Chapter 9: Financial Forecasting for Strategic Growth

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✎ Expected Learning Outcomes
After studying Chapter 9, you should able to:
1. Understand the concept and perspective of financial planning.
2. Explain the benefits that can be derived from financial planning.
3. Know the elements of a basic financial planning model.
4. Understand the determinants of a firm’s growth rates.
5. Know and apply the financial planning process using the Projected
Financial Statement Method (Percent of Sales Method).

Chapter 9: Financial Forecasting for Strategic Growth

INTRODUCTION

A lack of effective long-range planning is a commonly cited reason for

financial distress and failure. Long range planning is a means of
systematically thinking about the future and anticipating possible problems
before they occur. Planning is said to be a process that at best helps the firm
avoid stumbling into the future backward.

Financial planning establishes guidelines for change and growth in a firm. It

focuses on the big picture, which means that it is concerned with the major
elements of a firm’s financial and investment policies without dealing with
the individual components of those policies in detail.

9.1 WHAT IS FINANCIAL PLANNING?

Financial planning formulates the way in which financial goals are to be

achieved. A financial plan is thus, a statement of what is to be done in the
future. Many decisions have a long lead time which means they take a long
time to implement. In an uncertain world, this requires that decision made
far in advance of their implementation. For instance, if a firm wants to build
a factory in 2018, it might have to begin lining up contractors and financing
in 2016 or even earlier.

9.2 GROWTH AS FINANCIAL MANAGEMENT GOAL

As discussed in the earlier chapters, the appropriate goal is for the financial
manager is increasing the market value of the owner’s equity and not just
growth by itself. If the firm is successful in doing this then growth will
usually result. Growth may thus be a desirable consequence of good decision
making but it is not an end unto itself. However, while growth rate is used in
the planning process, it is considered a convenient means if summarizing

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Chapter 9: Financial Forecasting for Strategic Growth

various aspects of a firm’s financial and investment policies. Likewise, if we

think of growth as growth in the market value of the equity in the firm, then
goals of growth and increasing the market value of the equity in the firm are
not all that different.

9.3 PERSPECTIVE OF FINANCIAL PLANNING

For planning purposes, it is often useful to think of the future as having a

short-run and a long-run. The short-run planning, in practice, usually
covers the coming 12 months while financial planning over the long-run is
takes to be the coming two to five years. This time period is referred to as the
planning horizon and this is the first dimension of the planning process that
must be established.

The second dimension of the planning process that needs to be determined

is the level of aggregation. Aggregation involves the determination of all of the
individual projects together with the investment required that the firm will
undertake and adding up these investment proposals to determine the total
needed investment which is treated as one big project.

After planning horizon and level of aggregation are established, a financial

plan requires inputs in the form of alternative sets of assumptions about
important variables. This type of planning is particularly important for
cyclical businesses or business firms whose sales are strongly affected by
the overall state of the economy or business cycles.

9.4 WHAT ARE THE BENEFITS THAT CAN BE DERIVED FROM

FINANCIAL PLANNING?
Due to the amount spent in examining the different scenarios and variables
that will eventually become the basis for a company’s financial plan, it seems
reasonable to ask what the planning process will accomplish.

Among the more significant benefits of derived from financial planning are
the following.
1. Provides a rational way of planning options or alternatives.
The financial plan allows the firm to develop, analyse and compare many
different business scenarios in an organized and consisted way. Various
investment and financing options can be explored, and their impact on the
firm’s shareholders can be evaluated. Questions concerning the firm’s future
lines of business and optimal financing arrangements are addressed.
Options such as introducing new products or closing plants might be
evaluated.

2. Interactions or Linkages between investment proposals are

carefully examined.
The financial plan enables the proponents to show explicitly the linkages
between investment proposals for the different operating activities of the firm

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Chapter 9: Financial Forecasting for Strategic Growth

and its available financing choices. For example, if the firm is planning on
expanding or undertaking new investments and projects, all other relevant
variables such as source, terms and timing of financing are thoroughly
examined.

