Financial Forecasting& its Related Problems
Submitted By:
Sagar GulabaniSamir Kumar AgarwalShah DhwaniShailesh Kumar PandeySonal Misra
IntroductionFinancial planning indicates a firm’s
growth, performance, investments and requirements of funds during a given period of time, usually three to five years.
It involves the preparation of projected or pro forma profit and loss account, balance sheet and other statements.
Financial planning help a firm’s financial manager to regulate flows of funds which is his primary concern.
Financial Planning
Financing planning process involves thefollowing facets:
Evaluating the current financial condition of the firm.
Analyzing the future growth prospects and options.
Appraising the investment options to achieve the stated growth objective.
Projecting the future growth and profitability.
Estimating funds requirement and considering alternative financing options.
Comparing and choosing from alternative growth plans and financing options.
Measuring actual performance with the planned performance.
Financial Forecasting andModeling
•Financial forecasting is a planning process with respect to company’s management positions, the firm’s future activities relative to the expected economic, technical, competitive and social environment.
•A financial planning model establishes the relationship between financial variables and targets, and facilitates the financial forecasting and planning process.
•A financial planning model has the following three components:InputsModelOutput
Sales Projection
Productionplan
Prior BalanceSheet
CashBudget
Pro formaIncomeStatement
Pro formaBalanceSheet
Financial Forecasting
Three major Techniques of Financial Projections:
1.Proforma Financial Statements
2.Cash Budgets and
3.Operating BudgetsSales BudgetProduction Budget
Proforma Financial Statements
A comprehensive look at the likely future financial performance.
Pro forma Income Statement. (Represents the operational plan for the whole organization.)
Pro forma Balance sheet. (Reflects the cumulative impact of anticipated future decisions).
Preparation of Pro Forma Income Statements
Percent of Sales MethodAssumes that future relationship between
various elements of cost to sales will be similar to their historical relationships.
These cost ratios are generally based on the average of previous two or three years.
For example, Cost of Goods sold may be expressed as a percentage of Sales.
2. Budgeted Expense Method.Estimate the value of each item on the basis
of expected developments in the future period for which the pro forma P&L a/c is being prepared.
Calls for greater effort on the part of Management, since they have to define the likely happenings.
3. Combination method
Neither the Percent of sales method nor the Budgeted expense method should be used in isolation.
A combination of both methods work best.
Items which have stable relationship to sales can be forecasted using the Percent of sales method.
For items where the future is likely to be very different from the past, budgeted expense method can be used.
Proforma Income StatementActual figures for Quarter 31-3-2006
Assumptions Proforma for the qr ended 30-6-2006
1.No.of units sold
2.Net Sales
3.Cost of Goods sold:4.Labour5. Materials6.Distribution cost7. Overhead8. Total9. Ratio of CGS to Sales.10. Gross Profit11. GP Margin
14000
140000100%
2296025256459261992114800
82.0%2520018%
Sales decline 30% due to low demand.No change in Product mix.
20% of Cost of good22% of COG4% of COG
54% of COG
Increase by 1.5%
9800
98000100%
1636618002.63273.244188.281830
83.5%1617016.5%
Contd.Actuals Assumption Proforma
12. Expenses:13. Selling Expenses14. Admin. Expense15. Others16.Total17. Operating Profit18. Interest19. Depreciation20.PBT21. Tax @ 30%22.Net Income23.Dividends24.Retained earnings.25. Cash flow after dividends.
82504450Nil1270012500250020007000210049009004000
6000
A drop of Rs. 750 .A drop of Rs. 850
Rs.2000 only
No dividendsCarried to B/s.
Retained earning + Depreciation
75003600Nil1110050702000200010703217490749
2749
Pro forma Balance sheet only to explain not to be included.
Projections for Balance sheet can be made as under:
1. Employ Percent of Sales method to project items on the asset side, except “Investments” and “Misc Exp & Losses”.
2. Expected values for Investment and Misc exp can be estimated using specific information.
3. Use Percent of sales method to project values of current liabilities and Provisions. (Also referred to as ‘spontaneous liabilities’)
4. Projected values of R & S can be obtained by adding projected retained earnings from P&L proforma statement.
B/S Contd..
5. Projected value for Equity and preferential capital can be set tentatively equal to their previous values.
6. Projected values for loan funds will be tentatively equal to their previous level less repayments or retirements.
7. Compare the total of asset side with that of liabilities side and determine the balancing figure. (If assets exceed liabilities, the balancing figure represents external funding requirement. If liabilities exceeds Assets, the balancing item represents ‘surplus available funds’ )
PROFORMA BALANCE SHEET.
Actual Assumptions Proforma for June
Change
LIABILITIES:A. CAPITALB. R& S.
