This document provides an overview of financial planning and forecasting concepts. It discusses how financial managers prepare projected financial statements to assess future performance and financing needs. The key components of a financial plan are outlined, including sales forecasting, pro forma income statements, balance sheets, and cash flow statements. Methods for sales forecasting and preparing pro forma statements are explained. The concepts of internal growth rate, sustainable growth rate, and external financing requirements are defined and formulas are provided. The importance of financial planning and how balance sheet ratios may change over time are also summarized.

1. December 2022, DUBIA

2. Participants
• Tell us something about
YOU! A Two Minute
Elevator Speech!
• Name
• Background
• Expectations for this
course

3. 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

4. INTRODUCTION
Financial manager prepare pro forma or projected financial statements as to:
Assess whether the firm's forecasted performance squares with its own targets and
with the expectation of investors.
Examine the effect of proposed operating changes
Anticipate the financing needs of the firm
Estimate the future free cash flow.

5. THE PLANNING SYSTEM
Goals
Strategy
Research and
development
policy
Research and
development
budget
Marketing
policy
Marketing
budget
Production
policy
Personnel
policy
Financial
policy
Production
budget
Personnel
budget
Capital budget
and financing
plan
FINANCIAL PLAN
Profit and loss account
Balance sheet
Cash flow statement

6. COMPONENTS OF A FINANCIAL PLAN
 Economic Assumptions: Financial plan is based on certain assumptions about the economic
environment such as Interest rate, tax rate, inflation rate, growth rate, exchange rate etc
 Sales Forecast: Starting point of the financial forecasting exercise .
 Proforma Statements: Proforma P&L , Cash flow & Balance Sheet.
 Asset Requirements: Projected capital Investments & Working capital requirement.
 Financing Plan: Sources of financing for supporting capital expenditure & working capital.
For developing an explicit financial plan , capital budgeting decision, working capital decision,
capital structure decision and dividend decision have to be established.

7. BENEFITS OF A FINANCIAL PLAN
 Identifies advance actions to be taken in various areas.
Seeks to develop a number of options in various areas that can be exercised under different
conditions.
Facilitates a systematic exploration of interaction between investment and financing decisions.
Clarifies the links between present and future decisions.
Forecasts what is likely to happen in future and hence helps in avoiding surprises.
Ensures that the strategic plan of the firm is financially viable.
Provides benchmarks against which future performance inay be measured.

8. SALES FORECAST
 The sales forecast is typically the starting point of the financial forecasting exercise.
Sales forecasts may be prepared for varying planning horizons to serve different purposes
A sales forecast for a period of 3-5 years, or for even longer durations, may be developed mainly to
aid investment planning. Sales forecasts for shorter durations (six months, three months, one month)
may be prepared for facilitating working capita1 planning and cash budgeting.
 Sales forecasting techniques fall into three broad categories:
 Qualitative techniques : Based on Judgment
 Time series projection methods : Past behavior of time series
 Causal models – Develop forecast based on Cause & Effect relationship.

9. INTERNAL GROWTH RATE
While firms are interested in growth, they may be reluctant to raise external equity. Given
this reluctance, it is useful to calculate two growth rates in the context of long-term financial
planning: the internal growth rate and the sustainable growth rate.
Internal growth Rate :It is the maximum rate at which a firm can grow (in terms of sales or
assets) without external financing of any kind. Put differently, this is the growth rate that can be
sustained with retained earnings, which represent internal financing
Assumptions:
1. The assets of the firm will increase proportionally to sales.
2. The net profit margin (net profit to sales) is constant..
3. The dividend payout ratio (and the plough back ratio) is given.
4. Firm wants to grow by retention it does not raise external funds (neither equity or debt) to
finance assets.
Addition to assets = Addition to retained earnings
IGR = ROA * b
1 – (ROA * b)

10. INTERNAL GROWTH RATE
Internal growth rate = Net profit margin x Asset turnover x Plough back ratio
1 - Net profit margin x Asset turnover x Plough back ratio
Return on assets = Net profit margin x Asset turnover
Internal growth rate = Return on assets x Plough back ratio
1 - Return on assets x Plough back ratio
IGR = ROA * b
1 – (ROA * b)
To illustrate, suppose the return on assets and plough back ratio for Acme Chemicals are
12 percent and 60 percent respectively. What is the internal growth rate? The internal growth
rate is = 0.12 * 0.6 = 0.78 or 7.8 %
1- (0.12 -0.6)

