A Simple Financial Planning Model

We can begin our discussion of long-term planning models with a relatively simple example. The Computer field Corporation's financial statements from the most recent year are as follows:

Unless otherwise stated, the financial planners at Computer field assume that all variables are tied directly to sales and current relationships are optimal. This means that all items will grow at exactly the same rate as sales. This is obviously oversimplified; we use this assumption only to make a point. Suppose sales increase by 20 percent, rising from $1,000 to $1,200. Planners would then also forecast a 20 percent increase in costs, from $800 to $800×1.2= $960. The pro forma income statement would thus be:

The assumption that all variables will grow by 20 percent will enable us to easily construct the pro forma balance sheet as well:

Notice we have simply increased every item by 20 percent. The numbers in parentheses are the dollar changes for the different items. Now we have to reconcile these two pro formas. How, for example, can net income be equal to $240 and equity increase by only $50? The answer is that Computer field must have paid out the difference of $240 -50 = $190, possibly as a cash dividend. In this case, dividends are the plug variable. Suppose Computer field does not pay out the $190. In this case, the addition to retained earnings is the full $240. Computer field's equity will thus grow to $250 (the starting amount) plus $240 (net income), or $490, and debt must be retired to keep total assets equal to $600. With $600 in total assets and $490 in equity, debt will have to be $600 - 490 = $110. Since we started with $250 in debt, Computer field will have to retire $250 -110 = $140 in debt. The resulting pro forma balance sheet would look like this:

In this case, debt is the plug variable used to balance out projected total assets and liabilities. This example shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Because assets are growing, total liabilities and equity, the right-hand side of the balance sheet, will grow as well. The thing to notice from our simple example is that the way the liabilities and owners' equity change depends on the firm's financing policy and its dividend policy. The growth in assets requires that the firm decide on how to finance that growth. This is strictly a managerial decision. Note that, in our example, the firm needed no outside funds. This won't usually be the case, so we explore a more detailed situation in the next section.

Question:

a What are the basic components of a financial plan?

b Why is it necessary to designate a plug in a financial planning model?