Financial Management subject For undergraduate students (semester 4)

1. Financial Planning
Meeting 7

2. • 1. The process of financial planning.
• 2. Break even analysis, and operating leverage.
• 3. Cash budget.
• 4. Sales forecast in cash budget.
• 5. Additional funds needed (AFN- Additional Funds Needed)

3. 6 Steps in the Financial Planning Process
• 1. Establishing and defining the client-planner relationship
• 2. Gathering client data and determining goals and expectations
• 3. Analyzing and evaluating the client's financial status
• 4. Developing and presenting the financial planning
recommendations and/or alternatives
• 5. Implementing the financial planning recommendations
• 6. Monitoring the financial planning recommendations

5. 1. Establishing and defining the client-planner
relationship
• The financial planner explains or documents the services to be
provided and defines his or her responsibilities along with the
responsibilities of the client.
• The planner explains how he or she will be paid and by whom. The
planner and client should agree on how long the relationship will last
and on how decisions will be made.

6. 2. Gathering client data and determining
goals and expectations
• The financial planner asks about the client's financial situation,
personal and financial goals and attitude about risk. The planner
gathers all necessary documents at this stage before giving advice.

7. 3. Analyzing and evaluating the client's
financial status
• The financial planner analyzes client information to assess his or her
current situation and determine what must be done to achieve the
client's goals. Depending on the services requested, this assessment
could include analyzing the client's assets, liabilities and cash flow,
current insurance coverage, investments or tax strategies.

8. 4. Developing and presenting the financial
planning recommendations and/or alternatives
• The financial planner offers financial planning recommendations that
address the client's goals, based on the information the client
provided. The planner reviews the recommendations with the client
to allow the client to make informed decisions. The planner listens to
client concerns and revises recommendations as appropriate.

9. 5. Implementing the financial planning
recommendations
• The financial planner and client agree on how recommendations will
be carried out. The planner may carry out the recommendations for
the client or serve as a "coach, " coordinating the process with the
client and other professionals such as attorneys or stockbrokers.

10. 6. Monitoring the financial planning
recommendations
• The client and financial planner agree upon who will monitor the
client's progress toward goals. If the planner is involved, he or she
should report to the client periodically to review the situation and
adjust recommendations as needed.

11. Break-even analysis
• It is based on categorising costs to
• "variable" (costs that change when the production output changes) and
• "fixed" (costs not directly related to the volume of production)

12. Fixed Costs
• Fixed costs are those business costs that are not directly related to
the level of production or output.
• Even if the business has a zero output or high output, the level of
fixed costs will remain the same.
• In the long term fixed costs can change - as a result of investment in
production capacity or through the growth in expenses required to
support a larger, more complex business.

13. Examples of fixed costs:
• - Rent and rates
• - Depreciation
• - Research and development
• - Marketing costs (non- revenue related)
• - Administration costs

14. Variable Costs
• Variable costs are those costs which change directly with the level of
output.
• E.g. raw materials, direct labour, fuel and revenue-related costs such
as commission

15. "Direct" variable costs and
"Indirect" variable costs
• Direct variable costs are directly related to the production.
• E.g. Raw materials and the wages those working on the production
line
• Indirect variable costs cannot be directly related to production but
they do change with output.
• E.g. depreciation, maintenance and certain labour costs

16. Break-even analysis
• Total variable and fixed costs are compared with sales revenue
• in order to determine the level of sales volume, sales value or
production
• at which the business makes neither a profit nor a loss
• (the "break-even point")

18. The Break-Even Chart
• the "break-even point" is represented on the chart by the intersection
of the two lines:
• In the diagram above, the line OA represents the variation of income
at varying levels of production activity ("output").
• OB represents the total fixed costs in the business.
• As output increases, variable costs are incurred, meaning that total
costs (fixed + variable) also increase.
• At low levels of output, Costs are greater than Income.
• At the point of intersection, P, costs are exactly equal to income, and
hence neither profit nor loss is made.

19. The Break-Even Chart
• Sales ↑ - Output ↑ - variable costs ↑ - total costs (fixed + variable) ↑
• Break-even point: costs = income (output)
• Sales should cover costs

20. Operating leverage
• Measures a company’s fixed costs as a percentage of its total costs.
• It is used to evaluate the breakeven point of a business, as well as the
profit levels on individual sales.

21. High operating leverage
• A large proportion of the company’s costs are fixed costs.
• In this case, the firm earns a large profit on each sale, but must make
sufficient sales volume to cover its substantial fixed costs.
• If it can do so, then the entity will earn a major profit on all sales after
it has paid for its fixed costs.

22. Low operating leverage
• A large proportion of the company’s sales are variable costs, so it only
incurs these costs if there is a sale.
• In this case, the firm earns a smaller profit on each sale, but does not
have to generate much sales volume in order to cover its lower fixed
costs.
• It is easier for this type of company to earn a profit at low sales levels,
but it does not earn outsized profits if it can generate additional sales.