11. SUSTAINABLE GROWTH RATE
The sustainable growth rate is the maximum growth rate that a firm can achieve
without
resorting to external equity finance. This is the growth rate that can be sustained with
the
help of retained earnings matched with debt financing, in line with the debt-equity
policy of
the firm.
This is an important growth rate because firms are reluctant to raise external equity
finance
(even though they may not mind raising debt finance, in line with their debt -equity
policy)
for the following reasons:
(i) The dilution of control, consequent to the external equity issue, may not be
acceptable to the existing controlling interest.
(ii) There may be a significant degree of under pricing when external equity is raised.
(iii) The cost of issue tends to be high

12. SUSTAINABLE GROWTH RATE
It is the maximum rate at which the firm can grow by using both internal sources (Retained
Earnings) as well as additional external debt but without increasing 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 of finance.
SGR= Net profit margin x Asset turnover x (1 +Debt -equity ratio) x Plough back ratio
1- Net profit margin x Asset turnover x (1 +Debt -equity ratio) x Plough back ratio
Net profit = Net profit x Sales x Average Total assets
Average Equity Sales Average Total Assets Average Equity
(ROE) NPM ATR ( 1+ Debt / Equity)
Sustainable growth rate = Return on equity x Plough back ratio
1 - Return on equity x Plough back ratio

13. SUSTAINABLE GROWTH RATE
SGR = ROE * b
1 – (ROE * b)
Given the assumptions it enables the corporate to maintain the existing
ROE besides target D/E ratio and the target D/P ratio
SGR = NP*AT* A/E * b
1- (NP*AT* A/E * b)
Examining Eq. we find that other things being equal:
The higher the net profit margin, the higher the sustainable growth rate.
The higher the asset turnover, the higher the sustainable growth rate.
The higher the debt-equity ratio, the higher the sustainable growth rate.
The higher the plough back ratio, the higher the sustainable growth rate.

14. SUSTAINABLE GROWTH RATE
SGR of the firm can increased by any one or more of the following factors:
1. Increase in Net profit Margin
2. Increase in Asset turnover ratio
3. Increase in financial leverage
4. Increase in retention ratio (or Decrease in the dividend payout ratio).
Concluding Remarks: When a company grows @ higher than its SGR,it has
better operating margin (Higher NPM or ATR) or it is prepared to revise its
financing policy (by Increasing its RR or its D/E financial leverage ratio)
In case firm anticipates it is not possible to improve operating performance
nor it is willing to assume more risk it is prefer to grow at SGR or a rate
lower to conserve financial resources to avoid problem of liquidity &
solvency in future.

15. PRO FORMA PROFlT AND LOSS ACCOUNT
 There are two commonly used methods for preparing the pro forma profit and
loss account - the percent of sales method and the budgeted expense method.
Percent of Sales Method :The percent of sales method for preparing the pro
forma profit and loss account is fairly simple. Basically, this method assumes
that the future relationship between various elements of costs to sales will be
similar to their historical relationship. When using this method, a decision has
to be taken about which historical cost ratios to be used: Should these ratios
pertain to the previous year, or the average of two or more previous years?

16. 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 Sales
Net sales 1200 1280 100 . 0 1400 . 0
Cost of goods sold 775 837 65 . 0 910 . 0
Gross profit 425 443 35 . 0 490 . 0
Selling expenses 25 27 2 . 1 29 . 4
General and administration
expenses 53 54 4 . 3 60 . 2
Depreciation 75 80 6 . 3 88 . 2
Operating profit 272 282 22 . 3 312 . 2
Non-operating surplus/ deficit 30 32 2 . 5 35 . 0
Profit before interest and tax 302 314 24 . 8 347 . 2
Interest on bank borrowings 60 65 5 . 0 70 . 0
Interest on debentures 58 60 4 . 8 67 . 2
Profit before tax 184 189 15 . 0 210 . 0
Tax 82 90 6 . 9 96 . 6
Profit after tax 102 99 8 . 1 113 . 4
Dividends 60 63
Retained earnings 42 36

