Financial Planning & Forecasting

The Ingredients of a Financial Plan

 A financial plan consists of several ingredients

• Expectations about the economic environment
• A sales forecast
• Pro forma (forecasted) financial statements
• Asset requirements
• Required new financing
• Cash Budget
 We will focus on developing the pro forma
financial statements.
Forecasting: The % of Sales Method

 The most basic method of forecasting financial

statements (income statements and balance
sheets) is the percent of sales method
 This method assumes that certain expenses,
assets, and liabilities maintain a constant
relationship to the level of sales
 There are two inputs to this method:
• A sales forecast (exogenous)
• The percentages which are assumed to be constant
Steps to the financial planning process

1. Project financial statements and use the projections

to analyze the effects of the operating plan on
projected profits and various financial ratios.
2. Determine the funds needed to support the plan.
3. Forecast funds availability
4. Establish and maintain a system of controls
5. Develop procedures for adjusting the basic plan if
the economic forecasts do not materialize.
6. Establish a performance based management
compensation system
What are pro forma financial statements

 Proforma financial statements forecast the

company’s financial position and
performance over a period of years.
What are the four ways that proforma
financial statements are used by
managers?
1. Assess whether the company’s anticipated
performance is in line with the firm’s own
general targets.
2. “What if” analysis
3. Anticipate future financing needs
4. Estimate future cash flows
 Forecasting the Income Statement

Elcom Products International

Pro-forma Income Statement
For the Year Ended Dec. 31, 1997 ( Rs. 000's)
1998%* 1998* 1997% 1997 1996% 1996
Sales 100.00% 4,300.00 100.00% 3,850.00 100.00% 3,432.00
Cost of Goods Sold 83.93% 3,609.11 84.42% 3,250.00 83.45% 2,864.00
Gross Profit 690.89 15.58% 600.00 16.55% 568.00
No change Selling and G&A Expenses 7.79% 334.80 8.58% 330.30 6.99% 240.00
Fixed Expenses 100.00 2.60% 100.00 2.91% 100.00
Depreciation Expense 20.00 0.52% 20.00 0.55% 18.90
EBIT 236.09 3.89% 149.70 6.09% 209.10
Interest Expense 76.00 1.97% 76.00 1.82% 62.50
Earnings Before Taxes 160.09 1.91% 73.70 4.27% 146.60
Taxes @ 40% 64.04 0.77% 29.48 1.71% 58.64
Net Income 96.05 1.15% 44.22 2.56% 87.96
*Forecasted
Types of Assets and Liabilities

 There are two types of assets:

• Current assets are the firm’s short-term assets and can
generally be expected to vary directly with sales
• Fixed assets are the firm’s long-term assets and generally do
not vary directly with sales
 There are two types of liabilities:
• Spontaneous liabilities are those that occur naturally
during the ordinary course of doing business. These sources
vary directly with sales
• Discretionary liabilities are those that require a special
effort for the firm to obtain. These sources do not vary
directly with sales
Forecasting the Balance Sheet
Elcom Products International
Balance Sheet
As of Dec. 31, 1997
Assets 1998* 1997% 1997 1996% 1996
Cash and Equivalents 52.00 1.35% 52.00 1.68% 57.60
Accounts Receivable 444.51 10.44% 402.00 10.23% 351.20
Inventory 914.90 21.71% 836.00 20.84% 715.20
Total Current Assets 1411.40 33.51% 1290.00 32.75% 1124.00
Plant & Equipment 527.00 13.69% 527.00 14.31% 491.00
Accumulated Depreciation 186.20 4.32% 166.20 4.26% 146.20
Net Fixed Assets 340.80 9.37% 360.80 10.05% 344.80
Total Assets 1752.20 42.88% 1650.80 42.80% 1468.80
Liabilities and Owner's Equity
Accounts Payable 189.05 4.55% 175.20 4.24% 145.60
Short-term Notes Payable 225.00 5.84% 225.00 5.83% 200.00
Other Current Liabilities 163.38 3.64% 140.00 3.96% 136.00
Total Current Liabilities 577.43 14.03% 540.20 14.03% 481.60
Long-term Debt 424.61 11.03% 424.61 9.42% 323.43
Total Liabilities 1002.04 25.06% 964.81 23.46% 805.03
Common Stock 460.00 11.95% 460.00 13.40% 460.00
Retained Earnings 300.04 5.87% 225.99 5.94% 203.77
Total Shareholder's Equity 760.04 17.82% 685.99 19.34% 663.77
Total Liabilities and Owner's Equity 1762.08 42.88% 1650.80 42.80% 1468.80
Discretionary Financing Needed -9.88 Surplus
* Forecasted
Other Information Forecast Actual Actual
Sales 4300.00 3850.00 3432.00
Dividend 22.00
Discretionary Financing Needed

