1. Strategic and Operational Financial Planning
Chapter 22
Strategic and Operational Financial Planning
Professor John Zietlow MBA 621

2. Chapter 22: Overview 22.1 Overview of the Planning Process
22.2 Planning for Growth
Sustainable Growth
Pro Forma Financial Statements
22.3 Planning and Control
Short – Term Financing Strategies
The Cash Budget
Cash Receipts
Cash Disbursements
22.4 Summary

3. Overview of the Planning Process
Financial planning activities:
Setting long-run strategic goals
Preparing quarterly and annual budgets
Managing day-to-day fluctuations in cash balances
Long-term financial planning: invest in positive NPV projects
Added complexity – CFOs usually have many more projects that appear to have positive NPV than they can pursue
Limits on capital, production capacity, human resources and other inputs add complexity as well
Long-term financial planning – more an art than a science

4. Long-Term Financial Planning
Strategic plan – multiyear action plan for the major investment and competitive initiatives
Senior management develops strategic plan by answering questions such as:
In what emerging markets might we have a sustainable competitive advantage?
How can we leverage our competitive strengths across existing markets in which we currently do not compete
What threats to our current business exist, and how can we meet those threats?
Where in the world should we produce? Where should we sell?
Can we deploy resources more efficiently by exiting certain markets and using those resources elsewhere?

5. Contribution of Finance to Strategic Planning
Financial managers draw on a broad set of skills to asses the likelihood that a given strategic objective can be achieved
Finance involved in determining the feasibility of a strategic plan given firm’s existing and prospective sources of funding
Determine if firm’s ability to generate cash internally and raise cash externally are sufficient to fund projects included in strategic plan
Finance has a control function in the implementation of strategic plans
Financial analysts prepare cash budgets that help avoid liquidity problems
Finance contributes to strategic planning through risk management
Developing risk scenarios and ways to deal with them

6. Sustainable Growth
Growth can be measured by increases in firm’s market value, its asset base, the number of people it employs, increase in sales
Next figure illustrates the trade-off a firm faces when chooses to grow
Increase in Liabilities Accounts Payable Short-term debt Long-term debt
Increase in assets Cash Receivables Inventories Fixed Assets = +
Increases in Equity Retained Earnings

7. Sustainable Growth Model
Sustainable growth model (Higgins, 1981) – models how rapidly a firm can grow
Assumption of the model:
1. The firm will issue no new shares of common stock next year
2. The firm’s total asset turnover ratio, S/A, remains constant
3. The firm pays out a constant fraction, d, of its earnings as dividends
4. The firm maintains a constant asset-to-equity ratio, A/E
5. The firm’s net profit margin, m, is constant
Firm wants to increase sales by g percent
Asset turnover ratio constant => assets must increase by gA

8. Sustainable Growth Model (Continued)
The model is used to derive the sustainable growth rate g*
a) Asset turnover ratio remains constant (assumption 2) => assets must increase by gA (to 1 + gA) the next period
b) Retained earnings for the next period will equal S(m)(1+g)(1-d)
c) The ratio L/E must remain constant (from assumption 4, A/E ratio is constant):
d) Increase in liabilities equals S(m)(1+g)(1-d)(L/E) (from a and b)

9. Sustainable Growth Model (Continued)
e) Increase in assets must match increase in liabilities and equity
The sustainable growth rate that keeps the sources and uses of funds in balance:
Increase in profit margin or assets-to-equity increase sustainable growth rate
Increase in total asset turnover ratio (A/S is reducing in this case) has the same effect - increase in sustainable growth rate

10. Pro Forma Financial Statements
Forecasts of balance sheet and income statements
Communicate to investors future plans
Used for internal planning and control purposes
Start with “top-down” or “bottom-up” sales forecast
“Top-down” approach – use macroeconomic and industry forecast to establish sales goals
“Bottom-up” approach – forecast sales on a customer by customer basis
Many firms use combination of these two approaches
Percentage-of-sales method – models all items on the balance sheet and income statements to grow in proportion to sales
One item such as cash balance, or short term liability account is left as plug figure – adjusted after all projections to preserve the equality of left and right hands of balance sheet

11. Balance Sheet of Zinsmeister Shoes
Zinsmeister Shoe Balance Sheet as of December 31, 2004
Assets
Liabilities and Equity
Cash
$10,000
Accounts payable
$19,500
Accounts receivable
21,250
Credit line
5,000
Inventory
25,000
Current long-term debt
Current assets
$56,250
Current liabilities
$29,500
Gross fixed assets
$80,000
Long-term debt
$20,000
Less: Accumulated depreciation
20,000
Common stock
$20,200
Net fixed assets
$60,000
Retained earnings
$46,550
Total assets
$116,250
Total liabilities and equity

