2.1.

Financial Planning/Forecasting

Financial planning formulates the way in which financial goals are to be achieved. A
financial plan is thus a statement of what is to be done in the future. As we all know the
three most important decision areas of financial management are Investing, Financing and
Working Capital management. Funds requirement decision is concerned with the
estimation of the total funds or capital requirements for the business enterprise, while the
financing decision is concerned with the sources from which the funds are to be raised.
Financial planning, therefore, includes: (1) Estimating the amount of capital to be raised, (2)
determining the form and proportionate amount of securities, and (3) Laying down the
policies as to the administration of the financial plan.

A lack of effective long-range planning is a commonly cited reason for financial distress and
failure. Long-range planning is a means of systematically thinking about the future and
anticipating possible problems before they arrive. Financial planning establishes guidelines
for change and growth in a firm.

THE PERCENT OF SALES METHOD

Sales Forecast
A forecast of a firm’s unit and dollar sales for some future period; it is generally based on
recent sales trends plus forecasts of the economic prospects for the nation, region, industry,
and so forth.

Once sales have been forecasted, we must forecast future balance sheets and income
statements. The most commonly used technique is the percent of sales method, which
begins with the sales forecast, expressed as an annual growth rate in dollar sales revenues.

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Many items on the income statement and balance sheet are often assumed to increase
proportionally with sales. For example, the inventories-to-sales ratio might increase 20
percent, receivables/sales might increase 15 percent, variable costs might increase 60
percent of sales, and so forth.

Then, as sales increase, items that are tied to sales also increase, and the values of those
items for a particular year are estimated as percentages of the forecasted sales for that year.
The remaining items on the forecasted statements—items that are not tied directly to
sales—are set at “reasonable” levels.
STEP 1: FORECASTED INCOME STATEMENT
First, we forecast the income statement for the coming year. This statement is needed to
estimate both income and the addition to retained earnings. Table 2.1 shows the forecast
for 2002. Sales are forecasted to grow by 20 percent. The forecast of sales for 2002, shown
in Row 1 of Column 3, is calculated by multiplying the 2001 sales, shown in Column 1, by (1
+growth rate) = 1.2. The result is a 2002 forecast.
The percent of sales method assumes initially that all costs are a specified percentage of
sales.
STEP 2: FORECAST THE BALANCE SHEET
The assets shown on Lewis’ balance sheet must increase if sales are to increase. It might be
reasonable to assume that cash, accounts receivable, and inventory grow proportionally
with sales, but will the amount of net plant and equipment go up and down as sales go up
and down? The correct answer could be yes or no. When companies acquire plant and
equipment, they often install greater capacity than they currently need, due to economies
of scale. There is not necessarily a close relationship between sales and net plant and
equipment in the short term.
However, for some companies there is a fixed relationship between sales and plant and
equipment, even in the short term. For example, new stores in many retail chains achieve
the same sales during their first year as the chain’s existing stores. The only way these

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retailers can grow is by adding new stores, which results in a strong proportional
relationship between fixed assets and sales.
In the long run, there is a relatively close relationship between sales and fixed assets for all
companies: No company can continue to increase sales unless it eventually adds capacity.
Therefore, as a first approximation it is reasonable to assume that the long-term ratio of
net plant and equipment to sales will be constant.
Once the individual asset accounts have been forecasted, they can be summed to complete
the asset section of the balance sheet.
If Lewis’ assets are to increase, its liabilities and equity must also increase-the additional
assets must be financed. Some items on the liability side can be expected to increase
spontaneously with sales, producing what are called spontaneously generated funds.
Spontaneously generated funds are funds that are obtained automatically from routine
business transactions. For example, as sales increase, so will Lewis’ purchases of raw
materials, and those larger purchases will spontaneously lead to a higher level of accounts
payable.
For example, as sales increase, so will purchases of raw materials, and those larger
purchases will spontaneously lead to a higher level of accounts payable. More sales will
require more labor, and higher sales should also result in higher taxable income and thus
taxes. Therefore, accrued wages and taxes will both increase.
Retained earnings will also increase, but not at the same rate as sales: The new balance for
retained earnings will be the old level plus the addition to retained earnings, which we
calculated in Step 1. Also, notes payable, long-term bonds, preferred stock, and common
stock will not rise spontaneously with sales —rather, the projected levels of these accounts
will depend on financing decisions, as we discuss later.
In summary, (1) higher sales must be supported by additional assets, (2) some of the asset
increases can be financed by spontaneous increases in accounts payable and accruals, and
by retained earnings, but (3) any shortfall must be financed from external sources, using
some combination of debt, preferred stock, and common stock.
Additional Funds Needed (AFN) are Funds that a firm must raise externally through
borrowing or by selling new common or preferred stock. The AFN will be raised by some

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combination of borrowing from the bank as notes payable, issuing long-term bonds, and
selling new common stock.
STEP 3: RAISING THE ADDITIONAL FUNDS NEEDED
The financial staff of a company will raise the needed funds based on several factors,
including the firm’s target capital structure, the effect of short-term borrowing on the
current ratio, conditions in the debt and equity markets, and restrictions imposed by
existing debt agreements.

