Financial Forecasting

Sales (or Revenue)

Less Cost of Goods Sold

Equals Gross Income (or Gross Earnings)

Less Operating Expenses

Equals Operating Income

Income Less Depreciation
statement Equals EBIT

Less Interest Expense

Equals EBT

Less Taxes

Equals Net Income (Net Earnings, EAT, Profits)

• Assets • Liabilities + O’s Equity
• Cash • Bank Loan
• Accounts • Accounts Payable
Receivable
Balance • Wages Payable
• Inventory
sheet • Prepaid Taxes
• Taxes Payable
• Current Portion – L-
• Marketable T Debt
Securities
• Total Current
• Total Current Liabilities
Assets
• Long-Term Debt
• Gross PP&E
• Preferred Stock
• Accumulated
Depreciation • Common Stock

• Net PP&E • Retained Earnings

• Total Liabilities +
• Total Assets
Equity
Strategic Plan

• Corporate Purpose

• Corporate Strategies

• Operating Plans

• Financial Forecasting
Steps in Financial Forecasting

o Forecast sales

o Project the assets needed to support sales

o Project internally generated funds

o Project outside funds needed

o Decide how to raise funds

o See effects of plan on ratios and stock price

Financial Planning

Sales forecast

Pro-forma financial statement

External financial planning

Analyze historical ratios

o Are there any trends in the ratio?

o How does the ratio compare with historical averages?

o How does the ratio compare with industrial averages?

o What is happening in the economy and firm’s industry?

o What are the operating plans?

Sales forecast

o Review of sales during the past 5-10 years

o Determine the growth rate for the past 5 years (Simple average,
CAGR)

o Approach is simple but poor representation (higher numbers,

beginning and end data could be outliers also)

o Solution – Regression approach (Use Logest Function in Excel)

o Future sales will depend on economy (both domestic & global),

industry prospects, present product line, marketing campaign, etc.

o Accurate sales forecast is critical

Sales Forecast

Year Sales (in amount)

2014 2058

2015 2534

2016 2472

2017 2850

2018 3000
Additional Fund Needed

o Under the assumptions ratios remain constant

o If sales , firms usually have to purchase asset (e.g. inventories,

machines etc.) to support sales.

o Where will the firm get the money to purchase the assets?

⚫ Some liabilities (accounts payable) , as increase in asset should be equal

to increase in liability & equity

⚫ Firm should make a profit as sales  hence retained earning 

⚫ Any remaining asset  has to be financed by external fund

Additional Fund Needed

AFN = Required increase in asset – increase in spontaneous liability –

increase in retained earnings

= (A0/S0)∆S - (L0/S0)∆S –S1M(1-POR)

S0 Last year's sales

g Forecasted growth rate in sales
S1 Coming year's sales, S0 × (1 + g)
ΔS Change in sales = S1 – S0 = ΔS
A0 Assets that must increase to support the increase in sales
A0 / S0 Required assets per dollar of sales
L0 Last year's spontaneous liabilities, i.e., payables + accruals
L0 /S0 Spontaneous liabilities per dollar of sales
Profit margin (M) profit margin = net income/sales
Payout ratio (POR) Last year's dividends / net income = % of income paid out
INCOME STATEMENTS 2018 BALANCE SHEETS 2018
Assets
Sales 3,000.00 Cash 9.98
Costs except depreciation 2,616.20 ST Investments 0.00
Depreciation 100.00 Accounts receivable 375.00
Total operating costs 2,716.20 Inventories 615.00
EBIT 283.80 Total current assets 999.98
Less interest (INT) 88.00 Net plant and equip. 1,000.00
Earnings before taxes (EBT) 195.80 Total assets 1,999.98
Taxes (40%) 78.32
Income before pref. dividends 117.48 Liabilities and equity
Preferred dividends 4.00 Accounts payable 60.00
Net income for common (NI) 113.48 Accruals 140.00
Notes payable 110.00
Dividends to common (DIVs) 57.50 Total current liab. 310.00
Add. to retained earnings: (NI –
DIVs) 55.98 Long-term bonds 754.00
Shares of common stock 50.00 Total liabilities 1,064.00
Earnings per share (EPS) 2.27 Preferred stock 40.00
Dividends per share (DPS) 1.15 Common stock 130.00
Price per share (P) 23.00 Retained earnings 765.98
Total common equity 895.98
Total liab. & equity 1,999.98
Additional Fund Needed

