CH.

III
Financial Forecasting & Planning

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Chapter Outline

I. Financial forecasting Vs Financial Planning

II. Importance of sales forecasting

III. The financial planning process

IV. Methods of forecasting financial statements

• Percentage of sales method
• Pro-forma financial statement method

V.The EFR (External Fund Required( Formula

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Financial planning

 Definition - Financial planning is a process consisting of:

1.Analyzing the investment and financing choices open to the firm.
2.Projecting the future consequences of current decisions.
3.Deciding which alternatives to undertake.
4.Measuring subsequent performance against the goals set forth in the financial plan.

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Financial planning

 Components of a Financial Planning Model

Inputs. The inputs to the financial plan consist of the firm’s current
financial statements and its forecasts about the future.
The Planning Model. The financial planning model calculates the
implications of the manager’s forecasts for profits, new
investment, and financing. The model consists of equations
relating output variables to forecasts. For example, the equations
can show how a change in sales is likely to affect costs, working
capital, fixed assets, and financing requirements.

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Financial planning
 Components of a Financial Planning Model
 Outputs. The output of the financial model consists of financial statements
such as income statements, balance sheets, and statements describing sources
and uses of cash. These statements are called pro formas, which means that
they are forecasts based on the inputs and the assumptions built into the plan.

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Financial planning
 Components of a Financial Planning Model
 Outputs. The output of the financial model consists of financial statements
such as income statements, balance sheets, and statements describing sources
and uses of cash. These statements are called pro formas, which means that
they are forecasts based on the inputs and the assumptions built into the plan.

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Financial planning
 The Purpose of Planning and Plan Information
 The Planning Process: The planning process can pull a management team into a cohesive unit with common
goals.
 A Road Map for Running the Business: A business plan functions as a road map for getting an organization to
its goal.
 A Statement of Goals: A business plan is a projection of the future that generally reflects what management
would like to see happen.
 Predicting Financing Needs: Financial planning is extremely important for companies that rely on outside
financing.
 Communicating Information to Investors: A business plan is management’s statement about what the
company is going to be in the future, and can be used to communicate those ideas to investors.

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Financial planning
 Financial Planning vs Financial Forecasting
 Financial forecasting is the process of identifying the opportunities in
the future in terms of market size, customer base, or business
strategies. Forecasting involves making projections about what will
happen in the future. As a process, financial forecasting involves
estimating future business performance. It provides information of the
organization’s future revenues and costs that is needed by management
to project financing requirements. The “future” is the planning period
that could be short-term (one or less), medium term (3-5 years), or
long-term (over five years).

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Financial planning
 Financial Planning vs Financial Forecasting
 Some argue that financial planning and financial forecasting are one and the
same. However, financial forecasting is the basis for financial planning. Financial
planning is done effectively through financial forecasting.
 Financial planning is not just forecasting. Forecasting concentrates on the most
likely future outcome. But financial planners are not concerned solely with
forecasting. They need to worry about unlikely events as well as likely ones.

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Financial planning
 Financial Forecasting Procedures
The following procedures may be used in predicting the future (financial
forecasting).
1.Projection of Organization’s sales revenues -Financial forecasting begins
with sales forecast.
2.Estimation of the level of investments in current assets and fixed assets
3.Determination of the organization’s financing needs & sources of funds
4.Preparing pro forma or forecasted financial statements, namely, pro forma
income statement, pro forma balance sheet, and cash budget.

