Financial Forcasting Session

Financial Planning and
Forecasting Financial Statements
Source: Eugene F. Brigham and Michael C.

Ehrhardt, Khan and Jain, I M Pandy and
Srivastava and Misra et al. Lecture notes is
compiled from various sources. Credit goes
to the Authors. Please do not share this
Financial Planning
Strategic Plans:
Strategic plans usually begin with a statement of
the overall corporate purpose.
A corporate focus on creating wealth for the
company’s owners.
Corporate strategies are broad approaches
rather than detailed plans.

Financial Planning
Operating Plans:
Operating plans provide detailed implementation
guidance to help meet the corporate objectives
These plans can be developed for any time horizon, but
most companies use a 5-year horizon.
A 5-year plan is detailed for the first year, with each
succeeding year’s plan becoming less specific.
The plan explains who is responsible for each particular
function.
When specific tasksSource:
are to
Eugene be andaccomplished,
F. Brigham Michael C. sales and
profit targets, and the like.
Financial Planning - Process
The financial planning process has five steps:
• Project financial statements to analyze the
effects of the operating plan on projected
profits and financial ratios.
• Determine the funds needed to support the 5-
year plan
• Forecast the funds to be generated internally
and identify those to be obtained from
external sources
Financial Planning - Process
• Establish a performance-based management
compensation system that rewards employees
for creating shareholders wealth.
• Monitor operations after implementing the

plan, identify the cause of any deviations, and
take corrective actions.

What is Financial Forecasting?
• Financial forecasting is looking ahead to
develop a financial plan for the future
• Very important for the strategic growth of a

firm

What is Financial Forecasting?
• Forecasting sales
• Projecting the assets and internally generated

funds
• Projecting outside funds needed
• Deciding how to raise funds – additional funds

Additional Funds Needed (AFN)
• AFN is the amount of money a company must
raise from external sources to finance the
increase in assets required to support
increased level of sales.
• Additional funds needed is also called external

financing needed

Approaches to know Additional Funds
Needed (AFN)
There are two approaches to answer the
question – AFN
(i) Additional Funds Needed Formula

(ii) The forecasted Financial Statement Method
– (Percentage of Sales Method)

AFN Formula
• AFN method of financial planning assumes that the
company’s financial ratios do not change.
• In response to an increase in sales, a company must
increase its assets, such as property, plant and
equipment, inventories, accounts receivable, etc.
• Part of this increase in offset by spontaneous
increase in liabilities such as accounts payable, taxes
etc., and part is offset by increase in retained
earnings.
Additional Funds Needed (AFN) Formula
• A crude model to estimate external funds

needed to support Sales  after accounting
for internally generated and automatically
generated sources of funds.

Assumptions:
• Firm is operating at full capacity
• Each type of asset grows proportionally w/
sales
• Spontaneously generated liabilities grow
proportionally w/ Sales.
• Profit margin (M) is constant
• Firm can accurately forecast  in Sales.
AFN =increase in Assets-spontaneous increase in Liabilities
-increase in retained earnings
=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)
In brief:
AFN = Required -  in Spontaneous -  in RE

 in Assets Liabilities

“A NEGATIVE FIGURE FOR AFN MEANS THAT THERE IS A SURPLUS OF CAPITAL”

Notes: RR-retention ratio=1-payout ratio, ΔS –change in sales, M-Net Profit
margin Srivastava and Misra et al. Lecture notes is
CASE 1
Preliminary Financial Forecast:
Balance Sheets (Assets)
2018 2019E
Cash and equivalents $ 20M $ 25
Accounts receivable 240 300
Inventories 240 300
Total current assets $ 500 $ 625
Net fixed assets 500 625
Total assets Source: Eugene F. Brigham and Michael C.
$1,000 $1,250
Preliminary Financial Forecast: Balance Sheets (Liabilities
and Equity)
2018 2019E
Accts payable & accrued liab. $ 100 $ 125
Notes payable 100 190
Total current liabilities 200 315
Long-term debt 100 190
Common stock 500 500
Retained earnings 200 245
Total liabilities &Source:
equity Khan and Jain, I M Pandy and $1,000
Eugene F. Brigham and Michael C.
Ehrhardt, $1,250
Preliminary Financial Forecast:
Income Statements
2018 2019E
Sales $2,000.0 $2,500.0
Less: Variable costs 1,200.0 1,500.0
Fixed costs 700.0 875.0
EBIT $ 100.0 $ 125.0
Interest 16.0 16.0
EBT $ 84.0 $ 109.0
Taxes (40%) 33.6 43.6
Net income $ 50.4 $ 65.40
Dividends (30% Source:
of NI) Eugene F. Brigham and Michael C.
$15.12 $19.62
Addition to retained earnings
$35.28 $45.78
Key Assumptions in Preliminary Financial
Forecast for NWC
• Operating at full capacity in 2018.
• Each type of asset grows proportionally with sales.
• Payables and accruals grow proportionally with sales.
• 2018 profit margin (2.52%) and payout (30%) will be

maintained.
• Sales are expected to increase by $500 million. (%DS =

25%) Ehrhardt, Khan and Jain, I M Pandy and

Determining additional funds needed, using the
AFN equation
AFN =increase in Assets-spontaneous increase in Liabilities
=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)
= ($1,000/$2,000)($500)
– ($200/$2,000)($500)
– 0.0252($2,500)(0.7)
= 250-50-44.1
$155.9 million.
Notes: RR-retention ratio=1-payoutcompiled
ratio, from
ΔS –change in sales,
various sources. M-Net
Credit goes Profit margin
How different factors affect the AFN forecast.
Dividend payout ratio changes.

