FINANCIAL PLANNING AND

FORECASTING

Prof. Prapti Paul

INTRODUCTION

 While historical evaluation is important, anticipating what is

likely to happen in the future is even more important.

 Financial manager prepares pro forma, or projected financial

statements to :
(a) assess whether the firm’s forecasted performance squares
with its own targets and with the expectation of investors,
(b) examine the effect of proposed operating changes,
(c) anticipate the financing needs of the firm, and
(d) estimate the future free cash flows that determine the firm’s
value.
 THE PLANNING SYSTEM

 Financial planning is part of a larger planning system in the firm. The

planning process starts with the statement of the firm’s goal or mission,
which is usually stated in qualitative terms. Ex: mission statement of
Ranbaxy Laboratories is :’ to be a research oriented international
pharmaceutical company”. From the mission of the firm the strategy is
derived which defines the products and services the firm will produce and
the markets it will serve. To support the strategy, policies and budgets are
developed in various areas such as research and development, production,
marketing, personnel, and finance. These then get translated into the
financial plan.
 FINANCIAL PLANNING
 A long term financial plan represents a blue print of what a firm
proposes to do in the future. Typically it covers a period of 3 to 10
years. Planning over such a an extended time horizon tends to be in
fairly aggregative terms.
 Common elements of a corporate financial plan:
1. Economic assumptions: FP is based on certain assumptions
about eco. environment( interest rate, inflation rate, growth rate,
exchange rate and so on).
2. Sales forecast: it’s the starting point of the financial forecasting
exercise. Most financial variables are related to the sales figure.
3. Pro forma statements: heart of FP are pro forma (forecast) profit
and loss account and balance sheet.
4. Asset requirements: FP spells out projected capital investments
and WC requirements over time.
5. Financing plan: the FP delineates the proposed means of
financing.
6. Cash budget: shows the inflows and outflows expected in the
budget period.
BENEFITS OF FINANCIAL PLANNING
 Indentifies advance actions to be taken in various areas.
 Seeks to develop a no. of options in various areas that can be
exercised under different conditions.
 Facilitates a systematic exploration of interaction between
investment and financing decisions.
 Clarifies the links between present and future decisions.
 Forecasts what is likely to happen in future and hence helps avoid
surprises.
 Ensures that the strategic plan of the firm is financially viable.
 Provides benchmarks against which future performance may be
measured.
 SALES FORECAST
 Starting point of the financial forecasting exercise. Most of the
financial variables are projected in relation to the estimated level of
sales. Hence accuracy of the financial forecast depends critically on
the accuracy of the sales forecast.
 Sales forecast maybe prepared for varying planning horizons to
serve different purposes. A SF for a period of 3-5 years, or for
longer durations maybe developed mainly to aid investment
planning. A SF for a period of 1 year( or maybe 2 years in some
cases) is the basis for financial forecasting discussed. SF for shorter
durations (6 months, 3 months etc) are prepared for facilitating WC
planning and cash budgeting.
 Sales forecasting techniques can be divided into:
1. Qualitative techniques: rely on the judgement of experts to
translate qualitative info into quantitative estimates.
2. Time series projection methods: generate forecasts on the basis of
an analysis of the past behavior of time series.
3. Casual models: seek to develop forecasts based on cause- effect
relationship expressed in explicit, quantitative manner.
 PRO FORMA PROFIT AND LOSS ACCOUNT
 2 commonly methods used: 1) percent of sales 2) budgeted expense.

 Percent of sales method: this method assumes that the future

relationship between various elements of costs to sales will be similar to
their historical relationship. When using this method decision has to be
taken about which historical cost ratios to be used: should these ratios
pertain to the prev. year or the avg. of 2 or more prev. years?
 Illustration1: Pro forma Profit and Loss Account for Spaceage Electronics
for 20x3 based on percentage of sales method: (next slide)
 The illustration shows strict application of this method, although in
practice some deviation from a mechanical application of this method is
unavoidable.
 Distribution of earnings between dividends and retained earnings reflect a
managerial policy which is not easily expressible in mechanistic terms.
 20x1 20x2 Avg. %on Pro forma P&L A/c of 20x3
sales assuming sales of 1400

