Chapter 5
Financial Forecasting & Planning
14-1
Chapter Outline
I. Financial forecasting Vs Financial Planning
II. Importance of sales forecasting
III. The financial planning process
IV. Methods of forecasting financial statements
• Percentage of sales method
• Pro-forma financial statement method
V. The EFR (External Fund Required( Formula
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Financial planning
Definition - Financial planning is a process consisting of:
1. Analyzing the investment and financing choices open to
the firm.
2. Projecting the future consequences of current decisions.
3. Deciding which alternatives to undertake.
4. Measuring subsequent performance against the goals set
forth in the financial plan.
02-3
Financial planning
Components of a Financial Planning Model
Inputs. The inputs to the financial plan consist of the firm’s
current financial statements and its forecasts about the future.
The Planning Model. The financial planning model calculates
the implications of the manager’s forecasts for profits, new
investment, and financing. The model consists of equations
relating output variables to forecasts. For example, the
equations can show how a change in sales is likely to affect
costs, working capital, fixed assets, and financing
requirements.
02-4
Financial planning
Components of a Financial Planning Model
Outputs. The output of the financial model consists of
financial statements such as income statements, balance
sheets, and statements describing sources and uses of cash.
These statements are called pro formas, which means that
they are forecasts based on the inputs and the assumptions
built into the plan.
02-5
Financial planning
Components of a Financial Planning Model
Outputs. The output of the financial model consists of
financial statements such as income statements, balance
sheets, and statements describing sources and uses of cash.
These statements are called pro formas, which means that
they are forecasts based on the inputs and the assumptions
built into the plan.
02-6
Financial planning
The Purpose of Planning and Plan Information
The Planning Process: The planning process can pull a management
team into a cohesive unit with common goals.
A Road Map for Running the Business: A business plan functions as
a road map for getting an organization to its goal.
A Statement of Goals: A business plan is a projection of the future
that generally reflects what management would like to see happen.
Predicting Financing Needs: Financial planning is extremely
important for companies that rely on outside financing.
Communicating Information to Investors: A business plan is
management’s statement about what the company is going to be in
the future, and can be used to communicate those ideas to
investors.
02-7
Financial planning
Financial Planning vs Financial Forecasting
Financial forecasting is the process of identifying the
opportunities in the future in terms of market size,
customer base, or business strategies. Forecasting involves
making projections about what will happen in the future. As
a process, financial forecasting involves estimating future
business performance. It provides information of the
organization’s future revenues and costs that is needed by
management to project financing requirements. The
“future” is the planning period that could be short-term
(one or less), medium term (3-5 years), or long-term (over
five years).
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Financial planning
Financial Planning vs Financial Forecasting
Some argue that financial planning and financial forecasting
are one and the same. However, financial forecasting is the
basis for financial planning. Financial planning is done
effectively through financial forecasting.
Financial planning is not just forecasting. Forecasting
concentrates on the most likely future outcome. But
financial planners are not concerned solely with forecasting.
They need to worry about unlikely events as well as likely
ones.
02-9
Financial planning
Financial Forecasting Procedures
The following procedures may be used in predicting the future
(financial forecasting).
1. Projection of Organization’s sales revenues -Financial
forecasting begins with sales forecast.
2. Estimation of the level of investments in current assets and
fixed assets
3. Determination of the organization’s financing needs &
sources of funds
4. Preparing pro forma or forecasted financial statements,
namely, pro forma income statement, pro forma balance
sheet, and cash budget.
02-10
The Percentage-of-Sales Model
02-11
The Percentage-of-Sales Model
02-12
The Percentage-of-Sales Model
02-13
The Percentage-of-Sales Model
Example
Top Company has prepared the following Balance Sheet and Income
Statement for the year ended December 31, 2005.
Assets Liabilities and Stockholders’ Equity
Cash 175,000 A/P 140,000
A/R 150,000 Accrued liabilities 150,000
Inventory 800,000 Mortgage N/P 1,410,000
Plant Assets, Net 1,500,000 Common Stock 800,000
Retained earnings 125,000
Total 2,625,000 Total 2,625,000
Sales 2500000
Costs and Expenses except depreciation 1,400,000
Depreciation 200,000
Total costs and expenses 1,600,000
Income before taxes 900,000
Taxes (40%) 360,000
Net Income 540,000
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The Percentage-of-Sales Model
• Additional Information
The company plans to have dividend payout ratio of 45%
Sales are expected to increase by 25% during next year (2006).
