MODULE 4

FINANCIAL PLANNING AND FORECASTING

Learning Objectives

At the end of this module, you will be able to:

1. Discuss the importance of strategic planning and the central role that financial
forecasting plays in the overall planning process.
2. Use the AFN (Additional Funds Needed) equation discuss its relationship
between asset growth and the need for funds.
3. Understand Internal growth rate from Sustainable growth rate
4. Prepare forecasted financial statements

INTRODUCTION

The former player and manager for the New York Yankees, Yogi Berra once
said, “if you don’t know where you’re going, you probably won’t get there.”
That’s certainly true for a company - it needs plan, one that starts with the firm’s
general goals and details the steps that will be taken to get there.

Module 4 is about Financial planning and forecasting. The two are

interrelated functions of a finance manager. It has been emphasized that the
value of financial statements in so far as decision making is concerned, lie in the
usability for planning and strategy formulation. On a premise, before a major
decision is made, companies would test whether a proposed venture is able to
deliver return that would ultimately improve shareholders’ wealth. It has to start
with the projections of financial statements.

Long term decisions, often involve large capital infusion. A decision to

increase or decrease target revenue has to be carefully planned as this will not
only impact the revenue side, but the other elements of the financial statements:
the assets, liabilities, equity and even expenses. The succeeding discussions will
focus on the steps on how to prepare projected financial statement. It will begin
with how to forecast sales, cascading down to its effect to assets, and the
financing consequences of such targets.

Assigned Readings: Essentials of Financial Management, 4 th Edition,

Philippine Edition by Eugene F. Brigham, et al. (2019) Pages 202 -219

EXPLAIN:

Forecasting and the Strategic Planning

In any corporation, planning should always align with the over-all Vision
and Mission statement of the firm. Strategic planning ensures that all aspects
of the business go in unison, supporting the main idea for which the
corporation is existing. Thus, before any plan is made, it is to spring up from
the over-all objectives of the firm.
Financial planning is no exception to this. Key terms and their definitions
as taken in the context of strategic planning are presented next:
 Mission Statement – A condensed version of a firm’s strategic plan
 Corporate Scope – Defines the firm’s line of business and geographic
areas of operation
 Statement of Corporate Objectives – Sets forth the specific goals to
guide management
 Corporate Strategies – Broad strategies developed for achieving a
firm’s goal
 Operating Plan – Provides management a detailed implementation
guidance, based on corporate strategy, to help meet the corporate
objectives
 Financial Plan – The document that includes assumptions, projected
financial statements, and projected ratios that ties the entire planning
process together.

Forecasting will always raise the following questions:

 What is generally the first item to estimate when starting a business?
 What is the most difficult aspect of forecasting?

Steps in Financial Forecasting

1. Forecast sales
2. Project the assets needed to support sales
3. Project internally generated funds
4. Project outside funds needed
5. Decide how to raise funds
6. See effects of plan on ratios and stock price

The Sales Forecasting Process

 Forecasting the sales is always the beginning of the financial forecasting.
This is because sales drive a lot of assumptions and its effects go beyond
revenue. As sales forecast is developed, one will notice that the entire
organization takes part in the process. The finance department of the
company is the one ultimately responsible for consolidating and preparing
the sales forecast.
The marketing department provides data for sales estimates as this is
the team who have a direct interaction with customers. The top
management is through the policy and strategies alignment. Production
department determines whether the existing plant is capable of supporting
the planned sales. Their input is very valuable as they set the production
capacity and any excess sales projection versus the capacity will necessitate
additional investment in long term assets. The accounting Department,
under also in the Finance will provide data about historical trends through
financial statements, the depreciation on production assets, and advise on
tax effects of the planned actions. The interactions between these
departments are summarized on the picture that follows:
Forecasting Sales
 Review past sales (five to ten years).
 You can use average growth rate but it may not give you a correct
estimate.
 Use regression slope to compute growth rate. (Regression will
discussed separately)
 Consider changes in economy, market conditions, etc.
 Improper sales forecast can lead to serious financial planning issues.
 Sales forecasts are usually based on the analysis of historic data.
 An accurate sales forecast is critical to the firm’s profitability:
 The forecast of future sales is normally based on past sales growth
 This sales growth is determined as the difference between the recent
sales figure and the immediately preceding period figure, divide by the
latter.
 Effects of any events which are expected to impact future sales (such
as new products or economic conditions) are also included in the
forecast.
 Sales Growth imposes costs on the firm. It will require additional
resources in terms of:
o Current Assets: Inventory, A/R, Cash
o Fixed Assets: Plant and Equipment

