UNIT TWO

FINANCIAL ANALYSIS & PLANNING

2.1 INTRODUCTION
However, financial statements analysis by themselves does not give a complete picture about a
company’s financial condition, operating results, and cash flows. Neither can a real value of financial
statements could be derived in themselves alone. Therefore, to predict the future and to help
anticipate future conditions, financial statements should be analyzed further. This analysis helps to
identify current strengths and weakness of the firm. It facilitates planning the future, and helps to
control the firm’s financial activities better. To have all this benefits, however, a finance person
should perform a financial analysis.

2.2 MEANING AND OBJECTIVES OF FINANCIAL ANALYSIS

Financial analysis refers to analysis of financial statements and it is a process of evaluating the
relationships among component parts of financial statements.
The focus of financial analysis is on key figure in the financial statements and the significant
relationships that exist between them. Financial analysis is used by several groups of users like
managers, credit analysts, and investors.
The analysis of financial statements is designed to reveal the relative strengths and weakness of a
firm. This could be achieved by comparing the analysis with other companies in the same industry,
and by showing whether the firm’s position has been improving or deteriorating over time. Financial
analysis helps users obtain a better understanding of the firm’s financial conditions and performance.
It also helps users understand the numbers presented in the financial statements and serve as a basis
for financial decisions.

2.3 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS

A number of methods can be used in order to get a better understanding about a firm’s financial
status and operating results. The most frequently used techniques in analyzing financial statements
are:
i) Ratio Analysis – is a mathematical relationship among money amounts in the financial statements.
They standardize financial data by converting money figures in the financial statements. Ratios are
usually stated in terms of times or percentages. Like any other financial analysis, a ratio analysis
helps us draw meaningful conclusions and interpretations about a firm’s financial condition and
performance.
ii) Common size Analysis – expresses individual financial statement accounts as a percentage of a
base amount. A common size status expresses each item in the balance sheet as a percentage of
total assets and each item of the income statement as a percentage of total sales. When items in
financial statements are expressed as percentages of total assets and total sales, these statements
are called common size statements.
iii) Index Analysis – expresses items in the financial statements as an index relative to the base year.
All items in the base year are assumed to be 100%. Usually, this analysis is most appropriate for
income statement items.
i) External Analysis – an analysis performed by outsiders to the firm such as creditors, investors,
suppliers etc.
ii) Internal Analysis – an analysis performed by corporate finance and accounting departments for
the purpose of planning, evaluating, and controlling operating activities.
2.4 STAGES IN FINANCIAL ANALYSIS
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Financial analysis consists of the following three major stages.
i) Preparation. The preparatory steps include establishing the objectives of the analysis and
assembling the financial statements and other pertinent financial data. Financial statement
analysis focuses primarily on the balance sheet and the income statement. However, data from
statements of retained earnings and cash flows may also be used. So, preparation is simply
objective setting and data collection.
ii) Computation. This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial
statement analysis programs can be applied as part of this stage of financial analysis.
iii) Evaluation and Interpretation.
Interpretation. Involves the determination fo the meaningfulness of the analysis
and to develop conclusions, inferences, and recommendations about the firm’s performance and
financial condition. This is the most important of all the three stages of financial analysis.

2.5 TYPES OF FINANCIAL RATIOS

There are several key ratios that reveal about the financial strengths and weaknesses of a firm. We
will look at five categories of ratios, each measuring about a particular aspect of the firm’s financial
condition and performance.
2.5.1 Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the short –
term financial strength or solvency of a firm. In other words, liquidity ratios measure a firm’s ability
to pay its current liabilities as they mature by using current assets. There are two commonly used
liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the necessary
ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2001 and 2002
(In thousands of Birrs)
Assets 2002 2001
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity
Current liabilities:

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 Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds –5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
Preferred stock –5% (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders’ equity 55,800 43,500
Total liabilities and stockholders’ equity 153,900 136,800

