal and state income taxes at a total effective rate of 39%.
Libris expects assets and current liabilities to grow at 40%, 10% less than the revenue growth
rate. The company plans to pay dividends of $10 million next year.
a. What is the planned debt to equity ratio at the end of next year?
b. Do these results indicate a problem?

SOLUTION:
a. This is a slightly disguised version of the debt interest problem.
Next year’s EBIT is $300  $250 = $50.
Beginning capital (debt+equity) is $280  $40 = $240, which split 3:1 gives debt of $180 and
equity of $60.
 Financial Planning 91

Next year’s total assets are $280  1.4 = $392, while current liabilities are $40  1.4 = $ 56.
Capital is $392  $56 = $336. This sets up the debt-interest iteration problem. The result after two
iterations is shown below. Notice that Ending Equity = Beginning Equity + Net Income – Dividends.

Income Statement Balance Sheet

Beginning Ending
Revenue $300 Assets $280 $392
Cost/Exp 250
EBIT $ 50 Liabilities
Interest 27 Current $ 40 $ 56
EBT $ 23 Debt 180 272
Tax 9 Equity 60 64
EAT $ 14 $280 $392

The ending debt equity mix is

Debt $272 81%
Equity 64 19%
Capital $336 100%

And Debt : Equity is 4.25 : 1

b. Libris may have a problem with this plan. The company’s debt level is dangerously high now, and is
forecast to go higher in the next year. The firm is borrowing to fund asset growth while paying most of
current earnings out in dividends. Lenders are quite likely to resist advancing more funds under those
conditions.

Plans with Simple Assumptions – Example 4.3 (page 140)

5. The management of Coker Corp is doing a quick forecast of 20X9 using the modified percentage of
sales method in preparation for a more detailed planning exercise later in the month. The estimate is to
assume a 10% growth in sales. All other line items are to be assumed to grow at the same rate except
for fixed assets which is projected to increase by $88,000 due to an expansion program already
underway. Approximate financial statements for the current year, 20X8, and a planning worksheet are
shown below. The firm pays 9% interest on all of its debt. Assume the tax rate is a flat 25%. There are
no plans for dividends or the sale of additional stock next year. Make a forecast of Coker's complete
income statement and balance sheet. Work to the nearest thousand dollars. (Hints: The easiest way to
grow a number by 10% is to multiply it by 1.1 rather than taking 10% and adding. Do not grow
subtotals. For example grow Revenue and COGS by 10% rounding each to the nearest thousand and
subtract for Gross Margin. Don’t grow interest, debt or equity, use the debt/interest iterative technique.)

COKER CORP
CURRENT AND PROJECTED INCOME STATEMENTS
($000)
20X8 20X9
Revenue $642
COGS 289
Gross Margin $353

Expenses $240

EBIT $113
Interest (9%) 33
92 Chapter 4

EBT $ 80
Inc Tax (25%) $ 25
EAT $ 55

COKER CORP
CURRENT AND PROJECTED BALANCE SHEETS
($000)
ASSETS LIABILITIES & EQUITY
20X8 20X9 20X8 20X9
C/A $198 C/L $ 87
F/A 552 Debt 325
Total $750 Equity 338
Total $750

SOLUTION: Applying management's assumptions and iterating for interest and debt yields the
following:

COKER CORP
CURRENT AND PROJECTED INCOME STATEMENTS
($000)
20X8 20X9
Revenue $642 $706
COGS 289 318
Gross Margin $353 $388

Expenses $240 $264

EBIT $113 $124

Interest (9%) 33 30
EBT $ 80 $ 94
Inc Tax (25%) $ 25 24
EAT $ 55 $ 70

COKER CORP
CURRENT AND PROJECTED BALANCE SHEETS
($000)
ASSETS LIABILITIES & EQUITY
20X8 20X9 20X8 20X9
C/A $198 $218 C/L $ 87 $ 96
F/A 552 640 Debt 325 354
Total $750 $858 Equity 338 408
Total $750 $858

6. Larime Corp is forecasting 20X2 near the end of 20X1. The estimated year end financial
statements and a worksheet for the forecasts are shown below.

