Topic 2

Financial Planning

Part 1 COMM 370

Corporate Finance
Topic 2 – Financial Planning

Objective
Part 1: What we will cover…
• Ratios help us analyze the past, but we need to
us plan and forecast the future

• Based on a firm’s desired sales growth we can

• Basic financial statement forecasting what amount, if any, a firm needs to finance th
• External financing needed (EFN) • Financial planning models help firms to underst
financing implications of their growth plans and alt
• Spare capacity available
• Adjusting turnover ratios • Spreadsheets are used to develop a financial mo
allows us to forecast future funding needs.

• Formulas have been developed to help approxi

Have ‘Topic 2 – Supplementary Material.xls’
the results of the detailed financial models. Be car
spreadsheet handy as we will be referring toformulas make simplifying assumptions that make
the Excel spreadsheet realistic.
4
 Sumo Corp - Income Statement for 2018 Pro-Forma Statements & Financial Pla

2018
Objective:
Sales 6,000.0
Identify the financial requirements of a business p
COGS (70% of sales) 4,200.0
evaluate different financing options.
Operating expenses 500.0
EBIT Plan:
1,300.0
Interest expense 1. Determine what the planned (forecast) SALE
150.0
Taxable income 1,150.0
rate (g) for next year
2. Make assumptions about the firm’s ratios o
Tax (40% tax rate) 460.0
statement relationships.
Net income 690.0
3. Construct the pro-forma financial statements a
Dividend (1/3 of NI) 230.0 determine the external financing needed (EF
Addition to retained earnings 460.0
7

Sumo Corp - Balance Sheet as of Dec. 2018 Pro-Forma Statements & Financial Pla
In addition to the forecast sales growth rate yo
Assets: 2018 Liabilities & Equity: 2018
use past ratios or industry information for the f
Cash 320.0 Accounts payable 600.0
Acc. receivable 880.0 Notes payable 200.0
• Operating cost structure: variable and fixed co
Inventory 1,200.0 Current liabilities 800.0
margin, operating margin etc
Current assets 2,400.0 • Turnover ratios: use credit terms given to custo
Long-term debt obtained from suppliers / inventory level required
1,800.0
historical ratios
Net fixed assets 3,600.0
• Interest expense: from loan agreements and o/
Common stock 1,400.0
• Tax rate: use effective tax rate from past
Retained earnings 2,000.0
• Capital asset requirements: does sales growth
Total equity 3,400.0
additional capacity requirements or not
• Dividends: consider dividend policy and past pa
Total assets 6,000.0 Total liabilities & equity 6,000.0
8
 Sumo Corp’s Planned Growth in 2019 Sumo Corp’s Planned Growth in
Assumptions for Sumo’s pro-forma balance sheet: • Suppose the company wants sales to grow 20
– All current assets grow by 20%
• Assumptions for pro-forma income stateme
– Net fixed assets grow by 20%
– Cost structure is the same: COGS is 70% of
(new net investment if fixed assets grow at the same
rate as sales) – Operating expenses increase by 5%
– Interest expense is 5% of beginning notes p
– Accounts payable grows by 20% plus long-term debt
– The tax rate is still 40%
Under what circumstances are these reasonable
assumptions? – The dividend policy is the same (1/3 of NI pa
dividends)
What about long term debt and equity?
11 [where do these assumptions come from?]

Sumo Corp
Sumo Corp’s Planned Growth in 2019
Pro-Forma Income Statement for 20

In addition, for a first pass at the pro-forma balance sheet 2018

for 2019, make the following additional assumption: Sales (+ 20%) 6,000.0
– No external financing: common stock, notes payable,
COGS (70% of sales) 4,200.0
and long term debt do not change.
Operating expenses (+ 5%) 500.0
EBIT 1,300.0
– The only financing available is internal, that is, Interest (5% of beg. NP + LT debt) 150.0
through retained earnings. Taxable income 1,150.0
Tax (40% tax rate) 460.0
Why is doing this useful? Net income 690.0
Dividend (1/3 of NI) 230.0
Addition to retained earnings 460.0
12
 External Financing Needed Sumo Corp
Pro-Forma Balance Sheet as of Decemb
Based on the forecast financial statements, what is the
external financing needed?
Assets: 2018 2019F
Total asset requirement Cash (+20%) 320.0 384.0
Less: Total financing from debt and equity Accounts receivable (+20%) 880.0 1056.0
External Financing Needed
Inventory (+20%) 1,200.0 1440.0
What are the typical external financing options? Current assets 2,400.0 2,880.0
– Raise long term debt
– Issue more equity Net fixed assets (+20%) 3,600.0 4,320.0
– Reduce dividends
Total assets 6,000.0 7,200.0

