1. Business Finance
Michael Dimond

2. Module H: Forecasting for Financial Management
Financial planning process
Building pro forma financial statements
Analyzing & using pro forma financials

3. Financial Planning Process
Plans are developed according to purpose
Strategic Plan - long term (e.g. 5-year)
Necessarily less specific than operating plan
Tied to strategic goals
Strategic plan guides CapEx budget
Operating Plan - short term (e.g. 1-year)
Based on forecasts of sales & capacity
Operating Plan (O.P.) provides operating budget & cash budget
Used with pro forma financial statements to predict profit & cash flow
Plans are adjusted as needed
Strategic plan usually updated annually (or sooner, if events warrant)
Operating plan usually updated quarterly

4. Elements of Financial Planning
Sales Forecast – many needs depend directly on sales volume (often estimated using sales growth rate)
Pro Forma Statements – showing the operating plan in projected financial statements makes interpretation easier and more consistent
Asset Requirements – the additional assets that will be required to meet sales projections – sometimes based on capacity and efficiency assumptions
Financial Requirements – the amount of financing needed to pay for the required assets
Plug Variable – determined by management deciding what type of financing will be used to make the balance sheet balance
Economic Assumptions – explicit assumptions about the coming economic environment

5. Pro Forma Financial Statements
Pro forma = “in the form of”
Pro forma financials use the form of a balance sheet and income statement to present forecast information and support financial planning & analysis (FP&A)
Profit is the foundation of cash flow (see 4.1 Analyzing the firm's cash flow)
Cash flow is usually forecast through budgets: Capital budget, cash budget, operating budget, etc.
Profit comes from operations
Pro forma income statement
Assets support operations
Pro forma balance sheet
Pro forma financials are based on past performance and adjusted for expectations
Common-size financials
Marketing plans and sales forecasts
Capacity analysis and operating plans
CapEx budgets

6. Preparing the Pro Forma Income Statement
Start with sales forecast
Volume x Price = Revenue
Estimate profit using…
Volume x Variable Cost per Unit = Total Variable Costs OR
COGS as % of Sales (from common size income statement)
Estimating other costs
Percent-of-sales method uses data from common-size income statement
Not everything grows at the same rate as sales (e.g. Depreciation)
Estimating balance sheet items
Initially assume all assets, including fixed, vary directly with sales
Accounts payable will also normally vary directly with sales
Notes payable, long-term debt and equity generally do not vary directly with sales because they depend on management decisions about capital structure
The change in retained earnings will come from profits and dividend decisions

7. Financial Planning Example
Initial Assumptions
Revenues will grow at 15% (2,000*1.15)
All items are tied directly to sales, and the current relationships are optimal, so all other items will also grow at 15%
After the pro forma income statement, we need a pro forma balance sheet. Assets grow 15% to $1150, then…
Case 1
Dividends are the plug variable, so equity increases 15% ($90)
Dividends = 460 (NI) – 90 (increase in equity) = 370 dividends paid
Case 2
Debt is the plug variable and no dividends are paid
Equity = (NI) = 1,060
Debt = Assets – Equity = 1,150 – 1,060 = 90
Repay 400 – 90 = 310 of debt repaid

8. Financial Plannign Example, cont’d
Case 1
Dividends are the plug variable, so equity increases at 15%
Dividends = 460 (NI) – 370 (increase in equity) = 90 dividends paid
Case 2
Debt is the plug variable and no dividends are paid
Debt = 1,150 – ( ) = 90
Repay 400 – 90 = 310 in debt

9. Estimating Financing Needs
What if the pro forma balance sheet does not tie out?

10. Estimating Financing Needs, cont’d
The firm needs to come up with an additional $200 in debt or equity
TA – [TL&OE] = 10,450 – 10,250 = 200
Choose plug variable ($200 EFN)
Borrow more short-term (Notes Payable)
Borrow more long-term (LT Debt)
Sell more common stock (CS & APIC)
Decrease dividend payout, which increases the Additions To Retained Earnings (RE)

11. Evaluating Pro Forma Financials
Forecasts are not certain
Check the arithmetic & the internal logic
Common-size financials (vertical analysis)
Rates of growth of line items (horizontal analysis)
Ratio analysis (what questions do you need to answer?)
Examine OCF & FCF compared to history