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.