LARIME CORP
 Financial Planning 93

PROJECTED INCOME STATEMENT

($000)
20X1 20X2
$ % $ %
Revenue $245,622 100.0 100.0
COGS $142,461 58.0
Gross Margin $103,161 42.0

Expenses $ 49,124 20.0

EBIT $ 54,037 22.0

Interest (12%) $ 9,642 3.9
EBT $ 44,395 18.1
Inc Tax (43%) $ 19,090 7.8
EAT $ 25,305 10.3

LARIME CORP
PROJECTED BALANCE SHEET
($000)

ASSETS LIABILITIES & EQUITY

20X1 20X2 20X1 20X2
C/A $178,106 C/L $ 85,700
F/A $142,128 Debt $ 78,178
Total $320,234 Equity $156,356
Total $320,234

Management expects the following next year:

 An 8% increase in revenue.
 Price cutting will cause the cost ratio (COGS/Sales) to deteriorate (increase) by 1% of sales from its
current level.
 Expenses will increase at a rate that is three quarters of that of sales.
 C/A and C/L will increase proportionately with sales.
 Net fixed assets will increase by $5 million.
 All interest will be paid at 12%.
 Federal and state income taxes will be paid at a combined rate of 43%.

Make a forecast of Larime's complete income statement and balance sheet. Work to the nearest
thousand dollars.

SOLUTION: Applying management's assumptions and iterating for interest and debt yields the
following:

LARIME CORP
94 Chapter 4

PROJECTED INCOME STATEMENT

($000)

20X1 20X2
$ % $ %
Revenue $245,622 100.0 $265,272 100.0
COGS $142,461 58.0 $156,510 59.0
Gross Margin $103,161 42.0 $108,762 41.0

Expenses $ 49,124 20.0 $ 52,071 19.6

EBIT $ 54,037 22.0 $ 56,691 21.4

Interest (12%) $ 9,642 3.9 $ 8,476 3.2
EBT $ 44,395 18.1 $ 48,215 18.2
Inc Tax (43%) $ 19,090 7.8 $ 20,732 7.8
EAT $ 25,305 10.3 $ 27,483 10.4

LARIME CORP
PROJECTED BALANCE SHEET
($000)

ASSETS LIABILITIES & EQUITY

20X1 20X2 20X1 20X2
C/A $178,106 $192,354 C/L $ 85,700 $ 92,556
F/A $142,128 $147,128 Debt $ 78,178 $ 63,087
Total $320,234 $339,482 Equity $156,356 $183,839
Total $320,234 $339,482

7. The Eagle Feather Fabric Company expects to complete the current year with the following
financial results ($000).

INCOME STATEMENT BALANCE SHEET

Revenue $36,100 Assets
COGS 14,440 Cash $ 1,000
A/R 5,000
GM $21,660 Inventory 2,888
Expenses 12,635 Curr Assets $ 8,888
EBIT $ 9,025 Net F/A $ 7,250
Int (11%) $ 625 Total Assets $16,138
EBT $ 8,400
Tax (42%) $ 3,528 Liabilities & Equity
EAT $ 4,872 Accts Payable $ 1,550
Accruals 530
C/L $ 2,080
Debt $ 5,598
Equity $ 8,460
Total L&E $16,138
 Financial Planning 95

Forecast next year using a modified percentage of sales method assuming no dividends are paid and
no new stock is sold along with the following. (Note that negative debt in a forecast means the business
will generate more cash than is currently owed.)
a. a 20% growth in sales and a 40% growth in net fixed assets.
b. A 15% growth in sales with a 10% growth in expenses and a 20% growth in net fixed assets.
(Negative debt means the business will generate more cash than is currently owed.)

