FINANCIAL FORECASTING FOR STRATEGIC GROWTH

LEARNING OBJECTIVES
After studying module, you should be able to:

 Understand the concept and perspective of financial planning.

 Explain the benefits that can be derived from financial planning.  Know the elements
of a basic financial planning model.
 Understand the determinants of a firm’s growth rates.
 Know and apply the financial planning process using the Projected Financial Statement
Method

INTRODUCTION
A lack of effective long-range planning is a commonly cited reason for financial distress
and failure. Long range planning is a means of systematically thinking about the future and
anticipating possible problems before they occur. Planning is said to be a process that at best
helps the firm avoid stumbling into the future backward.

Financial planning establishes guidelines for change and growth in a firm. It focuses on the big
picture, which means that it is concerned with the major elements of a firm’s financial and
investment policies without dealing with the individual components of those policies in detail.

WHAT IS FINANCIAL PLANNING?

FINANCIAL PLANNING formulates the way in which financial goals are to be achieved. A
financial plan is a statement of what is to be done in the future. Many decisions have a long lead
time which means they take a long time to implement.

GROWTH AS A FINANCIAL MANAGEMENT GOAL

• GOAL (Financial Manager) is increasing the market value of the owner’s equity and not
just growth by itself.
• Growth may thus be a desirable consequence of good decision making but it is not an end
unto itself.
• Growth rate is used in the planning process, it is considered a convenient means
of summarizing various aspects of a firm’s financial and investment policies.

PERSPECTIVE OF FINANCIAL PLANNING

For planning purposes, it is often useful to think of the future as having a short-run and a long
run. The short run planning, in practice usually covers the coming 12 months while financial
planning over the long run planning is takes to be the coming to five years. This time period is
referred to as the planning horizon.
SHORT-RUN PLANNING- covers the coming 12 months

LONG-RUN PLANNING- takes to be the coming 2 to 5 years.

Planning horizon is the first dimension in the planning process.

The second dimension of the planning process that needs to be determined is the level of
aggregation. Aggregation involves the determination of all the individual projects together with
the investment that the firm will undertake.

After the planning horizon and level of aggregation are established, a Financial plans require
inputs in the form of alternative sets of assumptions about important variables. This type of
planning is particularly important for cyclical businesses or business firms whose sales are
strongly affected by the overall state of the economy or business cycles.

WHAT ARE THE BENEFITS THAT CAN BE DERIVED FROM

FINANCIAL PLANNING?
Due to the amount spent in examining the different scenarios and variables that will eventually
become the basis for a company’s financial plan, it seems reasonable to ask what the planning
process will accomplish

Among the more significant benefits of derived from financial planning are the following.

1. Provides a rational way of planning options or alternatives.

The financial plan allows the firm to develop, analyze and compare many different business
scenarios in an organized and consisted way. Various investment and financing options can be
explored, and their impact on the firm’s shareholders can be evaluated. Questions concerning the
firm’s future lines of business and optimal financing arrangements are addressed. Options such
as introducing new products or closing plants might be evaluated.

2. Interactions or Linkages between investment proposals are carefully

examined.
The financial plan enables the proponents to show explicitly the linkages between
investment proposals for the different operating activities of the firm and its available financing
choices. For example, if the firm is planning on expanding or undertaking new investments
and projects, all other relevant variables such as source, terms and timing of financing
are thoroughly examined.

3. Possible problems related to the proposal projects are identified actions to

address them are studied.
Financial planning should identify what may happen to the firm if different events take place.
Specifically, it should address what actions the firm will take if expectations do not
materialize and more generally, if assumptions made today about the future are seriously
in error. Thus, one objective of financial planning is to avoid surprises and develop contingency
plans.

4. Feasibility and internal consistency are ensured.

Financial planning is a way of verifying that the goals and plans made for specific areas of a
firm’s operations are feasible and internally consistent. The financial plan makes explicit the
linkages between different aspects of a firm’s business such as the market share, return on
equity, financial leverages, and so on. It also imposes a unified structure for reconciling goals
and objectives.

5. Managers are forced to think about goals and establish priorities.

Through financial planning, directions that the firm would take are established, risks are
calculated and educated alternative courses of action are considered thoroughly.

FINANCIAL PLANNING MODELS

These are created to help the executives explore the results of various business strategies.
Financial planning model will have the following common elements;

• Economic Environment Assumptions

• Sales Forecast
• Pro Forma Statements
• Asset Requirements Financial Requirement
• Additional Funds needed.

