Financial Management-II Financial planning and forecasting

1. Chapter Three
Financial
Forecasting
AcFn 3042 Chap. III FM II 1
Financial Management II (ACFN 3042)

2. ◼ Meaning:
❑ is a continuous process of directing and allocating
financial resources to meet strategic goals and
objectives.
◼ Concern:
❑ it is concerned with identifying the need for funding,
term of funding, and sources of funding.
Term Source
Spontaneous
Internal
Debt
Equity
Need
•
•
Short-term
Long-term
•
•
•
•
Initial Inv.
Expansion
Diversification
Refinancing
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AcFn 3042 Chap. III FM II
Financial Planning: Meaning and Concern

3. ◼ Economic Assumption
❑ Interest rate, inflation rate, growth rate,
exchange
◼ Sales forecast
❑ The starting point for financial forecasting.
◼ Pro forma statements
❑ Are the heart of financial plan
◼ Asset requirements
rate, etc
❑ Projected capital investment and WC requirements
◼ Financing Plan
❑ Define the proposed means of financing
◼ Cash budget
❑ Shows the cash inflow and outflow
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AcFn 3042 Chap. III FM II
Common Elements of a financial plan

4. Identifies
areas.
advance actions to be taken in various
◼
Seeks to develop a number of options in various areas
that can be exercised under different conditions.
◼
Facilitates a systemic exploration of interaction
◼
between investment and financing decisions.
Clarifies the link between present and future decisions
◼
Ensures that the strategic plan of the
viable
firm is financially
◼
Provides benchmarks against which future
◼
performance may be measured
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AcFn 3042 Chap. III FM II
Why Financial planning

5. Financial Forecasting
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AcFn 3042 Chap. III FM II

6. ◼ Financial forecasting is a process which involves:
❑ evaluation of a firm’s need for
productive capacity and
increased or reduced
❑ evaluation of the firm’s need for
◼ An accurate financial forecast is
firm as it helps
additional finance
very important to any
❑ to predict appropriate demand for its products.
to project its sales and accordingly to predict its assets
properly.
❑ It
It
a
contributes significantly to the firm’s profitability.
plays a crucial role in the value maximization goal of
firm.
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AcFn 3042 Chap. III FM II
Financial Forecasting

7. ◼ There are two methods to determine the additional
financial requirements. These are:
◼ The pro-forma financial statements method and
◼ The AFN Model /formula method/
◼ The major outcome of these methods is to estimate
the company's future need for external financing
(EFN or AFN).
◼ EFN or AFN are funds that the company must raise
externally
promissory
through borrowing (bank loans,
notes, bonds, etc.) or by issuing new
shares of common or preferred stock.
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AcFn 3042 Chap. III FM II
Methods of Financial Forecasting

8. ◼ Is the most widely used vehicle for financial
forecasting.
◼ Is simply a prediction of what the company’s financial
forecast
statements
period.
will look like at the end of the
◼ The percent-of-sales model forecast does provide
simple, logical estimates of many important variables
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AcFn 3042 Chap. III FM II
Pro-forma financial statement method

9. Illustration
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AcFn 3042 Chap. III FM II

10. Procedures:
Estimate Increase in sales
1.
Inc. in sales= current sales x expected inc in sales in %
Estimate additional investment in fixed assets
2.
If a firm is operating at full capacity, increase in sales requires
proportional investment in fixed assets. Hence,
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AcFn 3042 Chap. III FM II
Inc. In FA= (Cu. FA / Cu. Sales) * Inc. in Sales
Percentage of Sales Model

11. 3. Estimate increase in current assets
4. Estimate spontaneously generated funds/SGF/
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AcFn 3042 Chap. III FM II
Inc. in CA=CA/Cu. Sales x Inc. in Sales
Percentage of Sales Model

12. SGF:
- are funds that are obtained automatically from
routine business transactions.
- Arise from the purchase of goods & services
on credit, such as accounts payable and
accruals
- Are
that
equal to increases in current liabilities
are directly proportional to sales.
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AcFn 3042 Chap. III FM II
Percentage of Sales Model

13. SGF formula:
SGF=[Spontaneous Liab. /Cu. Sales] x Inc. in
Sales
5. Estimate Internally Generated Funds/IGF/
- These are funds obtained from
in the form of RE
internal sources
- Computed as:
IGF= Projected NI - Projected cash dividend
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AcFn 3042 Chap. III FM II
Percentage of Sales Model

14. 6. Additional Funds Needed (AFN)
- Refers to amount of funds that should be
obtained from external sources
debt capital or equity capital
Formula:
in the form of
AFN= [Inc. in FA + Inc. in
Note, though, that if a company is
CA] –
growing
[SGF + IGF]
very slowly and
thus not increasing assets very much, its spontaneous
funds plus its addition to retained earnings may be larger
than the required increase in assets.
In that case, the AFN is negative, indicating that a surplus of
capital is forecasted
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AcFn 3042 Chap. III FM II
Percentage of Sales Model

