Financial Planning &

Forecasting

Faculty: Faraz Naseem

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Contents
 Financial Planning
 Sales & Operations Plan
 Financial Statements Forecasting
 The AFN Formula

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Financial Planning
The Financial Planning Process
 Analyzing the investment and financing
choices open to the firm.
 Projecting the future consequences of
current decisions.
 Deciding which alternatives to undertake.
 Measuring subsequent performance
against the goals set forth in the financial
plan.
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 Financial Planning
Planning Horizon - Time horizon for a financial
plan.
Departments are often asked to submit 3
alternatives.
 Optimistic case = best case (Heavy capital investment and rapid
growth of existing markets)
 Expected case = normal growth (growth with its markets but not
significantly)
 Pessimistic case = (Planning for lean economic times)

 Financial plans help managers ensure that their

financial strategies are consistent with their
capital budgets. They highlight the financial
decisions necessary to support the firm’s
production and investment goals. 3-4
Financial Planning
Why Build Financial Plans?
 Contingency planning

 Considering options

 Forcing consistency

Three Requirements for Effective Planning

 Forecasting

 Choosing the Optimal Financial Plan

 Watching the Plan Unfold. 3-5

 Financial Planning Models
Inputs Planning Outputs
Model
Inputs - Current financial statements.
Forecasts of key variables (such as sales or
interest rates).
Planning Model - Equations specifying key
relationships.

Outputs - Projected financial statements

(pro forma). Financial ratios. Sources and
uses of funds.
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Financial Planning Models
Pro Formas - Projected or forecasted financial
statements.
Percentage of Sales Model - Planning model
in which sales forecasts are the driving
variable and most other variables are
proportional to sales.
Balancing Item - Variable that adjusts to
maintain the consistency of a financial plan.
Also called plug.
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The Ingredients of a Financial Plan
 A financial plan consists of several
ingredients
 Expectations about the economic
environment
 A sales forecast
 Cash Budget
 Pro forma (forecasted) financial statements
 Asset requirements
 Required new financing
 We will focus on developing the pro
formas financial statements 3-8
Planners Beware
 Many models ignore realities such as
depreciation, taxes, etc.
 Percent of sales methods are not
realistic because fixed costs exist.
 Most models generate accounting
numbers not financial cash flows
 Adjustments must be made to consider
these and other factors.
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Financial Statements Forecasting
 The Percent of Sales Method

 Once sales have been forecasted , we must forecast future

balance sheet and income statements.
 The most common method is the percent of sales method
 Many items on the income statement and the balance sheet
are assumed to increase proportionately with sales.
 Each item will grow at the same rate (%) as sales and this
approach is called the constant ratio method.
 Every case could vary so the assumptions pertaining to a
particular question need to be strictly followed.

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 Types of Assets and Liabilities

 There are two types of assets:

 Current assets are the firm’s short-term assets and can
generally be expected to vary directly with sales
 Fixed assets are the firm’s long-term assets and generally
do not vary directly with sales
 There are two types of liabilities:
 Spontaneous liabilities are those that occur naturally
during the ordinary course of doing business. These sources
vary directly with sales
 Discretionary liabilities are those that require a special
effort for the firm to obtain. These sources do not vary
directly with sales

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 Elvis Products International
Key Data

 Lets analyze this method in detail with the subsequent example

of Elvis Products International
 The company will be operating below capacity in 1998.
 Sales is expected to increase by 10%
 Spontaneous assets & liabilities grows proportionally with sales.
 Cash & equivalent levels are expected to be maintained at the same
as the previous year.
 The company expects to give $22,000 as dividends in 1998.
 We need to prepare here the forecasted financial statements of EPI
for 1998.

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 Forecasting the Income Statement
Elvis Products International
Pro Forma Income Statement
For the Year Ended December 31, 1998 (figures in ‘000)
1998* 1997 1996
Sales
Cost of Goods Sold
Sales $4,235.00
$3,575.00
$3,850.00
$3,250.00
$3,432.00
$2,864.00
Gross Profit
forecasted $660.00 $600.00 $568.00

No change Selling and G&A Expenses to increase $363.33 $330.30 $280.00

Fixed Expenses by 10% $100.00 $100.00 $100.00
Depreciation Expense $20.00 $20.00 $18.90
EBIT $176.67 $149.70 $169.10
Interest Expense $76.00 $76.00 $62.50
Earnings Before Taxes $100.67 $73.70 $106.60
Taxes @ 40% $40.27 $29.48 $42.64

Net Income $60.40 $44.22 $63.96

* Forecasted

Other Data
Cash Dividends $22.00 $15.00 $10.00
Increase in Retained Earnings $38.40 $29.22 $53.96

