Financial Planning and Control

© 2007 Thomson/South-Western 1
Essentials of
Chapter 17
Why is financial planning and control critical to
the survival of a firm?
What are pro forma financial statements?
What are operating breakeven and financial
leverage?
How can a firm use knowledge of leverage in
the financial forecasting and control process?

2
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

3
Financial Planning and Control

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.

4
Financial Planning: The Sales
Forecast
A forecast of a firm’s unit and
dollar sales for some future period,
generally based on recent sales
trends plus forecasts of the
economic prospects for the nation,
region, industry, etc.

5
Unilate Textiles: 2010 Sales
Projection
$1,500

$1,000

$500

$0
2005 2006 2007 2008 2009 2010

6
Projected (Pro Forma)
Financial Statements
A method of forecasting financial
requirements based on forecasted
financial statements
AFN = additional funds needed to
support the level of forecasted
operations

7
Projected Financial Statements

Determine how much money the firm

will need in a given period.
Determine how much money the firm
will generate internally during the same
period.
Subtract the funds generated internally
from the funds required to determine the
external financial requirements.

8
Step 1. Forecast the 2010
Income Statement: Unilate
Textiles
Assumptions:
Unilate operated at full capacity in 2009.
Sales are expected to grow by 10 percent.
The variable cost ratio remains at 82 percent
(same as 2009).
2010 dividend per share will be the same as in
2009.

9
Step 1. Forecast the 2010 Income
Statement
Unilate
Textiles
2009
Results
2010 Initial
Forecast Basis Forecast
Net Sales $ 1,500.0 x 1.10 $ 1,650.0
Cost of Goods Sold (1,230.0) x 1.10 (1,353.0)
Gross Profit 270.0 297.0
Fixed operating Costs (90.0) x 1.10 (99.0)
Depreciation (50.0) x 1.10 (55.0)
EBIT 130.0 143.0
Less Interest (40.0) (40.0)
EBT 90.0 103.0
Taxes (40%) (36.0) (41.2)
Net Income $ 54.0 $ 61.8
Common Dividends (29.0) (29.0)
Addition to Retained Earnings $ 25.0 $ 32.8
Earnings per Share $ 2.16 $ 2.47
Dividends per Share $ 1.16 $ 1.16
Number Common Shares
(millions) 25.0 25.0 10
Step 2. Forecast the 2010 Balance
Sheet
Unilate
Textiles
2009 Forecast
2010
Initial
Balances Basis Forecast
Cash $ 15.0 x 1.10 $ 16.5
Accounts Receivable 180.0 x 1.10 198.0
Inventory 270.0 x 1.10 297.0
Total Current Assets 465.5 511.5
Net Plant & Equipment 380.0 x 1.10 418.0
Total Assets $ 845.0 $ 929.5
Accounts Payable 30.0 x 1.10 33.0
Accruals 60.0 x 1.10 66.0
Notes Payable 40.0 40.0
Total Current Liabilities 130.0 139.0
Long-Term Bonds 300.0 300.0
Total Liabilities $ 430.0 $ 439.0
Common Stock 130.0 130.0
Retained Earnings 285.0 +$32.8 317.8
Owner's Equity $ 415.0 $ 447.8
Total Liabilites & Equity $ 845.0 $ 886.8
Additional Funds Needed $ 42.7
11
Step 3. Raising the Additional Funds
Needed
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.

12
Step 4. Financing Feedbacks

The effects on the income statement

and balance sheet of actions taken to
finance forecasted increases in assets

13
2010 Adjusted Forecast of Balance
Sheet
Unilate Textiles
Initial Adjusted Financing
Forecast Forecast Adjustment
Cash $ 16.5 $ 16.5
Accounts Receivable 198.0 198.0
Inventory 297.0 297.0
Total Current Assets 511.5 511.5
Net Plant & Equipment 418.0 418.0
Total Assets $ 929.5 $ 929.5
Accounts Payable $ 33.0 $ 33.0
Accruals 66.0 66.0
Notes Payable 40.0 46.8 $ 6.8
Total Current Liabilities 139.0 145.8
Long-Term Bonds 300.0 309.0 9.0
Total Liabilities 439.0 454.8
Common Stock 130.0 159.3 29.3
Retained Earnings 317.8 315.5 (2.3)
Owner's Equity 447.8 474.8
Total Liabilites & Equity $ 886.8 $ 929.5
Additional Funds Needed 42.7 - $ 42.8

