

Financial
Management MGT201
VU
Lesson
05
FINANCIAL
FORECASTING AND FINANCIAL
PLANNING
Learning
Objectives:
After
going through this lecture,
you would be able to have an
understanding of the following
concepts.
·
Financial
Forecasting and Financial
Planning.
·
Methods
of forecasting
Before
going into the detailed
calculation of cash flow, it is
important to know the principles
behind
financial
forecasting and financial
planning.
Although,
financial planning and forecasting cannot
reduce the uncertainty in our
lives, the idea is
simply
to acknowledge and identify different
points in time, where we expect some
future occurrences,
and
to prepare plans and contingencies in the light of
those forecasted happenings. Of course,
we cannot
be
certain about the future,
but we can always plan
and arrange for it.
Objectives
of Financial Forecasting:
Although,
financial planning and forecasting cannot
reduce the uncertainty in our
lives, the idea is
simply
to acknowledge and identify different
points in time, where we expect some
future occurrences,
and
to prepare plans and contingencies in the light of
those forecasted happenings. Of course,
we cannot
be
certain about the future,
but we can always plan
and arrange for it.
1)
Reduce cost of responding to
emergencies by anticipating the future
occurrences
2)
Prepare to take advantage of future
opportunities
3)
Prepare contingency and emergency
plans
4)
Prepare to deal with possible
outcomes
Planning
Documents:
There
are three types of documents that
are to be prepared while making a
financial plan. These
are
1)
Cash Budget
2)
Pro Forma Balance Sheet
3)
Pro Forma Income Statement
Here,
the term `pro forma' refers to
forecasting. These pro forma
statements are prepared on the basis
of
certain
estimates.
Methods
of forecasting
In
order to prepare pro forma
statements, two methods are
commonly practiced, which are
given
as
under
Percentage
of Sales: Simple
Cash
Budget: Detailed,
more complicated
Percentage
of sales:
Step
1: Estimate yearbyyear Sales Revenue
and Expenses
Step
2: Estimate Levels of Investment Needs
(in Assets) required meeting
estimated sales
(using
Financial
Ratios). That how the Assets
of the company changes with the change
in
Step
3: Estimate the Financing Needs
(Liabilities)
Explanation:
While
employing percentage of sales
method, we would estimate
the cash flows based on
the
sales
revenue. The first step is to
forecast the changes in the sales revenue
in the successive years.
Expenses
incurring in successive period
would also be estimated. These
expenses include cost of
goods
sold
expense, administrative, expense,
marketing expense, depreciation
expense, and other
expenses.
However,
these revenues and expenses
would be estimated on cash, rather
than accrual basis.
After
estimating the revenues and
expenses, we need to forecast the
anticipated changes in
assets
and liabilities as a result of
changes in sales. Having
forecasted the assets and
liabilities as a result
of
changes in sale, we would be
able to identify how much
capital the firm has to
invest in assets and
how
much the company needs to borrow as a
result of any shortfall.
Here, we would examine
the
various
heads of assets and
liabilities and their relationship
with sales. We can establish
these relations
by
identifying the changes in assets
and liabilities as a result of
change in sales, and to do
that certain
assumptions
need to be considered.
GENERAL ASSUMPTIONS
Current
Assets:
Generally
grow in proportion to
Sales.
Fixed
Assets: Do not always grow
in proportion to Sales. Ask if
you need to expand
property, office
or
factory space, machinery in
order to achieve your Sales
target.
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Financial
Management MGT201
VU
Current
Liabilities:
Also
called Spontaneous Financing.
Generally grow in proportion to
Sale
Long
Term Liabilities: Also,
called Discretionary Financing
does not grow in proportion
to Sales
Explanation:
Current
assets include cash,
marketable securities, accounts
receivable, inventory, and
prepaid
expenses.
Out of these current assets,
changes in cash, accounts
receivable and inventory can be
directly
linked
to changes in sales. However,
marketable securities and prepaid
expenses are independent
of
sales,
i.e., changes in sales may
not affect these two
heads. It is also important to
note that the current
assets
do not change exactly in the
same proportion as the sales
in real life situation,
i.e., an increase of
10
percent in sales may not necessarily
guarantee that the current
assets would also increase
by 10
percent.
However, for the sake of
simplicity we would assume
that the current assets
change
proportionally
as the sales change.
On
the other hand, fixed assets do
not change directly with a
change in sales. For
example, if
you
plan to increase the sales revenue by
20% then it is not necessary
to increase the fixed assets
by
20%.