1. Economic Environment Assumption

Economic assumptions are assumptions that is made by a company about the general
market environment. It operates during the period of its financial plan. The plan will have
state explicitly the economic environment in which the firm expects to reside over the life of
the plan. The other important economic assumptions that will have to be made are the
inflation rates, level of interest rates and the firm’s tax rate. Companies make economic
assumptions regarding the upcoming state of the economy, i.e., the marketplace. Businesses
try to predict what the business environment will be like and how it will affect their ability to
generate profits.
2. Sales Forecast
External supplied sales forecast is considered as the “driver” and shall be the “heart” of all
financial plans. The user of the planning model will supply this value and most other values
will be calculated based on it. The Planning will be focusing on projected future sales and
the assets and financing needed to support those sales. Most of time, the sales forecast will
be given as the growth rate in sales rather than as an explicit sales figure. Perfect sales
forecast is not possible, of course, it is because sales depend on the uncertain future state of
the economy.

Determinants of Growth Rates

A firm’s ability to sustain growth depends explicitly on the following factors:

• Profit Margin
An increase in profit margin will increase the firm’s ability to generate funds internally and it
will also increase its sustainable growth.

• Dividend Policy
A decrease in the percentage of net income paid out as dividends will increase the retention ratio.
These increases internally generated equity and thus increases sustainable growth.

• Financial Policy
An increase in the debt-equity ratio increases the firm’s financial leverage. Because of this, it
will make additional debt financing available, it increases the sustainable growth rate.

• Total Asset Turnover

An increase in the firm’s total asset turnover increases the sales generated for each peso in
assets. This decreases the firm’s need for new assets as sales grow and thereby increases the
sustainable growth rate. Notice that total asset turnover is the same as decreasing capital
intensity.

3. Pro forma Statements

A pro forma financial statement leverages hypothetical data or assumptions about future
values to project performance over a period that hasn’t yet occurred. Pro forma financial
statements are also defined as financial statements forecasted for future periods. They may
also be referred to as a financial forecast or financial projection. These projections can be
 useful in guiding important business decisions in interpreting or preparing pro forma
financial statements.

A financial plan will have a forecast statement of the following:

Financial Position
- it is often called the balance sheet, it reports the assets, liabilities, and equity of a
company on a given date. It helps to reveal the financial position of the company as
at a particular date.

Income Statement
- An income statement is a financial statement that shows you the company's income
and expenditures. It also shows whether a company is making profit or loss

Statement of Cash Flows

- The statement of cash flows, or the cash flow statement (CFS), is a financial
statement that summarizes the amount of cash and cash equivalents entering and
leaving a company

Statement of Stockholders’ equity

- Stockholders' equity is equal to a firm's total assets minus its total liabilities. These
figures can all be found on a company's balance sheet

These are called pro forma or projected statements which will show the different events
projected for the future.

4. Asset Requirements
The financial plan will describe projected capital spending. At a minimum, the projected
statement of financial position will contain changes in total fixed assets and net working capital.
These changes are effectively the firm's total capital budget. Proposed capital spending in
different areas must thus be reconciled with the overall increases contained in the long-range
plan.

— A common element of a financial plan that describes projected capital spending and the
proposed uses of networking capital.

Example:

How to Calculate Capital Expenditures

Let's say you own a furniture company and in 2018, you decided to spend money on new
equipment and an expanded facility. You then decided to calculate your company's capital
expenditures for that year. You determine the following information:
Capital Expenditures= PP & E (current period) — PP & E (prior period) + depreciation (current
period)

Depreciation = $15,000

PP&E at the end of 2018 = $50,000

PP&E at the beginning of 2018 = $35,000

CapEx= $50,000 - $35,000 + $15,000

= $30,000

5. Financial Requirements
The financial plan will include a section about the necessary financing arrangements. This part of
the plan should discuss dividend policy and debt policy. Sometimes firms will expect to raise
cash by selling new shares of stock or by borrowing. In this case, the plan will have to consider
what kinds of securities have to be sold and what methods of issuance are most appropriate.

6. Additional Funds Needed (AFN).

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 because projected total assets will exceed
projected total liabilities and equity. In other words, the statement of financial position will no
longer balance.
 the business?

AFN = Projected increase in assets - spontaneous increase in liabilities - any

increase in retained earnings.

