CHAPTER 14

FINACIAL FORECASTING
Prepared by: FAITH B. CALUNOD

ROLES OF FINANCIAL MANAGEMENT

Financial Management focuses on the objectives of financial management and all of the activities in the
planning cycle which work to achieve these objectives.
 It is about planning, organizing, and controlling the financial resources of a business.
 It is also concerned with the proper specification of the financial goals of the firm as well as the
measurement of performance relative to the achievement of these objectives.

OBJECTIVES OF THE FIRM

1. Financial Goals
 refer to shareholder wealth maximization through profit maximization
2. Social and Community Goals
 Pertain to providing benefits to its community through pollution control, equitable hiring practices
and fair trade and pricing standards.

WHAT TO DO TO OPERATIONALIZE THESE OBEJECTIVES?

1. PLAN
2. IMPLEMENT
3. CONTROL

To carry out these managerial decisions, accounting data must be generated, converted to information and
used to achieve the objective.

A CPA who is engaged in Management consultancy services may be in forefront or best positions to
providing advisory services relative to financial management particularly in the following areas:

1. Financial Analysis
2. Financial Forecasting
3. Working Capital Management and Financing Decisions
4. Capital Budgeting and Financing Decisions
5. Dividend Policy and External Growth through mergers and acquisition

NATURE OF FINANCIAL FORECASTING

Financial forecasting is simply a financial plan or budget for your business.

 It is an estimate of two essential future financial outcomes for a business – your projected
 income and expenses.
 It is also a way to let the company or firm think of the events before they occur and prepares for
it, particularly the need for raising funds.

Characteristics of Financial Forecasting

1. Incrementality- all benefits expense and investments that will change as a result of the decision
should be included in financial forecast. Example: Cost of additional support staff like an engineer to
support the product.

2. Working Capital Investments-investment is an exposure of cash that has the objective of

producing cash flow benefits in the future.

3. Economics and Pricing-financial forecasting should reflect current product prices and operating
cost. The company should never rely on higher future selling prices to justify current investments.

4. Accounting Rules-financial forecast should respect the accounting rules and practices that will
govern the company’s reporting over the period for which the forecast is made.

5. External Financing-cash flow forecasts should assume that the investments will be all cash , and
the investments should be included in the forecast at the point when the commitments to acquire
assets are made.

6.Financial Forecast Time Frame-financial forecast should provide a maximum of 5 years of cash
inflows.

Three Problems with Relying on Forecast

1.Faulty data
2.Unexpected events
3.Integrating Impact

Disadvantages of Using Financial Forecast

1.The data is going to be old.
2.It is impossible to factor in unique or unexpected events or externalities
3.Forecast can’t integrate their own impact.

STEPS IN FINANCIAL FORECASTING

Any forecast of financial management will involve the determination of

1. How much money will the firm need during a given period?
2. How much money will the firm generate internally or through operations during the same period?
3. How much additional funds or external financing will be required?
These are the different steps needed to accomplish financial requirements:
 Establish a base year
 Asses revenue and expenditure growth trends
 Clearly specify underlying assumptions
 Select a forecasting method
 Asses the reliability and validity of the data used to determine assumptions.
 Monitor actual revenue and expenditure levels against the forecast and explain variances
 Update the forecast based on changes

Projected Financial Statement Method

 Projected financial statement method is a summary of various component projections of

revenues and expenses for the budget period.
 They indicate the expected net income for the period.
 It is an important tool in determining the overall performance of a company. They include
the balance sheet, income statement and cash flow statements to indicate the company performance.

STEPS IN PROJECTED FINANCIAL STATEMENTS :

Step 1. Forecast the Income Statement or Statement of Comprehensive Income
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding production cost, direct
materials, direct labor, and overhead.
c. Estimates selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.

