R.A. Fiska Huzaimah S.E., M.

Si

Financial Planning
and Control

Financial Planning
The projection of sales, income, and assets based on alternative production and
marketing strategies, as well as the determination of the resources needed to achieve
these projections.

Financial Control

The phase in which financial plans are implemented.

Control deals with the feedback and adjustment process required to ensure
adherence to plans and modification of plans because of unforeseen changes.

Sales Forecasts
A forecast of a firms unit and dollar sales for some future period.
most important part of financial planning
generally based on the trend in sales in recent periods plus forecasts of the
economic prospects for the nation, region, industry, etc.
inaccurate sales forecasts can have serious repercussionsif the firm is too
optimistic, such assets as inventory will be built up too much; if the firm is too
conservative, it might miss valuable opportunities because existing production
capabilities might not be sufficient to meet new demand

Projected (Pro Forma)

Financial Statements

A method of forecasting financial requirements based on forecasted financial statements.

Help the firm determine what is needed to finance expected future operating activities
Information from these statements indicates how much financing will be generated by the
firm internally and how much needs to be generated externally (called additional funds
needed) by borrowing or by selling stock
To construct a pro forma balance sheet and a pro forma income statement:
Step 1: Forecast sales
Step 2: Forecast next periods income statement
Step 3: Forecast next periods balance sheet
Step 4: Raising the additional funds needed
Step 5: Financing feedbacks

Step 1:
Forecast sales
Example

Step 1:
Forecast sales

Example

Excels LOGEST Function

(1+g) rate using LOGEST = 1.0910358

g = 9.1% Management estimates g = 10%

Step 2:
Construct a Pro Forma Income Statement

Estimate the percentage growth (increase or decrease) in sales, cost of goods sold,
and other variable revenues and expenses
Change the current values by the estimates
An easy way to approach this task is to apply a single growth rate to all
revenue and expense categories that change when production changes
To be more accurate, each category should be examined individually to
determine what the effect of any forecasted change is

Example : Forecast Income Statement next year:

AgriCorp
Assumptions:
AgriCorp operated at full capacity last year.
Sales are expected to grow by 12 percent.
The variable cost ratio remains at 80 percent (same as last year)
Next years dividend payout will be maintained at 60 percent of net income.

Example : Forecast Income Statement: AgriCorp

Sales
Variable costs (80%)
Fixed Costs
EBIT = NOI
Interest
Taxable income (EBT)
Taxes @ 40%
Net Income
Dividends (60% of NI)
Addition to RE

Last Years
Results
$500.00
(400.00)
( 55.00)
45.00
( 10.00)
35.00
( 14.00)
21.00
12.60
8.40

x (1 + g)
x 1.12
x 1.12
x 1.12

Next Years
Initial Forecast
$560.00
(448.00)
( 61.60)
50.40
( 10.00)
40.40
( 16.16)
24.24
14.54
9.70

Step 3:
Construct a Pro Forma Balance Sheet
Example : Forecast Balance Sheet: AgriCorp
Assumptions
AgriCorp operated at full capacity last year.
Each type of asset grows proportionally with sales.
Payables and accruals (spontaneous sources of financing) grow proportionally with
sales.

Example : Forecast Income Statement: AgriCorp

Current assets
Fixed assets
Total assets
Payables & accruals
Notes Payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities & equity

Last Years
Results
x (1 + g)
$ 155.00 x 1.12
120.00
x 1.12
$ 275.00
30.00
13.00
43.00
100.00
143.00
44.00
88.00
132.00
$ 275.00

1.12

+9.70 RE

Next Years
Initial Forecast
$ 176.60
134.40
$ 308.00
$ 33.60
13.00
46.60
100.00
146.60
44.00
97.70
141.70
$ 288.30

Additional Funds Needed (AFN)

Higher sales must be supported by higher assets.

Asset increase can be financed by spontaneous increases in accounts
payable and accruals and by retained earnings.
Any short fall must be financed from external sources--by borrowing or by
selling new stock.

