CHAPTER 3 – FINANCIAL FORECASTING

PROFORMA STATEMENTS

 Finance is central to a company’s planning activities because:

1. The language of forecasting and planning is financial.
2. Virtually every corporate action has financial implications.
 Pro-forma financial statements are the most widely used vehicles for financial forecasting
 A pro-forma statement is simply a prediction of what the company’s financial statements will look
like at the end of the forecast period.
 Purpose is to estimate a company’s future need to external funding, a critical first step in financial
planning.
 The forecast does not say what form the new financing should take – whether trade credit, bank
borrowing, new equity, etc.
 Conversely, if the forecast says assets will fall below projected liabilities and owners’ equity; this
implies the company will generate more cash than necessary to run the business. Management’s
task will be to decide how best to deploy the excess.
 External Funding Required (EFR) = Total Assets – Liabilities plus Owners’ equity

PERCENT OF SALES FORECASTING

 Tying many of the Income Statement and Balance Sheet figures to future sales simplifies the
forecasting challenge.
 Rationale is that all variable costs and most CAs and CLs tend to vary directly with sales
 Nevertheless some independent forecasts of individual items such as plant and equipment will be
required.
 Step 1: Examine historical data to determine which FS items have varied in proportion to sales in
the past.
 Step 2: Forecast sales. It is critical to do this as accurately as possible
 Step 3: Estimate individual; FS items by extrapolating the historical patterns to the newly estimated
sales.

ESTIMATING THE EXTERNAL FUNDING REQUIRED

 Operating executives tend to be more interested in the IS, whereas financial executives tend to be
more interested in the BS.
 In estimating future financing requirements, the IS is interesting only in so far as it affects the BS.
Thus the BS is considered the key.
 For prepaid expenses and accrued wages, rough estimates will suffice for the Pro-forma BS.
 Net fixed assets for the pro-forma = current value + expected CAPEX – Depreciation.
 The bank loan is initially set to zero or unchanged until EFR is calculated.
 The current portion of LT debt is simply the principal repayment due the year after that of the
proforma.
 Unless the company plans to sell new equity in the forecast year, common stock should remain
constant.
 Retained earnings for the forecast year = Retained earnings in the current year + earnings after tax
for the forecast year – Dividends expected to be paid in the forecast year.
 As retained earnings grow, the loan needs decline.
 Last estimate the EFR as TA less (liabilities and owners’ equity).
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  Q: Will the company be liquid enough to repay and/or service the loan?
 Q: What is the attitude of the borrower toward financial planning?
 Q: Does the borrower know where his/her company is headed?

INTEREST EXPENSE

 Note the circularity involved in forecasting the interest expense and indebtedness.
 There are 2 common solutions:
1. Using a computer spreadsheet to solve the interest expense and EFR simultaneously.
2. Ignore the problem with the expectation that the first pass estimate will be close enough.
o Given the likely errors in predicting sales and other variables, the additional error caused by
a failure to determine interest expense accurately is usually not all that critical.
o Although an increased interest expense has a noticeable percentage effect on earnings, by
the time the increase filters through taxes and dividend payments, the effect on the EFN is
modest.

SEASONALITY

 If a company has seasonal financing requirements, knowledge of year-end loan needs may be of
little use in financial planning, since the year end may bear no relation whatsoever to the date of
the company’s peak financing needs.
 To avoid this (1) make monthly or quarterly forecasts rather than annual ones or make the date of
peak financing need the forecast horizon.

PROFORMA STATEMENTS & FINANCIAL PLANNING

 Proforma statements simply display the financial implications of the company’s operating plans.
The next step is to analyse the forecast to decide if it is acceptable or if it must be changed to avoid
certain identified problems.

Questions to ask: Is the estimated EFN too large?

