FINANCIAL FORECASTING

Role sof Financial Management

Financial Management focuses on the objectives of financial management
and all of the activities in the planning cycle which work to achieve these
objectives. It is about planning, organizing, and controlling the financial
resources of a business. It is also concerned with the proper specification of
the financial goals of the firm as well as the measurement of performance
relative to the achievement of these objectives.
Nature of Financial Forecasting
Financial forecasting is simply a financial plan or budget for your business. It
is an estimate of two essential future financial outcomes for a business
your projected income and expenses. It is also a way to let the company or
firm think of the events before they occur and prepares for it, particularly the
need for raising funds.
Business decisions, and especially financial related business decisions,
depend heavily forecast of future events. For example, when manager Kim
agrees to lend manager Rose an amount of money, the decision depends on
how Kim expects to be repaid.
Ideally, it is about the techniques financial managers use to predict the likely
future values of financial variables such as revenues, expenses and cash
balances.
Characteristics of Financial Forecasting
1.Incrementality- all benefits expense and investments that will change as a
result of the decision should be included in financial forecast. Example: Cost
of additional support staff like an engineer to support the product.
2.Working Capital Investments-investment is an exposure of cash that has
the objective of producing cash flow benefits in the future.
3.Economics and Pricing-financial forecasting should reflect current product
prices and operating cost. The company should never rely on higher future
selling prices to justify current investments.
4.Accounting Rules-financial forecast should respect the accounting rules and
practices that will govern the companys reporting over the period for which
the forecast is made.
5.External Financing-cash flow forecasts should assume that the investments
will be all cash , and the investments should be included in the forecast at
the point when the commitments to acquire assets are made.
6.Financial Forecast Time Frame-financial
maximum of 5 years of cash inflows.

forecast

should

provide

Three Problems with Relying on Forecast

1.Faulty data
1

2.Unexpected events
3.Integrating Impact

Disadvantages of Using Financial Forecast

1.The data is going to be old.
2.It is impossible to factor in unique or unexpected events or externalities
3.Forecast cant integrate their own impact.
Steps in Financial Forecasting
Any financial forecast will involve these three questions:
1. How much money will the firm need during a given period?
2. How much money will the firm generate internally or through
operations during the same period?
3. How much additional funds or external financing will be required?
These are the different steps needed to accomplish financial requirements:

Establish a base year

Asses revenue and expenditure growth trends
Clearly specify underlying assumptions
Select a forecasting method
Asses the reliability and validity of the data used to determine
assumptions.
Monitor actual revenue and expenditure levels against the forecast and
explain variances
Update the forecast based on changes

Projected Financial Statement Method

To estimate the external financial requirements, the projected or pro forma
financial statement method or the formula method maybe used.
Projected financial statement method is a summary of various component
projections of revenues and expenses for the budget period. They indicate
the expected net income for the period. It is an important tool in determining
the overall performance of a company. They include the balance
sheet, income statement and cash flow statements to indicate the company
performance.
Preparing Projected Financial Statements

Preparing projected financial statements require careful analysis. Prior to

preparing projected financial statements, an analyst studies the financial
history of the company. There may be some drawbacks, which the company
may have encountered down the years. To eradicate such hurdles and for the
betterment of the companys financial status, an analysis is conducted.

STEPS IN PROJECTED FINANCIAL STATEMENTS :

2

Step 1. Forecast the Income Statement or Statement of Comprehensive

Income
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding
production cost, direct materials, direct labor, and overhead.
c. Estimates selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.
Step 2. Forecast the Balance Sheet or Statement of Financial Position
a. Project the assets that will be needed to support the projected sales.
b. Project funds that will be spontaneously generated (through accounts
payable and accruals) and by retained earnings.
c. Project liability and shareholders equity accounts that will not rise
spontaneously with sales of (e.g. notes payable, long-term bonds,
preference shares, and ordinary shares) but we may change due to
financing decisions that will be made later.
d. Determine if additional funds will be needed through the following
formula:
Additional
=
Required
Spontaneous
Increase
Funds Needed (AFN)
Increase in Asset
Increase in Liabilitiesin Retained
Earnings
The additional financing needed will be raised by borrowing from the
bank as note payable, by issuing long-term bonds, by selling new ordinary
shares or by some combination of actions.
Step 3.Raising the AFN
The financing decision will consider the following factors:
(1)Target capital structure
(2)Effect of short-term borrowing in its current ratio
(3)Conditions in the debt and equity markets, or
(4)Restrictions imposed by existing debt agreements.
Step 4.Consider Financing Feedbacks
Depending on whether additional funds will be borrowed or will be raised
through ordinary shares, consideration should be given on additional interest
expense in the Income Statement, thus decreasing the retained earnings.
Apply the iteration process using the available financing mix until the AFN
would become so small that the forecast can be considered complete.
Illustrative Case I. Financial Forecasting (Percent of Sales Method)
The Elixir Company has the following statements which are representative of
the companys historical average.
Statement of Comprehensive Income
Sales
Cost of sales
Gross profit
Operating expenses
Earnings before

