Chapter 3

Forecasting and Financial

Planning
Learning Objective
1. Use the percent of sales method to forecast the financing
requirements of a firm.
2. Describe the limitations of the percent of sales forecast methods.
3. Prepare a cash budget and use it to evaluate the amount and
timing of a firm’s financing needs
 Financial Forecasting
Financial forecasting is the process of attempting to estimate a firm’s
future financing requirements. Three basic steps are involved:
1. Project the firm’s sales revenues and expenses over the planning
period.
2. Estimate the levels of investment in current and fixed assets that
are needed to support the projected sales forecast.
3. Determine the firm’s financing needs throughout the planning
period that are required to fund its assets
Financial forecasting is also can be defined as the process of estimating a
firm’s future financial need and requirement.
Definition and purpose
• It begin with forecasting sales and their related expenses.
• The basis steps involved in projecting financing needs are.
1. Project the firm’s sales
2. Project variables such as expenses
3. Estimate the level of investment in current and fixed assets that is required
to support the projected sales.
4. Calculate the firm’s financing needed.
Financial Planning Ingredients
• Sales Forecast – many cash flows depend directly on the level of sales
(often estimate sales growth rate)
• Pro Forma Statements – setting up the plan as projected (pro forma)
financial statements allows for consistency and ease of interpretation
• Asset Requirements – the additional assets that will be required to
meet sales projections
• Financial Requirements – the amount of financing needed to pay for
the required assets
• Plug Variable – determined by management decisions about what
type of financing will be used (makes the balance sheet balance)
 Sales forecast
The key ingredient in a firm’s planning process is the sales forecast. It reflects:
• Past trend in sales that is expected to carry through into the new year; and
• The influence of any anticipated events that might materially affect that trend.
Traditional financial forecasting takes the sales forecast as a given and projects
its impact on the firm’s various expenses, assets, and liabilities.
The most commonly used method for making these projections is the percent of
sales method.
Pro Forma Statement
• A financial plan will have a forecast balance sheet, income statement, and
statement of cash flows.
• These are called pro forma statements , or pro formas for short. The phrase
pro forma literally means “as a matter of form.”
• In our case, this means the financial statements are the form we use to
summarize the different events projected for the future.
• At a minimum, a financial planning model will generate these statements
based on projections of key items such as sales.
• In the planning models we will describe, the pro formas are the output from
the financial planning model.
• The user will supply a sales figure, and the model will generate the resulting
income statement and balance sheet.
 Percentage of Sales Approach
• When constructing a financial forecast, the sales forecast is used traditionally to
estimate various expenses, assets, and liabilities.
• The most widely used method for making these projections is the percent-of-
sales method, in which the various expenses, assets, and liabilities for a future
period are estimated as a percentage of sales.
• These percentages, together with the projected sales, are then used to construct
pro forma (planned or projected) balance sheets.
• The calculations for pro forma balance sheet are as follows
 Example
The Computer field Corporation’s financial statements from the most
recent year are as follows
Computer Field Corporation
Financial Statement
Income Statement Balance Sheet
Sales 1,000 Asset 500 Debt 250
Cost (800) Equity 250
Net Income 200 Total 500 500

Suppose the sales increase by 20%.

 Pro forma Computer Field Corporation
Financial Statement
Income Statement Balance Sheet
Sales 1,200 Asset 600 Debt 300
Cost (960) Equity 300
Net Income 240 Total 600 600
Percentage Sales Approach
• Some items vary directly with sales, others do not.
• Income Statement
• Costs may vary directly with sales - if this is the case, then the profit margin is constant
• Depreciation and interest expense may not vary directly with sales – if this is the case,
then the profit margin is not constant
• Dividends are a management decision and generally do not vary directly with sales – this
affects additions to retained earnings
• Balance Sheet
• Initially assume all assets, including fixed, vary directly with sales.
• Accounts payable also normally vary directly with sales.
• Notes payable, long-term debt, and equity generally do not vary with sales because they
depend on management decisions about capital structure.
• The change in the retained earnings portion of equity will come from the dividend
decision.
1. Express balance sheet items that vary directly with sales as a percentage of sales. Any item
that does not vary directly with sales (such as long-term debt) is designated not applicable
(n.a.).
2. Multiply the percentages determined in step 1 by the sales projected to obtain the amounts
for the future period.
3. Where no percentage applies (such as for long-term debt, common stock, and capital
surplus), simply insert the figures from the present balance sheet in the column for the
future period.
4. Compute the projected retained earnings as follows:
• Projected retained earnings = present retained earnings + projected net income – cash
dividends paid
(You will need to know the percentage of sales that constitutes net income and the dividend
payout ratio.)
5. Sum the asset accounts to obtain a total projected assets figure. Then add the projected
liabilities and equity accounts to determine the total financing provided. Since liability plus
equity must balance the assets when totaled, any difference is a shortfall, which is the
amount of external financing needed.
Example ROR ROR has projected a 25 percent increase in sales for the coming
year. Assuming the cost continue to run at 800/1000 = 80% and the profit
ROR ROR Corporation margin is constant.
Income Statement
Sales 1,000
New Sales = 1,000 x 1.25 = $1,250
Cost 800 New Cost = 800 x 1.25 = $ 1,000
Taxable Income 200 New taxable income = 1,250 – 1,000 = 250
Taxes (34%) 68 New tax = 250 x 0.35 = 85
Net Income 132
Profit Margin = net income/ net sales
Dividends 44
= 132/1000
Addition to retained earnings 88
= 13.2 x

