SH1663

Financial Planning Tools

I. The Financial Planning Process
A. Introduction to Financial Planning
• Financial planning is important for several reasons:
o Financial planning helps the business assess the impact of a particular strategy on the
company’s financial position, its cash flows, its reported earnings, and its need for
external financing.
o When a business develops financial plans, the management is better able to react to any
changes in the market condition, such as when sales is slower than expected or there is
a reduction in the supply of raw materials.
o Creating a financial plan helps managers understand the trade-offs involved in its
investments and financial plans. For example, by developing a financial plan,
management is better able to understand the trade-off between having sufficient
inventory to satisfy customer demands and the need to finance the investment in
inventory.

B. Long-term Planning Process

• Forecast sales – Forecasting sales begins with an understanding of the industry the business
belongs to, knowing the target market, and ultimately forecasting the market share in terms
of sales from that segment. Forecasted sales may increase based on the target increase in
market share or due to the increase in the market itself.
A fundamental truth in business is that a business acquires assets to generate sales. If the
firm wants to increase sales, then it has to acquire more assets. If the business wants to
increase sales by 25%, the assets need to increase by 25% as well. To increase the assets
by 25%, the other side of the balance sheet (liabilities and equity) needs to increase and
keep the balance sheet equal.

• Compute the dividend pay-out ratio and plowback ratio – These ratios analyze the
relationship between net income and dividends.
o The pay-out ratio is computed by dividing the cash dividends by net income. It is
expressed as a percentage. For example, if the firm has a net income of P5M and a cash
dividend of P3M, the pay-out ratio is 60%. This means that 60% of the net income goes
to the stockholders.
o The plowback ratio is the opposite of the pay-out ratio. It is the portion of income that
does not get paid out as dividends. It is also known as the retention ratio.
o If the business does not pay any dividends, the plowback ratio is 100% and the pay-out
ratio is zero.
o These ratios indicate how much of the profits are retained for business growth. Younger
businesses tend to have higher plowback ratios; these fast-growing companies are more
focused on business development.

• Identify the sources of funds – The business must learn to identify the funds that can come from
normal business activities (sales).
• Use the percentage of sales approach to prepare the pro-forma financial statements – The
percentage of sales approach is based on the premise that most balance sheets and income

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statement accounts vary with sales. If the forecasted sales growth is 25%, the accounts in the
income statement and balance sheet will also increase by 25%.
• Calculate the external financing need (EFN) – EFN, also known as Additional Funds Needed
(AFN) and Discretionary Financing Needs (DFN), is the required additional financing. It is
acquired through the sales of stocks and bonds.

II. Budgeting
A. Budgeting
• A budget estimates the amount of revenues and expenses a company may incur over a
future period. Budgeting represents a business’ financial position, cash flows and goals. A
company’s budget is usually re-evaluated periodically, usually once per fiscal year,
depending on how the management wants to update the information. Budgeting creates a
baseline to compare actual results to determine how the results vary from the expected
performance.
• It is also a financial plan expressed in quantitative terms, prepared by the management in
advance for a forthcoming period. It is the financial expression of a business plan or target.
• The budget sets the targets of the company and is updated once a year. The budget is
compared to actual results to determine variances from expected performance.

B. Types of Budgets
• Capital Budget – This budget estimates all capital asset acquisitions and summarizes all
expenses and costs of major purchases for the next year. Capital assets include items that
have useful lives of more than 12 months, such as buildings, building improvements, land,
furniture, fixtures, equipment, and computers.
• Operating Budget - Operating budgets indicate the products and services a firm expects to
use in a budget period. It describes all the income-generating activities of a firm, including
production, sales, and inventories of finished goods. An operating budget typically has two
(2) distinct parts: the expense budget and the revenue budget. The expense budget indicates
all expected expenses of a firm for the coming year, while the revenue budget shows all
projected revenues for the coming year.
• Cash Budget - A cash budget projects all cash inflows and outflows for the next year. A
cash budget is important because it allows administrators to timely identify periods with
cash overages and shortages so they can take necessary remedial action.
• Sales Budget - Sales budgets indicate the sales a firm expects to make in units and money
for a budget year. They detail the quantities of products or services a firm expects to sell,
revenues incurred from those sales and all expenses accrued during selling. Sales budget
forecasts determine sales potential or the maximum number of sales a firm can make. This
information is then used to plan resource allocations to achieve those sales levels. Sales
budgets serve as benchmarks or yardsticks against which actual sales performance is
measured and variables such as sales volume, profitability, and selling expenses are
controlled.
• Personnel Budget – This budget is also known as salary and wage budget. They are cost
estimations related to labor. They include the costs of recruitment, hiring, training,
assignment, salaries, overtime costs, additional benefits, and retirement.

