CHAPTER 9

FINANCIAL FORECASTING FOR STRATEGIC GROWTH

WHAT IS FINANCIAL PLANNING?
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. Many
decisions have a long lead time which mean they take long time to implement.
GROWTH AS FINANCIAL MANAGEMENT GOAL
The appropriate goal is for the financial manager is increasing the market value of
the owners’ equity and not just growth by itself. If the firm is successful doing this,
then growth will usually result.
PERSPECTIVE OF FINANCIAL PLANNING
The short run planning usually covers the coming 12 months while financial
planning over the long-run is takes to be coming two to five years. This time period
is referred to as the planning horizon and this is the first dimension of the planning
process that must be established.
The second dimension of the planning process that needs to be determined is the
level of aggregation. Aggregation involves the determination of all of the
individuals projects together with the investment required that the firm will
undertake and adding in these investments proposals to determine the total
needed investment which is treated as one big project.
After the planning horizon and level of aggregation are established, a financial plan
requires inputs in the form of alternative sets of assumptions about important
variables. This type of planning is particularly important for cyclical businesses or
business firms whose sales are strongly affected by the overall state of the
economy or business cycles.
WHAT ARE THE BENEFITS THAT CAN BE DERIVED FROM FINANCIAL PLANNING?
1. Provides a rational way of planning options or alternatives.
The financial plan allows the firm to develop, analyze and compare many
different business scenarios in an organized and consisted way. Various
 investment and financing options can be explored, and their impact on the
firm’s shareholders can evaluated.
2. Interactions or linkages between investment proposals are carefully
examined.
The financial plan enables the proponents to show explicitly the linkages
between investment proposals for the different operating activities of the firm
and its available financing choices.
3. Possible problems related to the proposal projects are identified actions to
address them are studied.
Financial planning should identify what may happen to the firm if different
events take place. Specifically, it should address what actions the firm will take
if expectations do not materialize and more generally, if assumptions made
today about the future are seriously in error. Thus, on objective of financial
planning is to avoid surprises and contingency plans.
4. Feasibility and internal consistency are ensured.
Financial planning is a way of verifying that the goals and plans made for specific
areas of firm’s operations are feasible and internally consistent. The financial
plan makes explicit the linkages between different aspects of firm’s business
such as the market share, return on equity, financial leverages, and so on. It also
imposes a unified structure for reconciling goals and objectives
5. Managers are forced to thing about goals and establish priorities.
Through financial planning, directions that the firm would take are established,
risks are calculated and educated alternative courses of action are considered
thoroughly.
FINANCIAL PLANNING MODELS
Financial planning process will differ from firm to firm, just as companies differ in
size and products. However, a basic financial planning model will have the following
common elements; (a) economic environment assumptions, (b) sales forecast, (c)
pro forma statements, (d) asset requirements, (e) financial requirement, and (f)
additional funds need.
1. Economic Environment Assumption. The plan will have to state explicitly the
economic environment in which the firm expects to reside over the life of
the plan. Among the more important economic assumption that will have to
be made are the inflation rates, level of interest rates and the firm’s tax rate.
2. Sales Forecast. An externally supplied sales forecast considered the “driver”
shall be the “heart” of all financial plans. The user of the planning model will
supply this value and most other values will be calculated based on it.
Planning will focus on projected future sales and the assets and financing
needed to support those sales.
3. Pro forma Statements. A financial plan will have a forecast statement of
financial position, income statement, statement of cash flows and statement
of stockholders’ equity.
4. Asset requirements. The financial plan will describe projected capital
spending. At a minimum, the projected statement of financial position will
contain changes in total fixed assets and net working capital. These changes
are effectively the firm’s total capital budget. Proposed capital spending in
different areas must thus be reconciled with the overall increases contained
in the long-range plan.
5. Financial requirements. The financial plan will include a section about the
necessary financing arrangements. This part of the plan should discuss
dividend policy and debt policy. Sometimes firms will expect to raise cash be
selling new shares of stock or by borrowing.
6. Additional Funds Needed. After the firm has a sales forecast and an estimate
of the required spending on assets, some amount of new financing will often
be necessary because projected total assets will exceed projected total
liabilities and equity. In other words, the statement of financial position will
no longer balance.
FINANCIAL PLANNING PROCESS
The planning process begins with a sales forecast for the next five or so years.
Then the assets required to meet the sales targets are determined, and decision
is made concerning how to finance the required assets. At that point. Income
statements and statements of financial position can be projected, and earnings
per share, as well as the key ratios can be forecasted.
THE PROJECTED FINANCIAL STATEMENT METHOD
Forecast of financial requirements involves (a) determining how much money
the firm will need during a given period, (b) determining how much money the
firm will generate internally during the same period, and (c) subtracting the
finds generated form the funds required to determine the external financial
requirement
The projected financial statement method is straightforward, one simply
projects the asset requirements for the coming period, then projects the
liabilities and equity that will be generated under normal operations, and
subtracts the projected liabilities/capital from the required assets to estimate
the additional funds needed (AFN).
Steps in the procedures
Step 1. Forecast the Income statement
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding
production costs; direct material, direct labor and overhead.
c. Estimate selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.
Step 2. Forecast the Statement of Financial Position.
a. Project the assets that will be needed to support projected sales.
b. Project funds that will be spontaneously generated (though accounts
payable and accruals) and by retained earnings.
c. Project liability and stockholders’ equity accounts that will not rise
spontaneously with sales (e.g., notes payable, long-term bonds,
preferred stock and common stock) 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 Required Spontaneous Increase In
Funds = Increase In - Increase In - Retained
Needed Assets Liabilities Earnings

