INTRODUCTION TO

FINANCE

FINANCIAL PLANNING AND

FORECASTING
 Learning Objectives
 Understand the concepts of Financial Planning
and steps in Financial Planning
 Understand and describe the concept of
financial forecasting
 Understand the importance of financial
forecasting to any type and size of business;
 Employ the steps of financial forecasting in
real life business situations;
 Apply the methods for financial forecasting.
 Be able to prepare of proforma financial
statements.
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Planning 1/4
 The oxford dictionary defines
 A plan as:-
 a detailed proposal for doing or
achieving something
 Verb – planning as:-
 decideon or arrange in advance;
 make a plan of

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Planning 2/4
 The application of the concept of planning in
the finance function in business is referred as
“Financial Planning”
 The financial planning is essentially a long
run activity, which seeks to determine the
financial direction in which the firm should be
moving in the future.
 Financial planning is broadly, concerned with
the economical procurement and
profitable use of fund.

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Planning 3/4
 It is concerned with
 the projection of financial data e.g. the
setting of various the budgets (expense
prioritization; savings and investments; tax
planning) - and hence the pro forma
financial statements;
 and the effect of alternative financial
policies on these statements.
 How to deal with financial emergencies etc

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Planning 4/4
 The financial planning is therefore part
of overall corporate planning …
 Which involves:
 Assessment of corporate goals,
 Developing a plan to meet those goals,
 Implementing the plan, and
 A periodic review to ensure that you are on
track to meet your goals (
Topic Three_Diagram 1.doc )
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Characteristics of a Sound Financial Plan 1/2

1. Simplicity – simple that may be easily

understood;
2. Flexibility – should allow a scope for
adjustment as and when new situations
emerge.
3. Solvency and liquidity – solvency requires
that short-term and long-term payments
should be made on date when they are due.
Solvency will be possible when liquidity of
assets is maintained.

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 Characteristics of a Sound Financial Plan 2/2

4. Based on clear-cut objectives – keep in

consideration the overall objectives of the
company;
5. Less dependence on outside sources – can be
possible by retaining a part of profits for ploughing
back.
6. Cost – the selection of various sources should be
such that the cost burden is minimum
7. Profitability – various securities/investments
should be adjusted so that profitability of the firm
is not jeopardized
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Considerations in Formulating Financial Plan 1/2

1. Nature of the industry – the needs for

funds are different for various industries.
The asset structure; element of seasonality;
stability of earnings are not common factors
for all industries;
2. Standing of the concern – e.g. credit
rating; past performance; management
attitudes etc, should be considered;
3. Future plans – e.g. expansion;
diversification in the near future will require a
flexible plan;
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Considerations in Formulating Financial Plan 2/2

4. Availability of resources – issues

concerning reliability; the pros and cons;
sufficiency and regularity of various sources
should be considered;
5. General economic conditions – prevailing
economic conditions at the national level
and international level will influence a
decision about financial plan;
6. Government control – policies; legislative
restrictions on using certain source should
be properly considered
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 Steps in Financial Planning 1
1. Establishing Financial Objectives
 Careful preparation of both S-T and L-T objectives;
 There should be an optimum utilization of funds to
take advantage of the prevailing economic situation
2. Formulating Financial Policies – to deal with
procurement; administration and distribution of
funds in the best possible way
1. Clear-cut plans of raising required funds and their
possible uses
2. Consider present and future needs for funds

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Steps in Financial Planning Cont’d
3. Formulating Procedures – to ensure
consistency of actions e.g. how lenders
should be approached; who should be
responsible, etc
4. Providing for Flexibility – the financial
planning should ensure proper flexibility in
objectives, policies and procedures so as to
adjust according to changing economic
situations.

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Preparation of Proforma Financial Statements

 A financial plan will have a forecasted

statement of financial position, P & L,
and statement cash flow - Pro forma
statements.
 These are used to provide a basis for:
 Analyzing future profitability and overall
financial performance
 Predicting internal and external financing
requirements.
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Basic Components a Financial Plan
1. Sales forecast
 Normally this is the “driver” of the financial planning
model, most other values are calculated based on it.
 Perfect sales forecast are not possible – depends on
uncertain future state of the economy
2. Pro forma statements
 Forecasted balance sheet, income statement and
cash flow statement – outputs of the financial planning
model
 They are used to summarize the projected future
events based on the key item e.g. sales

RILAGONYA F. Financial Planing & Forecasting 14

 Basic Components a Financial Plan
Cont…
3. Asset requirements
 The plan will describe projected capital spending
 The projected balance sheet, will contain
changes in total Non-current Assets and working
capital
4. Financial requirements
 The plan will include a section on the necessary
financing arrangements
 The focus should be on capital structure, sources of
long-term finance, and dividend policy
RILAGONYA F. Financial Planing & Forecasting 15
 Basic Components a Financial Plan
Cont…
5. The Plug
 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 (TA>C+L)
 A financial plug is a designated source(s) of
external financing needed to deal with any
shortfall (surplus) in financing and thereby to
bring the balance sheet into balance e.g.
raising new equity or paying an extra dividend

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 Basic Components a Financial Plan
Cont…
 Economic assumptions
 State explicitly the economic environment in
which the firm expects to reside over the life of
the plan e.g. interest rates, tax rates etc.

