Financial Planning and Forecasting:

▪ Financial planning is the process of managing financial

resources to achieve long term or short-term financial
goals.
▪ Growth in sales is an important objective of a firm.
▪ An increase in a firm’s market share will lead to higher
growth.
▪ The firm would need assets to sustain the higher growth
in sales.
▪ It may have to invest in additional fixed assets to
increase in production capacity.
▪ Similarly, firm would need additional current assets to
produce and sell more goods and service.
Cont.
▪ The firm may use its internal funds to finance current
and fixed assets.
▪ When the firm grows at high rate, internal funds may
not be sufficient.
▪ Thus, the firm would have to raise external funds either
by issuing equity or debt or both.
▪ Financial planning is the process of analyzing a firm’s
investment options and estimating the funds
requirement and deciding the sources of funds.
Cont.
▪ Financial planning process involves the following
facets (features):
I. Evaluating the current financial condition of the firm.
II. Analyzing the future growth prospects and options.
III. Appraising the investment options to achieve the stated
growth objective.
IV. Projecting the future growth and profitability.
V. Estimating funds requirement considering alternative
financing options.
VI. Measuring actual performance with the planned
performance.
Cont.
▪ Financial forecasting is an integral part of financial
planning.
▪ It is the process of using past data to predict the future
financial requirements.
▪ It is an act of deciding in advance, the amount of fund
requirements of the firm and the pattern of such
requirements.
▪ In this process of financial forecasting, the financial
manager is supposed to develop projected financial
statements.
▪ It facilitates financial manager to plan for future
financing requirements and to identify appropriate
sources of financing to meet future needs of fund.
 Financial forecasting techniques:
1. Percentage of sales method:
• A method of forecasting financial statements that
expresses each account as a percentage of sales is called
percentage of sales method.
• These percentages of sales can be constant, or they can
change over time.
• On the basis of projected sales and certain assumed
relationships with different figures in the balance sheet
projected financial statement can be prepared.
• Under this method, financial statements are prepared
based on the following assumptions:
 Financial forecasting techniques:
1. All the costs except depreciation are a specified % of
sales.
2. Fixed cost will increase if the firm operates at full
capacity.
3. Interest and preference dividend remained constant, but
these amounts will change when analyzing external
financing requirement.
4. If entire net income is not paid in dividend, then
retained earnings will increase.
5. All assets can be assumed to increase in direct
proportion of sales if the firm is operating at full
capacity. (spontaneous assets)
 Financial forecasting techniques:
6. If the firm is not operating at full capacity, then fixed
assets will not change, but current assets will increase as a
% of sales.

7. All current liabilities like; account payable, creditors,

bills payable, accruals except notes payable, can be
expected to increase spontaneously with sales.

8. All other financial accounts like; notes payable, long-

term debts, preferred stock, and common stock are not
changed with sales.
Procedures of Percentage of Sales Method:
Step-1: Identify the items of assets and liabilities that are
affected by the sales growth. (spontaneous assets & liab.)

Step-2: Calculate the % increase in each item based on

sales.
𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ
Eg., % increase in cash =
𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑆𝑎𝑙𝑒𝑠

Step-3: Calculate the projected value of assets and

liabilities.
Eg., Projected value of cash = Projected sales x % of
increase.
Cont.
Step-4: Calculate the addition to retained earnings for the
projected balance sheet.

i.e., Additional R/E = Projected sales x net profit margin x

retention ratio)
Here, Retention ratio = 1- dividend payout ratio. Or
Net income – dividend / net income

Step-5: Prepare projected or proforma balance sheet to

determine additional fund need (AFN).
Here, AFN = Total projected assets – total projected
liabilities and capital.
 2.Formula Method:
𝐴∗−𝐿∗
1. AFN = 𝑥 ∆ 𝑆 − 𝑆1 𝑥 𝑚 𝑥 𝑅𝑅
𝑆𝑜