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2010 Adjusted Forecast of Income
Statement
Unilate
Initial Adjusted Financing
Textiles
Forecast Forecast Adjustment
Net Sales $ 1,650.0 $ 1,650.0
C os t of Goods Sold (1,353.0) (1,353.0)
Gros s P rofit 297.0 297.0
Fixed operating C os ts 99.0 99.0
Depreciation (55.0) (55.0)
EBIT 143.0 143.0
Les s Interes t (40.0) (41.4) $ (1.4)
EBT 103.0 101.6 (1.4)
Taxes (40%) (41.2) (40.6) 0.6
Net Income $ 61.8 $ 61.0 (0.8)
C ommon Dividends (29.0) (30.5) (1.5)
Addition to R etained Earnings
$ 32.8 $ 30.5 $ (2.3)
Earnings per Share $ 2.47 $ 2.32
Dividends per Share $ 1.16 $ 1.16
Number C ommon Shares 25.0 26.3

15
Unilate Textiles: Adjusted Key
Ratios
A djusted
P relim inary Industry
2009 2010 A verage
Current R atio 3.6x 3.5x 4.1x
Inventory T urnover 4.6x 5.6x 7.4x
D ays Sales O utstanding 43.2 days 43.2 days 32.1 days
T otal A ssets T urnover 1.8x 1.8x 2.1x
D ebt R atio 50.9% 48.9% 45.0%
T im es Interest E arned 3.3x 3.5x 6.5x
Profit M argin 3.6% 3.7x 4.7%
Return on A ssets 6.4% 6.6% 12.6%
Return on E quity 13.0% 12.8% 17.2%

16
Other Considerations in Forecasting:
Excess Capacity
Suppose in 2009 fixed assets had
been operated at only 80% of
capacity:
Actual sales
Full Capacity Sales =
% of capacity
$1,500
= = $1,875 million.
0.80

17
Other Considerations in
Forecasting:
Economies of Scale
Unilate’s variable cost ratio is 82%
of sales.
Ratio might decrease to 80% if
operations increase significantly.
Changes in variable cost ratio affect the
addition to retained earnings which
affects the amount of AFN.

18
Other Considerations in
Forecasting: Lumpy Assets
Assets that cannot be acquired in
small increments, but must be
obtained in large, discrete
amounts

19
How different factors affect the AFN
forecast.
Dividend payout ratio changes.
 If reduced, more RE, reduce AFN.

Profit margin changes.

 If increases, total and retained earnings increase, reduce
AFN.
Plant capacity changes.
 Less capacity used, less need for AFN.

Payment terms increased to 60 days.

 Accounts payable would double, increasing liabilities,
reduce AFN.

20
Financial Control -
Budgeting and Leverage
The phase in which financial plans are
implemented; control deals with the
feedback and adjustment processes
required to ensure the firm is following
the right financial path to accomplish
its goals, and, if not, to make necessary
corrections. 

21
Operating Breakeven Analysis

An analytical technique for studying the

relationship between sales revenues,
operating costs, and profits
Operating breakeven analysis deals only
with the upper portion of the income
statement - the portion from sales to NOI

22
Unilate’s 2010 Forecasted
Operating Income

Sales (S)--(110 million units) $ 1,650.00

Variable cost of goods sold (VC) (1,353.00)
Gross profit (GP) 297.00
Fixed operating costs (F) (154.00)
Net operating income (NOI =EBIT) $ 143.00

23
Operating Breakeven Chart
Revenues
& Costs
Total Sales
1,400 Revenues (P x Q)
1,200 Operating Profit
(EBIT > 0) Total Operating
1,000 Costs (F + Q x V)
SOpBE =856 Operating Operating Breakeven
800
Loss Point (EBIT = 0)
(EBIT < 0)
600

