Questions 429
could occur with respect to inventories, and the required additions would be deter-
mined in exactly the same manner as for fixed assets. Theoretically, the same situation
could occur with other types of assets, but as a practical matter excess capacity nor-
mally exists only with respect to fixed assets and inventories.
Explain how economies of scale and lumpy asset acquisition affect financial fore-
casting.
If excess capacity exists, how will that affect the AFN?
Summary
This chapter described techniques for forecasting financial statements, which is a cru-
cial part of the financial planning process. As we will see throughout the rest of the
book, both investors and corporations regularly use forecasting techniques to help
value a company’s stock, to estimate the benefits of potential projects, and to estimate
how changes in capital structure, dividend policy, and working capital policy will in-
fluence shareholder value. The key concepts covered are listed below:
Financial forecastinggenerally begins with a forecast of the firm’s sales, in terms
of both units and dollars.
Either the projected,or pro forma, financial statement methodor the AFN
formula methodcan be used to forecast financial requirements. The financial
statement method is more reliable, and it also provides ratios that can be used to
evaluate alternative business plans.
A firm can determine its additional funds needed (AFN)by estimating the
amount of new assets necessary to support the forecasted level of sales and then
subtracting from that amount the spontaneous funds that will be generated from
operations. The firm can then plan how to raise the AFN most efficiently.
The higher a firm’s sales growth rate,the greaterwill be its need for additional
financing. Similarly, the smaller its retention ratio,the greaterits need for addi-
tional funds.
Adjustments must be made if economies of scaleexist in the use of assets, if ex-
cess capacityexists, or if assets must be added in lumpy increments.
Linear regressionand excess capacity adjustmentscan be used to forecast asset
requirements in situations where assets are not expected to grow at the same rate
as sales.
The type of forecasting described in this chapter is important for several reasons.
First, if the projected operating results are unsatisfactory, management can “go back
to the drawing board,” reformulate its plans, and develop more reasonable targets for
the coming year. Second, it is possible that the funds required to meet the sales fore-
cast simply cannot be obtained. If so, it is obviously better to know this in advance and
to scale back the projected level of operations than to suddenly run out of cash and
have operations grind to a halt. And third, even if the required funds can be raised, it
is desirable to plan for their acquisition well in advance.
Questions
Define each of the following terms:
a.Operating plan; financial plan; sales forecast
b.Pro forma financial statement; percent of sales method
c.Spontaneously generated funds
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426 Financial Planning and Forecasting Financial Statements