Percent of Sales Method

 In forecasting the financial statements, percent of sales method is
most commonly employed. It begins with the sales forecast expressed as an
annual growth rate in dollar sale revenue. Many items on the balance sheet
and income statement are assumed to change proportionally with sales.

A Better Financial Planning Model

The Income Statement

 The pro forma income statement is generated by recognizing all
variable costs that change directly with sales.
 Two key ratios are calculated – dividend payout ratio and retention
ratio.
 Dividend payout ratio measures the percentage of net income paid out
as dividends to shareholders, while retention ratio measures the
percentage of net income reinvested by the firm as retained earnings.

The Balance Sheet

 Some balance sheet items vary directly with sales while others do not.
 To determine which accounts vary directly with sales, a trend analysis
may be conducted on historic balance sheets of the firm.
 Typically, working capital accounts like inventory, accounts
receivables and accounts payables vary directly with sales.
 Fixed assets do not always vary directly with sales. It will do so, only if
the firm is operating at 100 percent capacity and fixed assets can be
incrementally changed.
 The ratio of total assets to net sales is called the capital intensity
ratio. This ratio tells us the amount of assets needed by the firm to
generate $1 sales.
 The higher the ratio, the more capital the firm needs to generate sales
—the more capital intensive the firm.
 Firms that are highly capital intensive are more risky than those that
are not because a downturn can reduce sales sharply but fixed costs
do not change rapidly.
 Only current liabilities are likely to vary directly with sales. The
exception here is notes payables (short-term borrowings) that changes
as the firm pays it down or makes an additional borrowing.
 Long-term liabilities and equity accounts change as a direct result of
managerial decisions like debt repayment, stock repurchase, issuing
new debt or equity.
 Retained earnings will vary as sales changes but not directly. It is
affected by the firm’s dividend payout policy.

Steps in Preparing the Preliminary Pro-forma Balance Sheet

 First, calculate the projected values for all the accounts that vary with
sales.
 Second, calculate the projected value of any other balance sheet
account for which an end-of-period value can be forecast or otherwise
determined.
 Third, enter the current year’s number for all the accounts for which
the next year’s figure cannot be calculated or forecast.
  At this point the balance sheet will be unbalanced. A plug value is
necessary to get the balance sheet to balance. The following
procedures may be done to remedy the situation:
o First, determine the retained earnings based on the firm’s
dividend policy.
o Next, the plug figure will represent the external financing
necessary to make the total assets equal total liabilities and
equity. This calls for management to choose a financing option –
choosing debt, equity or a combination – to raise the additional
funds needed.

The Management Decision

 The first decision relates to the firm’s dividend policy. Should the firm
alter its dividend policy to increase the amount of retained earning?
 If external funding is still needed, should the firm issue new debt, or
issue equity? Or, should it be a mix of both?
 It is important to recognize that while financial planning models can
identify the amount of external financing needed, the financing option
is a managerial decision.

Beyond the Basic Planning: Improving Financial Planning Models

 There are several weaknesses in the previously described models.
 First, interest expense was not accounted for. This is difficult to do so
until all the financing options are finalized.
 Second, all working capital accounts do not necessarily vary directly
with sales, especially cash and inventory.
 Third, how fixed assets are adjusted plays a significant role.
 When a firm is not operating at full capacity, sales may be increased
without adding any new fixed assets.
 Fixed assets are added in large discrete amounts called lumpy assets.
Since it requires time to get new assets operational, they are added as
the firm nears full capacity.

Managing and Financing Growth

 Managers prefer rapid growth as a goal to capture market share and
establish a competitive position.
 Most firms experiencing rapid growth fund the growth with debt,
increasing the firm’s leverage and putting it at risk.