6,000,000
3,600,000
2,400,000
1,140,000
1,260 000
3

interest and taxes

Interest expense

210,000

Earnings before taxes

Taxes(30%)

1,050,000
315,000

Earnings after taxes

Dividends(60%)

735,000
441,000

Statement of Financial Position

Assets
Cash

150,000

Accounts receivable

1,200,000

Inventory

2,250,000

Current assets

3,600,000

Fixed assets (net)

2,400,000

Total assets

6,000,000

Liabilities and Equity

Accounts payable
Accrued wages
Accrued taxes

750,000
30,000
60,000

Current liabilities

840,000

Notes payable bank

210,000

Long-term debt

450,000

Ordinary shares
Retained earnings

3600,000
900,000

Total liabilities
and equity

6,000,000

The firm is expecting a 20% increase in sales next year, and management is
concerned about the companys need for external funds. The increase in
sales is expected to be carried out without any expansion of fixed assets, but
rather through more efficient asset utilization in the existing store. Among
liabilities, only current liabilities vary directly with sales.
Using the percent-of-sales method, determine whether the company has
external financing needs or a surplus of funds.

Solution:
Step 1. Project the Statement of Comprehensive Income.

The projected income statement will show the following:

Sales
7,200,000
Cost of sales
(4,320,000)
Gross profit
2,880,000
Operating expenses
(1,368,000)
Earnings before interest and taxes
1,512,000
Interest expense
(210,000)
Earnings before taxes
1,302,000
Taxes (30%)
(390,600)
Earnings after taxes
911,400
Dividends (36% payment)
328,104
Step 2. Project the Statement of Financial Position.
The projected statement of financial position will show the following:
Assets
Cash
Accounts receivable
Inventory
Total current assets
Fixed assets (net)
Total assets

(1)
(3)
(4)

180,000
(2)
1,440,000
2,700,000
P4,320,000
2,400,000
P6,720,000

Liabilities and Equity

Accounts payable
(5)
900,000
Accrued wages
(6)
36,000
Accrued taxes
(7)
72,000
Current liabilities
1,008,000
Notes payable bank (4)
210,000
Long-term debt
(4)
450,000
Ordinary shares
(4)
3,600,000
Retained earnings
(8)
1,483,296
Total
6,751,296
Additional financing required
31,296*
Total
P6,720,000
Supporting computations:
1)
2)
3)
4)

5)
6)
7)
8)

Cash = 2.5% x P7.2M sales

Accounts Receivable = 20% of P7.2M
Inventory = 37.5% x P7.2M
No percentages are computed for fixed assets, notes payable, longterm debt, ordinary shares and retained earnings because they are not
assumed to maintain a direct relationship as with sales volume.
For simplicity, depreciation is not explicitly considered.
Accounts Payable = 12.5% of P7.2M
Accrued Expenses = 0.5% of P7.2M
Accrued Taxes = 1% of P7.2M
Retained Earnings = P900000 + P911,400 - P328,104

Formula Method
Additional financing needed (AFN) may also be computed as follows:
Additional
funds
=
needed

Required
increase
in assets

Required increase in assets =

(Present)

Spontaneous
increase in liabilities

Change in sales

Increase in
retained
earnings

Current

assets

Sales (Present)
Spontaneous increase
in liabilities =
Change in sales
Increase in retained earnings =
Dividend payment

Current Liabilities (Present)

Sales (Present)

Earnings after taxes

Solution:
Applied to Elixir Co. AFN is computed as follows:
AFN = (1,200,000) x (3 600 000 / 6,000,000) 000 / 6 000 000) (911,400 328,104)
= 720,000 - 168,000 - 583,296
=(31,296)

Illustrative Case II.

