FINANCIAL PLANNING MODULE 6

Financial plans help managers ensure that their financial strategies are consistent with
capital budgets. Highlight the financial decisions necessary to support the firms
production and investment goals or objectives for growth.
Financial planning process

Analysing investment and financing choices (I opportunities and sources of

funds)
o Find real opportunities with competitive advantage and expanding them
Projecting future consequences of current decisions
Deciding alternatives to undertake (options and consequences)
Measuring subsequent performance against goals set down in financial plan
(adjustment and improvement)
Capital budgeting

Why build financial plans?

Contingency planning
o How to deal with unexpected events i.e. sensitivity analysis whilst
changing variables / what if scenarios
o Formulate responses to situations
o Typically form best case / aggressive growth plan, normal growth plan,
retrenchment plan if firms market contracts
Considering options (can we allowing for growth options in our plans)
o New markets? Valuable follow-on investments - options
Forcing consistency (mutually consistent)
o Are all departments etc working towards the same plans / goals
o i.e. sales / profit growth goal of X% - what decisions / changes need to be
made to get there?
o Ensure goals arent distracting rest of business i.e. shifting priorities or
too much emphasis

Long term financial planning

Financial planning models support planning process by making it easier and cheaper to
construct and forecase financial statements.

Inputs
o Current financials statements and forecasts of key variables such as sales
and interest rates (also likely to include macroeconomic events)
o Typically principal forecast is growth in sales as other variable such as
labour and inventory levels are tied to sale
Planning Model
o Equations specifying key relationships and relating variables
implications of forecasts
Outputs
o Projected (pro forma) financial statements, ratios. Sources and uses of
cash. Forecasts based on inputs and assumptions

Percentage of Sales Model

Planning model in which sales forecast are the driving variable, most other
variables are proportionate to sales
Balancing (plug) variable
o Variable that adjusts to maintain the consistency of a financial plan
o Common plug variables include cash, dividends, debt and equity
Ensure consistency between growth assumptions and financing plans but they
do not identify the best financing plan

Limitations

Ignore depreciation important as tax shield (although relatively easily

accommodated)
Ignores short term debt (long term debt / equity issue may not always be
worthwhile)
o Assume firm able to issue small amounts of long term debt as needed at a
fixed interest rate regardless of changes in its leverage
Ignore non-linear relationship between costs / assets and sales
o Economies of sales (costs rise slower than sales)
o Lumpy assets extra sales only require additional assets when capacity
is exhausted (i.e. buying whole new machine, do not add assets in small
increments)
However more complex models cumbersome, may draw attention away from
big picture

Short term financial planning

Short term has different requirements, different factors / changes (i.e. seasonality) is
important which is immaterial in long term planning
Cash budgeting

Want advance warning of future cash requirements

Benchmark for subsequent performance

Steps
1) forecast sources of cash
a. cash sales
b. collection of credit sales / AR
i. keep track of average time taken to pay bills what proportion of
sales paid that quarter and what proportion carried into next
quarter as AR
c. asset disposals
d. other e.g. tax refund, insurance claim
2) forecast uses of cash
a. payments of accounts payable assumption these are payed on time
i. stretching your payables (expensive form of short term
financing, lose discounts)
ii. Could result in ill will increasing credit risk
b. labour, admin, other expenses (regular business expenses)
c. capex
d. tax, interest and dividend payments
3) calculate if firm is facing shortage or surplus
a. Financial plan sets out strategy for investing cash surpluses or financing
deficits

Deficits can be financed be through

-

Stretching payables
Bank financing

Questions to ask re Short Term FP

Is stretching payables feasible or wise? (based on costs, changes in supply etc)

Are there hidden costs to doing this? Will suppliers begin to doubt
creditworthiness?
Does the firm need a cash / securities bugger to guard against customers
stretching their payments (i.e. avoid reciprocal treatment)?
Does the plan yield satisfactory liquidity ratios? e.g. interest cover ratios for
banks concern if these worsen re default
Does the firm need to think about raising long term finance to finance any capex
in plan?
o Should be consistent with LT
Can operating and investment plans be adjusted to make short term financing
problems easier?
Can any extra debt taken on be repaid in the future?
How does short term financing plan leave company for following year?
If buying assets etc is long term financing an option? Or are we reflecting
preference in financing with retained earnings (short term borrowing only)?
Can you defer outflow? Change payment terms?