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 The Concept of Forecasting

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 The Concept of Forecasting
 A forecast is an educated guess or
inference or prediction of what the
future may be.
 Forecasting provides a logical basis for
preparing plans.
 The actual performance of the past, the
present situation and the likely trends
of the future are considered while
preparing plans.
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 Financial Forecasting - Defined
 A systematic process of analysing the
economic, social and financial
influences affecting the business …
 with an object of predicting business’s
TOTAL NEEDS OF FUNDS for the
FUTURE …
 on the basis of the PAST and PRESENT
information

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 Why Financial Forecasting?
 In the absence correct estimates of financial
requirements, the firm/company may:
 Suffer either from inadequate capital or from
excess capital
 Make poor managerial planning decisions e.g.
diversification, expansion, improvements,
assets acquisitions etc
 Poorly utilise resources
 Fail (business success depends on correct
forecasts)
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 Steps/Elements of Forecasting
1. Developing the basis
 Investigate the economic situations, position of
industry, products etc
2. Estimate future business operations
 Estimate the conditions and course of future events
within the industry – Quantitative estimates!!
3. Regulating Forecasts
 Compare forecasts Vs. actual results to determine
deviations. Take corrective actions
4. Reviewing the forecasting process
 Refining the forecasting process to improve forecasts
in the future

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 Methods For Short-run Forecasting
 A good sales forecast is an essential foundation for
forecasting financial requirement. But Why?
 We are going to discuss three principle methods of
short-run financial forecasting:
 Percent-of- Sales Method
 Scatter Diagram or Simple Regression Method
 Judgemental approach

 The firm's latest actual F/S are needed as the base

year for forecasting and hence preparation of pro-
forma statements.

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 Percent-of-Sales Method
 Under this approach, each element of the
statement of financial position is expressed
as a percentage of annual SALES. The
method work as follows:
1. Identify the balance sheet items that are
expected to vary directly with sales e.g.
inventory, debtors, creditors, etc.
2. Express those items that vary directly with sales
as percentage of sales e.g. debtors/sales x 100%
3. Establish the additional sales that must be financed

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Percent-of- Sales Method: Illustration
 We are going to illustrate this approach by using
review question no. 5. The items that are expected
to vary directly with sales are:
 Cash 02% Creditors 10%
 Debtors 17% accrued wages 05%
 Inventories 20% Loan na
 Non CA 30% shares na
Profit na
 Total Assets 69% Total liabilities 15%

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 Percent-of- Sales Method: Illustration cont…

 For every 1/= increase in sales, assets must

increase by 69 cents (0.69/=). The 0.69/=
must be financed in some manner.
 Creditors and accruals will supply 0.15/= for
each increase in sales.
 The additional funds requirement will
therefore be equal to 54% (i.e. 69% – 15%)
 which means for every 1.0/= increase in
sales, Mkuza must obtain 0.54/= of financing
(internally or externally)
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 Percent-of- Sales Method: Illustration cont…

 Mkuza expects to increase sales by

Tshs 60mil/= (i.e. 160mill – 100mil).
 Additional funds (AFN) = 54% x 60mil =
Tshs 32.4mil/= will be needed.
 If the company earns 4% after tax profit
on sales,
 then profit on the expected sales will
amount to 0.04 x 160mil = 6.4mil/=

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 Percent-of- Sales Method: Illustration cont…

 Given the company’s dividend policy:

 The plowback will be 50% of the profits.
 Retained earnings available for internal
financing = 0.5 x 6.4mil = Tshs 3.2mil/=
 The amount that should be obtained
from external sources (external funds
needs = EFN) will amount to Tshs
29.2m/= (i.e. 32.4–3.2)

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Percent-of- Sales Method- Illustration cont…

 The process may be expressed in equation form:

A L
External Funds Needed (EFN)  S  S  mST 1  d 
S S
 A-L
External Funds Needed (EFN)   S  mrST
 S 
 69 - 15 
EFN   60  0.04  0.5  160  29.2mil / 
 100 

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 Percent-of- Sales Method- Illustration cont…
Where :
A
 Assets (A) that increase with sales as a percent of Sales (S)
S
L
 Liabilities (L) that increase with sales as a percent of sales
S
S  Change in Sales  ST - S  (1  g)S - S  gS
m  Profit margin
ST  Projected sales for the year
d  dividend payout ratio  [Retention ratio (r)  1 - d]
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Percent-of- Sales Method- Illustration cont…

 Assume sales forecast for 2009 was

Tshs 103mil/= [a 3% sales growth (g)]
 EFN= 0.54 (3) – 0.02(103) = -0.44.

