FINANCIAL PLANNING AND FORECASTING By Prof Sameer Lakhani
OUTLINE• The Planning System• What and Why of Financial Planning• Sales Forecast• Proforma Profit and Loss Account• Proforma Balance Sheet• Financial modeling using spreadsheets• Growth and External Financing Requirement• Key Growth Rates
THE PLANNING SYSTEM Goals StrategyResearch anddevelopment Marketing Production Personnel Financial policy policy policy policy policyResearch and Capital budgetdevelopment Marketing Production Personnel and financing budget budget budget budget plan FINANCIAL PLAN Profit and loss account Balance sheet Cash flow statement
COMPONENTS OF A FINANCIAL PLAN• Economic Assumptions• Sales Forecast• Proforma Statements• Asset Requirements• Financing Plan• Cash Budget
SALES FORECAST• The sales forecast is typically the starting point of the financial forecasting exercise.• Sales forecasting techniques fall into three broad categories: • Qualitative techniques : Based on Judgement • Time series projection methods : Past behavior of time series • Causal models – Develop forecast based on Cause & Effect relationship.
PROFORMA PROFIT & LOSS ACCOUNT PERCENT OF SALES METHOD Historical Data Pro forma profit and 20X1 20X2 Average loss account of 20X3 percent assuming sales of 1400 of SalesNet sales 1200 1280 100 . 0 1400 . 0Cost of goods sold 775 837 65 . 0 910 . 0Gross profit 425 443 35 . 0 490 . 0Selling expenses 25 27 2.1 29 . 4General and administrationexpenses 53 54 4.3 60 . 2Depreciation 75 80 6.3 88 . 2Operating profit 272 282 22 . 3 312 . 2Non-operating surplus/ deficit 30 32 2.5 35 . 0Profit before interest and tax 302 314 24 . 8 347 . 2Interest on bank borrowings 60 65 5.0 70 . 0Interest on debentures 58 60 4.8 67 . 2Profit before tax 184 189 15 . 0 210 . 0Tax 82 90 6.9 96 . 6Profit after tax 102 99 8.1 113 . 4Dividends 60 63
PROFORMA PROFIT & LOSS ACCOUNT COMBINATION METHOD Historical Data Average Proforma Percent Profit and loss 20X1 20X2 of sales account of for 20X3Net sales 1200 1280 100.0 1400.0Cost of goods sold 775 837 65.0 910.0Gross profit 425 443 35.0 490.0Selling expenses 25 27 2.1 29.4General and administration 53 54 Budgeted 56.0Depreciation 75 80 Budgeted 85.0Operating profit 272 282 @ 319.6Non-operating surplus/ deficit 30 32 2.5 35.0Profit before interest and tax 302 314 @ 354.6Interest on bank borrowings 60 65 5.0 70.0Interest on debentures 58 60 Budgeted 65.0Profit before tax 184 189 @ 219.6Tax 82 90 Budgeted 90.0Profit after tax 102 99 @ 129.6Dividends 60 63 Budgeted 70.0Retained earnings 42 36 @ 59.6
PROFORMA BALANCE SHEET Historical Data Projection for March March Average of Percent March 31, 20X3 31, 20X1 31, 20X1 of Sales or some other based on a fore- basis -cast sales of 1400Net sales 1200 1280 100.0 1400.0AssetsFixed assets (net) 800 850 66.5 931.0Investments 30 30 No change 30Current assets, loans and advances • Cash and bank 25 28 2.1 29.4 • Receivables 200 212 16.6 232.4 • Inventories 375 380 30.4 425.6 • Pre-paid expenses 50 55 4.2 58.8Miscellaneous expenditures and losses 20 20 No change 20 Total 1500 1575 1727.2LiabilitiesShare capital • Equity 250 250 No change 250.0 • Preference 50 50 No change 50.0Reserves and surplus 250 286 Proforma income 345.6 statementSecured loans • Debentures 400 400 No change 400 • Bank borrowings 300 305 24.4 341.6Unsecured loans • Bank borrowings 100 125 9.1 127.4Current liabilities and provisions • Trade creditors 100 112 8.5 119.0 • Provisions 50 47 3.9 54.6External funds requirement Balancing figure 39.0 Total 1500 1575 1727.2
