CHAPTER FOUR: FINANCIAL FORCASTING & PLANNING

Financial planning is the process of estimating the required finance of a firm for its business decisions.
It is a continuous process of directing and allocating financial resources to meet strategic goals and
objectives. Financial planning is concerned with identifying the need for funding, term of funding, and
sources of funding.

Need for Funding Term of Sources of funding

 Initial investment Funding  Internal
 Expansion  Short-term sources(Retained
 Diversification  Long-term earnings)
 Refinancing(repaym  Spontaneous sources
ent of long-term

Financial planning starts at the top of the organization with strategic planning. Strategic planning is a
formal process for establishing goals and objectives over the long run. Strategic planning involves
developing a mission statement that captures why the organization exists and plans for how the
organization will thrive in the future. Based on a very thorough assessment of the organization and the
external environment, strategic objectives and corresponding goals are developed. Strategic plans are
implemented by developing an Operating or Action plan. A complete set of financial plans is included
in the operating plans.

Financial planning involves the following steps:

1. Identify major decisions or problems facing the firm

2. Constructionofaplanningmodeltoinvestigatetheconsequencesofalternativedecisionsorpolicies,w
hich is the primary concern of this section
3. Selection of the best alternative course of action
4. EvaluationofsubsequentperformanceagainstexpectationsTh
emajoruses of financial planning are:

1. To determine the most likely consequences of a given policy or decision

2. To investigate the consequences of possible risks or hazards
3. To effectively manage risk(risk management)
Financial plans help managers ensure that their financing strategies are consistent with their capital budgets. They
highlight the financing decisions necessary to support the firm’s production and investment goals. The output from
financial planning takes the form of budgets. The most widely used form of budgets is Pro-Forma or Budgeted
financial statement. The foundation for the budgeted financial statements is the detailed budget.

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Difference between financial planning and financial forecasting

Financial forecasting is the process of identifying the opportunities in the future in terms of market
size, customer base, or business strategies. In forecasting, we make projections about what we think
will happen in the future. As a process, financial forecasting involves estimating future business
performance. It provides information of the organization’s future revenues and costs that is needed by
senior management to project financing requirements. The“future”is the planning period that could be
short-term (one or less), medium term (3-5years), or long-term (over five years).

Some argue that financial planning and financial forecasting are one and the same. However, financial
forecasting is the basis for financial planning. Financial planning is done effectively through financial
forecasting.

Financial planning is not just forecasting. Forecasting concentrates on the most likely future outcome.
But financial planners are not concerned solely with forecasting. They need to worry about unlikely
events as well as likely ones. If a financial planner thinks ahead about what could go wrong, then
he/she is less likely to ignore the danger signals and he/she can react faster to trouble. Often financial
planners work through the consequences of the plan under the most likely set of circumstances and
then use sensitivity analysis to vary the assumptions on it a time.

Inputs for Preparing Financial Forecasts (Pro-Forma Financial Statements)

There are four major inputs for the preparation of Pro-Forma Financial statements.
1. Data from prior financial statements
 Previous sales levels and trends
 Past gross percentages
 Operating as well as non-operating expenses
 Trendsinthecompany’sneedtoborrowtosupportvariouslevelsofinventoryandtrendsinacco
unts receivable required to achieve previous sales volume
2. Unique Company Data
 Plant capacity
 Competition
 Financial constraints
 Personnel availability
3. Industry-Wide Factors
 Overall state of the economy (i.e. Boom, normal or recession)
 Economic status of the industry
 Population growth
 Elasticity of demand for the product or service the firm provides
 Availability of raw materials
4. Assumptions

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 Financial Forecasting Procedures
The following procedures may be used in predicting the future (financial forecasting).

1. Projection of Organization’s sales revenues

Financial forecasting begins with sales forecast. Sales forecast is a forecast of a firm’s units and Birr sales for some
future period. Sales forecast is usually based on group effort. It requires inputs from sales and marketing staff,
distributors, sales representatives, top management, production people, and accounting. The estimate of sales
revenues during the selected period is the most critical ‘guess estimate.”The following factors should be taken in to
consideration in sales forecast:

 The level of economic activity

 The firm’s probable market share in each distribution territory
 The firm’s production and distribution capacity
 The competitor’s capacity
 New product introduction by the firm and its competitors
 The firm’s pricing strategies
 The effects of inflation on prices
 Advertising campaign, promotional discounts, and credit terms
2. Estimation of the level of investments in current assets and fixed assets
Once sales forecast is obtained, the next step is to estimate the levels of current and fixed assets that
are necessary to support the projected sales.

3. Determination of the organization’s financing needs & sources of funds

This requires estimating additional resources required from external sources. Besides, it is essential to
predict cash inflows and outflows in relation to operating, investing, and financing activities of the
firm throughout the planning period.