AFN= Required Increase in Assets —

Spontaneous increase in liabilities — Increased in Retained Earnings
AFN= $200—$20—$66

The simplified formula is:

How do you compute additional funds needed by

AFN= $114 million

FINANCIAL PLANNING PROCESS

Well run companies generally base their operating plans on a set of forecasted financial
statements. The planning process begins with a sales forecast for the next five or so years. Then
the assets required to meet the sales targets are determined, and decision is made concerning how
to finance the required assets. At that point, income statements and statements of financial
position can be projected, and earnings per share, as well as the key ratios can be forecasted.
Once the “base-case” forecasted statements and ratios have prepared, top managers will ask
questions such as:

• Are the forecasted results as good as we can realistically expect, and if not, how might we
change our operating plans to produce better earnings and a higher stock price?

• How sure are we that we will be able to achieve the projected results? For example if our
base-case forecast assumes a reasonably strong economy but a recession occurs, would
we be better off under an alternative operating plan?
THE PROJECTED FINANCIAL STATEMENT METHOD
Any forecast of financial requirements involves (a) determining how much money the firm
will need during a given period, (b) determining how much money the firm will generate
internally during the same period, and (c) subtracting the funds generated from the funds
required to determine the external financial requirements.

The projected financial statement method is straightforward, one simply projects the asset
requirements for the coming period, then projects the liabilities and equity that will be generated
under normal operations, and subtracts the liabilities/capital from the required assets to estimate
the additional funds needed (AFN).

The steps in the procedures are as follows:

Step 1. Forecast the Income Statement.

a. Establish a sales projection.

b. Prepare the production schedule and project the corresponding production costs; direct
materials, direct labor and overhead.

c. Estimate selling and administrative expenses.

d. Consider financial expenses, if any.

e. Determine the net profit.

Step 2. Forecast the Statement of Financial Position.

a. Project the assets that will be needed to support projected sales.

b. Project funds that will spontaneously generated (through accounts payable and
accruals) and by retained earnings.

c. Project liability and stockholders' equity accounts that will not rise spontaneously with
sales (e.g., notes payable. long-term bonds, preferred stock and common stock) but may
change due to financing decisions that will made later.

d. Determine if additional funds will be needed by using the following formula.

Step 3. Raising the additional funds needed

The financing decision will consider the following factors. a. Target capital structure
b. Effect of short-term borrowing on its current ratio
c. Conditions in the debt and equity markets, or

d. Restrictions imposed by existing debt agreements.

Step [Link] financing feedbacks.

Depending on whether additional funds will be or will be raised through common stocks,
consideration should be given on additional interest expense in the income statement or
dividends, thus decreasing the retained earnings.

Apply the iteration process using the available financing mix until the AFN would become so
small that the forecast can be considered complete.

Financial Forecasting (Percent of Sales Method)

The Millennium Company has the following statements which are representative of the
company’s historical average.

Income Statement

Sales P 2,000,000
Cost of sales 1,200,000
Gross Profit 800,000
Operating Expenses _380,000_
Earnings before interest and taxes 420,000
Interest Expense _70,000_
Earnings before taxes 350,000
Taxes (35%) _122,500_
Earnings after taxes P 227,500

Dividends P 136,500
 Statement of Financial Position

Assets

Cash P 50,000
Accounts Receivables 400,000
Inventory _750,000_
Current Assets 1,200,000
Fixed Assets (net) _800,000_
Total Assets 2,000,000

Liabilities and
Equity
Accounts Payable P 250,000
Accrued wages 10,000
Accrued taxes _20,000_
Current liabilities 280,000
Notes payable – bank 70,000
Long-term debt 150,000
Ordinary Shares 1,200,000
Retained Earnings _300,000_
Total liabilities and equity P 2,000,000
The firm is expecting a 20 percent increase in sales next year, and management is concerned
about the company's need for external funds. The increase in sales is expected to be carried out
without any expansion of fixed assets, but rather through more efficient asset utilization in the
existing store. Among liabilities, only current liabilities vary directly with sales.

Using the percent-of-sales method, determine whether the company has external financing needs
or a surplus of funds Solution:

Step 1. Forecast the Income Statement.