3rd step
Next, we need to project the dividend payment. Retention Ratio = (net income – dividends) / net income
We assume that the company has a policy of = 88/132
paying out a constant fraction of net income in = 66.67% @ 2/3
the form of cash dividend;
4th step
DPR = cash dividend/net income New Projected Dividend;
= 44/132 DPR = 165 x 33.33% = 55
= 33.33% @ 1/3 R/earning = 165 x 2/3 = 110
 ROR ROR Corporation Balance Sheet
Asset Liabilities and Owners’ Equity
$ Percentage of $ Percentage of
Sales Sales
Current Assets Current Liabilities
Cash 160 16 A/P 300 30
A/R 440 44 Notes Payable 100 n/a
Inventory 600 60 Total 400 n/a
Total 1,200 L/Term Debt 800 n/a
Fixed Asset Owner’s Equity
Net Plant and Equipment 1,800 180 C/S and paid – in surplus 800 n/a
Retained Earnings 1,000 n/a
Total 1,800 n/a
Total Assets 3,000 300 Total Liabilities and Owners’ Equity 3,000 n/a

For example, the inventory side is equal to (600/1000) = 60%, for the year just ended. We assume that this applied to the
coming year, so for each $1 increase in sales, inventory will rise by $0.60.
External Financing Needed
• Is the amount of money that need to be raise from external sources
to finance the increase in assets required to support increase level of
sales.
• Also call as additional fund needed (AFN)
• In response to an increase in sales, a company must increase its assets,
such as property, plant and equipment, inventories, accounts
receivable, etc.
EFN
• External Financing Needed (EFN)
• The difference between the forecasted increase in assets and the forecasted increase in
liabilities and equity.

• Balance sheet items that generally vary directly with sales

• Acc. Payable
• Inventory
• Taxes Payable
• Marketable securities
• Accrued Wages
 Spontaneous Financing
• Spontaneous financing are trade credit and other accounts payable that
arise spontaneously in the firm’s day-to-day operations.
• Accrued expenses and accounts payable are the only liabilities allowed
to vary with sales. Because they vary directly with the level of sales,
they are referred to as sources of spontaneous financing.
• An increase in spontaneous liabilities is normally tied to an increase in a
company's cost of goods sold (or cost of sales), which are the costs
involved in production.
 ROR ROR Corporation Balance Sheet
Asset Liabilities and Owners’ Equity
$ Percentage of $ Percentage of
Sales Sales
Current Assets Current Liabilities
Cash 160 16 A/P 300 30
A/R 440 44 Notes Payable 100 n/a
Inventory 600 60 Total 400 n/a
Total 1,200 L/Term Debt 800 n/a
Fixed Asset Owner’s Equity
Net Plant and Equipment 1,800 180 C/S and paid – in surplus 800 n/a
Retained Earnings 1,000 n/a
Total 1,800 n/a
Total Assets 3,000 300 Total Liabilities and Owners’ Equity 3,000 n/a
 ROR ROR Corporation Partial Pro Forma Balance Sheet
Asset Liabilities and Owners’ Equity
$ Changes from $ Percentage of
previous year Sales
Current Assets Current Liabilities
Cash 200 40 A/P 375 75
A/R 550 110 Notes Payable 100 n/a
Inventory 750 150 Total 475 75
Total 1,500 300 L/Term Debt 800 n/a
Fixed Asset Owner’s Equity
Net Plant and Equipment 2,250 450 C/S and paid – in surplus 800 n/a
Retained Earnings 1,110 110
Total 1,910 n/a
Total Assets 3,750 750 Total Liabilities and Owners’ Equity 3,185 185
External Financing Needed 565 565