4. Preparing pro-forma or forecasted financial statements

 Pro-forma income statement

 Pro-forma balance sheet
 Cash budget

The Financial Planning Models

Financial planners use financial planning models to help them explore the consequences of alternative
financial strategies. These models may range from simple to complex which incorporates hundreds of
equations. Financial planning models are useful in supporting the financial planning process. They
make the preparation of pro-forma financial statements easier and cheaper. They save time and labor
in financial planning.
The major components of a financial planning model are classified in to three.

a. Input
(See inputs for preparing financial forecasts topic above)

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b. The planning model
The planning model calculates the implications of the manager’s forecasts for profits, new
investments, and financing. The model consists of equations relating output variables to forecasts.

c. Outputs
The outputs of the financial planning model are Pro-Forma financial Statements such as income
statements, balance sheet, and statements describing sources and uses of cash. Pro-forma Financial
Statements are forecasted or projected financial statements. The outputs of financial models also
include many of the financial ratios which indicate whether the firm will be financially fit and healthy
at the end of the planning period.

Planning Model Outputs

Inputs  Equations specifying  Projected financial
 Prior financial key relationships statements
statements of the firm  Financial ratios
 Unique company data  Sources & uses of cash
 Industry wide factors

There are different financial planning models. However, only two are discussed in this section.

1. Percentage-of-Sales Model
The Percentage of Sales Method is a financial forecasting approach which is based on the premise that
most Balance Sheet and Income Statement accounts vary proportionally with sales. Therefore, the key
driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i.e.,
forecasted) can be constructed and the firms needs for external financing can be identified.

2. Additional Funds Needed Model

The second financial planning model is the Additional Funds Needed model. This model is used to
compute external fund requirement and in turn used to prepare pro-forma financial statements.

1. Percentage-of-Sales Model
The first step is to express the Balance Sheet and Income Statement accounts which vary directly with
Sales as percentages of Sales. This is done by dividing the balance for these accounts for the current
year by sales revenue for the current year.

The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts Receivable,
Inventory, Accounts Payable, and accruals. Fixed Assets are also of tented closely to Sales, unless
there is excess capacity. (The issue of excess capacity will be addressed in Excess capacity adjustment
section.) In this section, we will assume that Fixed Assets are currently at full capacity and, thus, will
vary directly with sales.
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Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earnings which
have been reinvested in the firm. Thus, the change in this account is linked to Sales; however, the link
comes from relationship between Sales growth and Earnings.
The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically with
Sales. The changes in these accounts depend upon how the firm chooses to raise the funds needed to
support the forecasted growth in Sales.
On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming that all
costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage of Sales.
This indicates the Net Profit Margin.
Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends and
Addition to Retained Earnings are expressed as a percentage of Net Income to determine the Payout
and Retention Ratios respectively.
The percentage of sales model is useful first approximation for financial planning. It is also used to
determine additional funds needed from external sources.

Under percentage-of-sales model, the following procedures can be used to estimate external capital
requirements and, in turn, for the preparation of Pro-forma financial statements:

1. Estimate increase in sales

2. Estimate additional investment in fixed assets.
If the firm is operating at full capacity, increase in sales requires proportional investment in fixed
assets
Increase in Fixed Assets= Fixed Assets X Increase in sales
Sales
3. Estimate increase in working capital or current assets
Increase in Current Assets= Current Assets X Increase in sales
Current Sales

4. Estimate spontaneously generated funds

Spontaneously generated funds are funds that are obtained automatically from routine business
transactions. They arise from the purchase of goods and services on credit, such as accounts
payable, and accruals. Spontaneously generated funds are equal to increase in current liabilities
that are directly proportional to sales. Spontaneously generated funds may be computed as
follows:

Spontaneously Generated= Spontaneous Liabilities X Increase in

sales fund Current Sales

5. Estimate Internally Generated Funds

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 Internal Generated funds are funds obtained from internal sources in the form of retained
earnings. They may be computed as follows:

Internal Generated Funds= Projected Net income– Projected Cash Dividends

6. Additional Funds Needed (AFN)

This refers to theamountfundsthatshouldbeobtainedfromexternalsourcesintheformoflong-
termdebt capital or equity capital.

AFN= Increase in + Increase in - Spontaneously+ Internally

Fixed Assets current assets Generated Funds Generated Funds

ILLUSTRATION

Let’s consider the data presented below to illustrate the determination of external capital needed and the
preparation of pro-forma financial statements.

Assume that Top Company has prepared the following Balance Sheet and Income Statement for the
year ended December 31, 2005.

