ACC 223 BASIC FINANCIAL

MANAGEMENT

Financial Planning and

Forecasting

Presented By KP Henrique
Learning Objectives

Upon completion of this Lecture you will have to;

i. Understand Financial Planning
ii. Understand Financial Forecasting
iii. Prepare Cash Budgets
iv. Prepare Proforma Financial Statements

Presented By KP Henrique
Introduction

 Financial planning is an important aspect of the

firm’s operations because it provides road maps
for guiding, coordinating, and controlling the
firm’s actions to achieve its objectives.
 Two key aspects of the financial planning
process are cash planning and profit
planning.
 Cash planning involves preparation of the firm’s
cash budgets.
 Profit planning involves preparation of pro forma
(Forecasted) financial statements.
Presented By KP Henrique
 Objectives of Financial Planning

 Ensuring availability of funds:

 Financial planning majorly excels in the area of generating
funds as well as making them available whenever they are
required.
 This also includes estimation of the funds required for
different purposes, which are, long-term assets and working
capital requirements.
 Estimating the time and source of funds:
 Time is a game-changing factor in any business venture.
Delivering the funds at the right time at the right place is
very much crucial. It is as vital as the generation of the
amount itself.
 While time is an important factor, the sources of these funds
are necessary as well
Presented By KP Henrique
 Generating capital structure:
 The capital structure is the composition of the capital
of a company, that is, the kind and proportion
of capital required in the business. This includes
planning of debt-equity ratio both short-term and long-
term.
 Avoiding surplus funds:
 It is an important objective of the company to make
sure that the firm does not raise
unnecessary resources. Shortage of funds and the firm
cannot meet its payment obligations. Whereas with a
surplus of funds, the firm does not earn returns but
adds to costs.
Presented By KP Henrique
Forms of Financial Planning

Long Term Financial Planning



 Long-term financial plans lay out a company’s

planned financial actions and the anticipated impact
of those actions over periods ranging from 2 to 10
years.
 Five-year financial plans, which are revised as
significant new information becomes available, are
common.
 Generally, firms that are subject to high degrees of
operating uncertainty, relatively short production
cycles, or both, tend to use shorter planning horizons.

Presented By KP Henrique
Short Term (Operating) Financial Planning


 Short-term (operating) financial plans specify short-

term financial actions and the anticipated impact of
those actions.
 These plans most often cover a 1- to 2-year period.
Key inputs include the sales forecast and various
forms of operating and financial data. They also
include a number of operating budgets, the cash
budget, and pro forma financial statements.
 Short term financial planning focuses solely on
cash planning and profit planning.
Presented By KP Henrique
Cash Planning

 Cash planning is an informed projection of how

much cash will be needed for and collected from
the operations of the business or organization. It
involves the preparation of cash budgets.
 Cash Budget is a statement of the firm’s planned
inflows and outflows of cash.
 It is used by the firm to estimate its short-term cash
requirements, with particular attention being paid
to planning for surplus cash and for cash shortages.
 Typically, the cash budget is designed to cover a 1-
year period, divided into smaller time intervals.
Presented By KP Henrique
 The number and type of intervals depend on the
nature of the business. The more seasonal and
uncertain a firm’s cash flows, the greater the
number of intervals.
 Because many firms are confronted with a
seasonal cash flow pattern, the cash budget is
quite often presented on a monthly basis.
 Firms with stable patterns of cash flow may use
quarterly or annual time intervals.

Presented By KP Henrique
 The key input to cash budgeting (short term
financial planning) process is the firm’s sales
forecast. This prediction of the firm’s sales over a
given period is ordinarily prepared by the marketing
department.
 On the basis of the sales forecast, the financial
manager estimates the monthly cash flows that will
result from projected sales and from outlays related
to production, inventory, and sales.
 The manager also determines the level of fixed
assets required and the amount of financing, if
any, needed to support the forecast level of sales
and production.
Presented By KP Henrique
The Meaning of Financial Forecast

 A financial forecast is an estimate of future

financial outcomes for a company. Financial
forecasts estimate future income and expenses
for a business over a period of time, generally
the next year. They are used to develop
projections for profit and loss statements,
balance sheets and other cash flow forecasts.
 Financial forecasts can use historical accounting
and sales data, and external market and
economic indicators, to predict what will happen
to the company in financial terms over the given
period of time.
Presented By KP Henrique
Methods of Financial Forecasting

