3.3.1.

1 LESSON – Financial Planning and Forecasting

Chapter 6 – Financial Planning &             The marketing department provides data for sales
Forecasting estimates as this is the team who have a direct interaction
with customers. The top management is through the policy
  In any corporation, planning should always align and strategies alignment. Production department determines
with the over-all Vision and Mission statement of the firm. whether the existing plant is capable of supporting the
Strategic planning ensures that all aspects of the business go planned sales. Their input is very valuable as they set the
in unison, supporting the main idea for which the production capacity and any excess sales projection versus
corporation is existing. Thus, before any plan is made, it is the capacity will necessitate additional investment in long
to spring up from the over-all objectives of the firm. term assets. The accounting Department, under also in the
            Financial planning is no exception to this. Key terms Finance will provide data about historical trends through
and their definitions as taken in the context of strategic financial statements, the depreciation on production assets,
planning are presented next: and advise on tax effects of the planned actions. The
 Mission Statement – A condensed version of a firm’s interactions between these departments are summarized on
strategic plan the picture that follows:
 Corporate Scope – Defines the firm’s line of business
and geographic areas of operation
 Statement of Corporate
Objectives – Sets forth the
specific goals to guide
management
 Corporate Strategies –
Broad strategies
developed for achieving a
firm’s goal
 Operating Plan – Provides
management a detailed
implementation guidance,
based on corporate
strategy, to help meet the
corporate objectives
 Financial Plan – The
document that includes
assumptions, projected
financial statements, and
projected ratios that ties
the entire planning process
together.

 Forecasting will always raise the following

questions:

1. What is generally the first item to estimate when

starting a business?
2. What is the most difficult aspect of forecasting?

Steps in Financial Forecasting

1. Forecast sales
2. Project the assets needed to support sales
3. Project internally generated funds
Forecasting Sales
4. Project outside funds needed
 Review past sales (five to ten years).
5. Decide how to raise funds
6. See effects of plan on ratios and stock price  You can use average growth rate but it may not give
you a correct estimate.
 Use regression slope to compute growth rate.
The Sales Forecasting Process
(Regression will discussed separately)
            Forecasting the sales is always the beginning of the
financial forecasting. This is because sales drive a lot of  Consider changes in economy, market conditions, etc.
assumptions and its effects go beyond revenue. As sales  Improper sales forecast can lead to serious financial
forecast is developed, one will notice that the entire planning issues.
organization takes part in the process. The finance  Sales forecasts are usually based on the analysis of
department of the company is the one ultimately responsible historic data.
for consolidating and preparing the sales forecast.  An accurate sales forecast is critical to the firm’s
profitability:
3.3.1.1 LESSON – Financial Planning and Forecasting
 The forecast of future sales is normally based on past
sales growth
 This sales growth is determined as the difference
between the recent sales figure and the immediately
preceding period figure, divide by the latter.
 Effects of any events which are expected to impact
future sales (such as new products or economic
conditions) are also included in the forecast.
 Sales Growth imposes costs on the firm. It will require
additional resources in terms of:
 Current Assets: Inventory, A/R, Cash
 Fixed Assets: Plant and Equipment
Percent of Sales Method
In forecasting the financial statements, percent of
sales method is most commonly employed. It begins with
the sales forecast expressed as an annual growth rate in
dollar sale revenue. Many items on the balance sheet and
income statement are assumed to change proportionally with
sales.
A Better Financial Planning Model
The Income Statement                    firm’s dividend policy.
 The pro forma income statement is generated by
recognizing all variable costs that change directly
with sales.
 Two key ratios are calculated – dividend payout
ratio and retention ratio.
 Dividend payout ratio measures the percentage of
net income paid out as dividends to shareholders,
while retention ratio measures the percentage of net
income reinvested by the firm as retained earnings.
The Balance Sheet
 Some balance sheet items vary directly with sales
while others do not.
 To determine which accounts vary directly with
sales, a trend analysis may be conducted on historic
balance sheets of the firm.
 Typically, working capital accounts like inventory,
accounts receivables and accounts payables vary
directly with sales.
 Fixed assets do not always vary directly with sales.
It will do so, only if the firm is operating at 100
percent capacity and fixed assets can be
incrementally changed.
 The ratio of total assets to net sales is called
the capital intensity ratio. This ratio tells us the
amount of assets needed by the firm to generate $1
sales.
 The higher the ratio, the more capital the firm
needs to generate sales—the more capital intensive
the firm.
 Firms that are highly capital intensive are more
risky than those that are not because a downturn
can reduce sales sharply but fixed costs do not
change rapidly.
 Only current liabilities are likely to vary directly
with sales. The exception here is notes payables
(short-term borrowings) that changes as the firm
pays it down or makes an additional borrowing.
 Long-term liabilities and equity accounts change as
a direct result of managerial decisions like debt
repayment, stock repurchase, issuing new debt or
equity.
 Retained earnings will vary as sales changes but
not directly. It is affected by the firm’s dividend
payout policy.
 
