Financial Planning Model The Ingredients

Most financial planning models require the user to specify some assumptions about the future. Based on those assumptions, the model generates predicted values for a large number of other variables. Models can vary quite a bit in terms of their complexity, but almost all will have the elements that we discuss next.

Sales Forecast Almost all financial plans require an externally supplied sales forecast. In our models that follow, for example, the sales forecast will be the "driver," meaning that the user of the planning model will supply this value, and most other values will be calculated based on it. This arrangement is common for many types of business; planning will focus on projected future sales and the assets and financing needed to support those sales.

Frequently, the sales forecast will be given as the growth rate in sales rather than as an explicit sales figure. These two approaches are essentially the same because we can

100 PART TWO Financial Statements and Long-Term Financial Planning calculate projected sales once we know the growth rate. Perfect sales forecasts are not possible, of course, because sales depend on the uncertain future state of the economy. To help a firm come up with its projections, some businesses specialize in macroeco-nomic and industry projections.

As we discussed previously, we frequently will be interested in evaluating alternative scenarios, so it isn't necessarily crucial that the sales forecast be accurate. In such cases, our goal is to examine the interplay between investment and financing needs at different possible sales levels, not to pinpoint what we expect to happen.

Pro Forma Statements A financial plan will have a forecasted balance sheet, income statement, and statement of cash flows. These are called pro forma statements, or pro formas for short. The phrase pro forma literally means "as a matter of form." In our case, this means the financial statements are the form we use to summarize the different events projected for the future. At a minimum, a financial planning model will generate these statements based on projections of key items such as sales.

In the planning models we will describe, the pro formas are the output from the financial planning model. The user will supply a sales figure, and the model will generate the resulting income statement and balance sheet.

Asset Requirements The plan will describe projected capital spending. At a minimum, the projected balance sheet will contain changes in total fixed assets and net working capital. These changes are effectively the firm's total capital budget. Proposed capital spending in different areas must thus be reconciled with the overall increases contained in the long-range plan.

Financial Requirements The plan will include a section on the necessary financing arrangements. This part of the plan should discuss dividend policy and debt policy. Sometimes firms will expect to raise cash by selling new shares of stock or by borrowing. In this case, the plan will have to consider what kinds of securities have to be sold and what methods of issuance are most appropriate. These are subjects we consider in Part 6 of our book, where we discuss long-term financing, capital structure, and dividend policy.

The Plug After the firm has a sales forecast and an estimate of the required spending on assets, some amount of new financing will often be necessary because projected total assets will exceed projected total liabilities and equity. In other words, the balance sheet will no longer balance.

Because new financing may be necessary to cover all of the projected capital spending, a financial "plug" variable must be selected. The plug is the designated source or sources of external financing needed to deal with any shortfall (or surplus) in financing and thereby bring the balance sheet into balance.

For example, a firm with a great number of investment opportunities and limited cash flow may have to raise new equity. Other firms with few growth opportunities and ample cash flow will have a surplus and thus might pay an extra dividend. In the first case, external equity is the plug variable. In the second, the dividend is used.

Economic Assumptions The plan will have to state explicitly the economic environment in which the firm expects to reside over the life of the plan. Among the more important economic assumptions that will have to be made are the level of interest rates and the firm's tax rate.

Prosperity Pursuit

Prosperity Pursuit

Those who truly want to attain a financially free mindset, have only to set their minds on it, and acquire the proper means, as they do in relation to any other aim which they want to achieve, and it can be easily done.

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