With the increase of sales by 25%, we now can construct the New retained earning in
income statement 110
pro forma Balance Sheet
Percent of Sales and EFN
• External Financing Needed (EFN) can also be calculated as:
• If we want to project a sales by 25%, we need to raise $ 565 in new financing
either by few option
• S/term borrowing
• L/term borrowing
• New equity
• The decision is up to the top management. Let say the management choose to
raise by using the combination between s/term and l/term.
• Notes payable = 100 + 225 = 325
• L/term debt = 800 + 340 = 1,140
 ROR ROR Corporation Pro Forma Balance Sheet
Asset Liabilities and Owners’ Equity
$ Changes from $ Percentage of
previous year Sales
Current Assets Current Liabilities
Cash 200 40 A/P 375 75
A/R 550 110 Notes Payable 325 225
Inventory 750 150 Total 700 300
Total 1,500 300 L/Term Debt 1,140 340
Fixed Asset Owner’s Equity
Net Plant and Equipment 2,250 450 C/S and paid – in surplus 800 n/a
Retained Earnings 1,110 110
Total 1,910 110
Total Assets 3,750 750 Total Liabilities and Owners’ Equity 3,750 750
Example
TransExpress Inc. runs a shipping business and has forecasted a 10% increase in
sales over 2013. Its assets and liabilities at the end of 2012 amounted to $25
billion and $17 billion respectively. Sales for the period were $30 billion and it
earned a 4% profit margin. It reinvests 40% of its net income and pays out the
rest to its shareholders. Calculate additional funds needed.

= 0.272 billion
Solution
EFN = Increase in asset – increase in liabilities – increase in retained earning
• Increase in asset
= 2012 asset x sales growth rate
= 25 b x 10%
= $2.5 billion
• Spontaneous increase in liabilities Net Income/ sales
= 2012 liabilities x sales growth rate
= 17 b x 10%
= $ 1.7 billion 1 – (Cash Dividend/net income)
• Increase in retained earning
=2013 sales x profit margin x retention rate
= 2012 sales x (1 + sales growth rate) x profit margin x retention rate
= 30 b x (1 + 0.1) x 0.04 x 0.4
= $0.528 billion
EFN = 2.5 billion – 1.7 billion – 0.528 billion
 Jordan Corp. Jordan Corp.
Income Statement Pro Forma Income Statement

Sales 38,000 Sales 45,600

Costs 18,400
Costs 22,080
Taxable Income 19,600
Taxes (34%) 6.664 Taxable Income 23,520
Net Income 12,936 Taxes (34%) 7,996.80
Dividends 5,200 Net Income 15,523.20
Addition to R/E 7,736 Dividends
Addition to R/E

net income, or:

A 20 percent growth rate in sales is
projected. Prepare a pro forma Dividends payout ratio = ($5,200/$12,936) x 100
income statement assuming costs = 40.20%
vary with sales and the dividend
New Dividend Paid = 40.20% x 15,523.20
payout ratio is constant. What is
the projected addition to retained = $6,240.00
earnings? And the addition to retained earnings will be:
Addition to retained earnings = $15,523.20 – 6,240
Addition to retained earnings = $9,283.20
Limitation of the Percentage Sales Method
External Financing and Growth
• At low growth levels, internal financing (retained earnings) may
exceed the required investment in assets.
• As the growth rate increases, the internal financing will not be
enough, and the firm will have to go to the capital markets for
financing.
• Examining the relationship between growth and external financing
required is a useful tool in financial planning.
The Internal Growth Rate
• The internal growth rate tells us how much the firm can grow assets
using retained earnings as the only source of financing.
• The maximum growth rate a firm can achieve without external
financing of any kind.
ROA ×b
Internal Growth Rate =
1 − ROA × b
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
ROA =
Total Ass 𝑒𝑡

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒− 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

R etention ratio, b=
Net Income
 HOFFman Ventures
Income Statement and Balance Sheet
Income Statement
Sales 500
Costs 400
Taxable Income 100
Taxes (34%) 34
Net Income 66
Dividends 22
Addition to Retained Earning 44
Balance Sheet
Assets Liabilities and Owners’ Equity
Percentage
$ $ Percentages of Sales
s of Sales
Current Asset 200 Total Debt 250
Net Fixed Assets 300 Owner’s Equity 250
500 Total Liabilities 500
Total Assets and Owners’
Equity

Based on the information above, compute the growth rate for HOFFman Venture maintain if no

ROA×b
external financing is used?