But, if a company plans to double its
sales in the next three years, the
company might have to
increase
its fixed assets; however,
small yeartoyear changes in
sales do not affect the
fixed assets.
Current
liabilities include accounts
payable, short term portion of
long term liabilities and
accrued
expenses. Current liabilities
like current assets are
assumed to grow proportionally
with any
growth
in sales. If the sales of a company
increase by 30 percent, its current
liabilities would
also
increase
by 30 percent. Current liabilities are
also called spontaneous
financing since they move
in
direct
relation with changes in
sales.
However,
the long term liabilities, also
known as discretionary financing, do
not directly change
in
proportion to the changes in sales
revenue.
In
order to have a better understanding of the
aforementioned concepts, let us
take into
consideration
a numerical example.
Example:
Assume
that you are establishing
cafeteria as a new business venture. In
order to get your
project
funded you would be needing
capital. In addition, you
would also need to forecast
how your
business
would generate revenues and
incur expenses in the coming
years.
Suppose
you expect the Sales Revenue from
your Café (or Canteen) business to
grow from Rs
200,000
to Rs 300,000 and your Expenses to
grow from Rs 50,000 to Rs
70,000 after 1 year.
These
forecasts
can be based on the business
environment in which the business
operates, competition faced
by
the business, marketing efforts and
activities of the business and the
target market.
The
first thing we need to calculate
here is the sales growth rate.
The increase in the sales in
Rupee
terms
is 300,000200,000=Rs.100, 000. The
sales revenue has increased up to
rupees 100,000 rate of
increase
is 50% as present sales were
Rs.200, 000.
This
means that the Sales Revenue
growth rate is:
(300,000200,000)
/ 200,000 = 0.5 = 50%
Similarly
an increase in expenses of Rs 20,000
shows that the rate of increase in
expense is 40%
(i.e.,
increase of Rs 20,000 in expenses
divided by the expenses in year
one).
After
forecasting the growth rate in
revenues and expenses, the
next step is to estimate the
changes in
investment
and financing (i.e., changes in
assets and liabilities).
In
order to estimate these
changes, we would need to calculate a
few ratios.
In
order to estimate the current
assets for the next year, we
need to calculate the ratio
current
asset
to sales for the current
year. In order to arrive at the
estimate of current assets
for the next year we
would
simply multiply the estimated sales
for the next year with the
ratio.
Estimated
current assets for the
next year
=
[Current assets for the
current year/Current sales] x Estimated
sales for the next
year
If
we assume the current assets/sales
ratio to be 20 percent, putting in the values in
the
aforementioned
equation, we get
Current
assets for the next year =
300,000 x (0.2) =
60,000
This
shows that with an increase
in sales of Rs 100,000, the current
assets of the cafeteria are likely
to
increase
as 20 percent of the sales.
We
will assume here that there
is no change in the fixed assets. As
mentioned earlier,
fixed
assets
do not change with
yeartoyear changes in sales,
however, over a period of
time, the fixed
assets
may
be increased as the business requires
expansion.
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Financial
Management MGT201
VU
The
next step is to forecast the
retained earningsthe amount of profit
which would be
reinvested
in the business. Retained earning
forecasting is important so that
any shortfall in cash
could
be
identified and the amount of external
financing necessary for the
business could also be
assessed.
Retained
earnings can be estimated using the
following formula
Expected
Estimated retained earnings
=
estimated sales x profit margin x
plowback ratio
Plow
back ratio=1pay out
ratio
Pay
out ratio=dividend/net income
Profit
margin=net income/sales
Here,
we assume that the profit
margin ratio is 25 percent, whereas
payout ratio of the cafeteria is
50
percent
Estimated
retained earnings = 300,000 x 0.25 x
(10.5)
=75,000*(10.5)
=Rs.37, 500
Rs
37,500/ is predicted retained earnings
amount which should appear in the
pro forma balance sheet.
It
shoes
that half of the income will
be distributed among the owners & the other
half will be reinvested.
Now
let's forecast the external or
discretionary financing (external
financing), since we
have
estimated the revenues and expenses of
the business, the changes in assets
and the part of the net
income
that is to be reinvested in the
business.
The
formula will be used:
Estimated
discretionary financing
=
estimated
total assets estimated
total liabilities estimated
total equity
Estimated
total equity can be found
out by adding the retained earnings
plus initial
investment.
The business was started
with an initial investment of Rs
100,000 and then after one
year of
operations
the earnings retained out of the profit,
i.e., Rs 37,500 would be
added to the equity. Hence
the
total equity is Rs
137,500.
