UNIT-3 FINANCIAL PLANNING AND FORECASTING

INTRODUCTION In unit two we discussed how financial statements are analyzed to assess a firms past performance. While historical evaluation is important, anticipating what is likely to happen in the future is even more important. So you should know how to develop a financial plan.

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The financial manager prepares pro forma, or projected, financial statements to assess whether the firms forecasted performance squares with its own targets and with the expectation of investors, examine the effect of proposed operating changes, and anticipate the financial needs of the firm.

The Planning System

Financial planning is a part of a larger panning system in the firm. The planning process begins with a statement of the firms mission. Given its mission, management sets goals. Goals in turn inform strategy which is a plan to gain competitive edge over rival forms. To support the strategy, polices and budgets are developed in various areas such as research and development, marketing, production, personnel, and finance. These then get translated into the financial plan.
(show the Planning system)

 What and Why of Financial Planning A long-term financial plan represents a blueprint of what a firm proposes to do in the future. Typically it covers a period of three to ten years most commonly it spans a period of five years. Financial planning is the process of analyzing a firms investment options and estimating the funds requirement and deciding the sources of funds. Growth in sales is an important objective of most firms. An increase in a firms market share will lead to higher growth. The firm would need assets to sustain the higher growth in sales. It may have to invest in additional plant and machinery to increase its production capacity. Also, it would need additional current assets to production and sell more goods or services.

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The firm would have to acquire raw materials and convert them into finished goods after incurring manufacturing expenses. It may have to sell goods on credit because of the industry norm or to push up sales. This gives rise to debtors or accounts receivables. The firm may use its internally generated funds to finance current and fixed assets. When the firm grows at a high rate, internal funds may not be sufficient. Thus, the firm would have to rise external funds either by issuing equity or debt or both. Therefore, the capital budgeting decision, working capital decision, capital structure decision and dividend decision have to established for developing an clear financial plan.

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The benefits of financial planning or financial planning process involves the following facets: Evaluating the current financial condition of the firm then identifies advance actions to be taken in various areas. Analyzing the future growth prospects and options Appraising the investment options to achieve the stated growth objective or goal. Projecting the future growth and profitability. Estimating funds requirement and considering alternative financing options. Comparing and choosing from alternative growth plans and financing options. Measuring actual performance with the planned performance.

Financial Forecasting Financial forecasting is an integral part of financial planning. It uses past data to estimate the future financial requirements.

Financial Planning Model

Most financial planning models require the user to specify some assumption about the future. Based on those assumptions, the model generates predicted values for a long number of other variables. Models can vary quite a bit in terms of their complexity, but almost all will have the elements. Sales Forecast The sales forecast is typically the starting point of the financial forecasting exercise. Most of the financial variables are projected in relation to the estimated level of sales. Hence, the accuracy of the financial forecast depends critically on the accuracy of the sales forecast.

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Although the financial manager may participate in the process of developing the sales forecast, the primary responsibility for it typically vests with the marketing department or the planning group. Sales forecasts may be prepared for varying planning horizons to serve different purposes. A sales forecast for a period of 3-5 years, of for even longer durations, may be developed mainly to aid investment planning. A sales forecast for a period of one year (and in some cases two years) is the primary basis for the financial forecasting exercise (we will discuss in this chapter). Sales forecasts for shorter durations (six months, three months, one month) may be prepared for facilitating working capital planning and cash budgeting.

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Pro Forma Statements A financial plan will have a forecasted balance sheet and profit and loss account. These are called pro forma statements. This means the financial statements are the form we use to summarize the different events projected for the future. The Plug After the firm has a sales forecast and an estimate of the required spending on assets, some amount of new financing will often necessary because projected total assets will exceed projected total liabilities and equity. Because new financing may be necessary to cover all of the projected capital spending, a financial plug variable must be selected. The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.

A Simple Financial Planning Model Consider the following simplified financial statements for the ABC Company (assuming no income taxes).
Income Statement Balance Sheet
Sales. $1000 Assets. $500 Debt. $250 Costs. 800 Equity 250 Net Income$200 Total.$500 Total..$500 ABC Company has predicted a sales increase of 20 percent. It has predicted that every item on the balance sheet will increase by 20 percent as well. Required:- 1. Prepare Pro forma statements and reconcile them. 2. What are the plug variables here.