12. Income Statement of Zinsmeister Shoes
Zinsmeister Shoe Income Statement for the year ended December 31, 2004
Sales
$250,000
Less: Cost of goods sold
162,500
Gross Profit
$87,500
Less: Operating expense
$25,000
Less: Interest Expense
$3,000
Less: Depreciation
$10,000
Pretax Income
$49,500
Less: Taxes
17,325
Net income
$32,175

13. Assumptions to Generate Pro Forma Financial Statements
Use following assumptions:
1. Zinsmeister plans to increase sales by 30% next year (in 2005)
2. Gross profit margin will remain 35%
3. Operating expenses will equal 10% of sales, as in 2004
4. Interest rate paid on all debt is 10%
5. Invest additional $20 mil in fixed assets in Depreciation expense will increase from $10 mil to $15 mil
6. Tax rate is 35%
7. Cash holdings will increase by $1 mil next year
8. Accounts receivables are 8.5% of sales
9. Inventories equal 10% of sales
10. Accounts payable are 12% of cost of goods sold
11. Repay additional $5 mil in long-term debt next year
12. Pay 50% of net income as dividend

14. Pro Forma Income Statement for Zinsmeister Shoes
Using these assumptions, compute the income statement items
All begin with forecasted sales in 2005
1. Zinsmeister plans to increase sales by 30% next year
Sales = $250,000 X 1.3 = $325,000
2. Gross profit margin will remain 35%
Gross profit is $325,000 X 0.35 = $113,750
Cost of goods sold is then $211,250
3. Operating expenses will equal 10% of sales, as in 2004
Operating expenses = $325,000 X 0.1 = $32,500
11. Repay additional $5 mil in long-term debt next year
Interest expense = (Credit Line + Current long-term debt + Long-term debt) X Interest rate = ($5 mil + $5mil + $15mil) X 0.1 = $2.5mil (this assumption may change as other items are
4. Interest rate paid on all debt is 10%

15. Pro Forma Income Statement of Zinsmeister Shoes (Continued)
Sales
$325,000
Less: Cost of goods sold
211,250
Gross Profit
$113,750
Less: Operating expense
$32,500
Less: Interest Expense
$2,500
Less: Depreciation
$15,000
Pretax Income
$63,750
Less: Taxes
22,312
Net income
$41,438
Dividends
$20,719

16. Pro Forma Balance Sheet for Zinsmeister Shoes
Using these assumptions, compute the balance sheet items
7. Cash holdings will increase by $1 mil next year
Cash = $10 mil+ $1mil = $11 mil
8. Accounts receivables are 8.5% of sales
A/R = $325,000 X = $27,625
9. Inventories equal 10% of sales
Inventory = $325,000 X 0.1 = $32,500
5. Invest additional $20 mil in fixed assets in Depreciation expense will increase from $10 mil to $15 mil
Gross fixed assets = $80 mil + $20 mil = $100 mil
Accumulated depreciation = $20 mil + $15 mil = $35 mil

17. Pro Forma Balance Sheet for Zinsmeister Shoes (Continued)
10. Accounts payable are 12% of cost of goods sold
A/P = $211,250 X 0.12 = $25,350
Credit line used as plug figure
Credit should be $3,306,000 to balance the balance sheet
Initial estimate of $2.5 mil interest payment on the income statement too high
Given a credit line of $3,306,000, interest payment would be only $2.33 mil
The decline in interest expense increases the profit and retained earnings. Higher earnings – the credit line is reduced even more
Credit line, interest expense and retained earnings linked through the balance sheet, income statement assumption 4
iterative process to compute these items

18. Pro Forma Balance Sheet for Zinsmeister Shoes
Assets
Liabilities and Equity
Cash
$11,000
Accounts payable
$25,350
Accounts receivable
27,625
Credit line
3,306
Inventory
32,500
Current long-term debt
5,000
Current assets
$71,125
Current liabilities
$33,656
Gross fixed assets
$100,000
Long-term debt
$15,000
Less: Accumulated depreciation
35,000
Common stock
$20,200
Net fixed assets
$65,000
Retained earnings
$67,269
Total assets
$136,125
Total liabilities and equity

19. External Funds Required (EFR) for Zinsmeister Shoes
Forecast of external funds required can be modeled with the following equation:
- additional assets required to maintain a constant asset turnover ratio
- additional accounts payable available assuming that the ratio of accounts payable to sales remains constant
- additional financing source from increased
retained earnings
EFR for Zinsmeister is $8,111,000. In pro forma balance sheet external financing declined by $6.7 mil
Discrepancy because assets to sales ratio is actually not constant as equation assumes

20. Short-Term Financing Strategies
Growth is a very common long-term objective for many firms
Sales volumes usually vary along a long-term upward trend
Current assets tend to rise and fall with sales
Fixed assets follow the long-term upward trend of sales, but do not vary short-term with sales
Companies can adopt conservative, aggressive, or matching strategy to fund long-term trend and seasonal fluctuations
Conservative strategy – use long-term financing to cover both long-term investments as well as short-term
Aggressive strategy – use short-term financing to fund both seasonal peaks and part of long-term growth in sales and assets
Matching strategy – finance permanent assets (fixed assets plus permanent component of current assets) with long-term funding sources and temporary asset requirement with short-term financing

