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

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

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

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

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) / 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

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

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 = 160,000 - 0 - 137,500 = Rs 12,500 Copyright: M.S. Humayun

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

Forecasted (or Pro Forma) Cash Flow (‘000 Rs) Net Income 400 Add Depreciation Expense 100 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