What is Financial forecasting
• It is a part of planning process
• They are inferences of what the future may be
• Based on:
1. Economic assumptions (interest rates, inflation rate, growth rate
and so on)
2. Sales forecast
3. Pro forma statements of income account and balance sheet
4. Financing plan
5. Cash budget
6. Asset requirements
Need for financial forecasting
• Financial manager prepares pro forma or projected financial
statements to:
I. Assess the firm’s forecasted performance is in line with targets and
expectations of investors
II. Examine the effect of proposed operating changes
III. Anticipate the financing need of the firm
IV. Estimate the future free cash flows
Preparation of projected income statement
PERCENT OF SALES METHOD
• Assumes that future relationship between varies 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 good sold may be as a percentage of sales
Forecasting Income Statement
• Many items on the income statement are assumed to increase
proportionally with sales. For example, inventories to sale ratio,
assets, liabilities and costs. Then sales will increase these items will
also increase.
• The remaining items on the forecasted statements—items that are
not tied directly to sales , depend on the company’s dividend policy
and it’s relative use of debt and equity financing.
EXAMPLE: The forecasted sales is 25%
INCOME STATEMENT( $ in millions)
1999
Sales
Cost Of Goods Sold
Taxable Income
Taxes
Net Income
Dividends
Addition To Retained earnings
1200
(900)
300
(90)
210
(70)
140
PERCENTAGE OF SALES CALCULATIONS
The percentages in this box illustrate the calculations which were used to determine
the percentages of income statement
Cost = Cost/Sales = $200/1200 = 16.67%
Taxes = Taxes/ Taxable income = $90/300 = 30%
Net income = Net income/Sales = $210/1200 = 17.5%
Dividends = Dividends/Net income = $70/210 = 33.33%
•
INCOME STATEMENT( $ in millions)
1999
•
•
•
•
•
•
•
Sales
Cost Of Goods Sold
Taxable Income
Taxes
Net Income
Dividends
Addition To Retained earnings
1200
(900)
300
(90)
210
(70)
140
%
75%
25%
30%
17.5%
33.33%
66.67%
The percentages in this box illustrate the calculations which were used to
determine the percentages of income statement
INCOME STATEMENT( $ in millions)
Limitations of sales forecasting method
• First, the assessments made using this forecasting method only
represent rough approximations and generally lack detail.
• Not all assets can be accurately forecasted as a percentage of sales.
• Economic climate and demand can change or deteriorate over time,
problems start to arise when applying assumptions of the past to the
present or future using the percentage of sales forecasting method.
• Many expenses are fixed or have a fixed component, and so do not
correlate with sales. For example, rent expense does not vary with
sales
• The percentage-of-sales method is also seen as inflexible, lacking the
ability to deal with changing market conditions.