Financial Planning and Forecasting Financial Statements

The Sales Forecast. The entire financial forecasting endeavor begins with the sales forecast,
and therefore an accurate sales forecast is essential. If the forecast is too high, the firm as at
risk of over-investing in production assets that will not be fully utilized, increasing the firm’s
operating costs without a sufficient increase in revenue. Turnover ratios will be low,
depreciation and inventory costs will be high, and spoilage is likely to increase. If the forecast
is too low, the firm will not be in a position to compete on volume and possibly even cost
(loss of economies of scale), and thus may lose market share. In either case, the result is likely
to be decreased profits, low ROE, and a depressed stock price.

The sales forecast usually starts with a review of the sales figures for the past 5–10 years, both
numerically and graphically. If the sales trends have changed within the past 3–5 years, it may
be prudent to limit the analysis to that period of time, rather than impute an inaccurate trend
into the forecast. Keep in mind, however, that fewer data points make forecasting more
difficult. One way around that issue is to use monthly sales figures rather than annual sales
figures, but if the business is seasonal, you will need to incorporate that seasonality into the
forecast, which adds a layer of complexity to the task (one that will not be addressed in this
class).

A simple regression analysis is a good starting point for the sales forecast. The regression
model will enable you to predict the expected sales figures for the next 5 years based purely
on the past sales figures used in the model. For this purpose, Excel’s SLOPE and
INTERCEPT formulas will suffice to produce a simple regression model output.

X Y
Obs Year Sales Forecast SLOPE INTERCEPT
0 2004 2,058.0 2,142.8 220.0 2,142.8
1 2005 2,534.0 2,362.8
2 2006 2,472.0 2,582.8
3 2007 2,850.0 2,802.8
4 2008 3,000.0 3,022.8
5 2009 3,242.8
6 2010 3,462.8
7 2011 3,682.8
8 2012 3,902.8
9 2013 4,122.8

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The first 5 data points in the column Obs (Observation) were used as the X variable, while the
Sales figures (in millions) were used as the Y variable. The value of the first observation was
given as zero simply so that the first forecast figure is equal to the intercept; changing the Obs
values to start with 1 will not change the forecasted sales figures (because the intercept will
change). Each additional year adds the amount of the slope to the sales forecast. The graph
shows that the actual sales data varies from the forecast for the same period (not unexpected –
the regression model smoothes out the data to make it linear), but notice that the actual figures
are very close to the forecasted figures; if this were not the case, the regression model would
be a questionable method to use for this forecast. Since the actual and forecasted figures in
years 2004-2008 are very close, we will use the regression model output as our sales forecast.

In real life, this would not be the end of the sales forecasting process; other issues would be
taken into account (such as new products being introduced in the future, new markets being
entered, economic forecasts, promotional campaigns, etc.), and the data would be adjusted to
account for these other issues. These issues are beyond the scope of this class.

Financial Statement Forecasting – The Percent of Sales Method. Once sales have been
forecasted, we are ready to begin building pro forma financial statements in Excel. The most
commonly used method is the percent of sales method, where variable accounts are calculated
as a percent of the sales figure based on past history. Then those past percentages are applied
to the sales forecast to estimate future levels of those accounts.

There are two basic approaches to applying the percent of sales method: using the mean value
of the percentage over the time period being studied, or using any notable trend in the percent
of sales over the time period. Which approach you use is a judgment call. If the percent of
sales is hovering around some figure (going above and below it, back and forth), then there is
no obvious trend, and it makes sense to use the mean percentage. If the data are showing a
consistent increase or decrease in the percentage, then using that trend is more appropriate.
Note that these approaches both require multiple years' worth of data as inputs.

For example, the graph below shows the percent of sales for a firm's Cost of Goods Sold over
a 5-year period:

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This percent of sales is not showing a clear trend, but seems to be going up and down over
time. Therefore this variable would be best forecasted using the mean value over the 5-year
period. The next graph shows the same calculation for the firm's operating expenses:

This variable shows a clear increasing trend, and therefore is better forecasted using the trend.

The simplest way to forecast using the trend in the data is using Excel's TREND function. The
TREND function permits you to enter the past data (both the percentages and the years they
occurred) and then creates a forecasted value in the next period based on any existing trend in
the past data. Using the TREND function, Excel forecasted the firm's operating expenses as
follows:

Forecas
t
2005 2006 2007 2008 2009 2010
% Sales Operating Expenses 19.4% 19.7% 19.9% 20.1% 20.5% 20.7%

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As you can see, this forecasted point seems to fit the trend very well.

One other approach is possible: if the firm has specific plans to address particular line items in
the financial statements, then it may be more appropriate to estimate the impact of those plans
on the percent of sales and forecast those changes moving forward. For the operating expense
data above, the managers may decide to take proactive steps to reduce operating expenses as a
percent of sales, in which case using the TREND function would not be appropriate. They
would need to estimate the level of expenses based on expectations of changes being made to
how operating expenses are incurred, and then forecast the percent of sales based on those
changes. Examples of this will be seen in the pro forma income statement example below.

Income Statement. For the income statement, the operational costs (except depreciation) are
calculated as a percentage of the sales figure. Look at the firm’s incomes statements over the
past 3-5 years, and for each year calculate the ratio of each account to the sales figure for each
year (Cost of Goods Sold divided by Sales, Operating Expenses divided by Sales, etc.). Then
look at the result and try to spot any trends or patterns. If the percentages have a definite trend
in them, you may want to include that trend moving forward. If there are no obvious trends,
you can take an average of each metric over the years for which you have income statements,
then see how the average compares to the actual data points (you could also calculate a
standard deviation and see how big it is – if it is very small, then the mean is probably a good
estimate). If none of these make sense, you can always just use the most recent year’s
percentages for the forecast. Judgment is required in making these choices, and you should be
prepared to support your judgment with reasons and/or data.

Also, if you know of changes that are going to be implemented in the future, you are free to
adjust the future percentages to account for these changes. For an example of this (and of the
percent of sales method in general), we will use the following example, based on the sales
forecast produced earlier in this chapter.

Examples
For the examples below, the percentages are given, so that you can focus on how they are
applied and interpreted, rather than on how they are calculated.

A study of three years’ worth of income statements for the firm reveals the following items:
 COGS has been averaging approximately 60% of sales consistently for the past 3
years;
 Operating costs have been consistently averaging approximately 27.2% of sales;
 Depreciation has been steady at $100 million for the past several years;
 Interest expense is expected to be $88 million for the current year;
 Taxes are 40.0%;
 The firm’s preferred dividend amount is $4 million;
 The common dividend for this year is expected to be $1.15 per share, and there are 50
million shares outstanding.

In addition, the following facts were made available:

 Sales are expected to increase by 10% per year for the following 3 years;

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  The firm will be hiring a new purchasing manager during 2009, and that person is
expected to reduce the percentage of sales for COGS by 2 percentage points (200 basis
points) each year for the following 2 years;
 There will be a new union contract signed at the end of next year, and it is expected to
increase the percentage of sales for Operating Costs by 80 basis points in 2010 and
again by 50 basis points in 2011;
 New equipment purchases in 2009 are expected to increase Depreciation by $10
million, where it will stay for several years;
 The common dividend will be increased to $1.25 per share in 2009.

Based on these data we can construct the initial income statement for 2008, and then use the
information given to create pro forma statements for 2009 – 2011.

Pro Form Income Statements ($Millions)

% 2009 2010 2011

2008 Sales PF % Sales PF % Sales PF
Sales 3,000 110.0% 3,300 110.0% 3,630 110.0% 3,993
less COGS 1,800 60.0% 1,980 58.0% 2,105 56.0% 2,236
= Gross Income 1,200 1,320 1,525 1,757
less Operating Costs 816 27.2% 898 28.0% 1,016 28.5% 1,138
= EBITDA 384 422 508 619
less Depreciation 100 110 110 110
= EBIT 284 312 398 509
less Interest Expense 88 88 88 88
= EBT 196 224 310 421
less Taxes (40%) 78 90 124 168
= Net Income 118 135 186 253

Preferred Dividends 4 4 4 4
NI Available to Common 114 131 182 249
Dividends to Common 58 63 63 63
Retained Earnings 56 68 120 186

Notice that COGS decrease as a percent of sales, based on the efforts of the new purchasing
manager. Also notice the increase in the percent of Operating Costs due to the new union
contract. Finally, also notice that the Dividends to Common amount has been increased from
$1.15 per share to $1.25 per share in 2009 (based on 50 million shares). The Retained
Earnings figures given at the bottom of the example will be used in creating the pro forma
balance sheet.

This method is simple to perform, and MS Excel is an excellent tool for creating pro forma
statements.

Balance Sheet. If sales are to increase, some asset accounts are going to have to increase as
well. Firms write and deposit checks every day, with no way of knowing when they will clear.
Therefore they must keep enough cash on hand to avoid overdrafts. If cash is assumed to be a
percentage of sales (which is reasonable), then a higher level of sales will require a

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proportionally higher level of cash. More sales also means more inventory. Assuming
inventory varies with sales (again, quite reasonable), an increase in sales will require an
equivalent increase in inventory. Unless the credit policy is changed, an increase in sales will
also lead to an increase in accounts receivable, and it is likely to be a proportionate increase.

Unless the firm is operating at full capacity, an increase in sales (unless it is unusually large)
is not enough in itself to require an increase in fixed assets (like plant, property & equipment).
Choosing to invest in capital equipment and facilities is a strategic decision that requires a
large investment. Also, for many firms (particularly manufacturing firms), fixed assets do not
come in small amounts, but rather in large chunks (referred to as “lumpy assets”). Given this,
many firms use their long-term capital budget plan to indicate increases in fixed assets. Unless
you know otherwise, it is generally not good to assume that fixed assets will vary as a percent
of sales. For the example given below, we will assume that the firm has excess capacity.