Financing Feedback

Projected

Financial

(1,200,000) x (840

Statements

with

TABLE 2.1
Guyabano Company
Actual Income Statement
(Millions of Pesos Except Share per Data)
Sales
Cost except depreciation
Depreciation
Total Operating Costs
Earnings before interest and taxes
Less interest expense
Earnings before taxes
Taxes (30%)
Net income before preferred dividends
Preferred dividends
Net income available to ordinary shares
Shares Of Common Equity
Dividends per share
Dividends to common
Additional Retained Earnings

P6, 000,000
2,616.2
100.0
2,716.2
283.8
88.0
195.8
_ 58.7__
137.1
__4.0_
1,331.1
50.0
1.15
57.5
75.6

STEP 1.Forecast the First-Pass Income Statement

We call this a first pass because we will come back later and
incorporate financing feedback. First, we forecast the income
6

statement for the coming year. This statement is needed to estimate

both income and the addition to retained earnings. Table 2.2 shows the
forecast. Sales are forecasted to grow by 10 percent. The forecast of
sales, shown in Row 1 of Column 3, is calculated by multiplying 2015
sales, shown in Column 1, by (1 + growth rate) = 1.1. The result is a
forecast of P3,300 million. We assume that costs will equal 87.2
percent of sales. See Column 3, Row 2, of Table 2.2. Last year, the ratio
of depreciation to net plant and equipment was 10 percent, and
Guyabanos managers believe that this is a good estimate of future
depreciation.
Table 2.2 Guyabano Company: Actual and First-Pass Income
Statement
(Millions of Pesos:Except Share per Data)

Actual (2015)

First-Pass
Forecast (2016)

Forecast Basis
P
3
000.0 110% x 2016 Sales

Sales
Cost
depreciation

except 26
116.2

Depreciation

P 3 300.0

87.2% x 2016 Sales 2877.6

10% x
Plant

100

2016

Net
110

Total Operating Costs

2 716.2

2987.6

EBIT

283.8

312.4
Carry over from last
year
88

Less: Interest

88

EBT

195.8

224.4

Taxes (30%)

58.7

67.3

Net
Income
before
preferred dividends

137.1

157.1

Preferred Dividends

Net income available to

common

133.1

Shares
equity

of

Carry over from last

year
4
153.1

common

Dividends per share

50

50

1.15

Dividends to common

57.5

Additional to common

75.6

108% x 2016 DPS

1.25

DPS x # of Shares

62.5
90.6

Total operating costs, shown in Row 4, are the sum of other costs and
depreciation. EBIT is found by subtraction, while the interest charges shown
in Column 3 are simply carried over from Column 1. The final interest charge
will depend on the debt in 2016, which we discuss in the next section, so for
the first pass we simply carry over last years interest expense. Earnings
before taxes (EBT) is then calculated, as is net income before preferred
dividends. Preferred dividends are carried over from the 2015 column, and
they will remain constant unless Guyabano decides to issue additional
preferred stock. Net income available to common is then calculated, after
which the dividends are forecasted as follows. The most recent dividend pre
7

share was P1.15, and this dividend is expected to increase by about 8

percent , to P1.25. Since there are 50 million shares outstanding, the
projected dividends are P1.25(50) = P62.5 million. To complete the
forecasted income statement , the 62.5 million of projected dividends are
subtracted from the P130.6 million projected bet income, and the result is
the first-pass projection of the addition to retained earnings, P153.1-P62.5
=P90.6 million.

STEP 2. Forecast the First-Pass Balance Sheet

The assets shown on Guyabano balance sheet must increase if sales
are to increase. Guyabanos most recent ratio of cash to sales was
approximately 0.33 percent, and its managers believe this ratio will
remain constant in 2016. For the first pass, the amount of short-term
investments in Column 1 of Row 2 is simply carried over to Column 3 of
Table 2.3. Guyabanos most recent ratio of accounts receivable to sales
was 12.5 percent and we assume it will stay the same. The most
recent ratio of inventory to sales was 20.5 percent and we assume no
change in Guyabanos inventory management. The ratio of net plant
and equipment has grown fairly steadily in the past, and its managers
expect similar future growth.