S0 Last year's sales, i.e., 2018 sales 3,000.00

g Forecasted growth rate in sales 10.00%
S1 Coming year's sales, i.e., 2019 sales = S0 × (1 + g) 3,300.00
ΔS Change in sales = S1 – S0 = ΔS 300.00
Assets that must increase to support the increase in
A0 sales 1,999.98
A0 / S0 Required assets per dollar of sales 66.7%
Last year's spontaneous liabilities, i.e., payables +
L0 accruals 200.00
L0 /S0 Spontaneous liabilities per dollar of sales 7%
Profit margin (M) 2018 profit margin = net income/sales 3.8%
Payout ratio Last year's dividends / net income = % of income paid
(POR) out 50.7%

AFN =(A0/S0)∆S - (L0/S0)∆S –S1M(1-POR) 118.42

AFN = 200 – 20 – 61.58 118.42
AFN (PQs)

1. Baxter Video Products’ sales are expected to increase

from $5 million in 2007 to $6 million in 2008 or by
20%. Its assets totaled $3 million at the end of 2007.
Baxter is at full capacity, so its assets must grow at
the same rate as projected sales. At the end of 2007,
current liabilities were $1 million, consisting of
$250,000 of accounts payable, $500,000 of notes
payable, and $250,000 of accruals. The after-tax profit
margin is forecasted to be 5%, and the forecasted
payout ratio is 70%. Use the AFN formula to forecast
Baxter’s additional funds needed for the coming
year.
AFN (PQs)

1. Refer to Problem 1. What would be the additional funds

needed if the company’s year-end 2007 assets had been $4
million? Assume that all other numbers are the same. Why
is this AFN different from the one you found in Problem 14-
1? Is the company’s “capital intensity” the same or
different?
2. Refer to Problem 1. Return to the assumption that the
company had $3 million in assets at the end of 2007, but
now assume that the company pays no dividends. Under
these assumptions, what would be the additional funds
needed for the coming year? Why is this AFN different
from the one you found in Problem 14-1?
Forecasted Financial Statement
(FFS) Method
Advantages over AFN Method:
• It forecasts complete set of financial statements.
• It allows for different asset classes to grow at
different rates.
• Forecasts entire asset side of BS while AFN shows
only for net increase in assets
• It allows for spontaneous liabilities to grow at
different rate also.
• Retained earnings are forecasted using entire
income statement and dividend payments (as
compare of AFN method where it is limited to profit
margin and dividend retention ratio).
FFS Method

• Forecasted asset side and liabilities side should match.

• This indicates that firm has sufficient financing to
acquire the assets needed support forecasted level of
sales.
• “Plug Technique” is used to fill the gap between asset
and liabilities mismatch.
• If AFN is positive, raise additional capital and plug it in
form of notes payable.
• If AFN is negative, use this to payoff some debt,
repurchase or pay higher dividends.
• Or use the additional money for short-term investment
FFS Method

• Step 1: Analyze historical ratios

• Step 2: Forecast Income Statement
• Step 3: Forecast Balance sheet
• Step 4: Raise additional funds needed
• Step 5: Analyse the Forecast
FFS: Microdrive’s Ratios