Example : AFN: AgriCorp

If AgriCorp does not raise additional capital by borrowing from the bank or issuing new
stocks or bonds, then, based on the pro forma balance sheet, the following exists:
Total assets
Total liabilities and equity
Additional funds needed (AFN)

$308.00
288.30
19.70

Step 4:
Raising Additional Funds Needed (AFN)
Example : AFN: AgriCorp
AgriCorp plans to raise the additional funds needed (AFN) as follows:

Notes payable
New long-term debt
New common stock

Proportion
15.0%
20.0
65.0
100.0

Amount
$2.96
3.94
12.80
19.70

Cost
7.0%
10.0
dividend

Step 5:
Financing Feedbacks
Because interest and dividends must be paid with cash, any increase in these

costs will decrease the funds the firm has to investthat is, the amount of
income added to retained earnings will be less than originally forecasted.
When we consider the effects of the increased interest and dividend payments,

we find that the AFN is actually greater than originally expected.

Financing feedbacksthat is, the effects on the financial statements of actions

taken to finance forecasted increases in assetsmust be considered to

determine the exact amount of AFN.

Example : Financing Feedbacks: AgriCorp

Pro Forma Income Statement for Next Year ($ millions)2nd Pass
Last Years
Results
x (1+g)
$ 45.00
x 1.12
(10.00)
35.00
(14.00)
21.00

EBIT = NOI
Interest
Taxable income
Taxes @ 40%
Net Income
Dividends (60% of NI)
Addition to RE

12.60
8.40

Next Years
Initial Forecast
$ 50.40
(10.00)
40.40
(16.16)
24.24

2nd Pass
Forecast
$ 50.40
(10.60)
39.80
(15.92)
23.88

14.54
9.70

14.33
9.55

New interest = 10.00 + (2.96 x 0.07) + (3.94 x 0.10) = 10.60

) in addition to RE = 9.55 9.70 = 0.15

Example : Financing Feedbacks: AgriCorp

Pro Forma Balance Sheet for Next Year ($ millions)2nd Pass

Total assets
Payables & accruals
Notes payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities & equity

Last Years
Results
$275.00
30.00
13.00
43.00
100.00
143.00
44.00
88.00
132.00
275.00

x (1+g)
x 1.12

2nd Pass
Forecast
$308.00

Next Years
Initial Forecast
$308.00

x 1.12

+ 9.70

AFN1 = 2.96 + 3.94 + 12.80

AFN2 = 308.00 307.85

33.60
13.00
46.60
100.00
146.60
44.00
97.70
141.71
288.30

+ 2.96
+ 3.94
+12.80
- 0.15

=
=

19.70
0.15

33.60
15.96
49.56
103.94
153.50
56.80
97.55
154.35
307.85

Example : Financing Feedbacks: AgriCorp

Pro Forma Balance Sheet for Next Year ($ millions)Final Pass

Total assets
Payables & accruals
Notes payable
Current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total equity
Total liabilities & equity

Last Years
Results
$275.00
30.00
13.00
43.00
100.00
143.00
44.00
88.00
132.00
275.00

x (1+g)
x 1.12
x 1.12

+ 9.70

Final
Forecast
$308.00

Next Years
Initial Forecast
$308.00
33.60
13.00
46.60
100.00
146.60
44.00
97.70
141.71
288.30

+ 2.98
+ 3.97
+12.90
-0.15

Total AFN = 2.98 + 3.97 + 12.90 = 19.85 > 19.70 = AFN1

33.60
15.98
49.58
103.97
153.55
56.90
97.55
154.45
308.00

Other Considerations in Forecasting : Excess

Capacity

Excess capacityIf the firm has excess capacity, it will not have to increase plant and
equipment at the same growth rate as sales. To determine the level of sales current plant
capacity can handle, use the following equation:
Full capacity sales =

Current sales level

Percent of capacity used to

generate current sales level

ExampleIf AgriCorp currently operates at 80 percent capacity, then existing plant

and equipment can produce sales equal to:

$500
Full capacity sales =
$625
0.80
In this case, sales can grow by 25 percent before AgriCorp
needs to expand its plant and equipment.