1. Balance sheet

Liabilities and Stockholders’ Equity

Assets
Cash 175,000 As/P 140,000

As/R 150,000 Accrued liabilities 150,000

Inventory 800,000 Mortgage Ns/P 1,410,000

Plant Assets, Net 1,500,000 Common Stock 800,000

Retained earnings 125,000

Total 2,625000 Total 2,625,000

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2, Income Statement

Sales 2500000

Costs and Expenses except depreciation 1,400,000

Depreciation 200,000

Total costs and expenses 1,600,000

Income before taxes 900,000

Taxes (40%) 360,000

Net Income 540,000

Additional Information
1. The company plans to have dividend payout ratio of45%
2. Sales are expected to increase by 25% during next year (2006).
3. All assets are affected by sales proportionately. Accounts Payable and accrued liabilities are
also affected by sales.
4. All expenses are directly proportional to sales
5. The firm has been operating at full capacity.
6. The company has no preferred stock.
Assume that additional funds needed would be financed from bond issue and common stock in 40%
and 60% respectively.

a. Increase in sales=2,500,000x 25%=Br.

625,000ProjectedSales=Current sales +Planned increase
in sales

=2,500,000 + 625,000

=3,125,000

b. Increase in fixed assets=1,500,000X625,000

2,500,000

=375,000

If sales increase by 25%, fixed assets should increase by Br.375, 000

c. Increase in current assets= 1,125,000 X 625000

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 2,500,000

=281,250

Additional current assets of Br. 281,250 are needed if sales increase by 25%. Increase in assets as a
result of increase in sales by Br.625,000 is computed as the sum of increase in fixed assets and
increase in current assets i.e. 656,250 =375000 +281,250.

d. Spontaneously generated funds = 290,000X625,000

2,500,000

=72,500

e. Internally generated funds = Projected net Income – Projected cash dividend

Projected net income = Current Net income X Projected Sales
Current sales
= 540,000X3,125,000 =675,000
2,500,000
Projected Dividend=Projected net Income X Dividend Payout ratio

=675,000 X0.45 =303,750

Internally Generated Funds=675,000-303,750= 371,250

f. Additional Funds (External Capital) Needed

AFN= Increase in + Increase in - Spontaneously + Internally

Fixed Assets current assets Generated Funds Generated Funds

= (375,000 +281,250)–(72,500 +371,250)

=656,250 -443,750

=212,500

According to the financing policy, the company raises 40% of external capital requirement from bond
issue and the remaining from the issuance of common stock. Accordingly,

Additional Bond issue=212,500 X 0.40 =85,000

Additional Common stock=212,500 X 0.60 =127,500

Based on the above computations and the original data, the following pro-forma financial
statements could be prepared:

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Projected Income statement items:

Sales 3,125,000

Costs and expenses except depreciation(1,400,000x1.25) 1,750,000

Deprecation(200,000x1.25) 250,000

Top Company
Pro-Forma Income Statement
For the Year Ended December 31,2006
Sales……………………………………………………………… 3,125,000

Less: Costs and Expenses except depreciation……. 1,750,000

Depreciation……………………………………… 250,000

Total costs and expenses………………………………………. 2,000,000

Income Before Taxes……………………………………………… 1,125,000

Less: Income Taxes(40%)……………………………………….. 450,000

Net income………………………………………………………… 675,000

Projected Balance Sheet items:

Cash(175,000 x1.25) 218,750

Accounts receivable (150,000x 1.25) 187,500

Inventory (800,000 x1.25) 1,000,000

Fixed Assets(1,500,000x1.25) 1,875,000

Accounts Payable (140,000x1.25) 175,000

Accrued liabilities(150,000x1.25) 187,500

Mortgage notes payable 1,410,000

Bonds Payable 85,000

Common Stock (800,000+127,500) 927,500

Retained Earnings:

Beginning Retained Earnings 125,000

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 Add: Projected Net Income 675,000

Subtotal………………….. 800,000

Ded: Dividend………………….. 303,750

Retained Earnings, December31,2006 496,250

Top Company
Pro Forma Balance Sheet
December 31, 2006
Assets:

Current Assets:

Cash 218,750

Accounts receivable 187,500

Inventory 1,000,000

Total current assets 1,406,250

Fixed Assets 1,875,000

Total Assets 3,281,250

Liabilities & Stockholders ‘Equity:

Current Liabilities:

Accounts Payable 175,000

Accrued liabilities 187,500

Total current Liabilities 362,500

Long-term debts:

Mortgage notes payable 1,410,000

Bonds Payable 85,000 1,495,000

Total Liabilities 1,857,500

Stock holders’ Equity:

Common Stock 927,500

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 Retained Earnings 496,250 1,423,750

Total Liabilities and Stockholders’ Equity 3,281,250

Note that any excess fund may be used for short-term investment purpose or for repayment of
liabilities, especially long-term liabilities.