21. Quarterly Sales for Hershey Foods (1992 – 2002)
1,400
1,200
1,000
800
600
400
200
Year
Quarterly Sales ($ in millions)
Quarterly Sales

22. Financing Strategies Available to Hershey
1,400
1,200
1,000
800
600
400
200
Quarters ( )
1,600
1,800
Total Assets($ in millions)
Hershey’s Current Assets Matching Strategy Conservative Strategy Aggressive Strategy

23. Cash Budget Cash budget shows firm’s planned cash inflows and outflows
Used to estimate short-term cash requirements and provide the information needed to plan short-term investment (surplus cash) and short-term funding needs (cash shortages)
Key input in building cash budget– firm’s sales forecast
Estimate the monthly cash flows that will result from projected sales receipts and from production-related, inventory-related, and sales-related outlays
Cash receipts – include all firm’s cash inflows in a given financial period
Cash disbursements include all outlays of cash by the firm during a given financial period

24. Cash Receipts Most common components of cash receipts
Cash sales, collections of accounts receivable, and other cash receipts
Farrell Industries develops cash receipts forecasts for October, November, and December
Sales in August and September: $100,000 and $200,000
Forecasted sales for October, November, and December: $400,000, $300,000, and $200,000
80% of sales on credit, 20% cash sales
50% of sales collected next month; remaining 30% collected after two months
In December, $30,000 dividends from stock Farrell holds in a subsidiary
Table next slide shows schedule of cash receipts for Farrell

25. Schedule of Projected Cash Receipts for Farrell Industries
August
September
October
November
December
Forecast Sales
$100
$200
$400
$300
Cash Sales (20%)
$20
$40
$80
$60
Collection of accounts receivable
Previous month (50%) 50
100
200
150
Two months prior (30%) 30 60
120
Other cash receipts
Total cash receipts
$210
$320
$340

26. Cash Disbursements Cash disbursements items:
Cash purchases, fixed asset outlays, payments of accounts payable, interest payments, and rent and lease payments
Cash dividend payments, wages and salaries, loan principal payments, tax payments, and repurchase or retirement of stock
Depreciation: not included in the cash budget; does have a cash outflow effect through its impact on tax payments
Farrell Industries uses the following assumptions to compute cash disbursements for October, November, and December:
Purchases equal 70% of sales. Paid 10% in cash; 70% paid next month, and 20% two months after the purchase
October purchases = 70% X $400,000 = $280,000
$28,000 paid in cash, $196,000 paid in November, and $56,000 paid in December

27. Cash Disbursements (Continued)
Rent payments: $5,000 paid each months
Wages and salaries: 10% of monthly sales plus $8,000
October wages = 10% X $400,000 + $8,000 = $48,000
Tax payments: $25,000 taxes paid in December
Fixed assets outlays: $130,000 in new machinery paid in November
Interest payments: $10,000 due in December
Cash dividends payments: $20,000 dividends will be paid in November
Principal payments: $20,000 principal payment due in December
Table on next slide shows schedule of cash disbursements for Farrell Industries

28. Schedule of Projected Cash Disbursements for Farrell Industries
August
September
October
November
December
Purchases (70% of sales)
$70
$140
$280
$210
Cash Purchases (10%) $7
$14
$28
$21
Payments of accounts payable
Previous month (70%) 49 98
196
147
Two months prior (20%) 14 28 56
Rent payments 5
Wages and salaries 48 38
Tax payments 25
Fixed asset outlays
130
Interest payments 10
Cash dividend payments 20
Principal payments
Total cash disbursements
$213
$418
$305

29. Net Cash Flow, Ending Cash, Financing Needs and Excess Cash
The firm’s net cash flow: subtract cash disbursements from cash receipts for each period.
Ending cash balance can be found by adding the beginning cash balance to the firm’s net cash flow
Farrell constructs the cash budget using the cash receipts and disbursements and the following assumptions:
Cash balance at the end of September is $50,000
Notes payable and marketable securities are $0 at the end of September
$25,000 is the desired minimum cash balance
If cash balance is less than desired minimum cash balance: issue notes payable
If cash balance above desired minimum cash balance: invest in short-term marketable securities

30. Cash Budget for Farrell Industries
-51 47 50
Add: Beginning cash
-$16
-$51
$47
Ending cash balance 25
Less: Minimum cash balance
$41
$76
Required total financing (notes payable)
$22
Excess cash balance (marketable securities)
$35
-$98
-$3
Net cash flow
305
418
213
Less: Total cash disbursements
$340
$320
$210
Total cash receipts
December
November
October