Table 2.3 Guyabano Company: Actual, First-Pass and Second Pass

Projected Balance Sheets
(Millions of Pesos:Except Share per Data)

Once the individual asset accounts have been forcasted, they can be
summed to complete the asset section of the first-pass balance sheet. For
Guyabano, the total current assets forecasted are P11 + P0 + P412 + P677 =
P 1 100 million, and fixed assets add another P1 100 million. Therefore, as
Table 14E-2 shows, Guyabano will need a total of P2 200 million in assets to
support P3 300 million of sales. If assets are to increase, liabilities and equity
must also increase the additional assets must be financed. For Guyabono,
the most recent ratio of accounts payable to sales was 2 percent. Its
managers assume that the payables policy will not change. The most recent
ratio of accruals to sales was 4.67 percent, and this ratio is expected to stay
the same. Retained earnings will also increase, but not at the same rate as
sales: the new amount of retained earnings will be the old amount plus the
Table 2.4 Financing the AFN

Notes Payable
Long-term bonds
Common stock

Amount of New Capital

%
Dollars (Million)
25
P 22.35
25
22.35
50
44.7

Total
100%
P89.4
addition to retained earnings, which we calculated earlier. Also, notes
payable, long-term bonds, preferred stock, and common stock will not rise
spontaneously with sales rather, the projected levels of these accounts will
depend on financing decisions, as we discuss later. In summary, (1) higher
sales must be supported by additional assets, (2) some of the asset
increases will be financed by spontaneous increase in accounts payable and
accruals, and by retained earnings, but (3) any shortfall must be financed
from external sources, using some combination of debt, preferred stock, and
common stock.
The spontaneously increasing liabilities (accounts payable and
accruals) are forecasted and shown in Column 3 of Table 2.3, the first-pass
forecast. Then, those liability and equity accounts whose values reflect
conscious management decisions notes payable, long term bonds, preferred
stock, and common stock are initially set at their 2015 levels. Thus, 2016
notes payable are initially set at P110 million, the long-term bond is
forecasted at P754 million, and so on. The 2016 value for the retained
earnings (RE) account is obtained by adding the projected addition to
retained earnings as developed in the 2016 income statement (see Table 2.2)
to the 2015 ending balance:
2016 RE = 2015 RE + 2016 forecasted addition to RE
= P766 + P90.6
= P856.6 million
The forecast of total assets as shown in Column 3 (first-pass forecast)
of Table 2.3 is P2 200 million, which indicates the Guyabano must add P200
million of new assets in 2016 to support the higher sales level. However, the
forecasted liability and equity accounts as shown in the lower portion of
Column 3 rise by only P110.6 million, to P2 110.6 million. Therefore,
Guyabano must raise an additional P2 200 P 2 110.6 = P89.4 million, which
we define as Additional Funds Needed (AFN). The AFN will be raised by some
9

combination of borrowing from the bank as notes payable, issuing long-term

bonds, and issuing new common stock. Raising the Additional Funds Needed
Guyabanos financial staff will decide how to raise the needed funds based
on several factors, including the firms target capital structure, the effect of
short-term borrowing on the current ratio, conditions in the debt and equity
markets, and restrictions imposed by existing debt agreements. After
considering all of the relevant factors, the staff decided on the following
financing mix had the AFN been negative, Guyabano would had more funds
that it needed to finance its assets. In this case, Guyabano could reduce its
financing (that is, pay off some debt, buy back stock, or pay a larger
dividend). Instead, Guyabano will acquire additional short-term investments
with the extra funds.

These amounts, which are shown in Column 4 of Table 2.3, are added to the
initially forecasted amounts as shown in Column 3 to generate the second
pass balance sheet. Thus, in Column 5, notes payable increase to P110 +
P22.35 = P132.35 million, long-term bonds rise to P754 + P22.35 = P776.35
million, and common stock increases to P130 + P44.7 = P174.7 million. At
that point, the balance sheets in balance.

STEP 3. Financial Feedbacks

The projected financial statements are incomplete because they do not
reflect the fact that interest must be paid on the debt used to help finance
the AFN, and that dividends will be paid on the new shares of common stock.
Those payments, which are called financing feedbacks, will lower the net
income and retained earnings, shows in the projected statements, the
manual approach and the automatic approach.

