Forecasting Financial

Statements
Quote of the Day:
“Forecasts may tell you a great deal about
the forecaster; they tell you nothing about
the future” ----- Warren Buffet
Preview
 Growth rate , g, measured as ROE (1 – d) is internally generated constant
growth rate in OE but it is not the sustainable growth rate for a company.
 When a company grows at this constant growth rate it needs external
financing, called EFN (external funds needed) because when as OE grows
next year due to increase in RE then TA must also grow; and as both TA
and OE would grow therefore TL must also grow at the same growth rate
only then next year’s balance sheet would be balanced.
 But, growth in TL means external debt financing as short term or long
term loans would be needed.
 Therefore this growth rate, ROE (1 - d), is not sustainable growth rate for
a business because it requires raising external financing in the form of
loans, though no equity financing in the form of issuing shares is needed
because constant growth rate , g , has been defined as internally
generated growth in OE through increase in RE.
Sustainable Growth Rate
 Sustainable growth rate of a co is that growth rate in sales next year where
EFN (external funds needed) are zero.
 That means no financing is needed by issuing shares or taking bank loans, all
financing comes as spontaneous increase in some CL and as increase in RE.
 To estimate sustainable growth rate of a co we assume that 4 policies remain
constant:
1) Net profit margin (NI /S ratio)
2) Turnover of TA ( S /TA ratio)
3) Dividends payout ratio (DPS / EPS = d )
4) Number of shares outstanding are unchanged next year
 But, Equity multiplier ratio (TA / OE ratio) of co, is not necessarily same as
last year’s ratio.
Forecasting Financial Statements -
Exercise
Balance Sheet (Beginning of year 2015) I/S (End of 2015)
Cash 20 A/P 20 Sales 500
R/A 30 Accruals 40 Net Income 10
Inventory 100 ST Bank loan 20 d 50%
CA 150 CL 80 Net Profit NI / Sales
FA (Net) 50 LT Loan 20 Margin 10 / 500
(NPM) = 2%
TA 200 TL 100
Share Capital 20 gOE = ???
RE 80
OE 100
TL & OE 200
Forecasting Financial Statements -
Exercise

 ROE = NI /OEbeginning = 10 /100 = 10%

 gOE = ROE ( 1 - d)
= (10%) * (1 - 0.5)
= 10% * 0.5
= 5%
 Please prepare next year’s concise projected income statement at the
end of 2016 and full blown projected balance sheet at the beginning of
2016, that is end of 2015; and see if this Co grows next year’s at the
constant growth rate of 5% then would it need external financing ?
Forecasting Financial Statements -
Exercise

S1 =S0 (1 + g)
S1 =500 ( 1+ 0.05)
S1 = 525

Increase in S = S1 - So
=525 – 500 = 25
Forecasting Financial Statements –
External Funds Needed
 EFN
= Total Funds needed (or Increase in TA) – internally generated funds

 TFN: TA/S ratio tells one rupee of sales need how much assets.
TFN refers to amount of TA needed to support increase in sales.

 TFN = (TA/S * increase in sales)

Forecasting Financial Statements –
External Funds Needed
 EFN
= Total Funds needed (or Increase in TA) – internally generated funds

 TFN: TA/S ratio tells one rupee of sales need how much assets.
TFN refers to amount of TA needed to support increase in sales.

 TFN = (TA/S * increase in sales)

= (200/500) * 25 = 10
Forecasting Financial Statements –
External Funds Needed
Internally generated Funds:
1) Spontaneous Liabilities: Spontaneous liabilities / sales ratio tells one rupee of sales
need how much of such liabilities; and multiplying this ratio by increase in sales tells
higher sales would cause how much increase in such liabilities, and
hence, increase in these liabilities:
= (spontaneous Liabilities/S ratio* increase in S)
2) Retained Earnings: NI/S ratio tells one rupee of sales generates how much NI,
multiplying this ratio with next year’s sales give estimate of next year’s NI, and
multiplying that with ( 1 - d) gives increase in RE next year.
Hence, Increase in RE = (NI/S ratio *S1(1 – d))
Forecasting Financial Statements –
External Funds Needed
Internally generated Funds:
1) Spontaneous Liabilities: Spontaneous liabilities / sales ratio tells one rupee of sales
need how much of such liabilities; and multiplying this ratio by increase in sales tells
higher sales would cause how much increase in such liabilities, and hence, increase in
these liabilities:
= (spontaneous Liabilities/S ratio* increase in S)

= [(60/500) * (25)] = 3
2) Retained Earnings: NI/S ratio tells one rupee of sales generates how much NI,
multiplying this ratio with next year’s sales give estimate of next year’s NI, and
multiplying that with ( 1 - d) gives increase in RE next year.
Hence, Increase in RE = (NI/S ratio) * S1 * (1 – d)

= (10/500) * (525) * (1 – 0.5)

= 5.25
Forecasting Financial Statements –
External Funds Needed
EFN =[TA/S ratio* increase in S] –
[(Spontaneous Liabilities/S ratio* increase in S) + (NI/S ratio *S1(1–d))]
EFN = 10 -[(3 ) + (5.25)]
EFN = 10 - 8.25
EFN = 1.75 million.
Forecast Balance Sheet for Next year at
Growth Rate of 5%
Balance Sheet (Beginning of year 2015) Assumptions
Cash 20 A/P 20 • FA are being used at
R/A 30 Accruals 40 full capacity

Inventory 100 ST Bank loan 20 • End RE = Beg RE + NI

CA 150 CL 80 – Cash Dividends +
Stock Div
FA (Net) 50 LT Loan 20
TA 200 TL 100 • End OE = Beg OE + NI
Share Capital 20 – Cash Div + Shares
issued – Shares
RE 80 repurchased
OE 100
TL & OE 200
Forecast Balance Sheet for Next year at
Growth Rate of 5%
Assets Liabilities & OE
Cash 20*(1.05) = P/A 20*(1.05) = Net Profit
A/R 30*(1.05) = Accruals 40*(1.05) = Margin (NPM):
NI / S
Inventory 100*(1.05) = ST Bank (unchanged)
Loans NI Year 1:
CA LT Loans (unchanged) NPM * S1
FA (Net) TL
Cash Div = NI*D
TA Share Capital (unchanged)
End RE Beg RE + NI - Div
OE Beg OE + NI – Div +
Shares issued - SR
EFN TA – TL –OE =
TL & OE
Forecast Balance Sheet for Next year at
Growth Rate of 5%
Assets Liabilities & OE
Cash 20*(1.05) = 21 P/A 20*(1.05) = 21 NI / S = 10/500
A/R 30*(1.05) = Accruals 40*(1.05) = 42 = 2%
31.55
NI Year 1:
Inventory 100*(1.05) = ST Bank 20 (unchanged) NPM * S1
105 Loans = 525*(.02)
CA 157.55 LT Loans 20 (unchanged) =10.5
FA (Net) 50*(1.05) = 52.5 TL 103
Cash Div = NI*D
TA 210 Share Capital 20 (unchanged) = 10.5*0.5
End RE 80+10.5-5.25 = 85.25 = 5.25
OE 100+10.5– 5.25
=105.25
EFN TA – TL –OE = 1.75
TL & OE 210
External Funds needed

External funds can be raised from three sources:

1) Taking short term bank loan,
2) Taking long term bank loan or issuing long term corporate bonds which are
called in Pakistan TFCs(term finance certificates),
3) Issuing new shares to the existing shareholders called right issue or issuing
new shares to general public called seasoned issue
Calculating Sustainable Growth Rate

 S1 = S0*(1 + g)
 Increase in Sales = S1 - S0
= S0*(1 + g) - S0
= S0 + S0*g - S0
= S0*g
At sustainable Growth Rate, EFN = 0

EFN =[TA/S ratio* increase in S] –

[(Spontaneous Liabilities/S ratio* increase in S) + (NI/S ratio *S1(1–d))] = 0
Calculating Sustainable Growth Rate

 S1 = S0*(1 + g)
 Increase in Sales = S1 - S0
= S0*(1 + g) - S0
= S0 + S0*g - S0
= S0*g
At sustainable Growth Rate:
EFN =[TA/S ratio* increase in S] –
[(Spontaneous Liabilities/S ratio* increase in S) + (NI/S ratio *S1(1–d))] = 0

EFN = [TA/S * (S0*g)] – [ {(SL/S) * ( S0*g)} + { (NI/S) * S1 * (1 – d) } ] = 0

Calculating Sustainable Growth Rate -
Assumptions
 To attain sustainable growth rate in sales it is assumed that management of this
company keeps the following 5 policies constant, namely:
1) Net income as percentage of sales (also called net profit margin or profitability)
2) Total asset as percentage of sales, which is a measure called asset productivity
3) Dividend payout ratio (also called dividend policy, d)
4) Number of shares outstanding constant
5) Spontaneous CL as percentage of sales.
 There is no need to keep financial leverage as measured by TA/OE ratio ( also called
capital structure and equity multiplier), constant.
 Inverse of S /TA ratio (TA turnover) is TA/S which was used here. TA/S ratio shows
TA as %age of sales, and it is a measure of asset productivity; it is also a measure of
capital intensity of a business because if more TA are needed to generate 1 rupee of
sales then such a business is deemed as using capital intensive production methods.
 Calculating Sustainable Growth Rate -
Example
EFN =
(TA/S ratio* So g ) – [{ spontaneous CL /S ratio* So g } + { NI/S ratio *S1(1 - d)}]
0 = (0.4 * So g) – [{0.12*So g + {0.02*(So(1 + g)(1- d)}]
 Calculating Sustainable Growth Rate -
Example
EFN =
(TA/S ratio* So g ) – [{ spontaneous CL /S ratio* So g } + { NI/S ratio *S1(1 - d)}
0 = (0.4 * So g) – [{0.12*So g + {0.02*(So(1 + g)(1- d)}]
0= (0.4 * 500 g) – [(0.12 * 500 g) + (0.02 * {500(1 + g)} * (1 - 0.5)]
 Calculating Sustainable Growth Rate -
Example
0 = (0.4 * So g) – [{0.12*So g + {0.02*(So(1 + g)(1- d)}]
0= (0.4 * 500 g) – [(0.12 * 500 g) + (0.02 * {500(1 + g)} * (1 - 0.5)]
0 = 200g - [(60g + (0.02*(500 + 500g)*0.5)]
0 = 200g - [(60g + (5 + 5g)]
0 = 200g - [(65g + 5)]
0= 135g -5
5= 135g
G= 5/135
G= 0 .0370 or 3.7% per year = Sustainable growth rate
Forecast Income Statement for Next
Year at 3.7% growth rate
Sales Next year:
S1 = So * (1 + g)

Net Income for Next year:

NI 1 / S 1 = 0.02
NI 1 =
Dividend Next year:
Cash dividends = NI 1 * ‘d’
=
Forecast Income Statement for Next
Year at 3.7% growth rate
Sales Next year:
S1 = So * (1 + g)
= 500 * ( 1 + 0.037) = 518 million rupees
Net Income for Next year:
NI 1 / S 1 = 0.02
NI 1 = 0.02 * S1 = 0.02 * 518 = 10.37 million
Dividend Next year:
Cash dividends = NI 1 * ‘d’
= 10.37 * 0.5 = 5.18 million Rs.
Forecast Balance Sheet for Next year at
Growth Rate of 3.7%
Assets Liabilities & OE
Cash 20*(1.037) = P/A 20*(1.037) =
A/R 30*(1.037) = Accruals 40*(1.037) =
Inventory 100*(1.037) = ST Bank Loans (unchanged)
CA LT Loans (unchanged)
FA (Net) TL
TA Share Capital (unchanged)
End RE Beg RE + NI - Div
OE Beg OE + NI – Div + Shares
issued - SR
EFN TA – TL –OE =
TL & OE
Forecast Balance Sheet for Next year at
Growth Rate of 3.7%
Assets Liabilities & OE
Cash 20*(1.037) = 20.74 P/A 20*(1.037) = 20.7
A/R 30*(1.037) = 31.11 Accruals 40*(1.037) = 41.5
Inventory 100*(1.037) = 103.7 ST Bank Loans 20 (unchanged)
CA 125 LT Loans 20 (unchanged)
FA (Net) 50*(1.037) = 51.8 TL 102.2
TA 207.3 Share Capital 20 (unchanged)
End RE 80+10.37-5.1 = 85.18
OE 100+10.37– 5.18 =105.18
EFN TA – TL –OE = 0
TL & OE 207.3
Practice Questions

1) Forecast Income Statement, Balance Sheet, EFN assuming a growth rate of

15% for next year. Double Check EFN using the equation method.
Practice Questions
2) Forecast Income Statement, Balance Sheet, EFN assuming a growth rate of 20%
for next year. The latest relevant data from balance sheet (beginning of year, Jan
2015) and income statement( end of year, Dec 2015) are given in concise form: TA
= 500m, S = 1000m, CL = 200 m but out of that 50 million rupees is notes P/A to
MCB, a short term loan, rest of the CL are all spontaneous CL. NI =100m, Total Cash
Dividends paid = 30m. Find:
1) TFN (total funds needed) to expand TA to support growth in sales.
2) Funds generated by spontaneous increase in liability
3) Funds generated by increase in RE
4) Internally generated funds ( items 2 + 3 above)
5) EFN ( external funds needed) ( Item 1 - 4 above)
6) Sustainable growth rate for this firm
7) EFN, at 60% growth rate in sales
Practice Questions
3) Forecast Income Statement, Balance Sheet, EFN assuming a growth rate of 10%
for next year. The latest relevant data from balance sheet (beginning of year, Jan
2015) and income statement( beg of year) are given in concise form: TA = 5000m, S
= 10000m, CL = 2000 m but out of that 500 million rupees is notes P/A to MCB, a
short term loan, rest of the CL are all spontaneous CL. NI =100m, Total Cash
Dividends paid = 30m. Find:
1) TFN (total funds needed) to expand TA to support growth in sales.
2) Funds generated by spontaneous increase in liability
3) Funds generated by increase in RE
4) Internally generated funds ( items 2 + 3 above)
5) EFN ( external funds needed) ( Item 1 - 4 above)
6) Sustainable growth rate for this firm
Practice Questions
4) TA = 1000, TL = 400 & OE = 600
Sales = 3000, NI = 1000, d = 20%, Kc = 12% & number of shares outstanding = 100
million.
If next year, NPM increases by 2%, TATO increases by 1.5 times, Dividend payout
ratio increases by 10% & other policies remain constant, Forecast Income Statement
(Sales, NI, Expenses, EPS, DPS) & Balance sheet for the next year?