Chapter 5

FINANCIAL PLANNING AND

FORECASTING

 Centre for Financial Management , Bangalore

 OUTLINE
• The Planning System

• What and Why of Financial Planning

• Sales Forecast

• Proforma Profit and Loss Account

• Proforma Balance Sheet

• Financial modeling using spreadsheets

• Growth and External Financing Requirement

• Key Growth Rates

 Centre for Financial Management , Bangalore
 THE PLANNING SYSTEM

Goals

Strategy

Research and
development Marketing Production Personnel Financial
policy policy policy policy policy

Research and Capital budget

development Marketing Production Personnel
and financing
budget budget budget budget
plan

FINANCIAL PLAN
Profit and loss account
Balance sheet
Cash flow statement
 Centre for Financial Management , Bangalore
 STRATEGIC PLAN

 Corporate Purpose

 Corporate Scope

 Corporate Objectives

 Corporate Strategies

 Centre for Financial Management , Bangalore

 COMPONENTS OF A FINANCIAL PLAN

 Economic Assumptions

 Sales Forecast

 Proforma Statements

 Asset Requirements

 Financing Plan

 Cash Budget

 Centre for Financial Management , Bangalore

 SALES FORECAST

 The sales forecast is typically the starting point of the

financial forecasting exercise.

 Sales forecasting techniques fall into three broad categories:

 Qualitative techniques

 Time series projection methods

 Causal models

 Centre for Financial Management , Bangalore

 PROFORMA PROFIT & LOSS ACCOUNT PERCENT OF SALES METHOD
Historical data Average Pro forma statement of
20X1 20X2 percent of profit and loss of 20X3
sales assuming revenues from
operations of 1400

Revenues from Operations 1200 1280 100 1400

Other Income 8 10 0.72 10
Total Income Expenses 1208 1290 100.72 1410
Material expenses 547 590 45.84 642
Employee benefit expenses 274 295 22.94 321
Finance costs 60 65 5.04 71
Depreciation and amortization expenses 75 80 6.25 88
Other expenses 98 103 8.11
Total Expenses 1054 1133 88.17 113
Profit before Exceptional Items and Tax 154 157 12.55 1234
Exceptional Items 30 32 2.50 176
Profit before Tax 184 189 15.05 35
Tax Expense 82 90 6.93 211
Profit (Loss) for the Period from continuing Operation 102 99 8.12 97
Other Comprehensive Income 114
Total Comprehensive Income for the Year 102 99 8.12
Dividends 60 63
Retained Earnings 42 36
 Centre for Financial Management , Bangalore
 PROFORMA PROFIT & LOSS ACCOUNT
Historical data Average Pro forma statement of
COMBINATION
20X1 METHOD
20X2 percent of profit and loss of 20X3
sales assuming revenues from
operations of 1400

Revenues from Operations 1200 1280 100 1400

Other Income 8 10 0.72 10
Total Income Expenses 1208 1290 @ 1410
Material expenses 547 590 45.84 642
Employee benefit expenses 274 295 22.94 321
Finance costs 60 65 5.04 71
Depreciation and amortization expenses 75 80 Budgeted 85
Other expenses 98 103 Budgeted 107
Total Expenses 1054 1133 @ 1225
Profit before Exceptional Items and Tax 154 157 @ 185
Exceptional Items 30 32 2.50 35
Profit before Tax 184 189 @ 220
Tax Expense 82 90 Budgeted 90
Profit (Loss) for the Period from continuing Operation 102 99 @ 130
Other Comprehensive Income - -
Total Comprehensive Income for the Year
Dividends 60 63 Budgeted 70
Retained Earnings 40 36 @ 60

@These items are obtained using accounting identities.

 Centre for Financial Management , Bangalore
 PROFORMA BALANCE SHEET
Historical data Average Pro forma balance sheet
20X1 20X2 percent of 20X3 assuming revenues
sales from operating of 1400

Revenues from Operations 1200 1280 100 1400

ASSETS
Non- current Assets
Property , plant, and equipment 750 775 61.52 861
Investments 40 40 Budgeted 60
Long- term loans and advances 60 60 Budgeted 70
Current Assets
Inventories 375 380 30.47 427
Investments 30 33 2.54 36
Trade receivables 200 212 16.61 233
Cash and cash equivalents 25 28 2.14 30
Short – term loans and advances 20 22 1.69 24
1740