Step 3. Raising the additional funds needed.

The financing decision will consider the following factors:
a. Target capital structure;
b. Effect of short-term borrowing on its current ratio;
c. Conditions in the debt and equity markets; or
d. Restrictions imposed by existing debt agreements.
Step 4. Consider financing feedbacks.
Depending on whether additional funds will be borrowed or will be raised
through common stocks, consideration should be given on additional
interest expense in the income statement or dividends, thus decreasing
the retained earnings.
Apply the iteration process using the available financing mix until the AFN
would become so small that forecast can be considered complete

Illustrative Case 9-1. Financial Forecasting (Percent of Sales Method)

The millennium Company has the following statements which are
representative of company’s historical average
Income Statement
Sales ₱ 2,000,000
Cost of Sales 1,200,000
Gross profit 800,000
Operating expenses 380,000
Earnings before interest and taxes 420,000
Interest expense 70,000
Earnings before taxes 350,000
Taxes (35%) 122,500
Earnings after taxes ₱ 227,500
 Dividends ₱ 136,500

Statement of Financial Position

Assets
Cash ₱ 50,000
Accounts receivable 400,000
Inventory 750,000
Current Assets ₱ 1,200,000
Fixed assets (net) 800,000
Total assets ₱ 2,000,000

Liabilities and Equity

Accounts payable ₱ 250,000
Accrued wages 10,000
Accrued taxes 20,000
Current liabilities ₱ 280,000
Notes payable – bank 70,000
Long-term debt 150,000
Ordinary shares 1,200,000
Retained earnings 300,000
Total liabilities and equity ₱ 2,000,000

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 with sales.
Using the percent-of-sales method, determine whether the company has external
financing need or a surplus of funds
SOLUTION:
STEP 1. FORECAST THE INCOME STATEMENT
 Income Statement
Sales ₱ 2,400,000
Cost of Sales 1,440,000
Gross profit 960,000
Operating expenses 456,000
Earnings before interest and taxes 504,000
Interest expense 70,000
Earnings before taxes 434,000
Taxes (35%) 151,900
Earnings after taxes ₱ 282,100

Dividends ₱ 101,600

STEP 2. FORECAST THE STATEMENT OF FINANCIAL POSITION

Statement of Financial Position

Assets
Cash (1) ₱ 60,000
Accounts receivable (2) 480,000
Inventory (3) 900,000
Current Assets ₱ 1,440,000
Fixed assets (net) (4) 800,000
Total assets ₱ 2,240,000

Liabilities and Equity

Accounts payable (5) ₱ 300,000
Accrued wages (6) 12,000
Accrued taxes (7) 24,000
Current liabilities ₱ 336,000
Notes payable – bank (4) 70,000
Long-term debt (4) 150,000
Ordinary shares (4) 1,200,000
Retained earnings (8) 480,500
Total ₱ 2,236,500
Additional financing required 3,500
Total 2,240,000
Supporting computations:
(1) Cash = 2.5% x 2.4M sales
(2) Accounts Receivable = 20% of 2.4M
(3) Inventory = 37.5% of 2.4M
(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 considered.
(5) Accounts payable = 12.5% x 2.4M
(6) Accrued expenses = 0.5% of 2.4M
(7) Accrued taxes = 1% of 2.4M
(8) Retained earnings = 300,000 + 282,100 – 101,600
Formula Method
*Additional financing needed (AFN) may also be computed as follows:
Additional Required Spontaneous Increase In
Funds = Increase In - Increase In - Retained
Needed Assets Liabilities Earnings

Where:
Required Current Assets (Present)
= Change in sales x
Increase in assets Sales (Present)

Spontaneous Current Liabilities (Present)

increase in = Change in sales x
liabilities Sales (Present)

Increase in Earnings after

= - Dividend payment
retained earnings taxes

Applied to Millennium Co., AFN is computed as follows:

 1,200,000 280,000
𝐴𝐹𝑁 = (400,000 𝑥 ) − (400,000 𝑥 ) − 282,100 − 101,600
2,000,000 2,000,000

= 240 – 56,000 – 180,500

= 3,500