Table 2.5 Guyabano Company: Actual, First-Pass, and Second-Pass Income

Statement
(Millions of Pesos Except Share per Data)
First-Pass
Forecast
Actual (2015)
(2016)
P
3
Sales
000
P 3 300
Cost except 26
depreciation
116.2
2 877.6

Feedback

Second-Pass
Forecast
(2016)
P 3 300
2 877.6

Depreciation
100
Totall
Operating
Costs

110
2
716.2 2987.6

2 987.6

EBIT

283.8 312.4

312.4

Less Interest

88

EBT

195.8 224.4

88

Taxes (30%)
58.7
67.3
Net
Income
Before
Preferred Dividends
137.1 157.1
Preferred
4
4

110

Recalculated

90.6
221.8
66.5
155.3
4
10

Dividends
Net
income
available
to
common
Shares of common
equity
50
Dividends
per
share
1.15
Dividends
to
common
Additonal Retained
Earnings

133.1 153.1
50

151.3
2.43

2.43

1.25

1.25

57.5

62.5

65.5

75.6

90.6

85.8

a.)Manual Approach
To use the manual approach, we first forecast the additional interest
expense and dividends that result from external financings. We assume that
the average rate on the new and existing short-term debt is about 8.5% and
the average rate on old and new long-term debt is about 10.5%. (Notice that
these rates are slightly lower than the rates used previously. The approach
based interest expense on the debt at the beginning of the year, which
would understate the true interest expense if debt increases throughout the
year. Therefore, use slightly higher rates to compensate for this
understatement). Notes payable began the year at P110 million and ended
at P132.35 million, for an average balance of P121.18 million. The forecasted
interest on the notes payable is 0.085(P121.18)=P10.3 million. Long-term
bonds began the year atP754 million and ended at P776.35 million, for an
average balance of P765.18 million. The forecasted interest on long-term
bonds is 0.105(P765.18)=P80.34 million. Guyabano has no short-term
investments, so it has no interest income. If it had interest income, we would
subtract it from the total interest expense to get the net interest expense.
Since there is no interest income, the total forecasted interest expense is
P10.3 + P80.34 = P90.6 million, as shown in Row 6 of Column 5 in Table 2.5.
Also notice that taxes and net income fall due to the now-higher interest
charges.

11

Actual
(2015)

First-Pass
Forecast
(2016)

Second-Pass
Third-Pass
Forecast
Forecast
(2016)
Feedback (2016)

P10

P11

P11

P11

375

412.5

412.5

412.5

Inventories
615
Total
current
assets
1 000
Net plant and
equipment
1000

676.5

676.5

676.5

1 100

1 100

1 100

1 100

1 100

1 100

Total assets
Liabilities
Equity
Accounts
payable

2000

2 200

2 200

2 200

60

66

66

66

140

154

154

154

Notes payable 110

Total
current
liabilities
310
Long-term
bonds
754

110

132.35

132.35

330

352.35

352.35

754

776.35

776.35

Total liabilities

1 084

1 128.7

1 128.7

Preferred Stocks 40

40

40

40

Common Stocks 130

Retained
Earnings
766

130

174.7

174.7

856.6

856.6

Total Equity
896
Total liabilities &
equity
2 000
Required
operating assets
Specified sources
of financing

1 026.6

1 071.3

1 066.4

2 110.6

2 200

2 195.1

Assets
Cash
Short-term
investments
Accounts
receivable

Accruals

AFN

&

1 064

-4.9

851.7

2 200

2 200

2110.6

2195.1

89.4

4.9

The financing plan also calls for issuing P55.9 million of new common
stock. Guyabanos stock price was P23 at the end of 2015, and we assume
that new shares will be sold at this price, then P55.9/P23 = 2.43 million
shares of new stock will have to sold. Further, Guyabanos 2016 dividend
payment is projected to be P1.25 per share, so the 2.43 million shares of new
stock will require 2.43(P1.25) = P3.0375 million of additional dividend
payments. Thus, dividends to common stockholders as shown in the secondpass income statement increase to P62.5 + P3.0375 = P65.5375 million. The
net effect of the financing feedbacks is to reduce the addition to retained
earnings by P4.9 million, from P90.6 million to P85.8 million. This reduces the
balance sheet forecast of retained earnings by a like amount, so the 2016
balance sheet projection for retained earnings would fall by P4.9 million will
12

still exist as a result of financing feedback effects as shown in Table 2.6. How
will the second-pass shortfall be term debt, 25% as long-term bonds, and
50% as new common stock. Table 2.6 shows a third-pass balance sheet
reflecting the P4.9 million shortfall. We could create a fourth-pass balance
sheet by using this financing mix to add another P4.9 million to the liabilities
and equity side. Would the fourth pass balance? No, because the additional
P4.9 million in capital would require another increase in interest and dividend
payments, and this would affect the fourth-pass income statement. There
would still be a shortfall, although it would be much smaller than the P4.9
million shortfall on the third pass. We could continue repeating the process.
In each iteration, the additional financing would become smaller and smaller,
and after about 5 iterations, the AFN would be essentially zero. A better way
is to use iteration of Excel.