(C+D)C. RESERVESD. P&L
BalanceE. Total share
holders funds.
F. Total DebtG. Total
Liabilities (E+F)
65004500500400011000
750018500
Issue of shares Rs.500
P&L account.
70005250500475012250
750019750
+500+7500+750+1250
0+1250
Proforma Balance sheet contd..
Actuals Assumptions Proforma Change
ASSETS;H. GROSS BLOCK (I+j)I. LANDj. Plant & MachineryK. LESS DEPRECN.L. NET BLOCK (J-K)M. CURRENT ASSETS
(N+O)N. INVENTORIESO. CASH. Less: P. CURRENT
LIAILITIES.Q. ProvisionsR. Net current assets (M-P-Q)s. Total assets
(L+R)t. Additional funds
required.
24000
300021000100001100014500
105004000
5000
20007500
18500
No changeSale of 1000Depreciation of 9500
Increase by 2000Maintain CB of 3500
Decrease by 1000
23000
30002000095001050016000
125003500
4000
200010000
20500
-1000
0-1000-500-500+1500
+2000-500
-1000
0+2500
+2000
Other Proforma Statements
Cash BudgetOperating
Budget
Sales Budget Production Budget
Subjective Method
Objective Method
Executive Opinion
Sales Forceestimate
Trend Analysis
Regression Analysis
2nd Factor economic dev
3rd Factor Seasonal Variation
4th Factor Erratic events
1st Factor Population
Cash BudgetPrepared every month or every
week.
Helps in deciding the minimum amount of cash that can be kept to allow timely payments of obligations.
Shows the cash needs or excess.
Techniques of Sales Forecasting
1.Subjective Methods ( based on the opinions or judgments of knowledgeable individual within the organization- sales force to executives)
Jury of executive opinionSales force estimates
2. Objective MethodsTrend Analysis Via ExtrapolationRegression analysis
While doing trend analysis, the analyst must keep in mind that the time series of a product’s past sales is made up of four major factors:
Long-term trend- result of basic developments in population, capital formation and technology
Cycle-movements of sales as a result of swings in general economic activity, which tends to be somewhat periodic.
Seasonal variations- climatic factors, holidays, etc.
Erratic events- strikes, riots, earthquakes and other natural calamities.
Trend Analysis
Growth and External FinancingRequirement
New Investment = growth rate X initial assets
XYZ Co. started with Rs. 15,00,000 of fixed
assets and working capital and forecasts a growth of 10 percent.
What is the required addition to its assets?
Rs. 15,00,000 x 10% = Rs. 1,50,000/
External Financing Requirement
EFR = A (ΔS) less L (ΔS) less mS1 (1-d) S SWhere,EFR = external financing requirement
A/S = current assets and fixed assets as a proportion of sales
(ΔS) = expected increase in sales
M = net profit margin
S1 = projected sales for next year
D = dividend payout ratio
L/S = spontaneous liabilities as a proportion of sales
OrEFR = A less L less m (1+g) (1-d)(ΔS) S S gWhere, g is the growth rate in sales
ExampleXYZ Company has the following ratios:A/S 0 8 ΔS Rs lakh 0 3 = 0.8, =Rs. 5 lakh, L/S =0.3, m= 0.05, S1= Rs. 50 lakh, and d =
0.4
Solution:EFR = (0.8) (5) –(0.3) (5) – (0.05) (50) (0.6)
= Rs.1 lakh
The equation highlights that :
External financing depends on the firm’s projected growth in sales. Faster growth more needs in investments more needs to raise new capital. The firm should use new securities for new investment.
Low growth less needs in investments (can be through retained earnings) external funds is negative (surplus is used to pay off debt)
Growth rate is zero no needs of new
capital all retained earnings are surplus
Sustainable Growth Rate
Though having desire to grow, a firm may resist
to raise external equity due to various reasonlike: High issuing cost and Unacceptable
dilution of control etc. In this case the rate of growthwhich it can achieve without resorting to issue
ofexternal equity is calculated as below: m(1-d) A/Eg = A/So – m(1- d) A/E
Assumptions:
The assets of the firm will increaseProportionally to sales
Net profit margin is constant
Dividend-payout ratio and debt-equity ratio
will remain constant
External issue of equity will not beresorted to
Example
M = 0.05, d = 0.4, A/E = 1.5, A/S0 = 0.8.
Find growth out the rate of sustainableWith internal equity.Solution: 0.05(1-0.4) 1.5 g = 0.8 – 0.05(1- 0.4) 1.5 = 5.96%
Problems with ForecastingDifficulty in comparison
Differences in the basis of inventory valuation
Different depreciating method, estimated working life of assets.
Different treatment of extraordinary items of income and expenditure.
Impact of Inflation
Conceptual Diversity