2.

1 Financial Planning and Forecasting

Financial planning and forecasting are used wrongly interchangeably; they are distinct activities
in the financial planning process. Below, you will see that financial forecasting is an input to the
financial planning process.

2.1.1 The planning Process

Financial planning is the process of estimating the required finance of a firm for its operating
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.

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.

Need for Funding Term of Funding Sources of Funding

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

Financial planning involves the following steps:

1. Identification of 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 risks (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
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.

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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 years), 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.
Inputs for Preparing Financial Forecasts (Pro Forma Financial Statements)
There are four major inputs for the preparation of Pro Forma Financial statements. These are:
1. Data from prior financial statements that can be obtained systematically from:
 Previous sales levels and trends
 Past gross profit 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
2. Unique Company Data that include:
 Plant capacity
 Competition
 Financial constraints
 Personnel availability
3. Industry-Wide Factors that encompass:
 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 the service the firm provides
 Availability of raw materials
4. Assumptions that could be:
 All presumed circumstances underlying the operating and financing decisions of
the firm.

Financial Forecasting Procedures

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

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 2.1.2 The Procedures and Importance of Sales Forecasting

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 records. The estimate of sales revenues during the selected
period is the most critical estimate. The following factors should be taken into consideration in
sales forecasting:
 The level of economic activity
 The firm’s probable market share in each distribution territory
 The firm’s production and distribution capacity
 The competitors’ 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
The sales forecasting process is depicted below:
Marketing
Top Management

Sales Estimates
Goals, targets,
requirements,
& plans

Finance Sales Forecast

Department

Production
Production Financial Statements,
capacity and Accounting
Accounting conventions
schedules

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

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  Pro forma income statement
 Cash budget
 Pro forma balance sheet
2.1.3 Techniques of Determining Future Financial Needs

Financial planners use financial planning models to help them explore the consequences of
alternative financial strategies. These models may range from simple to complex and encompass
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 into three.
a. Input
(See inputs for preparing financial forecasts topic above)
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 forma
Financial Statements are forecasted or projected financial statements. The outputs of financial
models also include many of the financial ratios which indicate whether the firm will be
financially fit and healthy at the end of the planning period.

Inputs Outputs
Planning Model
 Prior financial
statements of the firm
 Unique company Equations specifying key Projected financial
data statements
relationships
 Industry wide factors
 Assumptions

There are different financial planning models. However, only two are discussed in this section.
(I) 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 financial statements) can be constructed and the firm’s
needs for external financing can be identified.

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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 the 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.

In 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 in the approximation for financial planning. It is
also used to determine additional funds needed from external sources.
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.
Fixed Assets
x Increase in Sales
Increase in Fixed Assets = Current Sales
3. Estimate increase in working capital or current assets
Current Assets
x Increase in Sales
Increase in Current Assets = 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:

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 Spon tan eous Liabilities
Spon tan eously Generated Funds  x Increase in 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:

Internal 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.
 Spon tan eously   Internally 
 Increase in   Increase in     
 Fixed Assets    Current Assets    Generated    Generated 
     Funds   Funds 
AFN= 
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 Jiru Company has prepared the following Balance Sheet and Income Statement for
the year ended December 31, 2012.
1. Balance sheet

Assets Liabilities and Stockholders’ Equity

Cash 175,000 As/P 140,000
As/R 150,000 Accrued liabilities 150,000
Inventory 800,000 Mortgage Ns/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 2,500,000
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 (2013).
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.

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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
x 625,000
b. Increase in fixed assets = 2,500 , 000
= 375,000
If sales increase by 25%, fixed assets should increase by Br. 375,000
1,125,000
x 625,000
c. Increase in current assets = 2,500,000
= 281,250
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.
290,000
x 625,000
d. Spontaneously generated funds = 2,500,000
= 72,500
e. Internally generated funds = Projected net Income – Projected cash dividends
Current Net Income
x Pr ojected Sales
Projected net income = Current Sales
540,000
x 3,125,000
= 2,500, 000 = 675,000
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
 Spon tan eously   Internally 
 Increase in   Increase in     
 Fixed Assets    Current Assets    Generated    Generated 
     Funds   Funds 
AFN= 
= (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:
Projected Income statement items:
Sales 3,125,000
Costs and expenses except depreciation (1,400,000 x1.25) 1,750,000
Deprecation (200,000 x 1.25) 250,000