3. Possible problems related to the proposal projects are identified

actions to address them are studied.
Financial planning should identify what may happen to the firm if different
events take place. Specifically, it should address what actions the firm will
take if expectations do not materialize and more generally, if assumptions
made today about the future are seriously in error. Thus, one objective of
financial planning is to avoid surprises and develop contingency plans.

4. Feasibility and internal consistency are ensured.

Financial planning is a way of verifying that the goals and plans made for
specific areas of a firm’s operations are feasible and internally consistent.
The financial plan makes explicit the linkages between different aspects of a
firm’s business such as the market share, return on equity, financial
leverages, and so on. It also imposes a unified structure for reconciling goals
and objectives.

5. Managers are forced to think about goals and establish priorities.

Through financial planning, directions that the firm would take are
established, risks are calculated and educated alternative courses of action
are considered thoroughly.

9.5 FINANCIAL PLANNING MODELS

Financial planning process will differ from firm to firm, just as companies
differ in size and products. However, basic financial planning model will have
the following common elements; (a) economic environment assumptions, (b)
sales forecast, (c) pro forma statements, (d) asset requirements, (e) financial
requirement, and (f) additional funds needed.

1. Economic Environment Assumption. The plan will have to state

explicitly the economic environment in which the firm expects to reside
over the life of the plan. Among the more important economic
assumption that will have to be made are the inflation rates, level of
interest rates and the firm’s tax rate.

2. Sales Forecast. An external supplied sales forecast considered the

“driver” shall be the “heart” of all financial plans. The user of the
planning model will supply this value and most other values will be
calculated based on it. Planning will focus on projected future sales
and the assets and financing needed to support those sales.

Oftentimes, the sales forecast will be given as the growth rate in sales rather
than as an explicit sales figure. Perfect sales forecast is not possible, of

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Chapter 9: Financial Forecasting for Strategic Growth

course, because sales depend on the uncertain future state of the economy.
To come up with its projections, firms could consult with some businesses
which specialize in macroeconomic and industry projections. Also,
evaluating alternative scenarios does not require sales forecast to be very
accurate because the financial planner’s goal is to examine the interplay
between investment and financing needs at different possible sales level, not
to pinpoint what we expect to happen.

Determinants of Growth Rates

A firm’s ability to sustain growth depends explicitly on the following factors:
 Profit Margin. An increase in profit margin will increase the firm’s
ability to generate funds internally and thereby increase its
sustainable growth.

 Dividend Policy. A decrease in the percentage of net income paid out

as dividends will increase the retention ratio. These increases
internally generated equity and thus increases sustainable growth.

 Financial Policy. An increase in the debt-equity ratio increases the

firm’s financial leverage. Because this makes additional debt financing
available, it increases the sustainable growth rate.

 Total Asset Turnover. An increase in the firm’s total asset turnover

increases the sales generated for each peso in assets. This decreases
the firm’s need for new assets as sales grow and thereby increases the
sustainable growth rate. Notice that total asset turnover is the same
thing as decreasing capital intensity.

The sustainable growth rate is a very useful planning number. What it

illustrates is the explicit relationship between the firm’s four major areas of
concern: (a) Its operating efficiency as measured by profit margin, (b) Its
asset use efficiency as measured by total asset turnover, (c) Its dividend
policy as measured by the retention ratio, and (d) Its financial policy as
measured by the debt-equity ratio.

3. Pro forma Statements. A financial plan will have a forecast statement

of financial position, income statement, statement of cash flows and
statement of stockholders’ equity. These are called pro forma or
projected statements which will summarize the different events
projected for the future.

4. Asset Requirements. The financial plan will describe projected capital

spending. At a minimum, the projected statement of financial position
will contain changes in total fixed assets and net working capital.
These changes are effectively the firm’s total capital budget. Proposed
capital spending in different areas must thus be reconciled with the
overall increases contained in the long-range plan.

