Chapter 6 – Financial Planning & Forecasting 

Essentials of Financial Management 4th Edition by Brigham, F., Houston, F., Hsu, J., Kong, Y & Bany-Ariffin, AN. (2019).
Pg. 202 - 219

Forecasting and the Strategic Planning

In any corporation, planning should always align with the over-all Vision and Mission statement of the firm.
Strategic planning ensures that all aspects of the business go in unison, supporting the main idea for which the
corporation is existing. Thus, before any plan is made, it is to spring up from the over-all objectives of the firm.

Financial planning is no exception to this. Key terms and their definitions as taken in the context of strategic
planning are presented next:

 Mission Statement – A condensed version of a firm’s strategic plan

 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: Steps in Financial Forecasting

 What is generally the first item to estimate 1. Forecast sales

when starting a business? 2. Project the assets needed to support sales
 What is the most difficult aspect of forecasting? 3. Project internally generated funds
4. Project outside funds needed
5. Decide how to raise funds
6. See effects of plan on ratios and stock price

The Sales Forecasting Process

Forecasting the sales is always the beginning of the financial forecasting. This is because sales drive a lot of
assumptions and its effects go beyond revenue. As sales forecast is developed, one will notice that the entire
organization takes part in the process. The finance department of the company is the one ultimately responsible for
consolidating and preparing the sales forecast.

The marketing department provides data for sales estimates as this is the team who have a direct interaction with
customers. The top management is through the policy and strategies alignment. Production department determines
whether the existing plant is capable of supporting the planned sales. Their input is very valuable as they set the
production capacity and any excess sales projection versus the capacity will necessitate additional investment in long
term assets. The accounting Department, under also in the Finance will provide data about historical trends through
financial statements, the depreciation on production assets, and advise on tax effects of the planned actions. The
interactions between these departments are summarized on the picture that follows:
 Forecasting Sales

 Review past sales (five to ten years).

 You can use average growth rate but it
may not give you a correct estimate.
 Use regression slope to compute growth
rate. (Regression will discussed
separately)
 Consider changes in economy, market
conditions, etc.
 Improper sales forecast can lead to
serious financial planning issues.
 Sales forecasts are usually based on the
analysis of historic data.
 An accurate sales forecast is critical to the
firm’s profitability:

 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:
o Current Assets: Inventory, A/R, Cash
o 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

 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 firm’s dividend policy.
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

 Managers prefer rapid growth as a goal to capture market share and establish a competitive
position.
 Most firms experiencing rapid growth fund the growth 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:
 Pay off debt.
 Buy back stock.
 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:
 A/S changes if assets are lumpy. Generally will
have excess capacity, but eventually a small
DS leads to a large DA.

Other Techniques for Forecasting Financial Statements

1. Regression Analysis for Asset Forecasting

o Relationship between type of asset and sales is linear.
o Get historical data on a good company, then fit a regression line to see how much a given sales
increase will require in way of asset increase.
2. Excess Capacity Adjustments
o Determine the full capacity sales given the operating capacity
o Consider the Target fixed assets-to-sales ratio
o Determine the Required level of fixed assets
Plowback and dividend payout ratios

 Plowback ratio – This is also known as the retention ratio. It indicates the ratio of the net income that is
retained for the year and was not declared as dividends.
 Dividend payout ratio – The portion of the net income for the year that was given out as dividends to
shareholders.

Example 1: Your company has net income of

$1,600 for the year. You paid out $400 in dividends
to your stockholders.

1. What is the dividend payout ratio?

2. What is the plowback ratio?
3. What is the dollar increase in retained
earnings?

Example 2. This year your company expects net

income of $2,800. You now adhere to a 60%
plowback ratio.

1. What is the expected dollar increase in

retained earnings?
2. How much do you expect to pay in
dividends?
3. What is the dividend payout ratio?

Example 3: Constant growth planning

You expect your sales, costs and assets to
grow by 10% next year. You will not pay any
dividends. Can you complete the pro forma
statement? Round all amounts to whole
dollars.

Example 4. Percentage of sales planning

The assets and current liabilities of Jennings, Inc. vary in direct proportion to the increase in sales. The current
sales are $2,000 and you expect them to increase by 20% next year. Net income is projected at 5% of sales.
The firm is not planning on issuing any more common stock nor paying any dividends. Using this information,
can you compile the pro forma balance sheet shown on the next section?

Example 5. External financing need

You project your sales will increase by $3,000 next year.

Net income is 10% of sales and accounts payable is
25% of sales. The capital intensity ratio is 2.5. No dividends are anticipated. How much external financing is
needed to fund this growth?
Solution…
Hints:
Step 1: Compute the increase in total assets
Step 2: Compute the increase in accounts payable
Step 3: Compute the increase in retained earnings
Step 4: Compute the additional long-term debt and equity   financing that is needed
Example 6. Pro forma with external financing
Your firm currently has long-term debt of $4,400,
common stock and paid in surplus of $10,000 and
retained earnings of $4,600. The capital intensity
ratio is 2.2 and the tax rate is 35%. Costs  are
72% of sales and accounts payable are 30% of
sales. Sales currently are $10,000 and are
expected to increase by 10% next year. The
dividend payout ratio is 20%. Long-term debt will
be used to fund 40% of the external funding
need. Given this information, can you complete
the pro forma financial statements that follows?