To estimate the needed external financing, the projected or pro forma financial statement

method or the formula method may be used.

Projected Financial Statement Method
Projected Financial Statements is summary of various component projections of revenues
and expenses for the budget period. They indicate the expected net income for the period.
Projected Financial Statements are an important tool in determining the overall
performance of a company. They include the balance sheet, income statement and cash flow
statements to indicate the company performance.
The Balance Sheet or Statement of Financial Position shows the assets, liabilities and
equity at a particular point in time. It is basically a snapshot of the entitys financial position. The
basic accounting formula is assets equal liabilities plus owners equity. The asset section of the
balance sheet should be presented in order of liquidity starting with the most liquid assets such as
cash, accounts receivable and inventory. The liabilities section should be presented in order of
maturity starting with liabilities that are payable over the next year such as a demand note
payable and accounts payable.
The Income Statement or Statement of Comprehensive Income captures profit
performance, demonstrates immediate capability to service debt for banks or real potential for
growth in returns for venture capital. This is often expressed in terms of sales volume, or
compared to industry benchmarks.
Preparing Projected Financial Statements:
Preparing projected financial statements require careful analysis. Prior to preparing projected
financial statements, an analyst studies the financial history of the company. There may be some
drawbacks, which the company may have encountered down the years. To eradicate such hurdles
and for the betterment of the companys financial status, an analysis is conducted.
Steps in Projecting Financial Statements:
Step 1. Forecast the Income Statement or Statement of Comprehensive Income
a. Establish a sales projection.
b. Prepare the production schedule and project the corresponding production costs, direct
materials, direct labor and overhead.
c. Estimate selling and administrative expenses.
d. Consider financial expenses, if any.
e. Determine the net profit.
Step 2. Forecast the Balance Sheet or Statement of Financial Position
a. Project the assets that will be needed to support the projected sales.
b. Project funds that will be spontaneously generated (through accounts payable and
accruals) and by retained earnings

c. Project liability and shareholders equity accounts that will not rise spontaneously with
sales (e.g., notes payable, long-term bonds, preference shares and ordinary shares) but
may change due to financing decisions that will be made later.
d. Determine if additional funds will be needed through the following formula:
Additional Funds Needed (AFN) = Required Increase in Asset
Spontaneous Increase in Liabilities Increase in Retained Earnings
The additional financing needed will be raised by borrowing from the bank as note
payable, by issuing long-term bonds, by selling new ordinary shares or by some combination of
actions.
Step 3. Raising the AFN
The financing decision will consider the following factors:
(1) Target capital structure
(2) Effect of short- term borrowing in its current ratio
(3) Conditions in the debt and equity markets, or
(4) Restrictions imposed by existing debt agreements.
Step 4. Consider financing feedbacks.
Depending on whether additional funds will be borrowed or will be raised through
ordinary shares, consideration should be given on additional interest expense in the Income
Statement, thus decreasing the retained earnings.
Apply the iteration process using the available financing mix until the AFN would
become so small that the forecast can be considered complete.
Illustrative Case 1. Financial Forecasting (Percent of Sales Method)
The Elixir Company has the following statements which are representative of the
companys historical average.
Statement of Comprehensive Income
Sales
P 6 000 000
Cost of Sales
3 600 000
Gross Profit
2 400 000
Operating expenses
1 140 000
Earnings before interest and taxes (EBIT)
1 260 000
Interest Expense
_210 000
Earnings before taxes (EBT)
1 050 000
Taxes (35%)
_367 500
Earnings after taxes (EAT)
P682 500
Dividends

P409 500
Statement of Financial Position
Assets

Cash
Accounts Receivable
Inventory
Current assets

P 150 000
1 200 000
2 250 000
3 600 000

Fixed assets (net)

Total assets

2 400 000
P 6 000 000
Liabilities and Equity

Accounts payable
Accrued wages
Accrued taxes
Current Liabilities
Notes payable bank
Long-term debt
Ordinary shares
Retained earnings
Total liabilities and equity

P 750 000
30 000
__60 000
P 840 000
210 000
450 000
3 600 000
___900 000
P 6 000 000

The firm is expecting a 20% increase in sales next year, and management is concerned
about the companys need for external funds. The increase in sales is expected to be carried out
without any expansion of fixed assets, but rather through more efficient asset utilization in the
existing store. Among liabilities, only current liabilities vary directly with sales.
Using the percent of sales method, determine whether the company has external
financing needs or surplus of funds.
Solution:
Step 1. Forecast the Statement of Comprehensive Income
The projected income statement will show the following:
Sales
Cost of Sales
Gross Profit
Operating expenses
Earnings before interest and taxes (EBIT)
Interest Expense
Earnings before taxes (EBT)
Taxes (35%)
Earnings after taxes (EAT)
Dividends (36% payment)

P 7 200 000
4 320 000
2 880 000
1 368 000
1 512 000
_210 000
1 302 000
_455 700
P846 300
P304 800

Step 2. Forecast the Statement of Financial Position

The projected statement of financial position will show the following:
Assets
Cash (1)
P 180 000
Accounts Receivable (2)
1 440 000
Inventory (3)
2 700 000
Current assets
4 320 000
Fixed assets (net) (4)
2 400 000
Total assets
P 6 720 000

Liabilities and Equity

Accounts payable (5)
Accrued wages (6)
Accrued taxes (7)
Current Liabilities
Notes payable bank (4)
Long-term debt (4)
Ordinary shares (4)
Retained earnings (8)
Total
Additional financing required
Total

P 900 000
36 000
____72 000
P 1 008 000
210 000
450 000
3 600 000
___1 441 500
P 6 709 500
_____10 500*
P 6 720 000

Supporting computations:
(1) Cash= 2.5 % x P 7.2M
(2) Accounts receivable = 20% of P 7.M
(3) Inventory = 37.5 % x P 7.2M
(4) No percentages are computed for fixed assets, notes payable, long-term debt, ordinary shares
and retained earnings because they are not assumed to maintain a direct relationship with sales
volume. For simplicity, depreciation is not explicitly considered.
(5) Accounts payable = 12.5% of P 7.2M
(6) Accrued expenses = 0.5% of P 7.2M
(7) Accrued taxes = 1% of P 7.2M
(8) Retained earnings = P 900 000 + P 846 300 P 304 800
Formula Method
Additional financing needed (AFN) may also be computed as follows:
Additional Funds Needed (AFN) =
Required Increase in Asset Spontaneous Increase in Liabilities Increase in
Retained Earnings
where:
Required Increase in Asset =
Change in sales x (Current assets (present)/ Sales (present))
Spontaneous Increase in Liabilities =
Change in sales x (Current liabilities (present)/ Sales (present))
Increase in Retained Earnings =
Earnings after taxes Dividend payment
Therefore:
AFN =
[(1 200 000) (3 600 000/ 6 000 000) (1 200 000) (840 000/ 6 000 000)
(846 300 304 800)]
= 720 000 168 000 541 500
= P 10 500