Other Considerations in Forecasting : Economic

of Scales
Economic of scale If economies of scale exist, the variable cost ratio might
change with changes in production activity, that is will affect the addition to retained
earnings whick affect the amount of AFN.
1,100
1,000

Declining A/S Ratio

Assets

Base
Stock

Sales
2,000

2,500

$1,000/$2,000 = 0.5; $1,100/$2,500 = 0.44. Declining ratio shows economies of

scale. Going from S = $0 to S = $2,000 requires $1,000 of assets. Next $500 of
sales requires only $100 of assets.

Other Considerations in Forecasting : Lumpy

Assets
Lumpy assets Many assets are not completely divisible.
some assets might have to be purchased in larger increments than the
firm would prefer
lumpy assets must be purchased in discrete increments, say, $10 million
per addition, which means we cannot simply increase assets by a growth
rate like 12 percent

Assets

1,500
1,000
500
Sales
500
1,000
2,000
A/S changes if assets are lumpy. Generally will have excess
capacity, but eventually a small S leads to a large A.

Financial Control
Budgeting and Leverage Analysis
Proper financial control helps to ensure the firm meets the expectations developed in the
planning stage, and, when results fall short of expectations, helps management determine
the reasons.

Breakeven analysis evaluation of the level of operations to determine the ability of

the firm to generate profits

Leverage analysis examination as to how well the firm can cover its fixed costs, both
operating and financial; gives an indication of risk

Operating Breakeven Analysis

Operating breakeven point is defined as the level of operations where the net
operating income, NOI = EBIT, equals zero

Total operating costs (both fixed and variable) = sales revenues

Operating Breakeven Analysis : example

Worldwide Widgets, Inc.s operations have the following characteristics:
Selling price (P)
Variable cost per unit (V)
Variable cost ratio = V/P
Fixed operating costs
Existing sales

$8.00
$6.00
0.75
$12,000.00
10,000 units

Operating Breakeven Analysis : example

Graph
Dollars
120,000
100,000
Total sales
80,000

ofit
r
p
ting
a
r
e
Op

60,000
Total operating costs

48,000
40,000
g lo
n
i
t
ra
Ope

20,000
0

2,000

ss

Fixed operating costs = $12,000

4,000

6,000

8,000

10,000
12,000
14,000
Units Produced and Sold

Operating Breakeven Analysis : example

Computation
Operating breakeven
Total fixed operating costs
Q OpBE
point in units sold
Sales price Variable operating

cost per unit

per unit

Operating breakeven
point in sales dollars

$12,000
$12,000

6,000 units
$8.00 $6.00
$2.00

SOpBE

Total fixed operating costs

1 Variable cost ratio

$12,000 $12,000

$48,000 = 6,000 x $8
1 0.75
0.25

Operating Breakeven Analysis : example

Uses

Determine the level of sales a product must achieve to make a profit.

Indicate the impact of general growth on the cost structure of the firm.
Show how modernization to improve efficiency affects fixed and variable costs,
thus profitability of operations

Operating Leverage Analysis

In business, leverage refers to the existence of fixed costs.

The presence of leverage means that a change in sales will result in a larger
change in operating income (EBIT), net income, or both.
Operating leverage exists if fixed operating costs, such as depreciation, are present.
The degree of operating leverage (DOL) is defined as the percent change in net
operating income, NOI, that results from a particular percent change in sales.

Operating Leverage
DOL is computed as follows:
DOL =

Sales -

Sales - Total variable costs

Gross profit
=
Total variable Total fixed
EBIT
-

operating costs operating costs

Generally, a firm with a high DOL is considered to have high risk associated with its
operations

Current Income Statement for Worldwide

Widgets : example
Sales in units
Sales @ $8 per unit
Variable costs @ $6 per unit
Gross Profit
Fixed operating costs
NOI = EBIT

10,000
$80,000
(60,000)
20,000
(12,000)
$ 8,000

Worldwide Widgets : example Operating

Leverage

Does Worldwide Widgets have operating leverage?

