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