Forecasting and Pro Forma Financial Statements

It is strongly advised that the student use the assigned case, construct ...
Allied Food Products, Sales in
                                        Millions of $
7. Forecasts are made for each division, both in the aggregate and on an individual product basis. The
   individual produ...
to recognize that this method can be easily adjusted to allow different income statement and balance sheet
items to grow a...

The assets shown on Allied's balance sheet must increase if sales are to increase. For...
Table 2. Allied, Balance Sheet: 2001-Actual and 2002-Forecast

                       2001, Actual       Forecast         ...
In summary, (1) higher sales must be supported by additional assets, (2) some of the asset increases can
be financed by sp...
discussed here.


The 2002 forecast as developed above is only the first part of Allied's total f...
Table 4. Inputs, AFN, Ratios
2002. We do not show the new financial statements, but the revised ratios are shown in the third column of
   Table 4. Her...
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Sales Forecast


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Sales Forecast

  1. 1. Forecasting and Pro Forma Financial Statements It is strongly advised that the student use the assigned case, construct an Excel worksheet with the various financial data included, and input the data from the case in the worksheet. Then using the Allied example as a guide, he/she should determine what needs to be done. For success, the work needs to be done with patience and care. Keep you eyes on every financial statement, and examine every item on these statements to make sure all items are consistent across all statements. In the Allied example some items are “plugs” – see Table 2, in the column “AFN”; these are items used to balance things out. For example, the firm may be short of funds and these must come from somewhere – e.g., borrowing from the bank or selling new common stocks. The borrowing can be short-term (notes) or long-term (bonds). This is an individual effort. But you may consult other students on “concepts” or developing a worksheet. While I encourage all of you to become proficient in constructing the various Financial reports in a worksheet format, you may get help from colleague or even use their worksheets – as long as their worksheets are cleared of their own work on this case. Forecasted Financial Statements In planning, one must make forecasts. In making forecasts, you consider a number of possibilities (called “states” of the world). One possibility is that business conditions will be “normal”, another that the economy will go into a mild recession and business suffers a little, and so on. To each possibility one associates a likelihood (or “probability”). If we have taken into account all possible outcomes, then these probabilities must sum to unity. Each possible “outcome” implies certain things about your business – e.g., if the economy experiences a mild recession your sales may drop. When all these outcomes are considered some average (“expected value”) of your future sales is obtained. This approach requires elaborate analyses. For the purpose of your case, use a simple growth based on the company’s recent past sales. Once sales are forecasted, you must also forecast income statements, balance sheets and cash flow statements for the entire forecast period. This provides an estimate of your profits, your need for plan and equipment, and your need for cash and capital. Without this information you are likely to run a great business into the ground: lose customers, lose suppliers, go bankrupt. The forecasted financial statements are referred to as “pro forma” statements. But be warned that these days companies often manipulate their financial reports to highlight or hide certain information; because of this the reports do not conform to GAAP (generally accepted accounting practices) and they have to give them a name – thus they call these pro forma statements as well; but these are NOT forecasted financial reports – they are whatever the reporting company wants them to be. Sales Forecast A forecast of a firm's unit and dollar sales for some future period; it is generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, and so forth. The sales forecast generally starts with a review of sales during the past five to ten years, expressed in a graph such as that in the Figure below. The graph could have contained 10 years of sales data, but Allied focuses on sales figures for the latest five years because the firm's studies have shown that its future growth is more closely related to recent events than to the distant past. Sales for 2002 are forecasted to rise 10% above the 2001 level; the 10% growth is the (approximate) average growth between 1997 and 2001. 1