Internal Growth Rate =

1 − ROA×b
Internal Growth Rate
• The internal growth rate is an important measurement for startup
companies and small businesses because it measures a firm's ability
to increase sales and profit without issuing more stock (equity) or
debt.
The Budget
• The cash budget, like the pro forma income statement and pro forma balance
sheet, is an essential tool of financial planning. The cash budget contains a detailed
listing of planned cash inflows and outflows for each year of the planning period.
• A company’s annual financial plan is called a budget.
• The budget is a set of formal (written) statements of management’s expectations
regarding sales, expenses, production volume, and various financial transactions of
the firm for the coming period.
• Simply put, a budget is a set of pro forma statements about the company’s
finances and operations.
• A budget is a tool for both planning and control. At the beginning of the period, the
budget is a plan or standard; at the end of the period, it serves as a control device
to help management measure the firm’s performance against the plan so that
future performance may be improved.
Structure of the budget
• It can be classified broadly into 2 categories:
• Operational Budget
• Which reflects the results of operating decision
• series of individual budgets that focus on financial items that are required to prepare the
budgeted income statement. They mainly deals with sales, production units and production and
operating costs of the company.
• Financial Budget
• Consists of capital and cash budget. It helps the company to use its limited cash resources to
finance the business operations and planned capital expenditures.
• The output of financial budget is the budgeted balance sheet which shows the short-term
financial well being of the company.
 The Cash Budget
• The cash budget represents a detailed plan of future cash flows in the future
period.
• It is prepared in order to forecast the firm’s future financial needs such as
financing and investment needs
• Also act as a tool for cash planning and control.
• it helps avoid the problem of either having idle cash on hand or suffering a
cash shortage.
• the cash budget indicates whether the shortage is temporary or permanent,
that is, whether short-term or long-term borrowing is needed
• A cash budget can also be used to compare actual cash flows against planned
cash flows so that management can evaluate both management’s
performance and management’s forecasting ability
 Cash Budget
• Cash flow comes into company
• Operations, such as receipts from sales and collections on accounts receivable
• The results of financing decisions, such as borrowings, sales of shares of common stock,
and sales of preferred stock
• The results of investment decisions, such as sales of assets and income from marketable
securities
• Cash flow leave the company
• Operations, such as payments on accounts payable, purchases of goods, and the payment
of taxes
• Financing obligations, such as the payment of dividends and interest, and the repurchase
of shares of stock or the redemption of bonds
• Investments, such as the purchase of plant and equipment
• The cash budget typically consists of four major sections:
• The receipts section, which gives the beginning cash balance, cash collections
from customers, and other receipts
• The disbursements section, which shows all cash payments made, listed by
purpose
• The cash surplus or deficit section, which simply shows the difference
between the cash receipts section and the cash disbursements section
• The financing section, which provides a detailed account of the borrowings
and repayments expected during the budget period
Cash Receipts Section
• Details all cash inflows the company anticipates to receive in the
budget period. It includes :
• Cash receipts from the company’s cash sales or cash collections from
customers who purchase goods or obtain services on credit terms.
• Other types of receipts, for example:
• Anticipated receipts of rental income
• Commissions and fees earned
• Interest and dividends from investments
• Proceeds from disposal of fixed assets and other investments
• Cash contributions through the issuance of bonds and shares of stocks.
Cash Disbursement/Payment Section
• Includes all cash payments that the company is expected to make
during the budget period. Typical payments include:
• Payment for purchase of raw materials
• Payments of labour costs in terms of salaries and wages
• Payment of operating expenses
• Anticipated payment for corporate taxes or income taxes
• Payment for purchase of plant, equipment and property
Financing Section
This section details the following:
1. The company’s expected short-term borrowings to finance any
cash deficiency expected in a budget period or to meet the
minimum required closing cash balance as per company policy in a
budget period
2. Any anticipated interest payment that comes with the borrowings.
Format of a Cash Budget
Company XYZ Sdn Bhd
Cash Budget for the period ending 31 December 20xx
RM
Opening cash balance Y,YYY
Add: Cash receipts (itemized) YYY
Total available cash Y,YYY
Less: Cash payments (itemized) YYY
Cash surplus/(deficit) Y,YYY
Financing YYY
Closing cash balance Y,YYY