Short term financing is liability originally scheduled for repayment within 1 year

Spontaneous
o Accruals expenses incurred but not paid (accrued wages / taxes)
Represent free financing
Difficult to manipulate
o Accounts payable (trade credit)
Deferred payment of purchases
Credit terms stated on invoice
Credit reputation suffers if payment delayed beyond due date
(could change payment policy so to punish debtor if repeat
behaviour)
Prompt payment discount usually offered
Negotiated financing
o Bank loans, bank bills, promissory notes, secured financing
o NB value more liquid stocks higher, if illiquid rates of return would
increase
o Bank overdraft
Firm can overdraw check account up to a certain level
Interest rate set at margin above base rate
Interest calculated daily on overdrawn balance
Usually secured by charge over assets
Penalty interest is charged if limit exceeded
Banks charge upfront / annual fees
o Self liquidating loans sale of goods provides cash to repay the loan
o Secured loans need for collateral. If short term only then collateral
restricted to liquid assets such as receivables, inventories or securities.

Safety margin / haircut difference between full value of assets

put up as securities and the amount the bank is prepared to lend
Short term revolving credit
Line of credit borrow up to an established limit
Short term loan e.g. 90 days renewable at maturity
Converts part of overdraft into permanent financing
Interest rate set at margin above base rate
Bank also charges commitment fee on average unused balance of
the borrowers credit line
i.e. if borrow 5, only use 3 still get charged for 5 b/c bank
still pays interest on supplying funds i.e. funds not used
Commercial paper
Unsecured notes issued by large firms (too risky for small firms)
Market restricted to good credits often back up issue by
arranging special back up line of credit with a bank making risk
of default small
Cheaper funding than bank bill able to bypass fees / bank and
sell debt directly to large investors
Usually sold through tender organised by major banks
Investors are banks, insurance companies, super funds (i.e.
informed investors)
Pledging accounts receivable
Firm pledges / assigns debtors / AR as security for loan if bank
fails to pay the loan bank can collect receivable from firms
customers and use cash to pay off the debt
Bank evaluates debtors and lends 50-90% of face value of
acceptable / credible debtors only (not full amount)
Bank has recourse to firm if debtors default firm still liable, risk
borne by firm
Usually only available when large volumes of debtors involved
Potential problems of priority with other secured creditors (may
need to renegotiate)
Factoring AR
Sell debtors to factor at discounted price
Debtors make payment to factor
Factoring can be with recourse or non-recourse
Recourse company liable to ensure factor gets full
amount
If non recourse is up to the factor to claim as much of
debt as possible
o Factor administers collection of receivables, takes
responsibility for bad debts and provides finance
Discounting represents factors charge for collection risk
Factoring an expensive / difficult form of short-term finance
Essentially borrowing on the strength of current assets
Pledging inventory
Firm pledges inventory as security for short term loan
Lender evaluates marketability / perishability of inventory
What inventory pledged is important banks want to be
sure it can be reold if you def
Lender usually advances up to 50% of book value (not market
value)
Potential problem of priority with other secured creditors

Terms of sale
Credit, discount and payment terms offered on a sale

Will vary with customer

E.g. COD cash on delivery if irregular customers
CBD cash before delivery if incurring heavy delivery costs
Many cases credit sales, buyer receives credit
Naturally demand earlier payment if customers less financially secure, small
accounts or goods perishable or quickly resold
Offer discount to encourage you to pay before final date
EOM is used for customers who buy items regularly illogical to require
separate payments for each delivery

Firm that buys on credit is effectively borrowing from its supplier. Save cash today but
have to pay later implicit loan
2/10 net 30 EOM

EOM indicates when the credit period starts usually the end of the purchase
month (therefore have more time if buy earlier in the month). If dropped the
credit period starts from the date of invoice
Net 30 means the credit period lasts 30 days
2/10 means firm gets 2% discount if payment is made within first 10 days of
credit period
In calculations per period will be low, annualised will be high
Going beyond net date cheaper loan by expending period but damages
creditworthiness
o Often high those who pay late often strapped for cash so it makes sense
to charge high rate

Minimum operating cash balance absorbs unexpected cash inflows and outflows
Short term deficits are not necessarily a bad thing could be seasonal or investing in
assets