Chapter 17

Financial
Forecasting
and Planning

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Slide Contents

Learning Objectives
1. An Overview of Financial Planning
2. Developing a Long-term Financial Plan
3. Developing a Short-Term Financial Plan
Key Terms

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Learning Objectives

1. Understand the goals of financial

planning.
2. Use the percent of sales method to
forecast the financing requirements of a
firm including its discretionary financing
needs.
3. Prepare a cash budget and use it to
evaluate the amount and timing of a
firms short-term financing requirements.

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17-3
17.1 An Overview
of Financial
Planning

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An Overview of Financial Planning

What is the primary objective of preparing

financial plans?
To estimate the future financing requirements
in advance of when the financing will be
needed.

The process of planning is critical to force

managers to think systematically about the
future, despite the uncertainty of future.

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17-5
An Overview of Financial Planning
(cont.)

Most firms engage in three types of

planning:
Strategic planning,
Long-term financial planning, and
Short-term financial planning

Strategic plan defines, in very general

terms, how the firm plans to make money
in the future. It serves as a guide for all
other plans.
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17-6
An Overview of Financial Planning
(cont.)

The long-term financial plan generally

encompasses a period of three to five
years and incorporates estimates of the
firms income statements and balance
sheets for each year of the planning
horizon.

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17-7
An Overview of Financial Planning
(cont.)

The short-term financial plan spans a

period of one year or less and is a very
detailed description of the firms
anticipated cash flows.
The format typically used is a cash
budget, which contains detailed revenue
projections and expenses in the month in
which they are expected to occur for each
operating unit of the company.

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17-8
17.2 Developing
a Long-Term
Financial Plan

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Developing a Long-Term Financial
Plan

Forecasting a firms future financing needs

using a long-term financial plan can be
thought of in terms of three basic steps:
1. Construct a sales forecast
2. Prepare pro-forma financial statements
3. Estimate the firms financing needs

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Developing a Long-Term Financial
Plan (cont.)

Step 1: Construct a Sales Forecast

Sales forecast is generally based on:

1. past trend in sales; and
2. the influence of any anticipated events that
might materially affect that trend.

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17-11
Developing a Long-Term Financial
Plan (cont.)

Step 2: Prepare Pro Forma Financial

Statements

Pro forma financial statements help forecast a

firms asset requirements needed to support
the forecast of revenues (step 1).
The most common technique is percent of
sales method that expresses expenses,
assets, and liabilities for a future period as a
percentage of sales.

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17-12
Developing a Long-Term Financial
Plan (cont.)

Step 3: Estimate the Firms Financing

Needs

Using the pro forma statements we can extract

the cash flow requirements of the firm.

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Financial Forecasting Example

Table 17-1 illustrates how Ziegen, Inc.

uses the percent of sales method to
construct pro forma income statement and
pro forma balance sheet.

The company uses the three-step

approach to financial planning.

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17-14
Financial Forecasting Example
(cont.)

Step 1: Forecast Revenues and Expenses

Zeigens financial analyst estimate the firm will

earn 5% on the projected sales of $12 million
in 2010.
Zeigen plans to retain half of its earnings and
distribute the other half as dividends.
See Table 17-1

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Financial Forecasting Example
(cont.)

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17-16
Financial Forecasting Example
(cont.)

Step 2: Prepare Pro Forma Financial

Statements

The firms need for assets to support firm sales

is forecasted using percent of sales method,
where each item in the balance sheet is
assumed to vary in accordance with its percent
of sales for 2010.

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17-17
Financial Forecasting Example
(cont.)

Step 3: Estimate the Firms Financing

Requirements
This involves comparing the projected level of
assets needed to support the sales forecast to
the available sources of financing.
In essence, we now forecast the liabilities and
owners equity section of the pro forma balance
sheet.

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Sources of Spontaneous Financing
Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses

are typically the only liabilities that vary
directly with sales.
Accounts payable and accrued expenses
are referred to as sources of spontaneous
financing. The percent of sales method
can be used to forecast the levels of both
these sources of financing.

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Sources of Discretionary Financing

Raising financing with notes payable, long-

term debt and common stock requires
managerial discretion and hence these
sources of financing are called
discretionary sources of financing.
The retention of earnings is also a
discretionary source as it is the result of
firms discretionary dividend policy.

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Summarizing Ziegens Financial
Forecast

Discretionary Financing Needs (DFN)

= {Total Financing Needs} less {Projected
Sources of Financing}

= {$7.2 m (increase in assets)} {$2.4m in

spontaneous financing + $2.5m in short and
long-term debt + $1.8 million in equity}
= $7.2 million - $6.7 million = $500,000

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17-21
Summarizing Ziegens Financial
Forecast (cont.)

The firm has to raise $500,000 with some

combination of borrowing (short-term or
long-term) or the issuance of stock.