 The answer is negative, meaning that

no external funds are needed.
 In fact the company will have
0.44mil/= in excess of its
requirement.
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 Percent-of- Sales Method- Illustration cont…

 A negative answer would mean at growth

rate g, no external funds are required
because the firm would have excess funds.
 A positive answer would mean, at growth
rate g, the firm would have a requirement of
external financing of X% of sales increase
 For Mkuza, the firm will have a requirement
of external financing of 48.7% of sales
increase
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Percent-of- Sales Method- Assumption

 Relationship between forecasted

financial variables (e.g. stock, current
liabilities etc) and sales remains
constant.
 Of course this will not hold if the B/S
items are transitorily high or low
 experience and judgments is required to
apply the technique in actual practice

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 Budgeting
 Long-range (strategic) planning involves the
determination of corporate objectives and the
determination of suitable plan for attaining
these objectives.
 The strategies have to be translated into
actions that need to be taken now (short-term
plans) in order to achieve the long-term
objectives.
 The budgeting process is one of such short-
term plans (though it can also be long-term)

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 Budgeting Defined
 Budgets are often regarded as “feed- forward”
systems due to this unique aspect of looking at
situations and attempting to take control in
advance.
 Accordingly a budget can be considered to be:
 A plan
 Quantitatively expressed (monetary)
 Covers a specific period of time (usually a year)
 A budget can also be defined as a systematic
plan for resource utilisation (e.g. manpower etc)

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 The Main Features of a Budget
 It is a future plan of action (predetermined)
prepared in advance of the period to which it
relates
 it is derived from long-term strategy of the
organization
 It is based on specific objectives to be achieved
 It is expressed in quantitative form, physical or
monetary units, or both.
 It lays down the policy to be followed so that the
objectives can be achieved
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Characteristics of a Good Budget
 Top management support: is a key factor in the
success of budget formation process
 Participation: it should involve as many people as
possible in drawing up a budget. This motivates and
reinforces commitment to the whole organisation
 Comprehensiveness: embrace the whole organization
 Flexibility: allow for changing circumstances
 Feedback: constantly monitor performance i.e.
existence of proper evaluation mechanism to avoid
padding of budgets
 Analysis of costs and revenues: this can be done on
the basis of product lines, departments or cost centres

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 Objectives of Budgeting
 Budgets serve a number of useful functions,
including:
 Planning annual operations
 Coordinating the activities of various parts of
the organisation
 Communication
 Controlling activities
 Evaluation

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 Advantages of Budgets
 It brings about efficiency and improvement in the working
of the organization.
 It is a way of communicating the plans to various units of
the organisation. By establishing the divisional,
departmental, sectional budgets, exact responsibilities are
assigned. It thus summarizes the possibilities of buck
passing if the budget figures are not met
 Clearly defines areas of responsibility. Requires
managers of budget centres to be made responsible for
the achievement of budget targets for the operations
under their personal control
 Participation in the budget process serves as a way of
motivating managers to achieve the goals set for the units.

RILAGONYA F. Financial Planing & Forecasting 39

 Advantages of Budgets Cont…
 It helps in reducing wastage and losses by
revealing them in time for corrective action.
 It serves as a basis for evaluating the
performance of managers. A budget is basically
a yardstick against which actual performance is
measured and assessed.
 It serves as an educational tool.
 Improves the allocation of scarce resources.
 Forces management to look ahead, to set out
detailed plans for achieving the targets for each
department

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 Advantages of Budgets Cont…
 Planning helps managers to avoid some
surprises and think about how they should react
to those suprises
 Financial planning forces managers to think
systematically about their goals for growth,
investment and financing
 Help in establishing goals to motivate managers
and provide standards for measuring
performance

RILAGONYA F. Financial Planing & Forecasting 41

 Problems in Budgeting
 When budgets are seen as pressure devices
imposed by management – can result in bad
labour relations, inaccurate record –keeping
etc.
 Budgets may lead to departmental conflicts
especially where there are disputes over
resources allocation, departments blaming
each other if targets are not realized, etc.

RILAGONYA F. Financial Planing & Forecasting 42

 Problems in Budgeting Cont…
 Waste may arise as managers adopt the
view, “we had better spend it or we will lose
it”. This is coupled with “empire building” in
order to enhance the prestige of a
department
 Managers may overestimate costs so that
they will not be blamed in the future should
they overspend [responsibility versus
controlling].

RILAGONYA F. Financial Planing & Forecasting 43

 Further Readings
 Ross et – al: Fundamentals of Corporate
Finance
 Weston J, F and Brigham E. F: Managerial
Finance
 Wright D.: Management Accounting
 Gupta S. K and Sharma R. K: Management
Accounting: Principles and Practice

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