Chapter 17

Financial
Forecasting
and Planning
Slide Contents

•  Learning Objectives
1.  An Overview of Financial Planning
2.  Developing a Long-term Financial Plan
3.  Developing a Short-Term Financial Plan
•  Principles Applied in this Chapter
•  Key Terms

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Learning Objectives

1.  Understand the goals of financial planning.

2.  Use the percent-of-sales method to
forecast the financing requirements of a
firm, including its discretionary financing
needs.
3.  Prepare a cash budget and use it to
evaluate the amount and timing of a firm s
short-term financing requirements.

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Principles Applied in This Chapter

Principle 2: There is a Risk-Return Tradeoff.

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 17.1 AN OVERVIEW OF
FINANCIAL PLANNING

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An Overview of Financial Planning

The primary objective of preparing financial

plans is to estimate the future financing
requirements in advance of when the
financing will be needed. Most firms engage
in three types of planning:
–  Strategic planning,
–  Long-term financial planning, and
–  Short-term financial planning

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An Overview of Financial Planning
(cont.)

•  Strategic plan defines, in very general

terms, how the firm plans to make money
in the future. It serves as a guide for all
other plans.

•  The long-term financial plan generally

encompasses a period of three to five years
and incorporates estimates of the firm s
income statements and balance sheets.

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An Overview of Financial Planning
(cont.)

The short-term financial plan spans a

period of one year or less and is a very
detailed description of the firm s anticipated
cash flows. The format typically used for
short-term financial plan is a cash budget.

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 17.2 DEVELOPING
A LONG-TERM FINANCIAL
PLAN

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Developing a Long-Term Financial
Plan

Three basic steps:

1.  Construct a Sales Forecast

2.  Prepare Pro Forma Financial Statements

3.  Estimate the Firm’s Financing Needs

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Developing a Long-Term Financial
Plan (cont.)

Step 1: Construct a Sales Forecast

Sales forecast is generally based on:

1.  past trend in sales; and

2. the influence of any anticipated events that

might materially affect that trend.

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Developing a Long-Term Financial
Plan (cont.)

Step 2: Prepare Pro Forma Financial

Statements

–  These statements help forecast a firm s asset

requirements needed to support the forecast of
revenues (step 1).
–  The most common technique is percent of
sales method that expresses expenses, assets,
and liabilities for a future period as a percentage
of sales.

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Developing a Long-Term Financial
Plan (cont.)

Step 3: Estimate the Firm s Financing Needs

–  Using the pro forma statements we can extract

the cash flow requirements of the firm.

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Financial Forecasting Example:
Ziegen, Inc.

Table 17-1 illustrates how Ziegen, Inc. uses

the percent of sales method to construct pro
forma income statement and pro forma
balance sheet. The company uses the three-
step approach to financial planning.

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Financial Forecasting Example:
Ziegen, Inc. (cont.)

Step 1: Forecast Revenues and Expenses

–  Zeigen s financial analyst estimate the firm will

earn 5% on the projected sales of $12 million in
2014.
–  Zeigen plans to retain half of its earnings and
distribute the other half as dividends.

–  See Table 17-1

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Table 17.1
Using the
Percent-of-
Sales Method
to Forecast
Ziegen, Inc.’s
Financing
Requirement
s for 2014

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Financial Forecasting Example:
Ziegen, Inc. (cont.)

Step 2: Prepare Pro Forma Financial

Statements

–  The firm s need for assets to support firm sales

is forecasted using percent of sales method,
where each item in the balance sheet is
assumed to vary in accordance with its percent
of sales for 2013.

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Financial Forecasting Example
(cont.)

Step 3: Estimate the Firm s Financing

Requirements

–  This involves comparing the projected level of

assets needed to support the sales forecast to
the available sources of financing. In essence,
we now forecast the liabilities and owner s equity
section of the pro forma balance sheet.

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Sources of Spontaneous Financing:
Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses,

referred to as spontaneous financing
sources are typically the only liabilities that
vary directly with sales. The percent of sales
method can be used to forecast the levels of
both these sources of financing.

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Sources of Discretionary Financing

•  Raising financing with notes payable, long-

term debt and common stock requires
managerial discretion and hence these
sources of financing are called
discretionary sources of financing.

•  The retention of earnings is also a

discretionary source as it is the result of
firm s discretionary dividend policy.

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 Summarizing Ziegen s Financial
Forecast (cont.)

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Summarizing Ziegen s Financial
Forecast

Discretionary Financing Needs (DFN)

= {Total Financing Needs} less {Projected
Sources of Financing}

= {$7.2 m (increase in assets)} – {$2.4m in

spontaneous financing + $2.5m in short and
long-term debt + $1.8 million in equity}
= $7.2 million - $6.7 million
= $500,000

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Summarizing Ziegen s Financial
Forecast (cont.)

•  The firm has to raise $500,000 with some

combination of borrowing (short-term or
long-term) or the issuance of stock.

•  Since they require a managerial decision,

they are referred to as the firm s
discretionary financing needs (DFN).

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Analyzing the Effects of Profitability and
Dividend Policy on the Firm s DFN

The table (on next slide) shows that as

dividend payout ratios and net profit margin
vary, DFN also changes significantly from a
negative $40,000 to $764,000.

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Analyzing the Effects of Profitability and Dividend
Policy on the Firm s DFN (cont.)

DFN for Various Net Profit Margins and

Dividend Payout Ratio (DPR)

Net Profit DPR =30% DPR=50% DPR=70%

Margin
1% $716,000 $740,000 $764,000
5% $380,000 $500,000 $620,000
10% $(40,000) $200,000 $440,000

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Analyzing the Effects of Sales
Growth on a Firm s DFN

•  Table 17-2 considers the impact of sales

growth rates of 0%, 20% and 40% on DFN.

•  It is observed that DFN ranges from

($250,000) at 0% growth rate to
$1,250,000 at 40% growth rate. A negative
DFN indicates that the firm has surplus
dollars in financing.

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Table 17.2
Discretionary
Financing
Needs (DFN)
and the
Growth Rate
in Sales

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Figure 17.1 Sales Growth and the
Discretionary Financing Needs of the Firm

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 CHECKPOINT 17.1:
CHECK YOURSELF

Estimating DFN

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The Problem

Pendleton’s management estimates that

under the most optimistic circumstances it
might experience a 25% rate of growth of
sales in 2014. Assuming that net income is
5% of firm sales and that both current and
fixed assets are equal to a fixed percent of
sales (as found in the above forecast), what
do you estimate the firm’s DFN to be under
these optimistic circumstances?

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Step 1: Picture the Problem

The firm s DFN is equal to the financing the

firm requires for the year that is not provided
by spontaneous sources such as accounts
payable and accrued expenses plus retained
earnings for the period.

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Step 2: Decide on a Solution Strategy

We can calculate the DFN using the following

equation:

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 Line Performa Income Statement for 2014

Step 3: 1 Growth Rate 25%

Solve 2
3
Sales
Net Income
$6,250,000.00
312,500.00
Performa Balance Sheet for 2011
Multiple Computation
4 Current Assets 0.20 $1,250,000.00

5 Net Fixed Assets 0.6 $3,750,000.00

6 Total 4+5 $5,000,000.00

7 Accounts Payable 0.2 $1,250,000.00

8 Accrued Expenses 0.1 $625,000.00

9 Notes Payable $500,000.00

10 Current Liabilities 7+8+9 $2,375,000.00

11 Long-term Debt $1,000,000.00

12 Common Stock (par) $100,000.00

13 Paid-in-capital $200,000.00

14 Retained Earnings $1,012,500.00

15 Common Equity 12+13+14 $1,312,500.00

$700,000 + $312,500

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Step 4: Analyze

•  DFN = $5,000,000 – $1,250,000

– $625,000 – $500,000
– $1,000,000 – $1,312,500
= $312,500

•  If the firm experiences a 25% growth rate

in sales, Pendleton can expect to raise
$312,500 during the coming year.

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 17.3 DEVELOPING A SHORT-
TERM FINANCIAL PLAN

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Developing a Short-Term Financial
Plan

A short-term financial plan is typically

presented in the form of a cash budget that
contains details concerning the firm s cash
receipts and disbursements. It includes the
following main elements:
–  Cash receipts,
–  Cash disbursements,
–  Net change in cash, and
–  New financing needed.

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Uses of the Cash Budget

1.  It is a useful tool for predicting the amount

and timing of the firm s future financing
requirements.

2.  It is a useful tool to monitor and control

the firm s operations.

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Table 17.3 Melco Furniture, Inc. Cash Budget for
the Six Months Ended June 30, 2014

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Key Terms

•  Cash budget
•  Discretionary financing needs (DFN)
•  Discretionary sources of financing
•  Long-term financial plan
•  Percent of sales method
•  Pro forma balance sheet
•  Pro forma income statement
•  Short-term financial plan
•  Sources of spontaneous financing
•  Strategic plan

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