After determining the above, you can complete the balance

sheet! 15

Sumo Corp – Final Pro-Forma Balance Sheet Sumo Corp

(December 2019 – Debt & Equity Financing)Pro-Forma Balance Sheet as of Decemb
Liabilities & Equity: 2018 2019F
Liabilities & Equity: 2018 2019F Change
Accounts payable (+20%) 600.0 720
Accounts payable 600.0 720 120.0
Notes payable 200.0 200.0 Notes
- payable (no change) 200.0 200.0
Current liabilities 800.0 920.0 Current liabilities
120.0 800.0 920.0

Long-term debt 1,800.0 2,033.0 Long-term debt (no change)

233.0 1,800.0 1,800.0

Common stock 1,400.0 1,633.0 Common stock (no change)

233.0 1,400.0 1,400.0
Retained earnings 2,000.0 2,614.00 Retained earnings
614.0 2,000.0 2,614.0
Total equity 3,400.0 4,247.0 Total equity
847.0 3,400.0 4,014.0

Total liabilities and equity 6,000.0 7,200.0 1,200.0

Total liabilities and equity 6,000.0 6,734.0
16
Alternative Scenario: Spare Capacity Alternative Scenario: Only Debt Fina

Liabilities & Equity: 2018 2019F

What will happen with EFN? Accounts payable 600.0 720
Notes payable 200.0 200.0
=> No need to recalculate Total Liabilities and Equity
Current liabilities 800.0 920.0
=>Recalculate Fixed Assets and Total Assets
Long-term debt 1,800.0 2,266.0
=> Recalculate EFN
Common stock 1,400.0 1,400.0
Retained earnings 2,000.0 2,614.00
Total equity 3,400.0 4,247.0

Total liabilities and equity 6,000.0 7,200.0

19

Sumo Corp
Pro-Forma Balance Sheet as of December 2019 Alternative Scenario: Spare Ca
Liabilities & Equity: 2018 2019F • Suppose
Change that Sumo was operating at 60% of c
last year, and sales growth is still expected to b
Accounts payable (+20%) 600.0 720 120.0
Notes payable (no change) 200.0 200.0 -
• Now the fixed percentage growth for every ite
Current liabilities 800.0 920.0 120.0did
in the previous example) is not appropriate.

Long-term debt (no change) 1,800.0 1,800.0 • -Why?

Common stock (no change) 1,400.0 1,400.0 • -What are the full capacity sales?
Retained earnings 2,000.0 2,614.0 614.0
Total equity 3,400.0 4,014.0 614.0
• Do we need to invest in fixed assets? How muc
Total liabilities and equity 6,000.0 6,734.0 734.0

20
 Alternative Scenario: Changing Sumo Corp
asset turnover ratios (or days) Pro-Forma Balance Sheet as of December

but
• Suppose that Sumo’s growth is still expected to be 20%,Assets: 2018 2019F
you are hoping to:
Cash (+20%) 320.0 384.0
- pay suppliers quicker to take advantage of a discount, or
Accounts receivable (+20%) 880.0 1056.0
- collect AR faster (or increase sales by extending credit
for longer), or Inventory (+20%) 1,200.0 1440.0
- sell inventory quicker Current assets 2,400.0 2,880.0

• Now the fixed percentage growth for the affected item Net
(as fixed assets (+20%) 3,600.0 3,600.0
we did in the original example) is not appropriate anymore.
Total assets 6,000.0 6,480.0
• Why?
EFN = 6,480 – 6,734 = (254) i.e. there is excess
• Which numbers will change and by how much?
What do you do if that is the case?
23

