FINANCIAL PLANNING AND FORECASTING

By Prof Sameer Lakhani

OUTLINE
The Planning System What and Why of Financial Planning Sales Forecast Proforma Profit and Loss Account Proforma Balance Sheet Financial modeling using spreadsheets Growth and External Financing Requirement Key Growth Rates

INTRODUCTION
Financial manager prepare pro forma or projected financial statements as to:

Assess whether the firm's forecasted performance squares with its own targets and with the expectation of investors.

Examine the effect of proposed operating changes

Anticipate the financing needs of the firm

Estimate the future free cash flow.

THE PLANNING SYSTEM

Goals

Strategy

Research and development policy

Marketing policy

Production policy

Personnel policy

Financial policy

Research and development budget

Marketing budget

Production budget

Personnel budget

Capital budget and financing plan

FINANCIAL PLAN Profit and loss account Balance sheet Cash flow statement

COMPONENTS OF A FINANCIAL PLAN

y Economic Assumptions: Financial plan is based on certain assumptions about the

economic environment such as Interest rate, tax rate, inflation rate, growth rate, exchange rate etc y Sales Forecast: Starting point of the financial forecasting exercise . y Proforma Statements: Proforma P&L , Cash flow & Balance Sheet. y Asset Requirements: Projected capital Investments & Working capital requirement. y Financing Plan: Sources of financing for supporting capital expenditure & working capital. For developing an explicit financial plan , capital budgeting decision, working capital decision, capital structure decision and dividend decision have to be established.

BENEFITS OF A FINANCIAL PLAN

y Identifies advance actions to be taken in various areas.

ySeeks to develop a number of options in various areas that can be exercised under different conditions. yFacilitates a systematic exploration of interaction between investment and financing decisions. yClarifies the links between present and future decisions. yForecasts what is likely to happen in future and hence helps in avoiding surprises. yEnsures that the strategic plan of the firm is financially viable. yProvides benchmarks against which future performance inay be measured.

SALES FORECAST
y The sales forecast is typically the starting point of the financial forecasting exercise. ySales forecasts may be prepared for varying planning horizons to serve different purposes yA sales forecast for a period of 3-5 years, or for even longer durations, may be developed mainly to aid investment planning. Sales forecasts for shorter durations (six months, three months, one month) may be prepared for facilitating working capita1 planning and cash budgeting. y Sales forecasting techniques fall into three broad categories: y Qualitative techniques : Based on Judgment y Time series projection methods : Past behavior of time series y Causal models Develop forecast based on Cause & Effect relationship.

PRO FORMA PROFlT AND LOSS ACCOUNT

y There are two commonly used methods for preparing the pro forma profit and loss account - the percent of sales method and the budgeted expense method.

yPercent of Sales Method :The percent of sales method for preparing the pro forma profit and loss account is fairly simple. Basically, 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?

PROFORMA PROFIT & LOSS ACCOUNT PERCENT OF SALES METHOD

Historical Data 20X1 Net sales Cost of goods sold Gross profit Selling expenses General and administration expenses Depreciation Operating profit Non-operating surplus/ deficit Profit before interest and tax Interest on bank borrowings Interest on debentures Profit before tax Tax Profit after tax Dividends Retained earnings 1200 775 425 25 53 75 272 30 302 60 58 184 82 102 60 42 20X2 1280 837 443 27 54 80 282 32 314 65 60 189 90 99 63 36 Average percent of Sales 100 . 0 65 . 0 35 . 0 2.1 4.3 6.3 22 . 3 2.5 24 . 8 5.0 4.8 15 . 0 6.9 8.1 Pro forma profit and loss account of 20X3 assuming sales of 1400 1400 . 0 910 . 0 490 . 0 29 . 4 60 . 2 88 . 2 312 . 2 35 . 0 347 . 2 70 . 0 67 . 2 210 . 0 96 . 6 113 . 4

BUDGETED EXPENSE METHOD

y Budgeted Expense Method :The percent of sales method, though simple, is too rigid and mechanistic. For deriving the pro forma profit and loss account we assumed that all elements of costs and expenses bore a strictly proportional relationship to sales. 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 loss account is being prepared. Obviously, this method requires greater effort on the part of management because it calls for defining Likely developments. yA Combination Method: 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 from the past, the budgeted expense method, which calls for managerial assessment of expected future developments.