SOLUTION:
INCOME STATEMENT
Current Year a b
Revenue $36,100 $43,320 $41,515
COGS 14,440 17,328 16,606
GM $21,660 $25,992 $24,909
Expenses 12,635 15,162 13,899
EBIT $ 9,025 $10,830 $11,010
Interest (11%) $ 625 521 414
EBT $ 8,400 $10,309 $10,596
Tax (42%) $ 3,528 4,330 4,450
EAT $ 4,872 $ 5,979 $ 6,146

BALANCE SHEET
ASSETS
Cash $ 1,000 $ 1,200 $ 1,150
A/R 5,000 $ 6,000 $ 5,750
Inventory 2,888 $ 3,466 $ 3,321
Current Assets $ 8,888 $10,666 $10,221
Net F/A $ 7,250 $10,150 $ 8,700
Total Assets $16,138 $20,816 $18,921

LIABILITIES & EQUITY

Accts Payable $ 1,550 $ 1,860 $ 1,783
Accruals $ 530 $ 636 $ 609
C/L $ 2,080 $ 2,496 $ 2,392
Debt $ 5,598 $ 3,881 $ 1,923
Equity $ 8,460 $14,439 $14,606
Total L&E $16,138 $20,816 $18,921

External Funding Requirement (EFR) – Example 4.4 (page 145)

8. Fleming, Inc. had a dividend payout ratio of 25% this year that resulted in a payout of $80,000 in
dividends. Return on sales (ROS) was 8% this year and is expected to increase to 9% next year. If
Fleming expects to have $305,100 available from next year’s retained earnings, what percent increase
are they forecasting in revenues?

SOLUTION:
This year’s EAT = $80,000/.25 = $320,000
This year’s revenues = $320,000/.08 = $4,000,000
Next year’s EAT = $305,100/.75 = $406,800
Next year’s revenue = $406,800/.09 = $4,520,000
% Increase in revenue = (4.52 – 4.0)/4.0 = 13%
96 Chapter 4

9. The Dalmation Corporation expects the following summarized financial results this year ($000)

INCOME STATEMENT BALANCE SHEET

Revenue $10,500 Assets
Cost/Exp. 9,100 Curr Assets $ 5,500
Tax $ 560 Net F/A $ 6,900
EAT $ 840 Total Assets $12,400
Dividends $ 420
Liabilities & Equity
Current $ 320
Debt $ 5,080
Equity $ 7,000
Total L&E $12,400

Use the EFR relation to estimate Dalmation's external funding requirements under the following
conditions.

a. Sales growth of 15%.

b. Sales growth of 20% and a reduction in the payout ratio to 25%.
c. Sales growth of 25%, elimination of dividends, and a 4% improvement in ROS to 12%.

SOLUTION:
a. EBT = $10,500  $9,100 = $1,400
Tax rate = $560/$1,400 = 40%
ROS = $840/$10,500 = 8%

EFR = g(ASSETS)  g(C/L)  (1-d)ROS(1+g)SALES

a. EFR = .15($12,400)  .15($320)  (1.5)(.08)(1.15)($10,500)

= $1,860  $48  $483
= $1,329

b. EFR = .20($12,400)  .20($320)  (1.25)(.08)(1.20)($10,500)

= $2,480  $64  $756
= $1,660

c. EFR = .25($12,400)  .25($320)  (1)(.12)(1.25)($10,500)

= $3,100  $80  $1,575
= $1,445

10. Lytle Trucking projects a $3.2 million EBIT next year. The firm’s marginal tax rate is 40%, and it
currently has $8 million in long-term debt with an average coupon rate of 8%. Management is
projecting a requirement for additional assets costing $1.5 million and no change in current liabilities.
They plan to maintain a 30% dividend payout ratio. Any additional borrowing required to fund next
year’s asset growth will carry a 7% coupon rate. Lytle does not plan to issue additional stock next year.
Use the EFR concept rather than the EFR equation to develop an algebraic formula of your own to
compute the additional debt needed to support a asset growth of $1.5 million. (Hint: Start with the idea
that additional debt = new assets – internally generated funds.Then write an algebraic expression for
internally generated funds based on the income statement from EBIT to EAT and the dividend payout
ratio.)
 Financial Planning 97

SOLUTION:
Let D = old debt AD = additional debt
NA = new assets RE = retained earnings = internally generated funds
T = tax rate d = dividend payout ratio
I = interest = .08D + .07AD
In general
EAT = EBT(1-T) EBT = EBIT – I RE = EAT(1-d)
Substituting gives
EAT = [EBIT – (.08D + .07AD)](1-T)
Now write the expression for additional debt
AD = NA – RE
= NA – EAT(1-d)
Substitute for EAT
AD = NA –[EBIT – (.08D + .07AD)](1-T)(1-d)
Substitute values ($M) from the problem
AD = 1.5 – [3.2 – (.08(8) + .07AD)](1-.4)(1-.3)
From which
AD = .437667 = $437,667