23. High and Low Operating Leverage
• It is essential to compare operating leverage among companies in the same
industry, as some industries have higher fixed costs than others.
• Most of a company’s costs are fixed costs that occur regardless of sales
volume.
• As long as a business earns a substantial profit on each sale and sustains
adequate sales volume, fixed costs are covered and profits are earned.
• Other company costs are variable costs incurred when sales occur. The
business earns less profit on each sale but needs a lower sales volume for
covering fixed costs.
• However, the business does not generate greater profits unless it increases
its sales volume.

24. High and Low Operating Leverage
• For example, a software business has greater fixed costs in
developers’ salaries, and lower variable costs with software sales.
Therefore, the business has high operating leverage.
• In contrast, a computer consulting firm charges its clients hourly,
resulting in variable consultant wages. Therefore, the business has
low operating leverage.

25. Examples of Operating Leverage
• Most of Microsoft’s costs are fixed, such as expenses for upfront
development and marketing. With each dollar in sales revenue
earned beyond the breakeven point, the company makes a profit.
Therefore, Microsoft has high operating leverage.
• Conversely, Walmart retail stores have low fixed costs and large
variable costs, especially for merchandise. Because Walmart stores
pay for holding the items they sell, the cost of goods sold increases as
sales increase. Therefore, Walmart stores have low operating
leverage.

26. • High operating leverage
• Fixed costs ↑ profit Sales ↑
• Low operating leverage
•
• Fixed costs ↓ - profit - Sales ↓

27. Cash Budget
• A cash budget is an estimation of the cash inflows and outflows for a
business over a specific period of time, and this budget is used to
evaluate whether the entity has sufficient cash to operate.
• Companies use sales and production forecasts to create a cash
budget, along with assumptions about necessary spending and
accounts receivable.
• If a company does not have enough cash to operate, it must raise
more capital by issuing stock or by taking on debt.

28. Cash Budget example
• ABC estimates it will sell 8,000 stools during the first month of 2018
• With a 5% increase in sales each subsequent month
• Each stool is sold for $16
• Prepare a sales budget for the March of 2018

29. • Step 1. You have been provided the sales in units for January. Sales
during February will be 5% larger than January:
• February sales in units = 8,000 x 105% = 8,400 units
• Step 2. Sales for March are expected to be another 5% more than
February sales. The sales for March are expected to be:
• March sales in units = 8,400 x 105% = 8,820 units

30. • Only amounts for future periods should be included in budgets.
• Prior period amounts are never displayed because they are historical
amounts, and by definition, a budget is an estimate of future activity.
• Every budget should begin with a standard, three-line statement
heading which includes the company name, the name of the budget,
and the time period it covers.
• The sales budget will appear as follows:

31. Additional funds needed (AFN)
• is the amount of money a company must raise from external sources
to finance the increase in assets required to support increased level
of sales.
• In response to an increase in sales, a company must increase its
assets, such as property, plant and equipment, inventories, accounts
receivable, etc.

32. S1 = new Sales = (1+g)(S0)

33. AFN= (A*/S0) ΔS - (L*/S0) ΔS - M(S1)(RR)
• A0*/S0 = Assets required per $1 of sales. When multiplied by the increase
in sales shows the required new assets for the coming year. The higher this
ratio, the more new assets the firm will need to support a given amount of
growth.
• L0*/S0 = Spontaneously generated funds per dollar of new sales. When
multiplied by ∆S, we find the new payables that are available to support
growth.
• M = Profit margin on sales
• S1 = new Sales = (1+g)(S0)
• RR = Retention Rate = (1 – Dividend Payout Ratio) = (1 –Dividends/Net
Income)

34. Example
• TransWorld Inc. runs a shipping business and has forecasted a 10%
increase in sales over 2013.
• Its assets and liabilities at the end of 2012 amounted to $25 billion
and $17 billion respectively.
• Sales for the period were $30 billion and it earned a 4% profit margin.
• It reinvests 40% of its net income and pays out the rest to its
shareholders.
• Calculate additional funds needed.

35. • Additional Funds Needed
• = Increase in Assets
• − Increase in Liabilities
• – Increase in Retained Earnings

36. Step 1
• Increase in Assets
• = 2012 assets × sales growth rate
• = $25 billion × 10%
• = $2.5 billion

37. Step 2
• Spontaneous Increase in Liabilities
• = 2012 liabilities × sales growth rate
• = $17 billion × 10%
• = $1.7 billion

38. Step 3
• Increase in Retained Earnings
• = 2013 sales × profit margin × retention rate
• = 2012 sales × (1 + sales growth rate) × profit margin × retention rate
• = $30 billion × (1 + 10%)×4%×40% = $0.528 billion

39. • Additional Funds Needed
• = $2.5 billion – $1.7 billion − $0.528 billion
• = $0.272 billion
• TransWorld must raise $272 million to finance the increased level of
sales.