1. Lecture No. 5 Financial Forecasting
Financial Management
Lecture No. 5
Financial Forecasting
Copyright: M.S. Humayun

2. Financial Planning & Forecasting
Objectives of Financial Forecasting
Reduce cost of responding to emergencies
Be prepared to take advantage of opportunities
Prepare contingency and emergency plans
Prepare to deal with possible outcomes
Planning Documents
Cash Budget
Pro Forma Balance Sheet
Pro Forma Income Statement
Methods
Percent of Sales: Simple
Cash Budget: Detailed, more complicated
Copyright: M.S. Humayun

3. Financial Forecasting Percent of Sales
Step 1: Estimate year-by-year Sales Revenue and Expenses
Step 2: Estimate Levels of Investment Needs (in Assets) required to Meet Estimated Sales (using Financial Ratios)
Step 3: Estimate the Financing Needs (Liabilities)
Copyright: M.S. Humayun

4. Percent of Sales Forecasting
General Assumptions:
Current Assets: Generally grow in proportion to Sales
Fixed Assets: Do not always grow in proportion to Sales. Ask if you need to expand property, office or factory space, machinery in order to achieve your Sales target.
Current Liabilities: Also called Spontaneous Financing.
Generally grow in proportion to Sales
Long Term Liabilities: Also called Discretionary Financing.
Do not grow in proportion to Sales
Copyright: M.S. Humayun

5. Percent of Sales Forecasting Numerical Example of Café
Suppose you expect the Sales Revenue from your Café (or Canteen) business to grow from Rs 200,000 to Rs 300,000 and your Expenses to grow from Rs 50,000 to Rs 70,000 after 1 year.
This means that the Sales Revenue growth rate is: (300, ,000) / 200,000 = 0.5 = 50%
Similarly, the Expenses growth rate is: (70,000-50,000) / 50,000 = 40%
Now, how do we estimate the required change in Investments (Assets) and Financing (Liabilities)? First compute some Key Financial Ratios.
Copyright: M.S. Humayun

6. Percent of Sales Forecasting Computing Key Financial Ratios
Use Previous Balance Sheets and Income Statements to compute the Average Financial Ratios for your Business.
If your business is new, use published Industry Averages for Financial Ratios.
Suppose that the Small Restaurant Industry Average for Financial Ratios is as follows:
Current Assets / Sales = 0.2 = 20%
Profit Margin = Net Income / Sales = 0.25 = 25%
Payout Ratio = Cash Dividends / Net Income = 50%
Now, we can estimate the changes in Investment (Assets) and Financing (Liabilities) required to meet the Sales Targets
Copyright: M.S. Humayun

7. Percent of Sales Forecasting Estimating Changes in Investment & Financing
Predicting Current Assets:
= Estimated Sales x (Current Assets / Sales)
= 300,000 x (0.20) = Rs 60,000 (Balance Sheet value)
Assume no changes (no increase) in Fixed Assets.
Predicting Retained Earnings (RE)
= Estimated Sales x Profit Margin x Plowback Ratio
= 300,000 x (0.25) x (1 - Payout Ratio) = 75,000 x (1-0.5)
= Rs 37,500 (Balance Sheet value)
Predicting Discretionary Financing (Liabilities)
= Estimated Total Assets - Estimated Total Liabilities - Estimated Equity
= 160, ,500 = Rs 12,500
Copyright: M.S. Humayun

8. Percent of Sales Forecasting
Construct the Cash Flow Statement Forecast (or Pro Forma Cash Flows) based on the Predicted Sales Revenue, Expenses, Assets, Liabilities, and Retained Earnings.
If the Business wants to maintain its present Financial Ratios constant and its owners (or shareholders) do not want to invest more equity, then at what sales growth rate (g) (also the growth rate of assets and liabilities) can the business grow sustainably?
g = ROE x (1 - b) where b = Dividend/Net Income
ROE = Net Income / Equity
Drawback of Percent of Sales Method: Rough approximate because does not account for Economies of Scale, Fixed Inventories, and Lumpy Assets.
Copyright: M.S. Humayun

9. Forecasted (or Pro Forma) Cash Flow
(‘000 Rs)
Net Income
Add Depreciation Expense
Subtract Increase in Current Assets:
Increase in A/c Receivable (400)
Increase in Inventory (700)
Add Increase in Current Liabilities:
Increase in A/c Payable 500
Cash Flow from Operations (100)
Cash Flow from Investments 0
Cash Flow from Financing 500
Net Cash Flow from All Activities 400
Note 1: Indirect Cash Flow Approach using Income Statement and two consecutive Balance Sheets
Note 2: Final Net Cash Flow from All Activities should match the difference in the difference in the closing balances in the Balance Sheets from June 30th 2001 and June 30th 2002
Note 3: Investments include all cash sale and purchases of non-current assets and marketable securities
Note 4: Financing includes all cash changes in loans, leasing, and equity etc.
Copyright: M.S. Humayun