Zebra Share Company

Income Statement
For the Year Ended December 31, 2002
________________________________________________________________________
Net sales Br. 196,200,000
Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,00
Net income Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease payment.
Zebra Share Company
Statement of Retained Earnings
For the Year Ended December 31, 2002
Retained earnings at beginning of year Br. 9,000,000
Add: Net income 3,900,000
Sub-total Br. 12,900,000
Less: Cash dividends
Preferred Br. 300,000
Common 3,300,000
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000
i) Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities
Current ratio = Current assets
Current liabilities
Zebra’s current ratio (for 2002) = Br. 57,600 = 1.51 times
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 Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in good position
to meet its current obligations. Conversely, relatively low current ratio is interpreted as an indication
that the firm may not be able to easily meet its current obligations. A reasonably higher current ratio
as compared to other firms in the same industry indicates higher liquidity position. A very high
current ratio, however, may indicate excessive inventories and accounts receivable, or a firm is not
making full use of its current borrowing capacity.
ii) Quick ratio (Acid – test ratio)- measures the short-term liquidity by removing the least liquid
current assets such as inventories. Inventories are removed because they are not readily or easily
convertible into cash. Thus, the quick ratio measures a firm’s ability to pay its current liabilities by
using its most liquid assets into cash.
Quick ratio = Current assets – Inventory
Current liabilities
Zebra’s quick ratio (for 2002) = Br. 57,600 – Br. 24,900 = 0.86 times
Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current liabilities.
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-term obligations, and
the higher the quick ratio the more liquid the firm’s position. But the quick ratio is more detailed and
penetrating test of a firm’s liquidity position as it considers only the quick asset. The current ratio, on
the other hand, is a crude measure of the firm’s liquidity position as it takes into account all current
assets without distinction.
2.5.2 Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios
include turnover ratios because they show how rapidly assets are being converted (turned over) into
sales or cost of goods sold.
Activity ratios are also called asset management ratios, or asset utilization ratios, or efficiency ratios.
Generally, high turnover ratios are associated with good asset management and low turnover ratios
with poor asset management.
Activity ratios include:
i) Accounts Receivable turnover – measures how efficiently a firm’s accounts receivable is being
managed. It indicates how many times or how rapidly accounts receivable are converted into cash
during a year.
Accounts receivable turnover = Net sales
Accounts receivable
Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio substantially
lower than the industry average may suggest that a firm has more liberal credit policy, more
restrictive cash discount offers, poor credit selection or in adequate cash collection efforts.
There are alternate ways to calculate accounts receivable value like average receivables and ending
receivables. Though many analysts prefer the first, in our case we have used the ending balances. In
computing the accounts receivable turnover ratio, if available, only credit sales should be used in the
numerator as accounts receivable arises only from credit sales.

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ii) Days sales outstanding (DSO) – also called average collection period. It seeks to measure the
average number of days it takes for a firm to collect its accounts receivable. In other words, it
indicates how many days a firm’s sales are outstanding in accounts receivable.
Days sales outstanding = 365 days
Accounts receivable turnover
Zebra’s days sales outstanding = 365 days = 39 days
9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days. If
Zebra’s credit period is less than 39 days, some corrective actions should be taken to improve the
collection period.
The average collection period of a firm is directly affected by the accounts receivable turnover ratio.
Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover – measures how many times per year the inventory level is sold (turned over).
Inventory turnover = Cost of good sold
Inventory
For Zebra Company (2002) = Br. 159,600 = 6.41times
Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the numerator rather
than sales. But when cost of goods sold data is not available, we can apply sales. In general, a high
inventory turnover is better than a low turnover. But abnormally high inventory turnover might result
from very low level of inventory. This indicates that stock outs will occur and sales have been very
low. A very low turnover, on the other hand, results from excessive inventory levels, presence of
inferior quality, damaged or obsolete inventory, or unexpectedly low volume of sales.
iv) Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It shows how many
birrs of sales are generated from one birr of fixed assets
Fixed assets turnover = Net sales___
Net fixed assets
Zebra’s fixed assets turnover = Br. 196,200 = 2.04X
Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.

A fixed assets turnover ratio substantially lower than other similar firms indicates under utilization of
fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low sales levels. This suggests
to the firm possibility of increasing outputs without additional investment in fixed assets.
The fixed assets turnover may be deceptively low or high. This is because the book values of fixed
assets may be considerably affected by cost of assets, time elapsed since their acquisition, or method
of depreciation used.
v) Total assets turnover – indicates the amount of net sales generated from each birr of total tangible
assets. It is a measure of the firm’s management efficiency in managing its assets.
Total assets turnover = Net Sales
Total assets

Zebra’s total assets turnover = Br. 196,200 = 1.27X

Br. 153, 900

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Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested in
total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.