ProblemPrepare the pro forma P&L & Balance sheet for the year 3 based on the followingassumptions.Projected sales for the year 3 is 850Forecast value for the following P&L accounts items may be derived using the percent ofsales method ( for this purpose assume that the average of the % for year 1 & 2 isapplicable)COGS , Selling Expenses, General & Admin exp , Non Operating surplus / deficit , InterestThe forecast values for the other items of the P&L account are as followsDepreciation 45Tax @ 50 %Dividends 21
ProblemForecast values for Balance sheet:Fixed assets : Budgeted at 300Investments : No change over 2 yearsCurrent assets : Percent of sales method wherein the percentages are based on the averageover 2 yearsMis expenditure & losses : Expected to be reduced to 5Equity & preference capital : No change over year 2Reserves & surplus : Proforma P & LBank borrowings & Current Liabilities & provision: Percent of sales method wherein thepercentages are based on the average over 2 yearsPublic deposit : No ChangeExternal fund required : Balancing figure
GROWTH AND EXTERNAL FINANCING REQUIREMENTEFR = A/S (△S) – L/S (△S) – mS1 (1 – d) – (△IM + SR)EFR = external funds requirementA/S = current assets and fixed assets as a proportion of sales△S = expected increase in sales L/S = current liabilities and provisions as a proportion of sales m = net profit margin S1 = projected sales for next year d = dividend payout ratio△IM = Change in level of Investment & miscellaneous Expenditure &
GROWTH AND EXTERNAL FINANCING REQUIREMENTManipulating Eq. a bit, we getEFR A L m (1 + g) (1 – d) = – –△S S S g IllustrationA/S = 0.90, △S = Rs. 6 million, L/S = 0.40, M = 0.05, S1 = Rs. 46 million, and d = 0.6EFR = (0.90) (6) – (0.4) (6) – (0.05) (46) (0.4) = Rs. 2.08 million EFR 0.05 (1 + g) (1 – 0.60) = 0.50 – △S g 0.20 (1 + g) = 0.50 – g g (%) 5 10 15 20 25EFR/△S 0.08 0.28 0.35 0.38 0.42
FORECASTING WHEN THE BALANCE SHEET RATIOS CHANGEThe assumption of constant ratios and identical growthrates may be appropriate sometimes, but not always. Inparticular its applicability is suspect in the followingsituations:• Economies of scale• Lumpy assets• Forecasting errors and excess assets
INTERNAL GROWTH RATEIt is the maximum rate at which a firm can grow (in terms of sales orassets) without external financing of any kind.Assumptions:1.Increase in asset of the firm in proportion of the sales.2.PAT margin is in direct proportion to sales.3.Firm has a target dividend payout ratio which is wants to maintain.4.Firm wants to grow by retention it does not raise external funds(neither equity or debt) to finance assets. IGR = ROA * b 1 – (ROA * b)
SUSTAINABLE GROWTH RATEIt is the maximum rate at which the firm can grow by using both internalsources (Retained Earnings) as well as additional external debt but withoutincreasing its financial leverage ( debt equity ratio).Additional Assumptions:1.The firm has a target capital structure (D/E ratio) which it wants to maintain.2.The firm does not intend to sell new equity shares as it is costly source offinance. SGR = ROE * b 1 – (ROE * b) Given the assumptions it enables the corporate to maintain the existingROE besides target D/E ratio and the target D/P ratio SGR = P*A* A/E * b 1- (P*A* A/E * b)
SUSTAINABLE GROWTH RATESGR of the firm can increased by any one or more of the following factors:1.Increase in Net profit Margin2.Increase in Asset turnover ratio3.Increase in financial leverage4.Increase in retention ratio (or Decrease in the dividend payout ratio). Concluding Remarks: When a company grows @ higher than itsSGR,it has better operating margin (Higher NPM or ATR) or it is prepared torevise its financing policy (by Increasing its RR or its D/E financial leverageratio) In case firm anticipates it is not possible to improve operatingperformance nor it is willing to assume more risk it is prefer to grow at SGR ora rate lower to conserve financial resources to avoid problem of liquidity &solvency in future.