Actual Actual Historical Industry

Ratio
2017 2018 Average Average

Costs to Sales 87.60% 87.20% 87.40% 87.10%

Depreciation to Net Plant
10.3 10 10.2 10.2
and Equipment
Cash to Sales 0.5 0.3 0.4 1
Accounts Receivable to Sales 11.1 12.5 11.8 10
Inventory to Sales 14.6 20.5 17.5 11.1
Net Plant & Equipment to
30.5 33.3 31.9 33.3
Sales
Accounts Payable to Sales 1.1 2 1.5 1
Accruals to Sales 4.6 4.7 4.6 2
Forecasted Income Statement
Forecast for
# Item Actual 2018 Forecast Basis
2019
1 Sales 3,000.00 110% × 2018 Sales = 3,300.00
2 Costs except depreciation 2,616.20 87.2% × 2019 Sales = 2,877.60
3 Depreciation expense 100 10% × 2019 Net Plant = 110
4 Total operating costs 2,716.20 2,987.60
5 EBIT 283.8 312.4
Net Short-term Interest
6 Less interest 88 (110@9%)+ Interest on Long term 92.8
Bonds (754@11%)
7 Earnings before taxes (EBT) 195.8 219.6
8 Taxes (40%) 78.3 87.8
9 NI before preferred dividends 117.5 131.8
Dividend rate (10%) × 2019 Pref.
10 Preferred dividends 4 4
stk.
11 NI available to common 113.5 127.8
12 Shares of common equity 50 50
13 Dividends per share 1.15 increase dividend @8% 1.25
14 Dividends to common 57.5 2019 DPS × Number of shares = 62.5
15 Additions to retained earnings 56 65.3
Actual 2018 Forecast Basis Forecast for 2019
Assets
1 Cash 10 0.33% × 2019 Sales 11
2 Short-term investments 0 Previous plus "plug" if needed 0
3 Accounts receivable 375 12.50% × 2019 Sales 412.5
4 Inventories 615 20.50% × 2019 Sales 676.5
5 Total current assets 1,000.00 1,100.00
6 Net plant and equipment 1,000.00 33.33% × 2019 Sales 1,100.00
7 Total assets 2,000.00 2,200.00
Actual 2018 Forecast Basis Forecast for 2019
Liabilities and Equity
8 Accounts payable 60 2.00% × 2019 Sales 66
9 Accruals 140 4.67% × 2019 Sales 154
Previous plus "plug" if needed
10 Notes payable 110 224.7
(110+114.7)
11 Total current liabilities 310 444.7
12 Long-term bonds 754 Same: no new issue 754
13 Total liabilities 1,064.00 1,198.70
14 Preferred stock 40 Same: no new issue 40
15 Common stock 130 Same: no new issue 130
2018 RE (766) + 2019 Additions to RE
16 Retained earnings 766 831.3
(65.3)
17 Total common equity 896 961.3
18 Total liabilities and equity 2,000.00 2,200.00
19 Required assets 2,200.00
A/P (66) + Accruals (154)+ Notes Payable
20 Specified sources of financing (110)+LT Bonds (754) + P.Shares (40) + 2,085.30
Common Stock (130) + RE (831.3)
21 Additional funds needed (AFN) 114.7
Required additional notes
22 114.7
Analysis of Forecasts
Preliminary Revised
Industry
Category Actual 2018 Forecast for Forecast for
Average 2018
2019 2019
Model Inputs
Costs (excluding depreciation) as % of sales 87.20% 87.20% 86.00% 87.10%
Accounts receivable as % of sales 12.50% 12.50% 11.80% 10.00%
Inventory as % of sales 20.50% 20.50% 16.70% 11.10%
Model Outputs
NOPAT (Net Operating Profit After Taxes) $170.3 $187.4 $211.2 —
Net Operating Working Capital $800.0 $880.0 $731.5 —
Total Operating Capital $1,800.0 $1,980.0 $1,831.5 —
Free Cash Flow (FCF) ($174.7) $7.4 $179.7 —
AFN (Additional Funds Needed) $114.7 ($57.5) — —
Ratios
Current Ratio 3.2X 2.5X 3.1X 4.2X
Inventory Turnover 4.9 1.9 6 9
Days Sales Outstanding 45.6 45.6 43.1 36
Total Assets Turnover 1.5 1.5 1.6 1.8
Debt Ratio 53.20% 54.50% 51.40% 40.00%
Profit Margin 3.80% 3.90% 4.60% 5.00%
Return on Assets (ROA) 5.70% 5.80% 7.20% 9.00%
Return on Equity (ROE) 12.70% 13.30% 15.40% 15.00%
Return on Invested Capital (NOPAT / Total Operating
9.50% 9.50% 11.50% 11.40%
Capital)
Some adjustments

After reviewing its preliminary forecast, management decided to take three

steps to improve its financial condition:
(1) It decided to lay off some workers and close certain operations. It
forecasted that these steps would lower operating costs (excluding
depreciation) from the current 87.2% to 86% of sales as shown in
Column 3.
(2) By screening credit customers more closely and being more aggressive
in collecting past-due accounts, the company believes it can reduce the
ratio of accounts receivable to sales from 12.5% to 11.8%.
(3) Finally, management thinks it can reduce the inventory-to-sales ratio
from 20.5% to 16.7% through the use of tighter inventory controls.