2.5.3 Leverage Ratios

Leverage ratios are also called debt management or utilization ratios. They measure the extent to
which a firm is financed with debt, or the firm’s ability to generate sufficient income to meet its debt
obligations. While there are many leverage ratios, we will look at only the following three.
i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.
Debt ratio = Total liabilities
Total assets
Zebra’s debt ratio = Br. 98,100 = 64%
Br. 153,900
Interpretation: At the end of 2002, 64% of Zebra’s total assets were financed by debt and 36%
(100% - 64%) was financed by equity sources.
A high debt ratio implies that a firm has liberally used debt sources to finance its assets. Conversely,
a low ratio implies the firm has funded its assets mainly with equity sources. Debt ratio reflects the
capital structure of a firm. The higher the debt ratio, the more the firm’s financial risk
ii) Times – interest earned – measures a firm’s ability to pay its interest obligations.
Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
Zebra’s times interest earned = Br. 10,500 = 3.50X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available to
meet its interest obligations. However, earnings before interest and taxes is an income concept and
not a direct measure of cash. Hence, this ratio provides only an indirect measure of the firm’s ability
to meet its interest payments.
iii) Fixed charges coverage – measures the ability of a firm to meet all fixed obligations rather than
interest payments alone. Fixed payment obligations include loan interest and principal, lease
payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and taxes
Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease payment.
Therefore,
Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X
Br. 3,000 + Br. 2,700
Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company are safely
covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable. The
fixed charges coverage ratio is required because failure of the firm to meet any financial obligation
will endanger the position of a firm.
2.5.4 Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales, total assets, and
owner’s equity. The following ratios are among the many measures of a firm’s profitability.
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i) Profit Margin – shows the percentage of each birr of net sales remaining after deducting all
expenses.
Profit margin = Net income
Net Sales
Zebra’s profit margin = Br. 3,900 = 2%
Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as well as
the amount of all costs and expenses of a firm.
ii) Return on investment (assets) – measures how profitably a firm has used its investment in total
assets.
Return on investment = Net income
Total assets
Zebra’s return on investment = Br. 3,900 = 2.53 %
Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
Generally, a high return on investment is sought by firms. This can be achieved by increasing sales
levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently utilizing assets.
iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on investments
made by themselves.
Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99%
Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity
We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment
1 – Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance. On the
contrary, a low ratio may indicate greater owner’s capital contribution as compared to debt
contribution. Generally, the higher the return on equity, the better off the owners.

DUPONT SYSTEM OF ANALYSIS

It is an approach to assess that a firm’s return on assets and return on equity show not only the firm’s
earning power but also efficiency and leverage. This analysis breaks down these two ratios as
follows:
Return on assets = Profit margin X Total assets turnover
Return on equity =Profit margin X Total assets turnover X Total assets/equity
= Profit Margin X Total assets turnover X Equity Multiplier
2.5.5 Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning. They
include:
i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common stock
outstanding. It does not reflect how much is paid as dividends.
Earnings per share = Net income – Preferred stock dividend
Number of common shares outstanding
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 Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000  Br. 10
Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.
ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each share
of its common stock outstanding.
Dividends Per Share = Total cash dividends on common shares
Number of common shares outstanding
Zebra’s DPs for 2002 = Br. 3,300 _ = Br. 1.00
Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.
iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.
Dividends pay-out = Dividends per share
Earnings per share
= Total dividends to common stockholders
Total earnings to common stockholders
Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%
Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.

2.6 COMPARING FINANCIAL RATIOS

To address whether a given ratio is high or low, good or bad, a meaningful basis is needed for
comparison. Two types of ratio comparisons can be made.
i) Cross – sectional analysis – is the comparison of a firm’s ratios to those other firms in the same
industry at the same point in time. Here, the firm is interested in how well it has performed in relation
to other firms. Generally, cross – sectional analysis is preformed based on industry averages of
different financial ratios.
ii) Time – series analysis – is an evaluation of a firm’s financial ratios over time. Here, the current
period ratios are compared with those of the past years. The purpose is to determine whether the firm
is progressing or deteriorating.
To obtain the highest possible information about a firm, usually, a combination of both cross –
sectional and time-series analyses are applied.

2.7 LIMITATIONS OF RATIO ANALYSIS

Even though ratio analysis can provide useful information about a firm’s financial conditions and
operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason could be a single
firm may have different divisions operating in different industries. Another reason could be the
financial statements may not be dated at the same point in time.
3. The financial statements of firms are not always reliable, particularly, when they are not audited.
4. Different accounting principles and methods employed by different companies can distort
comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.

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6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For example, the
inventory turnover ratio for a stationery materials selling company will be different at different
time periods of a year.
3. Financial planning
Planning includes attempting to make optimal decisions, projecting the consequence of these
decisions for the firm in the form of a financial plan and then comparing future performance against
that plan.
Financial planning is the task of determining how a business will afford to achieve its strategic goals
and objectives. Usually, a company creates a financial plan immediately after the vision and
objectives have been set. The financial plan describes each of the activities , resources, equipment
and materials that are needed to achieve these objectives, as well as the timeframes involved.
The financial planning activity involves the following task:
1. Assess the business environment ,
2. Confirm the business vision and objectives,
3. Identify the types of resources needed to achieve these objectives,
4. Quantify the amount of resource(labor, equipment, materials)
5. Calculate the total cost to create a budget,
6. Identify any risk and issues with the budget set.
3.1. Scope of financial planning
Financial planning should cover all areas of the client’s financial needs and should result in the
achievement of each of the client’s goals. The scope of financial planning would usually include the
following:
1. Risk management and insurance planning: managing cash flow risks through sound risk
management and insurance techniques.
2. Investment and planning issues: Planning, creating and managing capital accumulation to
generate future capital and cash flows for reinvestment and spending.
3. Retirement planning: planning to ensure financial independence at retirement.
4. Tax planning: planning for the reduction of tax liabilities and the freeing-up of cash flows for
other purposes.
5. Estate planning: planning for the creation, accumulation, conservation and distribution of
assets.
6. Cash flow and liability management: maintaining and enhancing personal cash flows through
debt and life style management.
7. Relationship management: Moving beyond pure product selling to understand and service the
core needs of the client.
8. Education planning for kids and the family members.
3.2. Types of financial plan
Financial planning is an important aspect of the firm’s operations because it provides road maps for
guiding, coordinating and controlling the firm’s actions to achieve its objectives. Financial planning
begins with long term or strategic financial plans. These, in turn, guide the formulation of short term
plans.
1. Long-term (strategic) financial plans:plans: Long term financial plans lay out a company’s
planed financial actions and the anticipated impact of those actions over periods ranging from
2 to 10 years.
2. Short-term (operating) financial plans:plans: Short- term financial plans specify short term
financial actions and the anticipated impact of those actions. These plans most often cover a 1
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 to 2 year period. Key inputs include the sales forecast and various forms of operating and
financial data. Key output include a number of operating budgets, the cash budget and
proforma financial statements. It focuses solely on cash and profit planning from the financial
manager’s perspective.
3.3. procedure of financial planning
For the purposes of financial planning, an organization should take the following steps:
1. Laying down financial objectives:
objectives: In order to make an effective financial planning first of
all the financial objectives o f the corporation should be laid down. The financial objectives
of a business help in determining policies and procedures. In the changing circumstances, the
business must determine its short term and long term objectives in present times. Short term
objectives should be determined in a manner that they help in the achievement of long term
objectives. The long term financial objective of business should stress the maximum and
economical use of the financial resources so that value of assets could be maximized.
2. Formulating financial polices:
polices: The formulation of policies is the second step in financial
planning. These policies act as guidelines for the procurement of funds, their utilization and
control.
These help in achieving the financial goals. Policies should be based on predetermined
objectives and practicable so that they can be implemented easily and effectively. The
policies should be determined at the top level of management. These policies can relate to
determination of capital structure, capitalization, sources of funds, realization of debt,
management of capital, distribution of profit, management of working capital, management
of inventory, etc.
3. Developing financial procedures:
procedures: To implement the policies, it is necessary that detailed
financial procedures be determined which explains all rules and sub rules. The subordinates
will come to know what work they have to do and how they have to do it.
