BAFINMAX – FINANCIAL

MANAGEMENT

FINANCIAL FORECASTING, PLANNING AND CONTROL

3RD TERM AY 2019-2020

J.A. SIMBILLO

THE FINANCIAL PLANNING PROCESS

Planning that begins with long-term, or strategic, financial plans that in turn guide the formulation of short-term, or operating, plans
and budgets

Steps of Financial Planning Process:

1. Project financial statements to analyze the effects of the operating plan on projected profits and financial ratios.
2. Determine the funds needed to support the plan.
3. Forecast funds availability.
4. Establish and maintain a system of controls to govern the allocation and use of funds within the firm.
5. Develop procedures for adjusting the basic plan if the economic forecasts upon which the plan was based do not
materialize
6. Establish a performance-based management compensation system.

Types of Financial Planning

1. Long-Term (Strategic) Financial Plans - Plans that lay out a company’s financial actions and the anticipated impact of
those actions over periods ranging from 2 to 10 years
2. Short-Term (Operating) Financial Plans - Plans that specify short-term financial actions and the anticipated impact of
those actions

Key Components of a Financial Plan

1. Sales Forecast
2. Pro-Forma Financial Statements
3. External Financing Plan

Steps in Financial Forecasting

1. Forecast sales
2. Project the assets needed to support sales
3. Project internally generated funds
4. Project outside funds needed
5. Decide how to raise funds
6. See effects of plan on ratios and stock price

Sales Forecast
 The prediction of the firm’s sales over a given period, based on external and/or internal data; used as the key input to the
short-term financial planning process
o External Forecast - A sales forecast based on the relationships observed between the firm’s sales and certain
key external economic indicators
o Internal Forecast - A sales forecast based on a buildup, or consensus, of sales forecasts through the firm’s own
sales channels
 Some considerations in doing the sales forecast
o Forecasting sales based upon historical sales information has limited value.
o Historical sales growth rates need to be adjusted for any known factors that will affect future sales. Future
sales depend upon many events that occur in the future.
o Examples include:
 State of domestic and international economy
 Growth prospects for the market in which the company operates
 The company´s product line
 The company´s marketing effort
o An accurate sales forecast is critical to avoid negative business issues:
 if the company´s market expands more than the company expects it to, the company will not be able to
meet the added demand and will lose customers to its competitors
 If the forecasted sales are too high, then the company could end up with excess capacity and inventory
o Management needs to use its best judgment about the future along with historical information and not simply rely
on a forecast made using regression analysis or any of the other forecasting techniques
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Example:

Measuring the Firm’s Cash Flow

 Depreciation - A portion of the costs of fixed assets charged against annual revenues over time.
o These are being considered to develop the projected cash flows especially if the company uses Indirect Method of
Cash Flows.
o Differences of Accounting and Tax treatments on depreciation methods should also be considered.
 Developing the Statement of Cash Flows
o Cash Flow from Operating Activities - Cash flows directly related to sale and production of the firm’s products
and services
o Cash Flow from Investing Activities – Cash flows associated with purchase and sale of both fixed assets and
equity investments in other firms.
o Cash Flow from Financing Activities – Cash flows that result from debt and equity financing transactions;
includes incurrence and repayment of debt, cash inflows from the sale of stock, and cash outflows to repurchase
stock or pay cash dividends.
o Classifying Inflows and Outflows of Cash
 A decrease in an asset is an inflow of cash
 An increase in an asset is an outflow of cash
 A decrease in a liability is an outflow of cash
 An increase in a liability is an inflow of cash
o Depreciation and amortization are noncash charges
 Noncash Charge - An expense that is deducted on the income statement but does not involve the actual
outlay of cash during the period; includes depreciation, amortization, and depletion
 Only changes in gross net fixed assets appear on the statement of cash flows
 Direct entries of changes in retained earnings are not included on the statement of cash flows
o Preparing the Statement of Cash Flows
 All cash inflows as well as net profit after taxes and depreciation are treated as positive values
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 All cash outflows, any losses, and dividends paid are treated as negative values

