Financial forecastingis an essential element in planning. It is the basis for budgeting and for estimating future financing requirements. A company can make finance either from internal or external sources. Internal financing refers to cash flow generated by the company’s normal operating activities. External financing on the other hand refers to capital provided by parties outside the company, such as investors and banks.
Companies can estimate their need for external financing by forecasting future sales and related expenses. There are various techniques which are used to estimate or forecast the finance requirements.
The Percent-of-Sales method for Financial forecasting
The basic steps in projecting a company’s financing needs are:
- Project the company’s sales. The sales forecast is the basis for most other forecasts.
- Project additional variables, such as expenses.
- Estimate the level of investment in current and fixed assets the company will need to make to support the projected sales.
- Calculate the company’s financing needs.
The most widely used method for projecting the company’s financing needs is the percent-of-sales method. This method requires financial planners to estimate future expenses, assets and liabilities as a percent of sales for that period. They then use those percentages together with projected sales, to construct forecasted balance sheets.
An example for Percent-of-Sales
- Assume that sales for 20X1 are $20, projected sales for 20X2 are $24, net income is 5 percent of sales and the dividend payout ratio is 40%.
- Express those balance sheet items that vary directly with sales as a percentage of sales. Any item such as long-term debt that does not vary directly with sales is designated not applicable.
- Multiply these percentages by the 20X2 projected sales ($24) to obtain the projected amounts.
- Insert figures in the long-term debt, common stock and paid-in capital from 20X1 balance sheet.
- Compute 20X2 retained earnings.
Sum the asset accounts, obtaining total projected assets of $7.2. Add to total the projected liabilities and equity to obtain $7.12, the total internal financing provided. Since liabilities and equity must total $7.2, but only $7.12 is projected, there is a shortfall of 0.08. This is the external financing needed.
Although one can forecast the additional funds required by setting up a pro forma balance sheet, it is often easier to use the formula.
External Funds Needed = Required increase in Assets – Spontaneous increase in Liabilities – Increase in retained earnings
EFN = (A/S) ΔS – (L/S) ΔS – (PM)(PS)(1-d) where
A/S = Assets that increase spontaneously with sales as a percentage of sales
L/S = Liabilities that increase spontaneously with sales as a percentage of sales
ΔS = Change in sales
PM = Profit margin on sales
PS = Projected sales
d = Dividend payout ratio
In the above example
A/S = $6/$20 = 30%
L/S = $2/$20 = 10%
ΔS = ($24 – $20) = $4
PM = 5% on sales
PS = $24
d = 40%
Substituting the above figures into the formula yields:
EFN = 0.3($4) – 0.1($4) – (0.05)($24)(1 – 0.4)
= $1.2 – $0.4 – $0.72
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