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

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

Economic Assumptions Sales Forecast Proforma Statements Asset Requirements Financing Plan

Cash Budget

SALES FORECAST
The sales forecast is typically the starting point of the financial forecasting exercise. Sales forecasting techniques fall into three broad categories: Qualitative techniques : Based on Judgement Time series projection methods : Past behavior of time

series
Causal models Develop forecast based on Cause & Effect relationship.

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 20X2 1280 837 443 27 Average percent of Sales 100 . 0 65 . 0 35 . 0 2.1 Pro forma profit and loss account of 20X3 assuming sales of 1400 1400 . 0 910 . 0 490 . 0 29 . 4

53 75 272 30 302 60 58 184 82 102 60 42

54 80 282 32 314 65 60 189 90 99 63 36

4.3 6.3 22 . 3 2.5 24 . 8 5.0 4.8 15 . 0 6.9 8.1

60 . 2 88 . 2 312 . 2 35 . 0 347 . 2 70 . 0 67 . 2 210 . 0 96 . 6 113 . 4

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

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

Problem
Prepare the pro forma P&L & Balance sheet for the year 3 based on the following
assumptions. Projected sales for the year 3 is 850 Forecast value for the following P&L accounts items may be derived using the percent of sales method ( for this purpose assume that the average of the % for year 1 & 2 is applicable) COGS , Selling Expenses, General & Admin exp , Non Operating surplus / deficit , Interest The forecast values for the other items of the P&L account are as follows Depreciation 45 Tax @ 50 % Dividends 21

Problem
Forecast values for Balance sheet:
Fixed assets : Budgeted at 300 Investments : No change over 2 years

Current assets : Percent of sales method wherein the percentages are based on the average
over 2 years Mis expenditure & losses : Expected to be reduced to 5

Equity & preference capital : No change over year 2

Reserves & surplus : Proforma P & L Bank borrowings & Current Liabilities & provision: Percent of sales method wherein the

percentages are based on the average over 2 years

Public deposit : No Change External fund required : Balancing figure

GROWTH AND EXTERNAL FINANCING

REQUIREMENT
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 0.05 (1 + g) (1 0.60) g 0.20 (1 + g) g 10 0.28 15 0.35 20 0.38 25 0.42

FORECASTING WHEN THE BALANCE SHEET RATIOS CHANGE

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: Economies of scale Lumpy assets

Forecasting errors and excess assets

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.

Assumptions:
1. Increase in asset of the firm in proportion of the sales. 2. PAT margin is in direct proportion to sales. 3. Firm has a target dividend payout ratio which is wants to maintain. 4. Firm wants to grow by retention it does not raise external funds (neither equity or debt) to finance assets. IGR = ROA * b 1 (ROA * b)

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 = 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 = P*A* A/E * b 1- (P*A* A/E * b)

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.

Thank You