 Ordinarily, the pro-forma balance sheet will not

balance!
 This is intentional, and the amount needed to make it
balance is referred to as the Discretionary Financing
Needed, DFN (or External Financing Needed, EFN or
EFR= Expected Funds required)
 This is a “plug figure” that represents the amount of
discretionary financing that the firm will need to
obtain in order to support its forecasted level of sales

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Factors affecting EFR

1. Sales growth: Higher growth sales require larger increases in

assets.
2. Capital Intensity ratio: Companies with higher assets to sales
ratio require more assets for a given increase in sales and
hence need greater external financing.
3. Companies that generate a large amount of liabilities from
accounts payable and accrued liabilities will have a small need
for external financing.
4. Profit margin: Higher the profit margin, larger the net income
and lower the need for external financing.
5. Retention ratio: Higher retention ratio will mean less need for
external financing.

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Illustration

1. A/S = 0.90; ΔS = Rs. 6 million; L/S = 0.40;

m = 0.05, S1 = Rs. 46 million and d= 0.6
What is Pioneer’s external funds requirement?

2. The following information is available for ABC

Limited : A/S = 0.6, S = Rs.300 million, L/S = 0.30, m
= 0.08, S1 = Rs.350 million, and d = 0.5. What is the
external funds requirement for the forthcoming year?
( Ans: 1 million)

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Internal growth rate

 The internal growth rate is the maximum

growth rate that can be achieved with no
external financing.
 It is that growth rate where addition to assets
= addition to retained earnings

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Sustainable growth rate

It is the rate of growth that can be sustained

with internal equity (retained earnings ) and
debt

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The Cash Budget

 A cash budget is a document which shows the

expected cash inflows and outflows for a chosen
time period (say, 6 or 9 months).
 The benefits of the cash budget are:
• It provides an estimate of the ending cash balance in
each month
• It provides estimates and sources of the cash inflows
and outflows
• It provides a basis of comparison against which
managers can be evaluated

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Parts of the Cash Budget

 In a simple cash budget, there are three parts:

• The Worksheet Area
• The Inflows and Outflows
• The calculation of the ending cash balance
 Essentially, a cash budget starts with the
beginning cash balance, adds expected cash
inflows, and subtracts any expected cash
outflows. The result is the expected ending
cash balance.

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Cash Budget: An Example

 Here is the information required to assemble the cash budget

for Barbie Pizzas:
• 40% of sales are for cash. Of the remainder, 75% is collected the
following month, and 25% is collected two months after the sale.
• Inventory purchases are equal to 50%of the next month’s sales.
60% of purchases are paid for the following month, and the
remainder one month later.
• Wages are 20% of sales. Leasing expenses is Rs.10,000 per month.
Interest payments of Rs. 30,000 are due in June and September. A
Rs. 50,000 dividend payment will be made in June. Taxes of Rs.
25,000 are due in June and September. A Rs.200,000 capital
improvement will be paid for in July.
• The company must keep a minimum cash balance of Rs. 15,000.