Sustainable Growth Rate – Example 4.5 (page 147)

11. The Bubar Building Co. has the following current financial results ($000).
Revenue $45,000 Assets $37,500
EAT $ 3,600 Equity $28,580
Dividends $ 1,800
On the average, other building companies pay about one quarter of their earnings in dividends, earn
about six cents on the sales dollar, carry assets worth about six months of sales, and finance one third of
their assets with debt.
Use the sustainable growth rate concept to analyze Bubar's inherent ability to grow without selling
new equity versus that of an average building company. Identify weak areas and suggest further
analyses.

SOLUTION:
gs = (1-d)  ROS  T/A  Equity
______ Turnover Multiplier
Bubar 6.24% = .5 8% 1.2 1.3
Industry 13.5% = .75 6% 2.0 1.5

Bubar's problems are its payout ratio and its asset utilization. The firm can't grow rapidly without
some equity capital, and it's paying most of its earnings out in dividends. It also seems to be using its
assets inefficiently. Management should check out old A/R, dead inventory, and fixed assets that aren't
being used.

12. Broxholme Industries has sales of $40 million, equity totaling $27.5 million and an ROS of 12%.
The sustainable growth rate has been calculated at 10.9%. What dividend payout ratio was assumed in
this calculation?
98 Chapter 4

SOLUTION: ($M)
ROS = EAT / Sales
From which
EAT = Sales (ROS)
= $40(.12)
= $4.8
Write the sustainable growth formula
gS = EAT(1-d) / equity
Substituting for EAT and equity yields
.109 = $4.8(1–d)]/$27.5
from which
d = .375 = 37.5%

Planning Fixed Assets - Example 4.6 (page 148)

13. Livetree Ltd. is developing a detailed financial plan for next year, and expects to have the following
fixed asset accounts by the end of this year ($000)

Gross $45,789
Accumulated Depreciation ( 26,328)
Net Fixed Assets $19,461

The capital plan already completed calls for expenditures of $7,042,000 on new equipment next
year, which will be depreciated straight line over a ten year period without a half year convention.
Assets currently on the books will depreciate by $4,258,000 next year.
Develop Livetree’s ending fixed asset balances for the planned year.

Solution:

Depreciation on new assets = $7,042,000 / 10 = $ 704,200

Depreciation on old assets = 4,258,000
Total $4,962,200

Fixed Assets Begin Add End

Gross $45,789,000 $7,042,000 $52,831,000
Accum Depr (26,328,000) (4,962,200) (31,290,200)
Net $19,461,000 $2,079,800 $21,540,800

Indirect Planning Assumptions – Example 4.7 (page 150)

14. The Winthrop Company is constructing a five-year plan. The firm's ACP is currently 90 days,
while its inventory turnover ratio is 3 based on COGS. The company has forecast aggressive revenue
growth along with efficiency improvements in manufacturing and credit and collections as follows:
(Year 0 is the current year.)
Year
0 1 2 3 4 5
Revenue ($000) $50.0 $57.5 $66.0 $76.0 $87.5 $100.0
Cost Ratio 60% 59% 58% 57% 56% 55%
ACP (days) 90 70 60 50 45 40
Inventory Turn 3 4 5 6 6.5 7
 Financial Planning 99

For each planned year:

a. Calculate the COGS.
b. Calculate the A/R balance at year-end.
c. Calculate the inventory balance at year-end.