 1. Preparation of Pro Forma Statements: Pro forma income statement- When sales increase 20% then automatically costs also increase 20%. So
Pro Forma Income statement Sales $1200 Costs 960 Net income $240

It also predicted that every item on the balance sheet will increase by 20%. So Pro Forma Balance Sheet Assets $600 (+100) Debt ..$300 (+50) Equity. 300 (+50) Total $600 (+100) Total . $600 (+100)

 Now let us reconcile these two pro formas. How, for example, can net income be equal to $240 and equity increase by only $50? The answer is that ABC Company must have paid out the difference of $240-50= $190, possibly as a cash dividend. In this case, dividends are the plug variable. Suppose ABC Company does not pay out the $190. In this case, the addition to retained earnings is the full $240. The Company equity will thus grow to $490 (($250 (the stating amount) + $240 (net income)) and debt must be retired to keep total assets equal to $600. With $600 in total assets and $490 in equity, debt will have to be $600 490 = $110. Since we started with $250 in debt, ABC will have to retire $250-110 = $140 in debt. The resulting pro forma balance sheet would look like this:

Pro Forma Balance Sheet Assets $600 (+100) Debt ..$110 (-140) Equity. 490 (+240) Total $600 (+100) Total . $600 (+100)

In this case, debt is the plug variable used to balance out projected total assets and liabilities. This illustration shows the interaction between sales growth and financial policy. As sales increase, so do total assets. This occurs because the firm must invest in net working capital and fixed assets to support higher sales levels. Because assets are growing, total liabilities and equity will grow as well.

 So far, we discussed a simple planning model in which every item increase at the same rate as sales. This may be a reasonable assumption for some elements. For others, such as long-term borrowings, it probably is not, because the amount of long-term borrowings is sometimes set by management, and it does not necessarily relate directly to the level of sales. Now let us discuss an extended version of simple financial planning model. The basic idea is to separate the income statement and balance sheet accounts into two groups, those that do vary directly with sales and those that do not. Given a sales forecast, we will then be able to calculate how much financing the firm will need to support the predicted sales level. The extended version of simple financial planning model is based on The percent of sales method, and Budgeted expense method Note: Those are two commonly used methods for preparing the Prof forma Profit & loss account or income statement

Percent of Sales Method: This method assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship. When using this method, a decision has to be taken about which historical cost ratios to be used: should these ratios pertain to the previous year , or the average of two or more previous years? This method may be a reasonable assumption for some elements. For others, such as dividends and retained earnings, it probably is not. Since the distribution of earnings between dividends are retained earnings reflects a managerial policy which is not easily expressible in mechanistic terms.

Budgeted Expense Method The budgeted expense method, on the other hand, calls for estimating the value of each item on the basis of expected developments in the future period for which the pro forma profit and loess account is being prepared. A Combination Method It appears that a combination of the two methods described above often works best. For certain items, which have a fairly stable relationship with sales, the percent of sales method is quite adequate. For other items, where future is likely to be very different form the past, the budgeted expense method, which calls for managerial assessment of expected future developments, is eminently suitable.

Pro Forma Balance Sheet In the pro forma balance sheet, it assumes that some of the items vary directly with sales and others do not.

Case study
The income statements and balance sheets of Modern Company for years 1 and 2 are as follows: Profit and Loss Account Year-1 Year-2 Net sales .. $1200 $1280 Cost of goods sold . 775 837 Gross profit . 425 443 Selling expenses 25 27 General & administration Exp.. 53 54 Depreciation .. 75 80 Operating profit .......................... 272 282 Non-operating surplus/deficit .. 30 32 PBIT . 302 314 Interest on bank borrowings . 60 65 Interest on debentures .. 58 60 PBT .. 184 189 Tax ... 82 90 PAT .. 102 99 Dividends . 60 63 Retained earnings . 42 36

Balance Sheet

Year-1 Year-2
$850 30 28 212 380 55 20
1575

Fixed assets (net) ................ $800 Investment ................... 30 Current assets, loans and advances: Cash and bank 25 Receivables 200 Inventories 375 Pre-paid expenses ......... 50 Miscellaneous exp. and losses. 20
Total 1500

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Balance Sheet
Liabilities: Share capital: Equity .. Preference . Reserves and surplus . Secured loans: Debentures .. Bank borrowings . Unsecured loans: Bank borrowings . Current liabilities and provisions: Trade creditors Provisions Total .

Year-1 Year-2
$250 50 250 400 300
100 100 50 1500

$250 50 286 400 305

125 112 47 1575

Required: Prepare the Pro forma income statement for year 3 and the Pro forma balance sheet as at the end of year 3, based on the following assumptions: 1. The projected sales for year 3 are 1400. 2. The forecast values for the following profit and loss account items may be derived using the percent of sales method (for this purpose, assume that the average of the percentages for years 1 and 2 is applicable). - Cost of goods sold - Selling expenses - Non-operating surplus/deficit - Interest on bank borrowings 3. The forecast values for the other items of the profit and loss account are as follows: - General and administration: $56 - Depreciation: 85 - Interest on debenture: 65 - Tax: 90 - Dividends: 70

4.

