Chapter 5 Presented by Group 6

Nick Feiler Xiaohan Hu John Langsdorf Wes Matthews Steve Potts

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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.

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.
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Managers 3 Profit Plan Questions

Does the organizations 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?

Three Wheels of Profit Planning

Profit Wheel Cash Wheel

ROE Wheel
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Three Wheels of Profit Planning

Operating Cash

Sales*

Accounts Receivable

Cash Wheel
Sales*
Asset Utilization

Inventory

Operating Expenses

Profit Wheel
Profits**

Investment in Assets

Profits**

ROE Wheel
Return on Equity

Stockholders Equity

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.
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Profit Wheel 5 steps

1) 2) 3) 4) 5)

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.
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Profit Wheel Step 1 Estimate the Level of Sales

1. 2. 3. 4.

External Variables
Macroeconomic factors Government regulations Competitor moves Customer demand

1. 2. 3. 4. 5. 6.

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
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Profit Wheel Step 2 Forecast Operating Expenses

1. 2. 3. 4. 5.

Variable costs forecast and reduction

Economic of scales Operating efficiency Bargaining power with suppliers Redesigning of products Increase price

1.
2. 3.

Non-variable costs
Committed costs Discretionary costs Activity-based indirect costs
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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

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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.
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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.

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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 Recd Cash Paid Direct (Short Term) & Indirect (Long Term) Methods
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Cash Wheel 4 Steps

Estimate Net Cash Flows from Operations 2) Estimate Cash Needed to Fund Growth in Operating Assets 3) Price the Acquisition and Divestiture of Long-Term Assets 4) Estimate Financing Needs and Interest Payments
1)
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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.

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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.
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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.

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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.
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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 / Shareholders Equity

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ROE Wheel 3 Steps

Calculate Overall Return on Equity

Estimate Asset Utilization Compare Projected ROE with Industry Benchmarks and Investor Expectations

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ROE Wheel Step 1 Calculate Overall Return on Equity

ROE = (Net Income/Sales)*(Sales/Assets)* (Assets/Shareholders Equity) Net Income/Sales = Profitability Ratio Sales/Assets = Asset Turnover Ratio Assets/Shareholders Equity = Financial Leverage Ratio

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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 managers direct span of control.

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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)

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ROE Wheel Step 2 ROCE Tree

Sales Prof it (-) COGS Selling and Admin. Expenses

Return/Sales Return on Capital Employed

(/)

Total Expenses

(x)

Sales

Other Expenses Cash Working Capital

Sales/Assets

(/) Total Assets

Inventories Accounts Receivable

(+) Productive Assets

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ROE Wheel Step 3 Compare Projected ROE with Industry Benchmarks and Investor Expectations
ROE The Limited The Gap Nike Boston Retail 10.6% 33.7% 25.2% Asset Profitability Turnover 2.4% 8.2% 8.7% 2.1 1.9 1.7 Financial Leverage 2.1 2.1 1.7

22.5%

6.4%

2.5

1.4

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Using the Profit Wheels to Test Strategy

Profit Wheel - Prepare profit plan Cash Wheel - Ensure cash will be adequate ROE Wheel - Compare each alternative
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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

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