SOLUTION:
a. Year: 0 1 2 3 4 5
Revenue ($000) $50.0 $57.5 $66.0 $76.0 $87.5 $100.0
Cost Ratio 60% 59% 58% 57% 56% 55%
COGS $30,000 $33,925 $38,280 $43,320 $49,000 $55,000

A/R ACP  Sales

b. ACP   360 Hence, A/R 
Sales 360

1. 2.
70  $57,500 60  $66,000
A/R   $11,181 A/R   $11,000
360 360

3. 4.
50  $76,000 45  $87,500
A/R   10,556 A/R   $10,938
360 360

5.
40  $100,000
A/R   $11,111
360

c.
COGS COGS
Inv. Turnover  Hence, Inventory 
Inv. Inv.Turnover

1. 2.
$33,925 $38,280
Inventory   $8,481 Inventory   $7,656
4 5

3. 4.
$43,320 $49,000
Inventory   $7,720 Inventory   $7,538
6 6.5

5.
$55,000
Inventory   $7,857
7
100 Chapter 4

15. Assume we’re at the end of “this year” planning “next year’s” financial statements. Calculate
the following using indirect planning assumptions as indicated. (To keep the calculations simple
formulate ratios using ending balance sheet figures only.)
a. Sales are forecast to be $58,400,000. Management wants to plan for a 45 day ACP next year.
What ending receivables balance should be planned for next year?
b. What ending inventory should be planned if revenue is expected to be $457,000 and the cost
ratio is 53% (cost of goods sold as a % of revenue) and management wants to forecast an inventory
turnover of 5X.
c. Normal credit terms from suppliers request payment within 30 days. In an effort to conserve
cash, management has decided to pay in 50 days. Nearly all payables come from purchases of
inventory. Materials makes up 60% of the Cost of Goods Sold. Next year’s revenue is forecast to be
$378M. The firm’s cost ratio is expected to be 56%. What figure should be included in next year’s
ending balance sheet for Accounts Payable?

SOLUTION:
a. A/R
ACP = ————  360
Sales

A/R
45 = ———————  360
$58,400,000

A/R = (45) ($58,400,000) / 360

A/R = $7,300,000

b. Cost of Goods Sold (COGS) = $457,000  .53 = $242,210

COGS
Inventory Turnover = ———————
Inventory

$242,210
5 = ————
Inventory

Inventory $242,210 / 5 = $48,442

c. Cost of Goods Sold (COGS) = Revenue x Cost ratio = $378M  .56 = $211.7M
The material content of COGS = $211.7M  .60 = $127.0M. This material accounts for the
bulk of the firm’s credit purchases, which generate payables.
Hence $127.0M will pass through Accounts Payable next year. If purchases are evenly
distributed throughout the year, and bills are paid in 50 days, 50/360 of that figure will be in payables at
any time including year-end. Hence,
Accounts Payable = $127.0M  (50/360) = $17.6M

Complex Plans: Concept Connection Example 4-8 (page

151)
 Financial Planning 101

16. The Owl Corporation is planning for 20X2. The firm expects to have the following financial results
in 20X1 ($000).

Income Statement
$ %
Revenue 37,483 100.0
COGS 14,807 39.5
Gross Margin 22,676 60.5
Expense 17,721 47.3
EBIT 4,955 13.2
Interest 1,380 3.7
EBT 3,575 9.5
Income Tax 1,430 3.8
EAT 2,145 5.7

Balance Sheet
Assets Liabilities and Equity
Cash 1,571 Accts Pay 1,388
Accts Rec 6,247 Accruals 985
Inventory 2,468
Curr Assets 10,286 Curr Liab 2,373

Fixed Assets Capital

Gross 25,608 Debt 12,390
Accum Dep (14,936) Equity 6,195
10,672 18,585

Total Assets 20,958 Total L&E 20,958

Management has made the following planning assumptions:

Income Statement
Revenue will grow by 10%.
The cost ratio will improve to 37% of revenues.
Expenses will be held to 44% of revenues.

Balance Sheet
The year end cash balance will be $1.5 million.
The ACP will improve to 40 days from the current 60.
Inventory turnover will improve to 7X from 6X.
Trade payables will continue to be paid in 45 days.
New capital spending will be $5M.
Newly purchased assets will be depreciated over 10 years
using the straight line method taking a full year’s
depreciation in the first year.
The company’s payroll will be $13.7 million at the end of 20X2.
No dividends or new stock sales are planned.

The following facts are also available:

The firm pays 10% interest on all of its debt.

102 Chapter 4

The combined state and federal income tax rate is a flat 40%.
The only significant payables come from inventory purchases, and
product cost is 75% purchased materials.
Existing assets will be depreciated by $1,727,000 next year.
The only significant accrual is payroll. The last day of 20X2 will
be one week after a payday.

