A board is asked to approve an expansion. It will cost money now, lift sales later and change the balance sheet. Before it signs, it needs to see next year’s profit, assets, debts and cash. A forecast set of financial statements shows what the plan does to the company and whether the money will be there.
It is also the input to valuation, ratio tests and decisions on how to finance the plan.
This topic covers how to build a forecast statement of profit or loss, statement of financial position and statement of cash flows from a set of assumptions, in the right order, and how to use forecasts to compare ways of financing (debt against equity) through return on capital employed, earnings per share and gearing. The previous topic covered business reorganisation and buy-backs.
The next covers evaluating financial performance and strategy. The May 2014 Pathfinder paper tested what a complete financial plan contains.
In 30 seconds
Set up a proforma and fill it in order. Profit or loss: revenue, gross profit, cost of sales as the balancing figure (with a working for opening inventory, purchases as the balancing figure and closing inventory), operating expenses, depreciation (on opening assets plus new purchases), interest (on all borrowing) and profit.
Financial position: share capital, retained earnings (opening plus the forecast profit), loans, non-current assets (plus additions less depreciation), current liabilities, then receivables and inventory from the stated days, with cash as the balancing figure. Cash flow: operating profit plus depreciation, less increases in working capital, less interest, then investing and financing flows; it must agree with the cash in the statement of financial position.
To compare financing, show before, equity issue and debt issue columns and compute ROCE, EPS and gearing.
Key terms in plain English
| Term | What it means |
|---|---|
| Forecast statements | Projected profit or loss, financial position and cash flows |
| Proforma | A blank layout filled in as the figures are worked out |
| Balancing figure | The amount that makes a statement balance, such as cash |
| Return on capital employed (ROCE) | Profit before interest and tax divided by long-term capital |
| Gearing | Long-term debt as a share of capital employed |
Syllabus check
This topic is in syllabus area B (business analysis). It covers:
- preparing forecasts of the statement of profit or loss, financial position and cash flows;
- appraising a strategy through its effect on the financial statements.
CAMA 2020 and financial statements
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Forecasts should be prepared with care, for the benefit of the company |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should test the assumptions in the forecasts they approve |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Forecasts are management information, not the statutory accounts, but the directors’ duties to keep proper records and present a true and fair view apply to the accounts that follow.
The order of working
Set up a proforma and fill the blanks as you go. In ICAN’s example, details of a plant purchase and the depreciation policy suggest working out depreciation and the new carrying amount together.
Forecast statement of profit or loss
- Revenue.
- Gross profit.
- Cost of sales as the balancing figure.
- The cost of sales working: opening inventory, purchases as the balancing figure, closing inventory.
- Other operating expenses.
- Depreciation: the rate applied in full to the opening assets and the new purchase.
- Interest: the rate applied in full to all borrowing, including new.
- Profit for the year.
Forecast statement of financial position
- Share capital (given).
- Retained earnings = opening + forecast profit − dividends.
- Loans, allowing for new borrowing.
- Non-current assets = opening + additions − depreciation.
- Current liabilities (from the stated days).
- Total equity and liabilities, which is also total assets.
- Receivables and inventory from the stated days; cash is the balancing figure.
Forecast statement of cash flows
Operating profit, add back depreciation, deduct increases in receivables and inventory, add increases in payables, deduct interest paid, then investing (capital expenditure) and financing (loans, shares, dividends). The closing cash must equal the cash in the statement of financial position, which proves the work.
ICAN’s example (₦000). The 20X1 statement shows non-current assets 300, inventory 100, receivables 200, cash 200 (total 800); share capital 50, retained earnings 350, non-current liabilities 100, trade payables 300. For 20X2: revenue grows 25% from 800; gross margin 40%; operating expenses 20% of revenue; depreciation 10%; plant costing 100 bought early and financed by a loan; interest 7% on all borrowing; receivables 3 months of revenue; inventory 3 months of cost of sales. Trade payables are 6 months of purchases.
- Profit or loss:
revenue 1,000; gross profit 400; cost of sales 600; opex 200; depreciation 10% × (300 + 100) = 40; operating profit 160; interest 7% × 200 = 14; profit 146.
Purchases = 600 + 150 (closing inventory) − 100 = 650. - Financial position:
non-current assets 360; inventory 150; receivables 250; retained earnings 350 + 146 = 496; non-current liabilities 200; payables 325.
Equity and liabilities = 50 + 496 + 200 + 325 = 1,071, so cash = 1,071 − 360 − 150 − 250 = 311. - Cash flow:
160 + 40 − 50 − 50 + 25 = 125; less interest 14 = 111; investing −100; financing +100; net +111; 200 + 111 = 311, which agrees.