Alternative Scenario: Adjust AP to

External Financing Neede
take advantage of supplier discounts
What will happen to Accounts Payable for 2019? Based on the forecast financial statements, what is
external financing needed?
 2018 AP turnover is 7 (or 365/7 = 52 days)
Total asset requirement
 If supplier credit terms are 2/10 net 45, that means that Less: Total financing from debt and equity
you can get 2% discount if you pay in 10 days External Financing Needed

What are the options when excess funds are forec

 A/P days must change from 52 to 10 or AP turnover
must increase from 7 to 36.5 times. – Repay long term debt
– Buy-back shares
 Recalculate the new AP amount on the balance sheet – Increase dividends
that is available as a source of financing:
COGS/new AP turnover = new AP balance on B/S
5,040/36.5 = 138 Consider the company life cycle…when is this
=> Recalculate total liabilities & equity and EFN 24
likely to be the case?
 But doesn’t this affect the
income statement?
Sumo Corp - Pro-Forma Income Statement for 2019

2018 2019F
Sales (+g%) 6,000.0 7,200.0
COGS (70% of sales) MAY NEED TO BE ADJUSTED* 4,200.0 4,939.2
4,896.0
Operating expenses (+ 5%) 500.0 525.0
EBIT 1,300.0 1,779.0
1,735.8
Interest expense (5% of beg. notes payable + LT debt) 150.0 100.0
Taxable income 1,150.0 1,679.0
1,635.8
Tax (40% tax rate) 460.0 671.6
654.3
Net income 690.0 1,007.4
981.5
Dividend (1/3 of NI) 230.0 335.8
327.2
Addition to retained earnings 460.0 671.6
654.3

27

Recalculate COGS, addition to

Does the new EFN make s
retained earnings….
Assets: 2018 2019F Change Liabilities & Equity: 2018 2019F Change
Cash (+g%) 320.0 384 64 Accounts payable (adj) 600.0 141 (459)
Accounts receivable (adj) 880.0 1056 176 Notes payable (no change) 200.0 200 -
Inventory (adj) 1,200.0 1411 211 Current liabilities 800.0 341 (459)
Current assets 2,400.0 2851 451
Long-term debt (no change) 1,800.0 1,800 -
Net fixed assets (adj) 3,600.0 4320 720
Common stock (no change) 1,400.0 1,400 -
Retained earnings 2,000.0 2,654 654
Total equity 3,400.0 4,054 654

Total assets 6,000.0 7171 1,171 Total liabilities and equity 6,000.0 6,195 195

DISCOUNT
EFN = 975 Consider whether the change in EFN makes sense…

Increased AP turnover, made EFN larger, but this is somewhat Here we just changed the AP turnover, but you can
offset by the larger addition to retained earnings resulting with
fromthe spreadsheet to see the impact alone or tog
the supplier discount! changing AR, inventory, fixed asset or AP turnover!
28
 When should you consider taking the d
• With terms “2/10 net 45 days”, you pay only 98% of t
you pay at day 10. I.e. 2% discount.

Topic 2 • Delaying payment is an important source of financ

businesses, BUT you forego the 2% discount

• Determine the interest rate you effectively pay for the

Financial Planning financing period between day 10 and day 52 (actual
2%/98% = 0.0204 and convert to an annual rate:

• EAR = [1 + 0.0204]365/42 – 1 = 19.2%

Part 2
• Note: if you forego the discount, you are in fact borro
suppliers at 19.2% per year. If this is an important so
financing, even if the rate is high, continue using it, b
access to cheaper financing, make use of that and ta
discount. Sumo foregoes $466 in financing to take a
the discount
31

Part 2: What we will cover… What we covered in Part

• Internal growth rate • Basic financial statement forecastin

• Sustainable growth rate • External financing needed (EFN)
• Growth and debt ratios • Spare or excess capacity
• Adjusting turnover ratios
Have ‘Topic 2 – Supplementary Material.xls’
spreadsheet handy as we will be referring to
the Excel spreadsheet
32
 Other Planned Growth Rates fo
Keeping other assumptions the same, what will h
with the forecasted EFN of Sumo, if

– The planned growth rate is only 15%?

– The planned growth rate is now 30%?