  2. 2. Allied Food Products, Sales in 4000 Millions of $ 2002- Forecast 3000 2000 1000 0 1996 1997 1998 1999 2000 2001 2002 2003 Allied had its ups and downs during the period from 1997 to 2001. In 1999, poor weather in California's fruit-producing regions resulted in low production, which caused 1999 sales to fall below the 1998 level. Then, a bumper crop in 2000 pushed sales up by 15 percent, an unusually high growth rate for a mature food processor. Based on a simple growth analysis, Allied's forecasters determined that the average annual growth rate in sales over the past five years was 9.1 percent. On the basis of this historical sales trend, on planned new-product introductions, and on Allied's forecast for the economy, the firm's planning committee projects a 10 percent sales growth rate during 2002, to sales of $3,300 million. Here are some of the factors Allied considered in developing its sales forecast: 1. Allied Food Products is divided into three divisions: canned foods, frozen foods, and packaged foods such as dried fruits. Sales growth is seldom the same for each of the divisions, so to begin the forecasting process, divisional projections are made on the basis of historical growth, and then the divisional forecasts are combined to produce a "first approximation" corporate sales forecast. 2. Next, the level of economic activity in each of the company's marketing areas is forecasted-for example, how strong will the economies be in each of Allied's six domestic and two foreign distribution territories, and what population changes are forecasted in each area? 3. Allied's planning committee also looks at the firm's probable market share in each distribution territory. Consideration is given to such factors as the firm's production and distribution capacity, its competitors' capacities, new-product introductions that are planned by Allied or its competitors, and potential changes in shelf-space allocations, which are vital for food sales. Pricing strategies are also considered-for example, does the company have plans to raise prices to boost margins, or to lower prices to increase market share and take advantage of economies of scale? Obviously, such factors could greatly affect future sales. 4. Allied's foreign sales present unique forecasting problems. In particular, its planners must consider how exchange rate fluctuations would affect sales. Allied must also consider the effects of trade agreements, governmental policies, and the like. 5. Allied's planners must also consider the effects of inflation on prices. Over the next five years, the inflation rate for food products is assumed by Allied to average 3 to 4 percent, and Allied plans to increase prices, on average, by a like amount. In addition, the firm expects to expand its market share in certain products, resulting in a 4 percent growth rate in unit sales. The combination of unit sales growth and increases in sales prices has resulted in historical revenue growth rates in the 8 to 10 percent range, and this same situation is expected in the future. 6. Advertising campaigns, promotional discounts, credit terms, and the like also affect sales, so probable developments for these items are also factored in. 2
  3. 3. 7. Forecasts are made for each division, both in the aggregate and on an individual product basis. The individual product sales forecasts are summed, and this sum is compared with the aggregated division/ forecasts. Differences are reconciled, and the end result is a sales forecast for the company as a whole but with breakdowns by the three divisions and by individual products. If the sales forecast is off, the consequences can be serious. First, if the market expands more than Allied has geared up for, the company will not be able to meet demand. Its customers will end up buying competitors' products, and Allied will lose market share. On the other hand, if its projections are overly optimistic, Allied could end up with too much plant, equipment, and inventory. This would mean low turnover ratios, high costs for depreciation and storage, and write-offs of spoiled inventory. All of this would result in low profits, a low rate of return on equity, and a depressed stock price. If Allied had financed an unnecessary expansion with debt, high interest charges would compound its problems. Thus, an accurate sales forecast is critical to the firm's well-being. FINANCIAL STATEMENT FORECASTING: Percent of Sales Method: A method of forecasting future financial statements that expresses each account as a percentage of sales. These percentages can be constant, or they can change over time. Once sales have been forecasted, we must forecast future balance sheets and income statements (called pro forma reports). The most commonly used technique is the percent of sales method, which begins with the sales forecast, expressed as an annual growth rate in dollar sales revenues. Although only one year is shown in our earlier example, Allied's managers actually forecasted sales for eight years, with these results: 10% in each of the years 2002-2005, 9% in 2006, 8% in 2007, and 7% in 2008 and 2009. This