Financial Planning

Financial Management 1

After studying Financial Planning, you should be able to:

• Understand the concept and perspective of financial planning

• Understand sample financial planning process

• Understand the elements of financial planning models

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Perspective of Financial PlanningPlanning Horizon

The future time for which a person or organization plans and the first element of the planning process. The short-run planning, in practice, usually covers the coming 12 months. The long-run planning, usually covers from two to five years or more.

ExampleIf a company wishes to make contingency plans for the next 10 years, it is said to have a 10-year planning horizon. Many companies maintain a five-year planning horizon, though some plan for longer or shorter periods. The longer a planning horizon is, the more uncertainty it has.

AggregationIt is a process whereby a number of a firm's smaller projects are combined and treated as an individual project to determine the investment required that the firm will have to manage.

*After the planning horizon and the level of aggregation are established, a financial plan requires input in the form of alternative sets of assumptions about important variables.

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What is Financial Planning?It’s the task of determining how a business will afford to achieve its strategic goals and objectives. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. Usually, a company creates a Financial Plan immediately after the vision and objectives have been set.

ExampleIf ABC Company wants to build a factory in 2020, it might have to begin

lining up contractors and financing in 2015 or even earlier.

Questions1. Is there enough money to build the factory?2. What are the policies to be followed to achieve this project?3. If there’s not enough resources, how can ABC finance the project?

Concept of Financial Planning

A lack of effective long-range planning is a commonly cited reason for distress and failure. Long-range planning is a means of systematically thinking about the future and anticipating possible problems before they occur. Planning is said to be a process that at best helps the firm avoid stumbling into the future backward. 4

Financial Planning Process

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Financial planning is all about allocating finite resources -- such as money, employees and equipment -- over time, to reach the broad goals set out in strategic planning. To do so involves measuring current performance against past data and trends for the future.

Financial Planning ModelsThe financial process will differ from firm to firm, just as companies differ in size and products. However, a basic financial planning model will have the following common elements;

Economic Environment Assumptions. Inflation rates, interest rates, and tax rates.

Sales Forecast. Planning will focus on projected future sales and the assets and financing needed to support the sales.

Pro forma Statements. Forecast statement of financial position, income statement, statement of cash flows and statement of stockholders’ equity.

Asset Requirements. Describe the projected capital spending.

Financial Requirements. Financing arrangements as to raising cash or borrowing or by selling new shares of stocks.

Additional Funds Needed (AFN). After the firm has a sales forecast and an estimate of spending assets, AFN might be needed to balance the financial statements.

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Time Value of Money

After studying time value of money, you should be able to:

• Understand the concept of time value of money

• Identify the difference between simple and compound interest

• Find the determination of future value and present value using a table

• Identify what is annuity and the types of annuities

• Understand the Rule of 72

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Time Value of MoneyWould you like to have

₱50,000 today or ₱50,000 in 5 years?

Obviously, ₱50,000 today!

Already you can tell the time value to

money.

Why Time?

Why considered time as an important element in your

decision?

TIME TIME allows you the opportunity to

postpone consumption and earn

INTEREST.8

Types of Interest

Simple Interest Product of the principal amount multiplied

by the period’s interest rate.

Compound InterestIs the interest paid on both principal and the amount of interest accumulated in the prior periods. The process of determining future value when compound interest is applied is called compounding.

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Simple Interest Example

XYZ Corporation deposits ₱1,000 in a bank at 10% interest a year. Compute the interest and the future value of the deposit at the end of 1 year.

Simple interest = Principal x Rate x TimeFuture Value = Principal + Simple Interest

SolutionPrincipal (beg. bal.) ₱1,000Simple Interest for 1 year (1,000 x 0.10) 100Future Value at the end of year 1 ₱1,100

₱1,000 ₱1,100

Present Value Future Value

0 1

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Compound Interest Example

Suppose that XYZ Corporation leaves its ₱1,000 on deposit for 2 years in a bank paying 10% annual interest. What is the future value at the end of 2 years?