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 Jiru Company
Pro Forma Income Statement
For the Year Ended December 31, 2013
Sales ……………………………………………………………… 3,125,000
Less: Costs and Expenses except depreciation ……. 1,750,000
Depreciation ……………………………………… 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
Projected Balance Sheet items:
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
Fixed Assets (1,500,000 x 1.25) 1,875,000
Accounts Payable (140,000 x 1.25) 175,000
Accrued liabilities (150,000 x 1.25) 187,500
Mortgage Notes Payable 1,410,000
Bonds Payable 85,000
Common Stock (800,000 + 127,500) 927,500
Retained Earnings:
Beginning Retained Earnings 125,000
Add: Projected Net Income 675,000
Subtotal………………….. 800,000
Deduct: Dividend ………………….. 303,750
Retained Earnings, December 31, 2009 496,250

Jiru Company
Pro Forma Balance Sheet
December 31, 2013
Assets:
Current Assets:
Cash 218,750
Accounts receivable 187,500
Inventory 1,000,000
Total current assets 1,406,250
Fixed Assets 1,875,000
Total Assets 3,281,250

Liabilities & Stockholders’ Equity:

Current Liabilities:
Accounts Payable 175,000
Accrued liabilities 187,500
Total current Liabilities 362,500
Long-term debts:

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Mortgage notes payable 1,410,000
Bonds Payable 85,000 1,495,000
Total Liabilities 1,857,500
Stockholders’ Equity:
Common Stock 927,500
Retained Earnings 496,250 1,423,750
Total Liabilities and Stockholders’ Equity 3,281,250
Note that any excess fund may be used for short-term investment purpose or for repayment of
liabilities, especially long-term liabilities.

(II) 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:
 Increase in 
 Re quired Asset   Increase in  
       Re tained 
 Increase   Spon tan eous Liability   Earnings 
AFN=  
A L
(S )  (S )  M ( S1)(1  D )
= So So
Where,
A = Assets that are tied directly to sales
S0 = Current sales
∆S = Change in sales
L = Liabilities that increase spontaneously
Current Net Income
M  Net Pr ofit M arg in 
Current Sales
S1 = Projected sales
D = Dividend payout ratio
Using Jiru Company data, Additional Funds Needed is computed as follows:
2,625,000 290,000
(625,000)  (625,000)  0.216(3,125,000)(1  0.45)
AFN = 2,500 ,000 2 ,500 ,000
= 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.

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 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
Assets
Capital intensity Ratio = Sales
 The lower the 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.
 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 costs. 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. If, for example, we have come to know 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 also be different from planned assets resulting in
excess capacity. Excess capacity may occur in terms of 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.

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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 (%)
Determine Target fixed assets (TFA) to sales ratio
Actual Fixed Assets
TFA/Sales Ratio = Full Capacity Sales
Determine the required level of fixed assets
RLFA = (TFA/Sales ratio) x projected sales
2. Determine additional investment in Fixed Assets
AIFA = Required Level of Fixed Assets - Actual Fixed Assets
To illustrate, assume that Jiru Company currently has 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.
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:
1,000,0000
a. Full capacity sales = 0 .8 = Br. 1,250,000
600,000
b. Total Fixed Assets to Sales ratio = 1,250,000 = 48%
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)
= 0.10 (1,400,000) (0.40)
= 56,000
i. AFN = (72,000 + 60,000) – (36,000 + 56,000)
= 132,000 – 92,000
= 40,000
2.1.4 Relationships between Financial Analyses and Planning

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Financial statement analysis involves analyzing the firm’s financial statements to extract
information that can facilitate decision-making. For example, an analysis of the financial
statement can reveal whether the firm will be able to meet its long-term debt commitment,
whether the firm is financially distressed, whether the company is using its physical assets
efficiently, whether the firm has an optimal financing mix, whether the firm is generating
adequate return for its shareholders, whether the firm can sustain its competitive advantage etc.