15. This is a much easier method of determining
◼
additional financial requirements than the pro
forma method.
The formula method is a shortcut to financial
◼
forecasting.
However,
method
many
of
companies
forecasting
use the pro forma
◼
their financial
the formula
requirements because the output of
method is less meaningful.
Under the shortcut method, we make the
◼
following assumptions.
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AcFn 3042 Chap. III FM II
The formula method

16. ◼ Assumptions:
❑ Each asset maintains a direct proportionate
relationship with sales
❑ Accounts payable and accruals increase in direct
proportion to sales increase
❑ The profit margin
are constant.
◼ Formula:
and the dividend pay-out ratios
◼ AFN = Required
Liab. – inc in RE
Inc. in Assets – Spontaneous Inc. in
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AcFn 3042 Chap. III FM II
The formula method

17. A0
( )S  (L0 / S0 )S  MS1 (1 d )
S
◼ AFN = 0
where:
A0 / S0  capital int ensity ratio
S  S1  S0
S1  Pr ojected sales
S0  Sales at time 0
L / S0  Spontan eous Liab. to
sales
M  Net profit m arg in
d  dividend payoutratio
A0  Total Assetsattime 0
L0  Total Spontan eous
Liabilities
at time 0
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AcFn 3042 Chap. III FM II
The formula method

18. T and T Private Limited Company (PLC) had sales of Br.
◼
5 million and total assets of Br. 4.6 million in 2019
(assume 65% of this fixed). The current liabilities during
the end of the same year were Br. 1.15 million. The
PLC’s net profit margin and dividend pay-out ratios are
4.5% and 35% respectively. All assets and current
liabilities
additional
will vary directly with sales. Determine the
are
funds needed (AFN) for 2020 if sales
projected to grow by 5% only.
Keeping all facts remains unchanged, what will be the
◼
AFN NPM is 6% and dividend payout ratio is 30%? What
does this imply?
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AcFn 3042 Chap. III FM II
Exercise

19. Excess Capacity Adjustment
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AcFn 3042 Chap. III FM II

20. ▪ The assumption of constant ratio between assets and
sales may not always hold true. In that case, the
percentage of sales model or Additional Funds Needed
model is not appropriate.
▪ The following are conditions under which constant ratios
are not maintained between asset and sales
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AcFn 3042 Chap. III FM II
EXCESS CAPACITY ADJUSTMENTS

21. Conditions
Economies of scale
1.
imply that as a plant gets larger and volume increases,
the average cost per unit of output drops. This is due to
lower operating and capital cost.
Plants also gain efficiencies when they become large
-
*
enough to fully utilize dedicated resources for tasks
such as materials handling, computer equipment, and
administrative support personnel.
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AcFn 3042 Chap. III FM II
EXCESS CAPACITY ADJUSTMENTS

22. 2. Lumpy Asset Increments
* Lumpy assets are assets that cannot be acquired in small
increments, but must be obtained (added) in large,
discrete units. Suppose, if we obtained that Br. 25,000 is
needed for additional investment in fixed assets, it may
be difficult to get fixed assets that exactly cost Br. 25,000.
The minimum prices for the lowest capacity fixed asset
may be Br. 45,000. Thus, if you decided to make
additional investment in fixed assets, you need to
purchase fixed assets of Br. 45,000 instead of Br. 25,000
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AcFn 3042 Chap. III FM II
EXCESS CAPACITY ADJUSTMENTS

23. 3. Excess assets due to forecasting errors
Actual assets to sales ratio may be different
from planned ratio because actual sales may
be different from planned sales. Actual
assets.
assets
assets may be different from planned
Excess capacity may occur in plant
and inventories
Read more on this !!!!
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AcFn 3042 Chap. III FM II
EXCESS CAPACITY ADJUSTMENTS

24. ◼
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AcFn 3042 Chap. III FM II
Illustration: Excess Capacity

25. ◼
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AcFn 3042 Chap. III FM II
Excess Capacity

26. Carter Corporation’s sales are expected to increase from
$5 million in 2008 to $6 million in 2009, or by 20%. Its
assets totaled $3 million at the end of 2008. Carter is at full
capacity, so its assets must grow in proportion to projected
sales. At the end of 2008, current liabilities are $1 million,
consisting of $250,000 of accounts payable, $500,000 of
notes payable, and $250,000 of accrued liabilities. Its profit
margin is forecasted to be 5%, and the forecasted retention
ratio is 30%.
◼
Use the AFN equation to forecast the additional funds
◼
Carter will need for the coming year.
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AcFn 3042 Chap. III FM II
Exercise

27. End of Chapter THREE
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AcFn 3042 Chap. III FM II