Forecast Owl’s income statement and balance sheet for 20X2. Round all calculations to the
nearest $1,000 and use a 360 day year.

SOLUTION:
Income statement and balance sheet line items are forecast as follows:

Revenue = 37,483 × 1.10 = 41,231

COGS = 41,231 × .37 = 15,255

Expense = 41,231 × ,44 = 18,142

Cash = 1,500

Accounts Receivable = 41,231 × (40 / 360) = 4,581

Inventory = 15,255 / 7 = 2179

Depreciation for fixed asset calculation

20X2 depreciation = 1,727 + 500 = 2,227

Fixed Assets Begin Add End

Gross 25,608 5,000 30,608
Accum Depr (14,936) (2,227) (17,163)
Net 10,672 2,773 13,445

Accounts Payable = (COGS × .75) × (45/360)

= (15,255 × .75) × (45/360) = 1,430

Accruals 13,700 / 52 = 263

Placing these amounts into financial statement form and iterating for debt/interest starting with 20X1’s
interest as a guess at 20X2’s interest, yields the following results after two iterations.

Income Statement
$ %
Revenue 41,231 100.0
COGS 15,255 37.0
Gross Margin 25,976 63.0
Expense 18,142 44.0
EBIT 7,834 19.0
Interest 1,108 2.7
EBT 6,726 16.3
Income Tax 2,690 6.5
 Financial Planning 103

EAT 4,036 9.8

Balance Sheet
Assets Liabilities and Equity
Cash 1,500 Accts Pay 1,430
Accts Rec 4,581 Accruals 263
Inventory 2,179
Curr Assets 8,260 Curr Liab 1,693

Fixed Assets Capital

Gross 30,608 Debt 9,781
Accum Dep (17,163) Equity 10,231
13,445 20,012

Total Assets 21,705 Total L&E 21,705

17. The Haverly Company expects to finish the current year with the following financial results,
and is developing its Annual Plan for next year.

HAVERLY COMPANY
THIS YEAR
INCOME STATEMENT
($000)

$ %
Revenue $73,820 100.0
COGS 31,743 43.0
Gross Margin $42,077 57.0

Expenses:
Marketing $17,422 23.6
Engineering 7,087 9.6
Fin & Admin 7,603 10.3
Total Expense $32,112 43.5

EBIT $ 9,965 13.5

Interest $ 2,805 3.8
EBT $ 7,160 9.7
Income Tax $ 3,007 4.1
EAT $ 4,153 5.6

HAVERLY COMPANY
THIS YEAR
INCOME STATEMENT
($000)

ASSETS LIABILITIES & EQUITY

Cash $ 8,940 Accounts Payable $ 1,984
Accounts Rec. $12,303 Accruals $ 860
104 Chapter 4

Inventory $ 7,054 Current Liabilities $ 2,844

Current Assets $28,297
Long Term Debt $22,630
Fixed Assets Equity
Gross $65,223 Stock Accounts $18,500
Accum. Deprec. ($23,987) Retained Earn. $25,559
Net $41,236 Total Equity $44,059

Total Assets $69,533 Total L&E $69,533

The following facts are available

1. Payables are almost entirely due to inventory purchases, and can be estimated through COGS,
which is approximately 45% purchased material.
2. Currently owned assets will depreciate an additional $1,840,000 next year.
3. There are two balance sheet accruals. The first is for unpaid wages. The current payroll of $32
million is expected to grow by 12% next year. The closing date of the year will be six working days
after a payday. The second accrual is an estimate of the cost of purchased items that have arrived in
inventory, but for which vendor invoices have not yet been received. This materials accrual is generally
about 10% of the payables balance at year end.
4. The combined state and federal income tax rate is 42%.
5. Interest on current and future borrowing will be at a rate of 12%.

PLANNING ASSUMPTIONS
Income Statement Items
1. Revenue will grow by 13% with no change in product mix. However, competitive pressure is
expected to force some reductions in pricing.
2. The pressure on prices will result in a 1.5% deterioration in next year's cost ratio.
3. Spending in the marketing department is considered excessive and will be held to 21% of
revenue next year.
4. Due to a major development project, expenses in the engineering department will increase by
20%.
5. Finance and administration expenses will increase by 6%.