(check using spreadsheet in supplementary m

What general conclusion can we draw from thi

35

EFN vs. g
EFN

0 g

• Note: this is not necessarily a line, but good for illustration

36
 Internal Growth Rate: Useful Formula Financial Constraints
Can we get an approximate estimate of a firm’s actual gi • Firms, especially small growing ones, are often
without going through the full financial planning? rationed by lenders and suppliers, and may be u
raise new equity financing.
gi = ROA × r / (1 – ROA × r)
• Can Sumo grow 20% in 2019 under these condit

where r = retention ratio (i.e. 1 – payout ratio)

• What is the maximum growth rate Sumo can
with no external financing (using retained ear
only – no AP financing, no increase in LT de
payable or common stock)?
i i
Note: using formula above g = 8.3% (actual g = 10%); not
100% accurate but close for Sumo and took little effort.

(Difference due to the fact that some items e.g. interest do39
not grow at the sales growth rate)

EFN & Internal Growth Rat

EFN

0 gi

• Internal Growth Rate gi: the sales growth rate t

supported with no external financing, i.e. EFN =
• 40The firm’s operations are funded with retained e
 Internal Growth Rate: Drivers Internal Growth Rate: Formula assu
gi = ROA × r / (1 – ROA × r) The formula above assumes everything (income
items and assets) grows at gi:
What happens with gi if ROA increases? • Total assets must also grow at gi (operating at f

=> gi increases
• No increase in accounts payable (no supplier cr
=> with higher ROA (given r), there is more addition to RE, term debt financing
so more internal funds to grow.

What will in turn make ROA increase? • The retention ratio (and payout ratio) will remain

=> Increase in total asset turnover • Operating expenses also grow at gi

=> Increase in profit margin
• 43Interest expenses grow at gi (least realistic)

Growing at gi: Debt Ratio Implications Internal Growth Rate: Drivers

Now think how of a firm’s (book) debt-to-equity ratio would gi = ROA × r / (1 – ROA × r)
change over time depending of its sales growth…

What happens with gi if the retention ratio (r) i

Suppose a firm is growing at gi each year (and thus not using
any external funds; just its own retained earnings). or equivalently the dividend payout ratio (d) d

How is the firm’s debt-to-equity ratio evolving over time? gi increases

=>Numerator (debt) is unchanged, but denominator (equity)
grows with additions to RE; D/E is decreasing!  with higher retention (given ROA), there is mor
to RE, so more internal funds to grow.
If in spreadsheet you set g=10%, you will see D/E falls!

Is this trend in the debt-to-equity ratio desirable?

Only if a firm has high leverage and is temporarily delevering, but
not if a firm is at its target (=> later capital structure sessions)44
 Towards the Sustainable Growth Rate Growing at gi: Debt Ratio Implica

Bank debt is the typical external funding of small firms;

so suppose now Sumo can borrow the funds needed. Liabilities & Equity: 2018 2019F
Accounts payable (no change) 600.0 600.0
Notes payable (no change) 200.0 200.0
If Sumo grows by retaining earnings and Current liabilities 800.0 800.0
borrowing, what will happen to its debt-to-equity ratio
over time? Long-term debt (no change) 1,800.0 1,800.0

– D/E would decrease if growth in E > growth inCommon

D stock (no change) 1,400.0 1,400.0
Retained earnings 2,000.0 2,498.19
Total equity 3,400.0 3,898.2
– D/E would increase if growth in E < growth in D
Total liabilities and equity 6,000.0 6,498.2

D/E 76.5% 66.7%

47

If Sumo grows 20% and covers all EFN with Towards the Sustainable Growth
borrowing, its D/E increases!

With no access to external financing, Sum

growth at gi = 10% using its retained earni
D/E decreases.

Can Sumo grow faster if it has access to e

financing?

48
 If growth is set at 16.8%, then D/E stays constant The Sustainable Growth Rat
If the firm cannot raise equity, but can borro
would you choose a growth rate that is “sus
the long run?

=>Sustainable Growth Rate (g*):

The maximum sales growth rate a firm can

- without external equity financing,

- using internally generated funds, and

- borrowing an amount to maintain a co

51
debt/equity ratio.

