Financial planning and forecasting
Financial planning projects future results, identifies funding needs, and helps firms grow without running out of money.
Why plan
Financial planning sets goals, forecasts future financial statements, and identifies how much external financing will be needed. It helps a firm avoid surprises, coordinate decisions across departments, and prepare for different scenarios.
Sales forecasts
Most financial plans start with a sales forecast, based on past trends, market research, economic conditions, and company strategy. Because most other items depend on sales, errors in the sales forecast ripple through the whole plan.
The percentage-of-sales method
The percentage-of-sales method assumes many income statement and balance sheet items, such as costs, inventory, and receivables, grow in proportion to sales. Items that do not vary with sales, such as long-term debt, are held constant unless the plan changes them.
External financing needed
When assets must grow faster than internally generated funds (retained earnings plus spontaneous liabilities such as accounts payable), the firm needs external financing from borrowing or issuing shares. The external financing needed (EFN) is the gap between required asset growth and available internal funding.
Internal and sustainable growth
The internal growth rate is the maximum growth possible using only retained earnings, without external financing: ROA x b / (1 - ROA x b), where b is the retention ratio. The sustainable growth rate is the maximum growth while keeping the debt-to-equity ratio constant: ROE x b / (1 - ROE x b).
Short-term planning and cash budgets
Short-term financial planning manages cash and working capital. The cash budget forecasts monthly inflows and outflows, showing when a firm needs short-term borrowing, such as a revolving credit line, and when surplus cash can be invested. Seasonal businesses rely heavily on cash budgets.
Scenario and sensitivity planning
Plans should test different scenarios: what if sales grow 5% instead of 15%, or interest rates rise? Sensitivity analysis shows which assumptions matter most. Contingency plans prepare responses, such as cutting costs or arranging backup financing.
Worked example
A company with ROE of 15% retains 60% of earnings (b = 0.6). Its sustainable growth rate = 0.15 x 0.6 / (1 - 0.15 x 0.6) = 0.09 / 0.91, about 9.9%. If it wants to grow sales at 20%, it must raise more equity, increase leverage, improve profitability, or retain more earnings.
Key takeaways
Financial planning forecasts statements and funding needs. Sales forecasts drive most other items. The percentage-of-sales method scales items with sales. External financing needed is the gap between required asset growth and internal funds. The internal growth rate uses only retained earnings; the sustainable growth rate keeps leverage constant. Cash budgets manage short-term needs. Scenario and sensitivity analysis prepare for uncertainty.
Flashcard
Forecasting results and funding needs
Check your understanding
A firm has ROE of 20% and retains half its earnings. What is its sustainable growth rate?