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Business Finance: Financial Planning Tools and Concepts
Business Finance: Financial Planning Tools and Concepts
Module 2 - Quarter 3
Financial Planning Tools and Concepts
FINANCIAL PLANNING TOOLS AND CONCEPTS
https://www.proprofs.com/quiz-school/story.php?title=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.
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.
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.
Production Budget- is a financial planning related to the units of production that the
management think that the business should produce in the upcoming period to match the
estimated sales quantity, based on the management’s judgement related to the competition in
the market, economic conditions, production capacity, consumer prevailing market demands
and past trends. 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:
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.
The Mellinial Company has the following statements representative of the company’s historical
average.
Mellinial Company
Income Statement
For the year ended Dec. 31, 2019
Sales P 2,000,000
Cost of Sales (1,200,000)
Gross profit 800,000
Operating expenses (380,000)
Earnings before interest and taxes 420,000
Interest expense 70,000
Earnings before taxes 350,000
Taxes (35%) (122,500)
Net Income/Earnings after taxes P 227,500
Dividends P 136,500
Mellinial Company
Statement of Financial Position
For the year ended Dec. 31, 2019
Assets
Cash P 50,000
Accounts receivable 400,000
Inventory 750,000
Total Current Assets P 1,200,000
Fixed Assets (net) 800,000
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.
Solution:
Assets
Cash (1) P 60,000
Accounts receivable (2) 480,000
Inventory (3) 900,000
Total current assets P1, 440,000
Supporting computations:
Formula Method * Additional Financing needed (AFN) may also be computed as follows:
Where:
= P 3,500
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:
3 Withdrawal P 5,000
18 Collection P 10,000
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?
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.
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:
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.
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.
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.
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
= 67days
= 13.5 days
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.
One of the common techniques in inventory is the ABC Inventory system/ABC Analysis.
Inventories classified as “A” are high valued items, which should safeguarded the most. • B items,
on the other hand, are average-cost items that should be safeguarded more than C items but not
as much as A items. • While C items have low cost and is the least safeguarded.
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.
1. The Accounting Equation
The basic accounting equation is:
ASSETS = LIABILITIES + OWNER’S EQUITY
• This means that the whole assets of the company comes from the liability, or debt of the company, and from the
capital of the owner of the
business, and the income it generated from the business operations. This reflects the double-entry bookkeeping, and
shown in the balance sheet.
• Double entry bookkeeping tells us that if we add something from the one side, which is asset, we must add the same
amount to the other
side to keep them in balance.
• For example, if we were to increase cash (an asset) we might have to increase note payable (a liability account) so
that the basic accounting equation remains in balance.
ASSETS = LIABILITIES + OWNER’S EQUITY
P 500.00 P 500.00
In double-entry bookkeeping, there is the concept of debit (dr) and credit (cr). Debit is the left, and credit is the right.
• There is also a concept of normal balances. A normal balance, either a debit normal balance or a credit normal
balance, is the side where a
specific account increases.
• In the accounting equation, asset is on the left side, while liabilities and equity is on the right side. Therefore, asset
has a debit normal
balance, meaning that cash as an asset is debited to increase, while credited to decrease.
• On the other hand, liabilities and owners’ equity have a credit normal balance. This means that a liability account is
credited to increase, while
debited to decrease. The accounting equation provides the foundation for what eventually becomes the balance sheet.
2. T-Account Analysis
In double-entry bookkeeping, the terms debit and credit are used to identify which side of the ledger account an entry
is to be made. Debits
are on the left side of the ledger and Credits are on the right side of the ledger. It does not matter what type of account
is involved.
• The debit to cash increases the Cash Account by PHP500 while the credit to Accounts Payable increases this liability
account by the same
PHP500.
• In the above example, we analyzed the accounting equation in terms of assets, liabilities, and owners’ equity. These
are called Real or
Permanent Accounts. These accounts remain open and active for the life of the enterprise.
• In contrast, there are accounts that reflect activities for a specific accounting period. These are called Nominal or
Temporary Accounts. After
the end of the specific period and the start of a new period, the balance of the nominal accounts are zero.
• Using the accounting equation, we can now expand the analysis that will include both real and nominal accounts. All
nominal accounts will be
then closed to a Retained Earnings account at the end of the period, which is an owner’s equity account
3. Nominal Accounts
There are two major categories of nominal accounts: Expense and Revenue accounts.
• Expense Accounts
- A resource, when not yet used up for the current period, is considered an Asset and will provide benefits at a future
time.
- On the other hand, a resource that has been used for the current period is called an Expense. At the end of each
accounting period,
expenses are closed out to the Retained Earnings Account which decreases the Owners’ Equity. Since expenses
decrease the owners’ equity,
those expense accounts carry a normal debit balance.
• Revenue Accounts
- Revenue Accounts reflect the accumulation of potential additions to retained earnings during the current accounting
period.
- At the end of the accounting period accumulation of revenues during the period are closed to the Retained Earnings
Account which
increases Owners’ Equity.
- Therefore revenue accounts carry a normal credit balance meaning the same balance as the Retained Earnings
Account.
Define the types of liquidity ratios and write the formulas on the board. Current ratio and quick
ratio.