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C. Preparing the Cash Budget

• The primary tool in short-term financial planning is the cash budget. It plots the business’
cash inflow and outflow. It is typically done monthly and is used to cover a year’s time.
• It is divided into three (3) parts: cash receipts, cash disbursements, and excess cash balance
(or required total financing). An example of a cash budget is shown below:
Cash Budget
Jan Feb Mar
Cash Receipts
Less: Cash Disbursements
Net Cash Flow
Add: Beginning Cash
Ending Cash
Less: Minimum Cash Balance
Required Total Financing
Excess Cash Balance

• Preparing the cash budget can be summarized in these steps:

o Forecast the business’ monthly sales. This can be done using historical figures.
o Forecast the sales and the credit sales from the projected monthly sales. Cash sales are
preferable to credit sales. If sales are made on credit, estimate when the receivables
would be collected.
o Consider all the other cash receipts. Other cash receipts are sources of cash other than
sales, such as interest payment received.
o Sum up the total cash receipts.
o Forecast the business’ monthly purchases.
o Forecast the business’ cash purchases and the credit purchases from the projected
monthly purchases. If purchases are made on credit, forecast when those debts will be
paid.
o Take into account other cash disbursements. These include wages and salaries, taxes,
capital expenditures, rent, and interest payments.
o Sum up the total cash disbursements.
o Subtract the total cash disbursements from the total cash receipts to get the net cash
flow.
o Add the beginning cash balance to the net cash flow to get ending cash balance. The
ending cash balance of the previous month will be the beginning cash balance of the
next month.
o Subtract the minimum cash balance from the ending cash balance. The minimum cash
balance, also known as the target cash balance, is the minimum cash balance the
business needs to have on hand to conduct its day to day operations. If the minimum
cash balance is greater than the ending cash balance, then short-term financing is
required. If the minimum cash balance is less than ending cash balance, the business
has excess cash.

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• Part 1 of the Cash Budget: Cash Receipts (Steps 1-4)

Sales Forecast JAN FEB MAR APR MAY
150,000 220,000 380,000 340,000 295,000
Cash Sales (15%) 22,500 33,000
Accounts Receivable Collections
1-month debt 82,500
2-month debt
Other Cash Receipts 150,000 150,000 150,000 150,000 150,000
Total Cash Receipts 172,500 265,500

• Part 2 of the Cash Budget: Cash Disbursements (Steps 5-8)

Sales Forecast JAN FEB MAR APR MAY
Purchases 120,000 176,000
Cash purchases 6,000 8,800
Accounts payable payment
1-month debt 96,000
2-month debt
Rent payments 15,000 15,000 15,000 15,000 15,000
Wages and salaries 19,500 23,000
Tax payments 40,000
Fixed asset outlay 200,000
Interest payment 110,000 110,000 110,000 110,000 110,000
Principal payments 150,000
Total cash disbursements 150,500 252,800

• Part 3 of the Cash Budget: Excess Cash Balance / Required Total Financing (Steps 9-11)

Sales Forecast JAN FEB MAR APR MAY

Cash Receipts 172,500 265,500
Less: Cash Disbursements 150,500 252,800
Net Cash Flow 22,000 12,700
Add: Beginning Cash
Ending Cash 70,000
Less: Minimum Cash
Balance
Required Total Financing
Excess Cash Balance

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III. Forecasting
A. Forecasting
• A forecast is an estimation of future trends and outcomes, based on past and present
data. It is a prediction of the upcoming events or trends in business, on the basis of
present business conditions. There is no target included in a forecast.
• Forecasting estimates a company’s future financial outcomes by examining historical
data. Companies use financial forecasting to determine how they should allocate their
budgets for a future period. Unlike budgeting, financial forecasting does not analyze
the variances between financial forecasts and actual performance. Financial forecasts
are updated regularly when there is a change in operations, inventory, and business
plan.
• The forecast is typically limited to major revenue and expense line items. There is
usually no forecast for financial position, though cash flows may be forecasted.
• The forecast may be used for short-term operational considerations, such as adjustments
to staffing, inventory levels, and the production plan.
B. Types of forecasts
• Financial Forecast - A financial plan that projects income and expenses, future sales,
future demand for a product, or anything that is expected to happen in the future.
• Cash Flow Forecast – Projects cash inflow (sources of cash) and cash outflow (uses of
cash).
• Investment Forecast – This forecast details where to put investments to get maximum
return.
• Projected Financial Statements – These show a summary of revenue and expense
projections for the budget period. They are prepared to guide managers on how to attain
their objectives.

References:
Benito, P. P., Chan Pao, T. P., & Yumang, K. (2016). Exploring small business and personal finance
in senior high. Quezon City: Phoenix Publishing House.
Bragg, S. (28, March 2013). What is the difference between a budget and a forecast? Retrieved from
Accounting Tools: http://www.accountingtools.com/questions-and-answers/what-is-the-
difference-between-a-budget-and-a-forecast.html
Gilani, N. (n.d.). Five different types of budgets. Retrieved from The Finance base website:
http://thefinancebase.com/five-different-types-budgets-3736.html
Lane, M. A. (2016). Percentage of sales method. Retrieved from Business Finance Online Site:
http://www.zenwealth.com/businessfinanceonline/FF/PercentageOfSales.html
Lopez-Mariano, N. D. (2014). Elements of finance. Quezon City: Rex Book Store.
Nickolas, S. (2015, April 22). What's the difference between budgeting and financial forecasting?
Retrieved from Investopedia website:
http://www.investopedia.com/ask/answers/042215/whats-difference-between-budgeting-and-
financial-forecasting.asp
S, S. (2016, January 22). Difference between budget and forecast. Retrieved from Key Differences
website : http://keydifferences.com/difference-between-budget-and-forecast.html

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