Now
we can easily solve the above
given equation
Estimated
discretionary financing
=
estimated total assets estimated
total liabilities estimated
total equity
=160,0000137,500=
Rs.22, 500
This
is the borrowing that we need to
raise in form of loan or the
equity, as a result of
growth
in sales.
After
calculating the estimated revenues,
expenses, assets and
liabilities, we are in a position
to
prepare
the pro forma cash flow
statement. The owners like
to see the company to grow at a steady
rate
rather
then high growth & slump
scenario. The shareholders
prefer those companies where
growth rate
is
steady and consistent & the
mangers need to make sure
that the growth rate remains
steady.
If
you want to maintain the
forecasted financial ratios
that you have calculated and
along with this we
do
not want additional personal
capital to be invested in the business,
then at what rate the
business is
growing
can be calculated by the following
formula
G
(Desired Growth Rate) =
return on equity x (1 pay
out ratio)
Pay
out ratio as defined above
equals, dividends/net
income.
Return
on equity is net income/ total
equity.
Return
on equity would be discussed in
detail when we would study
the rate of return &
capital
budgeting.
Drawback
of Percent of Sales
Method:
Despite
the fact that percentage of
sales method is widely used method
for forecasting, it
has
certain disadvantages.
The
first and the foremost problem with
this method is that it is only a
rough approximation and
is
not very detailed. The
other problem is that if there is a
change in fixed assets
during the forecasted
period
the percentage of sales method
would not yield a very
accurate answer. The third
problem is that
the
lumpy assets are not
taken into account while
using the percentage of sales method.
Here, lumpy
assets
refer to those assets which
can only be acquired in
large discrete units.
Summarizing
the above discussion, we can say
that in percentage of sales method
of
forecasting
pro forma cash flow
statement most of the heads in the
balance sheet are linked to
the sales
growth
of the business. First of all, we
need to know the ratios of
assets and liabilities to
sales for the
27
Financial
Management MGT201
VU
current
period. These ratios are
then applied to the estimated sales
for the next period to get a
forecast of
assets
and liabilities for the next
period.
After
understanding the dynamics of percentage of
sales method, and having prepared the
pro
forma
income statement and pro
forma balance sheet, we are
in a position to discuss the forecasted
or
pro
forma cash flow statement. A
pro forma cash flow
statement is just like an
ordinary cash flow
statement;
the only difference is that the
figures in a pro forma cash
flow statement are estimated
figures
rather
than actual ones. The estimated
statement is later compared to the
real aftereffect cash
flow
statement
to assess the quality of the
estimate.
After
calculating the estimated sales revenue,
we have already calculated the estimated
net
income
of the business, multiplying the
estimated figure of sales
for the next year with the
profit margin
ratio.
Forecasted net income gives the
starting point for an estimated
cash flow statement. If the
assets
are
20% of sales and depreciation
is10% of the assets then the
depreciation is 10% multiply
20% which
is
equal to 2% of sales. After
calculating depreciation at 2%,
you can calculate the
forecasted
depreciation
this will appear in our
forecasted cash flow
statement. Afterwards we would
see the
increases
and decreases in current
assets and current
liabilities. An increases in current
assets and
increase
in current liabilities can be calculated
using constant percentage of
sales approach. We can
compare
the forecasted cash flow
with the actual cash flow
statement to know how much
accurate our
estimates
are. If we use indirect cash
flow then the first thing is
our net income plus depreciation,
minus
increase
in current assets, plus
decrease in current liabilities,
would provide us with cash
flows from
operations.
PRO FORMA
CASH FLOW STATEMENT
(`000
Rs)
(`000
Rs)
(`000
Rs)
Net
Income
400
Add
Depreciation Expense
100
Subtract
Increase in Current
Assets:
Increase
in Cash
(400)
Increase
in Inventory
(700)
(1100)
Add
Increase in Current
Liabilities:
Increase
in A/c Payable
500
Cash
Flow from Operations
(100)
Cash
Flow from Investments
0
Cash
Flow from Financing
500
Net
Cash Flow from All
Activities
400
Note
1:
Indirect
Cash Flow Approach using
Income Statement and two consecutive
Balance
Sheets
Note
2:
Final
Net Cash Flow from All
Activities should match the
difference in the difference in
the
closing balances in the Balance Sheets
from June 30th 2001 and
June 30th 2002
Note
3:
Investments
include all cash sale and
purchases of noncurrent assets and
marketable
securities
Note
4:
Financing
includes all cash changes in
loans, leasing, and equity
etc.
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