BUSINESS FINANCE

Week 3-4
Financial Planning Tools and Concepts

What is Financial Planning process?

Planning is very much related to another management function, controlling. These

two management functions reinforce each other, and both are very important for the
success of an organization. Management planning is about setting the goals of the
organization and identifying ways to achieve them. This maybe be broken down into
long-term plans and short-term plans. Long-term plans reflected in a company’s
business strategy. In the process of planning, resources have be identified. These
resources include work force resources, production capacity, and financial resources.
Once a plan is set, it has been quantified. A plan that is not quantified is useless
because there will be no basis for monitoring performance and hence, no way of
gauging success. Quantified plans are in form of budgets and projected financial
statements. These budgets and projected financial statements has compared with the
actual performance. This is where the controlling function comes into play. It does not
mean that if actual; performance falls short of the budgets or of the projections, the
management is not doing its function. Reasons
have be identified for the shortfall so that corrective measures has made. In addition,
the analysis will show whether the reasons for not meeting the projections are due to
management incompetence or factors outside its control.

Steps in Financial Planning?

1. Set goals or objectives. For corporations, long term and short term identify
objectives. These has shown in company’s vision and mission statements. The vision
statement states where the company wants to be while the mission statement states
the plans on how to achieve the vision.
• Examples of a company’s Vision-Mission statements are as follows:
Jollibee Foods Corporation (JFC) Vision: To excel in providing great tasting food
that meets local preferences better than anyone; To become one of the three
largest and most profitable restaurant companies in the world by 2020.
Mission: To serve great tasting food, bringing the joy of eating to everyone.

2. Identify resources. Resources include production capacity, human resources who

will operate the operations and financial resources.
3. Identify goal-related tasks. In this step, management must figure out how to
achieve an objective. For example, if the target for this year is to increase sales by
15%, we must consider the task in achieving this goal. One task is to hire more sales
agents, if the management believes that number of sales agents is not enough to
support this 15% increase in sales.
4. Establish responsibility centers for accountability and timeline. If we
identified the task to achieve goals, the next important step to do is to identify which
department held accountable for this task.
5. Establish an evaluation system for monitoring and controlling. For
corporations, the management must establish a mechanism to allow plans to monitor.
This has been done, through quantified plans such as budgets and projected financial
statements. The management will then compare the actual results to the planned
budgets and projected financial statements. Any deviations from the budgets will
undergo investigations.
6. Determine contingency plans. In planning contingencies or unforeseen events
must be considered as well. Budgets and projected financial statements anchored on
assumptions.

Preparation of Budgets and Projected financial statement

What is budget?
Budget is a description in quantitative usually monetary terms of desired future
result. The process of preparing the budget requires management at all level to focus
on the future of the business entity.
Examples of Budgets:
Sales Budget - is a prediction of the firm’s sales over a specific period, based on
external and internal information. The sales budget has constructed by multiplying
budgeted unit sales by the selling price. See illustration below.
Cash budget- is a statement of the firm that has planned inflows and outflows of cash. It
forecasts the timing of theses cash outflows and matches them with cash inflows from sales
and other receipts. The cash budget is also a control tool to monitor the way the company
handles cash. See illustration below.
Example: Assume selling price is Php 100/unit sales for each month that has expected to be
collected as follows:
Month of sales: 20%
A month after sales: 50%
2 months after sales: 30

Projected financial statements is a tool of the company to set an overall goal of what
the company’s performance and position will be for and as of the end of the year. It
sets targets to control and monitor the activities of the company.
Forecast or calculate the following reports:
‣ Projected Income Statement
‣ Projected Statement of Financial Position
Application of the Projected Financial Statements Approach be
Step 1. Forecast the Income Statement
a. Establish a sales projection
b. Project the cost of sales
c. Prepare the production schedule and project the corresponding production costs,
direct materials, direct labor and overhead for manufacturing companies)
d. Estimate selling and administrative expenses.
e. Consider financial expenses if any
f. Determine the net profit
Step 2. Forecast the Statement of Financial Position.
a. Project the assets needed to support projected sales.
b. Project funds generated (through accounts payable and accruals) and by retained
earnings through profits generated.
c. Project liability and stockholder’s equity accounts that will not rise spontaneously
with sales (e.g., notes payable, long-term bonds, preferred stock, and ordinary shares)
but may change due to financing decisions made later.
d. Determine if additional funds needed by using the following formula.
Additional Funds Needed (AFN) = Required Increase in Assets - Spontaneous Increase
in Liabilities - Increase in Retained earnings
The additional financing needed raised by borrowing from the banks as notes payable,
by issuing long-term bonds by selling new ordinary shares or by some combination of
these actions.
Step 3. Raising the Additional funds needed.
The financing decision will consider the following factors:
a. Target capital structure:
b. Effect of short-term borrowing on its current ratio;
c. Conditions in the debt and equity markets; or
d. Restrictions imposed by existing debt agreements.
Step 4. Consider financing feedbacks.
Depending on whether additional funds borrowed or has raised through ordinary
shares, consideration has given on additional interest in the income statement or
dividends, thus decreasing the retained earnings.
Illustrative Case: Financial Forecasting (Percent of Sales Method)
The firm is expecting a 20% increase in sales next year, and management is
concerned about the company’s need for external funds. The increase in sales
expected to carry out without any expansion of fixed assets, but rather through more
efficient asset utilization in the existing store. Among liabilities, only current liabilities
vary directly with sales.
Using the percent-of-sales method, determine whether the company has external
financing needs or a surplus of funds.