Since they require a managerial decision,

they are referred to as the firms
discretionary financing needs (DFN).

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Summarizing Ziegens Financial
Forecast (cont.)

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Analyzing the Effects of Profitability and
Dividend Policy on the Firms DFN

After projecting DFN, we can easily

evaluate the sensitivity of DFN to changes
in key variables.

The table (on next slide) shows that as

dividend payout ratios and net profit
margin vary, DFN also changes
significantly from a negative $40,000 to
$764,000.

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Analyzing the Effects of Profitability and
Dividend Policy on the Firms DFN (cont.)

DFN for Various Net Profit Margins and

Dividend Payout Ratio (DPR)

Net Profit DPR =30% DPR=50% DPR=70%

Margin
1% $716,000 $740,000 $764,000
5% $380,000 $500,000 $620,000
10% $(40,000) $200,000 $440,000

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17-25
Analyzing the Effects of Sales
Growth on a Firms DFN

Table 17-2 considers the impact of sales

growth rates of 0%, 20% and 40% on
DFN.

It is observed that DFN ranges from

($250,000) at 0% growth rate to
$1,250,000 at 40% growth rate. A
negative DFN indicates that the firm has
surplus dollars in financing.

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Checkpoint 17.1
Estimating Discretionary Financing Needs
The Pendleton Chemical Company manufactures a line of
personal health care products used in preventing the spread of
infectious diseases. The companys principal product is a germ-
killing hand sanitizer called Bacteria-X. In 2010, Pendleton
had $5 million in sales, and anticipates an increase of 15% in
2011. After performing an analysis of the firms balance sheet,
the firms financial manager prepared the following pro forma
income statement and balance sheet for next year:

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17-29
Checkpoint 17.1

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17-30
Checkpoint 17.1

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Checkpoint 17.1

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Checkpoint 17.1

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Checkpoint 17.1

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Checkpoint 17.1: Check Yourself

Pendletons management estimates that

under the most optimistic circumstances it
might experience a 40% rate of growth of
sales in 2011. Assuming that net income
is 5% of firm sales and that both current
and fixed assets are equal to a fixed
percent of sales (as found in the above
forecast), what do you estimate the firms
DFN to be under these optimistic
circumstances?

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17-35
Step 1: Picture the Problem

The firms DFN is equal to the financing the

firm requires for the year that is not
provided by spontaneous sources such as
accounts payable and accrued expenses
plus retained earnings for the period.

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Step 2: Decide on a Solution
Strategy

We can calculate the DFN using the

following equation:

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 Line Performa Income Statement for 2011

Step 3: Solve 1
2
Growth Rate
Sales
40%
$7,000,000.00
3 Net Income
Performa Balance Sheet for 2011
Multiple Computation
4 Current Assets 0.20 $1,400,000.00

5 Net Fixed Assets 0.6 $4,200,000.00

6 Total 4+5 $5,600,000.00

7 Accounts Payable 0.2 $1,150,000.00

8 Accrued Expenses 0.1 $575,000.00

9 Notes Payable $500,000.00

10 Current Liabilities 7+8+9 $2,225,000.00

11 Long-term Debt $1,000,000.00

12 Common Stock (par) $100,000.00

13 Paid-in-capital $200,000.00

14 Retained Earnings $1,050,000.00

15 Common Equity 12+13+14 $1,350,000.00

$987,500 + Line3 - $287,500 17-38

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Step 4: Analyze

If the firm experiences a 40% growth rate

in sales, Pendleton can expect to raise
$1,025,000 during the coming year.

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17-39
17.3 Developing
a Short-Term
Financial Plan

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Developing a Short-Term Financial
Plan

Unlike a long-term financial plan that is

prepared using pro forma income
statements and balance sheets, short-term
financial plan is typically presented in the
form of a cash budget that contains details
concerning the firms cash receipts and
disbursements.

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17-41
Developing a Short-Term Financial
Plan (cont.)

Cash budget includes the following main

elements:
Cash receipts,
Cash disbursements,
Net change in cash, and
New financing needed.

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Uses of the Cash Budget

1. It is a useful tool for predicting the

amount and timing of the firms future
financing requirements.

2. It is a useful tool to monitor and control

the firms operations.

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17-44
Uses of the Cash Budget (cont.)

The actual cash receipts and

disbursements can be compared to
budgeted estimates, bringing to light any
significant differences.

In some cases, the differences may be

caused by cost overruns or poor collection
from credit customers. Remedial action
can then be taken.

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Key Terms

Cash budget
Discretionary financing needs (DFN)
Discretionary sources of financing
Long-term financial plan
Percent of sales method
Pro forma balance sheet
Pro forma income statement

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Key Terms (cont.)

Short-term financial plan

Sources of spontaneous financing
Strategic plan

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