Scribd
Upload
623 views

Financial Planning and Forecasting: Pro Forma Financial Statements

Financial forecasting involves creating pro forma financial statements to project a company's financial performance in future periods. This allows companies to estimate external financing needs, evaluate the impact of changes to operations, and set compensation targets. The process involves forecasting sales, projecting asset needs, estimating internally generated funds, determining additional external funds required, and deciding how to raise those funds. Key elements include sales forecasts, assumptions about asset growth and financing, and calculating additional funds needed using formulas like the AFN equation. Forecasting allows companies to identify capacity constraints, financing requirements, and sensitivity to changes in variables.

Uploaded by

Levi Lazareno Eugenio
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
623 views

Financial Planning and Forecasting: Pro Forma Financial Statements

Financial forecasting involves creating pro forma financial statements to project a company's financial performance in future periods. This allows companies to estimate external financing needs, evaluate the impact of changes to operations, and set compensation targets. The process involves forecasting sales, projecting asset needs, estimating internally generated funds, determining additional external funds required, and deciding how to raise those funds. Key elements include sales forecasts, assumptions about asset growth and financing, and calculating additional funds needed using formulas like the AFN equation. Forecasting allows companies to identify capacity constraints, financing requirements, and sensitivity to changes in variables.

Uploaded by

Levi Lazareno Eugenio
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 8

Financial Planning and Forecasting

1. Plans: strategic, operating, and financial

2. Pro forma financial statements

 Sales forecasts

 Percent of sales method

3. Additional Funds Needed (AFN) formula

Pro Forma Financial Statements


 Three important uses:

 Forecast the amount of external financing that will be required

 Evaluate the impact that changes in the operating plan have on the value of the firm

 Set appropriate targets for compensation plans

Steps in Financial Forecasting


 Forecast sales
 Project the assets needed to support sales
 Project internally generated funds
 Project outside funds needed
 Decide how to raise funds
 See effects of plan on ratios and stock price

2001 Balance Sheet (Millions of $)

2001 Income Statement (Millions of $)


AFN (Additional Funds Needed):Key Assumptions
 Operating at full capacity in 2001.
 Each type of asset grows proportionally with sales.
 Payables and accruals grow proportionally with sales.
 2001 profit margin (2.52%) and payout (30%) will be maintained.
 Sales are expected to increase by $500 million. (%ΔS = 25%)
Additional Funds Needed

AFN = Asset requirement

-Spontaneous financing

-Retained earnings

= (A*/S0) ΔS - (L*/S0) Δ S - M(S1)(1 - d)

Assets must increase by $250 million. What is the AFN, based on the AFN equation?

AFN = (A*/S0) Δ S - (L*/S0) Δ S - M(S1)(1 - d)

= ($1,000/$2,000)($500)

- ($100/$2,000)($500)

- 0.0252($2,500)(1 - 0.3)

= $180.9 million.

Projecting Pro Forma Statements with the Percent of Sales Method

 Project sales based on forecasted growth rate in sales

 Forecast some items as a percent of the forecasted sales

 Costs
 Cash
 Accounts receivable
 Items as percent of sales

 Inventories
 Net fixed assets
 Accounts payable and accruals
 Choose other items

 Debt (which determines interest)


 Dividends (which determines retained earnings)
 Common stock
Percent of Sales: Inputs

Other Inputs

2002 1st Pass Income Statement


2002 1st Pass Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.

2002 1st Pass Balance Sheet (Claims)

*From 1st pass income statement.

What are the additional funds needed (AFN)?

 Forecasted total assets = $1,250


 Forecasted total claims = $1,071
 Forecast AFN = $ 179
NWC must have the assets to make forecasted sales. The balance sheets must balance. So, we must
raise $179 externally.

Assumptions about How AFN Will Be Raised

 No new common stock will be issued.


 Any external funds needed will be raised as debt, 50% notes payable, and 50% L-T debt.
How will the AFN be financed?
Additional notes payable =
0.5 ($179) = $89.50  $90.
Additional L-T debt =
0.5 ($179) = $89.50  $89.
But this financing will add 0.08($179) = $14.32 to interest expense, which will lower NI and retained
earnings.
2002 2nd Pass Income Statement

2002 2nd Pass Balance Sheet (Assets)

No change in asset requirements.

2002 2nd Pass Balance Sheet (Claims)

Results After the Second Pass

 Forecasted assets = $1,250 (no change)


 Forecasted claims = $1,244 (higher)
 2nd pass AFN =$ 6 (short)
 Cumulative AFN= $179 + $6 = $185.
 The $6 shortfall came from the $6 reduction in retained earnings. Additional passes could be
made until assets exactly equal claims. $6(0.08) = $0.48 interest on 3rd pass.

Equation AFN = $181 vs. Pro Forma AFN = $185. Why are they different?

 Equation method assumes a constant profit margin.


 Pro forma method is more flexible. More important, it allows different items to grow at
different rates.
Suppose in 2001 fixed assets had been operated at only 75% of capacity.

Capacity sales = Actual Sales/ % of Capacity =$ 2,000/.75 = 2,667

With the existing fixed assets, sales could be $2,667. Since sales are forecasted at only $2,500, no new
fixed assets are needed.

How would the excess capacity situation affect the 2002 AFN?
 The projected increase in fixed assets was $125, the AFN would decrease by $125.
 Since no new fixed assets will be needed, AFN will fall by $125, to $179 - $125 = $54.

Q. If sales went up to $3,000, not $2,500, what would the F.A. requirement be?

A. Target ratio = FA/Capacity sales = $500/$2,667 = 18.75%.

Have enough F.A. for sales up to $2,667, but need F.A. for another $333 of sales:
DFA = 0.1875($333) = $62.4.

How would excess capacity affect the forecasted ratios?


1. Sales wouldn’t change but assets would be lower, so turnovers would be better.
2. Less new debt, hence lower interest, so higher profits, EPS, ROE (when financing feedbacks
considered).
3. Debt ratio, TIE would improve.

Summary: How different factors affect the AFN forecast.


 Excess capacity:
 Existence lowers AFN.
 Base stocks of assets:
 Leads to less-than-proportional asset increases.
 Economies of scale:
 Also leads to less-than-proportional asset increases.
 Lumpy assets:
 Leads to large periodic AFN requirements, recurring excess capacity.
Regression Analysis for Asset Forecasting
 Get historical data on a good company, then fit a regression line to see how much a given sales
increase will require in way of asset increase.
How would increases in these items affect the AFN?
 Higher dividend payout ratio?
Increase AFN: Less retained earnings.
 Higher profit margin?
Decrease AFN: Higher profits, more retained earnings.
 Higher capital intensity ratio, A*/S0?
Increase AFN: Need more assets for given sales increase.
 Pay suppliers in 60 days rather than 30 days?
Decrease AFN: Trade creditors supply more capital, i.e., L*/S0 increases.
Philippine Christian University
1648 Taft Ave, Malate, Manila, 1000 Metro Manila
(02) 526 2261

Financial Management

Concepts

Financial Forecasting

Submitted by:

Levi L. Eugenio

Submitted to:

Prof. Faustina C. Rana


October 3, 2015

You might also like