Video Transcript: Financial Planning

Hello, welcome. We're going to discuss financial planning. So how managers  use financial statements. A vital step in financial planning is to forecast financial  statements, which are called projected financial statements, or pro forma  statements. Managers use projected financial statements in four ways. One, by  looking at projected statements, they can assess whether the firm's anticipated  performance is in line with the firm's own general targets and investors  expectations. Two, pro forma statements can be used to estimate the effect of  proposed operating changes, enabling managers to conduct what if analysis. So what if analysis is exactly what it says. What if this happens? How are we going  to react? And what financial tools do we have to make sure that we can mitigate  whatever What if problems arise? Managers use performance statements to  anticipate the firm's future financing needs. So if we need an infusion of capital,  what is our mix like? Do we need more debt, or do we need to issue more  equity? Managers forecast free cash flows under different operating plans.  Forecast their capital requirements and then choose the plan that maximizes  shareholder value. Remember, that is the job of financial manager in any  corporation or any business to maximize shareholder value. An operating plan  provides detailed implement implementation guidance for a firm's operations,  including the firm's choice of market segments, product lines, sales and  marketing strategies, production processes and logistics. An operating plan can  be developed for any time horizon, but most companies use a five year horizon,  with the plan being quite detailed for the first year, but less and less specific for  each succeeding year, the plan explains who is responsible for each particular  function and when specific tasks are to be accomplished. An important part of  the operating plan is the forecast of sales, production costs, inventories and  other operating items. In fact, this part of the operating plan actually is a forecast for the company's expected free cash flow. Free cash flow is a primary source of a company's value. Using what if analysis, managers can analyze different  operating plans to estimate their impact on value. In addition, managers can  apply sensitivity analysis, scenario analysis and simulation to estimate the risk  of different operating plans, which is an important part of risk management. So  how do we continue to grow operating assets? A company's operating assets  can grow only by the purchase of additional assets. Therefore, a growing  company must continually obtain cash to purchase new assets. Some of this  cash might be generated internally by its operations, but some might have to  come externally from shareholders or debt holders. This is the essence of  financial planning, forecasting additional sources of financing required to fund  the operating plan. Connection between financial planning and free cash flow.  There's a strong connection between financial planning and free cash flow. A  company's operating operations generate the free cash flow, but the financial  plan determines how the free cash flow will be used. Free cash flow can be  used in five ways. One, pay dividends, pay out the stock dividend, pay out your 

shareholders right repurchase stock, the in so if we think we have positive  growth prospects, we want to repurchase our stock. That way, we can move the  stock price up, and we can pay back shareholders through stock repurchase,  pay the net after tax interest on debt, so with free cash flow, we can pay down  our debt after tax. Also repay the entire debt so we can pay down the interest.  We can pay down the debt right with free cash flow. That should usually be the  number one thing that we do is pay down the debt. We need to pay down the  debt first clear that out so there's no liability on our assets, so we don't have any risk for default, and therefore we can maintain our credit worthiness purchase  financial assets such as marketable securities. Marketable securities, stocks,  corporate debt issuances, those are marketable securities. We can go out into  the market and purchase that way. We can continue to make investments in our  operations, a company's financial plan must use free cash flow differently. If free  cash flow is negative, then if free cash flow is positive, obviously, if free cash  flow is negative, we need to find a way to make cash flow positive. So that is the part of financial planning we need to review and conduct analysis on how our  company is performing and if it's generating free cash flow that we can continue  to plan positively in the future. If free cash flow is positive, the financial plan  must identify how much free cash flow to allocate among its investors, investors  would be shareholders or debt holders, and how much to put aside for future  needs by purchasing marketable securities. So if we purchase marketable  securities, we're going to get a return, generate a return on those securities.  Therefore, we can use that cash flow, add it to our free cash flow, and then  reinvest that free cash flow into our operations. If free cash flow is negative,  either because the company is growing rapidly, which requires large investments in operating capital, or because the company has low net operating profit after  tax, then the total uses of free cash flow must also be negative. So we're if we're in the beginning growth stage, start up stage with our company. Obviously,  there's going to be high investment, so we're going to have negative cash flows  in the beginning. Hopefully, through our operations running smoothly, efficiently  and effectively, we can turn that negative free cash flow into positive free cash  flow, pay down debt, pay out shareholders and grow our business. For example, instead of repurchasing stock, the company might have to issue stock if we have negative cash flow. So if we have negative cash flow, obviously we want to have positive cash flow. So we can issue stock. When people buy that stock, we get  that money. And then we can apply that however we wish, to our business  creating free cash flow. So in or a company, instead of repaying debt, the  company might have to issue some corporate debt to fund operations generate  cash flow. Components of a financial plan, the financial plan must incorporate  one the need of the company's dividend policy, which determines the targeted  size and method of cash distribution to shareholders. So we need to know how  much we are going to distribute to shareholders, right. And usually our dividend 

payment is based on the amount of risk that you take by investing in our  company. So if we have a high dividend percentage, right? We have a high  dividend yield, then we will be telling the market, hey, we're somewhat highly  risked, right? So if we're up 7, 8, 9, percent in our debt yield, we're probably  going to signal to the market that we're kind of risky, right? Because it's a high  debt yield, you want debt yields, investment debt yields, I think probably around  three and a half percent is good. It's a good return on your capital, and it's  showing that the company is being a little aggressive with their debt yield, which  is fine, but we are not to the point where we're experiencing extreme risk with  the company. The capital structure, which determines the targeted mix of debt  and equity used to finance the firm, which in turn determines the relative mix of  distributions to shareholders and payments to debt holders. Notice you have to  pay the debt holders first and then pay out the common shares dividend yields.