External Funding Needed / Additional Fund Needed

 External funding needed (EFN) or additional funds needed (AFN) is
defined as the additional debt or equity a firm needs to issue so it can
purchase additional assets to support an increase in sales.
 EFN is tied to new investments the management has deemed
necessary to support the sales growth.
 The new investments are the projected capital expenditure plus the
increase in working capital necessary to sustain increases in sales.
 Companies first resort to internally generated funds in the form of
addition to retained earnings.
  Once internally generated funds are exhausted, the firm looks to raise
funds externally.
 EFN/ AFN = Projected increase in Assets – Spontaneous
Increase in Liabilities – Increase in Retained Earnings
 First, holding dividend policy constant, the amount of EFN depends on
the firm’s projected growth rate. Higher growth rate implies that the
firm needs more new investments and therefore, more funds to have
to be raised externally.
 Second, the firm’s dividend policy also affects EFN. Holding growth
rate constant, the higher the firm’s payout ratio, the larger the amount
of debt or equity financing needed.

How would increases in these items affect the EFN?

 Higher dividend payout ratio: Reduces funds available internally,
increases EFN.
 Higher profit margin: Increases funds available internally, decreases
EFN.
 Higher capital intensity ratio, A/S 0: Increases asset requirements,
increases EFN.

Implications of EFN
 If EFN is positive, then you must secure additional financing.
 If EFN is negative, then you have more financing than is needed. You
can use excess funds to:
o Pay off debt.
o Buy back stock.
o Buy short-term investments.

Summary: How different factors affect the EFN forecast.

 Excess capacity: lowers EFN.
 Economies of scale: leads to less-than-proportional asset increases.
 Lumpy assets: leads to large periodic EFN requirements, recurring
excess capacity.

Lumpy Assets
 Assets that cannot be acquired in small increments but must be obtained
in large, discrete units. In figure, a lumpy asset will have the following
behavior:
  A/S changes if assets are lumpy. Generally will have excess capacity,
but eventually a small DS leads to a large DA.

Other Techniques for Forecasting Financial Statements

1. Regression Analysis for Asset Forecasting
 Relationship between type of asset and sales is linear.
 Get historical data on a good company, then fit a regression line to see
how much a given sales increase will require in way of asset increase.
2. Excess Capacity Adjustments
 Determine the full capacity sales given the operating capacity
 Consider the Target fixed assets-to-sales ratio
 Determine the Required level of fixed assets

ELABORATE:

In the previous part, you have been given the conceptual discussion of
financial planning and forecasting. From this point forward, we will be giving
specific examples and problem solving applications that are useful to
concretize your understanding of the topic. In the last part of this section,
you will be given the set of assignments and case that you have to complete.

Plowback and dividend payout ratios

 Plowback ratio – This is also known as the retention ratio. It indicates
the ratio of the net income that is retained for the year and was not
declared as dividends.
 Dividend payout ratio – The portion of the net income for the year that
was given out as dividends to shareholders.
Example 1: Your company has net income of $1,600 for the year. You paid
out $400 in dividends to your stockholders.
a. What is the dividend payout ratio?
b. What is the plowback ratio?
c. What is the dollar increase in retained earnings?
Answers:

Example 2. This year your company expects net income of $2,800. You now
adhere to a 60% plowback ratio.
a. What is the expected dollar increase in retained earnings?
b. How much do you expect to pay in dividends?
c. What is the dividend payout ratio?
Answers:

Example 3: Constant growth planning

You expect your sales, costs and assets to grow by 10% next year. You will
not pay any dividends. Can you complete the pro forma statement? Round all
amounts to whole dollars.

Income Statement
Current Projected
Sales $800 $ _______
Costs $700 $ _______
Taxable income $100 $ _______
Taxes (34%) $ 34 $ _______
Net income $ 66 $ _______
Balance Sheet
Current Projected Current Projected
Assets $400 $_______ Debt $150 $_______
Equity $250 $_______
Answer:

Income Statement
Current Projected
Sales $800 $880
Costs $700 $770
Taxable income$100 $110
Taxes (34%) $ 34 $ 37
Net income $ 66 $ 73
Balance Sheet
Current Projected Current Projected
Assets $400 $440 Debt $150 $117
Equity $250 $323

Total $400 $440 Total$400 $440

Derivations

Example 4. Percentage of sales planning

The assets and current liabilities of Jennings, Inc. vary in direct proportion to
the increase in sales. The current sales are $2,000 and you expect them to
increase by 20% next year. Net income is projected at 5% of sales. The firm
is not planning on issuing any more common stock nor paying any dividends.
Using this information, can you compile the pro forma balance sheet shown
on the next section?
Refer to the previous information pertaining to this problem.
Enter n/a where the % of sales does not apply.

Solution…

Step 1. Step 2.
 Step 3

Step 4.

Example 5. External financing need

You project your sales will increase by $3,000 next year. Net income is 10%
of sales and accounts payable is 25% of sales. The capital intensity ratio is
2.5. No dividends are anticipated. How much external financing is needed to
fund this growth?

Solution…
Hints:
Step 1: Compute the increase in total assetstep
2: Compute the increase in accounts payableStep
3: Compute the increase in retained earningStep
4: Compute the additionlong-term debt and equity financing that is
needed
Example 6. Pro forma with external financing
Your firm currently has long-term debt of $4,400, common stock and paid in
surplus of $10,000 and retained earnings of $4,600. The capital intensity
ratio is 2.2 and the tax rate is 35%. Costs are 72% of sales and accounts
payable are 30% of sales. Sales currently are $10,000 and are expected to
increase by 10% next year. The dividend payout ratio is 20%. Long-term debt
will be used to fund 40% of the external funding need.

Given this information, can you complete the pro forma financial statements
that follows?
Solution…
Total liabilities and owners’ equity $24,200
Accounts payable -$ 3,300
Retained earnings -$ 6,202
Current long-term debt -$ 4,400
Current common stock -$10,000
External financing need $ 298

Example 7. Capacity level

Your firm has fixed assets of $28,000 and is operating at 80% of capacity.
Current sales are $18,000.
a. What is the full-capacity sales level?
b. What is the capital intensity ratio at the full-capacity sales level?

Solution…
Example 8. Capacity level
Your firm has projected sales of $1,600. The capital intensity ratio at the full-
capacity sales level of $1,900 is 1.20. Ignoring the capacity level, you have
projected net fixed assets at $2,100 and the external financing need at
$1,000. What is the external financing need if the capacity level is
considered?

Solution…

Internal Growth Rate Vs. Sustainable Growth Rate

Internal growth rate is the maximum rate of growth in sales and assets that a
company can achieve using only retained earnings. It is the rate of
growth up to which the company might not need any external financing.
A growth rate target higher than the internal growth rate must be financed
by external sources of capital i.e. debt or equity.

Internal growth rate can be calculated using the following formula:

Internal Growth Rate = Retention Ratio × ROA

Net Income
Internal Growth Rate = (1 - Dividend Payout Ratio) ×
Beg . Total Assets
An associated concept is the sustainable growth rate, a growth rate that
can achieved by maintaining the existing mix of debt and equity in the
company’s capital structure, without additional issuance of new equity.

This does not mean that additional debt will not be issued, it instead means
that additional equity retained will also allow the business to raise additional
debt and thus keep the overall capital structure the same. If assets are
leveraged 2x, they will continue to be leveraged 2x as every $1 of equity
retained in the business will allow the business to raise an additional $1 of
debt in order to then invest $2 in assets.

This change from unleveraged assets to leveraged equity is made in the

formula for sustainable growth by changing the first portion of the formula to
be return on equity (ROE) rather than ROA. Hence, the formula for
sustainable growth rate is:

Sustainable Growth Rate = Retention Ratio x ROE

Net Income
Sustainable Growth Rate = (1 - Dividend Payout Ratio) ×
Beg . Equity

SGR is greater than or equal to IGR.

SGR = IGR only when the company has zero debt.

For a more detailed description of the difference between Internal Growth

Rate and Sustainable Growth Rate, please visit this link --- >>>>
https://www.youtube.com/watch?v=4rWcDs7FhUM

Example 9. Internal Growth Rate

Your firm has net income of $6,000 and total assets of $30,000. The dividend
payout ratio is 40%. What is the internal growth rate?

Solution…
Return on Assets = Net Income / Beg. Total Assets
= 6,000 / 30,000
= 0.20

Plowback Ratio (Retention Ratio) = 1 – Dividend Pay-out Ratio

= 1 – 0.40
= 0.60

Internal Growth Rate = ROA (RR)

= 0.20 x 0.6
= 0.12 or 12%
Example 10. Sustainable Growth Rate
A firm has net income of $2,000 and pays $400 in dividends. Total equity is
$8,000. What is the sustainable growth rate?

Solution…
Return on Equity = Net Income / Beg. Equity
= 2,000 / 8,000
= 0.25

Plowback Ratio (Retention Ratio) = 1 – Dividend Pay-out Ratio

= 1– ( 2,000
400
)
= 1 – 0.20
= 0.80

Sustainable Growth Rate = ROE (RR)

= 0.25 x 0.8
= 0.20 or 20%

Since sustainable growth rate allows for external financing but only in the
proportion of its current capital mix, the sustainable growth rate is higher
than the internal growth rate.

But let us see how internal growth rate is related to sustainable growth rate
mathematically.

Let us multiply and divide the expression for internal growth rate with equity
and rearrange:

Internal Growth Rate = RI / NI × NI / Equity × Equity / Total Assets

RI / NI = Retention Ratio
RI = Retained Income

The first two expressions on the right-hand side are the definition of
sustainable growth rate. With this, we reach the following expression:

Internal Growth Rate = Sustainable Growth Rate × Equity / Assets

Equity / Assets = Equity Multiplier

Example 11. Sustainable Growth Rate and the Du Pont Equation

Your firm has a 10% net profit margin and a dividend payout ratio of 25%.
The debt-equity ratio is 40% and the total asset turnover rate is 2. What is
the sustainable rate of growth?

Hints:
Step 1. Find the equity multiplier using the debt-equity ratio
Step 2. Compute the ROE using the DuPont formula
Step 3. Find the plowback ratio using the dividend payout ratio
Step 4. Compute the sustainable growth rate
Solution…

Step 1
Equity Multiplier = 1 + Debt to Equity Ratio
= 1 + 0.40
= 1.4

Step 2.
ROE = PM x TAT x EM
= 0.10 x 2 x 1.4
= 0.28

Step 3.
Plowback/Retention Ratio = 1 – pay-out ratio
= 1 – 0.25
= 0.75

Step 4
Sustainable Growth Rate = ROE x RR
= 0.28 x 0.75
= 0.21 or 21%

ACTIVITY 1

Answer the following problems in from your textbook. This is a graded

activity
1. Problem 6-7, pg. 222-223
2. Problem 6-8, pg. 223
3. Problem 6-10, pg. 223
4. Problem 6-11, pg. 224
5. Problem 6-13, pg. 224-225

Specific Instructions
a. Due date is on October 16 10PM
b. Submissions will be online- MS Team (through MS Word, MS Excel, PDF
or an Image of your handwriting on a paper).
c. We will discuss the answers on a f2f meeting.

CASE STUDY ANALYSIS

Instructions:
1. Answer the case that follow. Answers to be submitted electronically
(MS Word, PDF, or an image of your write up on the paper. This is
due October 25 11:59PM
2. This is a group graded activity.
 3. The case will be discussed on the F2F meeting

Case Study #2: Growing Pains

“We are growing too fast,” said Mason. “I know I shouldn’t complain, but we
better have the capacity to fill the orders or we’ll be hurting ourselves.” Vicky
and Mason Coleman started their oatmeal snacks company in 1998, upon the
suggestions of their close friends who simply loved the way their oatmeal
tasted. Mason, a former college gymnastics coach, insists that he never
“intended to start a business,” but the thought of being able to support his
college team played a significant role in motivating him to go for it.

After considerable help from local retailers and a sponsorship by a major

bread company their firm, Oats ‘R’ Us, was established in 1998 and reached
sales of over $4 million by 2004. Given the current trend of eating healthy
snacks and keeping fit, Mason was confident that sales would increase
significantly over the next few years. The industry growth forecast had been
estimated at 30% per year and Mason was confident that his firm would be
able to at least achieve if not beat that rate of sales growth.
“We must plan for the future,” said Vicky. “I think we’ve been playing it
by ear for too long.” Mason immediately called the treasurer, Jim Moroney.
“Jim, I need to know how much additional funding we are going to need for
the next year,” said Mason. “The growth rate of revenues should be between
25% and 40%. I would really appreciate if you can have the forecast on my
desk by early next week.”
Jim knew that his fishing plans for the weekend had better be put aside
since it was going to be a long and busy weekend for him. He immediately
asked the accounting department to give him the last three years’ financial
statements (see Tables 1 and 2) and got right to work!

Table 1

Oats 'R' Us
Income Statement
For the Year Ended Dec. 31, 2004

2004 2003 2002

Sales $4,700,000 $3,760,000 $3,000,000
Cost of Goods Sold 3,877,500 3,045,600 2,400,000
Gross Profit 822,500 714,400 600,000
Selling and G&A
Expenses 275,000 250,000 215,000
Fixed Expenses 90,000 90,000 90,000
Depreciation Expense 25,000 25,000 25,000
EBIT 432,500 349,400 270,000
Interest Expense 66,000 66,000 66,000
EBT 366,500 283,400 204,000
Taxes @ 40% 146,600 113,360 81,600
Net Income $219,900 $170,040 $122,400
Retained Earnings $131,940 $102,024 $73,440

Table 2

Oats 'R' Us
Balance Sheet
For the Year Ended Dec. 31, 2004
Assets 2004 2003 2002
Cash and Cash Equivalents $60,000 $97,376 $48,000
Accounts Receivable 250,416 175,000 150,000
Inventory 511,500 390,000 335,000
Total Current Assets 821,916 662,376 533,000
Plant & Equipment 560,000 560,000 560,000
Accumulated Depreciation 175,000 150,000 125,000
Net Plant & Equipment 385,000 410,000 435,000
Total Assets $1,206,916 $1,072,376 $968,000

Liabilities and Owner's Equity

Accounts Payable $135,000 $151,352 $128,000
Notes Payable 275,000 275,000 250,000
Other Current Liabilities 43,952 50,000 46,000
Total Current Liabilities 453,952 476,352 424,000
Long-term Debt 275,000 250,000 300,000
Total Liabilities 728,952 726,352 724,000
Owner's Capital 155,560 155,560 155,560
Retained Earnings 322,404 190,464 88,440
Total Liabilities and Owner's Equity $1,206,916 $1,072,376 $968,000

Guide Questions:
1. Since this is the first time Jim and Mason will be conducting a financial
forecast for Oats ‘R’ Us, how do you think they should proceed? Which
approaches or models can they use? What are the assumptions
necessary for utilizing each model?
2. If Oats ‘R’ Us is operating its fixed assets at full capacity, what growth
rate can it support without the need for any additional external
financing?
3. Oats ‘R’ Us has a flexible credit line with the Midway Bank. If Mason
decides to keep the debt-equity ratio constant, up to what rate of
growth in revenue can the firm support? What assumptions are
necessary when calculating this rate of growth? Are these assumptions
realistic in the case of Oats ‘R’ Us? Please explain.
4. Initially Jim assumes that the firm is operating at full capacity. How
much additional financing will it need to support revenue growth rates
ranging from 25% to 40% per year?
5. After conducting an interview with the production manager, Jim
realizes that Oats ‘R’ Us is operating its plant at 90% capacity, how
much additional financing will it need to support growth rates ranging
from 25% to 40%?
6. What are some actions that Mason can take in order to alleviate some
of the need for external financing? Analyze the feasibility and
implications of each suggested action.
7. How critical is the financial condition of Oats ‘R’ Us? Is Vicky justified in
being concerned about the need for financial planning? Explain why.
8. Given that Mason prefers not to deviate from the firm’s 2004 debt-
equity ratio, what will the firm’s pro-forma income statement and
balance sheet look like under the scenario of 40% growth in revenue
for 2005 (ignore feedback effects).