The performance of a firm can be assessed by computing key ratios and analyzing to answer
such questions as: (a) how is the firm performing relative to the industry? (b) How is the firm
performing relative to the leading firms in their industry? (c) How does the current year
performance compare to the previous year(s)? (d) What are the variables driving the key ratios?
(e) What are the linkages among the ratios? (f) What do the ratios reveal about the future
prospects of the firm for various stakeholders such as shareholders, bondholders, employees,
customers etc.? Merely presenting a series of graphs and figures will be a futile exercise. We
need to put the information in a proper context by clearly identifying the purpose of our analysis
and identifying the key data driving our analysis. While the information used is historical, the
intent is clearly to arrive at recommendations and forecasts for the future rather than provide a
“picture of the past”.
Financial planning indicates a firm’s growth, performance, investments and requirements of
funds during a given period of time, usually three to five years. It involves the preparation of
projected or pro forma profit and loss account, balance sheet and cash flow statement. Financial
planning help a firm’s financial manager to regulate flows of funds which are his/her primary
concerns.

Budgeting is a good example of business analysis and planning in action. Companies use budgets
as both road maps for future operations and cost control methods. Proper budgeting requires the
use of previous financial data in order to create limits for future expenditures. Analysis and
planning coincide here because those creating the budget also need to make plans for additional
capital expenditures. The result is a workable plan that many individuals in the company will use
to complete operations and enhance the company’s overall operations.

C Summary

The annual reports of a company provide financial data, in the form of financial statements and
notes, management discussions, and the auditor’s opinion. The financial statements (the balance
sheet, income statement, statement of cash flows, and statement of shareholders’ equity), along
with the accompanying notes, provide information necessary to assess the operating performance
and the financial condition of the firm under consideration. Using this information, in
conjunction with an understanding of accounting, analysts can see where a business has been,
which may tell us something about where it is going.
The balance sheet provides information about the value of accounts at a point in time, generally
at the end of the fiscal year or the end of the fiscal quarter. The income statement provides
information about the operating performance of a company over a period of time (typically a
fiscal year or fiscal quarter). The statement of cash flows provides data on the cash flows of the
company over time and the sources of these cash flows. The statement of shareholders’ equity

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details the changes in the equity accounts over a period of time. The notes to financial statements
provide more detail on many accounts.
The analyses of statements help the management at self appraisal and the same help the
shareholders to judge the performance of the management. Apart from management there are
other interested parties like shareholders, debenture holders, potential investors, bankers, trade
creditors, journalists, legislators and politicians who are increasingly getting interested in the
analysis and interpretation of financial statements.
To interpret means to put the meaning of a statement into simple terms for the benefit of a
person. This is essentially done through the tools of analysis such as comparative statements,
common size statements and ratio analysis. These tools may be compared with the laboratory
tests, which aid a physician in the diagnosis of an illness. Just as laboratory tests are
only aids to a physician and the physician must use his/her intelligence in the correct diagnosis,
the tools of analysis only help in establishing relationship between one accounting figure and
another in the financial statements and go no far. It is the expert who has to grasp the
significance of related figures and form an opinion as to whether the ratio calculated indicates a
favorable or adverse state of affairs. Therefore while analysis comprises manipulating the
statements by breaking them into simpler statements via rearranging, regrouping and the
calculation of ratios, interpretation is the mental process of understanding the terms of such
statements and forming opinions of inferences about the financial health, profitability, efficiency
and such other aspects of the undertaking.

Managers prepare pro forma financial statements and then use them for four purposes: (1) to
assess whether the firm’s future performance is within the general targets and investors’
expectations: (2) to estimate the effect of proposed changes, (3) to predict the firm’s future
financing needs, and (4) to determine the firm’s future free cash flows that determine the firm’s
value. Managers forecast free cash flows under different operating plans and take the one that
maximizes the firm’s overall value. Security analysts make the same projections to determine the
stock price of the firm and consult their clients. Financial planning and forecasting is part of the
strategic and long-term planning that affects a firm’s operation in the long run. Hence, it should
be handled with utmost care.

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