17. BUDGETED EXPENSE METHOD
 Budgeted Expense Method :The percent of sales method, though simple, is too rigid and
mechanistic. For deriving the pro forma profit and loss account we assumed that all elements
of costs and expenses bore a strictly proportional relationship to sales. The budgeted expense
method, on the other hand, calls for estimating the value of each item on the basis of
expected developments in the future period for which the pro forma profit and loss account
is being prepared. Obviously, this method requires greater effort on the part of management
because it calls for defining Likely developments.
A Combination Method: For certain items, which have a fairly stable relationship with
sales, the percent of sales method is quite adequate. For other items, where future is likely to
be very different from the past, the budgeted expense method, which calls for managerial
assessment of expected future developments.

18. PROFORMA PROFIT & LOSS ACCOUNT
COMBINATION METHOD
Historical Data Average Proforma
Percent Profit and loss
20X1 20X2 of sales account of for
20X3
Net sales 1200 1280 100.0 1400.0
Cost of goods sold 775 837 65.0 910.0
Gross profit 425 443 35.0 490.0
Selling expenses 25 27 2.1 29.4
General and administration 53 54 Budgeted 56.0
Depreciation 75 80 Budgeted 85.0
Operating profit 272 282 @ 319.6
Non-operating surplus/ deficit 30 32 2.5 35.0
Profit before interest and tax 302 314 @ 354.6
Interest on bank borrowings 60 65 5.0 70.0
Interest on debentures 58 60 Budgeted 65.0
Profit before tax 184 189 @ 219.6
Tax 82 90 Budgeted 90.0
Profit after tax 102 99 @ 129.6
Dividends 60 63 Budgeted 70.0
Retained earnings 42 36 @ 59.6

19. PROFORMA BALANCE SHEET
 The projections of various items on the assets & liabilities side of the balance sheet
are derived as follows: Item Basis of Projection
Current Assets Percent of sales method wherein the proportion
are based on the average for the previous two
years.
Fixed Assets Same as above
Investments Assumptions of no change
Miscellaneous Exp Same as above
Current Liabilities &
Provision
Percent of sales method wherein the proportion
are based on the average for the previous two
years.
Equity & Preference
Capital
Previous values
Reserves & Surplus Proforma Income Statement
Debentures Previous values
Bank Borrowings Percent of sales method wherein the proportion
are based on the average for the previous two
years.
Unsecured loans Same as above

20. 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 1400
Net sales 1200 1280 100.0 1400.0
Assets
Fixed assets (net) 800 850 66.5 931.0
Investments 30 30 No change 30
Current 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 58.8
Miscellaneous expenditures and losses 20 20 No change 20
Total 1500 1575 1727.2
Liabilities
Share capital
• Equity 250 250 No change 250.0
• Preference 50 50 No change 50.0
Reserves and surplus 250 286 Proforma income 345.6
statement
Secured loans
• Debentures 400 400 No change 400
• Bank borrowings 300 305 24.4 341.6
Unsecured loans
• Bank borrowings 100 125 9.1 127.4
Current liabilities and provisions
• Trade creditors 100 112 8.5 119.0
• Provisions 50 47 3.9 54.6
External funds requirement Balancing figure 39.0
Total 1500 1575 1727.2

21. GROWTH AND EXTERNAL FINANCING
REQUIREMENT
When ratios remain constant financing requirement can be estimated as follows:
EFR = A/S (△S) – L/S (△S) – mS1 (1 – d) – (△IM + SR)
EFR = external funds requirement
A/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 & Losses
SR = Schedule repayment of term loans & debentures

