One of the most important actions a company takes is developing its strategic plan. A strategic plan defines the direction of the company and provides guideposts for decisions that will be made about resources.
A major part of the strategic plan is the financial forecast. The objective of the financial forecast is to analyze past, current, and future fiscal data and conditions to shape strategic decisions and policy. The financial forecast should be the best estimate of what will happen to the company financially over the next year.
Financial forecasting typically involves three key steps:
step by step
Sales Forecast
Financial Modeling
Estimation of Additional Funds Needed (AFN)
Every financial forecast starts with predicting revenue to develop a sales forecast. A sales forecast is an estimate of sales revenue over a specific time frame. Based on the sales and revenue forecasts, future costs can be estimated.
Sales forecasting methods
Once the sales forecast is determined, the next step is financial modeling, which consists of building an abstract representation of how financial decisions will affect the company. It is a mathematical model that simulates the performance of a business, portfolio, or project in different decision-making scenarios.
The main goal of building this financial forecast is to project the additional funds needed (AFN). Since the strategy of most companies is focused on sales growth, a business needs to determine what additional resources will be required to support that new sales level and how it will finance the acquisition of those resources.
Using AFN, a firm can realistically evaluate whether or not it will be able to generate the additional funding required to reach the new goal. Figuring out the amount of external funding needed is a key part of calculating AFN and involves some detailed mathematical formulas; however, a simplified version of the AFN formula can be expressed in the following way:
formula to know
Additional Funds Needed
AFN equals the projected increase in assets minus the spontaneous increase in the liabilities that occur, minus any increase in retained earnings that is not paid back to the shareholders.
EXAMPLE
You are analyzing the financial performance of ABC Company. Below is select financial information for the business from the end of the previous year:
Financial Information
Amount ($)
Sales
250,000
Total Assets
131,629
Total Liabilities
87,190
Based on this information:
Forecast the Increase in Assets, estimating a 30% growth rate.
Estimate the Spontaneous Increase in Liabilities, estimating a 30% growth rate.
Calculate the Increase in Retained Earnings (estimating a 30% growth rate and expecting a net profit margin of 15% on the new sales and retaining earnings of 50% on the new sales).
Based on your answers above, calculate Additional Funds Needed
Step 1: Forecast the Increase in Assets
Step 2: Estimate the Spontaneous Increase in Liabilities
Step 3: Calculate the Increase in Retained Earnings
Step 4: Calculate the Additional Funds Needed (AFN)
The small business will need $7,707 in additional funds to support its projected growth.
try it
You are analyzing the financial performance of a small business. Below is select financial information for the business from the end of the previous year:
The small business will need $58,000 in additional funds to support its projected growth.
terms to know
Financial Forecast
The best estimate of what the financial performance of a company will be over the next year using the firm’s historic financial and accounting data.
Sales Forecast
An estimate of sales revenue over a specific time frame.
Financial Modeling
The task of building an abstract representation (a model) of a financial decision-making situation.
Additional Funds Needed (AFN)
A financial estimation of how much additional funding a company will need to meet an increased sales goal.
2. Why Companies Create Pro Forma Financial Statements
Pro forma financial statements are essential tools for companies to anticipate future financial conditions, make informed strategic decisions, communicate with stakeholders, comply with regulations, and evaluate performance. They provide a structured way to envision potential future scenarios and prepare accordingly.
Companies may create pro forma financial statements for many reasons:
Planning and Forecasting: Helps businesses estimate future revenues, costs, and profits.
Decision-Making: Used to evaluate the financial impact of strategic decisions like launching a new product, entering a new market, or acquiring another company.
Budgeting: Acts as a foundation for creating detailed budgets.
Securing Financing: Often required by investors, banks, or lenders to assess the potential profitability and risk of a business.
Mergers and Acquisitions: Used to show how a merger or acquisition would affect the financial performance of the combined entity.
Internal Performance Evaluation: Allows management to compare actual results against projections to identify areas of over- or under-performance.
big idea
As a business moves through the planning process, it will perform a ratio analysis on its pro forma statements. This will allow the company to examine the impact of the strategic and financial statement changes it plans to make. It also allows the company to examine the projected earnings per share (EPS), the return on assets (ROA), and the return on equity (ROE) to ensure that these align with the projected growth goals.
3. Capacity Planning
Once sales forecasting is complete, a company must determine whether it has the capability of producing what it intends to sell, so it must address the issue of capacity. Capacity is the maximum level of output that a firm can produce. Capacity planning ensures that a firm will be realistic when predicting sales and is using its financial resources in the most efficient way possible.
In finance and economics, you’ll often hear the term “capacity utilization.” Capacity utilization is the extent to which a business’s resources are being used to generate output. If a firm has excess capacity, it is producing at a lower scale of output than it has been designed for. If a company produces too little, it may be missing out on sales; if it produces too much, it will have unsold inventory. This problem illustrates how important capacity is to sales and vice versa.
think about it
You are attempting to predict sales and capacity for your restaurant for the month.
What kind(s) of information might you need to make these predictions?
What may be some of the consequences of overestimating sales and capacity?
What may be some consequences of underestimating sales and capacity?
terms to know
Capacity
The maximum level of output that a firm can produce.
Capacity Planning
Ensures that a firm will be realistic when predicting sales and is using its financial resources in the most efficient way possible.
Capacity Utilization
The extent to which a business’s resources are being used to generate output.
Excess Capacity
When a firm is producing at a lower scale of output than it has been designed for.
summary
In this lesson, we learned that a financial forecast is the best estimate of what will happen to a company in financial terms over the next period. Financial forecasting is evaluated by financial modeling, which simulates the impact financial decisions will have on the business. A result of financial forecasting is the calculation of the AFN or additional funds needed. This helps a firm realistically examine what additional funding will be needed to generate the assets to support the projected sales level.
Companies create pro forma financial statements for many reasons, and there is a planning process that involves a ratio analysis to make sure that all the decisions that are being made will keep the performance of the organization in line with the strategic plan.
Capacity planning should also be examined in financial forecasting. This is the process of determining the production capacity needed by the firm to meet its new sales goals. Capacity utilization is the extent to which a company is using its capacity to create production efficiency.