2. Additional Funds Needed Model

The second financial planning model is the Additional Funds Needed model. This model is used to
compute external fund requirement and in turn used to prepare pro forma financial statements. The
model is shown below:

AFN =Required Asset Increase - Spontaneous Liability Increase-Increase in Retained Earnings

= A (∆S)- L(∆S) - M (S1) (1-d)

S0 S0

Where,

A=Assets that are tied directly to sales

S0=d Current sales

∆S = Change in sales

L=Liabilities that increase spontaneously

M= Net Profit margin

= Current Net Income /Current Sales

S1= Projected sales

D= Dividend payout ratio

Using Top Company data, Additional Funds Needed is computed as follows:

AFN=2,625,000(625,000)-290,000 (625,000) -540,000(3,125,000)(1–0.45)

2,500,000 2,500,000 2,500,000

= 1.05(625,000)–0.116(625,000)– 0.216(3,125,000) (0.55)

=212,500

Determinants of External Capital (Fund) Requirements

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 1. Sales growth rate
 The higher the sales growth rate ,the greater the need for external capital and vice versa
 The financial feasibility of the expansion plans should be reconsidered if the company
expects difficulties in raising the required capital.
2. Dividend payout ratio
 The higher the payout ratio, the greater the need for external capital requirement
 Management should balance between internally generated funds (by reducing payout
ratio) and the need for increasing stock price because divided policy affects stock price.
3. Capital intensity
 Capital intensity refers to the amount of asset required per Birr of sales
Capital intensity Ratio= Assets
Sales
 The lower capital intensity ratio, the lower the need for external capital

Excess capacity Adjustments Model

 The assumption of constant ratio between assets and sales may not always hold true. In that
case, the percentage of sales model or Additional Funds Needed model is not appropriate.
 What are the conditions under which constant ratios are not maintained between asset and sales?

1. Economies of scale
Economies of scale imply that as a plant gets larger and volume increases, the average cost per unit of
output drops. This is particularly due to lower operating and capital cost. A piece of equipment with
twice that capacity of another piece typically does not cost twice as much to purchase or operate.
Plants also gain efficiencies when they become large enough to fully utilize educated resources for
tasks such as materials handling, computer equipment, and administrative support personnel.

2. Lumpy asset increments

Lumpy assets are assets that cannot be acquired in small increments, but must be obtained (added) in
large, discrete units. Suppose, if we obtained that Br.25, 000 is needed for additional investment in
fixed assets, it may be difficult to get fixed assets that exactly cost Br. 25,000. The minimum prices for
the lowest capacity fixed asset may be Br. 45,000. Thus, if you decided to make additional investment
in fixed assets, you need to purchase fixed assets of Br. 45,000 instead of Br.25, 000.
3. Excess assets due to forecasting errors.
Actual assets to sales ratio may be different from planed ratio because actual sales may be different
from planed sales .Actual assets may be different from planned assets. Excess capacity may occur
Plant assets and inventories.
When excess capacity exists, sales can grow to the full capacity sales with no increase whatever in
fixed assets. However, beyond full capacity sales, increase in sales requires increase in assets. The
following steps may be used in determining additional investments in fixed assets in excess capacity
situation.
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 1. Determine full capacity sales( FCS)
FCS= Actual Sales
Current capacity utilization
2. Determine Target fixed assets (TFA) to sales ratio
TFA/Sales ratio=Actual fixed Assets
Full capacity sales
3. Determine the required level of fixed assets
=TFA/Sales ratio x projected sales

4. Determine additional investment in fixed Assets

=Required level of Fixed assets –Actual fixed Assets

To illustrate, assume that the company has currently investment in fixed assets in the amount of
Br.600, 000. It has been operating at 80% capacity. Its current sales amounted to Br. 1,000,000. The
company’s projected sales for the coming year are Br. 1,400,000.Current assets to sales ratio is 15%,
and Current liabilities to sales ratio is 9%.Current assets and Current liabilities increase in direct
proportion to increase in sales. Net profit margin is 10%.

Based on the above data, additional investments in fixed assets and additional funds needed are
determined as follows:

a. Full capacity sales=1,000,000=Br.1,250,000

0.08

b. TFA to sales ratio=600,000 = 48%

1,250,000

c. Increase in sales without increase in Fixed Assets

=Full capacity sales–current sales

=1,250,000 –1,000,000

=250,000

d. Required level of Fixed Assets=(TFA to sales ratio)x(projected sales)

=0.48x1,400,000

=672,000

e. Additional Investment in Fixed Assets=(1,400,000–1,250,000)x0.48

=72,000

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f. Increase in Current assets=0.15x 400,000=60,000

g. Spontaneously generated funds=0.09x400,000=36,000

h. Internally generated funds=M(S1)(1-d)

=0.10(1,400,000)(1–0.60)

=0.10(1,400,000)(0.40)

=56,000

i. (72,000+60,000) –(36,000 +56,000)

= 132,000–92,000

= 40,000

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