 Centre for Financial Management , Bangalore

 PROFORMA BALANCE SHEET
Historical data Average percent of sales Pro forma balance sheet
20X1 20X2 20X3 assuming revenues
from operating of 1400

EQUITY AND LIABILITIES

Equity

Equity share capital (Par Value 10) 300 300 No change 300
Other equity 250 286 Pro forma statement of 346
P&L
Non- current Liabilities
Borrowings 500 505 40.56 568
Provisions 55 50 4.24 59
Deferred tax liabilities (net) 45 50 3.83 54
Current Liabilities
Borrowings 200 200 16.15 226
Trade payables 100 112 8.54 120
Other current liabilities 20 30 2.01 28
Short- term provisions 30 17 1.91 27
External funds requirement 13
1740

 Centre for Financial Management , Bangalore

 COMPUTERISED FINANCIAL PLANNING SYSTEM
At the heart of a computerised financial planning system is
a model which specifies the relationships relevant to the firm. The
model defines relationships like the following

Cost of goods sold = 65 percent of sales

Selling expenses = Rs.100,000 + 5 percent of sales
Inventories = 15 percent of sales
 
 
 
 
A computerised financial planning system helps in:
 Preparing proforma financial statements
 Estimating the additional funds needed
 Calculating projected financial ratios
 Centre for Financial Management , Bangalore
GROWTH AND EXTERNAL FINANCING
REQUIREMENT
EFR = A/S (△S) – L/S (△S) – mS1 (1 – d) (5.2)
EFR = external funds requirement
A/S = current assets and fixed assets as a proportion of sales
△S = expected increase in sales
L/S = current liabilities and provisions (spontaneous liabilities) as a

proportion of sales

m = net profit margin

S1 = projected sales for next year
d = dividend payout ratio
 Centre for Financial Management , Bangalore
 GROWTH AND EXTERNAL FINANCING
REQUIREMENT
Manipulating Eq. (5.2) a bit, we get
EFR A L m (1 + g) (1 – d)
= – –
△S S S g

Illustration
A/S = 0.90, △S = Rs. 6 million, L/S = 0.40,
M = 0.05, S1 = Rs. 46 million, and d = 0.6
EFR = (0.90) (6) – (0.4) (6) – (0.05) (46) (0.4)
= Rs. 2.08 million
EFR 0.05 (1 + g) (1 – 0.60)
= 0.50 –
△S g
0.20 (1 + g)
= 0.50 –
g

g (%) 5 10 15 20 25
EFR/△S 0.08 0.28 0.35 0.38 0.42
 Centre for Financial Management , Bangalore
 FORECASTING WHEN THE BALANCE
SHEET RATIOS CHANGE

The assumption of constant ratios and identical growth

rates may be appropriate sometimes, but not always. In
particular its applicability is suspect in the following
situations:
• Economies of scale
• Lumpy assets
• Forecasting errors and excess assets

 Centre for Financial Management , Bangalore

 INTERNAL GROWTH RATE

The internal growth rate is the maximum growth

rate that can be achieved with no external financing
whatsoever. It is the growth rate that can be sustained
with retained earnings, which represents internal
financing.

Internal = Return on assets x Ploughback ratio

growth rate 1 – Return on assets x Ploughback ratio

 Centre for Financial Management , Bangalore

 SUSTAINABLE GROWTH RATE

The sustainable growth rate is the maximum growth

rate that a firm can achieve without resorting to
external equity finance.

Sustainable = Return on equity x Ploughback ratio

growth rate 1 – Return on equity x Ploughback ratio

 Centre for Financial Management , Bangalore

 SUMMING UP
 The strategic plan of a firm spells out its corporate purpose,
corporate scope, corporate objectives, and corporate strategies.
 Most financial plans have the following components : economic
assumptions, sales forecast, proforma financial statements, asset
requirements, financing plan, and cash budget.
 Sales forecasting methods fall into three broad categories:
qualitative techniques, time series projection methods, and
causal models.
 There are two commonly used methods for preparing the
proforma profit and loss account : the percent of sales method
and the budgeted expense method.
 Centre for Financial Management , Bangalore
 SUMMING UP

 The external funds requirement may be estimated as follows:

EFR = A/S(ΔS) – L/S (ΔS) – mS1 (1-d) – ((ΔIM + SR)
• The internal growth rate is the growth rate that can be achieved
with no external financing whatsoever.
• The sustainable growth rate is the growth rate that can be sustained
with the help of retained earnings matched with debt financing.

 Centre for Financial Management , Bangalore