Comparing ways of financing
To compare strategies, show the forecast statements before and after each option. ICAN’s example: raise ₦100,000 (in ₦000 shown as 100,000) by shares or by 10% borrowing on the first day. Before: capital employed 500,000, profit before interest and tax 100,000, interest 20,000, profit 80,000, 50,000 shares, long-term debt 90,000.
| Measure | Before | Equity issue | Debt issue |
|---|---|---|---|
| Capital employed | 500,000 | 600,000 | 590,000 |
| Interest | 20,000 | 20,000 | 30,000 |
| Profit for the year | 80,000 | 80,000 | 70,000 |
| ROCE | 20.0% | 16.7% | 16.9% |
| EPS | ₦1.60 | ₦0.53 | ₦1.40 |
| Gearing | 18.0% | 15.0% | 32.2% |
ROCE falls in both cases because capital employed rises; EPS falls far more with equity (the same profit over three times the shares); gearing falls with equity and rises with debt. These figures ignore the return earned on the new money, which would lift ROCE and EPS, and they ignore tax. Companies do not raise cash without a use.
The rules in more depth
Why cost of sales and cash are balancing figures
Gross profit and revenue fix cost of sales. Equity, liabilities and the other assets fix total assets, so cash is what is left.
Why purchases come from inventory
Opening inventory plus purchases less closing inventory equals cost of sales, so purchases follow.
Why interest uses all borrowing
The new loan is drawn early, so a full year of interest applies, unless the question gives a date.
Why the cash flow must agree
It proves the statements are consistent. A difference means an error.
Effect on analysis
Forecasts feed ratios and valuation. Test them against realistic assumptions and compare financing options.
Worked examples
Example 1: profit assumptions. Revenue was ₦500m and grows 20%. Gross margin is 35% and operating expenses (before depreciation) are 15% of revenue.
- Revenue = ₦600m; gross profit = ₦210m.
- Cost of sales = ₦390m; operating expenses = ₦90m.
- Profit before depreciation and interest = ₦120m.
Example 2: purchases. Cost of sales is ₦390m, opening inventory ₦50m and closing inventory is 2 months of cost of sales.
- Closing inventory.
390 ÷ 6 = ₦65m. - Purchases = 390 + 65 − 50.
- Purchases = ₦405m.
Example 3: working capital and cash. Receivables rise from ₦80m to ₦100m, inventory from ₦50m to ₦65m and payables fall from ₦100m to ₦67.5m.
- Receivables −₦20m; inventory −₦15m; payables −₦32.5m.
- Total effect on cash = −₦67.5m.
- This is why profit growth can still strain cash.
Example 4: financing and EPS. A company with 50m shares and profit of ₦80m (EPS ₦1.60) issues 100m new shares.
- New EPS = 80 ÷ 150.
- EPS = ₦0.53, ignoring the return on the new money.
- The fall is from the extra shares, not weaker profit.
How to score full marks
- Set up a proforma and work in order.
- Show workings for purchases, depreciation and interest.
- Make cash the balancing figure and prove it with the cash flow.
- State assumptions where the question is silent.
- For financing, compute ROCE, EPS and gearing for each option.
- Comment on what the figures ignore.
Common mistakes in the exam
- Forgetting to depreciate the new asset.
- Calculating interest on the old loan only.
- Using opening cash as closing cash.
- Not rolling retained earnings forward.
- A cash flow that does not agree with the statement of financial position.
- Ignoring the return on new funds in the comment.
Quick revision
- P&L: revenue, gross profit, cost of sales, purchases (balancing), expenses, depreciation, interest.
- SOFP: capital, retained earnings, loans, assets, payables; cash is the balancing figure.
- Cash flow must agree with SOFP cash.
- Financing comparison: ROCE, EPS, gearing before, with equity, with debt.
- A complete financial plan has objectives, assumptions, strategies and contingencies.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. In a forecast profit or loss, purchases are found as:
- Cost of sales + closing inventory − opening inventory
- Revenue − profit
- Cost of sales − closing inventory
- Opening inventory only
Show the answer
A. The inventory working.
Question 2. The balancing figure in a forecast statement of financial position is usually:
- Cash
- Share capital
- Loans
- Revenue
Show the answer
A. After other items are fixed.
Question 3. Retained earnings at the end equal:
- Opening + profit − dividends
- Profit only
- Opening only
- Dividends
Show the answer
A. Rolled forward.
Question 4. Depreciation on a new plant bought early is charged:
- For the full year
- Not at all
- At half rate always
- In the next year only
Show the answer
A. Unless the question says otherwise.
Question 5. An equity issue, ignoring the use of the funds, tends to:
- Cut EPS and gearing
- Raise EPS
- Raise gearing
- Raise ROCE
Show the answer
A. More shares, more equity.
Question 6. A debt issue, ignoring the use of the funds, tends to:
- Raise gearing
- Cut gearing
- Raise equity
- Raise revenue
Show the answer
A. Debt is added.
Question 7. The forecast cash flow must:
- Agree with cash in the statement of financial position
- Equal profit
- Equal dividends
- Exceed revenue
Show the answer
A. It proves the work.
Question 8. A complete financial plan includes all EXCEPT:
- A detailed profile of all management staff
- Stated objectives
- Assumptions
- Contingency plans
Show the answer
A. The Pathfinder answer.
Question 9. ROCE uses:
- Profit before interest and tax
- Profit after tax
- Dividends
- Revenue
Show the answer
A. Over long-term capital.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) State the order in which a forecast statement of profit or loss is built. (4 marks) (b) Explain why cash is the balancing figure in a forecast statement of financial position. (3 marks) (c) State what a complete financial plan includes. (3 marks)
Question 12 (20 marks). At the start of the year (₦m): non-current assets 200, inventory 50, receivables 80, cash 40 (total 370); share capital 100, retained earnings 120, loan 50, payables 100. Revenue of ₦500m will grow 20%. Gross margin 35%; operating expenses before depreciation 15% of revenue; depreciation 10% of the year-end cost of assets, including plant of ₦60m bought early and financed by a loan; interest 8% on all borrowing; receivables 2 months of revenue; inventory 2 months of cost of sales; payables 2 months of purchases.
Ignore tax and dividends. (a) Prepare the forecast statement of profit or loss. (7 marks) (b) Prepare the forecast statement of financial position. (8 marks) (c) Prepare the forecast statement of cash flows. (5 marks)
Question 13 (10 marks). A company with capital employed of ₦500m, profit before interest and tax of ₦100m, interest of ₦20m, 50m shares and long-term debt of ₦90m raises ₦100m. (a) Calculate ROCE, EPS and gearing before. (3 marks) (b) Calculate them after an equity issue of 100m shares. (4 marks) (c) Comment. (3 marks)
Model answers
Show the model answer to Question 11
(a) Order (4 marks). Revenue; gross profit; cost of sales as a balancing figure, with the purchases working; other expenses; depreciation; interest; profit. (0.5 each, up to 4)
(b) Cash (3 marks). Equity, liabilities and the other assets are fixed by the assumptions. (1.5) Total assets must equal total equity and liabilities, so cash is what is left. (1.5)
(c) Financial plan (3 marks). Clearly stated strategic, operating and financial objectives; the assumptions on which it is based; a description of the underlying strategies; contingency plans for emergencies. Any three. (1 each)
Show the model answer to Question 12
(a) Profit or loss (7 marks).
- Revenue = 600
- gross profit = 210
- cost of sales = 390. (2)
- Operating expenses = 90. (1)
- Depreciation = 10% × (200 + 60) = 26. (1.5)
- Interest = 8% × (50 + 60) = 8.8. (1.5)
- Profit = 210 − 90 − 26 − 8.8 = 85.2. (1)
(b) Financial position (8 marks).
- Closing inventory.
390 ÷ 6 = 65 - purchases = 390 + 65 − 50 = 405
- payables = 405 ÷ 6 = 67.5
- receivables = 600 ÷ 6 = 100. (3)
- Non-current assets.
200 + 60 − 26 = 234. (1) - Retained earnings.
120 + 85.2 = 205.2 - equity = 305.2
- loan = 110.
- Total = 305.2 + 110 + 67.5 = 482.7. (2)
- Cash = 482.7 − 234 − 65 − 100 = 83.7. (2)
(c) Cash flow (5 marks).
- Profit before interest and depreciation add-back.
85.2 + 8.8 + 26 = 120 less interest 8.8 = 111.2 before working capital. - Working capital.
receivables −20, inventory −15, payables −32.5 = −67.5. - Operating cash flow = 43.7. (3)
- Investing −60; financing +60.
- Net increase 43.7; closing cash = 40 + 43.7 = 83.7, agreeing with (b). (2)
Show the model answer to Question 13
(a) Before (3 marks).
- ROCE = 100 ÷ 500 = 20%.
- EPS = 80 ÷ 50 = ₦1.60.
- Gearing = 90 ÷ 500 = 18%.
- (1 each)
(b) Equity issue (4 marks).
- Capital employed.
600, so ROCE = 16.7%. (1.5) - EPS = 80 ÷ 150 = ₦0.53. (1.5)
- Gearing = 90 ÷ 600 = 15%. (1)
(c) Comment (3 marks). ROCE and EPS fall because capital and shares rise while profit is unchanged, and gearing falls. (1.5) The figures ignore the return earned on the new funds, which would lift ROCE and EPS. (1.5)
Pathfinder on Forecast profit or loss, financial position, cash flows and financing options
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The question asked which item is NOT part of a complete financial plan. The options were a detailed profile of all management staff, clearly stated strategic, operating and financial objectives, the assumptions on which the plan is based, a description of the underlying strategies and contingency plans for emergencies. The answer is the profile of all management staff. Read the revision list and the order of working.
Revise first: The order of working
Case questions ask for ROCE, EPS and gearing under debt and equity. See the section on comparing ways of financing.
Revise first: Comparing ways of financing
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: May 2014 multiple-choice 17.
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