Net sales 1200 1280 100.0 1400.0

COGS 775 837 65.0 910.0
Gross profit 425 443 35.0 490.0
Selling expenses 25 27 2.1 29.4
Administration exp 53 54 4.3 60.2
Depreciation 75 80 6.3 88.2
Operating profit 272 282 22.3 312.2
Non operating surplus/ 30 32 2.5 35.0
deficit
PBIT 302 314 24.8 347.2
Int. on B. loan 60 65 5.0 70.0
Int. on deb 58 60 4.8 67.2
PBT 184 189 15.0 210.0
Tax 82 90 6.9 96.6
PAT 102 99 8.1 113.4
Dividends 60 63
Retained earnings 42 36
 Budgeted expense method: this method calls for estimating
the value of each item on the basis of expected developments in the
future period for which the pro forma profit and loss account is being
prepared. This method requires greater efforts on the part of the
management because it calls for defining likely developments.
 A combination method: a combination of the two methods
described above often works best. For certain items which have a
fairly stable relationship with sales, the percent of sales method is
quite adequate. For other items where future is likely to be very
different from the past, the budgeted expense method which calls for
managerial assessment of expected future developments is eminently
suitable. Illustration (next slide) presents pro forma profit and loss
account for Spaceage Electronics constructed by using a combination
of percent of sales and the budgeted expense method. COGS, selling
expenses and interest on bank loan are assumed to change
proportionally with sales, the proportions being the avg. of the 2
preceding years. All the remaining items have been budgeted on some
specific basis.
 20x1 20x2 Avg. %on Pro forma P&L A/c of 20x3
sales assuming sales of 1400

Net sales 1200 1280 100.0 1400.0

COGS 775 837 65.0 910.0
Gross profit 425 443 35.0 490.0
Selling expenses 25 27 2.1 29.4
Administration exp 53 54 Budgeted 56.0
Depreciation 75 80 Budgeted 85.0
Operating profit 272 282 @ 319.6
Non operating surplus/ 30 32 2.5 35.0
deficit
PBIT 302 314 @ 354.6
Int. on B. loan 60 65 5.0 70.0
Int. on deb 58 60 Budgeted 65.0
PBT 184 189 @ 219.6
Tax 82 90 Budgeted 90.0
PAT 102 99 @ 129.6
Dividends 60 63 Budgeted 70.0
Retained earnings 42 36 @ 59.6

@ These items are obtained using accounting identities.

 PRO FORMA BALANCE SHEET
 The projections of various items on the asset side and liabilities side of the
balance sheet maybe derived as follows:
1. Employ percent of sales method to project the items on the assets side,
except investments and miscellaneous expenditure and loses.
2. Estimate the expected values for investments and miscellaneous
expenditure and losses using specific info applicable to them.
3. Use the percent to sales method to derive projected values of current
liabilities and provisions( referred to as spontaneous liabilities).
4. Obtain the projected value of reserves and surplus by adding the projected
retained earnings ( from the pro forma profit and loss account) to the
reserves and surplus figure of the previous period.
5. Set the projected values for equity and preference capital to be tentatively
equal to their previous values.
6. Assume that the projected values for loan funds will be tentatively equal
to their previous levels less repayments or retirements as per terms and
conditions applicable to them.
7. Compare the total of the assets side with that of the liabilities side and
determine the balancing item( if assets>liabilities then b/fig is external
funds required. If liab>assets then b/fig represents surplus plus available
funds)
 Dec 31, Dec Avg. % of sales or other Proj for Dec 31,
20x1 31,20x2 20x3 on sales of
1400
Net sales 1200 1280 100.0 1400.0

Assets

Fixed assets(net) 800 850 66.5 931

Investments 30 30 No change 30

CA, loans & advances

•Cash and bank 25 28 2.1 29.4
•Receivables 200 212 16.6 232.4
•Inventories 375 380 30.4 425.6
•Pre paid expenses 50 55 4.2 58.8
Miscellaneous expenditure 20 20 No change 20

