Financial Planning and

Forecasting Financial Statements

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 Financial Planning
Strategic Plans:
Strategic plans usually begin with a statement of
the overall corporate purpose.
A corporate focus on creating wealth for the
company’s owners.
Corporate strategies are broad approaches
rather than detailed plans.

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 Financial Planning
Operating Plans:
Operating plans provide detailed implementation
guidance to help meet the corporate objectives
These plans can be developed for any time horizon,
but most companies use a 5-year horizon.
A 5-year plan is detailed for the first year, with each
succeeding year’s plan becoming less specific.
The plan explains who is responsible for each
particular function.
When specific tasks are to be accomplished, sales
and profit targets, and the like.
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 Financial Planning - Process
The financial planning process has five steps:
• Project financial statements to analyze the
effects of the operating plan on projected
profits and financial ratios.
• Determine the funds needed to support the 5-
year plan
• Forecast the funds to be generated internally
and identify those to be obtained from
external sources
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 Financial Planning - Process
• Establish a performance-based management
compensation system that rewards employees
for creating shareholders wealth.

• Monitor operations after implementing the

plan, identify the cause of any deviations, and
take corrective actions.

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 What is Financial Forecasting?
• Financial forecasting is looking ahead to
develop a financial plan for the future

• Very important for the strategic growth of a

firm

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 What is Financial Forecasting?
• Forecasting sales

• Projecting the assets and internally generated

funds

• Projecting outside funds needed

• Deciding how to raise funds – additional funds

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 Additional Funds Needed (AFN)
• AFN is the amount of money a company must
raise from external sources to finance the
increase in assets required to support
increased level of sales.

• Additional funds needed is also called external

financing needed

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Approaches to know Additional Funds
Needed (AFN)
There are two approaches to answer the
question – AFN

(i) Additional Funds Needed Formula

(ii) The forecasted Financial Statement Method
– (Percentage of Sales Method)

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 AFN Formula
• AFN method of financial planning assumes that
the company’s financial ratios do not change.
• In response to an increase in sales, a company
must increase its assets, such as property, plant
and equipment, inventories, accounts receivable,
etc.
• Part of this increase in offset by spontaneous
increase in liabilities such as accounts payable,
taxes etc., and part is offset by increase in
retained earnings.
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 Additional Funds Needed (AFN)
Formula

• A crude model to estimate external funds

needed to support Sales  after accounting
for internally generated and automatically
generated sources of funds.

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 Additional Funds Needed (AFN)
Formula
Assumptions:
• Firm is operating at full capacity
• Each type of asset grows proportionally w/
sales
• Spontaneously generated liabilities grow
proportionally w/ Sales.
• Profit margin (M) is constant
• Firm can accurately forecast  in Sales.
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 Additional Funds Needed (AFN)
Formula
AFN =increase in Assets-spontaneous increase in Liabilities
-increase in retained earnings
=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

In brief:

AFN = Required -  in Spontaneous -  in RE

 in Assets Liabilities

“A NEGATIVE FIGURE FOR AFN MEANS THAT THERE IS A SURPLUS OF

CAPITAL”

Notes: RR-retention ratio=1-payout ratio, ΔS –change in sales, M-Net

Profit margin
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 CASE 1
Preliminary Financial Forecast:
Balance Sheets (Assets)
2008 2009E
Cash and equivalents $ 20M $ 25
Accounts receivable 240 300
Inventories 240 300
Total current assets $ 500 $ 625
Net fixed assets 500 625
Total assets $1,000 $1,250
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Preliminary Financial Forecast: Balance Sheets (Liabilities
and Equity)

2008 2009E
Accts payable & accrued liab. $ 100 $ 125
Notes payable 100 190
Total current liabilities 200 315
Long-term debt 100 190
Common stock 500 500
Retained earnings 200 245
Total liabilities & equity $1,000 $1,250
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 Preliminary Financial Forecast:
Income Statements
2008 2009E
Sales $2,000.0 $2,500.0
Less: Variable costs 1,200.0 1,500.0
Fixed costs 700.0 875.0
EBIT $ 100.0 $ 125.0
Interest 16.0 16.0
EBT $ 84.0 $ 109.0
Taxes (40%) 33.6 43.6
Net income $ 50.4 $ 65.40
Dividends (30% of NI) $15.12 $19.62
Addition to retained earnings $35.28 $45.78
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 Key Assumptions in Preliminary Financial
Forecast for NWC
• Operating at full capacity in 2008.