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Chapter 9: Financial Forecasting for Strategic Growth

5. Financial Requirements. The financial plan will include a section

about the necessary financing arrangements. This part of the plan
should discuss dividend policy and debt policy. Sometimes firms will
expect to raise cash by selling new shares of stock or by borrowing. In
this case, the plan will have to consider what kinds of securities have
to be sold and what methods of issuance are most appropriate.

6. Additional Funds Needed (AFN). After the firm has a sales forecast
and an estimate of the required spending on assets, some amount of
new financing will often be necessary because projected total assets
will exceed projected total liabilities and equity. In other words, the
statement of financial position will no longer balance.

Because new financing may be necessary to cover all the projected capital
spending, a financial “plug” variable must be selected. The plug is the
designated source(s) of external financing needed to deal with any shortfall
(or surplus) in financing and thereby bring the statement of financial
position into balance.

For example, a firm with a great number of investment opportunities and

limited cash flow may have to raise new equity. Other firms with few growth
opportunities and ample cash flow will have a surplus and thus might pay
an extra dividend. In the first case, external equity is the plug variable; and
the second, the dividend is used.

9.6 FINANCIAL PLANNING PROCESS

Well run companies generally base their operating plans on a set of

forecasted financial statements. The planning process begins with a sales
forecast for the next five or so years. Then the assets required to meet the
sales targets are determined, and decision is made concerning how to
finance the required assets. At that point, income statements and
statements of financial position can be projected, and earning per share, as
well as the key ratios can be forecasted.

Once the “base-case” forecasted statements and ratios have been prepared,
top managers will ask questions such as:

Are the forecasted results as good as we can realistically expect, and if not,
how might we change our operating plans to produce better earnings and a
higher stock price?

How sure are we that we will be able to achieve the projected results? For
example, if our base-case forecast assumes a reasonably strong economy but
a recession occurs, would we be better off under an alternative operating
plan?

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Chapter 9: Financial Forecasting for Strategic Growth

9.7 THE PROJECTED FINANCIAL STATEMENT METHOD

Any forecast of financial requirements involves:

(a) Determining how much money the firm will need during a given period,
(b) Determining how much money the firm will generate internally during the
same period, and
(c) Subtracting the funds generated from the funds required to determine the
external financial requirements.

The projected financial statement method is straightforward, one simply

projects the asset requirements for the coming period, then projects the
liabilities and equity that will be generated under normal operations, and
subtracts the projected liabilities/capital from the required assets to
estimate the additional funds needed (AFN).

The steps in the procedures are as follows:

Step 1. Forecast the Income Statement.
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding
production costs; direct materials, direct labor and overhead.
c. Estimate selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.

Step 2. Forecast the Statement of Financial Position.

a. Project the assets that will be needed to support projected sales.
b. Project funds that will be spontaneously generated (through accounts
payable and accruals) and by retained earnings.
c. Project liability and stockholders’ equity accounts that will not rise
spontaneously with sales (e.g., notes payable, long-term bonds,
preferred stock and common stock) but may change due to financing
decisions that will be made later.
d. Determine if additional funds will be needed by using the following
formula.
Additional funds needed = Required increased in assets – Spontaneous
increased in liabilities – Increased in retained earnings

The additional financing needed will be raised by borrowing from the bank
as notes payable, by issuing long-term bonds, by selling new common stock
or by some combination of these actions.

Step 3. Raising the additional funds needed.

The financing decision will consider the following factors:
a. Target capital structure.
b. Effect of short-term borrowing on its current ratio.
c. Conditions in the debt and equity markets, or
d. Restrictions imposed by existing debt agreements.

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The additional financing needed will be raised by borrowing from the bank
as notes payable, by issuing long-term bonds, by selling new common stock
or by some combination of these actions.

Step 4. Consider financing feedbacks.

Depending on whether additional funds will be borrowed or will be raised
through common stocks, consideration should be given on additional
interest expense in the income statement or dividends, thus decreasing the
retained earnings.

Apply the iteration process using the available financing mix until the AFN
would become so small that the forecast can be considered complete.

9.7.1 Illustrative Case

9.1 Financial Forecasting (Percent of Sales Method)

The Millennium Company has the following statements which are
representative of the company’s historical average.

