Chapter Three

Financial Forecasting and Planning

3.1. An overview of financial forecasting
Financial forecasting is an integral part of financial planning. It uses past data to estimate the
future financial requirements. It is an essential element for financial planning, is the basis for
budgeting activities and estimating future financing needs. Financial forecasts begin with
forecasting sales and their related expenses. A financial planning model establishes the
relationship between financial variables and targets, and facilitates the financial forecasting and
planning process. A model makes it easy for the financial managers to prepare financial
forecasts. It makes financial forecasting automatic and saves the financial managers’ time and
efforts performing a tedious activity. Financial planning models help in examining the
consequences of alternative financial strategies. A financial planning model has the following
three components:

1. Inputs: The model builder starts with the firm’s current financial statements and the future
growth prospects. The firm’s growth prospects depend on the market growth rate, firm’s
market share and intensity of competition. The growth objective is determined by the
management team consisting of marketing, manufacturing and finance executives.
2. Model: The model defines the relations between financial variables and develops appropriate
equations. For example, net working capital and fixed assets investment may be related to
sales. As sales change, they may change in direct proportion to sales. Hence the model will
specify working capital and fixed assets as ratio of sales. Similarly, given the pay-out policy
of the firm, dividend may be specified as a ratio of profit after tax.
3. Output: Applying the model equations to the inputs, output in the form of projected or pro
forma financial statements are obtained. The output shows the investment and funds
requirement, given the sales growth objective and relationships between the financial
variables.
What is the primary objective of preparing financial plans?
 To estimate the future financing requirements in advance of when the financing will be
needed.
  The process of planning is critical to force managers to think systematically about the
future.
A company’s annual financial plan is called a budget. The budget is a set of formal (written)
statements of management’s expectations regarding sales, expenses, production volume, and
various financial transactions of the firm for the coming period. Simply put, a budget is a set of
pro forma statements about the company’s finances and operations. A budget is a tool for both
planning and control. At the beginning of the period, the budget is a plan or standard; at the end
of the period, it serves as a control device to help management measure the firm’s performance
against the plan so that future performance may be improved. Financial Planning is a process by
which funds required for each course of action is decided. A financial plan has to consider
capital structure, capital expenditure and cash flow. Financial planning indicates a firm’s growth,
performance, investments and requirements of funds during a given period of time, usually three
to five years. It involves the preparation of projected or pro forma profit and loss account,
balance sheet and cash flow statement.
The major steps in preparing the financial plan (budget) are:

1. Prepare a sales forecast

2. Determine production volume
3. Estimate manufacturing costs and operating expenses
4. Determine cash flow and other financial effects
5. Formulate projected financial statements
Benefits of financial planning:
 Effective utilization of funds
 Flexibility in capital structure is given adequate consideration
 Formulation of policies and instituting procedures for elimination of all types of wastages
in the process of execution of strategic plans.
 Maintaining the operating capability of the firm through the evolution of scientific
replacement schemes for plant and machinery and other fixed assets.
Factors affecting financial planning:
 Nature of the industry
 Size of the company
 Status of the company in the industry
  The capital structure of a company
 Flexibility
 Government policy
Shortcut Approach to formulating the financial plan (budget)
In practice a shortcut approach to budgeting is quite common and may be summarized as
Follows:
1. A pro forma income statement is developed using past percentage relationships between
relevant expense and cost items and the firm’s sales. These percentages are then applied to
the firm’s forecasted sales.
2. A pro forma balance sheet is estimated by determining the desired level of certain balance
sheet items, then making additional financing conform to those desired figures. The
remaining items, thus, are estimated to make the balance sheet balance. There are two basic
assumptions underlying this approach:
i. The firm’s past financial condition is an accurate predictor of its future condition.
ii. The value of certain variables such as cash, inventory, and accounts receivable can be
forced to take on specified desired values.
Forecasting growth rates and outside financing
External financing needed and growths are obviously related. All other things staying the same,
the higher the rate of growth in sales or assets, the greater will be the need for external financing.
We will take the firm’s financial policy as given and then examine the relationship between that
financial policy and the firm’s ability to finance new investments and thereby grow. Once again,
we emphasize that we are focusing on growth, because growth is an appropriate goal; instead, for
our purposes, growth is simply a convenient means of examining the interactions between
investments and financing decisions. In effect, we assume that the use of growth as a basis for
planning is just a reflection of the very high level of aggregation used in the planning process.
External financing needed (EFN) and growth the first thing we need to do is establish the
relationship between EFN and growth. There is a direct link between sales growth and external
financing.
The Internal Growth Rate: Internal growth rate is the first maximum growth rate of a firm can
achieve without external financing of any kind. We will call this the internal growth rate because
this is the rate the firm can maintain with internal financing only. The required increase in assets
is exactly equal to the addition to retained earnings, and external financing needed is therefore
zero.

