Forecasting and Budgeting expenses, assets, and liabilities for a future
period as a percentage of sales.
Why do firms fail financially?
1. Undercapitalization
2. Poor control over cash
3. Inadequate expense control
Financial Planning
It provides and roadmap for guiding,
coordinating, and controlling firms actions to
achieve goals.
Two Key aspects of Financial Planning:
1. Cash Planning (Cash Budget)
2. Profit Planning (Proforma I/S)
3. Financing Planning (Proforma B/S)
Corporate Financial Planning
Scenario Analysis – each division might be
asked to prepare three different plans for the
near term future:
a. Worst Case – making the worst possible
assumptions about the company’s
products and the state of economy.
b. Normal Case – making most likely
assumptions about the company and
economy.
c. A best case – each division would be
required to work out a case base on the
most optimistic assumptions.
What will Financial Planning accomplish?
1. Interactions – the plan must make explicit
the linkages between investment
proposals and the firm’s financing
choices.
2. Options – the plan provides an
opportunity for the firm to weigh its
various options.
3. Feasibility – the different plans must fit
into the overall corporate objective of
maximizing shareholder wealth.
4. Avoiding Surprises – nobody plans to fail,
but many fail to plan.
Developing a Long Term Financial Plan
Forecasting a firm’s future financing needs
using a long-term financial plan can be thought
of in terms of three basic steps:
1. Construct a sales forecast.
Sales forecasts are usually based on the
analysis of historic data.
An accurate sales forecast is critical to the firm’s
profitability.
2. Prepare pro-forma financial statements.
Statements help forecast a firm’s asset
requirements needed to support the forecast of
revenues. The most common technique is the
percent of sales method that expresses
3. Estimate the firm’s financing needs.
Using the proforma statements we can extract
the cash flow requirements of the firm.
AFN = Additional Funds Needed to support the
level of forecasted operations
Sources of Spontaneous Financing:
Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses,
referred to as spontaneous financing sources
are typically the only liabilities that vary directly
with sales. The percent of sales method can be
used to forecast the levels of both these sources
of financing.
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 firm’s discretionary
dividend policy.
DFN = Proforma Assets
Less: Accounts Payable
Accrued Expenses
Notes Payable
Long-term debts
Common Equity
Proforma Assets = Total Financing Needs
DFN = Total Financing Needs – Projected
Sources of Financing
Internal and Sustainable Growth
Internal growth is achieved by retained
earnings.
Sustainable growth is achieved if retained
earnings are supplemented by external debt
financing (while D/E ratio is maintained at
present target)
Financial Policy and Growth
A firm may not wish to sell any new equity
Debt capacity = the ability to borrow to increase
firm value
If a firm borrows to its debt capacity sustainable
growth rate can be achieved.
g* = ROE x R / (1 – ROE x R)
Factors that affect External Financial
Requirements
1. Sales Growth (Change in Sales)
2. Capital Intensity (A* / S0)
 3. Spontaneous Liabilities to sales ratio
(L* / S0)
4. Profit Margin (M)
5. Retention Ratio (RR)
AFN = Required Inc. in Assets – Spontaneous
Liabilities – Inc. in Retained Earnings
AFN = (A* / S0)Ch.S - (L* / S0)Ch.S – M(S1)(RR)
How would increase in Sales affect the AFN?
1. Higher Sales – increases asset
requirements, increases AFN.
2. Higher Capital Intensity Ratio, (A* / S0)?
– Increases AFN: Need more assets for
given sales increase.
3. Pay suppliers in 60 days rather than 30
days? – Decrease AFN: trade creditors
supply more capital, (L* / S0) increases.
4. Higher Profit Margin – Increases in funds
internally, decreases AFN.
5. Higher Retention Ratio – Decreases
AFN: due to increase in retained
earnings.
Other considerations in Forecasting: Excess
Capacity
Full Capacity Sales = Current Sales Level /
(Percent of capacity used to generate current
sales level)
Target Fixed Assets/Sales = Actual FA / Full
capacity Sales
Required Level of FA = (Target FA/Sales) *
(projected Sales)
Implications of AFN
1. If AFN is positive, then you must secure
additional financing.
2. If AFN is negative, then you have more
financing than is needed.
a. Pay off debts
b. Buy back stock
c. But short term investments
Financing Control – Budgeting and Leverage
The phase in which financial plans are
implemented; control deals with the feedback
and adjustment processes required to ensure
the firm is following the right financial path to
accomplish its goals, and, if not, to make
necessary corrections.
Financial Control – a process in which a firm
periodically compares its actual revenues, costs
and expenses with its budget.
Importance of Budgeting and Control
Functions
1. If projected operating results are not
satisfactory, management can
reformulate its plans.
2. If funds required to meet sales forecast
cannot be obtained, management can
sale back projected levels of operations
3. If required funds can be raised, it is best
to plan for their acquisition in advanced.
4. Any deviation from projections needs to
be handled to improve future forecasts.
Budget
Is a forecast of the future. A written estimation
of the financial performance of a particular
department, a specific project, a business unit
or an organization.
Budgeting
Primarily the activity of preparing the budgets.
Types of budgeting:
1. Zero Based Budgeting – current year’s
budget is prepared from scratch without
considering the budget of the previous
year.
2. Traditional Budgeting – it considers last
year’s budget as the base. The changes
are done based on the inflation rate,
consumer demand, market situation etc.
3. Incremental Budgeting – in this, current
year’s budget is prepared by making
changes in the past year’s budget
considering the inflation factor. It’s a
quick and easy method of preparing
budgets.
4. Activity Based Budgeting – Activity based
budgeting is a budgeting method where
budget is prepared after considering the
cost drivers. It does an in depth analysis
of activities measuring cost.
Budgetary Control
Is the establishment of Budgets relating to the
responsibilities of executives of a policy and the
continuous comparison of the actual with the
budgeted results, either to secure by individual
action the objective of the policy or to provide
basis for its revision.
Characteristics:
1. Establishment of budgets
2. Analysis of variations
3. Taking remedial actions
4. Revisions of budgets