400
200 Total Fixed Costs (F)
154
0
0 20 40 57 60 80 100 120
Units QOpBE
24
Breakeven Computation
Sales = Total operating Total
= +
Total
revenues costs variable costs fixed
(P x Q) = TOC
costs = (V x Q) + F
F F
QOpBE = P-V = Contribution margin

QOpBE $154.0 million $154.0 million

= = $2.70
$15.00 - $12.30

= 57.04 million units ≈ 57.0 million units

25
Operating Breakeven Point
F F
SOpBE = V = Gross profit margin
1- ( ) P

SOpBE = $154.0 = $154.0 = $154.0 = 855.6 million

(
$12.30
1- $15.00 ) 1 - 0.82 0.18

For the proposal to break even, Unilate

must sell 57 million units or $855,600,000
of product.

26
Operating Leverage

The existence of fixed operating

costs, such that a change in sales
will produce a larger change in
operating income (EBIT)

27
Degree of Operating Leverage

The percentage change in NOI

(or EBIT) associated with a given
percentage change in sales

28
Calculating the Degree of
Operating Leverage
Gross Profit
DOL S =
EBIT
$297
= $143 = 2.08x

Each 1 percent change in sales, will result

in a 2.08 percent change in operating
income.

29
Operating Income at Sales Levels
of 110 and 99 Million Units
2010
F o r c a s t e d S a le s U n it P e rce n t
O p e r a t io n sD e c r e a s e C h a n g e Change
S a le s in u n its 110 99 (1 1 ) -1 0 .0 %
S a le s r e v e n u e s $ 1 ,6 5 0 .0 $ 1 ,4 8 5 .0 $ (1 6 5 .0 ) -1 0 .0 %
V a r ia b le c o s t o f g o o d s s o ld(1 ,3 5 3 .0 ) (1 ,2 1 7 .7 ) 1 3 5 .3 -1 0 .0 %
G ro s s p ro f it 2 9 7 .0 2 6 7 .3 ( 2 9 .7 ) -1 0 .0 %
F ix e d o p e r a tin g c o s ts (1 5 4 .0 ) (1 5 4 .0 ) - 0 .0 %
N e t o p e r a tin g in c o m e ( E$B IT ) 1 4 3 .0 $ 1 1 3 .3 $ ( 2 9 .7 ) -2 0 .8 %

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Financial Breakeven Analysis

Determining the operating income

(EBIT) the firm needs to just cover
all of its fixed financing costs and
produce earnings per share equal
to zero

31
Financial Breakeven
Computation
Earnings available to common stockholders
EPS = =0
Number of common shares outstanding

(EBIT - I)(1 - T) - Dps

= =0
Shrsc

Dps
EBITFinBE = I + = $41.4 + 0 = $41.4
(1 - T)

32
Financial Leverage

The existence of fixed financial

costs such as interest and
preferred dividends when a change
in EBIT results in a larger change in
EPS

33
Unilate Textiles:
Degree of Financial Leverage

EBIT EBIT
DFL = =
EBIT - I EBIT - [financial BEP]

$143.0 $143.0
DFL110 = = = 1.41x
$143.0 - $41.4 $101.6

34
Degree of Total Leverage
Gross profit
DTL =
EBIT- [Financial BEP]
S - VC Q(P - V)
= =
EBIT- I [Q (P - V) - F] - I
$297.0
= = 2.92x
$101.6
= DOL x DFL = 2.08 x 1.41 = 2.92x

35
Importance of Forecasting and
Control Functions
If projected operating results are not satisfactory,
management can reformulate its plans.
If funds required to meet sales forecast cannot be
obtained, management can sale back projected
levels of operations.
If required funds can be raised, it is best to plan for
their acquisition in advance.
Any deviation from projections needs to be handled
to improve future forecasts.

36
Chapter 17 Essentials
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

37
Chapter 17 Essentials
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

38
Example 4-13 Page 173
SUE WILSON IS THE NEW FINANCIAL MANAGER OF NORTHWEST
CHEMICALS (NWC), AN OREGON PRODUCER OF SPECIALIZED
CHEMICALS SOLD TO FARMERS FOR USE IN FRUIT ORCHARDS. SHE
IS RESPONSIBLE FOR CONSTRUCTING FINANCIAL FORECASTS AND
FOR EVALUATING THE FINANCIAL FEASIBILITY OF NEW
PRODUCTS.
 