 The forecasting methods to be used

depend on factors such as:
 The nature of the funds being forecasted
 Short- or long term funds
 Availability of relevant data
 Internally and/or externally
 The firm’s [“processing”] capabilities
 The
costs and benefits of each of the possible
methods

Presented By KP Henrique
 The forecasting methods include:
 Cash cycle (cashflow) method
 Percent of sales method
 Also known as the Proforma Balance Sheet Method
 Judgemental methods
 Statistical methods
 Regression, time series etc
 Most firms will employ a combination of
the above and other methods

Presented By KP Henrique
 The Cash Cycle Method

 This method is based on the observed fluctuation

of cash during operation/financial period
 When cash is in short there is a need to “raise funds”
 When there is high cash level, plans should be devised
to utilize (invest) the extra cash
 This method is partly judgemental and partly
statistical
 Suitable where a fairly stable cash flow cycle exists (or can
be projected)
 It is a short-term forecasting method
 It is simple and cheap
 Gives a reasonable estimation of when to raise funds and how much
 Forms a reasonable basis for preparing cash budget
Presented By KP Henrique
Cash Budgets

 In a summary Cash Budget involves:

 Preparing a schedule of cash receipts
 based on the main revenue driver such as sales forecasts (in
terms of quantities and prices)
 To include other receipts (e.g. from asset disposal)
 Preparing a schedule of cash expenditure:
 For main recurrent activities (e.g. production)
 For other activities (e.g. planned capital expenditure,
dividend)
 Determining net cashflow
 Determining Cumulative cash balance
 Determining whether there is excess cash or
cash deficit
Presented By KP Henrique
Preparation of Cash Budgets

 The Cash Budgeting General Formula;

Opening Balance of Cash + Cash Receipts –

Cash Disbursements = Closing Balance of
Cash
Cash Receipts


 Cash receipts include all of a firm’s inflows of

cash during a given financial period. The most
common components of cash receipts are cash
sales, collections of accounts receivable, and
other cash receipts.
Presented By KP Henrique
Cash Disbursements/Cash Payments


 Cash disbursements include all outlays of cash by the firm

during a given financial period.
 The most common cash disbursements are Cash
purchases, Fixed-asset outlays, Payments of accounts
payable, Interest payments, Rent (and lease) payments,
Cash dividend payments, Wages and salaries, Principal
payments (loans), Tax payments, Repurchases or
retirements of stock, etc.
 It is important to recognize that depreciation and other
noncash charges are NOT included in the cash budget,
because they merely represent a scheduled write-off of an
earlier cash outflow.
Presented By KP Henrique
Purposes of Budgets

 Communication
 Different departments and units must
communicate with each other during the budget
process to coordinate their plans and efforts.
 Coordinating
 Different units in the company must also
coordinate the many different tasks they
perform. For example, the number and types of
products to be marketed must be coordinated
with the purchasing and manufacturing
departments to ensure goods are available

Presented By KP Henrique
 Planning
 A budget is ultimately the plan for the operations
of an organization for a period of time. Many
decisions are involved, and many questions must
be answered. Old plans and processes are
questioned as well as new plans and processes.
Managers decide the most effective ways to
perform each task
 Control
 Once a budget is finalized, it is the plan for the
operations of the organization. Managers have
authority to spend within the budget and
responsibility toPresented
achieve revenues specified
By KP Henrique
 Evaluation
 One way to evaluate a manager is to compare
the budget with actual performance.
 Did the manager reach the target revenue within
the constraints of the targeted expenditures? Of
course, other factors, such as market and general
economic conditions, affect a manager’s
performance.
 Whether a manager achieves targeted goals is an
important part of managerial responsibility

Presented By KP Henrique
Activity
Read about the Advantages and
Disadvantages of Budgets

Presented By KP Henrique
Percentage of Sales Method

 This is used for profit planning – the preparation of pro

forma financial statements
 Whereas cash planning focuses on forecasting cash
flows, profit planning relies on accrual concepts to
project the firm’s profit and overall financial position.
It focuses on the preparation of forecasted financial
statements (Pro forma financial statements).
 Shareholders, creditors, and the firm’s management
pay close attention to the pro forma statements which
are projected income statements and balance sheets.

