4.1 What Is Financial Planning?
Financial planning establishes guidelines for a firm's growth and change. It is a systematic way of thinking about the future and anticipating potential problems. While growth is a common focus, it's important to remember that growth itself is not the goal; the appropriate goal is to increase the market value of the owners' equity.
Dimensions of Financial Planning
- Planning Horizon: The time period the plan covers, typically the next two to five years.
- Aggregation: The process of combining individual investment proposals from different operational units into one large project for planning purposes.
The process involves creating multiple scenarios (e.g., worst case, normal case, best case) to explore options, avoid surprises, and ensure the firm's goals are feasible and internally consistent.
4.2-4.3 The Percentage of Sales Approach
The percentage of sales approach is a common financial planning method for generating pro forma statements. The core idea is to separate accounts into two groups: those that vary directly with sales and those that do not.
Steps in the Percentage of Sales Method
- Project Sales: Start with a sales forecast, which is the "driver" of the model.
- Create Pro Forma Income Statement: Assume costs are a constant percentage of sales to project net income. A constant dividend payout ratio is often assumed to project dividends and the addition to retained earnings.
- Create Pro Forma Balance Sheet:
- Identify accounts that vary with sales (e.g., cash, accounts receivable, inventory, accounts payable) and express them as a percentage of sales.
- Project these accounts based on the new sales forecast.
- For accounts that do not vary with sales (e.g., long-term debt, equity), initially assume no change.
- Project the new retained earnings based on the pro forma income statement.
- Determine External Financing Needed (EFN): After projecting assets and liabilities/equity, the balance sheet will likely not balance. The difference (Projected Total Assets - Projected Total Liabilities & Equity) is the External Financing Needed (EFN). This "plug" figure represents the amount of new financing required to fund the projected growth.
The Importance of Capacity Utilization
A critical assumption is whether the firm is operating at full capacity. If a firm has excess capacity, it can increase sales without needing to purchase new fixed assets. This significantly reduces the EFN. For example, if a firm is at 70% capacity, its sales can grow by over 40% before any new fixed assets are needed.
4.4 External Financing and Growth
There is a direct relationship between a firm's growth rate and its need for external financing. Higher growth rates require more investment in assets, leading to a greater need for EFN. Two key growth rates help in analyzing this relationship:
The Internal Growth Rate
This is the maximum growth rate a firm can achieve with no external financing of any kind. It is the rate the firm can maintain using only its internal financing (addition to retained earnings). The formula is:
Internal Growth Rate = $\frac{ROA \times b}{1 - ROA \times b}$
Internal Growth Rate Formula Components:
- $ROA$: Return on Assets (Net Income / Total Assets).
- $b$: The retention or plowback ratio (1 - Dividend Payout Ratio).
The Sustainable Growth Rate
This is the maximum growth rate a firm can achieve with no external equity financing, while maintaining a constant debt-equity ratio. It is the rate the firm can maintain by using internal financing and issuing debt to keep its capital structure constant. The formula is:
Sustainable Growth Rate = $\frac{ROE \times b}{1 - ROE \times b}$
Sustainable Growth Rate Formula Components:
- $ROE$: Return on Equity (Net Income / Total Equity).
- $b$: The retention or plowback ratio (1 - Dividend Payout Ratio).
Determinants of Growth
A firm's ability to sustain growth depends on four factors:
1. Profit Margin: Higher profit margin increases internally generated funds.
2. Dividend Policy: A lower dividend payout (higher retention ratio) increases internal equity.
3. Financial Policy: A higher debt-equity ratio makes more debt financing available.
4. Total Asset Turnover: Higher asset turnover means less need for new assets to support sales growth.
Chapter Review and Critical Thinking Questions
Solution: Future sales are the key input because a firm's need for assets and its generation of financing are fundamentally driven by its level of sales. The sales forecast determines the future asset requirements and the projected profits and retained earnings. All other elements of the financial plan flow from this initial forecast.
Solution: Yes, it is possible. The sustainable growth rate is the maximum growth rate a firm can achieve *without* issuing new equity and while keeping its debt-equity ratio constant. A firm can grow faster than its sustainable growth rate by issuing new equity, increasing its debt-equity ratio, or by changing its profit margin, asset turnover, or dividend policy.
Solution: A negative EFN means the firm has a surplus of financing. This tells us that the firm's growth rate of 15% is less than its internal growth rate (the maximum rate with no external financing). Since the internal growth rate is always less than the sustainable growth rate, the sustainable growth rate must also be greater than 15%.
Solution: A negative EFN at a 20% growth rate means the firm's sustainable growth rate is greater than 20%. We do not know for certain if the internal growth rate is greater or less than 20%. The sustainable growth rate is calculated assuming the firm is issuing new debt. A negative EFN in this case only tells us that the firm's growth is below its sustainable rate. It could be above or below its internal rate, which assumes no new debt is issued.
Solution: No, it probably would not have. The company's failure was a result of it growing too fast. The rapid growth in sales created a massive need for investment in capacity and working capital, which the company could not finance. Less popular products would have resulted in slower, more manageable growth.
Solution: This policy lengthened the cash cycle. The company had to spend cash on production and capacity expansion long before it received any cash from sales. This created a severe working capital drain, as the firm had to finance its inventory and production process without any corresponding cash inflow.
Solution: No, it was not a wise choice. While the low price fueled the high demand, it also reduced the company's profit margin. A lower profit margin reduces the amount of internal financing (retained earnings) the firm can generate, which in turn reduces its sustainable growth rate. The low price exacerbated the problem of growing too fast.
Solution: A lender would likely be hesitant because of the firm's high risk. The company's financial statements would show low or negative profits, poor liquidity, and a weak balance sheet. The rapid, chaotic growth and lack of financial planning would signal to a lender that the business was out of control, making it a poor credit risk.
Solution: The biggest culprit was the company's inability to manage its growth. All three factors are symptoms of this underlying problem. The "too many orders" (rapid growth) led to "too little production capacity," which in turn created "too little cash" due to the need for investment and a long cash cycle. The core problem was a lack of financial planning to support the sales growth.
Solution: A small company in this situation needs to slow down its sales growth to a manageable, sustainable level. It can do this by raising prices, which will reduce demand, increase profit margins, and provide more internal financing. It can also seek external equity financing from venture capitalists or other investors, but this requires a solid business and financial plan.