4. Preparation of financial plan: plan: Under this process, total capital requirement is determined. It
is called capitalization. To determine the capitalization, fixed assets, current assets,
preliminary expenses and other expenses are determined to make correct estimate of
necessary funds. After determining the total fund requirements, it is determined in what
proportion the funds will be raised from different sources. It is called capital structure.
5. Reviewing of financial planning:
planning: Financial planning is a continuous process of business.
The financial objectives, policies, procedures, capitalization and capital structure should be
modified according to the changing internal and external circumstances.
3.4. Benefits of financial planning
1. Identifies advance actions to be taken in various areas.
2. Seeks to develop a number of options in various areas that can be exercised under
different conditions.
3. Facilitates a systematic exploration of interaction between investment and financing
decisions.
4. Clarifies the links between present and future decisions.
5. Forecasts what is likely to happen in future and hence helps in avoiding surprises.
6. Ensures that the strategic plan of the firm is financially viable.
7. Provides benchmarks against which future performance may be measured.
3.5. Limitations of financial planning
Although financial planning is very important for the success of a business, yet it has
some limitations, which can be outlined as under:
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 1. Based on forecasts:
forecasts: financial plan is based on forecasts. Forecasts are based on
certain assumptions. Future is uncertain and, therefore, these forecasts can be wrong.
The financial plan based on the wrong forecasts cannot be much useful. This
uncertainty is higher in case of long term financial plan than the short term financial
plan.
To overcome this limitation to some extent, financial plan should be revised and they
should be prepared on the basis of flexible budget.
2. Rigid attitude of management:
management: changing circumstances make it necessary to change
the financial plan. But managers hesitate to change the financial plan and try to
implement the pre determined plan strictly. This has several reasons. First, the
amount of capital expenditure in the financial plan is high and changes in them
become difficult. The payment for raw material and machinery etc., is arranged in
advance, changes in them can increase the complexities.
3. Lack of coordination: for the success of financial plan there should be coordination
between the finance department and other departments. But in actual practice, due to
lack of coordination the financial plan cannot be implemented effectively.
Financial forecasting
Financial forecasting describes the process by which firms think about and prepare for the future.
The forecasting process provides the means for a firm to express its goal and priorities and to ensure
that they are internally consistent. It also assists the firm in identifying the asset requirements and
needs for external financing.
Financial forecasting is that process in which the future financial condition of the firm is shown on
the basis of past accounts, funds flow statements, financial ratios and economic conditions of the firm
and industry. The projection of future plan of management in terms of finance is financial
forecasting.
3.1. Advantages of financial forecasting
Financial forecasting can:
I. Serve as an advance warning system: When prepared and presented early in the budget
planning process, forecasting future revenues and expenditures can alert elected and
appointed officials of the financial limitations under which the next year’s budget (and future
years) is developed. This helps elected officials understand the financial situation, eliminate
surprises and provides time for them to take the necessary preventive actions.
II. Improve the policy development and budget preparation process: Financial forecasting can
provide information about potential changes in services, new demands for service,
anticipated revenues and any expected surplus and deficits.
III. Evaluate alternative financial plans: financial forecasting can illustrate the immediate and
long-term fiscal implications of various economic and policy scenarios.
3.2. Tools of financial forecasting
1. Sales forecast: the sales forecast is typically the starting point of the financial forecasting
exercise. Most of the financial variables are projected in relation to the estimated level of
sales. Hence, the accuracy of the financial forecast depends critically on the accuracy of the
sales forecast.
A wide range of sales forecasting techniques and methods are available. They may be
divided in to three broad categories:
i. Qualitative techniques: these techniques rely essentially on the judgment of experts to
translate qualitative information in to quantitative estimates.
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 ii. Time series projection methods: these methods generate forecasts on the basis of
analysis of the past behavior of time series
iii. Causal models: these techniques seek to develop forecasts based on cause –effect
relationships expressed in explicit, quantitative manner.
2. Proforma income statement:
statement: the proforma income statement is a projection of income for a
period of time in the future.
3. Proforma or projected balance sheet:sheet proforma balance sheet is forecasting of flow of
funds and according to this the estimation of every item should be made and checked. The
preparation of proforma balance sheet is made on the basis of proforma income statement and
supporting schedules and budgets.

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