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model
Example
Top Company has prepared the following Balance Sheet and Income
Statement for the year ended December 31, 2005.
Assets Liabilities and Stockholders’ Equity
Cash 175,000 A/P 140,000
A/R 150,000 Accrued liabilities 150,000
Inventory 800,000 Mortgage N/P 1,410,000
Plant Assets, Net 1,500,000 Common Stock 800,000
    Retained earnings 125,000
Total 2,625,000 Total 2,625,000
Sales   2500000
Costs and Expenses except depreciation 1,400,000  
Depreciation 200,000  
Total costs and expenses   1,600,000
Income before taxes   900,000
Taxes (40%)   360,000
Net Income   540,000

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The Percentage-of-Sales Model
• Additional Information
The company plans to have dividend payout ratio of 45%
Sales are expected to increase by 25% during next year (2006).
All assets are affected by sales proportionately. Accounts Payable
and accrued liabilities are also affected by sales.
All expenses are directly proportional to sales
The firm has been operating at full capacity.
The company has no preferred stock.
Assume that additional funds needed would be financed from
bond issue and common stock in 40% and 60% respectively.

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model
 Determinants of External Capital (Fund) Requirements
1.Sales growth rate
• The higher the sales growth rate, the greater the need for external capital
and vice versa
• The financial feasibility of the expansion plans should be reconsidered if the
company expects difficulties in raising the required capital.
2.Dividend payout ratio
• The higher the payout ratio, the greater the need for external capital
requirement
• Management should balance between internally generated funds (by
reducing payout ratio) and the need for increasing stock price because
divided policy affects stock price.
3.Capital intensity
• Capital intensity refers to the amount of asset required per Birr of sales
• Capital intensity Ratio = Assets/ Sales
• The lower capital intensity ratio, the lower the need for external capital

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The Percentage-of-Sales Model
 Excess capacity Adjustments
The assumption of constant ratio between assets and sales may not
always hold true. In that case, the percentage of sales model or
Additional Funds Needed model is not appropriate.
What are the conditions under which constant ratios are not
maintained between asset, and sales?
1. Economies of scale
Economies of scale imply that as a plant gets larger and volume
increases, the average cost per unit of output drops. This is
particularly due to lower operating and capital cost. A piece of
equipment with twice that capacity of another piece typically does
not cost twice as much to purchase or operate. Plants also gain
efficiencies when they become large enough to fully utilize dedicated
resources for tasks such as materials handling, computer equipment,
and administrative support personnel.

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The Percentage-of-Sales Model
 Excess capacity Adjustments …
2. Lumpy asset increments

Lumpy assets are assets that cannot be acquired in small increments,

but must be obtained (added) in large, discrete units. Suppose, if we
obtained that Br. 25,000 is needed for additional investment in fixed
assets, it may be difficult to get fixed assets that exactly cost Br. 25,000.
The minimum prices for the lowest capacity fixed asset may be Br.
45,000. Thus, if you decided to make additional investment in fixed
assets, you need to purchase fixed assets of Br. 45,000 instead of Br.
25,000.

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The Percentage-of-Sales Model
 Excess capacity Adjustments …
3. Excess assets due to forecasting errors.
Actual assets to sales ratio may be different from planed ratio
because actual sales may be different from planed sales. Actual
assets may be different from planned assets. Excess capacity may
occur plant assets and inventories.
When excess capacity exists, sales can grow to the full capacity sales
with no increase whatever in fixed assets. However, beyond full
capacity sales, increase in sales requires increase in assets.
The following steps may be used in determining additional
investments in fixed assets in excess capacity situation.

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model

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The Percentage-of-Sales Model
• Increase in sales without increase in Fixed Assets (FA)
= Full capacity sales – current sales = 1,250,000 – 1,000,000 = 250,000
• Required level of FA = (TFA to sales ratio) x (projected sales)
= 0.48 x 1,400,000 = 672,000
• Additional Investment in FA = (1,400,000 – 1,250,000) x 0.48 = 72,000
• Increase in Current assets = 0.15 x 400,000 = 60,000
• Spontaneously generated funds= 0.09 x 400,000 = 36,000
• Internally generated funds = M (S1) (1-d) = 0.10(1,400,000) (1 –0.60)
= 56,000
• AFN = (72,000 + 60,000) – (36,000 + 56,000)
= 132,000 – 92,000 = 40,000

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The Pro-forma Financial Statement Method
• Refer Cost and Management Accounting – Master Budget

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