Note:- The company expects to give cash dividends of $22 in 1998

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Forecasting the Balance Sheet Elvis Products International Elvis Products International
Pro Forma Balance Sheet
As of December 31, 1998 (figures in ‘000)
Assets 1998* 1997 1996
Cash and Equivalents $52.00 $52.00 $57.60
Accounts Receivable $442.20 $402.00 $351.20
Inventory $919.60 $836.00 $715.20
Total Current Assets $1,413.80 $1,290.00 $1,124.00
Plant & Equipment $527.00 $527.00 $491.00
Accumulated Depreciation $186.20 $166.20 $146.20
Net Fixed Assets $340.80 $360.80 $344.80
Total Assets $1,754.60 $1,650.80 $1,468.80
Liabilities and Owner's Equity
Accounts Payable $192.72 $175.20 $145.60
Short-term Notes Payable $225.00 $225.00 $200.00
Other Current Liabilities $154.00 $140.00 $136.00
Total Current Liabilities $571.72 $540.20 $481.60
Long-term Debt $424.61 $424.61 $323.43
Total Liabilities $996.33 $964.81 $805.03
Common Stock $460.00 $460.00 $460.00
Retained Earnings $264.39 $225.99 $203.77
Total Shareholder's Equity $724.39 $685.99 $663.77
Total Liabilities and Owner's Equity $1,720.72 $1,650.80 $1,468.80

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Discretionary Financing Needed -$33.88 Deficit
* Forecasted
Equity or Debt?
 Firms can borrow in the following ways
in a capital structure:
 Debt
 Equity
 Equity includes issuance of shares.
 Cost of Equity vs. Cost of Debt?

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Short Term or Long Term
Financing?
 Debt includes the following:
 Trade Credits
 Short Term Loans/Commercial Papers
 Long Term Loans/Bonds
 Maturity Horizons should match
 Cost of STF vs. LTF?
 Firms can also meet deficit by
disinvestments
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Discretionary Financing Needed
 Ordinarily, the pro-forma balance sheet will not
balance!
 This is intentional, and the amount needed to make it
balance is referred to as the Discretionary Financing
Needed, DFN (or External Financing Needed, EFN)
 This is a “plug figure” that represents the amount of
discretionary financing that the firm will need to
obtain in order to support its forecasted level of sales
 In the case of Elvis Products International , the
discretionary financing figure is $33.88 which has to
be provided in one of the following ways (shown in
the next slide)
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Discretionary Financing Needed

The four common methods of discretionary financing

are as follows:-

 Borrow more short-term (Notes Payable)

 Borrow more long-term (LT Debt)
 Sell more common stock
 Decrease dividend payout

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 The AFN Formula

 Most Firms forecast their capital requirements by

constructing pro forma income statements and balance
sheets as explained before.
 However if the ratios are expected to remain constant,
then the following formula can be used to forecast
financial requirements

AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)

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 The AFN Formula
AFN = (A*/S0)S (L*/S0)S M(S1)(1 - d)
Required Increase in
Spontaneous
AFN = assets retained
liability
increase earnings
increase

 A* = assets that are tied directly to sales, hence must increase if

sales are to increase.
 S0 = Sales during the last year.
 L* = Liabilities that increase spontaneously.
 S1 = total sales projected for next year.
 S = change in sales.
 M = profit margin
 However if the ratios are expected to remain constant, then the
following formula can be used to forecast financial requirements

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 Example

 To illustrate the calculation of AFN, consider the

given data of Funky House for 2001.
 Operating at full capacity in 2001.
 Each type of asset grows proportionally with sales.
 Payables and accruals grow proportionally with sales.
 2001 profit margin (2.52%) and payout (30%) will
be maintained.
 Sales are expected to increase by $500 million.
(%S = 25%)

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 2001 Balance Sheet
(Millions of $)

Cash & sec. $ 20 Accts. pay. &

accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed Retained
assets 500 earnings 200
Total assets $1,000 Total claims $1,000

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 2001 Income Statement
(Millions of $)

Sales $2,000.00
Less: COGS (60%) 1,200.00
SGA costs 700.00
EBIT $ 100.00
Interest 16.00
EBT $ 84.00
Taxes (40%) 33.60
Net income $ 50.40
Dividends (30%) $15.12
Add’n to RE $35.28
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What is the AFN, based on the
AFN equation?
AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)
= ($1,000/$2,000)($500)
- ($100/$2,000)($500)
- 0.0252($2,500)(1 - 0.3)
= $180.9 million.

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THE END

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