Financial Planning & Pro Forma Statements: Forecasts, Budgets & Scenarios

TAKEAWAYS:

• Financial planning is the process of forecasting future financial needs and preparing budgets to achieve business goals, using pro forma statements (projected financial statements) as the foundation.
• Pro forma financial statements (income statement, balance sheet, cash flow) are prepared using historical data, assumptions, and growth projections to estimate future performance.
• Budgeting is a quantitative plan for future operations, divided into operational budgets (sales, production, expenses) and financial budgets (cash, capital expenditure).
• Scenario analysis tests how sensitive financial outcomes are to changes in key variables (e.g., sales volume, interest rates), helping businesses prepare for uncertainty.
• Rolling forecasts and zero-based budgeting are advanced techniques used to improve accuracy and accountability in financial planning.
• Financial planning failures (e.g., overestimating sales, ignoring liquidity risks) can lead to cash shortages, missed opportunities, or bankruptcy—common pitfalls in Nepali startups like Pathao during peak seasons.

1. Introduction to Financial Planning

Financial planning is the art and science of predicting future financial needs and allocating resources to achieve business objectives. It bridges the gap between strategic goals (e.g., expanding Daraz’s delivery network) and operational execution (e.g., hiring drivers, purchasing bikes). Unlike accounting (which records past transactions), financial planning looks forward to ensure sustainability.

Key Objectives of Financial Planning:

• Ensure liquidity: Avoid cash shortages (e.g., NTC’s working capital needs during festival seasons).
• Optimize capital structure: Balance debt and equity (e.g., Ncell’s bond issuance for 5G expansion).
• Allocate resources efficiently: Prioritize high-return projects (e.g., Khalti’s focus on fintech innovation).
• Mitigate risks: Prepare for downturns (e.g., eSewa’s contingency plans for cyberattacks).

2. Pro Forma Financial Statements

Pro forma statements are projected financial statements based on assumptions about future operations. They are the backbone of financial planning, used to:

• Evaluate investment opportunities.
• Secure financing (e.g., banks reviewing Daraz’s pro forma cash flow before lending).
• Set performance targets.

Types of Pro Forma Statements:

How to Prepare a Pro Forma Income Statement

Example: GreenLeaf Organic Farms (Kathmandu) wants to expand its herbal tea production. Historical data shows:

• 2023 Sales: Rs. 5,000,000 (Rs. 100 per kg).
• COGS: 60% of sales.
• Operating Expenses: Rs. 1,000,000 (fixed) + 10% of sales (variable).
• Tax Rate: 25%.

Assumptions for 2024:

• Sales increase by 20% (new market in Pokhara).
• COGS remains 60%.
• Operating expenses increase by 15% (higher marketing costs).

flowchart TD
  A["Historical Sales: Rs. 5,000,000"] --> B["Projected Growth: +20% (New Market in Pokhara)"]
  B --> C["2024 Sales: Rs. 6,000,000"]
  C --> D["COGS (60%): Rs. 3,600,000"]
  C --> E["Operating Expenses: Fixed Rs. 1,150,000 + Variable Rs. 600,000 = Rs. 1,750,000"]
  D & E --> F["EBIT: Rs. 6,000,000 - Rs. 3,600,000 - Rs. 1,750,000 = Rs. 650,000"]
  F --> G["Tax (25%): Rs. 162,500"]
  F --> H["Net Income: Rs. 487,500"]

Pro Forma Income Statement for GreenLeaf Organic Farms (2024):

How to Prepare a Pro Forma Balance Sheet

Using GreenLeaf’s 2023 balance sheet data:

• Current Assets (2023): Rs. 2,000,000 (Rs. 1M cash, Rs. 1M inventory).
• Non-Current Assets: Rs. 3,000,000 (land, machinery).
• Current Liabilities: Rs. 1,500,000 (accounts payable).
• Long-Term Debt: Rs. 1,000,000.
• Retained Earnings (2023): Rs. 1,500,000.

Assumptions for 2024:

• Purchase new machinery: Rs. 500,000 (paid in cash).
• Increase inventory by 10% (due to expansion).
• Borrow Rs. 200,000 for working capital.

flowchart TD
    A["2023 Balance Sheet"] --> B["Add: New Machinery (Rs. 500K)"]
    B --> C["Subtract: Cash (Rs. 500K)"]
    C --> D["Increase Inventory by 10%: Rs. 110K"]
    D --> E["Add: New Loan (Rs. 200K)"]
    E --> F["2024 Pro Forma Balance Sheet"]

Pro Forma Balance Sheet for GreenLeaf Organic Farms (2024):

3. Budgeting: The Quantitative Plan

Budgets are detailed financial plans that allocate resources to achieve goals. They are divided into:

1. Operational Budgets: Focus on day-to-day activities.

   • Sales Budget: Forecasts revenue (e.g., Daraz’s Q3 sales target).
   • Production Budget: Plans raw material purchases (e.g., NTC’s fiber optic cable orders).
   • Expense Budget: Estimates costs (e.g., Pathao’s driver wages).

2. Financial Budgets: Focus on cash and capital.

   • Cash Budget: Ensures liquidity (e.g., Khalti’s daily transaction forecasting).
   • Capital Expenditure (CapEx) Budget: Plans long-term investments (e.g., Ncell’s 5G tower purchases).

