InthispresentationIwillintroducesomebasicelementsoffinancialforecastingandhow

theyconnectwiththefinancialplan.

Theproformafinancialstatementsinthefinancialplanwillincludeforecastsforanumber
ofitems.Thecashbudgetwillhaveforecastsofcash flowstoshowthatcashbalances
wontgonegative.Thefinancialplanwillindicateiftherewillbeaneedtoraisemoneyin
thefutureandhowitwouldberaised.Finally,therewillbeforecastsoffutureearningsto
showwhetherassetpurchasescanbefundedinternallyorwhetheranymoneyborrowed
canberepaid.
Forecastingisacomplicatedsubjectandeachcompanyscircumstanceswillbeunique.In
thispresentationwewillfocusonsomebasictechniquesandprinciplesusedinforecasting
withaparticularemphasisonfinancingassetpurchases.

Wewillstartwithanexampleofasmallcompany(BayCitiesGranola amanufacturerof
gourmet granola)thatexpectsitsbusinesstogrowoverthenextfewyears.Wecanthink
abouttheforecastingprocessproceedinginseveralsteps.First,wewillforecasthowfast
salescangrowovertime.Thiswillbedoneinthebusiness/marketingpartofthebusiness
plan.Next,wewillneedtodeterminehowmuchadditionalassetswewillneedtosupport
thisgrowth.Finally,wewilllookathowthoseassetswillbefinanced.

Thesimplest approachtofinancialforecastingisthepercentofsalesapproach.There
areavarietyofproblemswiththisapproach,whichwewilldiscusslater,butitprovidesa
simplestartingpointforunderstandingfinancialforecasting.Thefirststepistomakean
assumptionthatsaleswillgrowatcertainrate.Ideallythisisbasedonadetailedmarket
analysisincludingconsumerdemandandcompetitorbehavior.
Everythingelseontheincomestatementandthebalancesheetareassumedtogrowat
thesamerateassales.Sincecostswillincreaseatthesamerateasrevenuetheprofit
marginwillremainthesame.Itsassumedthatthefirmwillneedmoreassetstosupport
theincreasedsalesandtheamountofassetswillincreaseproportionatelyandevenlyover
theyears.Finally,itisassumedthatthecapitalstructurewillremainthesamesothat
liabilitiesandequitywillincreaseatthesamerateasassets.
Thisassumptiongenerallyworksbestforlarge,establishedbusinessesbutitalsoprovidesa
placetostartforsmallbusinesses.

Heresasimple exampleofusingthepercentofsalesapproachtoforecastfinancial
variablesoneyearout(2016)basedonthecurrentyear(2015).Revenueisassumedto
growby20%andeverythingelsegrowsatthesamerate.Sinceassets,liabilitiesandequity
allgrowatthesameratethisleavesthecapitalstructure(theshareofassetsfinancedby
debtandequity)thesame.Atthispoint,theforecastdoesnotspecificwherethecompany
willborrowtheadditionalmoneyorhowitwillincreaseitsequity.

Inapriorpresentation wesawthatabusinessplanincludesaninvestmentplanthatshows
howmuchandwhatkindofassetsthecompanyneedstoacquireandthenafinancingplan
whichsetsouthow thoseassetsarepaidfor,thatis,howwillthecompanyraisethemoney
topurchasetheassetsneededtoexpanditssales.
Thepreviousslidesetoutthenumbersforbothpartsoftheplan.Thecompanywould
need$30,000moreinassetsandwouldraise$10,000bydebtand$30,000byequity.

Therearevarietyofproblemswith theassumptionthateverythingincreasesatthesame
rateassales.
Whileitmightbereasonablethatvariablecostsincreaseatthesamerateassales,fixed
costswont(thatswhywecallthemfixed)andsoourforecastwouldlikelyoverestimate
futurecosts.
Assets(machines,buildings,etc.)comeinfixedsizessoitsunrealistictoplanonincreasing
everythingbyafixedpercentageeachyear.Ifyouhaveawarehouse,howdoyouincrease
yourwarehousesizeby3%eachyear?Morerealisticisthatassetsarelumpy,inother
words,theycomeinfixedsizes.Youmighteitherhavetobuynewwarehouseinyearone
whichwouldprovideyouwithmorecapacitythanyouneed(andagreaterneedtoraise
fundsatthestart)oryoumayhavetodelayyourpurchaseofanewwarehousewhich
wouldslowthegrowthofsales.
Finally,mostcompaniesdontraisemoneybyincreasingequityanddebtatthesamerate
eachyear.Theymighthavepreferencesoverhowtheyllgetadditionalfundsorwantto
focusonraisingmoneythoughonesourceatatime,perhapsduetofixedcostsofissuing
newdebtorequity.Wewilldiscussthismorelaterinthepresentation.

Iftheassumptionsbehindthepercentofsalesapproacharenotgoodapproximations,the
forecastwillneedtoprovidemoredetail.Thismayincludemakingseparateforecastsfor
fixedandvariablecosts(wherefixedcostsareunchangedandvariablecostsincreaseatthe
samerateassales)orbeingspecificaboutwhenassetsarepurchasedandhowbigeach
purchasewillberatherthanassumingthattheamountofassetsincreasesmoothly.
Finally,theforecastcanconnectthefinancingplanwiththeassetforecastbyindicating
howtheassetsarefinanced.