Future Value = PV x (1+r)n

SolutionBalance at the beginning of year 2 ₱1,100Interest for 2nd year (1,100 x 0.10) 110Future Value at the end of year 2

₱1,210₱1,000 ₱1,100 ₱1,210PV FV 1 FV 2

0 1 211

Comparison

Simple Interest

Year Beg.Amount

Simple Interest

End. Amount

1 ₱1,000 ₱100 ₱1,100

2 1,000 100 1,200

3 1,000 100 1,300

4 1,000 100 1,400

5 1,000 100 1,500

Total ₱500

Compound Interest

Beg. Amount

Compound Interest

End. Amount

₱1,000 ₱100.00 ₱1,100.00

1,100 110.00 1,210.00

1,210 121.00 1,331.00

1,331 133.00 1,464.10

1,464 146.41 1,610.51

₱610.51

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Present Value

The second key concept regarding the time value of money is present value. This is the current value of a future amount of money, or series of payments, evaluated at an appropriate

discount rate.

Discount rate, sometimes called the required rate of return, is the rate of interest that is used to find present values.

Discounting is the process of determining the present value of a future amount.

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Present Value ExampleXYZ company expects to receive ₱1,100 one year from now. What is the present value of this amount if the discount rate is 10%?

PV = FVn / (1+i)n

Substitute i = 0.10 and n = 1, FV = ₱1,100

PV = ₱1,100 (1.10) 1

= ₱1,000

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Determination of Present Value Using a Table

Example

XYZ Company expects to receive ₱1,000 five years from now and wants to know what this money is worth today. The value today of ₱1,000 to be received five years from now discounted at 10% is calculated at follows:

Substitute i = 0.10 and n =5, PVPV55 = 1,000

PV = (₱1,000) (0.62092) = ₱620.92 OR Manually

= (₱1,000) / 1+(1.1x1.1x1.1x1.1x1.1) or (₱1,000) (1+ 0.10)5

= (₱1000) / (1.61051) = ₱620.9215

Determination of Future Value Using a Table

Instead of computing the value of the term (1 + i) n , you can use a table to find the value.

Example

Using Table 1, what is the future value of ₱1,000 compounded for 5 years at 10% interest rates?

Future Value for 5 years = (₱1,000) (1.61051)

= ₱1,610.51

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Annuity

An Annuity represents a series of equal payments (or receipts) occurring over a specified number.

Types of Annuities

• Ordinary Annuity: Payments or receipts occur at the end of each period.

• Annuity Due: Payments or receipts occur at the beginning of each period.

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The Rule of 72

How long does it take to double ₱5,000 at a compound rate

of 12% per year (approx.)?

Double Your Money

Approx. Years to Double = 72 72 / i%

7272 / 12% = 6 Years6 Years

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Working Capital Policies

After studying working capital policies, you should be able to:

• Understand the concept of working capital

• Learn how to trace cash and understand working capital movement

• Understand Alternative Current Assets Investment Policies

• Understand Alternative Current Assets Financing Policies

• Advantages and Disadvantages of Short-term Financing

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Working Capital Terminology

• The management of short-term (ST) assets (investments) and short-term (ST) liabilities (financing sources). Current Assets are the assets that are available within 12 months. Current Liabilities are the liabilities that are due within 12 months Working capital only includes current liabilities that are specifically used to finance current assets.

• Working capital does not include current liabilities that might be due in the current period if they are due from long-term capital decisions, even though these must be considered when assessing the firm’s ability to meet its current obligations.

Net Working Capital = Current assets – (Short-term payables + accruals)

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Tracing Cash and Net Working Capital

1. Operating cycle. The length of time in which the firm purchases or produce inventory, sell it and receive cash.

Formula can be used to solve operating cycle.