 If yes, then management must change its plans to conform to the financial realities.
 Yes could be because (1) Company does not want to borrow that specific amount, or (2) bank is
unwilling to grant such a large loan.
 This is where operating plans and financial plans merge to provide a coherent strategy.
 If the funding available is less than the EFN estimated, then the company need to modify its
operating plans to shave off the unavailable portion of the projected EFN.
 This can be done using methods that involve subtle trade-offs among growth, profitability and
funding needs, e.g. tightening up the collection ARs and/or (2) settling for a more modest
improvement in AP period.
 Note that (1) may drive away some customers; and (2) will sacrifice some prompt payment
discounts. Thus (1) may reduce sales, while (2) may increase GSA expenses.
 To test the revised operating plan, implement the changes in assumptions and rollout a revised
proforma forecast.
 Conclusion: Proforma forecasts contribute mightily to the planning process by
(1) providing a vehicle for evaluating alternative plans
(2) quantifying the anticipated costs and benefits of each, and
(3) indicating which plans are financially feasible

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COMPUTER-BASED PLANNING

 Have an assumptions box containing all of the information and assumptions required to construct
the forecast. This is a real time saver if you later want to change assumptions.
 Two steps are required to get from the assumptions to the completed forecasts.

First Step: Enter a series of equations tying the inputs to the forecasted outputs.

 There are only 3 tricky equations:

(1) Forecasted interest expense = Interest rate x (End-of-period LTD + Current portion of LTD +
Forecasted EFN)
(2) Equity = End-of-period Equity + Retained Earnings
(3) EFN = Total assets – (Liabilities + Shareholders’ Equity)

Second Step: Incorporate the interdependence between interest expense and EFN.

 To avoid the circular reference warning in Excel software older than 2017, select “Tools” 
“Options”  “Calculation”  “Manual”  “Iteration”, set the maximum number of iterations to
something above e.g. 50. Press OK.
 With the computer no longer in automatic calculation mode, you will need to tell the computer
when to calculate by pressing the F9 key.
 NB: In MS Excel 2007, click the “MS Office button”  “Excel Options”  “Formulas”  “Calculation
Options”  “Enable Iterative calculation”, then click “OK”.
 To modify a forecast assumption, just change the appropriate entry in the assumptions box and
press F9.

COPYING WITH UNCERTAINTY

SENSITIVITY ANALYSIS (WHAT-IF)

 Involves systematically changing one of the assumptions on which the proforma statements are
based and observing how the forecast responds.
 The reverse is useful in at least 2 ways:
1. It provides information about the range of possible outcomes.
2. It enables managers to determine which assumptions most strongly affect the forecast and
which are secondary. They also enable them to focus on these factors most critical to the
plan’s success.

SCENARIO ANALYSIS

 Forecasts seldom err on one assumption at a time.

 Scenario analysis looks at how a number of assumptions might change in response to a particular
economic event.
 If the proper assumptions are that inventories will initially rise when sales drop below expectations
and the profit margin will decline as the company slashes prices to maintain volume, failure to
include these complementary effects will cause an underestimate of the need for outside financing.

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STEP 1: Identify a few carefully chosen events, or scenarios, that might plausibly befall the company,

 e.g. loss of a major customer,

 Successful introduction of a major new product, or
 Entry of an important new competitor

STEP 2: Either reaffirm the original assumption or substitute a new, more accurate one, i.e. revise or rethink
the variables in the original forecast.

STEP 3: Generate a separate forecast for each scenario.

SIMULATION

 is a computer-assisted extension of sensitivity analysis

 STEP 1: Assign a probability distribution to each uncertain element in the forecast
 STEP 2: Ask a computer to pick at random a value for each uncertain variable consistent with the
assigned probability distribution.
 STEP 3: Generate a set of proforma statements based on selected values.
 Repeat Step 2 and 3 to produce a large number of trials.
 The output is a table or graph summarising the results of many trials
 The principal advantage of simulation analysis is that it allows all of the uncertain input
variables to change at once.
 The principal disadvantage is that the results are often difficult to interpret:
1. Because a few executives are used to thinking about future events in terms of
probabilities;
2. With simulation much of the planning goes on inside the computer and managers too
often only see the results.

CASH FLOW FORECASTS

 A cash flow forecast is simply a listing of all anticipated sources of cash and uses of cash by the
company over the forecast period.
 The difference between the forecasted sources and forecasted uses is the EFN.
 Cash flow forecast are straight forward, easily understood, and commonly used.
 Weakness: They are less informative compared to proformas e.g. with cash flow forecasts, unlike
proformas, evaluating the company’s ability to raise EFN is more difficult.

