1. Chapter 5 Presented by Group 6
Nick Feiler
Xiaohan Hu
John Langsdorf
Wes Matthews
Steve Potts

2. Building a Profit Plan
Budget – Plan to generate or consume resources; cost center or profit center.
Profit Plan – Budgets of Profit Centers that generate profits and are accountable for both revenues and expenses.

3. Three Objectives of the Planning Process
Translate the strategy of the business into a detailed plan to create value.
Evaluate whether sufficient resources are available to implement the intended strategy.
Create a foundation to link economic goals with leading indicators of strategy implementation.

4. Managers’ 3 Profit Plan Questions
Does the organization’s strategy create economic value?
Does the organization have the cash to fund their strategy and remain solvent?
Does the organization create enough value to attract the financial resources that it needs to fund long-term investment in new assets?

5. Three Wheels of Profit Planning
Profit Wheel
Cash Wheel
ROE Wheel

6. Three Wheels of Profit Planning
Operating
Cash
Sales*
Profit
Wheel
Cash
Wheel
Accounts
Receivable
Inventory
Operating
Expenses
Investment
in Assets
Profits**
Sales*
Profits**
ROE
Wheel
Asset
Utilization
Stockholders’
Equity
Return on
Equity

7. Profit Wheel/3Wheels
The profit plan summarizes the expected revenue inflows and expense outflows for a specified future accounting period.
Usually managers go back and forth, projecting sales, operating expenses, profits, and required investment in assets.
Then they work on the cash wheel and the ROE wheel to ensure resources will be available to implement the profit wheel.

8. Profit Wheel – 5 steps Estimate the Level of Sales
Forecast Operating Expenses
Calculate Expected Profit
Price the Investment in New Assets
Close the Profit Wheel and Test Key Assumptions.

9. Profit Wheel – Step 1 Estimate the Level of Sales
External Variables
Macroeconomic factors
Government regulations
Competitor moves
Customer demand
Internal Decisions
Product mix and pricing
Marketing programs
New Product Introduction and
Change in product quality and feature
Manufacturing and distribution capacity
Customer service levels

10. Profit Wheel – Step 2 Forecast Operating Expenses
Variable costs forecast and reduction
Economic of scales
Operating efficiency
Bargaining power with suppliers
Redesigning of products
Increase price
Non-variable costs
Committed costs
Discretionary costs
Activity-based indirect costs

11. Profit Wheel – Step 3 Calculate Expected Profit
Profit defined
The residual economic value after interest expense and
income taxes
Calculating Profit
NOPAT: Net Operating Profit after Taxes
EBIAT: Earnings before Interest and after Taxes

12. Profit Wheel – Step 4 Price the Investment in New Assets
Assets to Consider for Investment:
1) Operating Assets
2) Long-Term Assets
Most common investment evaluation technique is net present value.

13. Profit Wheel – Step 5 Close the Profit Wheel and Test Key Assumptions
Perform a Sensitivity Analysis
Objective: Estimate how profit might change when assumptions prove to be under- or overstated.

14. Cash Wheel
The cash wheel illustrates the operating cash flow cycle of a business.
Important as companies have limited cash reserves and borrowing capacity.
Operating cash = Cash Rec’d – Cash Paid
Direct (Short Term) & Indirect (Long Term) Methods

15. Cash Wheel – 4 Steps Estimate Net Cash Flows from Operations
Estimate Cash Needed to Fund Growth in Operating Assets
Price the Acquisition and Divestiture of Long-Term Assets
Estimate Financing Needs and Interest Payments

16. Cash Wheel – Step 1 Estimate Net Cash Flows from Operations
The calculation of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a simple technique to estimate operating cash flow.
Refer to Exhibit 2.

17. Cash Wheel – Step 2 Estimate Cash Needed to Fund Growth in Operating Assets
EBITDA is a rough measure that ignores any changes in working capital needed to operate the business.
Examples include: A/R (accounts receivable), Inventory, and A/P (accounts payable).
Refer to Exhibit 2.

18. Cash Wheel – Step 3 Price the Acquisition and Divestiture of Long-Term Assets
Different strategies and initiatives will require different levels of investment and cash.
Examples here are Fixed Asset purchases, such as computer equipment or machinery.
Refer to Exhibit 2.

19. Cash Wheel – Step 4 Estimate Financing Needs and Interest Payments
Lastly, need to account for cash needed or generated by financing and income tax.
Examples here are dividends, interest expense, interest received, and repayment of debt principal.
Refer to Exhibit 2.

20. ROE Wheel
Return on Investment (ROI): a ratio measurement of the profit output of the business as a percentage of financial investment inputs.
Return on Equity (ROE): the appropriate internal measure of ROI for managers.
ROE = Net Income / Shareholder’s Equity

21. ROE Wheel – 3 Steps Calculate Overall Return on Equity
Estimate Asset Utilization
Compare Projected ROE with Industry Benchmarks and Investor Expectations

22. ROE Wheel – Step 1 Calculate Overall Return on Equity
ROE = (Net Income/Sales)*(Sales/Assets)*
(Assets/Shareholder’s Equity)
Net Income/Sales = Profitability Ratio
Sales/Assets = Asset Turnover Ratio
Assets/Shareholder’s Equity = Financial Leverage Ratio

23. ROE Wheel – Step 2 Estimate Asset Utilization
ROCE = Return on Capital Employed: Measures the effective utilization of capital and assets.
= (Net Income/sales)*(Sales/Capital Employed)
Capital Employed = Assets within a manager’s direct span of control.

24. ROE Wheel – Step 2 Asset Utilization Measures
Working Capital Turnover = (Sales) / (Current Assets – Current Liabilities)
Accounts Receivable Turnover = (Net Sales on Credit) / (Average Net Receivables)
Inventory Turnover = (Cost of Goods Sold) / (Average Inventory)
Fixed Asset Turnover = (Sales) / (Property, Plant, and Equipment)

25. ROE Wheel – Step 2 ROCE Tree

26. ROE Wheel – Step 3 Compare Projected ROE with Industry Benchmarks and Investor Expectations

27. Using the Profit Wheels to Test Strategy
- Prepare profit plan
Cash Wheel
- Ensure cash will be adequate
ROE Wheel
- Compare each alternative

28. Chapter Summary
Profit plan describes business strategy in economic terms
Profit plan is used to assess the ability of different strategies to generate value and to estimate whether sufficient resources will be available to implement the chosen strategy