Illustration:
The 2001 balance sheet and income statement for the Lewis Company are shown below.
Lewis Company
Income Statement
For the Year ended on December 31, 2001 (Thousands of Dollars)

Lewis Company
Balance Sheet
As of December 31, 2001 (Thousands of Dollars)

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Additional Information:
The firm operated at full capacity in 2001. It expects sales to increase by 20 percent during
2002 and expects 2002 dividends per share to increase to $1.10.
Required:
a. Use the projected financial statement method to determine how much outside
financing is required, developing the firm’s pro forma balance sheet and income
statement, and use AFN as the balancing item.
b. The financial staff of Lewis Company, after considering all of the relevant factors,
decided on the following financing mix to raise the additionally needed fund:
SOURCE OF CAPITAL PERCENTAGE AMOUNT INTEREST RATE
OF NEW CAPITAL
Notes payable 25% 8%
Long-term debt 25 10
Common stock 50
Total 100%

c. How will your answer in section (b) change, if the firm must maintain a current
����� ������ ������ ����� ����
ratio ������� ����� = ����� ������� �����������
of 2.3 and a debt ratio ���� ����� = ����� ������
of
40 percent? In other words, how much financing will be obtained using notes
payable, long-term debt, and common stock under the new restrictions?
Solution:
a. AFN = $667.

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Table 2.1 Forecasted Income Statements
Particulars Actual Forecast Basis 2002
2001 Forecast
Sales 8,000 1.2x2001 Sales 9,600
Operating Costs 7,450 1.2x2001 operating costs 8,940
EBIT 550 660
Interest 150 150
EBT 400 510
Taxes 160 204
Net Income 240 306
Common Dividends 156 165
(150x$1.1)
Retained Earnings 84 141

Table 2.2 Forecasted Balance Sheet

Particulars Actual Forecast Basis 2002 Forecast
2001 First AFN Second
Pass Pass
Cash 80 1.2x2001 Cash 96 96
Accounts Receivables 240 1.2x2001 A/R 288 288
Inventories 720 1.2x2001 Inv. 864 864
Total Current Assets 1,040 1,248 1,248
Fixed Assets 3,200 1.2x2001 FA 3,840 3,840
Total Assets 4,240 5,088 5,088
Accounts Payables 160 1.2x2001 A/P 192 192
Accruals 40 1.2x2001 Accruals 48 48
Notes Payables 252 252 +166.75 418.75
Total Current Liabilities 452 492 658.75
Long Term liabilities 1,244 1,244 +166.75 1410.75
Total Debt 1,696 1,736 2069.50
Common Stock 1,605 1,605 +333.50 1938.50
Retained Earnings 939 +141 1,080 1080
Total liabilities and Equity 4,240 4,421 + 667 5088

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Additional Funds Needed (AFN) 5,088 - 4,421 = 667
b. The financial staff of Lewis Company, after considering all of the relevant factors,
decided on the following financing mix to raise the additionally needed fund:
SOURCE OF CAPITAL PERCENTAGE AMOUNT AFN from each source
OF NEW CAPITAL
Notes payable 25% 166.75
Long-term debt 25 166.75
Common stock 50 333.5
Total 100% 667
c. Given target current ratio of 2.3 and target debt ratio of 405, the Increase in notes
payable will be $50.60; increase in Long-term Debt becomes $248.60 and Increase
in C/S $367.80 which will be computed as follows.
����� ������ ������ 1,248
������� ����� = = 2.3 =
����� ������� ����������� ����� ������� �����������
1,248
����� ������� ����������� = = 542.60
2.3
����� ������� ����������� = �������� + �������� ������� + ����� �������
192 + 48 + ����� ������� = 542.60
����� ������� = 542.60 − 240
����� ������� = 302.60
���������� ����� ������� = 302.60 − 252 = $50.60

����� ���� ����� ����

���� ����� = = = . 40
����� ������ 5,088
����� ���� = . 40 × 5,088 = 2,035.20
����� ���� = ����� ������� ����������� + ���� ���� ����
2,035.20 = 542.60 + ���� ���� ����
���� ���� ���� = 1,492.60
���������� ���� ���� ���� = 1,492.60 − 1,244 = 248.60
��� = ���������� ����� ������� + ���������� ���� ���� ���� + ���������� ������ �����
��� = 50.60 + 248.60 + ���������� ������ �����
���������� ������ ����� = ��� − 299.20 = 367.80