Presented By KP Henrique
 The approaches for estimating the pro forma
statements are all based on the belief that the
financial relationships reflected in the firm’s past
financial statements will not change in the
coming period.
 Three inputs are required for preparing pro forma
statements:
 Financial statements for the preceding year and
 The sales forecast for the coming year.
 A variety of assumptions must also be made.
Presented By KP Henrique
 Percentage of Sales Method

 The percent of sales method is a financial

forecasting model in which all of a business's
accounts financial line items like costs of goods
sold, inventory, and cash are calculated as a
percentage of sales.
 Those percentages are then applied to future sales
estimates to project each line item's future value.

Presented By KP Henrique
Preparation of Pro forma
Financial Statements Using
PSM
 Financial planning and forecasting
involves the preparation of three pro
forma financial statements;
 Income statement
 Statement of financial position, and
 Statement of cashflows
 However, this lecture covers the first two
pro forma financial statements

Presented By KP Henrique
The Trail

Presented By KP Henrique
Percentage of Sales Method Process

I. Determine your estimated growth and most

recent annual sales figures.
II. Determine if a correlation between sales and
specific line items you want to forecast exists. E.g
Inventory, Accounts receivable, Accounts payable,
Cash, Costs of goods sold, Net income etc.
III. Determine the line item balances and their
percentages relative to sales.
IV. Calculate forecasted sales (1+Growth Rate/100) x
Current sales
V. Apply line items' relative percentages to your
forecasted sales figure
Presented By KP Henrique
Example

 Barbara started a business and managed to have

sales amounting to $50,000 in her first year of
business. At the end of the same year the
following balances were noted;
• Inventory — $20,000
• Accounts receivable — $10,000
• Accounts payable — $7,000
• Cash — $15,000
• Costs of goods sold — $15,000
• Net income — $35,000
• If she expects a 40% sales increase next year,
what will be her forecasted ending balances
Presented By KP Henrique
Solution
 When divided by Barbara's $50,000 in revenue,
those figures amount to these percentages:
• Inventory — 40%
• Accounts receivable — 20%
• Accounts payable — 14%
• Cash — 30%
• Costs of goods sold — 30%
• Net Income — 70%

Presented By KP Henrique
 As previously mentioned, she expects to see a
40% increase. To determine her forecasted sales,
she would use the following equation.
 (1+Growth Rate/100) x Current sales =
Forecasted Sales
 So calculating her forecasted sales would look
like this: (1+40/100) x 50,000 = 50,000 (1.4) =
$70,000
 From there, she would determine the forecasted
value of the previously referenced accounts.

Presented By KP Henrique
 Apply line items' relative percentages to your
forecasted sales figure.
 Barbara's figures would look like this:
• Forecasted inventory — $28,000

• Forecasted accounts receivable — $14,000

• Forecasted accounts payable — $9,800

• Forecasted cash — $21,000

• Forecasted costs of goods sold — $21,000

• Forecasted net income — $49,000

Presented By KP Henrique
Preparing Pro forma
Statement of Financial
Position Using PSM
 Process
 Identify the balance sheet items that are
expected to vary directly with sales e.g.
inventory, debtors, creditors, etc.
 Express those items that vary directly with sales
as percentage of sales e.g. debtors/sales x 100%
 Establish the additional sales that must be
financed (Additional Financing)

Presented By KP Henrique
 Example
 For example, for the XYZ Ltd, we show the following
balance sheet accounts and their percent of sales,
based on a sales volume of Tshs 200 million.
XYZ Ltd
Balance Sheet and Percent – of – Sales Table (‘000s)

Cash Tshs 5,000 Accounts payable Tshs 40,000

Accounts receivable 40,000 Accrued expenses 10,000
Inventory 25,000 Notes payable 15,000
Total current assets Tshs 70,000 Common stock 10,000
Equipment 50,000 Retained earnings 45,000
Total assets Tshs 120,000 Total liabilities and Tshs 120,000
stockholders’ equity

Presented By KP Henrique
 Percentage of Sales
Tshs 200 million Sales
Percent of sales
Cash 2.5% Accounts 20.0%
payable
Accounts 20.0 Accrued 5.0
receivable expenses

Inventory 12.5 25.0%

Total current 35.0
assets

Equipment 25.0
60.0%
Presented By KP Henrique
 Cash of Tshs 5 million represents 2.5 percent of sales of
Tshs 200 million; receivables of Tshs 40 million is 20
percent of sales; and so on. No percentages are computed
for notes payable, common stock, and retained earnings
because they are not assumed to maintain a direct
relationship with sales volume.
 Note that any monetary (Tshs) increase in sales will
necessitate a 60 percent increase in assets, of which 25
percent will be spontaneously or automatically financed
through accounts payable and accrued expenses, leaving
35 percent to be financed by profit or additional outside
sources of financing. We are assuming equipment
increases in proportion to sales. In certain cases, capacity,
and equipment (or plant and equipment) will not increase.
Presented By KP Henrique
 We will assume that the ABC Ltd has an after-tax
return of 6 percent on sales (Tshs) and 50 percent
of profits are paid out as dividends
 If sales increase from Tshs 200 million to Tshs 300
million, The Tshs 100 million increase in sales will
necessitate Tshs 35 million (35 percent) in
additional financing. Since it will earn 6 percent
on total sales of Tshs 300 million, it will show a
profit of Tshs 18 million.
 With a 50 percent dividend payout, Tshs 9 million
will remain for internal financing. This means
Tshs 26 million out of Tshs 35 million must be
financed from outside sources.
Presented By KP Henrique
 Our formula to determine the need for new funds
is:
 Required ANew Funds L (RNF);
RNF = S   S   PS2 1  D 
S S
Where:
A/S = Percentage relationship of variable assets to sales [60%]
S = Change in sales [Tshs 100 million]
L/S = Percentage relationship of variable liabilities to sales [25%]
P = Profit margin [6%]
S2 = New sales level [Tshs 300 million]
D = Dividend payout ratio [0.50]
Presented By KP Henrique
 Plugging in the values, we get:
 RNF = 60% (Tshs 100million) – 25% (Tshs 100
million) – 6% (Tshs 300 million) (1 – 0.5)
= Tshs 60 million – Tshs 25 million – Tshs 18
million (0.5)
= Tshs 35 million – Tshs 9 million
= Tshs 26 million required sources of new
funds
 Presumably the Tshs 26 million can be financed

at the bank or through some other appropriate

sources.
Presented By KP Henrique
Judgmental Method

 Under a judgmental approach a firm estimates the values

of certain balance sheet accounts and uses its external
financing as a balancing, or “plug,” figure.
 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 balance sheet will no longer balance.
 Because new financing may be necessary to cover all of
the projected capital spending, a financial “plug”
variable must be selected. The plug is the designated
source or sources of external financing needed to deal
with any shortfall (or surplus) in financing and thereby
bring the balance sheet into balance.
Presented By KP Henrique
 The judgmental approach represents an improved
version of the percent-of-sales approach to pro
forma balance sheet preparation.
 Under the judgmental approach for developing a
pro forma balance sheet, the amount of external
financing needed to bring the statement into
balance.
 It can be either a positive or a negative value.

Presented By KP Henrique
 A positive value for “external financing required,”
means that, based on its plans, the firm will not
generate enough internal financing to support its
forecast growth in assets.
 To support the forecast level of operation, the firm
must raise funds externally by using debt and/or
equity financing or by reducing dividends.
 Once the form of financing is determined, the pro
forma balance sheet is modified to replace “external
financing required” with the planned increases in the
debt and/or equity accounts.
Presented By KP Henrique
 A negative value for “external financing required” indicates
that, based on its plans, the firm will generate more
financing internally than it needs to support its forecast
growth in assets. In this case, funds are available for use in
repaying debt, repurchasing stock, or increasing dividends.
 Once the specific actions are determined, “external financing
required” is replaced in the pro forma balance sheet with the
planned reductions in the debt and/or equity accounts.
 Besides being used to prepare the pro forma balance sheet,
the judgmental approach is frequently used specifically to
estimate the firm’s financing requirements.

Presented By KP Henrique
Activity
Read about Financial Forecasting
Using Statistical Methods (Simple
Linear Regression)

Presented By KP Henrique