Step 2. Forecast the Balance Sheet or Statement of Financial Position

a. Project the assets that will be needed to support projected sales
b. Project funds that will be spontaneously generated (through accounts payable and accruals)
and by retained earnings.
c. Project liability and shareholders’ equity accounts that will not rise spontaneously with sales
(e.g. notes payable, long-term bonds, preference shares and ordinary shares) but may change due
to financing decisions that will be made later.
d. Determine if additional funds will be needed by using the following formula

Additional Funds = Required Increase - Spontaneous - Increase in

Needed (AFN) in Assets Increase in Liabilities Retained Earnings
(RIA) (SIL) (IRE)
Where:

RIA = Change in sales x Current assets (present)

Sales (present)

SIL = Change in sales x Current liabilities (present)

 Sales (present

IRE = Earnings after taxes - Dividend Payment

The AFN will be raised by borrowing from the bank as notes payable, by issuing long-term bonds, by
selling new ordinary shares or by some combinations of these actions.

Step 3.Raising the AFN

The financing decision will consider the following factors:
(1) Target capital structure
(2) Effect of short-term borrowing in its current ratio
(3) Conditions in the debt and equity markets, or
(4) Restrictions imposed by existing debt agreements.

Step 4.Consider Financing Feedbacks

Depending on whether additional funds will be borrowed or will be raised through ordinary shares,
consideration should be given on additional interest expense in the Income Statement, thus
decreasing the retained earnings.
Apply the iteration process using the available financing mix until the AFN would become so small
that the forecast can be considered complete.

Illustrative Case I. Financial Forecasting ( Percent of Sales Method)

The Elixir Company has the following statements which are representative of the company’s historical
average.

Statement of Comprehensive Income

Sales P6,000,000
Cost of Sales 3,600,000
Gross Profit 2,400,000
Operating Expenses 1,140,000
EBIT 1,260,000
Interest Expense 210,000
Earning before taxes 1,050,000
Taxes (35%) 367,500
Earnings after taxes P 682,500

Dividends P 409,500
Statement of Financial Position

Assets
 Cash P 150,000
Accounts Receivable 1,200,000
Inventory 2,250,000
Current Assets P 3,600,000
Fixed Assets (net) 2,400,000
Total assets 6,000,000

Liabilities and Equity

Accounts payable P 750,000

Accrued wages 30,000
Accrued taxes 60,000
Current liabilities P 840,000
Note payable-bank 210,000
Long-term debt 450,000
Ordinary shares 3,600,000
Retained earnings 900,000
Total Liabilities and equity P 6,000,000

The firm is expecting a 20 percent increase in sales next year, and management is concerned about the
company’s need for external funds. The increase in sales is expected to be carried out without any
expansion of fixed assets, but rather through more efficient asset utilization in the existing store. Among
liabilities, only current liabilities vary directly with sales.

Using the percentage-of-sales method, determine whether the company has external financing needs or a
surplus of funds.

SOLUTION:

STEP 1. Project the statement of Comprehensive Income

The projected income statement will show the following:

Sales P 7,200,000
Cost of Sales 4,320,000
Gross Profit 2,880,000
Operating Expenses 1,368,000
EBIT 1,512,000
Interest Expense 210,000
Earnings before taxes 1,302,000
Taxes (35%) 455,700
Earnings after taxes P 846,300

Dividends (36% payment) P 304,800

STEP 2. Project the Statement of Financial Position.

The projected statement of financial position will show the following:

Assets

Cash (1) P 180,000

Accounts Receivable (2) 1,440,000
Inventory (3) 2,700,000
Total current assets P 4,320,000
Fixed assets (net) (4) 2,400,000
Total assets P 6,720,000

Liabilities and Equity

Accounts payable (5) P 900,000

Accrued wages (6) 36,000

Accrued taxes (7) 72,000

Current liabilities P 1,008,000
Notes payable-bank (4) 210,000
Long-term debt (4) 450,000
Ordinary shares (4) 3,600,000
Retained earnings (8) 1,441,500
Total P 6,709,500
Additional Financing needed 10,500*
Total P 6,720,000
Supporting computations:

(1) Cash = 2.5% x P7.2M sales

(2) Accounts receivable = 20% of P7.2M
(3) Inventory = 37.5% x P7.2M
(4) No percentage are computed for fixed assets, notes payable, long-term debt, ordinary shares and
retained earnings because they are not assumed to maintain a direct relationship with sales volume. For
simplicity, depreciation is not explicitly included.
(5) Accounts payable = 12.5% of P7.2M
(6) Accrued expenses = 0.5% of P7.2M