Inflows and Outflows of Cash

Inflows (sources) Outflows (uses)

Decrease in any asset Increase in any asset

Increase in any liability Decrease in any liability

Net profit after taxes Net loss after taxes

Depreciation and other noncash charges Dividends paid

Sale of stock Repurchase or retirement of stock

 Interpreting the Statement

o Operating Cash Flow (OCF) - The cash flow a firm generates from its normal operations; calculated as net
operating profits after taxes (NOPAT) plus depreciation
 Net Operating Profit After Taxes (NOPAT) = EBIT × (1−T)
 OCF=NOPAT+ Depreciation=[EBIT ×(1−T )]+Depreciation
o Free Cash Flow (FCF)
 The amount of cash flow available to investors (creditors and owners) after the firm has met all
operating needs and paid for investments in net fixed assets and net current assets
 FCF=OCF – Net Fixed Asset Investment – Net Current Asset Investment
 Net Fixed Asset Investment = Change in Net Fixed Assets + Depreciation
 Net Current Asset Investment = Change in Current Assets − Change in (Accounts Payable +
Accruals)

Cash Planning: Cash Budgets

 Cash Budget (Cash Forecast) - A statement of the firm’s planned inflows and outflows of cash that managers use to
estimate its short-term cash requirements
 Preparing the Cash Budget
o Total Cash Receipts - All of a firm’s inflows of cash during a given financial period.
o Total Cash Disbursements - All outlays of cash by the firm during a given financial period
o Net Cash Flow, Ending Cash, Financing, and Excess Cash
 Net Cash Flow - The mathematical difference between the firm’s cash receipts and its cash
disbursements in each period.
 Ending Cash - The sum of the firm’s beginning cash and its net cash flow for the period.
 Required Total Financing - Amount of funds needed by the firm if the ending cash for the period is
less than the desired minimum cash balance; typically represented by notes payable.
 Excess Cash Balance - The (excess) amount available for investment by the firm if the period’s ending
cash is greater than the desired minimum cash balance; assumed to be invested in marketable securities.
 Evaluating the Cash Budget
o The cash budget indicates whether managers should expect a cash shortage or surplus in each of the months
covered by the forecast
o It is a critical planning tool because it helps managers secure borrowing arrangements, such as bank lines of
credit, before the firm actually needs the money
 Coping with Uncertainty in the Cash Budget
o Forecasts are almost inevitably wrong, at least to some degree
 Scenario Analysis
 Prepare several cash budgets, based on pessimistic, most likely, and optimistic forecasts
 The use of several cash budgets, based on differing scenarios, also should give the financial
manager a sense of the riskiness of various alternatives
 Cash Flow within the Month
o Because the cash budget shows cash flows only on a monthly basis, the information provided by the cash budget
is not necessarily adequate for ensuring solvency
 A firm must look more closely at its pattern of daily cash receipts and cash disbursements to ensure
that adequate cash is available for paying bills as they come due

PRO-FORMA (PROJECTED) FINANCIAL STATEMENTS

Financial statements that forecast the company’s financial position and performance over a period of years.
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MANAGEMENT
MANAGEMENT USES OF PRO-FORMA FINANCIAL STATEMENTS:
1. By looking at projected statements, they can assess whether the firm’s anticipated performance is in line with the firm’s
own general targets and with investors’ expectations.
2. Pro-forma statements can be used to estimate the effect of proposed operating changes.
3. Managers use pro forma statements to anticipate the firm’s future financing needs.
4. Projected financial statements are used to estimate future free cash flows, which determine the company’s overall value.

