FINANCIAL FORECASTING:

Sales Forecast:

A Sales forecast is prepared keeping in view the past sales trend that is likely to
be repeated in future and the influence of events that might affect this trend.

The methods used for forecasting sales can be divided into two categories:

(1) Subjective Methods: These methods are based on the opinions and
judgments of knowledgeable and experienced individuals within the
company. The two subjective methods are:

(i) Jury of Executive Opinion: Under this method, each member of the
jury makes an independent sales forecast based on the available data
and their judgmental abilities. Any differences in the individual opinions
are then reconciled by the chief executive of the jury after a meeting with
all the members. The disadvantage of this method is that it is based on
individual opinions.

(ii) Sales Force Estimates: Sales representatives can estimate the

probable demand in a better manner as they are in direct touch with the
market. The disadvantage of this method is that the sales force might set
targets that can be easily met.

(2) Objective Methods: These methods are based on statistical analysis. The
two objective methods of forecasting sales are:

(i) Trend analysis via Extrapolation: This method assumes that the
sales for the coming period will change to the same extent as it changed
from the prior period to the current period. Hence, the past trend in sales
is identified and this is projected into the future. The time series of any
variable is made up of four components:

(a) Secular Component: It is the long-term trend present in the series

due to changes in factors like population, capital formation etc. This
trend is identified by fitting a straight line to the sales data.

(b) Cyclical Component: It reflects the periodic movement in the data

series e.g the periodic movement of a business cycle is an example of
cyclical trend.

(c) Seasonal Component: Sometimes a series follows a consistent

pattern because of climatic factors, customs, etc. Such patterns
 constitute the seasonal component of the time series and can be used
for short-range forecasting.

(d) Irregular variations: Certain variations in the data will be caused as

a result of factors which are beyond control. Such variations should
be removed from the data in order to have a normal series.

While estimating sales, the past sales data series is broken into the
components mentioned above and then recombined to produce a
sales estimate.

(ii) Regression Analysis: Regression analysis is used to estimate the value

of a dependent variable (like sales) based on the value of various
independent variables (like income, population etc.). Using the criterion
of least squares, the line of best fit is fitted to the data in such a way that
the sum of the squared deviations of the actual data from the estimated
data is minimized.

Financial Forecasting:

Firms need to plan their future activities keeping in view the expected changes
in the economic, social, technical and competitive environment. The top and
middle-level managers plan their business activities in terms of financial
projections keeping in view the various factors that will affect the business.
Three main tools are used for making financial projections. These are:
(a) Pro-forma Financial Statements
(b) Cash Budgets
(c) Operating Budgets

(a) Pro-forma Financial Statements: Proforma statements are financial

projections based on a set of assumptions about the future performance of a
company and its funding requirements. They provide a comprehensive
picture of the likely future performance of a company. There are basically
three types of proforma statements:
(i) The Proforma operating statement or Income Statement (i.e. Profit
and Loss statement) represents an operational plan for the business as
a whole.
(ii) The Proforma balance sheet reflects the anticipated cumulative impact
of assumed future decisions on the financial condition of the business
at a selected point of time.
(iii) The Proforma funds flow statement reflects the expected movements of
funds during the forecast period.

Preparation of Pro-forma Income Statement: There are two commonly used

methods for preparing the pro forma Income Statement:
 1. Percent of Sales Method: In this method we assume that the future
relationship between various components of cost to sales will be similar to
their historical relationship.
How to Prepare: under this method we calculate ratio of every item
given in the income statement as % of Sales. If the figures of more than
one year are given then we apply the average percentage for calculation.

Practical Question on Pro forma Income Statement:

Question : 1 The Profit and Loss statement of Vaishnavi Ltd. for the years
2000 and 2001 are given below. If the sales for the year 2002 are estimated at
Rs.22,00,000, prepare a pro -forma income statement for the year 2002 using the
percent of sales method.
(Rs. ’000)
2000 2001
Total sales 1,200 1,800
Cost of goods sold 700 1,100
Gross Profit 500 700
Selling and administration 180 220
expenses
Depreciation 50 80
Operating profit 270 400
Non-operating surplus 40 80
EBIT 310 480
Interest 160 160
Tax 60 100
Profit after tax 90 220
Dividends 30 60
Retained earnings 60 160

2. Budgeted Expenses Method: This method is not too rigid and

mechanistic as percent of sales method is. It calls for estimating the value
of each item on the basis of expected developments in the future for which
pro forma income statement is prepared. For example calculating the
amount of depreciation, Administrative Expenses or Interest on
Debentures as per Budgeted value in place of calculating it as% of Sales.

3. Combination Method: It is a combination of aforementioned two

methods. For certain items, which have a fairly stable relationship with
sales, the percent of Sales method is quite adequate but for some other
items where future is likely to be different from the past, the budgeted
method is regarded as best. Combination method is therefore, neither too
simplistic as % of Sales method nor unduly onerous as the budgeted
expense method.

List of items in Income statement which are not calculated as % of Sales:

a) General & Administration Expenses
b) Depreciation
 c) Interest on Debentures
d) Tax
e) Dividends etc are taken as per the Budgeted figures calculated by the
Management.