PROFORMA PROFIT & LOSS ACCOUNT COMBINATION METHOD

Historical Data 20X1
Net sales Cost of goods sold Gross profit Selling expenses General and administration Depreciation Operating profit Non-operating surplus/ deficit Profit before interest and tax Interest on bank borrowings Interest on debentures Profit before tax Tax Profit after tax Dividends Retained earnings 1200 775 425 25 53 75 272 30 302 60 58 184 82 102 60 42

20X2
1280 837 443 27 54 80 282 32 314 65 60 189 90 99 63 36

Average Percent of sales

100.0 65.0 35.0 2.1 Budgeted Budgeted @ 2.5 @ 5.0 Budgeted @ Budgeted @ Budgeted @

Proforma Profit and loss account of for 20X3

1400.0 910.0 490.0 29.4 56.0 85.0 319.6 35.0 354.6 70.0 65.0 219.6 90.0 129.6 70.0 59.6

PROFORMA BALANCE SHEET

y The projections of various items on the assets & liabilities side of the balance sheet are derived as follows:
Item Current Assets Basis of Projection Percent of sales method wherein the proportion are based on the average for the previous two years. Same as above Assumptions of no change Same as above Percent of sales method wherein the proportion are based on the average for the previous two years. Previous values Proforma Income Statement Previous values Percent of sales method wherein the proportion are based on the average for the previous two years. Same as above Balancing Item

Fixed Assets Investments Miscellaneous Exp Current Liabilities & Provision Equity & Preference Capital Reserves & Surplus Debentures Bank Borrowings

Unsecured loans External funds

PROFORMA BALANCE SHEET

Historical Data March March Average of Percent 31, 20X1 31, 20X1 of Sales or some other basis 1200 1280 100.0 800 30 25 200 375 50 20 1500 250 50 250 400 300 100 100 50 1500 850 30 28 212 380 55 20 1575 250 50 286 400 305 125 112 47 1575 66.5 No change 2.1 16.6 30.4 4.2 No change Projection for March 31, 20X3 based on a fore-cast sales of 1400 1400.0 931.0 30 29.4 232.4 425.6 58.8 20 1727.2 250.0 50.0 345.6 400 341.6 127.4 119.0 54.6 39.0 1727.2

Net sales Assets Fixed assets (net) Investments Current assets, loans and advances Cash and bank Receivables Inventories Pre-paid expenses Miscellaneous expenditures and losses Total Liabilities Share capital Equity Preference Reserves and surplus Secured loans Debentures Bank borrowings Unsecured loans Bank borrowings Current liabilities and provisions Trade creditors Provisions External funds requirement Total

No change No change Proforma income statement No change 24.4 9.1 8.5 3.9 Balancing figure

GROWTH AND EXTERNAL FINANCING REQUIREMENT

When ratios remain constant financing requirement can be estimated as follows: EFR = A/S ( S) L/S ( S) mS1 (1 d) ( IM + SR) EFR = external funds requirement A/S = current assets and fixed assets as a proportion of sales S = expected increase in sales L/S = current liabilities and provisions as a proportion of sales m = net profit margin S1 = projected sales for next year d = dividend payout ratio IM = Change in level of Investment & miscellaneous Expenditure & Losses SR = Schedule repayment of term loans & debentures

GROWTH AND EXTERNAL FINANCING REQUIREMENT

Manipulating Eq. a bit, we get EFR S

A S

L S

m (1 + g) (1 d) g Illustration

A/S = 0.90, M = 0.05,

S = Rs. 6 million, S1 = Rs. 46 million,

L/S = 0.40, and d = 0.6

EFR = (0.90) (6) (0.4) (6) (0.05) (46) (0.4) = Rs. 2.08 million EFR S = 0.50 = 0.50 g (%) EFR/ S 5 0.08 10 0.28 0.05 (1 + g) (1 0.60) g 0.20 (1 + g) g 15 0.35 20 0.38 25 0.42 See Excel Sheet

FORECASTING WHEN THE BALANCE SHEET RATIOS CHANGE

In our discussion so far we assumed that the ratios of assets and liabilities to sales (A/S and L / S ) remain constant over time. This implies that each 'spontaneous' asset and liability account changes at the same rate as sales. Graphically, it means that the relationship is linear and passes through the origin as shown in Exhibit

The assumption of constant ratios and identical growth rates may be appropriate sometimes, but not always. In particular, its applicability is suspect in the following situations,

FORECASTING WHEN THE BALANCE SHEET RATIOS CHANGE

Economies of Scale: In the use of many kinds of assets, economies of scale occur. This means that the ratios change over time as the size of the firm increases. For example, as sales expand inventories grow less rapidly than sales and hence the ratio of inventory to sales falls. Here we find that the inventory-to-sales ratio is 0.5 or 50 per cent, when sales are Rs 200 million, but the ratio declines to 0.45 or 45 percent when sales rise to Rs 400 million. The relationship depicted in Exhibit 5.6(b) is linear, but not one that passes through the origin. Often, however, a curvilinear relationship of the kind shown in Exhibit 5.6(c) obtains. In such a situation, larger increases in sales can be supported by smaller increases in inventories.