b.)Automatic Approach
Spreadsheets can be used to automate the balancing process. Excel
and other spreadsheets have a feature that causes worksheets to iterate
until balancing criteria have been satisfied, thus almost instantly going
through enough passes to cause the balance sheet to balance.
Other Illustrations:
Illustrative Case 3.
Owens Electronics has 90 operating plants in seven southwestern
states. Sales for last year were P100 million, and the balance sheet at yearend is similar in percentage of sales to that of previous years (and this will
continue in the future). All assets (including fixed assets) and current
liabilities will vary directly with sales.
BALANCE SHEET (in P millions)
Assets Liabilities and Stockholders Equity
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .P 2
Accounts
Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Accounts
Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Accrued Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
..2
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . 23
Accrued
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Current
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.25

13

Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. 40
Notes
Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. .15
Retained
Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35
Total liabilities and Total assets . . . . . . . . . . . . . . . . . . . . .
85
Stockholders
equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

Other Illustrations:
Illustrative Case 3.
Owens Electronics has 90 operating plants in seven southwestern
states. Sales for last year were P100 million, and the balance sheet at yearend is similar in percentage of sales to that of previous years (and this will
continue in the future). All assets (including fixed assets) and current
liabilities will vary directly with sales.

BALANCE SHEET (in P millions)

Assets Liabilities and Stockholders Equity
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 2
Accounts
Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Accounts
Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Accrued Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. 23
Accrued
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Current
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
25
14

Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. 40
Notes
Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. 15
Retained
Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Total liabilities and Total assets . . . . . . . . . . . . . . . . . . . . 85
Stockholders
equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

Owens has an after-tax profit margin of 7% and a dividend payout

ratio of 40%. If sales grow by 10% next year, determine how many acdollars
of new funds are needed to finance growth?
Solution:
AFN = (A*/S0) S (L*/S0) S MS1(RR)
= (A*/S0) S (L*s0) S MS1 (1-D)
= (85/100) (P10 000 000) (25/100) (P10 000 000) (P10 000
000) (0.07) (0.60)
= 8 500 000 2 500 000 4 620 000
= P1 380 000

Illustrative Case 4.
Tess Shop Inc., a national clothing line, had sales of P300 million last
year. The business has a steady net profit margin of 8% and a dividend
payout ratio of 25%. The statement of financial position for the end of last
year is shown below.

Assets
Cash
Accounts Receivable
Inventory
Plant and Equipment

Total Assets

Statement of Financial Position

End of Year
(P millions)
Liabilities and Equity
P20
Accounts Payable
P70
25
Accrued expenses
20
75
Other payables
30
120
Ordinary Shares
40
Retained Earnings
80
Total
liabilities
P240
and equity
P240

15

The firms marketing staff has told the president that in the coming
year there will be a large increase in the demand for overcoats and wool
stocks. A sale increase of 15% is forecast for the company.
All statement of financial position items are expected to maintain the
same percent of sales relationships as last year, expect for ordinary shares
and retained earnings. No change is scheduled in the number of ordinary
shares outstanding and retained earnings will change as dictated by the
profits and dividend policy of the firm. (Remember the net profit margin is
8%)
a. Will external financing be required for the company during the
coming year?
b. What would be the need for external financing if the net profit
margin went up to 9.5% and the dividend payout ratio was increased to
50%? Explain.

Solutions:
a. AFN = (A*/S0) S (L*/S0) S MS1(RR)
= (A*/S0) S (L*S0) S MS1 (1-D)
Where: S = 15% (P300 000 000)
= P45 000 000
= (240/300) (P45 000 0000) - (345 000 000) (0.8) (1.25)
= P 2 700 000
** A negative figure for AFN means that an excess of funds (P2.7M) is
available for investment. No external funds are needed.
b. AFN = P36 000 000 P18 000 000 (0.95) (345 000 000) (1.5)
= P1 612 500 external funds required
The net profit margin slightly, from 8% to 9% which decreases the need for
external funding. The dividend payout ratio increased tremendously,
however from 25% to 50%, necessitating more external financing. The effect
of the dividend policy change overpowered the effect of the net profit margin
change.

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