Total 1500 1575 1727.2

Liabilities

Share capital
•Equity 250 250 No change 250
•Preference 50 50 No change 50
Reserves and surplus 250 286 Pro forma income statement 345.6

Secured loans
•Debentures 400 400 No change 400
•Bank borrowing 300 305 24.4 341.6
Unsecured loans
•Bank borrowings 100 125 9.1 127.4
Current liab and provisions
•Creditors 100 112 8.5 119.0
•Provisions 50 47 3.9 54.6
External fund requirement Balancing figure 39.0

Total 1500 1575 1727.2

The pro forma balance sheet 20x3 is derived as follows:

Item Basis of projection

Current assets Percent of sales method wherein the proportions are based
on the avg. for prev. 2 years.
Fixed assets -----do------

Investments Assumption of no change

Miscellaneous expenditure -----do----

Current liabilities and provisions Percent of sales method wherein the proportions are based
on the avg. for prev. 2 years.
Equity and preference capital Previous values

Reserves and surplus Pro forma profit and loss account

Loan funds Previous value

External funds required Balancing item

CIRCULARITY PROBLEM
 Arises when the pro forma financial statements are prepared
because the profit and loss account and the balance sheet are
inter-related. The pro forma balance sheet cannot be prepared
unless the pro forma profit and loss account, showing the amount
of retained earnings to be carried to the balance sheet is ready. At
the same time, without the pro forma balance sheet, one cannot
figure out the interest expense associated with the amount of
external financing, an item required to prepare the proforma
profit and loss account.
GROWTH AND EXTERNAL FINANCING
REQUIREMENT
 When ratios remain constant, financing requirement maybe
estimated as follows:
EFR= A ( S) – L ( S) –mS1 (1-d) – ( IM+SR) …………..(6.1)
S S
Where EFR= external funds requirement
A/S= current assets and fixed assets as a proportion of sales
S = expected increase in sales
L/S= current liabilities and provisions as % of sales
m = net profit margin
S1= projected sales for next year
d= dividend payout ratio
IM = change in level of investments and miscellaneous
expenditures and losses put together
SR= scheduled repayment of term loans and debentures
 If we assume that the last term on the right hand side of Eqn (6.1) i.e.
( IM +SR) is zero, the EFR is:

EFR=A/S ( S)- L/S ( S) – mS1 (1-d) ……………(6.2)

Manipulating Eqn (6.2):

EFR = A - L – m(1+g) (1-d)
S S S g
 ILLUSTRATIONS:
 The foll info is available for Pioneer Limited: A/S =0.90, S= 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 for the forth coming year? Also find the
relationship between EFR and sales when g(%)= 5, 10, 15, 20, 25.

 (Answer: EFR= 2.08 million; EFR/ S = 0.08,0.28, 0.35, 0.38, 0.42)

 The assets to sales ratio of H Co., Inc is 0.8 and the ratio of spontaneous
liabilities to sales is 0.6 for the present year. Existing sales revenue is
Rs.1,000. the co. follows a retention ratio of 0.4. If the co. plans a 10%
increase in sales without taking recourse to external funds, what will be
the profit margin?
 (Answer: m=4.54%)
 The balance sheet of Z Co. Ltd on 31-3-2001:

Capital 2000000 Fixed assets 1000000

Creditors 280000 Stock 500000
Profit and loss a/c 120000 Debtors 200000
. . Cash and Bank . 700000
2400000 2400000

The purchase and sale estimates for the year 2002 are:
Purchases: Up to 28-2-02, Rs 2820,000 & for March 2002, Rs 220,000
Sales: Up to 28-2-02, Rs 3840,000 & for March 2002, Rs 400,000

The mgt decides to invest Rs 200,000 in purchase of fixed assets which

depreciate @ 10% on cost. The time lag for payment to trade creditors for
purchases and receipts from sales is one month. The business earns a gross
profit of 25% on turnover. The sundry expenses, excluding depreciation
amount, are 10% of the turnover.
Draft pro forma financial statements assuming that creditors are all trade
creditors for purchase and debtors for sale. There is no other item of current
assets and liabilities apart from stock and cash and Bank balance.