Asmentionedonthepreviousslide,the financialforecastcanspecifyhowthecompanywillchoose
toraisemoney.Therearebasicallythreeoptions:thefirmcanusedebt(borrowmoney),thefirm
canissuenewequity,orthefirmcanreinvestearnings(retainedearnings)whichisanothertypeof
equityfinancing.
Welldiscussthetheorybehindchoosingthebestcapitalstructureinalaterlecture,butone
commonapproachisthatfirmsprefertoraisefundsinthisorder:
1)Internal funds(retainedearnings)
2)Externalfunds
A)NewDebt
B)NewEquity
Wecanusethisinformationwhenforecastingbydeterminingtheamountofmoneybeingraised
andthenassumingitisfirstsatisfiedbytheamountofinternalfundsavailable.Iftherearenot
enoughinternalfunds,thentheremainderwouldberaisedbyexternalfunds,firstwithnewdebt
andthenwithnewequity,subjecttoanyconstraintsonthetargetedcapitalstructure.
Inpractice,thereisabackandforthbetweentheinvestmentplanandthefinancingplan.Ifthe
initialforecastshowsthatthefirmwouldhavetoobtainexternalfunds,managementmayinstead
scalebackexpansionplanstoavoidhavingtoissuenewdebtorequity.Thentheforecastwould
havetoberedonewiththenewsalesassumptions.

Thefinancingdecisionconnectsthreeseparatepartsofthebusiness plan.
Theinvestmentplansetsouttheamountofadditionalassetsthatmustbepurchased.
Theincomestatementandthedividendpaymentplansetsouttheamountofearningsthat
areavailabletobereinvestedinthecompany.(Ifwearecommittedtoreturning60%of
earningsbacktoequityinvestorsasdividendsthen40%ofearningsareavailabletobe
reinvestedinthecompany)
Ourtargetcapitalstructure(themixofequityanddebtandhowitisraised)fromthe
financingplanlimitstheamountofmoneythatcanberaisedexternally.
Forexample,ifthe financingplansaysthatthecompanywillnotraiseanexternalfunds
thentheincreaseinassetsislimitedbytheamountofearningsretained.Iftheadditionto
retainedearningsisnotsufficienttopayfortheplannedpurchaseofassets,theneitherthe
companywilleitherhavetoreduceitsassetspurchasesoralternativelyreducetheir
dividendpaymentsinordertoreinvestmoreinthecompany.

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Ifthereisarestrictiononhowfundsareraised thentherewillbealimitonhowfastassets
cangrowwhichwilllimithowfastsalescangrow.
Ifacompany onlyusesretainedearningstofinancenewassetsthentherateofgrowthfor
thecompany(intermsofassets)willequaltheadditiontoretainedearningsdividedby
assets.Thisiscalledtheinternalgrowthrate.Theadditiontoretainedearningsequalsthe
amountofequitymultipliedbythereturnonequitymultipliedbytheplowbackratio(the
fractionofearningsthatisreinvestedinthecompany).Fromthisequationwecanseethat
themoreprofitablethecompanyisorthemoreitreinvestsinitself,thefasteritwillgrow.
Sustainablegrowthrateassumesthatthefirmwillissuenonewequityandwillkeepits
debt/equity ratioconstant. Imaginethattheplowbackratiois1 (allearningsare
reinvestedinthecompany)andearningsare30%ofequity.Ifweaddthatbacktoequity,
thenequitywillgrowat30%.Debtwillalsohavetogrowat30%tokeepthedebt/equity
ratioconstant.Sincebothequityanddebtare growingat30%thenassetswillgrowat30%
aswell. Ifwereducetheplowbackratio,thenlessmoneywillbeaddedtoequityand
equity, debtandassetswillallgrowmoreslowly.

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Moresophisticated modelswillcombinethevariousideaspresentedinthispresentation.
Theywillmakeseparateforecastsforsalesandforitemsthatarenotexpectedtogrow
proportionatelytosales.Theseforecastswillgenerateaninvestmentplanforassets.A
financingplanwilllayouthowthemoneyisraisedandtheeffectonthecapitalstructure.
Theresultsofthefinancingplanmayconstraintheinvestmentplanwhichwillaffectthe
salesforecastandsomanagementwilloftenhavetorevisethevariousassumptionsuntil
allplansagree.
Wecanseehowthevariouspartsofthebusinessplaninteractbylookingatthe
connectionsbetweenbalancesheetitemsandincomestatementitems.Forexample,if
debtincreases(balancesheet),thatwillincreaseinterestcosts(incomestatement),which
willreducetheadditiontoretainedearnings(incomestatement),whichwillreducethe
increaseinequity(balancesheet),whichwillreducetheincreaseinassets(balancesheet),
whichwillreducetheincreaseinearnings(incomestatement).

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Afewfinalcommentsonforecasting.Generally, collegeclasses(includingthisone)present
forecastingasaverymechanisticactivity;putabunchofnumbersinaspreadsheetanduse
somesimpleformulastoforecastthefuture.Inpractice,theresmuchmorejudgement
involved.Whenforecasting,youneedtoaskyourselfifthenumbersbeingproducedseem
reasonable,particularlywithrespecttosalessinceitisoftentheprimarydriverofthe
forecast.Onewaytodothisistohaveastoryforhowconsumersandcompetitorfirms
mustbehavefortheforecaststocometrueandthenquestionwhetherthatbehavior
seemsreasonable.
Sinceforecastsincludeanumberofdifferentassumptions,itsimportanttoperform
sensitivityanalysis,whichinvolveschangingtheassumptionstoseehowtheforecast
changes.Forexample,assumethatsalesgrowmoreslowlythanexpectedandseeifthat
putsstressonthecompanyscashposition.Welldiscusssensitivityanalysisinmoredetail
inthesectionofthecourseoncapitalbudgeting.

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