(7) Accrued taxes = 1% of P7.2M

(8) Retained earnings = P900,000 + P846,300 - P304,800

*****
AFN = [ ( S) (CAP) ( S) (CLP) (EAT - DP) ]
SP SP

= [ (1.2M) (3.6M) (1.2M) (840K) (846.3K - 304.8K) ]

(6M) (6M)

= 720,000 - 168,000 - 541,500

AFN = P10,500

Illustrative Case II. Projected Financial Statement with Financial Feedback

For Guyabano Company, the following data have been made available:

Guyabano Company
Statement of Comprehensive Income
Year 2019
(Thousands of Pesos)

Sales P 18,000
Operating costs ( inclusive of P600 depreciation) 16,296
EBIT 1,704
Less Interest expense 528
Earnings before taxes 1,176
Taxes (40%) 471
Net income before preference dividend 705
Dividends to preference 24
Net income available to ordinary shares 681
Dividends to ordinary shares

Addition to RE P342

Guyabano Company
Statement of Financial Position
December 31, 2019
(Thousands of Pesos)

Assets

Cash P 60
Accounts Receivable 2,250
Inventories 3,690
Total Current assets 6,000
Net plant and equipment 6,000
Total assets P12,000

Liabilities and Equity

Accounts payable P 360

Notes payable 660
Accruals 840
Total current liabilities 1,860
Long-term bonds 4,524
Total liabilities P 6,384

Preference share 240

Ordinary shares (150,000 shares) 780
Retained earnings 4,596
Total equity P5,616
Total liabilities and equity P 12,000
Additional information follows:

1. Historical costs for the last five years ( in Thousand Pesos)

YEAR Sales
2015 12,384
2016 15,204
2017 14,382
2018 17,100
2019 18,000
2020 19,800 (projected*)
2. Assets and spontaneous liabilities will increase by 10%.
3. Ordinary shares outstanding, 150,000.
4. Ordinary share dividends are projected at P7.20 per share.
5. Market value per share at the end of 2019 is 140,000.

Required:

1. Construct the pro forma financial statements using the projected financial statement method. How much
additional capital will be required? Assume the firm operated at full capacity in year 2019. Do not include
financing feedback.

SOLUTION:
1. Based on the data and assumptions given, the ff projections are made and the additional financing
needed determined.

Figure14.1
Projected Statement of Comprehensive Income (First Pass)
(Thousands of Pesos)

2019 2020 Forecast

Actual Basis First Pass

Sales P 18,000 x 110% P 19,800
Operating costs(inclusive P 16,296 x 110% 17,925
of P600 depreciation)
EBIT 1,704 x 110% 1,875
Less Interest expense 528 528
Earnings before taxes 1,176 1,347
Taxes (40%) 471 540
NI before PD 705 807
Dividends to PS 24 24
NI available to OS P 681 P 783
Dividends to ordinary 348 375
Addition to RE 408
Discussion:

Figure 14.1 shows Guyabano’s actual 2019 and forecasted 2020 statement of comprehensive income. For
year 2020 EBIT are projected at P1,875,000 and earnings after taxes of P807,000. Dividends to preference
shares and ordinary shares are projected at P24,000 and P375,000, respectively.

Figure 14.2

Projected Statement of Financial Position (First pass)

(Thousands of pesos)

2019 2020 Forecast

Actual Basis First Pass
Assets
Cash P 60 x 110% P 66
Accounts receivable 2,250 x 110% 2,475
Inventories 3,690 x 110% 4,059
Total current assets P 6,000 P 6,600
Net plant and 6,000 x 110% 6,600
equipment
Total assets 12,000 13,200

Liabilities and Equity

Accounts payable P 360 x 110% P 396
Notes payable 660 660
Accruals 840 x 110% 924
Total current liab P 1,860 1,980
Long-term bonds 4,524 4,524
Total liabilities 6,384 P 6,504

Preference Shares P 240 P 240

Ordinary shares & 780 780
APIC (150,000 shares)
Retained earnings 4,596 + 408 5,004
Total Equity P 5,616 P 6,024
Total Liab. and Equity P 12,000 P 12,528

AFN P672
Cumulative AFN P672
Discussion:

Figure 14.2 contains Guyabano’s 2019 actual and its projected 2020 statement of financial position. Total
assets are projected at P13,200,000 while the forecasted liability and equity accounts total to only
P12,528,000. Since the resources or assets required to support the higher sales level exceed the available
sources, it means that additional funds will have to be obtained.

