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11-10

BUILD A MODEL: FORECASTING FINANCIAL STATEMENTS

Start with the partial model in the file Ch 11 P10 Build a Model.xls from the textbook's web site. Cumberland Industries' financial planners must forecast the company's financial results for the coming year. The forecast will be based on the percent of sales method, and any additional funds needed will be obtained by using a mix of notes payable, long-term debt, and common stock. No preferred stock will be issued. Data for the problem, including Cumberland Industries' balance sheet and income statement, can be found in the spreadsheet problem for Chapter 9. Use these data to answer the following questions.

a. Cumberland Industries has had the following sales since 1997. Assuming the historical trend continues, what will sales be in 2003?

Year

Sales

1997

1998

1999

2000 2001 2002

\$129,215,000 180,901,000 235,252,000 294,065,000 396,692,000 455,150,000

Base your forecast on a spreadsheet regression analysis of the 1997-2002 sales. By what percentage are sales predicted to increase in 2003 over 2002? Is the sales growth rate increasing or decreasing?

b. Cumberland's management believes that the firm will actually experience a 20 percent increase in sales during 2003. Construct the 2003 pro forma financial statements. Cumberland will not issue any new stock or long-term bonds. Assume Cumberland will carry forward its current amounts of short-term investments and notes payable, prior to calculating AFN. Assume that any additional funds needed (AFN) will be raised as notes payable (if AFN is negative, Cumberland will purchase additional short-term investments). Use an interest rate of 9 percent for short-term debt (and for the interest income on short-term investments) and a rate of 11 percent for long-term debt. No interest is earned on cash. Use the beginning of year debt balances to calculate net interest expense. Assume dividends grow at an 8 percent rate.

c. Now create a graph that shows the sensitivity of AFN to the sales growth rate. To make this graph, compare the AFN at sales growth rates of 5, 10, 15, 20, 25, and 30 percent.

d. Calculate net operating working capital (NOWC), total operating capital, NOPAT, and operating cash flow (OCF) for 2002 and 2003. Also, calculate the free cash flow (FCF) for 2003.

e. Suppose Cumberland can reduce its inventory to sales ratio to 5 percent and its cost to sales ratio to 83 percent. What happens to AFN and FCF?

 Sue Wilson, the new financial manager of Northwest Chemicals (NWC), an Oregon pro ducer of specialized chemicals for use in fruit orchards, must prepare a financial forecast for 2003. NWC's 2002 sales were \$2 billion, and the marketing department is forecasting a 25 percent increase for 2003 . Sue thinks the company was operating at full capacity in 2002, but she is not sure about this. The 2002 financial statements, plus some other data, are shown below. A. 2002 BALANCE SHEET (MILLIONS OF DOLLARS) Percent Percent of Sales of Sales Cash and securities \$ 20 1% Accounts payable and Accounts receivable 240 12% accruals \$ 100 5% Inventories 240 12% Notes payable 100 Total current assets \$ 500 Total current liabilities \$ 200 Net fixed assets 500 25% Long-term debt 100 Total assets \$1,000 Common stock 500 Retained earnings 200 Total liabilities and equity \$1,000 B. 2002 INCOME STATEMENT (MILLIONS OF DOLLARS) Percent of Sales Sales \$2,000.00 Cost of goods sold (COGS) 1,200.00 60% Sales, general, and administrative costs (SGA) 700.00 35% Earnings before interest and taxes \$ 100.00 Interest 10.00 Earnings before taxes \$ 90.00 Taxes (40%) 36.00 Net income \$ 54.00 Dividends (40%) 21.60 Addition to retained earnings \$ 32.40 C. KEY RATIOS NWC Industry Profit margin 2.70 4.00 Return on equity 7.71 15.60 Days sales outstanding (365 days) 43.80 days 32.00 days Inventory turnover 8.33X 11.00X Fixed assets turnover 4.00 5.00 Debt/assets 30.00% 36.00% Times interest earned 10 X 9.40X Current ratio 2.50 3.00 Return on invested capital (NOPAT/ Operating capital) 6.67% 14.00%

See Ch 11 Show.ppt for a

PowerPoint presentation of the Mini Case and Ch 11 Mini Case.xls for detailed calculations.

Assume that you were recently hired as Wilson's assistant, and your first major task is to help her develop the forecast. She asked you to begin by answering the following set of questions.

a. Describe three ways that pro forma statements are used in financial planning.

b. Explain the steps in financial forecasting.

c. Assume (1) that NWC was operating at full capacity in 2002 with respect to all assets, (2) that all assets must grow proportionally with sales, (3) that accounts payable and accruals will also grow in proportion to sales, and (4) that the 2002 profit margin and dividend payout will be maintained. Under these conditions, what will the company's financial requirements be for the coming year? Use the AFN equation to answer this question.

d. How would changes in these items affect the AFN: (1) sales increase? (2) the dividend payout ratio increases? (3) the profit margin increases? (4) the capital intensity ratio increases? and (5) NWC begins paying its suppliers sooner? (Consider each item separately and hold all other things constant.)

e. Briefly explain how to forecast financial statements using the percent of sales approach. Be sure to explain how to forecast interest expenses.

f. Now estimate the 2003 financial requirements using the percent of sales approach. Assume (1) that each type of asset, as well as payables, accruals, and fixed and variable costs, will be the same percent of sales in 2003 as in 2002; (2) that the payout ratio is held constant at 40 percent; (3) that external funds needed are financed 50 percent by notes payable and 50 percent by long-term debt (no new common stock will be issued); (4) that all debt carries an interest rate of 10 percent; and (5) interest expenses should be based on the balance of debt at the beginning of the year.

g. Why does the percent of sales approach produce a somewhat different AFN than the equation approach? Which method provides the more accurate forecast?

h. Calculate NWC's forecasted ratios, and compare them with the company's 2002 ratios and with the industry averages. Calculate NWC's forecasted free cash flow and return on invested capital (ROIC).

i. Based on comparisons between NWC's days sales outstanding (DSO) and inventory turnover ratios with the industry average figures, does it appear that NWC is operating efficiently with respect to its inventory and accounts receivable? Suppose NWC were able to bring these ratios into line with the industry averages and reduce its SGA/Sales ratio to 33 percent. What effect would this have on its AFN and its financial ratios? What effect would this have on free cash flow and ROIC?

j. Suppose you now learn that NWC's 2002 receivables and inventories were in line with required levels, given the firm's credit and inventory policies, but that excess capacity existed with regard to fixed assets. Specifically, fixed assets were operated at only 75 percent of capacity.

(1) What level of sales could have existed in 2002 with the available fixed assets?

(2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2003?

k. The relationship between sales and the various types of assets is important in financial forecasting. The percent of sales approach, under the assumption that each asset item grows at the same rate as sales, leads to an AFN forecast that is reasonably close to the forecast using the AFN equation. Explain how each of the following factors would affect the accuracy of financial forecasts based on the AFN equation: (1) economies of scale in the use of assets and (2) lumpy assets.