If assets are to increase, then liabilities and equity must increase as well, as the additional
assets must be financed. Some current liabilities can be expected to increase spontaneously
with the increase in sales – these are referred to as spontaneously generated funds. For
example, the increase in inventory resulting from the increase in sales will lead to an increase
in accounts payable. Accrued wages and taxes are likely to increase as well (more sales will
require more labor and thus more taxable income). Retained earnings will increase, but this
item is not calculated as a percentage of sales, but is instead taken from the pro forma income
statement. Other liability and equity accounts are left at their previous year’s levels.

The pro forma balance sheet is created in two passes: in the first pass, the increase in the asset
accounts, the spontaneously generated funds, and the addition to retained earnings from the
income statement are included. It is unlikely that the spontaneously generated funds will be
enough to cover the increase in assets, so the first pass of the balance sheet will not balance.
The difference between the level of assets and the level of liabilities & equity is referred to as
the Additional Funds Needed (AFN). Your textbook gives a formula for calculating the AFN,
and you should be familiar with that formula, but the formula will give a different answer for
the same data than the percent of sales method will. This is because the AFN formula assumes
a constant Net Margin, which is not a reasonable assumption. The percent of sales method
does not make that assumption.

In the following example (for the same firm used in the examples above), their 2008 balance
sheet is given below:

2008
Cash and Equivalents 50
Accounts Receivable 375
Inventories 615
Total Current Assets 1,040
Net Plant & Equipment 935
Total Assets 1,975

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 Accounts Payable 60
Notes Payable 110
Accruals 115
Total Current Liabilities 285
LT Debt 754
Total Liabilities 1,039
Preferred Stock 40
Common Stock 130
Retained Earnings 766
Total Equity 936
Total Liabilities & Equity 1,975

The following rates were calculated based on an analysis if the firm’s balance sheets for the
past 5 years:
 Cash is calculated as 1.67% of sales;
 Receivables are calculated as 12.5% of sales;
 Inventories are calculated as 20.5% of sales;
 Payables are calculated as 2.0% of sales;
 Accruals are calculated as 3.83% of sales;
 The firm has plenty of extra production capacity, so there is no need to increase fixed
assets;
 The addition to retained earnings for 2009 is $68 million (based on the pro forma
income statement in the earlier example);
 Any additional funds needed are to be raised as 50% notes payable, 50% LT debt, and
0% common equity.

Based on this data and the 2008 balance sheet given above, we are ready to create the 2009
pro forma balance sheet (given on the next page). Notice that cash, receivables, inventories,
payables and accruals are increased according to their percent of sales, while retained
earnings is increased based on the pro forma income statement. All other accounts are held at
their prior level. This results in a need for $18 million (AFN) to fund the increase in assets. In
the schedule at the bottom you will see that the funds were raised according to the schedule
given in the notes above, and that this was enough to make the balance sheet balance on the
second pass.

This technique is quite simple and straightforward, and while the examples are simplified,
they represent very well how this method is used in business to forecast a firm’s financial
statements for many years into the future, in support of the firm’s strategic plan. An analyst
with these skills will be quite valuable to his or her employer.

Complications. These pro forma statements do not take into account the fact that new debt
will increase the interest paid on the income statement, which will lower the amount of net
income reported (and thus the retained earnings used in the pro forma balance sheet). This
creates a circularity in the spreadsheet that requires a sharp analyst to handle effectively (as
opposed to doing pass after pass after pass).

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Analysis of the Forecast. Once the pro forma statements are finished, they must be analyzed
to determine whether the forecasts meet the firm’s financial targets as set forth in the plan. If
not, they must be redone. Key ratios must be calculated to determine the impact the forecast
has on the firm’s liquidity, asset management, leverage and profitability.

Pro Forma Balance Sheet

($Millions)

2009
Sales 2009 Forecast
1st 2nd
2008 % Sales Forecast Pass AFN Pass
Cash and Equivalents 50 1.67% 3,300 55 55
Accounts Receivable 375 12.50% 413 413
Inventories 615 20.50% 677 677
Total Current Assets 1,040 1,144 1,144
Net Plant & Equipment 935 935 935
Total Assets 1,975 2,079 2,079

Accounts Payable 60 2.00% 66 66

Notes Payable 110 110 9 119
Accruals 115 3.83% 127 127
Total Current Liabilities 285 303 312
LT Debt 754 754 9 763
Total Liabilities 1,039 1,057 1,075
Preferred Stock 40 40 40
Common Stock 130 130 0 130
Retained Earnings 766 68 834 834
Total Equity 936 1,004 1,004
Total Liabilities & Equity 1,975 2,061 2,079

Additional Funds Needed 0 18 0

$
New Capital Raised % (Millions)
Notes Payable 50.0% 9
LT Debt 50.0% 9
Common Stock 0.0% 0
Total Capital Raised 100.0% 18

One simple mathematical truth to keep in mind: for variables being calculated as a percent of
sales, the percent increase in sales will also be the percent increase in the variable. For
example, in the balance sheet above, we calculated Cash as 1.67% of sales, and so calculated
the new value as 1.67% of the new sales figure. But notice that Cash increased by 10% (from
50 to 55) -- the same percentage increase as sales. All the other variables can be calculated the
same way, as long as the percent of sales is not changing over time (like with the Income
Statement above, or if using a trend rather than a mean).

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