There are two forms of financial planning that are extremely important in maintaining the health of an organization: cash planning and profit planning. Cash planning focuses on the development of the organization’s cash budget, while profit planning concerns the preparation of pro forma income statements. Although these two planning processes are vital in the development of the company’s future plans, they have very different development processes and uses.
Forecasting is an important part of the company’s planning process. Forecasting gives the company an idea of future of future revenue based on the sales forecast. This forecast gives the company an idea of how much product is going to be necessary to satisfy customer demands over the upcoming time period. This is helpful in estimating how quickly products need to be assembled, and what level of raw materials must be kept on hand (Gitman, 2009).
The forecasting process begins with the development of the sales forecast. The company develops the sales forecast for the upcoming time period based on previous performance and sales estimates from the company’s sales people. Additionally, the previous period’s financial statements are necessary in order to compare the generated forecast with the previous period’s net profits before taxes (Gitman, 2009).
One simple method for generating a pro form income statement is the percent-of-sales method. This method assumes that all costs are variable and must increase as sales increase. Therefore, by using the examining the previous period’s costs as a percentage of total sales, an estimate can be made on the upcoming period’s pro form income statement based on the sales forecast’s projected sales (Scranton University, n.d.). Unfortunately, the percent-of-sales method ignores costs related to fixed assets. Since these costs are not truly variable, they tend to rise and fall inappropriately when sales rise and fall. According to Gitman (2009), the percent-of-sales method “tends to understate profits when sales are increasing” and “overstate profits when sales are decreasing” (p. 131).
Unlike the pro-forma forecast, the cash budgeting process focuses on cash inflows and outflows rather than profits. Like the pro-forma forecasting process mentioned above, the cash budgeting process begins with the sales forecast. The sales forecast is used to determine the anticipated cash receipts for the upcoming period. These cash receipts can be broken down further into time-based categories depending on how frequently accounts receivables are collected. Cash disbursements are also projected based on the anticipated costs generated by the sales forecast numbers. These disbursements are cash flows only, and do not reflect other noncash charges such as depreciation. The cash budgeting process does not previous data to be generated. The inflows and outflows on the cash budget are representative of the forecasted sales data (Gitman, 2009).
Pro-forma statements have an important impact on the budgeting process. With the pro-forma statements in hand, the company can change the upcoming period’s budget in order to achieve financial goals. Pro-forma statements highlight possible future shortcomings. These shortcomings may result in the need for external financing or a change in how the company operates over the upcoming period. Therefore, pro-forma statements are not a statement of future fact, but merely a projection of future standing if current trends continue. Financial managers should use these projections to modify the company’s upcoming budget and change those projections if necessary (Gitman, 2009).
Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.
Scranton University. (n.d.) Financial forecasting and pro-forma statements. Retrieved November 28, 2008.