Yes, because the firm has fixed operating costs equal to $12,000.
Worldwides degree of operating leverage is:

DOL =

Gross profit $20,000

2.5
EBIT
$8,000

DOL = 2.5x means that for every 1 percent deviation in sales from expectations,
there will be a 2.5 percent deviation in EBIT (in the same direction) from
expectations.

Effect of DOL for Worldwide Widgets

Sales ($8/unit)
Variable costs ($6/unit)
Gross Profit
Fixed operating costs
NOI = EBIT

Current
Forecast
$80,000
(60,000)
20,000
(12,000)
$ 8,000

If Sales are
10% Lower
$72,000
(54,000)
18,000
(12,000)
$ 6,000

Percent
Deviation
-10.0%
-10.0%
-10.0%
- 0.0%
-25.0%

DOL = 2.5; as a result, a 10 percent decrease in sales will result in a 25 percent

(2.5 x 10%) decrease in EBIT

Operating Leverage and Operating Breakeven

Generally, a higher degree of operating leverage (DOL) implies that greater risk is
associated with the firms operations.
Risk is variability.
The closer the firm operates to its breakeven point, the riskier its operations are
considered.
Everything else equal, firms with higher DOLs operate closer to their operating
breakeven points, and thus cannot cover fixed operating costs as easily as firms with
lower DOLs.

Financial Breakeven Analysis

Financial breakeven point is defined as the level of operating income (NOI or

EBIT) that covers all fixed financing charges.

At the financial breakeven point, EPS = 0.

For the most part, fixed financial charges include interest paid on debt and
preferred stock dividends.

For firms that do not have preferred stock, the financial breakeven point, EBIT FinBE,
is simply interest on debt.

Most firms do not have preferred stock.

Financial Breakeven Analysis : example

Worldwide Widgets, Inc. is financed with the following sources of long-term funds:
Bonds @ 8% interest
Preferred stock

$ 50,000
0

Common stock (5,000

shares outstanding)
Total capital

50,000
$100,000

Financial Breakeven Analysis : Graph

EPS ($)
2.00
1.50
1.00
Financial breakeven point

0.50
0
-0.50
-1.00
-1.50
-2.00

-8,000

-4,000

4,000

8,000

12,000

16,000
EBIT ($)

Financial Breakeven Analysis :

Computation

The financial breakeven point is computed as follows:

EBITFinBE = Interest costs +

Preferred dividend payments

1 - Tax rate

If Worldwide Widgets marginal tax rate is 40 percent, its financial breakeven point
is:
EBITFinBE = $50,000(0.08) +

$0
$4,000
1 - 0.4

Financial Breakeven Analysis : Uses

Financial breakeven analysis gives an indication as to how the firms mix of

debt and preferred stock (fixed financing) affects EPS (net income).

Financial Leverage

Financial leverage exists if the firm has fixed financial charges:

interest on debt

preferred dividends

The degree of financial leverage (DFL) is the percent change in EPS that results from a
particular percent change in net operating income.
DFL is computed as follows:
DFL =

EBIT
EBIT
=
dividends
EBIT - Financial BEP EBIT - Interest Preferred
1 - Tax rate

If a firm has no preferred stock, the DFL simplifies to:

DFL =

EBIT
EBIT - Interest

Generally, a firm with a high DFL is

considered to have high risk associated with
its financing.

Current Income Statement

for Worldwide Widgets : example
Sales
Variable costs (75% of sales)
Gross Profit
Fixed operating costs
NOI = EBIT
Interest = $50,000 x 0.08
Taxable income (EBT)
Taxes (40%)
Net income

$80,000
(60,000)
20,000
(12,000)
$ 8,000
( 4,000)
4,000
( 1,600)
$ 2,400

Financial Leverage : example

Does Worldwide Widgets have financial leverage?

Yes, because the firm has a fixed financing costthat is, interestequal to
$4,000.
Worldwides degree of financial leverage is:
DFL =

EBIT
$8,000

2.0
EBIT I $8,000 $4,000

DFL = 2.0x means that for every 1 percent deviation in EBIT from expectations, there
will be a 2.0 percent deviation in EPS (in the same direction) from expectations.