22. GROWTH AND EXTERNAL FINANCING
REQUIREMENT
Manipulating Eq. a bit, we get
EFR A L m (1 + g) (1 – d)
△S S S g
Illustration
A/S = 0.90, △S = Rs. 6 million, L/S = 0.40,
M = 0.05, S1 = Rs. 46 million, and d = 0.6
EFR = (0.90) (6) – (0.4) (6) – (0.05) (46) (0.4)
= Rs. 2.08 million
EFR 0.05 (1 + g) (1 – 0.60)
△S g
0.20 (1 + g) See Excel Sheet
g
g (%) 5 10 15 20 25
EFR/△S 0.08 0.28 0.35 0.38 0.42
= – –
= 0.50 –
= 0.50 –

23. FORECASTING WHEN THE BALANCE SHEET RATIOS
CHANGE
In our discussion so far we assumed that the ratios of assets and liabilities to sales (A/S and
L / S ) remain constant over time. This implies that each 'spontaneous' asset and liability
account changes at the same rate as sales. Graphically, it means that the relationship is linear
and passes through the origin as shown in Exhibit
The assumption of constant ratios and identical growth rates may be appropriate sometimes,
but not always. In particular, its applicability is suspect in the following situations,

24. FORECASTING WHEN THE BALANCE SHEET RATIOS
CHANGE
Economies of Scale: In the use of many kinds of assets, economies of scale occur. This means
that the ratios change over time as the size of the firm increases. For example, as sales expand
inventories grow less rapidly than sales and hence the ratio of inventory to sales falls. Here
we find that the inventory-to-sales ratio is 0.5 or 50 per cent, when sales are Rs 200 million,
but the ratio declines to 0.45 or 45 percent when sales rise to Rs 400 million.
The relationship depicted in Exhibit 5.6(b) is linear, but not one that passes through the
origin. Often, however, a curvilinear relationship of the kind shown in Exhibit 5.6(c) obtains.
In such a situation, larger increases in sales can be supported by smaller increases in inventories.

25. FORECASTING WHEN THE BALANCE SHEET RATIOS
CHANGE
Lumpy Assets: In many industries, fixed assets have to be added in large, discrete units
due to technological reasons. Due to such lumpy increments of fixed assets, the relationship
between fixed assets and sales is as shown in Exhibit
Forecasting Errors and Excess Assets : The relationships depicted in Exhibit reflect target, or
projected, relationship between sales and assets. Actual sales often differ from projected
sales and hence the actual asset/sales ratio may differ from the planned ratio.
To illustrate, suppose that a firm has a fixed assets to sales ratio of 1:2 and, in anticipation of an
increase in sales from Rs 200 million to Rs 300 million, it increases its fixed assets from Rs 100
million to Rs 150 million. However, if the sales remain stagnant at Rs 200 million, it will have an
excess capacity which can support a sales increase of Rs 100 million. In such a situation, if the
firm were to prepare its forecast for the following year it should recognize that additional sales of
Rs 100 million will require no further investment in fixed assets.

26. INTERNAL GROWTH RATE
While firms are interested in growth, they may be reluctant to raise external equity. Given
this reluctance, it is useful to calculate two growth rates in the context of long-term financial
planning: the internal growth rate and the sustainable growth rate.
Internal growth Rate :It is the maximum rate at which a firm can grow (in terms of sales or
assets) without external financing of any kind. Put differently, this is the growth rate that can be
sustained with retained earnings, which represent internal financing
Assumptions:
1. The assets of the firm will increase proportionally to sales.
2. The net profit margin (net profit to sales) is constant..
3. The dividend payout ratio (and the plough back ratio) is given.
4. Firm wants to grow by retention it does not raise external funds (neither equity or debt) to
finance assets.
Addition to assets = Addition to retained earnings
IGR = ROA * b
1 – (ROA * b)

27. INTERNAL GROWTH RATE
Internal growth rate = Net profit margin x Asset turnover x Plough back ratio
1 - Net profit margin x Asset turnover x Plough back ratio
Return on assets = Net profit margin x Asset turnover
Internal growth rate = Return on assets x Plough back ratio
1 - Return on assets x Plough back ratio
IGR = ROA * b
1 – (ROA * b)
To illustrate, suppose the return on assets and plough back ratio for Acme Chemicals are
12 percent and 60 percent respectively. What is the internal growth rate? The internal growth
rate is = 0.12 * 0.6 = 0.78 or 7.8 %
1- (0.12 -0.6)