Assets and Liabilities

6. An enhanced cash management system will reduce cash balances by 10%.
7. The ACP will be reduced by 15 days. (Calculate the current value to arrive at the target.)
8. The inventory turnover ratio (COGS/Inv.) will decrease by .5.
9. Capital spending is expected to be $7 million. The average depreciation life of the assets to be
acquired is five years. The firm uses straight-line depreciation, and takes a half-year in the first year.
10. Bills are currently paid in 50 days. Plans are to shorten that to 40 days.
11. A dividend totaling $1.5 million will be paid next year. No new stock will be sold.

Develop next year's financial plan for Haverly based on these assumptions and last year's financial
statements. Include a projected income statement, balance sheet and a statement of cash flows.

SOLUTION: ($000) Individual items are forecast as follows:

INCOME STATEMENT

REVENUE: $73,820  1.13 = $83,417

COST: Cost Ratio = 43% + 1.5% = 44.5%

 Financial Planning 105

COGS = $83,417  .445 = $37,121

EXPENSE: Marketing $83,417  .21 = $17,518

Engineering $ 7,087  1.20 = $ 8,504
F&A $ 7,603  1.06 = $ 8,059
Expense total $34,081

BALANCE SHEET

ASSETS
CASH: $8,940  .90 = $8,046

A/R $12,303
A/R: Current ACP   360   360  60 days
Sales $73,820

Target ACP = 60  15 = 45 days

A/R
Next year: 45   360
$83,417
A/R = $10,427

INVENTORY:
COGS $31,743
Current Inv. Turn. =   4 .5
INV $7,054

Target Inv. Turn. = 4.5  .5 = 4.0

Next year: 4.0 = $37,121/Inv.
Inventory = $9,280

CURRENT ASSETS = $27,753

FIXED ASSETS:
GROSS = $65,223 + $7,000 = $72,223
DEPRECIATION Old $ 1,840
New 700
Previous Accum. 23,987 ($26,527)
Net Fixed Assets $45,696

TOTAL ASSETS = $73,449

LIABILITIES
40
ACCTS PAYABLE = $37,121  .45   $1,856
360
ACCRUALS: Annual payroll $32,000  1.12 = $35,840

6
Wage accrual = $35,840  =$ 827
260
Materials accrual = .1  $1,856 = $ 186
106 Chapter 4

Accruals $ 1,013

Putting these items into financial statements and iterating for debt and equity yields the following.

HAVERLY COMPANY
INCOME STATEMENTS
($000)
THIS YEAR NEXT YEAR
$ % $ %
Revenue $73,820 100.0 $83,417 100.0
COGS 31,743 43.0 37,121 44.5
Gross Margin $42,077 57.0 $46,296 55.5

Expenses:
Marketing $17,422 23.6 $17,518 21.0
Engineering 7,087 9.6 8,504 10.2
Fin & Admin 7,603 10.3 8,059 9.6
Total Exp. $32,112 43.5 $34,081 40.8

EBIT $ 9,965 13.5 $12,215 14.7

Interest $ 2,805 3.8 $ 2,708 3.2
EBT $ 7,160 9.7 $ 9,507 11.4
Income Tax $ 3,007 4.1 $ 3,993 4.8
EAT $ 4,153 5.6 $ 5,514 6.6

DIVIDENDS $ 1,500
NET TO RE $ 4,014

HAVERLY COMPANY
BALANCE SHEETS
($000)
ASSETS ____ LIABILITIES & EQUITY
THIS YR NEXT YR THIS YR NEXT YR
Cash $ 8,940 $ 8,046 Accts. Payable $ 1,984 $ 1,856
Accts. Rec. $12,303 $10,427 Accruals $ 860 $ 1,013
Inventory $ 7,054 $ 9,280 Current Liab $ 2,844 $ 2,869
Curr Assets $28,297 $27,753
Long Term Debt $22,630 $22,507
Fixed Assets Equity
Gross $65,223 $72,223 Stock Accts $18,500 $18,500
Accum Depr ($23,987) ($26,527) Retained Earn $25,559 $29,573
Net $41,236 $45,696 Total Equity $44,059 $48,073