Effect of DFL for Worldwide Widgets

Current
Forecast

If EBIT is
25% Lower

Percent
Deviation

EBIT
Interest
Taxable income (EBT)
Taxes (40%)
Net income = EAC

$ 8,000
(4,000)
4,000
(1,600)
$ 2,400

$ 6,000
(4,000)
2,000
( 800)
$ 1,200

-25.0%
0.0%
-50.0%
-50.0%
-50.0%

EPS = EAC/5,000

$0.48

$0.24

-50.0%

DFL = 2.0; as a result, a 25 percent decrease in EBIT will

result in a 50 percent (2.0 x 25%) decrease in EPS

Financial Leverage and

Financial Breakeven

Generally, a higher degree of financial leverage (DFL) implies greater risk is

associated with the firms financial mix.
Risk is variability.
The closer the firms operates to its financial breakeven point, the riskier its financial
position is.
Everything else equal, firms with higher DFLs operate closer to their financial
breakeven points, and thus cannot as easily cover fixed financial costs as firms with
lower DFLs.

Combining Operating and Financial

Leverage (DTL)

The degree of total leverage (DTL) is the combination of DOL and DFL.
DTL is the percent change in EPS associated with a particular percent change
in sales
DTL = DOL x DFL
DTL DOL DFL

Gross profit
EBIT
Gross profit

EBIT
EBIT Financial BEP EBIT Financial BEP

Everything else equal, a higher degree of total leverage, DTL, is associated

with greater total riskboth operating risk and financial risk.

Total Leverage
Worldwides degree of total leverage is:

DTL = DOL DFL 2.5 2.0 5.0

Gross profit
$20,000
=

5.0
EBIT I
$8,000 $4,000

DTL = 5.0x means that for every 1 percent deviation in sales from expectations,
there will be a 5.0 percent deviation in EPS (in the same direction) from
expectations.

Effect of DTL for Worldwide Widgets

Current
Forecast
Sales
Variable operating costs
Gross profit
Fixed operating costs
EBIT
Interest
Taxable income (EBT)
Taxes (40%)
Net income = EAC
EPS = EAC/5,000

$ 80,000
(60,000)
20,000
(12,000)
8,000
( 4,000)
4,000
( 1,600)
2,400
$0.48

If Sales are
10% Lower
$ 72,000
(54,000)
18,000
(12,000)
6,000
( 4,000)
2,000
( 800)
1,200
$0.24

Percent
Deviation
-10.0%
-10.0%
-10.0%
0.0%
-25.0%
0.0%
-50.0%
-50.0%
-50.0%
-50.0%

DTL = 5.0; as a result, a 10 percent decrease in sales will result in a

50 percent (5.0 x 10%) decrease in EPS

Using Leverage Analysis for

Financial Control

Knowledge of the degree of leverage, whether operating, financial, or both, helps

determine how a change in sales will affect incomeoperating income, net income,
or both.

Greater leverage indicates that greater changes in income (either NOI or net
income) will result from changes in sales.

The greater variability that is associated with greater leverage suggests greater risk.

Using Leverage Analysis for

Financial Control

Knowledge of the degree of leverage, whether operating, financial, or both, helps

determine how a change in sales will affect incomeoperating income, net income,
or both.

Greater leverage indicates that greater changes in income (either NOI or net
income) will result from changes in sales.

The greater variability that is associated with greater leverage suggests greater risk.

Chapter EssentialsThe Answers

Why is financial planning and control critical to the survival of a firm?

Forecasts of future operations are needed so that the firm can make

arrangements for expected changes in production and future financing needs

What are pro forma financial statements?

The firm projects what it thinks the balance sheet and income statement will

look like if future expectations come true

Chapter EssentialsThe Answers

What are operating breakeven and financial leverage?

The financial breakeven point is the level of EBIT that a firm must

generate so that EPS equals zero

Financial leverage represents the fixed financial costs of the firm

How can a firm use knowledge of leverage in the financial forecasting and
control process?
A firm uses the concept of leverage to estimate how fixed costs (operating

and financial) affect its bottom line