eight-year period is called the explicit forecast period, with the eighth year being the forecast horizon Note: A sales forecast is actually the expected value of a probability distribution, so there are many possible levels of sales. Because any sales forecast is subject to uncertainty, financial planners are just as interested in the degree of uncertainty inherent in the sales forecast, as measured by the standard deviation, as in the expected level of sales. The initially forecasted growth rate is 10 percent, but high growth attracts competitors, and eventually the market becomes saturated. Therefore, population growth and inflation determine the long-term sales growth rate for most companies. Reasonable values for the long-term sales growth rate are from 5 to 7 percent for companies in mature industries. Allied's managers believe that a long-term sales growth rate of 7 percent is reasonable. Its managers also believe that competition will drive their growth rate down to this level within seven or eight years, so they have chosen an eight-year forecast period. Companies often have what is called a competitive advantage period, during which they can grow at rates higher than the long-term growth rate. For companies with proprietary technology or strong brand identities, such as Microsoft or Coca-Cola, the competitive advantage period might be as long as 20 years. For companies that produce commodities or that are in highly competitive industries, the competitive advantage period might be as short as two or three years, or even be nonexistent. To summarize, most financial plans have a forecast period of at least 5 years, with 5 to 15 years, depending on the expected length of the competitive advantage period, being most common. Many items on the income statement and balance sheet are often assumed to increase proportionally with sales. For example, the inventories-to-sales ratio might increase 20 percent, receivables/sales might increase 15 percent, variable costs might increase 60 percent of sales, and so forth. Then, as sales increase, items that are tied to sales also increase, and the values of those items for a particular year are estimated as percentages of the forecasted sales for that year. The remaining items on the forecasted statements - items that are not tied directly to sales - are set at "reasonable" levels. Note that if the forecasted percentage of sales for each item is the same as the percentage for the prior year, then each item will grow at the same rate as sales. While the financial statement forecasting method often begins by assuming that many key items will grow at the same rate as projected sales, it is important 3
  4. 4. to recognize that this method can be easily adjusted to allow different income statement and balance sheet items to grow at different rates. This process is particularly straightforward whenever a spreadsheet is used to develop the forecast. With this understanding in mind, we explain in the following section how to use this method to forecast Allied's financial statements. STEP 1. FORECASTED INCOME STATEMENT First, we forecast the income statement for the coming year. This statement is needed to estimate both income and the addition to retained earnings. Table 1 shows the forecast for 2002. Sales are forecasted to grow by 10 percent. The forecast of sales for 2002, shown in Row 1 of Column 3, is calculated by mul- tiplying the 2001 sales, shown in Column 1, by (1 + growth rate) = 1.10. The result is a 2002 forecast of $3,300 million. Table 1. Allied Food Products: Actual 2001 and Projected 2002 Income Statements (Millions of Dollars) 2001, Actual (1) Forecast Basis (2) 2002, Forecast (3) Sales 3,000 1.10x 2001 Sales = 3,300 Costs, except Depreciation 2616 .872x2002 Sales = 2878 Depreciation 100 0.1x2002 Net plant = 110 Total operating costs 2716 2988 EBIT 284 312 Interest 88 88 (a) Earnings before tax 196 224 Tax at 40% 78 89 Net income before preferred dividends 118 135 Dividends to preferred 4 4 (a) Net income for common 114 131 Dividends to common 58 63 Addition to retained earnings 56 68 (a) Same as prior year The percent of sales method assumes initially that all costs except deprecia tion are a specified percentage of sales. For 2001, Allied's ratio of costs to sales is 87.2 percent ($2,616/$3,000 = 0.872). Thus, for each dollar of sales in 2001, Allied incurred 87.2 cents of costs. Initially, the company's managers assume that the cost structure will remain unchanged in 2002. We can explore the impact of an improvement in the cost structure, but for now we assume that costs will equal 87.2 percent of sales. See Column 3, Row 2. Allied's managers assume that depreciation will be a fixed percentage of net plant and equipment. For 2001, the ratio of depreciation to net plant and equipment is 10 percent ($100/$1,000 = 0.10), and Allied's managers believe that this is a good estimate of future depreciation. The forecasted net plant and equipment for 2002 is $1,100. Therefore, the forecasted depreciation for 2002 is 0.10($1,100) = $110. Total operating costs, shown in Row 4, are the sum of costs and depreciation. EBIT is found by subtraction, while the interest charges in Column 3 are simply carried over from Column 1. Earnings before taxes (EBT) is then calculated, as is net income before preferred dividends. Preferred dividends are carried over from the 2001 column, and they will remain constant unless Allied decides to issue additional preferred stock. Net income available to common is then calculated, after which the 2002 dividends are forecasted as follows. The 2001 dividend per share is $1.15, and this dividend is expected to increase by about 8 percent, to $1.25. Since there are 50 million shares outstanding, the projected dividends are $1.25(50) = $62.5 million, rounded to $63 million. To complete the forecasted income statement, the $63 million of projected dividends are subtracted from the $131 million projected net income, and the result is the first-pass projection of the addition to retained earnings, $131 - $6 = $68 million. We call it “first-pass” because we may make errors in ensuring that all the financial statements are consistent so we go back and correct them 4
  5. 5. 5
  6. 6. STEP 2. FORECAST THE BALANCE SHEET The assets shown on Allied's balance sheet must increase if sales are to increase. For example, companies such as Allied write and deposit checks every day. Because they don't know exactly when all of these checks will clear, they can't predict exactly what the balance in their checking accounts will be on any given day. Therefore, they must maintain a balance of cash and marketable securities to avoid overdrawing their accounts. For now we simply assume that the cash required to support the company's operations is proportional to its sales. Allied's 2001 ratio of cash to sales was approximately 0.33 percent ($10/$3,000 = 0.003333), and its managers believe this ratio will remain constant in 2002. Therefore, the forecasted cash balance for 2002, shown in Column 3 of Table 2, is 0.003333($3,300) = $11 million. Unless a company changes its credit policy or has a change in its types of customers, accounts receivable will increase proportionately with sales. Allied's 2001 ratio of accounts receivable to sales was $375/$3,000 = 0.125 = 12.5%. One could examine the effect of a change in credit policy, but for now we assume a constant credit policy and customer base. Therefore, the forecasted accounts receivable for 2002 is 0.125($3,300) = $412.5 million, rounded to $412 million as shown in Column 3 of Table 2. As sales increase, companies generally need more inventory. For Allied, the 2001 ratio of inventory to sales is $615/$3,000 = 20.5%. Assuming no change in Allied's inventory management, the forecasted inventory for 2002 is 0.205($3,300) = $676.5 million, rounded to $677 million as shown in Column 3 of Table 2. It might be reasonable to assume that cash, accounts receivable, and inventory grow proportionally with sales, but will the amount of net plant and equipment go up and down as sales go up and down? The correct answer could be yes or no. When companies acquire plant and equipment, they often install greater capacity than they currently need, due to economies of scale. For example, it was economically better for GM to build the Saturn automobile plant with a capacity of about 320,000 cars per year than to build the plant with a capacity of only 50,000 cars per year and then add capacity each year. Saturn's sales were far below 320,000 units for the first few years of production, so it was possible to increase sales during those years without also increasing plant and equipment. Even if a factory is at its maximum rated capacity, most companies can produce additional units by reducing the amount of downtime due to scheduled maintenance, by running machinery at a higher than optimal speed, or by running a second (or third) shift. Therefore, there is not necessarily a close relationship between sales and net plant and equipment in the short term. However, for some companies there is a fixed relationship between sales and plant and equipment, even in the short term. For example, new stores in many retail chains achieve the same sales during their first year as the chain's existing stores. The only way these retailers can grow is by adding new stores, which re- sults in a strong proportional relationship between fixed assets and sales. In the long run, there is a relatively close relationship between sales and fixed assets for all companies: No company can continue to increase sales unless it eventually adds capacity. Therefore, as a first approximation it is reasonable to assume that the long-term ratio of net plant and equipment to sales will be constant. For the first years of a forecast, managers generally use the actual planned dollars of investment in plant 6