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Expected sales

Rs.
April 291000
May 365000
June 387000
July 329000
August 238000
September 145000
October 92000

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Cash Budget: Worksheet Area

 The worksheet area is where we gather certain key

numbers which will be used in the rest of the cash
budget.
Barbie Barbeques
Cash Budget
For the Period June to September 1998
April May June July August September October
Sales 291,000 365,000 387,000 329,000 238,000 145,000 92,000
Collections:
Cash 40% 154,800 131,600 95,200 58,000
First Month 45% 164,250 174,150 148,050 107,100
Second Month 15% 43,650 54,750 58,050 49,350
Total Collections 362,700 360,500 301,300 214,450
Purchases 50% 182,500 193,500 164,500 119,000 72,500 46,000
Payments:
First Month 60% 116,100 98,700 71,400 43,500
Second Month 40% 73,000 77,400 65,800 47,600
Total Payments 189,100 176,100 137,200 91,100

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Cash Budget: Inflows & Outflows

 This section shows all of the cash collections

and disbursements. Note that these are only
cash inflows and outflows. The cash budget is
not the same as the income statement.
Collections 362,700 360,500 301,300 214,450
Less Disbursements:
Inventory Payments 189,100 176,100 137,200 91,100
Wages 20% 77,400 65,800 47,600 29,000
Lease Payment 10,000 10,000 10,000 10,000
Interest 30,000 0 0 30,000
Dividend (Common) 50,000 0 0 0
Taxes 25,000 0 0 25,000
Capital Outlays 0 200,000 0 0
Total Disbursement 381,500 451,900 194,800 185,100

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Cash Budget: The Ending Cash Balance

 This section is where we calculate the ending cash

balance and determine if we will need to borrow for
each month.
Beginning Cash Balance 20,000 15,000 15,000 121,500
Collections - Disbursement (18,800) (91,400) 106,500 29,350
Unadjusted Cash Balance 20,000 1,200 (76,400) 121,500 150,850
Current Borrowing Needed 0 13,800 91,400 0 0
Ending Cash Balance 20,000 15,000 15,000 121,500 150,850
Notes:
Minimum Acceptable Cash 15,000

Note that Barbie Pizzas will need to borrow in June and July, and will
have excess cash in August and September.

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 The balance sheet of Vasundhara Corporation as at March 31, 2007 is shown
below:
 Share capital 500 Fixed assets 750
 Retained Earnings 120 Inventories 400
 Term Loans 360 Receivables 330
 Short-term Bank Borrowings 300 Cash 90
 Accounts Payable 210
 Provisions 80
 1570 1570

The sales of the firm for the year ending on March 31, 2007 were 2,800. Its profit
margin on sales was 8 percent and its dividend payout ratio was 30 percent. The tax
rate was 40 percent. Vasundhara Corporation expects its sales to increase by 40
percent in the year ending March 31, 2008. The ratio of assets to sales and
spontaneous current liabilities to sales would remain unchanged. Likewise the
profit margin ratio, the tax rate, and the dividend payout ratio would remain
unchanged.
 Required: a. Estimate the external funds requirement for the year 2008.
 b. Prepare the following statements, assuming that the external funds
requirement would be raised equally from term loans and short-term bank
borrowings: (i) projected balance sheet and (ii) projected profit and loss account.
( Ans : Rs. 292)

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 The balance sheet of MGM Limited as at March 31, 2007 is shown below:
 Share capital 4,200 Fixed assets 8,870
 Retained Earnings 2,480 Inventories 3,480
 Term Loans 3,920 Receivables 2,580
 Short-term Bank Borrowings 2,490 Cash 180
 Accounts Payable 1,240
 Provisions 780
 15,110 15,110

The sales of the firm for the year ending on March 31, 2007 were 31,410. Its
profit margin on sales was 7 percent and its dividend payout ratio was 50
percent. The tax rate was 34 percent. MGM Limited expects its sales to increase
by 30 percent (i.e by 9,423) in the year 20X8. The ratio of assets to sales and
spontaneous current liabilities to sales would remain unchanged. Likewise the
profit margin ratio, the tax rate, and the dividend payout ratio would remain
unchanged.
 Required: a. Estimate the external funds requirement for the year 2008.
 b. Prepare the following statements, assuming that the external funds
requirement would be raised from term loans and short-term bank borrowings
in the ratio 1:2 (i) projected balance sheet and (ii) projected profit and loss
account.