### Case were $2 billion, and the marketing

Case (2) NEW WORLD CHEMICALS INC Financial Forecasting Sue Wilson, the new financial manager of New World Chemicals (NWC), a California producer of specialized chemicals for use in fruit orchards, must prepare a financial forecast for 1998. NWC’s 1997 sales were $2 billion, and the marketing department is forecasting a 25 percent increase for 1998. Wilson thinks the company was operating at full capacity in 1997, but she is not sure about this.

The 1997 financial statements, plus some other data, are given in Table 1. 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. Assume (1) that NWC was operating at full capacity in 1997 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 1997 profit margin and dividend payout will be maintained. Under these conditions, what will the company’s financial requirements be for the coming year? b. Now estimate the 1998 financial requirements using the projected financial statement approach.

Assume (1) that each type of asset, as well as payables, accruals, and fixed and variable costs, grow at the same rate as sales; (2) that the payout ratio is held constant at 30 percent; and (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). c. Why do the two methods produce somewhat different AFN forecasts? Which method provides the more accurate forecast? d. Calculate NWC’s forecasted ratios, and compare them with the company’s 1997 ratios and with the industry averages.How does NWC compare with the average firm in its industry, and is the company expected to improve during the coming year? e. Suppose you now learn that NWC’s 1997 receivables and inventory 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 1997 with the available fixed assets? What would the fixed assets/sales ratio have been if NWC had been operating at full capacity? 2. How would the existence of excess capacity in fixed assets ffect the additional funds needed during 1998? f.

Without actually working out the numbers, how would you expect the ratios to change in the situation where excess capacity in fixed assets exists? Explain your reasoning. g. 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? If the company were able to bring these ratios into line with the industry averages, what effect would this have on its AFN and its financial ratios? .

The relationship between sales and the various types of assets is important in financial forecasting. The financial statement method, 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) excess capacity; (2) base stocks of assets, such as shoes in a shoe store; (3) economies of scal in the use of assets; and (4) lumpy assets. 1.How could regression analysis be used to detect the presence of the situations described above and then to improve the financial forecasts? Plot a graph of the following data, which is for a typical well-managed company in NWC’s industry, to illustrate your answer.

YEAR SALES INVENTORIES 1995 $ 1,280 $ 118 1996 1,600 138 1997 2,000 162 1998E 2,500 192 2. On the same graph that plots the above data, draw a line which shows how the regression line would have to appear to justify the use of the AFN formula and the projected financial statement forecasting method.As a part of your answer, show the growth rate in inventory that results from a 10 percent increase in sales from a sales level of (a) $200 and (b) $2,000 based on both the actual regression line and a hypothetical regression line which is linear and which goes through the origin. How would changes in these items affect the AFN? (1) The dividend payout ratio, (2) the profit margin, (3) the capital intensity ratio, and (4) if NWC begins buying from its suppliers on terms which permit it to pay after 60 days rather than after 30 days.

(Consider each item separately and hold all other things constant. Table 1 Financial Statements and Other Data on NWC (Million of Dollars) A. 1997 Balance Sheet Cash and securities $ 20 Accounts payable and accruals $ 100 Accounts receivable 240 Notes payable 100 Inventory 240 Total current liabilities $ 100 Total current assets $ 500 Long-term debt 100 Net fixed assets 500 Common stock 500 Retained earnings 200 Total assets $ 1,000 Total liabilities and equity $ 1,000 B. 1997 Income Statement Sales $2,000. 00 Less: Variable costs 1,200. 00 Fixed costs 700. 00 Earnings before interest and taxes $ 100.

00 Interest 6. 00 Earnings before taxes $ 84. 00 Taxes (40%) 33. 60 Net income $ 50.

40 Dividends (30%) 15. 12 Addition to retained earnings $ 35. 28 C. Key Ratios NWC INDUSTRY COMMENT Basic earnings power 10. 00% 20.

00% Profit margin 2. 52 4. 00 Return on equity 7. 20 15. 60 Days sales outstanding (360 days) 43. 20 days 32.

00 days Inventory turnover 8. 33 ? 11. 00 ? Fixed assets turnover 4. 00 5. 00 Total assets turnover 2. 00 2.

50 Debt/assets 30. 00% 36. 00% Times interest earned 6. 25 ? 9. 44 ? Current ratio 2. 50 3. 00 Payout ratio 30.

00% 30. 00%

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