PART I. FINANCIAL FORECASTING
 
SUE MUST PREPARE A FINANCIAL FORECAST FOR 2010 FOR
NORTHWEST. NWC’S 2009 SALES WERE $2 BILLION, AND THE
MARKETING DEPARTMENT IS FORECASTING A 25 PERCENT
INCREASE FOR 2010. SUE THINKS THE COMPANY WAS OPERATING
AT FULL CAPACITY IN 2009, BUT SHE IS NOT SURE ABOUT THIS.
THE 2009 FINANCIAL STATEMENTS, PLUS SOME OTHER DATA, ARE
GIVEN IN TABLE IP 4-1.

 
39
Example Continue Page 2
TABLE IP4-1. FINANCIAL STATEMENTS AND OTHER DATA ON NWC
($ MILLIONS)

A. 2000 BALANCE SHEET

CASH & SECURITIES $ 20 ACCOUNTS PAYABLE AND ACCRUALS $ 100

ACCOUNTS RECEIVABLE 240 NOTES PAYABLE 100
INVENTORIES 240 TOTAL CURRENT LIABILITIES $ 200
TOTAL CURRENT ASSETS $ 500 LONG-TERM DEBT 100
COMMON STOCK 500
NET FIXED ASSETS 500 RETAINED EARNINGS 200
TOTAL ASSETS $1,000 TOTAL LIABILITIES AND EQUITY $1,000