Example: Suppose ABC Company, net income was $66 and total assets were $500. ROA is thus
$66/500= 13.2%. Of the $66 net income, $44 was retained, so the retention ratio or plowback
ratio, b, is $44/66= 2/3(66.67%). With these given numbers, we can calculate the internal growth
rate as:

Therefore, ABC Company can expand at a maximum growth rate of 9.65% per year without
external financing.
The Sustainable Growth Rate: Sustainable growth rate is the second maximum growth rate of a
firm can achieve without external equity financing while maintaining a constant debt-equity
ratio. This rate is commonly called the sustainable growth rate because it is the maximum rate of
growth a firm can maintain without increasing its financial leverage. There are various reasons
why a firm might wish to avoid equity sales.
For example, new equity sales can be very expensive. Alternatively, the current owners may not
wish contribute additional equity. We have seen that if the ABC Company wishes to grow more
rapidly than at a rate of 9.65% per year, then external financing must be arranged.

This is identical to the internal growth rate except that ROE, return on equity, is used instead of
ROA. For instance, Suppose ABC Company, net income was $66 and total equity was $250;
ROE is thus $66/250= 26.4%. The plowback ratio, b, is still 2/3, so we can calculate the
sustainable growth rate as:
 ABC Company current year
ABC Company can expand at a maximum growth rate of 21.36% per year without external
equity financing. ABC grows at exactly the sustainable growth rate of 21.36%. What will the pro
forma statements look like? At a 21.36% growth rate, sales will rise from $500 to $606.8. The
pro forma income statement will look like this:
ABC Company
Pro Forma Income Statement

We construct the balance sheet, in this case, that owners’ equity will rise from $250 to $303.4
because the addition to retained earnings is $53.4.
ABC Company
 Pro Forma Income Statement
As illustrated, external financing needed is $53.4. If ABC Company can borrow this amount,
then total debt will rise to $303.4, and the debt-equity ratio will be exactly 1.0. At any other
growth rate, something would have to change.

Determinants of Sustainable Growth rate

Financial statement forecasting: the percentage of sales method

When constructing a financial forecast, the sales forecast is used traditionally to estimate various
expenses, assets, and liabilities. The most widely used method for making these projections is the
percentage-of-sales method, in which the various expenses, assets, and liabilities for a future
period are estimated as a percentage of sales. These percentages, together with the projected
sales, are then used to construct pro forma (planned or projected) balance sheets. The
calculations for a pro forma balance sheet are as follows:

1. Express balance sheet items that vary directly with sales as a percentage of sales. Any
item that does not vary directly with sales (such as long-term debt) is designated not
applicable (n.a.).
2. Multiply the percentages determined in step 1 by the sales projected to obtain the
amounts for the future period.
3. Where no percentage applies (such as for long-term debt, common stock, and capital
surplus), simply insert the figures from the present balance sheet in the column for the
future period.
4. Compute the projected retained earnings as follows:

5. Sum the asset accounts to obtain a total projected assets figure. Then add the projected
liabilities and equity accounts to determine the total financing provided. Since liability
plus equity must balance the assets when totaled, any difference is a shortfall, which is
the amount of external financing needed.

Example 1: For the following pro forma balance sheet, net income is assumed to be 5% of sales
and the dividend pay-out ratio is 4%.
Although the forecasting of additional funds required can be made by setting up pro forma
balance sheets as described above, it is often easier to use the following simple formula:
Alternatively, compute external finance needed (EFN):

Inserting these figures into the formula, we get the same result:

The $80,000 in external financing can be raised by issuing notes payable, bonds, or stocks,
singly or in combination. One important limitation of the percentage-of-sales method is that the
firm is assumed to be operating at full capacity. On the basis of this assumption, the firm does
not have sufficient productive capacity to absorb projected increases in sales and thus requires an
additional investment in assets. The major advantage of the percentage-of-sales method of
financial forecasting is that it is simple and inexpensive to use. To obtain a more precise
projection of the firm’s future financing needs, however, the preparation of a cash budget is
required.
Example 2: Performing financial forecasting and determining the external funds needed (EFN) of
ABC Company considering the following financial data.

ABC Company expects its sales to increase by $2,000,000 in the next year. In this problem, all
the asset accounts (including fixed assets) and current liabilities vary with sales. ABC
Company is operating at full capacity. (a) Forecast ABC’s need for external funds by:
1. Constructing a pro forma balance sheet and
2. Using the simple formula.

Note: