CHAPTER 4

FINANCIAL
FORECASTING
AND PLANNING
 An Overview of Financial Planning
2

 What is the primary objective of preparing

financial plans?
 To estimate the future financing requirements in advance
of when the financing will be needed.

 The process of planning is critical to force

managers to think systematically about the future,
despite the uncertainty of future.

Siti Aishah Kassim (FM1n2)

An Overview of Financial Planning (cont.)
3

 Most firms engage in three types of planning:

 Strategic planning,

 Long-term financial planning, and

 Short-term financial planning

 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.

Siti Aishah Kassim (FM1n2)

An Overview of Financial Planning (cont.)
4

 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 for each year of the
planning horizon.

Siti Aishah Kassim (FM1n2)

An Overview of Financial Planning (cont.)
5

 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 is a cash budget, which
contains detailed revenue projections and expenses
in the month in which they are expected to occur
for each operating unit of the company.

Siti Aishah Kassim (FM1n2)

 Developing Long-Term Financial Plan
6

 Forecasting a firm’s future financing needs

using a long-term financial plan can be
thought of in terms of three basic steps:
1. Construct a sales forecast
2. Prepare pro-forma financial statements
3. Estimate the firm’s financing needs

Siti Aishah Kassim (FM1n2)

Developing a Long-Term Financial Plan (cont.)
7

 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.

Siti Aishah Kassim (FM1n2)

Developing a Long-Term Financial Plan (cont.)
8

 Step 2: Prepare Pro Forma Financial Statements

 Pro forma financial 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.

Siti Aishah Kassim (FM1n2)

Developing a Long-Term Financial Plan (cont.)
9

 Step 3: Estimate the Firm’s Financing Needs

 Using the pro forma statements we can extract the cash

flow requirements of the firm.

Siti Aishah Kassim (FM1n2)

 Financial Forecasting Example
10

 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.

Siti Aishah Kassim (FM1n2)

Financial Forecasting Example (cont.)
11

 Step 1: Forecast Revenues and Expenses

 Zeigen’s financial analyst estimate the firm will earn 5%

on the projected sales of $12 million in 2010.
 Zeigen plans to retain half of its earnings and distribute
the other half as dividends.
 See Table 17-1

Siti Aishah Kassim (FM1n2)

Siti Aishah Kassim (FM1n2) 12
Financial Forecasting Example (cont.)
13

 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 2010.

Siti Aishah Kassim (FM1n2)

Financial Forecasting Example (cont.)
14

 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.

Siti Aishah Kassim (FM1n2)

 Sources of Spontaneous Financing –
Accounts Payable and Accrued Expenses
15

 Accounts payable and accrued expenses are typically

the only liabilities that vary directly with sales.
 Accounts payable and accrued expenses are referred to
as sources of spontaneous financing. The percent
of sales method can be used to forecast the levels of
both these sources of financing.

Siti Aishah Kassim (FM1n2)

 Sources of Discretionary Financing
16

 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.

Siti Aishah Kassim (FM1n2)

 Summarizing Ziegen’s Financial Forecast
17

 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

Siti Aishah Kassim (FM1n2)

 Summarizing Ziegen’s Financial Forecast
(cont.)
18

 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).

Siti Aishah Kassim (FM1n2)

 Summarizing Ziegen’s Financial Forecast
(cont.)
19

Siti Aishah Kassim (FM1n2)

 Analyzing the Effects of Profitability and Dividend
Policy on the Firm’s DFN
20

 After projecting DFN, we can easily evaluate the

sensitivity of DFN to changes in key variables.

 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.

Siti Aishah Kassim (FM1n2)

 Analyzing the Effects of Profitability and Dividend
Policy on the Firm’s DFN (cont.)
21

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

Siti Aishah Kassim (FM1n2)

 Analyzing the Effects of Sales Growth on a
Firm’s DFN
22

 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.

Siti Aishah Kassim (FM1n2)

Siti Aishah Kassim (FM1n2) 23
Siti Aishah Kassim (FM1n2) 24
 Developing Short-Term Financial Plan
25

 Unlike a long-term financial plan that is prepared

using pro forma income statements and balance
sheets, 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.

Siti Aishah Kassim (FM1n2)

 Developing Short-Term Financial Plan
(cont.)
26

 Cash budget includes the following main

elements:
 Cash receipts,
 Cash disbursements,

 Net change in cash, and

 New financing needed.

Siti Aishah Kassim (FM1n2)

Siti Aishah Kassim (FM1n2) 27
 Uses of the Cash Budget
28

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.

Siti Aishah Kassim (FM1n2)

 Uses of the Cash Budget (cont.)
29

 The actual cash receipts and disbursements can be

compared to budgeted estimates, bringing to light
any significant differences.

 In some cases, the differences may be caused by

cost overruns or poor collection from credit
customers. Remedial action can then be taken.

Siti Aishah Kassim (FM1n2)

 30

THE END

Siti Aishah Kassim (FM1n2)