Supporting computations:
(1) Cash = 2.5% x P 2.4M sales
(2) Accounts receivable = 20% of 2.4M
(3) Inventory = 37.5% x P 2.4 M
(4) No percentages computed for fixed assets, notes payable, long-term debt,
ordinary shares and retained earnings because they are not assumed to maintain a
direct relationship with sales volume. For simplicity, depreciation is not explicitly
considered.
(5) Accounts payable = 12.5% of 2.4M
(6) Accrued expenses = 0.5% of P 2.4M
(7) Accrued taxes = 1% of P 2.4M
(8) Retained earnings = P 300,000 + P 282,100 – P 101,600

= 240,000 – 56,000 -180,500

= 240,000 – 56,000 -180,500
= P 3,500

What is Cash Flow Statement?

It is a process of closely monitoring of in and out of cash in the business.

Example: Ms. Amelia Enriquez engaged in a laundry shop. It was already her 2 nd year
of operation and all the in and out of cash for the month as follows:
Let us assume that Amelia laundry shop projected 3 months of cash flow for planning
an expansion of her business. Let us say that there is an increase of collection of 25%
and all expenses will stay the same. By month of May, Amelia granted a loan
amounted Php 150,000. How much is the cash flow ending balance of Amelia for the
month of May?

WORKING CAPITAL MANAGEMENT?

Businesses require adequate capital to succeed in business environment. There are
two types of capital required by business: fixed capital and working capital.
Businesses require investment in asset, which has utilized over a longer period. These
long-term investments considered as fixed capital, e.g. plant, machinery, etc.

Working capital refers to company’s investment in short term asset such as cash,
inventory, short-term marketable securities, and account receivable. Net Working
capital refers to the difference between the firm’s current assets and current
liabilities. If the firm’s current assets exceed its current liabilities, the firm has a
positive working capital. On the other hand, if current liabilities exceed current assets,
the firm has a negative working capital.

Working Capital Management specifically refers to the efficient management of the

firm’s current assets (cash, receivables, and inventory) and current liabilities (short-
term payables). Through working capital management, managers have given the
challenge to balance risk and profitability that comes along each current asset and
liability to contribute positively to the firm’s value.

Cash Management System

The cash management involves the maintenance of a cash and marketable securities
investment level, which will enable the company to meet its cash requirements and at
the same time optimize the income on idle funds.
A financial officer has the following specific objectives in monitoring cash balances:

 To meet the ash disbursement needs (payments schedule)

 To minimize the funds committed to transactions and precautionary cash balances;
and
 To avoid misappropriation and handling losses in the normal course of business

Reasons for Holding Cash

Although cash has generally considered a non-earning asset, business firms must hold
cash for the following reasons:
1. Transaction Motive - cash needed to facilitate the normal transactions of the
business, that is, to carry out its purchases and sales activities.
2. Precautionary Motive - Cash may held beyond its normal operating requirement
level in order to provide for a buffer against contingencies such as unexpected slow-
down in accounts receivable collection, strike or increase in cash needs beyond
management’s original projections.
3. Speculative Motive- cash held ready for profit making or investment
opportunities that may come up such as a block of raw materials inventory offered at
discounted prices or a merger proposal.
4. Contractual Motive-A company may be required by a bank to maintain a certain
compensating balance in its demand deposit account as a condition of a loan
extended to it.