• Each type of asset grows proportionally with sales.

• Payables and accruals grow proportionally with sales.

• 2008 profit margin (2.52%) and payout (30%) will be

maintained.

• Sales are expected to increase by $500 million. (%DS =

25%)
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Determining additional funds needed, using the
AFN equation
AFN =increase in Assets-spontaneous increase in
Liabilities
-increase in retained earnings
=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

= ($1,000/$2,000)($500)
– ($200/$2,000)($500)
– 0.0252($2,500)(0.7)
= 250-25-44.1
$155.9 million.
Notes: RR-retention ratio=1-payout ratio, ΔS –change in sales, M-Net Profit margin
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 How different factors affect the AFN forecast.

Dividend payout ratio changes.

If reduced, more RE, reduce AFN.
Profit margin changes.
If increases, total and retained earnings increase, reduce
AFN.
Plant capacity changes.
Less capacity used, less need for AFN.
AP Payment terms increased to 60 days from 30.
Accts. payable would double, increasing liabilities, reduce
AFN.

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 SALES FORECAST

• Sales forecast generally starts with a review of

sales during the past 5 to 10 years.
• Forecasting the future sales growth rate
always begins with a look at past growth.

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 CASE 2 – MICRODRIVE
SALES FORECAST
The sales figures of the Microdrive company for the past 5 years given
below. Forecast the sales for the year 2008.

Year Sales
2003 2058.00
2004 2534.00
2005 2472.00
2006 2850.00
2007 3000.00

Forecast the sales for the year 2008

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 CASE 2 - Solution
growth
Sales rate
2003 2058.00
2004 2534.00 23%
2005 2472.00 -2%
2006 2850.00 15%
2007 3000.00 5%

Average growth
rate = 10.31%
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 CASE 2 - Solution
MODEL 1

GROWTH RATE BY USING

TREND FUNCTION 3242.8
FORECASTED SALES FOR
2008
GROWTH RATE 8.09%
MODEL 2

GROWTH RATE BY USING

LOGGEST FUNCTION 1.0910358

GROWTH RATE 9.104%

Y - Sales and X - year

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 CASE 2 - Solution

MODEL 3

GROWTH RATE BY
USING

RATE FUNCTION

GROWTH RATE 9.88%

nper=4:PV=2058:FV=-3000

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 MicroDrive Case – Sales Forecast -
Summary
Although it is useful to calculate the past growth
in sales, much more is involved in estimating
future sales.
Future sales will depend on the economy, the
industry prospectus, the company’s current
product line, proposed products that are in
pipeline, marketing campaigns etc.
Any company should incorporate all the issues
mentioned above into its sales forecast.

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 MicroDrive Case – Part II
After much discussion and analysis, MicroDrive’s
managers decided to forecast a 9.88% increase
in sales.
How will MicroDrive’s managers incorporate this
increased level of sales into the Financial Plan?
In particular, will MicroDrive have to raise any
additional external funds in order to implement
the plan?

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MicroDrive – Financial Statements

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MicroDrive Case – Part II - Solution
We assume that non of a firm’s ratios will
change.
If the sales increase, firms usually have to
purchase assets such as inventories and
machines etc. In order to support the increased
level of sales.
Where will the firm get money to purchase the
projected increase in assets?

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MicroDrive Case – Part II - Solution
There are three sources:
First, some liabilities such as accounts payable
usually increase when sales increase.
Balance sheet require that total assets equal to
total liabilities and equity.
Therefore, this spontaneous increase in
liabilities is a source of funds for the projected
increase in assets.