FORECASTING WHEN THE BALANCE SHEET RATIOS CHANGE

Lumpy Assets: In many industries, fixed assets have to be added in large, discrete units due to technological reasons. Due to such lumpy increments of fixed assets, the relationship between fixed assets and sales is as shown in Exhibit

Forecasting Errors and Excess Assets : The relationships depicted in Exhibit reflect target, or projected, relationship between sales and assets. Actual sales often differ from projected sales and hence the actual asset/sales ratio may differ from the planned ratio. To illustrate, suppose that a firm has a fixed assets to sales ratio of 1:2 and, in anticipation of an increase in sales from Rs 200 million to Rs 300 million, it increases its fixed assets from Rs 100 million to Rs 150 million. However, if the sales remain stagnant at Rs 200 million, it will have an excess capacity which can support a sales increase of Rs 100 million. In such a situation, if the firm were to prepare its forecast for the following year it should recognize that additional sales of Rs 100 million will require no further investment in fixed assets.

INTERNAL GROWTH RATE

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: the internal growth rate and the sustainable growth rate. Internal growth Rate :It 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 Assumptions: 1. The assets of the firm will increase proportionally to sales. 2. The net profit margin (net profit to sales) is constant.. 3. The dividend payout ratio (and the plough back ratio) is given. 4. Firm wants to grow by retention it does not raise external funds (neither equity or debt) to finance assets. Addition to assets = Addition to retained earnings

IGR =

ROA * b 1 (ROA * b)

INTERNAL GROWTH RATE

Internal growth rate = Net profit margin x Asset turnover x Plough back ratio 1 - Net profit margin x Asset turnover x Plough back ratio

Return on assets = Net profit margin x Asset turnover Internal growth rate = Return on assets x Plough back ratio 1 - Return on assets x Plough back ratio

IGR =

ROA * b 1 (ROA * b)

To illustrate, suppose the return on assets and plough back ratio for Acme Chemicals are 12 percent and 60 percent respectively. What is the internal growth rate? The internal growth rate is = 0.12 * 0.6 = 0.78 or 7.8 % 1- (0.12 -0.6)

SUSTAINABLE GROWTH RATE

The sustainable growth rate 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 is an important growth rate because firms are reluctant to raise external equity finance (even though they may not mind raising debt finance, in line with their debt -equity policy) for the following reasons: (i) The dilution of control, consequent to the external equity issue, may not be acceptable to the existing controlling interest. (ii) There may be a significant degree of under pricing when external equity is raised. (iii) The cost of issue tends to be high Addition to assets = Additional retained earnings + Additional debt

SUSTAINABLE GROWTH RATE

It is the maximum rate at which the firm can grow by using both internal sources (Retained Earnings) as well as additional external debt but without increasing its financial leverage ( debt equity ratio). Additional Assumptions: 1. The firm has a target capital structure (D/E ratio) which it wants to maintain. 2. The firm does not intend to sell new equity shares as it is costly source of finance. SGR= Net profit margin x Asset turnover x (1 +Debt -equity ratio) x Plough back ratio 1- Net profit margin x Asset turnover x (1 +Debt -equity ratio) x Plough back ratio Net profit = Average Equity (ROE) Net profit x Sales NPM Sales x Average Total assets

Average Total Assets Average Equity ATR ( 1+ Debt / Equity)

Sustainable growth rate = Return on equity x Plough back ratio 1 - Return on equity x Plough back ratio

SUSTAINABLE GROWTH RATE

SGR = ROE * b 1 (ROE * b) Given the assumptions it enables the corporate to maintain the existing ROE besides target D/E ratio and the target D/P ratio SGR = NP*AT* A/E * b 1- (NP*AT* A/E * b) Examining Eq. we find that other things being equal: The higher the net profit margin, the higher the sustainable growth rate. The higher the asset turnover, the higher the sustainable growth rate. The higher the debt-equity ratio, the higher the sustainable growth rate. The higher the plough back ratio, the higher the sustainable growth rate.

SUSTAINABLE GROWTH RATE

SGR of the firm can increased by any one or more of the following factors: 1. Increase in Net profit Margin 2. Increase in Asset turnover ratio 3. Increase in financial leverage 4. Increase in retention ratio (or Decrease in the dividend payout ratio).

Concluding Remarks: When a company grows @ higher than its SGR,it has better operating margin (Higher NPM or ATR) or it is prepared to revise its financing policy (by Increasing its RR or its D/E financial leverage ratio) In case firm anticipates it is not possible to improve operating performance nor it is willing to assume more risk it is prefer to grow at SGR or a rate lower to conserve financial resources to avoid problem of liquidity & solvency in future.

SOLVED PROBLEMS

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The pro forma income statement of Modern Electronics Ltd for year 3 based on the per cent of sales method is given below

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The pro forma income statement of Modern Electronics for year 3 using the combination method is given below

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As in problem 1, assume that sales will grow to 1020 in year 3. Assume that all items on the assets side, except investment and miscellaneous expenditures and losses, will grow proportionally to sales. Likewise, trade credit and provisions will be proportional to sales. Obtain the estimated value of retained earnings from the pro forma profit and loss account developed in problem 2. Finally estimate the amount of external financing needed for year 3.

UNSOLVED PROBLEMS
The pro forma balance sheet of Modern Electronics Ltd for year 3 is given below

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Solving the above equation we get g = 7.14%

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