The forecast values of various balance sheet items may be derived as follows: - Fixed assets (net): Percent of sales method wherein the percentages are based on the average for the previous two years. - Investments: No change over year 2. - Current assets: Percent of sales method wherein the percentages are based on the average for the previous two years. - Miscellaneous expenditure and losses: No change over year 2. - Equity and preference capital: No change over 2. - Reserves and surplus: Pro forma profit and loss account. - Debentures: No change over year 2. - Bank borrowing (secured and unsecured) and current liabilities and provisions: Percent of sales method wherein the percentages are based on the average for the previous two years. - External fund required: Balancing item.

Financial Modeling Using Spreadsheets

Required:- Based on the above case study prepare financial modeling using spreadsheet.

Growth and External Financial Requirements

External financing needed and growth are obviously related. All other things staying the same, the higher the rate of growth in sales or assets, the greater will be the need for external financing. So far (previously discussed cases), we took a growth rate as given, and then we determined the amount of external financing needed to support that growth. Now let us take the firms financial policy as given and then examine the relationship between that financial policy and the firms ability to finance new investments and thereby grow.

Mini Case Study

The most recent financial statement for Jap Jeans, Inc., are shown here: Income Statement Sales .$500 Costs 400 Taxable income . 100 Taxes (34%).. 34 Net Income ... $66 Dividends ..$22 Addition to retained earnings 44 Balance Sheet Liabilities & Assets Owners' Equity Current assets $200 Current liabilities. $50 Net Fixed Assets. 300 Lon-term debt ... 200 Owners equity .. 250 Total.. $500 Total $500

Additional Information:- Assets, costs and current liabilities are proportional to sales. Long-term debt and equity are not. Jap Jeans maintains a constant 33.33% dividend payout ratio. Like every other firm in its industry, net years sales are projected to increase by exactly 20%. Use the percentage of sales method and assume the company is operating at full capacity. Required:- What is the external financing needed?

 External financial requirement may also be estimated as follows: EFR = A/S (S) L/S (S) mS1 (1 - d) + (IM + SR) Where EFR = External funds requirements A/S = Assets to Sales ratio = 100% S = Expected increase in sales = $100 L/S = Ratio of current liabilities (spontaneous liabilities) to sales = 10% m = Net profit margin = 13.2% (79.2/600x100) S1 = Projected sales for next year = $600 D = Dividend payout ratio = 33.33% IM = Expected change in the level of investments and miscellaneous expenditure and losses put together. SR = Scheduled repayment of term loans and debentures. Therefore, EFR = 1.0 (100) 0.10 (100) (0.132) (600) (0.6667) EFR = 100 10 52.80 = $37.2

Key Growth Rates

While firms are interested in growth, they may be reluctant to raise external equity. Given this reluctance, it is useful to calculate two growth rates in the context of long-term financial planning. Internal growth rate Sustainable growth rate

Internal Growth Rate The IGR is the maximum rate at which a firm can grow (in terms of sales or assets) without external financing of any kind. Put differently, this is the growth rate that can be sustained with retained earnings, which represent internal financing. To determine the IGR the following assumptions are made: The assets of the firm will increase proportionally to sales, The net profit margin after taxes is in direct proportion to sales, The firm has a target dividend payout ratio which it wants to maintain, The firm will not raise external finance.

Sustainable Growth Rate The SGR is the maximum growth rate that a firm can achieve without resorting to external equity finance. This is the growth rate that can be sustained with the help of retained earnings matched with debt financing, in line with the debt-equity policy of the firm. This an important growth rate because firms are reluctant to rise external equity finance for the following reasons:
The firm has a target capital structure (D/E ratio) which it wants to maintain, The current owners may not wish to bring in new owners or contribute additional equity, The firm does not intend to sell new equity shares as it is a costly source of finance.

Mini Case Study

The most recent financial statements for Boston Turkey Company are shown here:

Income Statement Sales .$6,475 Costs 3,981 Taxable income . 2,494 Taxes (34%).. 8,48 Net Income ... $1,646 Balance Sheet Liabilities & Assets Owners' Equity Current assets $9,000 Debt .......... $22,000 Net Fixed Assets..25,000 Equity 12,000 Total $34,000 Total . $34,000

Additional Information: Asset and costs are proportional to sales. Debt and equity are not. Boston Turkey maintains a constant 40% dividend payout ratio. No external equity financing is possible. Required:- 1. What is the internal growth rate? and, 2. What is the sustainable growth rate?