Zulfiqar Hasan, Associate Professor (Finance)
What is Corporate Financial Planning?
In general usage, a financial plan can be a budget, a plan for spending and saving future income. This plan allocates future income to various types of expenses, such as rent or utilities, and also reserves some income for short-term and long-term savings.
Financial planning is the task of determining how a business will afford to achieve its strategic goals and objectives.
Corporate Financial Planning is the method by which financial goals are to be achieved. Financial planning is the process of successfully meeting financial needs of life through the proper management of finances.
Corporate Financial Planning is the process of determining a company's financial needs or goals for the future and how to achieve them.
Corporate financial planning involves deciding what investments and activities would be most appropriate under both the company's individual and broader economic circumstances.
All things being equal, short-term financial planning involves less uncertainty than long-term financial planning because, generally speaking, market trends are more easily predictable in the short term.
Likewise, short-term financial plans are more easily amendable in case something goes wrong.
It is the roadmap to Financial Health, & Sustainable Wealth creation.
Financial Planning Process
Planning Time Horizon: divide decisions into short-run decisions (usually next 12 months) and long-run decisions (usually 2 – 5 years)
Level of Aggregation: combine capital budgeting decisions into one big project
Assumptions and Scenarios: Make realistic assumptions about important variables. Run several scenarios where you vary the assumptions by reasonable amounts. Determine at least a worst case, normal case, and best case scenario
Financial Planning Model Ingredients
Sales Forecast: many cash flows depend directly on the level of sales (often estimated using sales growth rate)
Pro Forma Statements: setting up the plan using projected financial statements allows for consistency and ease of interpretation
Asset Requirements: the additional assets that will be required to meet sales projections
Financial Requirements: the amount of financing needed to pay for the required assets
Plug Variable: determined by management deciding what type of financing will be used to make the balance sheet balance
Economic Assumptions: explicit assumptions about the coming economic environment
Scenario Analysis in Corporate Financial Planning
Each division might be asked to prepare three different plans for the near term future:
A Worst Case: This plan would require making the worst possible assumptions about the company’s products and the state of the economy. It could mean divestiture and liquidation.
A Normal Case: This plan would require making the most likely assumptions about the company and the economy.
A Best Case: Each division would be required to work out a case based on the most optimistic assumptions. It could involve new products and expansion.
Role of Corporate Financial Planning
Examine interactions: help management see the interactions between decisions. The plan must make explicit the linkages between investment proposals and the firm’s financing choices
Explore options: give management a systematic framework for exploring its opportunities. The plan provides an opportunity for the firm to weigh its various options
Avoid surprises: help management identify possible outcomes and plan accordingly. Nobody plans to fail, but many fail to plan
Ensure feasibility and internal consistency: help management determine if goals can be accomplished and if the various stated (and unstated) goals of the firm are consistent with one another. The different plans must fit into the overall corporate objective of maximizing shareholder wealth
Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input?
The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level.
What Determines Growth?
Profit margin: An increase in profit margin will increase the firm’s ability to generate funds internally and thereby increase its sustainable growth.
Dividend policy: A decrease in the percentage of net income paid out as dividends will increase the retention ratio. This increases internally generated equity and thus increases sustainable growth.
Financial policy: An increase in the debt-equity ratio increases the firm’s financial leverage. Because this makes additional debt financing available, it increases the sustainable growth rate.
Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for each dollar in assets. This decreases the firm’s need for new assets as sales grow and thereby increases the sustainable growth rate.
External Funds Needed (EFN)
The difference between the right-hand-side and the left-hand-side of the statement at this stage is called “additional funds needed” (AFN) or external funds needed (EFN).
If this number is positive, this means that the firm needs to raise money externally to support the firm’s growth.
This amount can be financed by an increase in notes payable, long-term bonds, preferred stock, common stock, or a combination of the above.
Rule of thumb: the higher the rate of growth in sales, the greater will be the need for external financing.
Internal Growth Rate and Sustainable Growth Rate
Internal Growth Rate
The internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing.
Relying solely on internally generated funds will increase equity (retained earnings are part of equity) and assets without an increase in debt. Consequently, the firm’s leverage will decrease over time.
If there is an optimal amount of leverage, as we will discuss in later chapters, then the firm may want to borrow to maintain that optimal level of leverage. This idea leads us to the sustainable growth rate.
Sustainable Growth Rate
The sustainable growth rate is the maximum growth rate that a firm can achieved with no external equity financing (no new shares) while maintaining a constant debt-equity ratio.
The sustainable growth rate is a measure of how much a firm can grow without borrowing more money.
SGR is positively related to 4 variables: (1) retention ratio, (2) profit margin, (3) total asset turnover, and (4) equity multiplier.
Increasing the Sustainable Growth Rate
A firm can do several things to increase its sustainable growth rate:
a. Sell new shares of stock
b. Increase its reliance on debt
c. Reduce its dividend-payout ratio
d. Increase profit margins
e. Decrease its asset-requirement ratio