Income Statement
Sales ₱2,000,000
Cost of sales 1,200,000
Gross Profit 800,000
Operating expenses 380,000
Earnings before interests and 420,000
taxes 70,000
Interest expenses 350,000
Earnings before taxes 122,000
Taxes (35%) ₱227,500
Earnings after taxes ₱136,500
Dividends

Statement of Financial Position

Assets
Cash ₱50,000
Account receivable 400,000
Inventory 750,000
Current assets ₱1,200,000
Fixed assets (net) 800,000
Total assets ₱2,000,000

Liabilities and Equity

Accounts payable ₱250,000
Accrued wages 10,000
Accrued taxes 20,000
Current liabilities ₱280,000
Notes payable – bank 70,000
Long-term debt 150,000
Ordinary shares 1,200,000
Retained earnings 300,000
Total liabilities and equity ₱2,000,000

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Chapter 9: Financial Forecasting for Strategic Growth

The firm is expecting a 20 percent increase in sales next year, and

management is concerned about the company’s need for external funds. The
increase in sales is expected to be carried out without any expansion of fixed
assets, but rather through more efficient asset utilization in the existing
store. Among liabilities, only current liabilities vary directly with sales.

Using the percent-of-sales method, determine whether the company has

external financing needs or a surplus of funds.

Solution:
Step 1. Forecast the Income Statement.
The projected income statement will show the following:

Sales ₱2,400,000
Cost of sales 1,440,000
Gross profit ₱960,000
Operating expenses 456,000
Earnings before interests and ₱504,000
taxes 70,000
Interest expenses ₱434,000
Earnings before taxes 151,900
Taxes (35%) ₱282,100
Earnings after taxes ₱101,600
Dividends (36%) payment

Step 2. Forecast the Statement of Financial Position.

The projected income statement will show the following:

Assets
Cash (1 ₱60,000
Account receivable ) 480,000
Inventory (2 900,000
Current assets ) 140,000
Fixed assets (net) (3 800,000
Total assets ) ₱2,240,000

(4
)

Liabilities and Equity

Accounts payable (5) ₱300,000
Accrued wages (6) 12,000
Accrued taxes (7) 24,000
Current liabilities ₱336,000
Notes payable – bank (4) 70,000
Long-term debt (4) 150,000
Ordinary shares (4) 120,0000
Retained earnings (8) 480,500
Total ₱2,236,000
Additional financing 3,500
required ₱2,240,000
Total

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Chapter 9: Financial Forecasting for Strategic Growth

Supporting computations:
1. Cash = 2.5% x P 2.4M sales.
2. Accounts receivable = 20% of 2.4M sales
3. Inventory = 37.5% x 2.4M
4. No percentages are computed for fixed assets, notes payable, long-
term debt, ordinary shares and retained earnings because they are not
assumed to maintain a direct relationship with sales volume. For
simplicity, depreciation is explicitly considered.
5. Accounts payable = 12.5% of P2.4M
6. Accrued expenses = 0.5% of P2.4M
7. Accrued expenses = 1% of P2.4M
8. Retained earnings = P300,000 + P282,100 – P101,600

Formula Method:
*Additional financing needed (AFN) may also be computed as follows:
Additional funds needed = Required increased in assets – Spontaneous
increased in liabilities – Increased in retained earnings

Where;

Required increase in assets = Change in Sales x Current Assets (present)

Sales (present)

Spontaneous increase = Change in Sales x Current Liabilities (present)

in liabilities Sales (present)

Increase in retained earnings = Earnings after taxes – Dividend

Applied to Millennium Co., AFN computed as follows:

AFN = 400,000 x 1,200,000 - 400,000 x 1,200,000 - 282,100 - 101,600

2,000,000 2,000,000

= 240,000 - 56,000 -180,500

= ₱ 3,500

9.7.2 Illustrative Case

9.2 Projected Financial Statements with Financing Feedback.

For Tamarind Company, the following data have been made available:

