134 Corporate Finance
The following guidelines would be useful in financial forecasting.- Forecast the volumes (in terms of the number of units) and average price realization for the planning
horizon. The product of the two gives sales in rupees. It might be useful to bifurcate domestic and export
sales wherever applicable. - Retained earnings in yeart = REt – 1 + PATt – Divt
- Raw materials and consumables, cost of power, selling expenses generally vary as percentage of sales.
- Wages and salaries, factory overheads; administration, selling and distribution overheads are fixed in
nature. - Forecast the percentage increase in fixed costs beyond the first year.
- Estimate the current asset requirements as percentage of sales. The individual components of current
asset, viz., cash, inventory may be expressed as percentage of current asset (or the company may have a
policy of maintaining, say, 30 days inventory, etc. Use this information to forecast). - Estimate current liabilities as a percentage of current assets.
- Depreciation schedule of fixed assets needs to be drawn up to estimate the amount of depreciation in
each of the years. - Use the marginal tax rate to calculate profit after tax.
- Ending equity = Beginning equity + Retained earnings for the year + Share capital issued if any.
- Draw up the loan amortization schedule and then calculate the value of long-term liabilities for each
of the years. - Calculate interest on the outstanding amount at the stated percentage rate.
The percent-of-sales forecasting model provides an estimate of the amount of external financing that is
needed in the coming year to support the expected growth of the company.
External funding requirement = Increase in assets required to support the increase in sales – [Additional
funds provided by spontaneous current liabilities like accounts payable + Proforma increase in retained
earnings]:
= [(At/St) ∆St=1] – [(Lt/St) (∆St=1) + Et=1 – Dt+1]where
A/S is asset intensity, ∆St=1 = increase in sales,
E is the expected increase in earnings after taxes,
D is total dividends, and
(Lt/St) (∆St=1) is the additional funds provided by spontaneous current liabilities.
This formulation assumes that a company’s capital investment is closely associated with the next year’s
sales. The capital budgeting process defines expected increase in fixed assets as the sum of capital expend-
itures plus other necessary expenditures and there need not be a proportional relationship between fixed
assets and sales. Consequently, the formulation can be rewritten as:
External funding requirement = [(CAt/St) (∆St=1) + ∆FAt=1] – [(Lt/St) (∆St=1) + Et=1 + Dept+1 – Dt+1]where
(CAt/ St) (∆St=1) is the forecast of change in current assets,
∆FAt=1 is the total capital expenditure planned for t + 1, and
Dept+1 is the depreciation expense expected in the forecast period.