Operating = Inventory x 365 + Accounts Receivables x 365 Cycle Cost of Sales Credit SalesExample

Suppose that State Farm has annual sales of ₱1 million, cost of goods sold of ₱650,000, average inventories of ₱116,000, and average accounts receivable of ₱150,000. Assuming that all State Farm sales are on credit, what will be the firm’s operating cycle?

Operating = 116,000 x 365 + 150,000 x 365 = 119.89 days Cycle 650,000 1,000,000

So it will take State Farm almost 120 days from the time they receive raw materials, to produce, market, sell and collect cash for their finished goods.

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Tracing Cash and Net Working Capital

2. Cash Conversion Cycle. The length of time funds are tied up in working capital or the length of time between paying for working capital and collecting cash from the sale of inventory.

Formula can be used to solve operating cycle.

Cash Conversion = Operating - Accounts Payable x 365 Cycle Cycle Cost of SalesExample

Using the data from the previous example, assuming that the average accounts payable balance is ₱120,000, what will be the firm’s cash conversion cycle?

Cash Conversion = 119.89 - 120,000 x 365 = 52.5 days Cycle 650,000

The cash conversion cycle will be 53 days.

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Case AnalysisInventory = Average Inventory = 116,000 = 65.14 daysConversion Cost of Sales 65,000 Period 365 days 365 days

Average = Average Accounts Receivable = 150,000 = 54.75 daysCollection Credit Sales 1,000,000Period 365 days 365 days

Payables = Average Payables = 120,000 = 67.38 daysDeferral Cost of Sales 650,000 Period 365 days 365 days

Inventory Conversion Period (65 days) Average Collection Period (55 days)

Operating Cycle (120 days)

Average Payment Period (67 days) Cash Conversion Cycle (53 days)23

Alternative Current Asset Investment Policies

• Relaxed Current Asset Investment PolicyHolds a great deal of cash, marketable securities,

receivables, and inventories relative to sales. When receivables are high, the firm has a liberal credit policy, which results in a high level of accounts receivables.

• Restricted Current Asset Investment PolicyWhen a firm has restricted or tight investment policy,

holdings of currents assets are minimized.

• Moderate Current Asset Investment PolicyThis is a policy that is between the relaxed and restricted

policies.

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Alternative Current Assets Policies

Currents Assets Turn Over ofPolicy per ₱100 of Sales Current Assets: Sales/CARelaxed ₱30 3.3xModerate 23 4.3Restricted 16 6.3

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Alternative Current Assets Financing Policies

• Maturity Matching ApproachExamples• Inventory expected to be sold in 30 days would be financed with a 30-day

bank loan.• A machine expected to last for 5 years would be financed with a 5-year

loan.• A 20 years building would be financed with a 20-year mortgage bond.

• Aggressive ApproachExample

Suppose a company borrows ₱1 million on a 1-year basis and uses the funds to buy machinery that will lower labor costs by ₱200,000 per year for 10 years.

• Conservative ApproachSafest approach in current assets financing.

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A financing policy that matches asset and liability maturities This would be considered a moderate current asset financing policy.

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A policy in which all of the fixed assets of a firm are financed with long-term capital, but some of the firm’s permanent current assets

are financed with short-term non-spontaneous sources of funds.

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A policy in which all of the fixed assets, all of the permanent current assets, and some of the temporary current assets of a firm are

financed with long-term capital.

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Advantages of Short-Term Financing

Speed A short-term loan can be obtained much faster than long-term credit.

Flexibility For regular needs, avoid long-term debt because the

cost of issuing long-term debt is higher.

Cost of Long-Term versus Short-Term Debt Short term interest rates are generally lower than long-

term rates.

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Disadvantages of Short-Term Financing

Risk of Long-Term versus Short-Term Debt Short-Term Debt subjects the firm to more risk than

long-term debt does. • Short-term interest expenses

fluctuate. • Firm may not be able to repay short-term debt

and be forced into bankruptcy.

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Thank you!

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