Total Assets $69,533 $73,449 Total L&E $69,533 $73,449

HAVERLY COMPANY
CHANGES IN WORKING CAPITAL
NEXT YEAR ($000)

A/R $1,876
Inventory ($2,226)
A/P ($ 128)
 Financial Planning 107

Accruals $ 153
($ 325)

HAVERLY COMPANY
STATEMENT OF CASH FLOWS
NEXT YEAR ($000)

OPERATING ACTIVITIES
EAT $ 5,514
Depreciation 2,540
Increase in W/C (325)
Cash Flow From
Operating Activities $ 7,729

INVESTING ACTIVITIES
Increase in Gross Fixed Assets ($7,000)

FINANCING ACTIVITIES
Decrease in Debt ($ 123)
Dividend ($1,500)
($1,623)
NET CASH FLOW ($ 894)

RECONCILIATION
Beginning Cash $8,940
Net Cash Flow ($ 894)
Ending Cash $8,046

Cash Budgeting – Example 4.9 (page 162)

18. Lapps Inc. makes a gift product that sells best during the holiday season. Retailers stock up in
the fall so Lapps’ sales are largest in October and November and drop dramatically in December. The
firm expects the following revenue pattern for the second half of this year ($000). The third quarter
figures are actual results while the fourth quarter is a projection.

Jul Aug Sep Oct Nov Dec

Revenue $5,500 $6,000 $7,500 $8,000 $9,500 $4,000

Historically, Lapps collects its receivables according to the following pattern.

Months after sale 1 2 3

% collected 60% 20% 9%

The firm offers a 2% prompt payment discount, which is taken by about half of the customers
that pay in the first month.
Lapps receives inventory one month in advance of sales. The cost of material is 40% of
revenue. Invoices are paid 45 days after receipt of material.
The firm uses temporary labor to meet its seasonal production needs so payroll can be estimated
at 35% of the current month’s sales.
Other expenses are a constant $1.8 million per month. A $0.7 million tax payment is scheduled
for November and an expansion project will require cash of $0.5 million in October and $0.8 million in
108 Chapter 4

December. Lapps also has a $6 million short-term loan outstanding at the end of September. Monthly
interest is 1% of the previous month end balance.
Prepare Lapps’ cash budget for the fourth quarter.

SOLUTION:
Jul Aug Sep Oct Nov Dec
Revenue $5,500 $6,000 $7,500 $8,000 $9,500 $4,000

Collections from (first month is 60%  .99 = 59.4% to reflect prompt payment discount)
sales made in
Jul $3,267 $1,650 $ 495
Aug $3,564 $1.800 $ 540
Sep $4,455 $2,250 $ 675
Oct $4.752 $2,400
Nov $5,643
$6,750 $7,542 $8,718

Inventory receipts (40% of next month’s sales)

$3,000 $3,200 $3,800 $1,600
Payment for inventory received in
Aug $1,500 $1,500
Sep $1,600 $1,600
Oct $1,900 $1,900
Nov $ 800
Disbursements for materials $3,100 $3,500 $2,700

Payroll at 35% of revenue $2,800 $3,325 $1,400

Other Expenses $1,800 $1,800 $1,800
Tax Payment $ 700
Project $ 500 $ 800
Total Disb. Before interest $8,200 $9,325 $6,700

Cash flow before interest ($1,450) ($1,783) $2,018

Interest ($ 60) ($ 75) ($ 94)
Net Cash Flow ($1,510) ($1,858) $1,924

Cum cash flow (loan) ($6,000) ($7,510) ($9,368) ($7,444)

19. Blue & Noble is a small law firm that does all of its business through billings (no cash sales).
Historically the firm has collected 40% of its revenue in the month of billing, 50% during the first
month after billing and 8% during the second month after billing. Two percent typically remains
uncollectable. Revenue projections for the coming year are $47,500 for January and $50,000 for
February. Cash receipts of $50,600 are expected in March. What revenues are the projected for March?

SOLUTION:
$50,600 = .4(March Rev.) + .5($50,000) + .08($47,500)
$50,600 = .4 (March Rev) + $25,000 + $3,800
$21,800 = .4(March Rev.)
March Rev = $54,500