Tamarind Company
Income Statement

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Year 2014
(Thousands of Pesos)
Sales ₱ 6,000
Operating costs (inclusive of ₱200 5,432
depreciation) 588
Earnings before interest and taxes 176
Less interest expense 392
Earnings before taxes 157
Taxes (40%) 235
Net income before preference dividend 8
Dividend to preference ₱ 227
Net income available to ordinary ₱ 114
Dividends to ordinary

Additional retaining earnings:

Tamarind Company
Statement of Financial Position
December 31, 2014
(Thousands of Pesos)
Assets
Cash ₱ 20
Account receivable 750
Inventories 1,230
Total current assets ₱ 2,000
Net plant and 2,000
equipment ₱ 4,000
Total assets

Liabilities and Equity

Accounts payable ₱ 120
Notes payable 220
Accruals 280
Total current liabilities ₱ 620
Long-term bonds 1,508
Total liabilities ₱ 2,128
Preference shares ₱ 80
Ordinary shares (50,000 260
shares) 1,532
Retained earnings ₱ 1,872
Total equity ₱ 4,000
Total liabilities and equity

Additional information follows:

1. Historical sales for the last five years (In Thousand Pesos).

Year Sales
20x0 ₱ 4,116
20x1 5,068
20x2 4,944
20x3 5,700
20x4 6,000
20x5 6,000 (projected*)

2. Assets and spontaneous liabilities will increase by 10%.

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Chapter 9: Financial Forecasting for Strategic Growth

3. Ordinary shares outstanding, 50,000.

4. Ordinary share dividends are projected at ₱2.50 per share.
5. Market value per share at the end of 2012 is ₱46.67.

REQUIRED:
I. Construct the pro forma financial statements using the projected financial
statement method. How much additional capital will be required? Assume
the firm operated at full capacity in year 2014. Do not include financing
feedback.

Solution:
Based on the data and assumptions given, the following projections are
made, and the additional financing needed determined.

Figure 9.1
Projected Income Statement (First Pass)
(Thousands of Pesos)
2015 Forecast
Actual Basis First Pass
Sales ₱6,000 110 % ₱6,000
Operating costs (inclusive of ₱200 depreciation) 5,432 110 % 5,975
Earnings before interest and taxes) 568 625
Less: interest expense 176 110 % 176
Earning before taxes 392 449
Taxes (40%) 157 180
Net income before preference dividend 235 269
Dividends to preference 8 8
Net income available to ordinary ₱227 ₱261
Dividends to ordinary 116 125
Addition to retain earnings 136
Figure 9.2
Projected Financial of Statement Position (First Pass)
(Thousand of Pesos)
2015 Forecast
Actual Basis First Pass
Assets
Cash ₱20 110 % ₱22
Account Receivable 750 110 % 825
Inventories 1,230 110 % 1,353
Total current assets ₱2,000 2,400
Net plant and equipment 2,000 110 % ₱4,400
Total assets ₱4,000
Liabilities and equity 110 % ₱132
Accounts Payable ₱120 110 % 220
Notes Payable 220 308
Accruals 280 ₱660
Total current liabilities 620 1,508
Long-term bonds 1,508 ₱2,168
Total liabilities ₱2,128 ₱80
Preference shares ₱80 260
Ordinary shares (50,000 shares) 260 + 136 1,668
Retained Earnings 1,532 ₱2,008
Total equity ₱1,872 ₱4,176
Total Liabilities and Equity ₱4,000

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Additional Funds Needed (AFN) ₱ 224

Cumulative AFN ₱ 224

DISCUSSION:
Figure 9-1 shows Tamarind’s actual 2014 and forecasted 2015 income
statement. For year 2015 earnings before interest and taxes are projected at
₱625,000 and earnings after taxes of ₱269,000. Dividends to preference
shares and ordinary shares are projected at ₱8,000 and ₱125,000,
respectively.

Figure 9-2 contains Tamarind’s 2014 actual and projected 2015 statements
of financial position. Total assets are projected at ₱4,400,000 while the
forecasted liability and equity accounts total to only ₱4,176,000. Since the
resources or assets requires to support the higher shares level exceed the
available sources, it means that additional funds will have to be obtained.

The AFN of ₱224,000 will be raised by borrowing from the bank as notes
payable or by issuing long-term bonds or by selling new ordinary shares, or
by some combination of these actions.

II. Assume that after considering all the relevant factors, Tamarind decided
on the following funds financing mix to raise the AFN of ₱224,000:

Percent Amount Interest Rate Notes payable

Notes payable 25 % ₱56,000 8%
Long-term debt 25 56,000 10 %
Ordinary 50 112,000 -
shares* 100 % ₱224,000
Total
*2,400 shares

Construct the pro-forma income statement and statement of financial

position to incorporate the financing feedback which results from adopting
the financing mix Given above.

Solution:
Figure 9.3
Project Income Statement (Second Pass)
For 2015
2014 2015 Forecast
Actual First Pass Feedback Second Pass
Sales ₱6,000 ₱6,000 ₱6,600
Operating Costs
(inclusive of ₱200 depreciation) 5,232 5,975 5,925
Earnings before interest and taxes 568 625 625
Lest: Interest expense - 176 176 +6 186
Earnings before taxes 392 449 439
Taxes (40%) 157 180 -4 176
Net income before preference 235 269 263
dividend 8 8 8
Dividends to preference ₱227 ₱261 ₱255
Net income available to ordinary 116 125 +6 131
Dividends to ordinary 136 124

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Addition to retained earnings

Figure 9.4
Projected Statement of Financial Position (Second Pass)
Thousands of Pesos
2014 2015 Forecast
Actual First Pass Feedback Second Pass
Assets
Cash ₱20 ₱22 ₱22
Account Receivable 750 825 825
Inventories 1,230 1,353 1,353
Total Current Assets ₱2,000 ₱2,000 ₱2,000
Net plant and equipment 2,000 2,000 2,000
Total assets ₱4,000 ₱4,000 ₱4,000

Liabilities and Equity

Account Payable ₱120 ₱132 ₱132
Notes payable 220 220 + 56 276
Accruals 280 308 308
Total Current Liabilities ₱620 ₱600 ₱716
Long-term bonds 1,508 1,508 + 56 1,564
Total liabilities ₱2,128 ₱2,168 ₱2,280

Preference shares ₱80 ₱80 ₱80

Ordinary shares (50,000 shares) 260 260 112 372
Total equity 1,532 1,668 1,656
Retained Earnings ₱1,872 ₱2,008 ₱2,108
Total Liabilities and Equity
Before AFN ₱4,000 ₱4,176 ₱4,388

Additional Funds Needed ₱12

(AFN) ₱4,400
Total Liabilities and Equity ₱236
Cumulative AFN

In Figure 9-4 the second pass 2015 Statement of Financial Position shows
that a shortfall of ₱12,000 will still exist as a result of financing feedback
effects due to the additional interest (net of taxes) and dividend payments
that reduced the projected retained earnings. This amount raises the
cumulative AFN from ₱224,000 to ₱236,000.

If additional iterations are done (9.e., 3rd, 4th, 5th, etc.), the additional
financing needed would become smaller and smaller until the forecast would
be considered to be completed. Making a spreadsheet using Lotus 1-2-3 or
some other program can facilitate the iteration process and arrive at the final
forecast.

9.8 ANALYSIS OF THE FORECAST

Next year’s forecast as developed above is only the first part of total
forecasting process. Forecasting is an iterative process, both in the way the

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financial statements are generated and in the way the financial plan is
developed. For planning purposes, the consultant or financial staff develops
a preliminary forecast based on a combination of past policies and trends.
This will serve as a starting point or “baseline” forecast. The model is then
modified to see what effects alternative operating plans would have on the
firm’s earnings and financial condition. Likewise, alternative operating plans
are examined under different sales growth rate scenarios and linked to the
firm’s dividend policy and capital structure decisions. The revised forecast or
model can also be used to analyse alternative working capital policies.

Chapter 9 | Financial Forecasting for Strategic Growth