Pro forma Balance Sheet : While preparing the Pro-forma Balance Sheet
following points should be kept in mind :

Liabilities Basis of Assets Basis of Projection

Projection
Equity and Previous Fixed Assets Percent of Sales
Preference Capital Values
Reserve & Surplus As per Pro Current Assets Percent of Sales
forma
Income
Statement
Loan Funds Previous Investments & Assumption of No
Values Miscellaneous Change unless other-
Expenditures wise mentioned
Current Liabilities Percent of
and Bank Sales
Borrowings

Note: 1. The Projected Value of Retained Earnings is obtained by adding

projected Retained Earnings ( from Pro forma Income Statement) to the Reserve
& Surplus figures of the Previous Period.
2.. If total of Assets is greater than Total of Liabilities, the balancing figure
indicates the ‘External Funds Required’ and if Liability exceeds assets the
balance represents ‘ Surplus Available Funds’.
3. Pro-forma Income Statement and Balance Sheet are complementary to each
other.
4. Without Proforma Income Statement, Proforma Balance Sheet can not be
prepared as there are certain values like Amount of retained Earnings, which
are carried to Balance sheet from pro forma income statement. Similarly items
like Interest on External funds cannot be calculated unless we prepare Proforma
balance sheet. This problem in the language of finance is known as
Problem of Circularity.

Growth & External Funds Requirement (EFR) :

The finance manager plans the future investments based upon its growth
prospects and various other factors. In most situations, it might not be able to
meet the finance required for the new investments from the retained earnings
and in such a case it has to look for external means of financing.
Calculation of EFR:

The external financing requirement can be computed as:

A L
EFR = (∆S) − (∆S) − mS1 (1 − d)
S S
where, EFR is the external financing requirement
A/S is Current assets and fixed assets as a proportion of sales.
∆S is the expected increase in sales.
L/S represents the spontaneous liabilities as a proportion of sales.
m is the net profit margin.
S1 is the projected sales for next period.
and d is the dividend payout ratio.

Thus, the firm’s external requirement will depend on its projected growth in
sales; the greater the growth in sales, the more will be the funds required and
higher will be the external financing required. At lower growth rates, the firm
generates more funds than required for expansion and in such a case the firm
might use the surplus for other useful purposes.
Firms having a high volume of retained earnings can generate a higher growth
rate without raising any external finance. In such a case the maximum sales
growth rate that can be financed by using only retained earnings and no external
finance, can be computed by equating EFR to zero.

Question : 2
The balance sheet of Shruti Ltd. is given below:

Liabilities Assets
Share capital 6,00,000 Fixed Assets 6,00,000
Retained Earnings 3,00,000 Current Assets 12,00,000
Long-term Loans 4,50,000
Short-term Bank Borrowings 2,25,000
Creditors 2,25,000
18,00,000 18,00,000

The sales for the company are expected to increase by 25% in the next year. The
sale to net worth ratio is 5. Profit margin is 40% of the growth rate in sales.
Dividend pay out ratio is twice the growth rate in sales.
Compute the External Fund Requirement for the company?

Ans - Rs. 1.125 lakh.

Sustainable Growth Rate:

Some firms might not prefer to raise external equity for financing their
investments because of the following disadvantages associated with it:
(i) High cost of issue
(ii) Large degree of under-pricing required.
(iii) Dilution of control involved.
Such firms would like to know the growth rate which they can achieve without
issuing external equity and this growth rate that can be achieved without the
use of any external equity is termed as Sustainable Growth rate. It is computed
as:
m(1 − d) A
g= E
A − m(1 − d) A
S0 E
where, E is the equity employed
d is the dividend payout ratio
A/E is the total assets to equity ratio
A/S0 is the total assets as a proportion of sales
m is the net profit margin.

The above formula is based on the following assumptions:

(i) The assets of the firm will increase proportionately to sales.
(ii) Net profit margin will remain constant.
(iii) Dividend payout ratio and debt-equity ratio will remain constant.
(iv) External issue of equity will not be resorted to.

Question : 3 Given below is the balance sheet of Deeksha Ltd. for the year
2001:
(in lakhs)
Liabilities Assets
Share capital 150 Net Fixed Assets 300
Reserves and Surplus 50 Current Assets:
Secured loans 200 Inventories 150
Current Liabilities and Provisions: Sundry Debtors 150
Sundry Creditors 130 Cash and Bank Balance 50
Bank finance for working capital 100
Provisions 20

650 650

The turnover of the company for the last year was Rs. 10 crore. The company
earns a net profit of 5% and pays out 50% of profits as dividends. Compute the
maximum growth rate in sales that can be achieved by the company without
raising external equity.
(Ans. 14.29%)

Practical Question on Pro forma Balance Sheet, EFR and Income

Statement :

Q.4 The Balance Sheet of Deepak Cables Limited as on December 31,

2010 is as follows :

Liabilities Assets
Share capital 150 Fixed Assets 400
Retained Earnings 180 Inventories 200
Long-term Loans 80 Receivables 150
Short-term Bank Borrowings 200 Cash 50
Creditors 140
Provisions 50
800 800

The Sales of the Firm for the year ending December 31st 2010 were 1000. Its
profit Margin on Sales was 6% and its Dividend payout ratio was 50%. The Tax
Rate was 60%. Deepak Cables expects its sales to increase by 30% in the year
2011.The ratio of Assets to Sales and Spontaneous Current Liabilities to sales
would remain unchanged. Likewise, the Profit Margin Ratio, the Tax Rate and
the Dividend Payout Ratio would remain unchanged.

Required:
1. Find out the External funds requirement for the Year 2011.
2. Prepare the following statements assuming that the EFR would be raised
equally from term loans and short term bank borrowings : (a) Projected
Balance Sheet ( b) Projected Profit & Loss Account.

Ans. EFR -144