Financial Planning and

Forecasting
 What is financial planning ?

 Financial plan is a blueprint of what a

firm proposes to do in future.
 Financial forecasting is the starting
point in financial planning.
 It covers a period of 3-10
years,commonly a period of 5 years.
 Financial planning & forecasting – Why?

 Planning and monitoring own performance

 Satisfying investors expectations
 Assess effect of any proposed changes in
operating/investing/financing actiivties
 Quantify financing need of the firm
 Calculation of future cash flows for firm
valuation
 Elements of a financial plan
 Economic Assumptions – explicit assumptions
about the coming economic environment
 Sales Forecast – many cash flows depend
directly on the level of sales (often estimate
sales growth rate)
 Pro Forma Statements – setting up the plan as
projected (pro forma) financial statements
allows for consistency and ease of
interpretation
 Asset Requirements – the additional assets that
will be required to meet sales projections
 Financial Requirements – the amount of
financing needed to pay for the required assets
 Plug Variable – determined by management
decisions about what type of financing will be
used (makes the balance sheet balance)
 Sales forecast : How ?

 Developing quantitative estimates from qualitative

information

 Time series analysis for developing forecasts

 Technical estimates stated in quantitative terms

 Percent of Sales Approach

 Some items vary directly with sales, others do not.

 Income Statement
 Costs may vary directly with sales - if this is the case,
then the profit margin is constant
 Depreciation and interest expense may not vary directly
with sales – if this is the case, then the profit margin is
not constant
 Dividends are a management decision and generally do
not vary directly with sales – this affects additions to
retained earnings
 Percent of Sales Approach

 Balance Sheet
 Initially assume all assets, including fixed, vary directly
with sales.
 Accounts payable also normally vary directly with sales.
 Notes payable, long-term debt, and equity generally do
not vary with sales because they depend on
management decisions about capital structure.
 The change in the retained earnings portion of equity
will come from the dividend decision.
 External Financing Needed (EFN)
 The difference between the forecasted increase in assets
and the forecasted increase in liabilities and equity.
 Percent of Sales and EFN

External Financing Needed (EFN) can also be

calculated as:

 Assets  Spon Liab

    Sales   ΔSales  ( PM  Projected Sales)  (1  d )
 Sales  Sales
 Income Stt. Balance Sheet

Liabilities Rs.L Assets Rs.L

Rs. L
Equity share
Sales 1200 capital 400Fixed assets 800
R &S 200
COGS 700
Current
Operating expenses 300
Assets 200
Interest 50
LT debt 150
EBT 150
ST debt 150
Tax(40 %) 60
PAT 90 Current
Dividends (30 %) 27 Liabilities 100
Retained earnings 63
Total 1000 1000
 Projected Financial Statements

 Assuming growth rate of 20 % for sales over the last

year & using % sales method…

 Projected financial statements & EFN……

 External Financing and Growth

 At low growth levels, internal financing (retained

earnings) may exceed the required investment in
assets.
 As the growth rate increases, the internal financing
will not be enough, and the firm will have to go to
the capital markets for financing.
 Examining the relationship between growth and
external financing required is a useful tool in
financial planning.
 The Internal Growth Rate

 The internal growth rate tells us how much the

firm can grow assets using retained earnings as the
only source of financing.

ROA  b
Internal Growth Rate 
1 - ROA  b
.132  .667
  .0965
1  .132  .667
 9.65%
 The Sustainable Growth Rate

 The sustainable growth rate tells us how much the

firm can grow by using internally generated funds
and issuing debt to maintain a constant debt ratio.
 Using the Hoffman Co.
 ROE = 66 / 250 = .264
 b = .667

ROE  b
Sustainabl e Growth Rate 
1 - ROE  b
.264  .667
  .214
1  .264  .667
 21.4%
 Determinants of Growth

 Profit margin – operating efficiency

 Total asset turnover – asset use efficiency
 Financial leverage – choice of optimal debt ratio
 Dividend policy – choice of how much to pay to
shareholders versus reinvesting in the firm
 Financial Forecasting and Modelling

 Financial forecasting is an integral part of

financial planning. It uses past data to estimate
the future financial requirements.
 A financial planning model establishes the
relationship between financial variables and
targets, and facilitates the financial forecasting
and planning process.
 A financial planning model has the following
three components:
 Inputs
 Model
 Output
 Constructing Financial Model

 To prepare the next year’s proforma profit and loss

statement, balance sheet and funds flow statement,
the planning team through a consultative process
in the company, made several assumptions and
models about the relationships between financial
variables.
 Based on the model inputs and assumptions, the
planning team developed the model equations for
proforma profit and loss statement, funds flow
statement and balance sheet.
 Prepare proforma financial statements
Financial Forecasting using spreadsheet model