Steps in Preparing the Preliminary Pro-forma
Balance Sheet
 First, calculate the projected values for all the accounts
that vary with sales.
 Second, calculate the projected value of any other
balance sheet account for which an end-of-period value
can be forecast or otherwise determined.
 Third, enter the current year’s number for all the
accounts for which the next year’s figure cannot be
calculated or forecast.
 At this point the balance sheet will be unbalanced. A
plug value is necessary to get the balance sheet to
balance. The following procedures may be done to
remedy the situation:
o First, determine the retained earnings based on the
o Next, the plug figure will represent the external
financing necessary to make the total assets equal
total liabilities and equity. This calls for
management to choose a financing option –
choosing debt, equity or a combination – to raise
the additional funds needed.
 
The Management Decision
 The first decision relates to the firm’s dividend policy.
Should the firm alter its dividend policy to increase the
amount of retained earning?
 If external funding is still needed, should the firm issue
new debt, or issue equity? Or, should it be a mix of
both?
 It is important to recognize that while financial planning
models can identify the amount of external financing
needed, the financing option is a managerial decision.
Beyond the Basic Planning: Improving Financial
Planning Models
 There are several weaknesses in the previously
described models.
 First, interest expense was not accounted for. This is
difficult to do so until all the financing options are
finalized.
 Second, all working capital accounts do not necessarily
vary directly with sales, especially cash and inventory.
 Third, how fixed assets are adjusted plays a significant
role.
 When a firm is not operating at full capacity, sales may
be increased without adding any new fixed assets.
 Fixed assets are added in large discrete amounts called
lumpy assets. Since it requires time to get new assets
operational, they are added as the firm nears full
capacity.
Managing and Financing Growth
3.3.1.1 LESSON – Financial Planning and Forecasting

 Managers prefer rapid growth as a goal to capture  A/S changes if assets are lumpy. Generally will have
market share and establish a competitive position. excess capacity, but eventually a small DS leads to a large
 Most firms experiencing rapid growth fund the growth DA.
with debt, increasing the firm’s leverage and putting it
at risk.
External Funding Needed / Additional Fund
Needed       
 External funding needed (EFN) or additional funds
needed (AFN) is defined as the additional debt or equity
a firm needs to issue so it can purchase additional assets
to support an increase in sales.
 EFN is tied to new investments the management has
deemed necessary to support the sales growth.
 The new investments are the projected capital
expenditure plus the increase in working capital
necessary to sustain increases in sales.
 Companies first resort to internally generated funds in
the form of addition to retained earnings.
 Once internally generated funds are exhausted, the firm
looks to raise funds externally.
 EFN/ AFN = Projected increase in Assets –
Spontaneous Increase in Liabilities – Increase in
Retained Earnings
 First, holding dividend policy constant, the amount of
EFN depends on the firm’s projected growth rate.
Higher growth rate implies that the firm needs more
new investments and therefore, more funds to have to
be raised externally.
 Second, the firm’s dividend policy also affects EFN.
Holding growth rate constant, the higher the firm’s
payout ratio, the larger the amount of debt or equity
financing needed.
How would increases in these items affect the EFN?
 Higher dividend payout ratio: Reduces funds available
internally, increases EFN.
 Higher profit margin: Increases funds available
internally, decreases EFN.
 Higher capital intensity ratio, A/S0: Increases asset
requirements, increases EFN.
Implications of EFN
 If EFN is positive, then you must secure additional
financing.
 If EFN is negative, then you have more financing than
is needed. You can use excess funds to:
o Pay off debt.
o Buy back stock.
o Buy short-term investments.
Summary: How different factors affect the EFN
forecast.
 Excess capacity: lowers EFN.
 Economies of scale: leads to less-than-proportional
asset increases.
 Lumpy assets: leads to large periodic EFN
requirements, recurring excess capacity.
Lumpy Assets
 Assets that cannot be acquired in small increments but
must be obtained in large, discrete units. In figure, a lumpy
asset will have the following behavior: