CHAPTER 03: FINANCIAL PLANNING AND FORECASTING

INTRODUCTION

Planning is a big part of modern corporate life, especially in large companies. To grow and
prosper, firms have to conduct two types of planning exercises: strategic planning and—a subset
of strategic planning—operational planning. Financial planning is a critical component of the
operational planning process. Strategic planning is long range in nature and deals with the
overall direction of the firm.

While strategic planning focuses more on the overall direction of the business and the industry,
operational planning, as the phrase denotes, is designed to be a blueprint detailing where the firm
wants to be at some future point in time and what resources are needed to get it there.
Operational plans are generally conducted at two levels—long-term and short-term. Long-term
plans are typically done over a 5-year planning horizon while short-term plans are conducted
over a 12- to 18-month window.

The numbers in a plan are largely projected financial statements. That is, they’re estimates of
what the firm’s statements will look like in the future if the assumptions about the business made
by the planners come true. Such statements based on hypothetical circumstances are called pro
forma, meaning they are cast “as if” the planning assumptions are true.

This unit deals primarily with financial planning. Simply put, that means projecting a company’s
financial statements into the future. However, financial planning is a part of a broader activity
known as business planning.

An overview of the corporate planning process

Marketing plan

Long-term Strategic Operational Operational Production plan

Goals of the Plan Objectives Plan
Firm Human Resource
plan

Financial plan

Figure 3.1 corporate planning process

The operational plan consists of a marketing plan, production plan, human resource plan, and a
financial plan. The marketing plan lays out the marketing resources needed to meet the
operational objectives and includes such things as advertising strategy, marketing promotions,

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channels of distribution and distribution incentives, and assignment of sales territory. The
production plan consists of facilities needed to meet the operational objectives including the
number of shifts, plant refurbishment and expansions, vendor and supplier arrangements,
inventory control, etc. The human resource plan is concerned with the personnel aspect of the
objectives. The financial plan lays out the financial resources that are needed to achieve the
operational objectives of the firm including the financial objectives of the firm.

3.1 THE PURPOSE OF PLANNING AND PLAN INFORMATION

The two major audiences for a firm’s business plan and the information it contains are
the firm’s own management and outside investors.

The Managerial Value of Planning

Business planning has several managerial benefits. One has to do with the process of creating the
plan, while the others are related to using the finished product.

The Planning Process: The planning process can pull a management team into a cohesive unit
with common goals. It helps everyone understand what the objectives of the organization are,
why they’re important, and how the organization intends to achieve them. Creating a plan forces
the team to think through everything that has to be done in the coming period, making sure
everyone understands what they have to do.
A Road Map for Running the Business: A business plan functions as a road map for getting an
organization to its goal. Comparing the details of operating performance with the plan and
investigating deviations is an important management process. When a business goes off course,
such a comparison is the best way to understand the firm’s problems and come up with solutions.

A Statement of Goals: A business plan is a projection of the future that generally reflects what
management would like to see happen. Accordingly, it can be viewed as a set of goals for the
company as a whole and for its individual departments. A plan contains revenue targets,
departmental expense constraints, and various development goals for products and processes.
Different people are responsible for different goals, and performance against them can be
measured and evaluated. It’s especially common to tie executive bonuses to the achievement of
goals within business plans.

Predicting Financing Needs: Financial planning is extremely important for companies that rely
on outside financing. Only through accurate financial planning can a corporate treasurer predict
when he or she will need to turn to financial markets to raise additional money to support
operations.

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

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investors. A plan predicts the future character of the enterprise. It makes an estimate of
profitability and cash flow. The financial information tells equity investors what returns they can
expect and debt investors where the firm will get the money to repay loans. Small firms use the
business plan document itself in dealing with investors. Large companies convey selected plan
information to securities analysts who use it and past performance as a basis for
recommendations to clients.

3.2 NATURE OF FINANCIAL PLANNING

Financial planning is the process of estimating the required finance of a firm for its business
decisions. It is a continuous process of directing and allocating financial resources to meet
strategic goals and objectives. Financial planning is concerned with identifying the need for
funding, term of funding, and sources of funding.

Need for Funding Sources of funding

 Initial investment
Term of Funding Internal sources
 Expansion  Short-term (Retained earnings)
 Diversification  Long-term Spontaneous sources
 Refinancing (repayment of Equity capital
long-term debt) Debt capital

Financial planning starts at the top of the organization with strategic planning. Strategic planning
is a formal process for establishing goals and objectives over the long run.

Strategic planning involves developing a mission statement that captures why the organization
exists and plans for how the organization will thrive in the future. Based on a very thorough
assessment of the organization and the external environment, strategic objectives and
corresponding goals are developed. Strategic plans are implemented by developing an Operating
or Action plan. A complete set of financial plans is included in the operating plans.

Financial planning involves the following steps:

1. Identify major decisions or problems facing the firm
2. Construction of a planning model to investigate the consequences of alternative decisions or
policies, which is the primary concern of this section
3. Selection of the best alternative course of action
4. Evaluation of subsequent performance against expectations

The major uses of financial planning are:

1. to determine the most likely consequences of a given policy or decision
2. to investigate the consequences of possible risks or hazards
3. to effectively manage risk (risk management)

Financial plans help managers ensure that their financing strategies are consistent with their
capital budgets. They highlight the financing decisions necessary to support the firm’s
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production and investment goals. The output from financial planning takes the form of budgets.
The most widely used form of budgets is Pro Forma or Budgeted financial statement. The
foundation for the budgeted financial statements is the detailed budget.

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. In forecasting, we make projections about what we think 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 senior 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).
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. If a financial planner thinks ahead about what could
go wrong, then he/she is less likely to ignore the danger signals and he/she can react faster to
trouble. Often financial planners work through the consequences of the plan under the most
likely set of circumstances and then use sensitivity analysis to vary the assumptions one at a
time.

3.3 INPUTS FOR PREPARING FINANCIAL FORECASTS

There are four major inputs for the preparation of Pro Forma Financial statements.
1. Data from prior financial statements such as previous sales levels and trends, past gross
percentages, operating as well as non-operating expenses, trends in the company’s need to
borrow to support various levels of inventory and trends in accounts receivable required to
achieve previous sales volume, etc.
2. Unique company data such as plant capacity, competition, financial constraints, personnel
availability, etc.
3. Industry-wide factors such as overall state of the economy (i.e. Boom, normal or recession),
economic status of the industry, population growth, elasticity of demand for the product or
service the firm provides availability of raw materials, etc.
4. Assumptions

3.4 FINANCIAL FORECASTING PROCEDURES

The following procedures may be used in predicting the future (financial forecasting).

1. Projection of Organization’s sales revenues

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Financial forecasting begins with sales forecast. Sales forecast is a forecast of a firm’s units and
Birr sales for some future period. Sales forecast is usually based on group effort. It requires
inputs from sales and marketing staff, distributors, sales representatives, top management,
production people, and accounting. The estimate of sales revenues during the selected period is
the most critical ‘guesstimate.” Factors that should be taken in to consideration in sales forecast
include the level of economic activity, the firm’s probable market share in each distribution
territory, the firm’s production and distribution capacity, the competitor’s capacity, new product
introduction by the firm and its competitors, the firm’s pricing strategies, the effects of inflation
on prices, advertising campaign, promotional discounts, and credit terms.

2. Estimation of the level of investments in current assets and fixed assets

Once sales forecast is obtained, the next step is to estimate the levels of current and fixed assets
that are necessary to support the projected sales.

3. Determination of the organization’s financing needs & sources of funds

This requires estimating additional resources required from external sources. Besides, it is
essential to predict cash inflows and outflows in relation to operating, investing, and financing
activities of the firm throughout the planning period.

4. Preparing pro forma or forecasted financial statements, namely, pro forma income statement,
pro forma balance sheet, and cash budget.

3.5 THE FINANCIAL PLANNING MODELS

Financial planners use financial planning models to help them explore the consequences of
alternative financial strategies. These models may range from simple to complex which
incorporates hundreds of equations. Financial planning models are useful in supporting the
financial planning process. They make the preparation of pro forma financial statements easier
and cheaper. They save time and labor in financial planning.
The major components of a financial planning model are classified in to three.

a. Input
b. The planning model-The planning model calculates the implications of the manager’s
forecasts for profits, new investments, and financing. The model consists of equations
relating output variables to forecasts.
c. Outputs
The outputs of the financial planning model are Pro Forma financial Statements such as income
statements, balance sheet, and statements describing sources and uses of cash. Pro form Financial
Statements are forecasted or projected financial statements. The outputs of financial models also

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include many of the financial ratios which indicate whether the firm will be financially fit and
healthy at the end of the planning period.

There are different financial planning models. However, only two are discussed in this section.

Percentage-of-Sales Model

The Percentage of Sales Method is a financial forecasting approach which is based on the
premise that most Balance Sheet and Income Statement accounts vary proportionally with sales.
Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma
Financial Statements (i.e., forecasted) can be constructed and the firms needs for external
financing can be identified.

The first step is to express the Balance Sheet and Income Statement accounts which vary directly
with Sales as percentages of Sales. This is done by dividing the balance for these accounts for the
current year by sales revenue for the current year.

The Balance Sheet accounts which generally vary closely with Sales are Cash, Accounts
Receivable, Inventory, Accounts Payable, and accruals. Fixed Assets are also often tied closely
to Sales, unless there is excess capacity. (The issue of excess capacity will be addressed in excess
capacity adjustment section.) In this section, we will assume that Fixed Assets are currently at
full capacity and, thus, will vary directly with sales.

Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earnings
which have been reinvested in the firm. Thus, the change in this account is linked to Sales;
however, the link comes from relationship between Sales growth and Earnings

The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automatically
with Sales. The changes in these accounts depend upon how the firm chooses to raise the funds
needed to support the forecasted growth in Sales.

On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assuming
that all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentage
of Sales. This indicates the Net Profit Margin.

Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividends
and Addition to Retained Earnings are expressed as a percentage of Net Income to determine the
Payout and Retention Ratios respectively.

The percentage of sales model is useful first approximation for financial planning. It is also used
to determine additional funds needed from external sources.

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Under percentage-of-sales model, the following procedures can be used to estimate external
capital requirements and, in turn, for the preparation of Pro forma financial statements:
1. Estimate increase in sales
2. Estimate additional investment in fixed assets.
If the firm is operating at full capacity, increase in sales requires proportional investment in fixed
assets.
¿ Assets
Increase ∈¿ Assets= × Increase∈ sales
Current Sales
3. Estimate increase in working capital or current assets
Current Assets
Increase ∈Current Assets= × Increase∈ sales
Current Sales
4. Estimate spontaneously generated funds
Spontaneously generated funds are funds that are obtained automatically from routine
business transactions. They arise from the purchase of goods and services on credit, such as
accounts payable, and accruals. Spontaneously generated funds are equal to increase in
current liabilities that are directly proportional to sales. Spontaneously generated funds may
be computed as follows:

Spontaneous Liabilities
Spontaneously Generated Funds= × Increase ∈sales
Current Sales

5. Estimate Internally Generated Funds

Internal Generated funds are funds obtained from internal sources in the form of retained
earnings. They may be computed as follows:

Internally Generated Funds= Projected Net income – Projected Cash Dividends

6. Additional Funds Needed (AFN)
This refers to the amount funds that should be obtained from external sources in the form of
long-term debt capital or equity capital.

( ) (
AFN = Increase∈¿ assets ¿ + Increase∈¿ Current assets − Spontaneously +
¿
Internally
Generated Funds Generated Funds )
Let’s consider the data presented below to illustrate the determination of external capital needed
and the preparation of pro forma financial statements.

Assume that Top Company has prepared the following Balance Sheet and Income Statement for
the year ended December 31, 2005.

1. Balance sheet

Assets Liabilities and Stockholders’ Equity

Cash 175,000 A/P 140,000

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 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

2. Income Statement

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

Additional Information
1. The company plans to have dividend payout ratio of 45%
2. Sales are expected to increase by 25% during next year (2006).
3. All assets are affected by sales proportionately. Accounts Payable and accrued liabilities
are also affected by sales.
4. All expenses are directly proportional to sales
5. The firm has been operating at full capacity.
6. 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.

a. Increase in sales = 2,500,000 x 25% = Br. 625,000

Projected Sales = Current sales + Planned increase in sales

= 2,500,000 + 625,000 = 3,125,000

1,500,000
b. Increase in fixed assets = ×625,000=375,000
2,500,000
If sales increase by 25%, fixed assets should increase by Br. 375,000

1,125,000
c. Increase in current assets = ×625,000=281,250
2,500,000
Additional current assets of Br. 281,250 are needed if sales increase by 25%. Increase in assets
as a result of increase in sales by Br. 625,000 is computed as the sum of increase in fixed assets
and increase in current assets i.e. 656,250 = 375000 + 281,250.

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 290,000
d. Spontaneously generated funds = ×625,000=72,500
2,500,000
e. Internally generated funds = Projected net Income – Projected cash dividend
Current Net income
Projected net income= × Projected Sales
Current sales

540,000
Projected net income= ×3,125,000=675,000
2,500,000

Projected Dividend = Projected net Income X Dividend Payout ratio

= 675,000 X 0.45 = 303,750

Internally Generated Funds = 675,000 -303,750 = 371,250

f. Additional Funds (External Capital) Needed

( ) (
AFN = Increase∈¿ assets ¿ + Increase∈¿ Current assets − Spontaneously +
¿
Internally
Generated Funds Generated Funds )
= (375,000 + 281,250) – (72,500 + 371,250)

= 656,250 - 443,750 = 212,500

According to the financing policy, the company raises 40% of external capital requirement from
bond issue and the remaining from the issuance of common stock. Accordingly,

Additional Bond issue = 212,500 X 0.40 = 85,000

Additional Common stock = 212,500 X 0.60 = 127,500

Based on the above computations and the original data, the following pro forma financial
statements could be prepared:

Top Company
Pro Forma Income Statement
For the Year Ended December 31, 2006
Sales …………………………………………………………………………..3,125,000
Less: Costs and Expenses except depreciation (1,400,000 x1.25) 1,750,000
Depreciation (200,000 x 1.25) …………………………… 250,000
Total costs and expenses ………………………………………. 2,000,000
Income Before Taxes ……………………………………………… 1,125,000
Less: Income Taxes (40%) ……………………………………….. 450,000
Net income ………………………………………………………… 675,000

Top Company
Pro Forma Balance Sheet
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 December 31, 2006
Assets:
Current Assets:
Cash (175,000 x1.25) 218,750
Accounts receivable (150,000 x 1.25) 187,500
Inventory (800,000 x 1.25) 1,000,000
Total current assets 1,406,250
Fixed Assets (1,500,000 x 1.25) 1,875,000
Total Assets 3,281,250

Liabilities & Stockholders’ Equity:

Current Liabilities:
Accounts Payable (140,000 x 1.25) 175,000
Accrued liabilities (150,000 x 1.25) 187,500
Total current Liabilities 362,500
Long-term debts:
Mortgage notes payable 1,410,000
Bonds Payable 85,000 1,495,000
Total Liabilities 1,857,500
Stockholders’ Equity:
Common Stock (800,000 + 127,500) 927,500
Retained Earnings  496,250 1,423,750
Total Liabilities and Stockholders’ Equity 3,281,250
Retained Earnings:
Beginning Retained Earnings 125,000
Add: Projected Net Income 675,000
Subtotal………………….. 800,000
Less: Dividend ………………….. 303,750
Retained Earnings, December 31, 2006 496,250
Note that any excess fund may be used for short-term investment purpose or for repayment of
liabilities, especially long-term liabilities.

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Additional Funds Needed Model
The second financial planning model is the Additional Funds Needed model. This model is used
to compute external fund requirement and in turn used to prepare pro forma financial statements.
The model is shown below:

AFN =Required Asset Increase−Spontaneous Liability increase−Increase∈Retained Earnings

A ( ∆ S ) L ( ∆ S)
AFN = − −M ( S 1 ) ( 1−D )
S0 S0

Where, A = Assets that are tied directly to sales; S0 = Current sales; ∆ S = Change in sales; L =
Liabilities that increase spontaneously; M = Net Profit margin = Current Net Income/Current
Sales; S1 = Projected sales; D = Dividend payout ratio

Using Top Company data, Additional Funds Needed is computed as follows

2625000 ( 625000 ) 290000 ( 625000 ) 540000

AFN = − − ( 3125000 )( 1−0.45 )
2500000 2500000 2500000

= 1.05 (625,000) –0.116 (625,000) – 0.216 (3,125,000) (0.55)

= 212,500

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

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.

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  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.

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.
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.
1. Determine full capacity sales (FCS)
Actual sales
FCS=
Current capacity utilization

2. Determine Target fixed assets (TFA) to sales ratio

TFA ¿ Sales ratio=Actual ¿ assets ¿
Full capacity sales
3. Determine the required level of fixed assets
Required level of ¿ assets=TFA ¿ Sales ratio× Projected sales

4. Determine additional investment in fixed Assets

Additional investment ∈¿ assets=Required level of ¿ assets−Actual ¿ assets

To illustrate, assume that the company has currently investment in fixed assets in the amount of
Br. 600,000. It has been operating at 80% capacity. Its current sales amounted to Br. 1,000,000.
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The company’s projected sales for the coming year are Br. 1,400,000. Current assets to sales
ratio is 15%, and Current liabilities to sales ratio is 9%. Current assets and Current liabilities
increase in direct proportion to increase in sales. Net profit margin is 10%.

Based on the above data, additional investments in fixed assets and additional funds needed are
determined as follows:

1,000,000
a. Full capacity sales= =Br .1,250,000
0.08
600,000
b. TFA ¿ Sales ratio= ×100=48 %
1,250,000
c. Increase in sales without increase in Fixed Assets

= Full capacity sales – current sales

= 1,250,000 – 1,000,000 = 250,000

d. Required level of Fixed Assets = (TFA to sales ratio) x (projected sales)

= 0.48 x 1,400,000 = 672,000

e. Additional Investment in Fixed Assets = (1,400,000 – 1,250,000) x 0.48 = 72,000

f. Increase in Current assets = 0.15 x 400,000 = 60,000
g. Spontaneously generated funds= 0.09 x 400,000 = 36,000
h. Internally generated funds = M (S1) (1-d)

= 0.10(1,400,000) (1 –0.60) = 56,000

i. AFN = (72,000 + 60,000) – (36,000 + 56,000)

= 132,000 – 92,000 = 40,000

Exercise
Assume that Minas Co. has the following balance sheet as of 31 December 2016:

Assets Liabilities & Equity

Cash 20,000 Accounts payable 20,000
Accounts receivable 25,000 Accruals 10,000
Inventory 15,000 Notes payable 30,000
Fixed assets 180,000 Long term debts 60,000
Common stock 100,000
Retained earnings 20,000
Total 240,000 Total 240,000

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Sales for the year just ended were br400,000 and fixed assets were used at 100% capacity. Its
current assets were also used at optimal levels. Sales are expected to grow by 30% next year.
Dividend payout ratio will be 20%. Projected net profit margin is 4%. Any additional funds will
be raised 20% using notes payable, 40% using common stock, and the remaining using long term
debts. Any excess fund will be used to reduce notes payable.

Required: Compute the following:

a. Planned increase in sales.____________________________________________________

b. Increase in working capital.__________________________________________________
c. Increase in fixed assets._____________________________________________________
d. Spontaneously generated funds.________________________________________________
e. Internally generated funds.____________________________________________________
f. Additional funds needed._____________________________________________________
g. The amount by which sales can increase without requiring external funding.____________
h. Projected cash balance, notes payable balance, and retained earning balance.____________

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