CHAPTER FOUR
4. FINANCIAL FORECASTING
4.1. Overview of Financial Forecasting
Planning is a means of systematically thinking about the future and anticipating possible
problems before they arrive. Financial planning formulates the way in which financial goals are
to be achieved. A financial plan is thus a statement of what is to be done in the future. Every
resource allocation decision embodies a forecast of future. These forecasts mainly fall under two
broader classifications, namely, short run and long run forecasts. Short run forecasts time span
coverage is usually one year or less while long term forecasts are seeing several years into the
future.
Financial planning, usually the term is related to long term, indicates a firm’s growth,
performance, investment and requirement of funds (which includes Internal and External
Financing ) during a given period of time, usually three to five years. Most financial planning
models require the user to specify some assumptions about the future. Based on those
assumptions, the model generates predicted values for a large number of variables. Almost all
financial plans require an externally supplied sales forecast. A financial plan will have a
forecasted balance sheet, income statement, and statement of cash flows. These are called pro
forma statements, which are the output from the financial planning model.
The Sales Forecast has to take into account what we expect to sell at what sales price. Most of
the time it will be given as the growth rate in sales rather than explicit sales figure.
4.2. Methods of Forecasting Financial Requirement
A. The Formula Method
To determine the external fund needed using the formula the following steps should be
performed:
Isolate all balance sheet items which have a direct relation with sales
Express all identified items as percent of sales
1
Obtain projected sales value
A) Internal Fund Available (IFA) (Change in Retained Earnings/CIRE)
IFA = mbs2 = REp - REb = NIb - Db
Where: m= profit margin RA = Responsive Assets
b = Retention rate RL = Responsive Liabilities
S2 = sales of the 2nd period S = Base Year Sales
B) AFN= CS (∑ RA – ∑ RL)/S CS = Change in Sales
C) Total External Fund Needed (EFN) = AFN – IFA
B. PERCENT OF SALES OF METHOD
Under this method the assumption is that a constant r/p exists b/n sales and the items on the I/S
and the B/S. Thus, we indicate a change in the sales level and ascertain our released financing
needs.
Pro forma Income Statement
For the year ended:
2023 % of sales 2024
Revenues:
Net sales 50,000 100% 80,000
Other income 10,000 20% 16,000
Total income 60,000 96,000
Cost and Expenses:
COGS 15,000 30% 24,000
2
Administrative Exp. 20,000 40% 32,000
Total cost and expense 35,000 56,000
Earnings from operations 25,000 40,000
Interest expense 5,000 10% 8,000
EBT (Earning Before Tax) 20,000 32,000
Tax 12,000 24% 19,200
N/I 8,000 12,800
PROFORMA BALANCE SHEET
A PFBS shows the approximate composition of projected assets and liabilities as well as the
external funds they must be raised to support the growth in sales. The percent of sales method
assumes that selected b/s items released to operation vary directly with sales. They are called
Responsive (Spontaneous) Items.
BALANCE SHEET
31-12-23 % of sales 31-12-24
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Assets
Cash 6,000 12% 9,600
A/R 20,000 40% 32,000
Inventories 15,000 30% 24,000
Prepaid expense 8,000 NA 8,000
Net fixed assets 25,000 50% 40,000
Total assets 74,000 132% 113,600
Liabilities
N/P 12,000 NA 12,000
A/P 16,000 32% 25,600
Accrued liabilities 8,000 16% 12,800
L.T liabilities 14,000 NA 14,000
Total liabilities 50,000 48% 64,400
SHE
Common stock 18,000 NA 18,000
R/E 6,000 NA 6,000
Total SHE 24,000 24,000
Total liabilities and SHE 74.000 88,400
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Assume that the sale of 2021 is 50,000 and that of 2002 is 80,000, and
Dividend declared and paid for the year 2022 is 4,800.
NA = Not Applicable.
Total Assets (total fund required) 113,600
Total L+C (total fund available) 88,400
Total additional fund required 25,200
Internal fund available (N/I) 8,000
Additional external fund required 17,200
THE FORMULA METHOD
A) Internal Fund Available(IFA) (Change in Retained Earnings/CIRE)
IFA = mbs2
Profit margin (m) = N.I / Sales = 12,800/80,000
= 0.16
Retention rate (b) = amount retained/NI
= 8,000/12,800
= 0.625
Sales of the 2nd period (S2) = 80,000
IFA (CIRE) = mbs2
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= 0.16 x 0.625 x 80,000
= 8,000
B) AFN Formula (Additional Fund Needed)
AFN= (∑RA – ∑ RL) CS/S)
(66,000 - 24,000) 30,000/50,000)
= 42,000 X 0.6 = 25,200
C) Total External Fund Needed (EFN) = AFN – IFA = 25,200 – 8,000 = 17,000
OR
AFN =
Percent of sales of total assets 132
Percent of sales of total Liabilities 48
Percent of fund required for additional sales 84%
Additional sales (increase in sale) = 30,000
Additional Fund Needed = 84% of 30,000 = 25,200
