CH.

III
Financial Forecasting

14-1
Overview of Financial Forecasting
 Financial managers should be able to plan before hand in
making investment and financing decisions.
 A financial forecast is an estimation, or projection, of likely
future income or revenue and expenses, while a financial plan
lays out the necessary steps to generate future income and
cover future expenses.
 Financial forecasting is the process of identifying the
opportunities in the future in terms of market size, customer
base, or business strategies by examining historical
performance data, such as revenue, cash flow, expenses, or
sales.

02-2
Cont…
 Forecasting involves making projections about what will
happen in the future. As a process, financial forecasting
involves estimating future business performance.
 It provides information of the organization’s future revenues
and costs that is needed by management to project financing
requirements.
 The “future” is the planning period that could be short-term
(one or less), medium term (3-5 years), or long-term (over five
years).

02-3
Overview …
Meaning and purpose of financial forecasting
• Financial forecasting is one of the four major jobs of a firm’s
financial staff, namely performing financial forecasting and
analysis, making investment decisions, and making financial
decisions.
 Some argue that financial planning and financial forecasting are one
and the same. However, financial forecasting is the basis for financial
planning. Financial planning is done effectively through financial
forecasting.
 Financial planning is not just forecasting. Forecasting concentrates on
the most likely future outcome. But financial planners are not
concerned solely with forecasting. They need to worry about unlikely
events as well as likely ones.

02-4
 Overview …
• Firm can forecast its income statement, balance sheet and other related
statements. Besides, key ratios can be projected.

• Once financial statements and ratios have been forecasted, the

financial forecast will be analyzed.

• Finally, the firm’s management will have an opportunity to make

some decisions beforehand.

• So, all in all, financial forecasting is a pre-requirement for the

investment, financing as well as dividend policy decisions of a firm.

02-5
Dimensions of financial planning

• Financial planning is an process that looks at firms entire

financial picture in order to create strategies for achieving short
and long term- goals .

• Short run , is usually the coming 12 months

• We focus on financial planning over the long run, this time period
called planning horizon.

• In drawing up a plan , all of the individual projects and

investments the firm will undertaken are combined to determine
the total needed investment.
02-6
Dimensions …
• Total proposal of each operational units added up are and treated as one
project this process is called aggregation

• Once planning horizon and level of aggregation are established a

financial plan requires inputs in the form of alternative sets of
assumption about important variables.
• A Worst case : would be require making relatively pessimistic about the
company's product & state of economy.
• A normal case : would be require making the most likely assumption
about the company's product & state of economy.
• A best case : each division would be require to work out a case based
on optimistic assumption .

02-7
Forecasting growth rates and outside financing

02-8
Growth rate…

• For Dawa company, net income was $66 & total assets were $ 500. ROA =
net income /total assets =66/500 = 13.2%, of 66 net income $44 was
retained, so ,b = retained /total assets = 44/66 = 0.67

Internal growth rate = ROA xb/1-ROAxb

= 0.132*0.67/1-0.132*0.67

= 9.65%

Thus , company can expand at a maximum rate of 9.65% without external

financing.

02-9
Growth rate…

02-10
Growth rate …

02-11
Procedure for financial forecasting
Procedures
1) Forecasting of sales for the future period
 Is a forecast of a firm’s unit and birr sales for some future period
 It is based on recent sales trends and forecast of the economic
prospects of the nation, region, industry and other factors.
 It starts with reviewing the sales of the recent pasts.
- Factors should be considered during sales forecasting
 Historical sales growth pattern of the firm at both divisional and
corporate level
 The level of economic activity in each of the firm’s marketing areas
 The firm’s probable market share
 The effect of inflation on the firm’s future pricing of products
 The effect of advertising campaigns, cash and trade discounts, , credit
terms and other similar factors alike on future sales
 Individual products’ sales forecasts at each divisional level

02-12
Procedure…
2) Determining the asset required to meet the sales targets
Sales forecasts are also ground for determination of the firm’s assets
requirement
If sales are to increase, then assets must also grow
The amount each asset account must increase depends weather the firm was
operating at full capacity or not
If higher sales are projected, more cash will be needed for transactions, higher
sales will create higher receivables. Similarly, higher sales require higher
inventory and higher plant and equipment
3) Deciding on how to finance the required assets
 Some of the required finance can be covered by the increased retained
earnings
 The retained earnings increment will result from increased sales and profit
 Still some other portion of the finance can be covered by some liabilities
which will grow by the same proportion with that of sales.
 The remaining finance must be obtained from available external sources
02-13
Procedure …
The sub-procedures of financial statement forecast
1. Determining how much money (finance) the firm will need
during the forecasted period
2. Determining how much of the total required finance, the firm
will be able to generate internally during the same period. Two
source of finances
a. Net income portion (retained earnings)
b. Increase in firm’s liabilities (spontaneous finance)
3. Determining the additional external financial requirements
This finances is called Additional Fund Needed (AFN) -
This raise externally through borrowing (bank loans,
promissory notes, bonds, etc.) or by issuing new shares of
common stock or preferred stock.

02-14
Forecasting external financing needs
Example
• Dawa share company is a medium sized firm in manufacturing of various
household utensils. The financial manager is preparing the financial
forecast of the following year.
Assets Liability and Equity
cash -----------------Br. 10,000 A/payable ----- Br. 90,000
A/receivable -----------70,000 Accruals ---------- 40,000
inventories ------------150,000 current Liabilities ---- Br. 143,000
Current Assets ----- Br. 230,000 Long term debt -------------- 200,000
Net fixed Assets ----------- 370,000 Common stock ------------------ 120,000
Retained earning ---------- 150,000
Total Assets ------------ Br. 600,000 Total liability and equity --- 600,000
During the year just completed, the firm had sales of Br. 1,800,000

02-15
External financing needs …
• In the following year, due to increased demand to the firm’s products the
financial manager estimates that sales will grow at 10%.
• There are no preferred stocks outstanding during the year. The firm’s
dividend pay-out ratio is 60%. It is also known that the firm’s assets
have been operating at full capacity.
• During the same year, Dawa’s operating costs were 1,620,000 and are
estimated to increase proportionately with sales.
• Assume the company’s interest expense will be Br. 40,000 during the
next year and its tax rate is 40%.
• All balances sheets element expected to increased by 10% exceed long
term loan and common stock.
• Required: Determine the additional fund needed of Dawa share
company for next year using the pro forma financial statement method.

02-16
External financing needs …
• First we develop the pro forma income statement
pro forma Income statement
Sales (Br.1,800,000*1.10)--------------------------- Br. 1,980,000
Opearting Costs (Br.1,620,000*1.10) ----------- 1,782,000
Earnings before interest and taxes (EBIT) ------ Br. 198,000
Interest Expense ---------------------------------------- 40,000
Earnings before taxes (EBT) --------------------------- Br. 158,000
Taxes (Br.158000*40%) --------------------------------- 63,200
Net income ----------------------------------------------- Br. 94,800
Dividends to common stock (94,800*60%) ------------ Br. 56,880
Addition to retained earnings (Br.94,800-56,880) ---- Br. 37,920

02-17
External financing needs …
• Then we construct the pro forma balance sheet

Assets Liability and Equity

cash (10,000*1.10) -----------------Br. 11,000 A/payable(90,000*1.10) ----- Br. 99,000
A/receivable (Br.70,000*1.10) -----------77,000 Accruals(40,000*1.10) ---------- 44,000
inventories (150,000*1.10) ---------------165,000 current Liabilities ---- Br. 143,000
Total Current Assets ----------------- Br. 230,000 Long term debt -------------- 200,000
Net fixed Assets (370,000*1.10) ----------- 370,000 Common stock ------------------ 120,000

Retained earning(150,000+137,920) --- 187,920

Total Assets -------------- Br. 660,000 Total liability and equity --- 650,920

• Dawa’s forecasted total assets as shown above are Br. 660,000.

However, the forecasted total liabilities and equity amount to only
Br. 650,920

02-18
 External financing needs …
• Since the balance sheet must balance,

i.e. A = L+OE, the difference must be covered by additional funds.

Therefore, AFN = Br. 660,000-650,920 = Br. 9,080.

AFN = Increase in Asset – increase in normally generated funds

=[Br.660,000-600,000]–[(Br99,000)+(Br.44,00 - Br. 40,000) +Br.37,920]

= Br 60,000 – Br. 50,920

= Br.9,080

02-19
Financial statement forecasting: the percentage of sales method

02-20
Percentage of sales …

02-21
Percentage of sales …

02-22
Percentage of sales …
Example
Top Company has prepared the following Balance Sheet and Income
Statement for the year ended December 31, 2005.
Assets Liabilities and Stockholders’ Equity
Cash 175,000 A/P 140,000
A/R 150,000 Accrued liabilities 150,000
Inventory 800,000 Mortgage N/P 1,410,000
Plant Assets, Net 1,500,000 Common Stock 800,000
Retained earnings 125,000
Total 2,625,000 Total 2,625,000
Sales 2500000
Costs and Expenses except depreciation 1,400,000
Depreciation 200,000
Total costs and expenses 1,600,000
Income before taxes 900,000
Taxes (40%) 360,000
Net Income 540,000

02-23
Percentage of sales …
• Additional Information
 The company plans to have dividend payout ratio of 45%
 Sales are expected to increase by 25% during next year (2006).
 All assets are affected by sales proportionately. Accounts Payable
and accrued liabilities are also affected by sales.
 All expenses are directly proportional to sales
 The firm has been operating at full capacity.
 The company has no preferred stock.
 Assume that additional funds needed would be financed from
bond issue and common stock in 40% and 60% respectively.

02-24
Percentage of sales …

02-25
Percentage of sales …

02-26
Percentage of sales …
Top company
Pro-Forma Income Statement
For the Year Ended December 31, 2006
Sales ……………………………………………………………………………… 3,125,000
Less: Costs and Expenses except depreciation (1,400,0000*1.25) ... 1,750,000
Depreciation (200,000*1.25) ………………………………… 250,000
Total Costs and Expenses ………………………………………………….. 2,000,000
Income before Taxes ……………………………………………………………… 1,125,000
Less : Income taxes (40%) ………………………………………………………… 450,000
Net income ………………………………………………………………..675,000

02-27
Percentage of sales …

02-28
Percentage of sales …

02-29