Chapter Three

Financial Forecasting
 Meaning and purpose of financial
forecasting
• Financial forecasting is one of the major jobs of
a firm’s financial staff, namely performing
financial forecasting and analysis, making
investment decisions, and making financial
decisions.

• It is generally a planning process which involves

forecasting of sales, assets, and financial
requirements

• In other words, financial forecasting is a process which

involves:
– Evaluation of a firm’s need for increased or reduced
productive capacity and
– Evaluation of the firm’s need for additional finance
 Importance …
An accurate financial forecast is very
important to any firm in several aspects:
• It helps a firm to predict appropriate
demand for its products.
• It helps a firm to project its sales and
accordingly to predict its assets
properly.
• It contributes significantly to the firm’s
profitability.
• It plays a crucial role in the value
maximization goal of a firm.
 Cont’d…

• Financial forecasts are also means for

forecasted financial statements

• Firm can forecast its Income Statement,

Balance sheet and other related statements.
Besides, key ratios can be projected

• So, all in all, financial forecasting is a pre

requirement for the investment, financing, as
well as dividend policy decisions of a firm.
Dimensions of Financial Planning
The followings are the three dimensions
of financial planning
• Planning Horizon
• Aggregation and
• Alternative sets of assumptions
– A worst case
– A normal case
– A best case
Alternative sets of assumptions
 Financial Policy and Growth
The two growth rates that are
particularly useful in long-range
planning:

• Internal growth rate and

• Sustainable growth rate

 The Internal growth Rate
• It is the maximum growth rate that
can be achieved with no external
financing of any kind(without issuing
new equity or debt.
• In case, the required increase in
assets is exactly equal to the addition
to retained earnings and external
finance need is therefore zero.
Internal growth rate can be computed by
using the following formula:
The Sustainable Growth Rate
• It is the maximum growth rate a firm can
achieve with no external equity financing
while it maintains a constant debt–equity
ratio
• The precise value can be calculated as
follow:
 Procedures in financial forecasting

The financial forecasting process generally

involves the following procedures:

• Forecasting of sales for the future

period
• Determining the assets required to meet
the sales targets, and
• Deciding on how to finance the required
assets
 Sales Forecast
• Sales forecast is a forecast of a firm’s
unit and birr sales for some future
period.
• It is generally based on recent sales
trends and forecast of the economic
prospects of the nation, region, industry
and other factors.
• This procedure starts usually by
reviewing the sales of the recent pasts.
 Factors to consider

• The historical sales growth pattern of

the firm at both divisional and
corporate levels,
• The level of economic activity in each
of the firm’s marketing areas,
• The firm’s probable market share,
 Cont’d…
• The effect of inflation on the firm’s
future pricing of products,
• The effect of advertising campaigns,
cash and trade discounts, credit
terms, and other similar factors alike
on future sales,
• Individual products’ sales forecasts at
each divisional level.
 Determination of Assets Required

• Sales forecasts are also grounds for

determination of the firm’s assets
requirement.
• If sales are to increase, then assets
must also grow.
• The amount each asset account must
increase depends whether the firm
was operating at full capacity or not.
 Cont’d…
• If higher sales are projected, more
cash will be needed for transactions,
higher sales will create higher
receivables.
• Similarly, higher sales require higher
inventory and higher plant and
equipment.
 Deciding on how to finance the required assets

• Some of the required finance can be

covered by the increased retained earnings.
• The retained earnings increment will result
from increased sales and profit.
• Still some other portion of the finance can
be covered by some liabilities which will
grow by the same proportion with that of
sales.
• The remaining finance must be obtained
from available external sources.
The forecast of financial requirements,
involves again three sub procedures.
1. Determining total finance the firm will
need during the forecasted period.
2. Determining the amount of internally
during the same period.
3. Determining the additional external
financial requirements
 Financial Planning Model

Financial planning Techniques

Pro forma Financial Statement Method

Percentage of sales method

 Pro forma Financial Statement

• It is simply a method of forecasting

financial requirements based on
forecasted financial statements.
• As a result, this method is also called
the projected financial statements
method.
• Under this method, the asset
requirements are first projected for
the fore coming future period.
 Cont’d…
• The forecast of assets helps to
determine the total financial
requirements.
• Then, the liabilities and equity that
will be generated under normal
operations are projected.
• Finally, the additional funds needed
will be estimated.
 Steps Involved

