An Overview of Financial Planning and Forecasting

What is the primary objective of preparing financial plans? The answer is 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,
despite the uncertainty of future.

Most firms engage in three types of planning:

 Strategic planning,
 Long-term financial planning, and
 Short-term financial planning

Strategic plan defines, in very general terms, how the firm plans to make money in the future. It
serves as a guide for all other plans.

The long-term financial plan generally encompasses a period of three to five years and
incorporates estimates of the firm’s income statements and balance sheets for each year of the
planning horizon.

The short-term financial plan spans a period of one year or less and is a very detailed
description of the firm’s anticipated cash flows.

The format typically used is a cash budget, which contains detailed revenue projections and
expenses in the month in which they are expected to occur for each operating unit of the
company.

What is Forecasting and its relation to planning?

A forecast is a prediction about a condition or situation at some future time. Much of human
activity is based on forecasts. When we go to a motion picture, we assume we will find the
picture enjoyable-that is, we forecast an enjoyable experience. We routinely listen to weather
forecasts on the radio to help us plan future activities. Forecasting is an important part of our
lives. Some managers use the terms forecasting, planning, and modeling interchangeably to
describe a large, involved process by which the firm decides what it wants to accomplish and
how it intends to accomplish it. Other managers have much more specific, detailed processes in
mind when they use these same terms. The differences in these terms, as expressed in the
following paragraphs, will apply throughout the course.

As has been noted, forecasting is a process by which predictions are made about some future
condition. Planning is a process by which a firm develops a scheme to accomplish something. A
plan can be very broad in nature and may have nothing to do with forecasting. The planning
process frequently depends on forecasts. If the planning group had been charged with the review
of the basic plant modernization decision, then it would have had to rely heavily on forecasting.
The group would need to evaluate estimates (forecasts) of the cost of modernization, estimates of
the increased productivity (lower operating expenses) it would make possible, and so forth.
Planning usually involves forecasting.

Overview:

 It is a Part of Planning process.

 They are inferences as to what the future may be.
 Extends over a time horizon.
 Based on:
o Economic assumptions (interest rate, inflation rate, growth rate and so on).
o Sales forecast.
o Pro forma statements of Income account and Balance sheet.
o Asset requirements.
o Financing plan.
o Cash Budget

Techniques of Financial projections

1. Pro-forma Financial Statements.

2. Cash Budgets.
3. Operating Budgets.
4. Sales Budget

Pro forma Financial Statements

 A comprehensive look at the likely future financial performance.
 Pro forma Income Statement. (Represents the operational plan for the whole

organization.)

 Pro forma Balance sheet. (Reflects the cumulative impact of anticipated future decisions).

Difference between Pro Forma Financials and Financial Projections

 Pro Forma financial statements and financial projections are very similar. In fact, some
would say they are synonymous. In my opinion the key difference between the two is as
follows:
 Financial projections are built on a set of assumptions, and can be built from scratch for a
startup company. Pro Forma financial statements on the other hand are based on your
current financial statements, and then are changed based on one event. For example,
your pro forma statements might explore what your business financials would look like if
you secured a new loan, or how they might change if you received investment. Financial
projections on the other hand would include assumptions about sales, financing, and
expenses as a whole.

Preparation of Pro Forma Income Statements

 Percent of Sales Method

o It assumes that future relationship between various elements of cost to sales will
be similar to their historical relationships.
o These cost ratios are generally based on the average of previous two or three
years. For example; Cost of Goods sold may be expressed as a percentage of
Sales.

 Budgeted Expense Method

o Estimate the value of each item on the basis of expected developments in the
future period for which the pro forma P&L a/c is being prepared.
 o Calls for greater effort on the part of Management, since they have to define the
likely happenings.

 Combination method

o Neither the Percent of sales method nor the Budgeted expense method should be
used in isolation.
o A combination of both methods work best.
o Items which have stable relationship to sales can be forecasted using the Percent
of sales method.
o For items where the future is likely to be very different from the past, budgeted
expense method can be used.

Example of a Pro forma Income statement:

Preparation of Pro forma Balance sheet

Projections for Balance sheet can be made asunder:

1. Employ Percent of Sales method to project items on the asset side, except “Investments”
and “Misc Exp & Losses”.

2. Expected values for Investment and Misc exp can be estimated using specific information.

3. Use Percent of sales method to project values of current liabilities and Provisions. (Also
referred to as ‘spontaneous liabilities’)

4. Projected values of R & S can be obtained by adding projected retained earnings from
P&L pro forma statement.
5. Projected value for Equity and preferential capital can be set tentatively equal to their
previous values.