B. 2000 INCOME STATEMENT

SALES $2,000.00
LESS: VARIABLE COSTS (1,200.00)
FIXED COSTS ( 700.00)
EARNINGS BEFORE INTEREST AND TAXES $ 100.00
INTEREST ( 16.00)
EARNINGS BEFORE TAXES $ 84.00
TAXES (40%) ( 33.60)
NET INCOME $ 50.40
DIVIDENDS (30%) $ 15.12
ADDITION TO RETAINED EARNINGS $ 35.28
Example 4-13 Page 173
C. 2009 KEY RATIOS
NWC INDUSTRY
PROFIT MARGIN 2.52% 4.00%
RETURN ON EQUITY 7.20% 15.60%
DAYS SALES OUTSTANDING (360 DAYS) 43.20 DAYS
32.00 DAYS
INVENTORY TURNOVER 5.00x
8.00x
FIXED ASSETS TURNOVER 4.00x 5.00x
TOTAL ASSETS TURNOVER 2.00x 2.50x
TOTAL DEBT RATIO 30.00% 36.00%
TIMES INTEREST EARNED 6.25x
9.40x
CURRENT RATIO 2.50x 3.00x
PAYOUT RATIO 30.00% 30.00%
ASSUME THAT YOU WERE RECENTLY HIRED AS SUE’S
ASSISTANT, AND YOUR FIRST MAJOR TASK IS TO HELP HER
DEVELOP THE FORECAST. SHE ASKED YOU TO BEGIN BY
ANSWERING THE FOLLOWING SET OF QUESTIONS:
Example 4-13 Page 173
A. ASSUME THAT NWC WAS OPERATING AT FULL
CAPACITY IN 2009 WITH RESPECT TO ALL ASSETS.
ESTIMATE THE 2010 FINANCIAL REQUIREMENT
USING THE PROJECTED FINANCIAL STATEMENT
APPROACH, MAKING AN INITIAL FORECAST PLUS
ONE ADDITIONAL “PASS” TO DETERMINE THE
EFFECTS OF “FINANCING FEEDBACKS.” ASSUME
THAT (1) EACH TYPE OF ASSET AS WELL AS
PAYABLES, ACCRUALS, AND FIXED AND VARIABLE
COSTS GROW AT THE SAME RATE AS SALES; (2) THE
PAYOUT RATIO IS HELD CONSTANT AT 30 PERCENT;
(3) EXTERNAL FUNDS NEEDED ARE FINANCED 50
PERCENT BY NOTES PAYABLE AND 50 PERCENT BY
LONG-TERM DEBT (NO NEW COMMON STOCK WILL
BE ISSUED); AND (4) ALL DEBT CARRIES AN
INTEREST RATE OF 8 PERCENT.
Example 4-13 Page 173
I. INCOME STATEMENT:
2010 Forecast
2009 Forecast Feed-
Actual Basis 1st Pass Back 2nd
Pass
Sales $2,000.00 x 1.25 $2,500.00 $2,500.00
Less: Var. costs (60%) (1,200.00) x 1.25 (1,500.00)
1,500.00
Fixed costs (700.00) x 1.25 (875.00)
(875.00)
EBIT $ 100.00 $ 125.00 $ 125.00
Interest (8%) (16.00) (16.00) +14.34a
(30.34)
EBT $ 84.00 $ 109.00 $ 94.66
Taxes (40%) (33.60) (43.60) (37.86)
Net income $ 50.40 $ 65.40 $ 56.80
Dividends (30%) $ 15.12 $ 19.62 $ 17.04
RE addition $ 35.28 $ 45.78 $ 39.76
a External funds are financed with 50 percent notes payables and 50percent long-
term debt, so the change in interest expense equals 0.08($89.61) + 0.08($89.61) =
$7.17 + $7.17 = $14.34.
Example 4-13 Page 173
II. BALANCE SHEET:
2010 Forecast
2009 Forecast Feed-
Actual Basis 1st Pass Back 2nd Pass
Cash & securities $ 20.00 x 1.25 $ 25.00 $
25.00
Accounts receivable 240.00 x 1.25 300.00 300.00
Inventories 240.00 x 1.25 300.00 300.00
Tot. current assets $ 500.00 $ 625.00 $
625.00
Net fixed assets 500.00 x 1.25 625.00 625.00
Total assets $1,000.00 $1,250.00 $1,250.00
A/P and accruals $ 100.00 x 1.25 $ 125.00
$ 125.00
Notes payable 100.00 100.00 +89.61a 189.61
Total current liab. $ 200.00 225.00 $
314.61
Long-term debt 100.00 100.00 +89.61b
189.61
Common stock 500.00 500.00 500.00
Retained earnings 200.00 +45.78 245.78 -6.02c
239.76
Total liab & equity $1,000.00 $1,070.78
$1,243.98
AFN $ 179.22 $ 6.02
Cumulative AFN $ 185.24
aΔ in notes payable = $179.22(0.5) = $89.61.
bΔ in long-term debt = $179.22(0.5) = $89.61.
cΔ in RE = $39.76 - $45.78 = -$6.02. Process would continue until AFN = $0.
Example 4-13 Page 173
B. CALCULATE NWC’S FORECASTED RATIOS, AND COMPARE THEM WITH THE COMPANY’S 2009
RATIOS AND WITH THE INDUSTRY AVERAGES. HOW DOES NWC COMPARE WITH THE AVERAGE
FIRM IN ITS INDUSTRY, AND IS THE COMPANY EXPECTED TO IMPROVE DURING THE COMING YEAR
Key ratios NWC
2009 2010 Industry
Actual 2nd pass 2009
Profit margin 2.52% 2.27% 4.00%
ROE 7.20% 7.68% 15.60%
Days sales outstanding (DSO) 43.20 days 43.20 days 32.00 days
Inventory turnover 5.00x 5.00x 8.00x
Fixed assets turnover 4.00x 4.00x 5.00x
Total assets turnover 2.00x 2.00x 2.50x
Debt/assets 30.00% 40.34% 36.00%
Times interest earned 6.25x 4.12x 9.40x
Current ratio 2.50x 1.99x 3.00x
Payout ratio 30.00% 30.00% 30.00%
NWC’s profit margin and ROE are only about half as high as the industry
average—NWC is not very profitable relative to other firms in its industry.
Further, its DSO is too high, and its inventory turnover ratio is too low,
which indicates that the company is carrying excess inventory and
receivables. In addition, its debt ratio is forecasted to move above the
industry average, and its coverage ratio is low and forecasted to decline
even more. The company is not in good shape, and things do not appear
to be improving.