All assets are affected by sales proportionately. Accounts Payable
and accrued liabilities are also affected by sales.
All expenses are directly proportional to sales
The firm has been operating at full capacity.
The company has no preferred stock.
Assume that additional funds needed would be financed from
bond issue and common stock in 40% and 60% respectively.
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The Percentage-of-Sales Model
02-16
The Percentage-of-Sales Model
02-17
The Percentage-of-Sales Model
02-18
The Percentage-of-Sales Model
Compiled by Andualem 02-19
The Percentage-of-Sales Model
02-20
The Percentage-of-Sales Model
Determinants of External Capital (Fund) Requirements
1. Sales growth rate
• The higher the sales growth rate, the greater the need for external capital
and vice versa
• The financial feasibility of the expansion plans should be reconsidered if
the company expects difficulties in raising the required capital.
2. Dividend payout ratio
• The higher the payout ratio, the greater the need for external capital
requirement
• Management should balance between internally generated funds (by
reducing payout ratio) and the need for increasing stock price because
divided policy affects stock price.
3. Capital intensity
• Capital intensity refers to the amount of asset required per Birr of sales
• Capital intensity Ratio = Assets/ Sales
• The lower capital intensity ratio, the lower the need for external capital
02-21
The Percentage-of-Sales Model
Excess capacity Adjustments
The assumption of constant ratio between assets and sales may
not always hold true. In that case, the percentage of sales model
or Additional Funds Needed model is not appropriate.
What are the conditions under which constant ratios are not
maintained between asset, and sales?
1. Economies of scale
Economies of scale imply that as a plant gets larger and volume
increases, the average cost per unit of output drops. This is
particularly due to lower operating and capital cost. A piece of
equipment with twice that capacity of another piece typically
does not cost twice as much to purchase or operate. Plants also
gain efficiencies when they become large enough to fully utilize
dedicated resources for tasks such as materials handling,
computer equipment, and administrative support personnel.
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The Percentage-of-Sales Model
Excess capacity Adjustments …
2. Lumpy asset increments
Lumpy assets are assets that cannot be acquired in small
increments, but must be obtained (added) in large, discrete units.
Suppose, if we obtained that Br. 25,000 is needed for additional
investment in fixed assets, it may be difficult to get fixed assets
that exactly cost Br. 25,000. The minimum prices for the lowest
capacity fixed asset may be Br. 45,000. Thus, if you decided to
make additional investment in fixed assets, you need to purchase
fixed assets of Br. 45,000 instead of Br. 25,000.
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The Percentage-of-Sales Model
Excess capacity Adjustments …
3. Excess assets due to forecasting errors.
Actual assets to sales ratio may be different from planed ratio
because actual sales may be different from planed sales. Actual
assets may be different from planned assets. Excess capacity may
occur plant assets and inventories.
When excess capacity exists, sales can grow to the full capacity
sales with no increase whatever in fixed assets. However, beyond
full capacity sales, increase in sales requires increase in assets.
The following steps may be used in determining additional
investments in fixed assets in excess capacity situation.
02-24
The Percentage-of-Sales Model
02-25
The Percentage-of-Sales Model
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The Percentage-of-Sales Model
• Increase in sales without increase in Fixed Assets (FA)
= Full capacity sales – current sales = 1,250,000 – 1,000,000 = 250,000
• Required level of FA = (TFA to sales ratio) x (projected sales)
= 0.48 x 1,400,000 = 672,000
• Additional Investment in FA = (1,400,000 – 1,250,000) x 0.48 = 72,000
• Increase in Current assets = 0.15 x 400,000 = 60,000
• Spontaneously generated funds= 0.09 x 400,000 = 36,000
• Internally generated funds = M (S1) (1-d) = 0.10(1,400,000) (1 –0.60)
= 56,000
• AFN = (72,000 + 60,000) – (36,000 + 56,000)
= 132,000 – 92,000 = 40,000
02-27
The Pro-forma Financial Statement Method
• Refer Cost and Management Accounting – Master Budget
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