2. Percentage of External Fund Requirement (PEFR) =

𝐴∗−𝐿∗ 1+𝑔
- m x RR x ( )
𝑆𝑜 𝑔

3. Sustainable growth rate = The growth rate in

sales at which AFN is zero:
AFN= 0, ∆ 𝑆 = So x g and S1= So (1+g)
 2.Formula Method:
Here;
A* = Total spontaneous assets
L* = Total spontaneous liabilities / financing
𝐴∗
= Capital intensity ratio = The amount of assets
𝑆𝑜
required per rupee of sales or increased % on assets
based on sales.
𝐿∗
𝑥 𝑆1 = 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑆𝑝𝑜𝑛𝑡𝑎𝑛𝑒𝑜𝑢𝑠 𝑙𝑖𝑎𝑏𝑖𝑡𝑖𝑒𝑠
𝑆𝑜
S1 x M x RR = Addition to Retained earnings.
∆𝑆
G = Growth rate in sales =
𝑆𝑜
 Capacity adjustment:
• When a company operates at full capacity, the
amount of additional capacity required varies
exactly with the change in sales.
• However, if the fixed assets of the firm are not
utilized in full capacity and still some idle
capacity remains, the additional investment in
fixed assets does not increase proportionately
with sales.
• There is no need for new fixed asset
investment if the idle capacity of the fixed
assets is sufficient to satisfy the additional
sales.
 Capacity adjustment:
• In such a case, only current assets are
proportionately change with sales.
• For example :
Liab. and equity Rs. Assets Rs.
Account payable 10,000 Cash 18,750
Notes payable 21,250 Account receivable 37,500
Accruals 6,250 Inventory 60,000
Long-term debt 62,500 Fixed assets 183,750
Common stock 112,500
Retained earnings 87,500

300,000 300,000
Cont.
Sales for the current year was Rs. 500,000
and expected to increase in sales by
Rs.150,000 in the coming year. Net profit
margin is 15% and dividend payout ratio is
60%.
Assume that fixed assets of the company were
utilized to 75% capacity in the current year.
𝐴𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
Full capacity sales =
𝐴𝑐𝑡𝑢𝑎𝑙 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑡𝑖𝑙𝑖𝑧𝑒𝑑
Therefore, full capacity sales = Rs.666,667
Cont.
Now, Target fixed assets to sales ratio:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 183,750
= = = 0.2756
𝐹𝑢𝑙𝑙 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑠𝑎𝑙𝑒𝑠 666,667
Required level of fixed assets = Projected
sales x Target FA to sales ratio
= 650,000 x 0.2756 = Rs.179,140
It means that the company needs a total of
Rs.179,140 in fixed assets but its existing FA
is Rs.183,750 which could cover this need.
Cont.
𝐴∗−𝐿∗
Therefore, AFN = 𝑥 ∆ 𝑆 − 𝑆1 𝑥 𝑚 𝑥 𝑅𝑅
𝑆𝑜
116,250−16,250
= x 150,000 – 650,000 x 0.15 x 0.4
500,000
= - Rs.9000 (surplus).
Now it is assumed that FA of the company are being
utilized to 90% capacity in the current year.
𝐴𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
Full capacity sales =
𝐴𝑐𝑡𝑢𝑎𝑙 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑢𝑡𝑖𝑙𝑖𝑧𝑒𝑑
Therefore, full capacity sales = Rs.555,556.
Cont.
Now, Target fixed assets to sales ratio:
𝐴𝑐𝑡𝑢𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 183,750
= = = 0.33075
𝐹𝑢𝑙𝑙 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑠𝑎𝑙𝑒𝑠 555,556
Required level of fixed assets = Projected sales x
Target FA to sales ratio
= 650,000 x 0.33075 = Rs.214,988
The company has a total of Rs.183,750 in FA that
must be increased to Rs.214,988 in the coming
year.
Therefore, additional investment in FA = 214,988 –
183,750 = Rs. 31,238.
Cont.
𝐴∗−𝐿∗
Therefore, AFN = 𝑥 ∆ 𝑆 − 𝑆1 𝑥 𝑚 𝑥 𝑅𝑅 +
𝑆𝑜
Additional investment in FA
116,250−16,250
= x 150,000 – 650,000 x 0.15 x 0.4
500,000
+ 31,238
= Rs.22,238.