Can Sustainable Growth Rate Change? The Sustainable Growth Rat

• Changes in components of ROE (profit margin, asset With the same assumptions about growth in
turnover, or leverage) will affect g*. expenses and retention ratio as before, we
an approximate estimate of a firm’s actual g*
• Changes in the retention ratio (or payout ratio) will also
affect the sustainable growth rate.
formula:

• A company can increase its sustainable growth rate by: g* = ROE × r / [1 – ROE × r]
− Increasing the D/E ratio (increasing leverage)
For Sumo, the formula gives g* = 15.6%
− Increasing the profit margin by better controlling costs
− Increasing the sales/total assets ratio (asset turnover)
− Increasing the retention ratio by reducing dividends Trying a few numbers in our spreadsheet to
D/E remains unchanged gives g* = 16.8%
g* is a useful “reference” growth rate for firms that
borrow, but not necessarily an optimal strategy. Why?52
 Planned Growth & Debt Ratio EFN vs. g, gi, and g*
What are the implications for the D/E of various
combinations of business plans and financing plans? EFN

(Typically small firms can borrow, but cannot easily issue

equity. Assume that EFN will be covered with borrowing)

Case 1 – Low growth: 0 < g < gi

0
• RE are more than enough to finance low growth gi g* g
(EFN<0), so no need of external funds.
• You can also pay dividends, accumulate cash, or do
something with the money.
• The D/E is falling (accumulation of RE).
55

EFN vs. g, gi, and g* Planned Growth & Debt Ra

• Think of the chosen growth rate (g) (toget
EFN assumptions on costs, etc.) as the firm’s busin
• The business plan requires that the firm rais
(debt or equity) equal to the associated EFN.
• This EFN and how the EFN is financed is the fi
plan.
Case 1
0 • The business plan and the financing plan will
gi g* g firm’s financial condition (D/E) from one year to
• To get an idea how, compare the current
statements (D/E) with the pro-forma ones for n
• More generally, we want to understand
combined business/financial strategy of a firm
56 its future.
 Different regions of growth Planned Growth & Debt Ra
Case 3 – High growth : g > g*
Case 2 – Medium growth: gi < g < g*
If the large EFN is funded only with new borrowing, what
will happen to the firm’s D/E ratio over the years? • RE are not enough to finance growth (EFN>0),
external funds are needed.
• D/E will increase (debt grows faster than equity) • If EFN is funded with bank debt, borrowing wil
over the years but less quickly than equity.
Is this optimal? Maybe temporarily if firms has low leverageWhy? The growth in equity (through retained earn
and wants to get to a target D/E. But in general it could lead
exceeds the growth of debt.
to bankruptcy!
• D/E falls (but less than in Case 1, when g<gi).
What are viable options to fund growth in the long run? Would it make sense to grow at g < g* over the
• Grow issuing equity and debt to keep D/E stable. => Maybe temporarily if firm has high leverage an
D/E
• Grow raising equity, but not debt, if equity is available. reduce leverage to get to a target D/E
would be falling; not ideal. 59

EFN vs. g, gi, and g* EFN vs. g, gi, and g*

EFN EFN

Case 3 Case 2
0 0
gi g* g gi g* g

60
 Caveats on Financial Planning M
Summary & Conclusions
• Models do not indicate which financial policies m
value. In other words, there is no financial theor
• Financial planning models are simple, but very
• Models rely on simplifying assumptions that m
useful to forecast a firm’s external financial needs.
realistic (e.g., not everything grows in proportion t
• They are useful to construct pro-forma financial
statements, which lead to cash flow forecasts. • If you complicate models too much by adding m
• Any assumptions can be built into the analysis if may become less practical to use (defeating the
you use a spreadsheet.
 However, they are useful tools to plan investment
• External financing needs increase with the speed financing decisions.
of growth.  Be aware of the assumptions and use them to for
financial needs and financial statements, which
of cash flow projections
63

Financial Planning Models – Main

Summary & Conclusions
• Help managers assess the feasibility and con
• The questions are: of their business / financial plans.