Developing the pro forma Income statement

Constructing the pro forma Balance sheet

Forecasting for AFN

Steps in Pro forma Income Statement

First, forecast sales

Second, costs of goods sold

Third, other expenses

Fourth, Compute NI

Finally, compute the amount of RE

 2. Constructing the pro forma
Balance sheet
• In the forecast of the firm’s balance
sheet, first, those balance sheet
items that are expected to increase
directly with sales are forecasted
• Some of the assets increase can be
financed by retained earnings, and
spontaneous finance.
• The remaining balance must be
financed from external sources.
 Cont’d…
• Next, the spontaneously increasing
liabilities are forecasted.
• Then, the liability and equity items
that are not directly affected by
sales are set.
• Next, the value of retained earnings
for the forecasted period is obtained.
• Finally, the AFN will be raised.
 For Example
• Blue Nile Share Company is a medium
sized firm engaged in manufacturing of
various household utensils.
• The financial manager is preparing the
financial forecast of the following year.
• At the end of the year just completed,
the condensed balance sheet of the
company has contained the following
items.
 Cont’d…
Assets Liabilities and Equity
Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000
A/receivable -----------------------70,000 Accruals --------------------------------40,000
Inventories -----------------------150,000 Current liabilities -------------Br. 130,000
Current assets -------------Br. 230,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Common stock ------------------------120,000
_________ Retained earnings --------------------150,000
Total assets ------------------Br. 600,000 Total liabilities and equity ------Br. 600,000
 Cont’d…
• During the year just completed, the firm
had sales of Br. 1,800,000.
• In the following year, due to increased
demand to the firm’s products the
financial manager estimates that sales
will grow at 10%.
• There are no preferred stocks
outstanding during the year.
• The firm’s dividend pay-out ratio is 60%.
• It is also known that the firm’s assets
have been operating at full capacity.
 Cont’d…
• During the same year, Blue Nile’s
operating costs were Br. 1,620,000 and
are estimated to increase
proportionately with sales.
• Assume the company’s interest expense
will be Br. 40,000 during the next year
and its tax rate is 40%.
• Required: Determine the AFN of Blue
Nile Share Company for the next year
using the pro forma financial statements
method.
 First, we develop the pro forma income statement

Pro Forma Income Statement

____________________________________________________________________________________________________________
Sales (Br. 1,800,000 x 1.10) ------------------------------------------------------------------------------Br. 1,980,000
Operating costs (Br. 1,620,000 x 1.10) ----------------------------------------------------------------------1,782,000
Earnings before interest and taxes (EBIT) ----------------------------------------------------------------Br. 198,000
Interest expense -----------------------------------------------------------------------------------------------------40,000
Earnings before taxes (EBT) --------------------------------------------------------------------------------Br. 158,000
Taxes (Br. 158,000 x 40%) ---------------------------------------------------------------------------------------63,200
Net income -----------------------------------------------------------------------------------------------------Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) ---------------------------------------------------------Br. 56,880
Addition to retained earnings (Br. 94,800 – Br. 56,880) ------------------------------------------------Br. 37,920
 Then, we construct the pro forma balance sheet

Pro Forma Balance Sheet

____________________________________________________________________________________________________________
Assets Liabilities and Equity
Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) -------------Br. 99,000
A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10) --------------------44,000
Inventories (Br. 150,000 x 1.10) ----------165,000 Current liabilities ----------------------------Br. 143,000
Current assets ---------------------------Br. 253,000 Long-term debt (the increase is unknown) ----200,000
Net fixed assets (Br. 370,000 x 1.10) ----407,000 Common stock (as long-term debt) ------------120,000
_______ Retained earnings (Br. 150,000 + Br. 37,920)-187,920
Total assets -----------------------Br. 660,000 Total liabilities and equity -------------Br. 650,920
 Cont’d…
Therefore, AFN = Br. 660,000 – Br. 650,920 = Br. 9,080.

Or AFN = Increase in Increase in normally

assets – generated funds

= [Br. 660,000 – Br. 600,000] – [(Br. 99,000 – Br. 90,000) + (Br. 44,000 – Br.
40,000) + Br. 37,920]
= Br. 60,000 – Br. 50,920
= Br. 9,080
The Percentage-of-Sales Model
Example
Top Company has prepared the following Balance
Assets
Sheet
Cash
and Income Statement
175,000 A/P
for the year ended
Liabilities and Stockholders’ Equity
140,000
A/R 150,000 Accrued liabilities 150,000
December
Inventory
31, 2005.
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

Sales 2500,000
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
 The company plans to have dividend payout ratio of 45%
 Sales are expected to increase by 25% during next year (2006).
 All assets are affected by sales proportionately. Accounts Payable
and accrued liabilities are also affected by sales.
 All expenses are directly proportional to sales
 The firm has been operating at full capacity.
 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.
 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