CASH BUDGET

 A corporate cash budget is a simple listing of cash receipts and disbursements over a forecast
period for the purpose of anticipating future cash shortages and surpluses.
 They are often used to manage short-term cash
 Problem: Company accounts are based on accrual accounting while cash budgets are strictly cash
accounting.
 Translate projections of sales and purchase into their cash equivalents
 Adjust credit sales for time lags between sale and receipt of cash from the sale.
 Credit purchases will need to be adjusted for the lag between the purchases of an item and
payment of the resulting Aps.
 Raw materials purchased are usually a certain percentage of the following month’s sales

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  If payment terms are 30 days after purchase, then cash payments for a particular month will equal
the previous month’s purchases.

SOURCES OF CASH in a cash budget include:

1. Credit sales
2. Sale of used equipment
3. Proceeds from a new bank loan
4. Interest income
5. Cash from the exercise of employee stock options.

CASH DISBURSEMENTS include:

1. Payment of credit purchases

2. Wages and salaries
3. Interest payments
4. Rent
5. Taxes
6. A principal loan repayment
7. Any other cash disbursements

 NB: Depreciation does not appear in a cash budget because it is a noncash charge.
 The bottom portion of a cash budget shows the effect of the company’s anticipated cash inflows
and outflows on its need for external funding.
 One month’s cash balance becomes next month’s beginning balance.
 Throughout each month cash rises or falls according to that month’s net cash receipts and
disbursements.
 Comparing the ending cash balances with the minimum desired level of cash s specified by the
treasurer yields a monthly estimate of the company’s cash surplus or deficit.
 The cash surplus or deficit figures measure the company’s future need for external financing or its
projected surplus cash.
 The excess cash can be used to pay down other debt, purchase marketable securities or invest
elsewhere in the business.

THE TECHNIQUES COMPARED

 NB: The proforma statements, Cash flow forecasts and the cash budget all produce the same
estimate of external funding required as long as the assumptions are the same.
 The estimate of new financing needs is not biased by inflation
 Thus the 3 forecasting techniques are equivalent. The choice of which one to use depends on the
purpose of the forecast.
1. For planning purposes and credit analysis – Use proforma statements
2. For short-term forecasting and management of cash – Use the cash budget
3. A cash flow forecast lies in between – Presents a broader picture of the company’s operations
than a cash budget and is easier to construct than proformas.

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PLANNING IN LARGE COMPANIES

 Involves 3 formal stages that recur on an annual cycle:

STAGE 1: Headquarters executives and division managers hammer out a corporate strategy, which involves:

1. a broad-ranging analysis of the market threats and opportunities the company faces;
2. An assessment of the company’s own strengths and weaknesses; and
3. A determination of the performance goals to be sought by each of the company’s business
units.
 The process at this stage is creative and qualitative.

STAGE 2: Division managers and department personnel translate the qualitative, market-related goals
established in Stage 1 into a set of internal division activities deemed necessary to achieve the agreed-on
goals.

 By this time, top management will likely have indicated the resources to be allocated to each
division.
 So the plans should generally be consistent with senior management’s resource commitments.

STAGE 3: Department personnel develop a set of quantitative plans and budgets based on the activities
defined in Stage 2.

 Involves putting a price tag on the agreed-on division activities in the form of operating budgets
and capital budgets
 Capital budgets include expenditures on costly, long-lived assets
 Operating budgets include recurring expenditures such as materials, salaries, etc.
 The integration of the detailed divisional budgets at headquarters produces the company’s financial
forecast, which will contain few surprises if management has been realistic about available
resources.
 Forecasting techniques (proforma, cash budgets, cash flow forecasts) become increasingly
important:
1. As a means of articulating the financial implications of the chosen strategy, and
2. As a vehicle for testing alternative strategies
 Therefore, financial forecasting is a family of techniques for translating creative ideas and strategies
into concrete action plans.