Example: Sales Budget for GreenLeaf Organic Farms

Cash Budget Example

Using GreenLeaf’s pro forma income statement and balance sheet:

• Starting Cash (Dec 2023): Rs. 500,000.
• Cash Inflows (Jan 2024):
  • Sales Revenue: Rs. 6,000,000 (collected 60% in month, 40% next month).
  • Loan Proceeds: Rs. 200,000.
• Cash Outflows (Jan 2024):
  • COGS: Rs. 3,600,000 (paid 70% in month, 30% next month).
  • Operating Expenses: Rs. 1,750,000 (paid in full).
  • Machinery Purchase: Rs. 500,000 (paid in full).

flowchart TD
    A["Starting Cash: Rs. 500K"] --> B["Add: Sales (60%): Rs. 3.6M"]
    B --> C["Add: Loan: Rs. 200K"]
    C --> D["Total Inflows: Rs. 4.3M"]
    D --> E["Subtract: COGS (70%): Rs. 2.52M"]
    E --> F["Subtract: Expenses: Rs. 1.75M"]
    F --> G["Subtract: Machinery: Rs. 500K"]
    G --> H["Ending Cash: Rs. 430K"]

Cash Budget for GreenLeaf (January 2024):

4. Scenario Analysis: Testing Assumptions

Scenario analysis tests how financial outcomes change with different assumptions. Three common scenarios:

1. Optimistic: Best-case assumptions (e.g., sales grow 30%).
2. Pessimistic: Worst-case assumptions (e.g., sales drop 20%).
3. Base Case: Most likely assumptions (e.g., sales grow 10%).

Example for GreenLeaf:

Visualization:

5. Advanced Techniques in Financial Planning

(a) Rolling Forecasts

Instead of annual budgets, businesses update forecasts quarterly or monthly (e.g., NTC adjusts its fiber network expansion plans every 3 months based on demand).

(b) Zero-Based Budgeting (ZBB)

Every expense is justified from scratch each period (e.g., Pathao re-evaluates driver incentives annually).

(c) Flexible Budgets

Adjusts for actual output levels (e.g., Daraz’s budget scales with seasonal demand).

6. Common Pitfalls in Financial Planning

7. Real-World Applications

## In the real world

1. Daraz’s Seasonal Budgeting

   • Idea Used: Rolling forecasts and flexible budgets.
   • How: Daraz adjusts its inventory and delivery budgets monthly based on real-time sales data (e.g., higher budgets in Dashain/Bihu). During the 2023 Dashain, Daraz’s cash budget had to account for a 50% spike in orders, requiring pre-positioned inventory and temporary hiring.

2. NTC’s Working Capital Management

   • Idea Used: Pro forma cash flow statements.
   • How: NTC forecasts peak season demand (e.g., New Year’s Day) and ensures sufficient cash reserves to cover increased maintenance costs and employee bonuses. In 2022, NTC’s pro forma analysis revealed a Rs. 200 million shortfall in January, prompting early debt refinancing.

3. Khalti’s Scenario Analysis for Fintech Risks

   • Idea Used: Pessimistic scenario modeling.
   • How: Khalti tests its financial models for cyberattacks (e.g., a 30% drop in transactions) and regulatory changes (e.g., new RBI fees). In 2021, a pessimistic scenario revealed that a single data breach could cost Khalti Rs. 50 million in lost transactions, leading to enhanced cybersecurity budgets.

8. Worked Example: Financial Planning for a Nepali Retail Shop

Business: Bhaktapur Bookshop (owned by Mr. Sharma). Goal: Expand to a second location in Kathmandu.

Step 1: Pro Forma Income Statement (2024)

• 2023 Sales: Rs. 8,000,000.
• Assumptions:
  • Sales grow by 15% (new market).
  • COGS remains 55%.
  • Operating expenses increase by 10% (rent, salaries).

Issue Identified: The shop is not profitable under these assumptions. Mr. Sharma must either:

• Reduce operating expenses (e.g., negotiate lower rent).
• Increase sales (e.g., launch a loyalty program).

Step 2: Revised Budget with Scenario Analysis

Optimistic Scenario: Sales grow by 25%.

Action Plan: Mr. Sharma decides to:

1. Increase marketing spend by Rs. 500,000 to hit the 25% sales target.
2. Secure a Rs. 1 million loan to cover initial losses until profitability.

9. Exam Tip

1. Understand the Link Between Pro Forma Statements and Budgets

   • Examiners often ask how a pro forma income statement feeds into a cash budget. Always show the cash flow implications of projected profits (e.g., taxes reduce cash, but retained earnings increase equity).

2. Master Scenario Analysis

   • Expect questions like: "How would a 10% decline in sales affect GreenLeaf’s net income?" Always calculate three scenarios (optimistic, base, pessimistic) and discuss strategic responses.

3. Apply Real-World Examples

   • Use Nepali businesses (e.g., Daraz, NTC, Khalti) to explain concepts. For instance:
     • "NTC uses pro forma cash flow statements to plan for seasonal demand spikes during festivals."
     • "Khalti employs zero-based budgeting to justify every fintech expense annually."

4. Show Your Work for Numerical Problems

   • For pro forma statements or budgets, present a clear table with calculations. Partial marks are lost if steps are missing. Example:

     Sales (2024) = 2023 Sales × (1 + Growth Rate)
                  = Rs. 5,000,000 × 1.20 = Rs. 6,000,000
     

5. Compare Budgeting Techniques

   • Know the differences between:
     • Incremental Budgeting (last year’s budget + inflation).
     • Zero-Based Budgeting (justify every expense).
     • Flexible Budgeting (adjusts for output levels).

6. Watch for Liquidity Risks

   • Many exam questions test whether you recognize cash flow vs. profit. A business can be profitable but insolvent (e.g., high accounts receivable delays cash). Always ask:
     • "Does this scenario ensure sufficient liquidity?"

10. Summary Table: Key Concepts