6. Projected values for loan funds will be tentatively equal to their previous level less
repayments or retirements.

7. Compare the total of asset side with that of liabilities side and determine the balancing
figure. (If assets exceed liabilities, the balancing figure represents external funding
requirement. If liabilities exceeds Assets, the balancing item represents ‘surplus available
funds’ )

Example of Pro forma Balance sheet

Other Pro forma statements

o Cash Budget
o Operating Budget
o Sales Budget
o Production Budget
o Sales and Distribution expenses budget
o Administrative overheads budget.
 The Sales Forecasting Process

Techniques of sales forecasting

 Subjective Methods:

o Jury of Executive opinion

o Sales Force estimates
 Objective methods:

o Trend Analysis by Extrapolation (Long term trend, Cyclical variations,

Seasonal variations, and erratic movement)
o Regression Analysis (Relationship between dependent variable Sales, and
independent variables like Income, etc).

The sales forecasting process:

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.
 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.
 Growth and External Financing Requirement
When ratios remain constant, it is assumed that the increased growth will require an equal
increase in assets. Such increase in assets will be funded by external financing.

External funding Requirement (EFR) is calculated as follows:

EFR= A/S (ΔS) –L/S (ΔS) – m S1(1-d)

Where, EFR= external funds requirement

A/S = Current Assets and Fixed Assets as proportion of Sales

L/S= CL and Provisions (spontaneous liabilities) as a

proportion of Sales.

ΔS= Expected increase in sales.

M = Net profit Margin

S1= Projected sales for next year

d = dividend payout ratio

 Example: For XYZ corporation

Balance sheet (2002) of a company XYZ, in millions of dollars

Income Statement (2002) of a company XYZ, in millions of dollars

Key Ratios
Key assumptions
 Operating at full capacity in 2002.
 Each type of asset grows proportionally with sales.
 Payables and accruals grow proportionally with sales.
 2002 profit margin (2.52%) and payout (30%) will be maintained.
 Sales are expected to increase by $500 million. (%DS = 25%)

Determining additional funds needed, using the AFN equation

AFN = (A*/S0) ΔS – (L*/S0) ΔS – M (S1) (RR)

= ($1,000/$2,000)($500) – ($100/$2,000)($500) –.0252($2,500)(0.7)

= $180.9 million.

How shall AFN be raised?

 The payout ratio will remain at 30 percent (d = 30%; RR = 70%).
 No new common stock will be issued.
 Any external funds needed, will be raised as debt, 50% notes payable and 50% L-T debt.

Forecasted Income Statement (2003)

 Poor
Current ratio
2.50x
3.00x
”
Payout ratio
30.00%
Forecasted Balance Sheet (2003) - Assets

30.00%
O. K.

Forecasted Balance Sheet (2003) - Liabilities and Equity

What is the additional financing needed (AFN)?

  Required increase in assets = $ 250
 Spontaneous increase in liab. = $ 25
 Increase in retained earnings = $ 46
 Total AFN = $ 179

XYZ must have the assets to generate forecasted sales. The balance sheet must balance,
so we must raise $179 million externally.

How will the AFN be financed?

 Additional Notes payable
o 0.5 ($179) = $89.50
 Additional L-T debt
o 0.5 ($179) = $89.50
 But this financing will add to interest expense, which will lower NI and retained earnings.
We will generally ignore financing feedbacks.

Forecasted Balance Sheet (2003)- Assets – 2nd pass

Forecasted Balance Sheet (2003) - Liabilities and Equity – 2nd pass

Why do the AFN equation and financial statement method have different
results?
 Equation method assumes a constant profit margin, a constant dividend payout, and a
constant capital structure.
 Financial statement method is more flexible. More important, it allows different items to
grow at different rates

What was the net investment in operating capital?

 OC2003 = NOWC + Net FA

= $625 - $125 + $625 = $1,125

 OC2002 = $900

 Net investment in OC = $1,125 - $900 = $225

How much free cash flow is expected to be generated in 2003?

FCF = NOPAT– Net inv. in OC

= EBIT (1 – T) – Net inv. in OC

= $125 (0.6) – $225

= $75 – $225

= -$150.