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MicroDrive Case – Part II - Solution
Second, the firm should make a profit on new
sales.
Part of this profit will be used to pay dividends,
but remaining profit can be used to help
purchase the new assets.
Recall that the net income not paid out as
dividends is an addition to retained earnings.
Therefore, this increase in equity is a source of
financing for the projected increase in assets.
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MicroDrive Case – Part II - Solution
Finally, any remaining increase in assets must be
financed by additional external funds, such as
additional bank loans, long-term debt.

AFN formula applies this logic and defines the

Additional Funds Needed (AFN)

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MicroDrive Case – Part II - Solution
AFN =increase in Assets-spontaneous increase
in Liabilities
-increase in retained earnings

=(A0*/S0)ΔS – (L0*/S0) ΔS – M(S1)(RR)

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MicroDrive Case – Part II - Solution

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MicroDrive Case – Part II - Solution
To increase sales by $300 million, the formula
suggests that MicroDrive must increase assets by
approximately $198 million (result from AFN
formula). (assumption – growth rate=9.88%)

The $198 million of new assets must be financed in

some manner.

Note: The AFN may differ, if growth rate is different

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MicroDrive Case – Part II - Solution
• Of the $20 million will come from a spontaneous
increase in liabilities, while other $61.51 million
will be obtained from retained earnings.

• The remaining $116.33 million must be raised

from external sources.

Note: The AFN may differ, if growth rate is different

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MicroDrive Case – Part II - Solution
The AFN equation shows that external financing
requirements depend on five key factors:
Sales Growth (change in sales):
Rapidly growing companies require large
increase in assets and more external financing,
other things held constant

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MicroDrive Case – Part II - Solution
Capital Intensity (A0*/S0):
The amount of assets required per dollar of
sales, (A0*/S0) is called capital intensity ratio.
This ratio has a major effect on capital
requirements.
Companies with higher assets-to-sales ratios
require more assets for a given increase in sales,
hence a greater need for external financing

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MicroDrive Case – Part II - Solution
Spontaneous liabilities to sales ratio (L0*/S0):
Companies that spontaneously generate a large
amount of liabilities from accounts payable and
accruals will have a relatively lower need for
external financing.

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MicroDrive Case – Part II - Solution
Profit Margin (M)
The higher the profit margin, the larger the net
income available to support increase in assets,
hence the lower the need for external financing.
Retention Ratio (RR)
Companies that retain more of their earnings as
opposed to paying them out as dividends will
generate more retained earnings and thus have
less need fro external financing.
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Live case

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 Conclusion
• AFN formula provides an accurate forecast
only for companies whose ratios are all
expected to remain constant.
• The AFN formula is useful for quickly obtaining
a “back of the envelope” estimate of external
financing requirements, but the percent of
sales method, is used by most companies for
their detailed financial planning.

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Percent-of-Sales Method – Forecasted
Financial Statement (FFS) Method
• FFS actually forecasts the complete set of
financial statements.

• However, logic of this approach is similar to

that of the AFN formula.

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 Contrast AFN model and FFS model
Both begin with Sales forecast
Both forecast assets and spontaneous liability
• AFN  capital intensity (A/S) assumed constant
for all assets
• AFN  spontaneous liabilities to sales intensity
(L/S) assumed constant for all spontaneous
liabilities

• FFS  (each Asset)/Sales different for all assets

• FFS  (each spontaneous. liabilities)/Sales
different for all spontaneous liabilities.
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 Percent of Sales Method to forecast
financial statements
STEP 1:
Project sales based on forecasted growth in sales
STEP 2:
Forecast some items as a percent of the forecasted sales
costs
cash
accounts receivable
inventories
net fixed assets
accounts payable and accruals

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 Percent of Sales Method to forecast
financial statements
Step 3
Choose other items
debt
dividend policy
common stock

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 Sources of Financing needed to
support asset requirements
• Based on certain assumptions and choices, we
can estimate:
Required assets to support sales
specified sources of financing

Additional Funds Needed (AFN) is

Required assets MINUS specified sources of
financing
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 AFN – POSITIVE - NEGATIVE
• IF AFN is positive, then you must secure
additional financing

• If AFN is negative, then you have more

financing than is needed.
– Pay off debt
– Buy back stock
– Buy short-term investments

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MICRODRIVE CASE AND SOLUTION

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