If reduced, more RE, reduce AFN.
Profit margin changes.
If increases, total and retained earnings increase, reduce
AFN.
Plant capacity changes.
Less capacity used, less need for AFN.
AP Payment terms increased to 60 days from 30.
Accts. payable would double, increasing liabilities, reduce
AFN.

SALES FORECAST
• Sales forecast generally starts with a review of

sales during the past 5 to 10 years.
• Forecasting the future sales growth rate
always begins with a look at past growth.

CASE 2 – MICRODRIVE
SALES FORECAST
The sales figures of the Microdrive company for the past 5 years given
below. Forecast the sales for the year 2008.
Year Sales
2003 2058.00
2004 2534.00
2005 2472.00
2006 2850.00
2007 3000.00
Forecast the sales for the year 2008

CASE 2 - Solution
growth
Sales rate
2003 2058.00
2004 2534.00 23%
2005 2472.00 -2%
2006 2850.00 15%
2007 3000.00 5%
Average growth
rate = 10.31%
CASE 2 - Solution
MODEL 1
GROWTH RATE BY USING

TREND FUNCTION 3242.8
FORECASTED SALES FOR 2008

GROWTH RATE 8.09%
MODEL 2
GROWTH RATE BY USING
LOGGEST FUNCTION 1.0910358

GROWTH RATE 9.104%

Y -Ehrhardt,
Sales Khan
andandXJain, I M Pandy and
- year
CASE 2 - Solution
MODEL 3
GROWTH RATE BY
USING
RATE FUNCTION
GROWTH RATE 9.88%
nper=4:PV=2058:FV=-3000

MicroDrive Case – Sales Forecast - Summary
Although it is useful to calculate the past growth

in sales, much more is involved in estimating
future sales.
Future sales will depend on the economy, the
industry prospectus, the company’s current
product line, proposed products that are in
pipeline, marketing campaigns etc.
Any company should incorporate all the issues
mentioned above into its sales forecast.
MicroDrive Case – Part II
After much discussion and analysis, MicroDrive’s
managers decided to forecast a 10% increase in
sales.
How will MicroDrive’s managers incorporate this
increased level of sales into the Financial Plan?
In particular, will MicroDrive have to raise any
additional external funds in order to implement
the plan?
MicroDrive – Financial Statements
MICRODRIVE
NCOME STATEMENT AND BALANCE S

MicroDrive Case – Part II - Solution
We assume that non of a firm’s ratios will
change.
If the sales increase, firms usually have to
purchase assets such as inventories and
machines etc. In order to support the increased
level of sales.
Where will the firm get money to purchase the
projected increase in assets?
There are three sources:
First, some liabilities such as accounts payable
usually increase when sales increase.
Balance sheet require that total assets equal to
total liabilities and equity.
Therefore, this spontaneous increase in
liabilities is a source of funds for the projected
increase in assets.
Second, the firm should make a profit on new
sales.
Part of this profit will be used to pay dividends, but
remaining profit can be used to help purchase the
new assets.
Recall that the net income not paid out as
dividends is an addition to retained earnings.
Therefore, this increase in equity is a source of
financing for the projected increase in assets.
Finally, any remaining increase in assets must be
financed by additional external funds, such as
additional bank loans, long-term debt.
AFN formula applies this logic and defines the

Additional Funds Needed (AFN)

AFN =increase in Assets-spontaneous increase
in Liabilities
=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

AFN Calculation

To increase sales by $300 million, the formula
suggests that MicroDrive must increase assets by
approximately $XXX million (result from AFN
formula). (assumption – growth rate=XXX%)
The $XXX million of new assets must be financed in

some manner.
Note: The AFN may differ, if growth rate is different

• Of the $XX million will come from a spontaneous
increase in liabilities, while other $XXXX million
will be obtained from retained earnings.
• The remaining $XXXX million must be raised from

external sources.
Note: The AFN may differ, if growth rate is different

The AFN equation shows that external financing
requirements depend on five key factors:
Sales Growth (change in sales):
Rapidly growing companies require large
increase in assets and more external financing,
other things held constant

Capital Intensity (A0*/S0):
The amount of assets required per dollar of
sales, (A0*/S0) is called capital intensity ratio.
This ratio has a major effect on capital
requirements.
Companies with higher assets-to-sales ratios
require more assets for a given increase in sales,
hence a greater need for external financing
Spontaneous liabilities to sales ratio (L0*/S0):
Companies that spontaneously generate a large
amount of liabilities from accounts payable and
accruals will have a relatively lower need for
external financing.