Chapter 3 42
Budget Period
• The period used in constructing a cash budget differs from one
company to another depending upon its nature and the degree of
accuracy with which the estimates of cash flows can be made.
• It can be prepared on a monthly, quarterly, half-yearly or annual basis.
• The typical budget period is one year and it can be broken down into
12 monthly periods. A 15-month budget period is also commonly
used.
Stages in the preparation of a cash budget
1. Forecast anticipated cash inflows
2. Forecast anticipated cash outflows
3. Determine net cash flow
4. Determine the need for financing to cover a cash shortage.
5. Compute the ending cash balance
6. Analyze the result
Example
• Consider below are the sales figures for KK Company.
Jan (‘000) Feb (‘000) March (‘000)
Sales 300 400 550

• Only 10% of customers agreed to pay immediately for the metal boxes.
Of the remaining customers, 60% agreed to pay after one month and
40% after two months.
• The metal box company has a labour cost equal to 20% of the sales
value a materials cost equal to 25% of the sales value and an overhead
cost equal to 15% of the sales value. Assuming that KK have $150,000
cash at the start of January. Prepare the cash budget for KK Company.
 Example
Microsoft Excel
97-2003 Worksheet

• Consider Salco Furniture Company Inc., a regional distributor of household furniture. Salco is in the process of preparing a
monthly cash budget for the upcoming 6 months (January through June 2016). The company’s sales are highly seasonal,
peaking in the months of March through May. Roughly 30 percent of Salco’s sales are collected 1 month after the sale, 50
percent 2 months after the sale, and the remainder during the third month following the sale.
• Salco attempts to pace its purchases with its forecast of future sales. Purchases generally equal 75 percent of sales and are
made 2 months in advance of anticipated sales. Payments are made in the month following purchases. Wages, salaries, rent,
and other cash expenses are recorded in the excel. Additional expenditures are recorded in the cash budget related to the
purchase of equipment in the amount of $14,000 during February and the repayment of a $12,000 loan in May.
• In June, Salco will pay $7,500 interest on its $150,000 long-term debt for the period of January to June 2016. Interest on the
$12,000 short-term note repaid in May for the period January through May equals $600 and is paid in May. Salco currently
has a cash balance of $20,000 and wants to maintain a minimum balance of $10,000. Additional borrowing necessary to
maintain that minimum balance is estimated in the final section of Table 14-3. Borrowing takes place at the beginning of the
month in which the funds are needed. Interest on the borrowed funds equals 12 percent per annum, or 1 percent per month,
and is paid in the month following the one in which funds are borrowed.
Analyzing the result
• The financing-needed line in Salco’s cash budget determines that the
firm’s cumulative short-term borrowing will rise to $97,599 by May.
• However, this need for borrowing begins to subside in June and the
firm is able to reduce its borrowing to $79,875. Note that the cash
budget indicates not only the amount of financing needed during the
period but also when the funds will be needed.
Important of Cash Budget
• Helps managers to assess whether the business needs to borrow cash
to finance its short-term operations.
• Helps to identify short-term financial requirements and surpluses
based on the company’s budgeted activities.
• To keep track of the movement of anticipated cash flows in terms of
inflows and outflows.
• Designed to plan and control the use of financial resources
Benefits of Cash Budget
1. It establishes a sound basis for exercising control over the cash flows and
liquidity of the company.
2. It coordinates the timing of cash needs. It will inform the company when
there might be a shortage of cash or an abnormally large cash requirement.
3. It tells the management the periods when there are likely to be excess cash
and the availability of idle cash for investment.
4. It helps the company to arrange needed funds on the best terms and
prevent the accumulation of excess cash.
5. It enables the company which has sufficient cash to take advantage of cash
discount on its accounts payable, to pay off debts when they are due, to
formulate a dividend policy and to develop a capital expenditure plan.
 Funding the shortfall
Cash shortfalls can be handled in 4 ways:
1. Cash from savings
2. Unsecured loans (letters of credit)
3. Secured loans (using accounts receivable or inventories)
4. Other sources (commercial paper, trade credit, or banker’s acceptance).
 Managing the surplus
When a company has excess funds, it has 4 options:
1. Put the surplus in a savings account or invest it in marketable securities.
2. Repay lenders and owners (retire debt early or pay extra dividends).
3. Replace aging assets.
4. Invest in the company, accepting positive net present value projects
Sources and Uses of Cash
• Cash is considered to be the life-blood of a business. Cash shortages
can be stifling and expensive while excesses can lead to poor returns.

• Since most businesses do not function on a pure cash basis, it is

critical for them to forecast their needs for cash in advance.

• The cash budget is the analytical tool that estimates the future timing
of cash inflow and cash outflow and projects potential shortfalls and
surpluses.