28. SUSTAINABLE GROWTH RATE
The sustainable growth rate is the maximum growth rate that a firm can achieve
without
resorting to external equity finance. This is the growth rate that can be sustained with
the
help of retained earnings matched with debt financing, in line with the debt-equity
policy of
the firm.
This is an important growth rate because firms are reluctant to raise external equity
finance
(even though they may not mind raising debt finance, in line with their debt -equity
policy)
for the following reasons:
(i) The dilution of control, consequent to the external equity issue, may not be
acceptable to the existing controlling interest.
(ii) There may be a significant degree of under pricing when external equity is raised.
(iii) The cost of issue tends to be high

29. SUSTAINABLE GROWTH RATE
It is the maximum rate at which the firm can grow by using both internal sources (Retained
Earnings) as well as additional external debt but without increasing 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 of finance.
SGR= Net profit margin x Asset turnover x (1 +Debt -equity ratio) x Plough back ratio
1- Net profit margin x Asset turnover x (1 +Debt -equity ratio) x Plough back ratio
Net profit = Net profit x Sales x Average Total assets
Average Equity Sales Average Total Assets Average Equity
(ROE) NPM ATR ( 1+ Debt / Equity)
Sustainable growth rate = Return on equity x Plough back ratio
1 - Return on equity x Plough back ratio

30. SUSTAINABLE GROWTH RATE
SGR = ROE * b
1 – (ROE * b)
Given the assumptions it enables the corporate to maintain the existing
ROE besides target D/E ratio and the target D/P ratio
SGR = NP*AT* A/E * b
1- (NP*AT* A/E * b)
Examining Eq. we find that other things being equal:
The higher the net profit margin, the higher the sustainable growth rate.
The higher the asset turnover, the higher the sustainable growth rate.
The higher the debt-equity ratio, the higher the sustainable growth rate.
The higher the plough back ratio, the higher the sustainable growth rate.

31. SUSTAINABLE GROWTH RATE
SGR of the firm can increased by any one or more of the following factors:
1. Increase in Net profit Margin
2. Increase in Asset turnover ratio
3. Increase in financial leverage
4. Increase in retention ratio (or Decrease in the dividend payout ratio).
Concluding Remarks: When a company grows @ higher than its SGR,it has
better operating margin (Higher NPM or ATR) or it is prepared to revise its
financing policy (by Increasing its RR or its D/E financial leverage ratio)
In case firm anticipates it is not possible to improve operating performance
nor it is willing to assume more risk it is prefer to grow at SGR or a rate
lower to conserve financial resources to avoid problem of liquidity &
solvency in future.

32. SOLVED PROBLEMS

33. SOLVED PROBLEMS

34. SOLVED PROBLEMS

35. UNSOLVED PROBLEMS

36. UNSOLVED PROBLEMS
The pro forma income statement of Modern Electronics Ltd for year 3 based on the per cent of sales method
is given below

37. UNSOLVED PROBLEMS
The pro forma income statement of Modern Electronics for year 3 using the
combination method is given below

38. UNSOLVED PROBLEMS
As in problem 1, assume that sales will grow to 1020 in year 3. Assume that all items on the assets
side, except investment and miscellaneous expenditures and losses, will grow proportionally to
sales. Likewise, trade credit and provisions will be proportional to sales. Obtain the estimated
value of retained earnings from the pro forma profit and loss account developed in problem 2.
Finally estimate the amount of external financing needed for year 3.

39. UNSOLVED PROBLEMS
The pro forma balance sheet of Modern Electronics Ltd for year 3 is given below

40. UNSOLVED PROBLEMS

41. UNSOLVED PROBLEMS

42. UNSOLVED PROBLEMS

43. UNSOLVED PROBLEMS

44. UNSOLVED PROBLEMS

45. UNSOLVED PROBLEMS

46. UNSOLVED PROBLEMS
Solving the above equation we get g = 7.14%

47. UNSOLVED PROBLEMS

48. UNSOLVED PROBLEMS

49. UNSOLVED PROBLEMS

50. UNSOLVED PROBLEMS

51. UNSOLVED PROBLEMS