Profit Margin (M)
The higher the profit margin, the larger the net
income available to support increase in assets,
hence the lower the need for external financing.
Retention Ratio (RR)
Companies that retain more of their earnings as
opposed to paying them out as dividends will
generate more retained earnings and thus have
less need fro external financing.
Live case
TATA MOTORS
AFN

Conclusion
• AFN formula provides an accurate forecast
only for companies whose ratios are all
expected to remain constant.
• The AFN formula is useful for quickly obtaining
a “back of the envelope” estimate of external
financing requirements, but the percent of
sales method, is used by most companies for
their detailed financial planning.
Percent-of-Sales Method – Forecasted
Financial Statement (FFS) Method
• FFS actually forecasts the complete set of
financial statements.
• However, logic of this approach is similar to

that of the AFN formula.

Contrast AFN model and FFS model
Both begin with Sales forecast
Both forecast assets and spontaneous liability
• AFN  capital intensity (A/S) assumed constant for
all assets
• AFN  spontaneous liabilities to sales intensity (L/S)
assumed constant for all spontaneous liabilities
• FFS  (each Asset)/Sales different for all assets

• FFS  (each spontaneous. liabilities)/Sales different
for all spontaneous liabilities.
Percent of Sales Method to forecast financial statements
STEP 1:
Project sales based on forecasted growth in sales
STEP 2:
Forecast some items as a percent of the forecasted sales
costs
cash
accounts receivable
inventories
net fixed assets
accounts payable and accruals
Percent of Sales Method to forecast financial statements
Step 3
Choose other items
debt
dividend policy
common stock

Sources of Financing needed to support asset
requirements
• Based on certain assumptions and choices, we
can estimate:
Required assets to support sales
specified sources of financing
Additional Funds Needed (AFN) is

Required assets MINUS specified sources of
financing
AFN – POSITIVE - NEGATIVE
• IF AFN is positive, then you must secure
additional financing
• If AFN is negative, then you have more

financing than is needed.
– Pay off debt
– Buy back stock
– Buy short-term investments
MICRODRIVE CASE AND SOLUTION


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Financial Planning and

Forecasting Financial Statements

Source: Eugene F. Brigham and Michael C.

Source: Eugene F. Brigham and Michael C.

• Monitor operations after implementing the

Source: Eugene F. Brigham and Michael C.

• Very important for the strategic growth of a

Source: Eugene F. Brigham and Michael C.

• Projecting the assets and internally generated

• Projecting outside funds needed

• Deciding how to raise funds – additional funds

• Additional funds needed is also called external

Source: Eugene F. Brigham and Michael C.

(i) Additional Funds Needed Formula

Source: Eugene F. Brigham and Michael C.

• A crude model to estimate external funds

Source: Eugene F. Brigham and Michael C.

=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

AFN = Required -  in Spontaneous -  in RE

Source: Eugene F. Brigham and Michael C.

• Each type of asset grows proportionally with sales.

• Payables and accruals grow proportionally with sales.

• 2018 profit margin (2.52%) and payout (30%) will be

• Sales are expected to increase by $500 million. (%DS =

25%) Ehrhardt, Khan and Jain, I M Pandy and

=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

Dividend payout ratio changes.

Source: Eugene F. Brigham and Michael C.

• Sales forecast generally starts with a review of

Source: Eugene F. Brigham and Michael C.

Forecast the sales for the year 2008

GROWTH RATE BY USING

FORECASTED SALES FOR 2008

GROWTH RATE BY USING

LOGGEST FUNCTION 1.0910358

GROWTH RATE 9.104%

GROWTH RATE 9.88%

Source: Eugene F. Brigham and Michael C.

Although it is useful to calculate the past growth

Source: Eugene F. Brigham and Michael C.

AFN formula applies this logic and defines the

Source: Eugene F. Brigham and Michael C.

=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

Source: Eugene F. Brigham and Michael C.

Source: Eugene F. Brigham and Michael C.

The $XXX million of new assets must be financed in

Note: The AFN may differ, if growth rate is different

• The remaining $XXXX million must be raised from

Note: The AFN may differ, if growth rate is different

Source: Eugene F. Brigham and Michael C.

Source: Eugene F. Brigham and Michael C.

Source: Eugene F. Brigham and Michael C.

• However, logic of this approach is similar to

Source: Eugene F. Brigham and Michael C.

• FFS  (each Asset)/Sales different for all assets

Source: Eugene F. Brigham and Michael C.

Additional Funds Needed (AFN) is

• If AFN is negative, then you have more

Source: Eugene F. Brigham and Michael C.

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