– Can you raise the funds you need? • Are often the basis for forecasts of future ca
forecasts, which key to value a firm.
– What does this do to your capital structure
(D/E)?
• Used by entrepreneurs to describe a business
• With some simplifying assumptions we can prospective investors (e.g., in requesting a loan
develop simple formulas for the internal growth – a good description of business plan & assu
and sustainable growth rates. – estimate of financial requirements (amount r
– pro-forma financial statements indicating fea
• Comparing planned growth rates with gi and g* financial plan based on the borrowing you ar
provides critical information about a firm’s future requesting.
financing needs and trend in the debt ratio.
64
 Applying what you’ve learned… Applying what you’ve learn

67

Appendix: All Formulas Work

Applying what you’ve learn
In the supplementary materials spreadsheet, (Sumo),
assumptions are that operating and interest expense grows
at a different rate from EBIT causing the calculated gi and g*,
to be slightly different from that indicated by the spreadsheet.

In the spreadsheet, Sumo(2), we amend assumptions so

that all of NI grows at g in 2019.These are the assumptions
used to derive gi and g*, so now the formulas are exact in
this case!

Take a look at the example, to confirm that if Sumo grows:

• at gi then EFN = 0 and D/E decreases

• at g* & funds EFN with debt, then D/E remains the same68
 Optional Appendix: Derivation
Formal Calculation of EFN
Formulas for EFN, gi, and g*
• Increase in assets = A × g • We are at the end of year t and want to calculate the
financing we need for sales to grow at a rate g in yea
• Addition to RE = NI × r × (1+g)
• EFN = Growth in Assets – Increase in AP – Addition
• EFN = Increase in assets - Addition to RE • We now make the following simplifying assumptions:
– For sales to grow at g total assets must also grow
• EFN = A × g - NI × r × (1+g) = [A – NI × r ] × g - NI × r operate at full capacity and sales/assets is always
• Remember the figure with EFN in the Y-axes and g in – The firm will not increase its accounts payable.
the x-axis that we used to discuss things? – The firm’s retention ratio will remain the same for
– Operating expenses also grow at g.
• Slope: [A – NI × r ] ; > 0 if NI > 0 and r > 0 – Interest expenses grow at g (even if debt does no

• Intercept: - NI × r ; < 0 if NI > 0 and r >0 • Now everything grows at g → the percentage sales
71

Def. of Vars. Based on Accounting Data f

The Internal Growth Rate
– A = total assets (from balance sheet at end of y
• Internal Growth Rate gi: the rate of sales growth that
can be supported with no external financing, i.e. EFN –= D = total debt (from balance sheet at end of yea
0.
– E = total equity (from balance sheet at end of y
i
• [A - NI × r ] × g - NI × r = 0 – NI = net income (from income statement for yea

• Solving yields gi = NI × r / [A - NI × r ] – r = retention ratio = Chg in retained earnings / n

= 1- dividend payout ratio = 1
• Divide by A & recall ROA = NI / A
– ROA = return on assets = net income / total ass
• Then, gi = ROA × r / (1 – ROA × r) – ROE = return on equity = net income / total equi
– g = projected sales growth rate (from year t to y
72
Calculating the Sustainable Growth Rate The Sustainable Growth Rat
[A – (1+D/E) × NI × r] × g* = (1+D/E) × NI × r Sustainable Growth Rate g*: the maximum sales gr
firm can achieve without external equity financing
Note that 1+D/E = (E+D)/E = A/E borrowing to maintain a constant debt/equity rati
ROE and r).
Thus, (1+D/E) × NI × r = A/E × NI × r = A × ROE ×The
r gap between a firm’s external financing needs an
portion that can be covered with new borrowing is call
Plug this expression into first line: External Equity Financing Needed (EEFN).

[A – A × ROE × r] × g* = A × ROE × r EEFN = EFN – New Borrowing

= Increase in assets – Addition to RE – New bo

Divide by A to get: [1 – ROE × r] × g* = ROE × r
Conceptually, g* is the growth rate such that EEFN =
Thus, g* = ROE × r / [1 – ROE × r]
75

Calculating the Sustainable Growt

EEFN = A × g – NI × r × (1+g) – NI × r × (1+

What is the last term?

NI × r × (1+g) × (D/E) = ΔRE × (D/E) = (ΔRE

Now solve for g*:

A × g* – NI × r × (1+g*) – NI × r × (1+g*) × (

A × g* – (1+D/E) × NI × r × (1+g*) = 0

A × g* – (1+D/E) × NI × r – (1+D/E) × NI × r

[A – (1+D/E) × NI × r] × g* = (1+D/E) × NI ×