Preparing the Pro Forma Financial Statements

 Percent of Sales Method - A simple method for developing the pro forma income statement; it forecasts sales and then
expresses the various income statement items as percentages of projected sales
o This is the most common method, which begins with the sales forecast expressed as an annual growth rate in
peso sale revenue.
o Many items on the balance sheet and income statement are assumed to change proportionally with sales.
o Steps on using Percent of Sales Method
1. Analyze the Historical Ratios – The percent of sales method assumes that costs in a given year will be
some specified percentage of that year’s sales. Thus, The company will begin the analysis by calculating
the ratio of costs to sales for several past years.
 Some items on the liability side of the balance sheet can be expected to increase spontaneously
with sales, producing what are called spontaneously generated funds.
 The two primary types of spontaneous funds are accounts payable and accruals.
2. Forecast the Income Statement
 Steps
 Forecast Sales
 Forecast Earnings before Interest and Taxes (EBIT)
 Forecast Interest Expense - The actual net interest expense is the sum of the firm’s
daily interest charges less its daily interest income, if any, from short-term
investments.
 2 Assumptions
1. Specifying the Balance of Debt for Computing Interest Expense
- Interest expense is actually based on the daily balance of debt
during the year.
o 3 Approaches
 base the interest expense on the debt balance
shown at the end of the forecasted year
 base the interest expense on the average of the
debt at the beginning and end of the year
 base the interest expense on the amount of debt
at the beginning of the year as shown on the last
balance sheet
2. Specifying Interest Rates - Rather than trying to specify the rate on
each separate debt issue, the company usually specify only two
rates, one for short-term notes payable and one for long-term bonds.
The interest rate on short-term debt usually floats, and because the
best estimate of future rates is generally the current rate, it is most
reasonable to apply the current market rate to short-term loans.
 Completing the Income Statement
3. Forecast the Balance Sheet
 Steps
a. Determine the amount of new assets needed to support the forecasted Sales -
b. Determine the amount of internal funds that will be available
c. Plan to raise any required additional financing
4. Raising the Additional Funds Needed
 Additional Funds Needed - the required assets minus the specified sources of financing
 AFN = (A*/S0)∆S - (L*/S0)∆S - M(S1)(RR)
 Where:
 A*/S0: assets required to support sales; called capital intensity ratio.
 ∆S: increase in sales.
 L*/S0: spontaneous liabilities ratio
 M: profit margin (Net income/sales)
 RR: retention ratio; percent of net income not paid as dividend.
 Implications:
 If AFN is positive, then you must secure additional financing.
 If AFN is negative, then you have more financing than is needed.
1. Pay off debt.
2. Buy back stock.
3. Buy short-term investments.
 How Would Increases in Various Items Affect the AFN?
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 Higher sales:
o Increases asset requirements, increases AFN.
 Higher dividend payout ratio:
o Reduces funds available internally, increases AFN.
 Higher profit margin:
o Increases funds available internally, decreases AFN.
 Higher capital intensity ratio, A*/S0:
o Increases asset requirements, increases AFN.
 Pay suppliers sooner:
o Decreases spontaneous liabilities, increases AFN.
 How different factors affect the AFN forecast.
 Excess capacity: lowers AFN.
 Economies of scale: leads to less-than-proportional asset increases.
 Lumpy assets: leads to large periodic AFN requirements, recurring excess
capacity.
 Judgmental Approach
o A simplified approach for preparing the pro forma balance sheet under which the firm estimates the values of
certain balance sheet accounts and uses its external financing as a balancing, or “plug,” figure

 Evaluation of Pro Forma Statements

o The major weaknesses of the approaches to pro forma statement development outlined above lie in two
assumptions:
1. That the firm’s past financial performance will be replicated in the future
2. That certain variables (such as cash, accounts receivable, and inventories) can be forced to take on
certain “desired” values
o These assumptions cannot be justified solely on the basis of their ability to simplify the calculations involved
o However pro forma statements are prepared, analysts must understand how to use them to make financial
decisions
1. Financial managers and lenders can use pro forma statements to analyze the firm’s inflows and outflows
of cash, as well as its liquidity, activity, debt, profitability, and market value
2. Various ratios can be calculated from the pro forma income statement and balance sheet to evaluate
performance
3. Cash inflows and outflows can be evaluated by preparing a pro forma statement of cash flows
4. After analyzing the pro forma statements, the financial manager can take steps to adjust planned
operations to achieve short-term financial goals