The AFN of P672,000 will be raised by borrowing from the bank as notes payable or by issuing long-term
bonds or by selling new ordinary shares, or by some combination of theses actions.

II. Assume that after considering all the relevant factors, Guyabano decided on the following funds
financing mix to raise AFN of P672,000:

Percent Amount Interest rate

Notes payable 25% P 168,000 8%
Long-term debt 25 168,000 10%
Ordinary share* 50 336,000 -
Total 100 P 672,000

*2,400 shares

Construct the proforma statement of comprehensive income and statement of financial position to
incorporate the financing feedback which results from adopting the financing mix given above.

SOLUTION

Figure 14.3

Projected Statement of Comprehensive Income (Second Pass)

For 2020

2019 2020 Forecast

ACTUAL FIRST PASS FEEDBACK SECOND PASS
Sales P18,000 P19,800 P19,800
Operating costs 16,296 17,925 17,925
(inclusive of P600
depreciation)
EBIT 1,704 1,875 1,875
Less Interest 528 528 +30 558
Expense
Earnings before 1,176 1,347 1,317
taxes
Taxes (40%) 471 540 -12 528
Net Income before 705 807 789
preference
dividend
Dividends to 24 24 24
Preference
NI available to P681 P783 P765
orinary
Dividends to 342 375 +18 393
ordinary
Addition to RE 408 372

Figure 14.4

Projected Statement of Financial Position (Second Pass)

(Thousands of Pesos)

2019 2020 Forecast

Actual First Pass Feedback Second Pass
Assets
Cash P 60 P 66 P 66
Accounts receivable 2,250 2,475 2,475
Total current assets 3,690 4,059 4,059
Net plant and equipment P6,000 P 6,600 P 6,600
Total assets 6,000 6,600 6,600
P12,000 13,200 13,200

Liabilities and Equity

Accounts payable 360 P 396 P 396
Notes payable 660 660 +168 828
Accruals 840 924 924
Total CL P 1,860 1,980 P 2,148
Long-term bonds 4,524 4,524 +168 4,692
Total Liabilities P6,834 P 6,504 P 6,840

Preference shares P240 P 240 P 240

Ordinary shares & APIC 780 780 +336 1,116
(150,000 shares)
RE 4,596 5,004 4,968
Total Equity P5,616 P 6,024 P 6,324
Total Liabilities and Equity P12,000 P 12,528 P 13,164
 AFN P 36
Cumulative AFN P 708

In Figure 14.4 the second pass 2020 Statement of Financial position shows that a shortfall of P36,000 will
still exist as a result of financing feedback effects due to the additional interest (net of taxes) and dividends
payment that reduced the projected retained earnings. This amount raises the cumulative AFN from
P672,000 to P708,000.

If additional iterations are done (ie. 3rd, 4th, 5th, etc.), the additional financing needed would become smaller
and smaller until the forecast would be considered to be completed.

Analysis of the forecast

Next year’s forecast as developed above is only the first part of total forecasting process. Forecasting is an
iterative process, both in the way financial statements are generated an in the way financial plan is
developed. For planning purposes, the consultant or financial staff develops a preliminary forecast based
on a combination of past policies and trends. This will serve as starting point or “base line” forecast. The
model is the modified to see what effects alternative operating plans would have on the firm’s earnings
and financial condition. Likewise, alternative operating plans are examined under different sales growth
rate scenarios and linked to the firm’s dividend policy and capital structure decisions. The revised forecast
or model can also be used to analyze alternative working capital policies.