Cash Conversion Cycle - A firm operating cycle begins from the time goods for sale
manufactured to the eventual collection of cash from the sale of these goods. The
operating cycle of a firm is mainly composed of two current asset categories:
inventories and accounts receivable. It measures as the sum of the Average Age of
Inventory and Average Collection Period. The average age of inventory refers to the
time that lapsed when a good manufactured and eventually sold. The average
collection period on the other hand refers to the time when the sale made and
collected. Both measured in days.
 Operating cycle= Average Age of Inventory + Average Collection
Period

Firms would generally want to speed up their operating cycle. The faster their
operating cycle is, the faster they can convert other forms of current assets to cash,
which has used to pay current obligations.
However, in the process of producing and selling goods, firms would incur obligations
for purchases of raw materials or finished goods on account which results in accounts
payable. An account payable reduces the number of days a firm’s resource has tied
up to its operating cycle. Thus, including accounts payable in our earlier equation,
gives us the firm’s cash conversion cycle.
Cash Conversion Cycle = Operating Cycle – Average Payment Period
The average payment period is the time it takes for the firm to pay its accounts
payable expressed in number of days. The operating cycle less average payment
period provides us the firm’s cash conversion cycle. Carefully analyzing the equations
provided above, a firm’s cash conversion cycle re expressed as follows.

Cash conversion cycle = Average Age of Inventory + Average Collection

Period –
Average payment period.

Illustration:
Bloom Manufacturing had an average age of inventory of 18.5 days, an average
collection period of 48.5 days and an average payment period of 53.5 days. Bloom is
operating and cash conversion cycle obtained as follows:

Operating Cycle = Average Age of Inventory + Average Collection Period =

18.5 days + 48.5 days = 67days

Cash Conversion Cycle= Operating Cycle – Average Payment period= 67days

- 53.5 days
= 13.5 days
Inventory Management- The objective in managing inventory is to convert it as
quickly as possible to cash without losing sales due to stock outs. Therefore, the
financial manager plays a crucial role in overseeing that the firm maintains an
appropriate quantity of inventory – not too much and not too little. Maintaining too
much inventory implies that the firm incurs more costs associated with carrying these
inventories. However, carrying too little inventory quantities might lead to possible
stock outs that could further lead to lost sales, and worst, lost customers.

Inventory in A Manufacturing Company - In a manufacturing company, there are three

types of inventory:
a. Raw materials – these are purchased materials not yet put into production
b. Work in process – these are goods and labor put into production but not finished.
c. Finished goods – these are goods put into production and finished. These are ready
to be sold.

Accounts Receivable Management - represents assets of the entity that expected

to be collected and thus converted to cash. A firm would generally want to collect its
receivables as quickly as possible without losing customers due to imposing very tight
collection procedures. Thus, sound accounts receivable management practices would
form three parts: credit selection, credit terms and credit monitoring
One popular credit selection technique is the use of the 5 C’s of credit:

a. Character: The applicant’s record of meeting its past obligations has judged.
However, if the applicant does not have any credit history, he or she may be required
to have a co-maker. A co-maker is another person who signs the loan and assumes
equal responsibility for repayment.
b. Capacity: This emphasizes the customer’s ability to repay its obligations in
reference to its current financial position or standing. It determines whether the
customer has sufficient resources or sources of funds that it can use to settle
obligation
c. Capital: The applicant’s net worth which can be arrived at by deducting total
liabilities from total assets.
d. Collateral: The amount of assets the customer has that could serve as a security
in the event that the obligation is not paid.
e. Condition: This includes current economic and industry conditions that might
affect the customer’s ability to repay its obligations.

The use of the 5C’s of credit will allow the firm to carefully assess the customer’s
ability to repay its obligations along with the level of risk that the firm will be
subjected to once it decides to grant credit to the customer. It requires experience to
fully assess and review the credit worthiness of customers and subsequently decide.

Credit Scoring- Another used in granting credit to customers is through credit

scoring. Credit scoring applies statistically derived weights to a credit applicant’s
scores on key financial and credit characteristics to predict whether he or she will pay
the requested credit on time. In this procedure, a credit score obtained that reflects
the customer’s creditworthiness, reflecting its overall credit strength. The score
obtained has compared to a pre-determined standard in order to arrive at a decision
of whether accepting or rejecting the customer’s credit. This method is an inexpensive
way to obtain credit ratings for customers.
Direction: Answer the problem below and forecast the Income statement using
percent of Sales Method.
The Gospel Company has the following statements, which are representative of the
company’s historical average.