The projected income statement will show the following:

Sales P 2,400,000
Cost of sales 1,440,000
Gross Profit 960,000
Operating Expenses _456,000_
Earnings before interest and taxes 504,000
Interest Expense _70,000_
Earnings before taxes 434,000
Taxes (35%) _151,900_
Earnings after taxes _P 282,100_

Dividends (36% payment) P 101,600_

Step 2. Forecast the Statement of Financial Position.
The projected statement of financial position will show the following:
Assets
Cash (1) P 60,000
Accounts Receivables (2) 480,000
Inventory (3) _900,000_
Current Assets P 1,440,000
Fixed Assets (net) (4) _800,000_
Total Assets P 2,240,000

Liabilities and Equity

Accounts Payable (5) P 300,000

Accrued wages (6) 12,000
Accrued taxes (7) _24,000_
Current liabilities P 336,000
Notes payable – bank (4) 70,000
Long-term debt (4) 150,000
Ordinary Shares (4) 1,200,000
Retained Earnings (8) _480,000_
Total P 2,236,500
Additional financing required ____3,500
Total P 2,240,000

Supporting computations:

(1) Cash = 2.5% x P2.4M sales

(2) Accounts receivables = 20% of P 2.4 M

(3) Inventory = 37.5% x 2.4M

(4) No percentages are computed for fixed assets, notes payables, long-term debt, ordinary shares
and retained earnings because they are not assumed to maintain a direct relationship with
sales volume. For simplicity, depreciation is not explicitly considered.

(5) Accounts payable = 12.5 % of P 2.4M

(6) Accrued expense = 0.5 % of P 2.4M

(7) Accrued taxes = 1% of P 2.4M
(8) Retained earnings = P 300,000 + P 282,100 – 101,600

Formula Method

Additional financing needed (AFN) may also be computed as follows:

Additional Required - Spontaneous Increase in x
increase in increase in - retained liabilities
Funds = assets
earnings
needed

Where:
Change in
Required sales
increase in
assets = Current Assets (present)
Change in Sales (present)
Spontaneous sales x
increase in
liabilities
= Current Liabilities
(present)
Earnings
Sales (present)
Increase in after taxes -
retained
earnings = Dividend Payment

Applied to Millennium Co., AFN is computed as follows:

1,200,000 280,000
AFN = (400,000 x ) - (400,000 x )
2,000,000 2,000,000

- 282,100 – 101,600
=240,000 – 56,000 – 180,500
= P 3,500

Review Questions:
IDENTIFICATION
 1. It is the assumptions that is made by a company about the general market
environment. (ECONOMIC ASSUMPTIONS)

2. It is often called the balance sheet, it reports the assets, liabilities, and equity of a
company on a given date. (FINANCIAL POSITION)

3. It is a financial statement that summarizes the amount of cash and cash equivalents
entering and leaving a company. (STATEMENT OF CASH FLOWS)

4. It begins with a sales forecast for the next five or so years. Then the assets required to
meet the sales targets are determined, and decision is made concerning how to finance
the required assets. (FINANCIAL PLANNING PROCESS/PLANNING
PROCESS)

5. In this step of the financial planning process, you will develop an action plan. This
requires choosing ways to achieve your goals. (STEP 5: CREATE AND
IMPLEMENT YOUR PLAN)

6. It is the first step of financial planning process where the financial planner will help
you determine your current financial situation with regard to income, savings, living
expenses, and debts. (GATHER INFORMATION AND DETERMINE YOUR
CURRENT SITUATION)

7. It is one of the elements of Financial Planning Model which states that a financial plan
will have a forecast statement of financial position, income statement, statement of
cash flows and statement of stockholders’ equity. (PRO FORMA STATEMENTS)

8. It is considered as the “driver” and shall be the “heart” of all financial plans. (SALES
FORECAST)

9. One of the Financial Models in which states that the financial plan will include a
section about the necessary financing arrangements. This part of the plan should
discuss dividend policy and debt policy. Sometimes firms will expect to raise cash by
selling new shares of stock or by borrowing. (FINANCIAL REQUIREMENTS)

[Link] is equal to a firm's total assets minus its total liabilities. These figures can all be
found on a company's balance sheet. (STATEMENT OF STOCKHOLDERS
EQUITY)

ESSAY
1. What is the importance of financial planning in business?
2. What are the difference between financial planning and financial forecasting? Are they
the same or not? Explain.
3. Give one benefits that can be derived from financial planning and explain it with your
own understanding?

Financial Management
FINANCIAL FORECASTING FOR STRATEGIC GROWTH
Submitted by Group 3 – BSBA FM 2A

Members:
Amita, Arvie
Amoroso, Gabriel francis M.
Apino, Andrea Mae B.
Bandola, Gemma Rose
Bulanhigan, Roselyn B.
 Josafat, Allyanna
Kabiling, Kate P.
Labrador, Kristine Bernadeth F.

Date of Submission: January 25, 2022