  7. 7. Table 2. Allied, Balance Sheet: 2001-Actual and 2002-Forecast 2001, Actual Forecast First Pass AFN Second (1) Basis, (2) (3) (4) Pass (5) Cash and near cash 10 .33% x 2002 sales 11 11 Accounts Rec 375 12.5% x ’02 sales 412 412 Inventories 615 29.5% x ’02 sales 677 677 Tot current assets 1000 1100 1100 Net Plant & Equip 1000 33.33%x ’02 sales 1100 1100 Total assets 2000 2200 2200 Acc. Payable 60 2% x ’02 sales 66 66 Notes Payable 110 110 +28 138 Accruals 140 4.67% x ’02 sales 154 154 Tot Current Liab 310 330 358 Long-term bonds 754 754 +28 782 Total Debt 1064 1084 1140 Preferred Stock 40 40 40 Common stock 130 130 +56 186 Retained Earnings 766 +68 834 834 Total Equity 896 964 1020 Tot Liab and equity 2000 2088 +112 2200 AFN 112 Note: AFN stands for Additional Funds Needed. This figure is shown in the last row of column (3); then column (4) shows how the required $112 of AFN is used. and equipment. If those estimates are not available, it is reasonable to assume an approximately constant ratio of net plant and equipment to sales. For Allied, the ratio of net plant and equipment to sales for 2001 is $1,000/$3,000 = 33.33%. Allied's net plant and equipment have grown fairly steadily in the past, and its managers expect steady future growth. Therefore, they forecast net plant and equipment for 2002 to be 0.3333($3,300) = $1,100 million. Once the individual asset accounts have been forecasted, they can be summed to complete the asset section of the balance sheet. For Allied, the total current assets forecasted for 2002 are $11 + $412 + $677 = $1,100 million, and fixed assets add another $1,100 million. Therefore, as Table 2 shows, Allied will need total assets of $2,200 million to support $3,300 million of sales in 2002. Note: Spontaneously Generated Funds: funds that are obtained automatically from routine business transactions If Allied's assets are to increase, its liabilities and equity must also increase-- the additional assets must be financed. Some items on the liability side can be expected to increase spontaneously with sales, producing what are called spontaneously generated funds. For example, as sales increase, so will Allied's purchases of raw materials, and those larger purchases will spontaneously lead to a higher level of accounts payable. For Allied, the 2001 ratio of accounts payable to sales is $60/$3,000 = 0.02 = 2%. Allied's managers assume that their payables policy will not change, so the forecasted accounts payable for 2002 is 0.02($3,300) = $66 million. More sales will require more labor, and higher sales should also result in higher taxable income and thus taxes. Therefore, accrued wages and taxes will both increase. For Allied, the 2001 ratio of accruals to sales is $140/$3,000 = 0.0467 = 4.67%. If this ratio does not change, then the forecasted level of accruals for 2002 will be 0.0467($3,300) = $154 million. Retained earnings will also increase, but not at the same rate as sales: The new balance for retained earnings will be the old level plus the addition to retained earnings, which we calculated in Step 1. Also, notes payable, long-term bonds, preferred stock, and common stock will not rise spontaneously with sales - rather, the projected levels of these accounts will depend on financing decisions, as we discuss later. 7
  8. 8. In summary, (1) higher sales must be supported by additional assets, (2) some of the asset increases can be financed by spontaneous increases in accounts payable and accruals, and by retained earnings, but (3) any shortfall must be financed from external sources, using some combination of debt, preferred stock, and common stock. The spontaneously increasing liabilities (accounts payable -and accruals) are forecasted and shown in Column 3 of Table 2, the first-pass forecast. Then, those liability and equity accounts whose values reflect conscious management decisions - notes payable, long-term bonds, preferred stock, and common stock - are initially set at their 2001 levels. Thus, 2002 notes payable are initially set at $110 million, the long-term bond account is forecasted at $754 million, and so on. The 2002 value for the retained earnings (RE) account is obtained by adding the projected addition to retained earnings as developed in the 2002 income statement (see Table 1) to the 2001 ending balance: 2002 RE = 2001 RE + 2002 forecasted addition to RE = $766 + $68 = $834 million. The forecast of total assets as shown in Column 3 (first-pass forecast) of Table 2 is $2,200 million, which indicates that Allied must add $200 million of new assets in 2002 to support the higher sales level. However, the forecasted liability and equity accounts as shown in the lower portion of Column 3 rise by only $88 million, to $2,088 million. Since the balance sheet must balance, Allied must raise an additional $2,200 - $2,088 = $112 million, which we define as Additional Funds Needed (AFN). The AFN will be raised by some combination of borrowing from the bank as notes payable, issuing long-term bonds, and selling new common stock. STEP 3. RAISING THE ADDITIONAL FUNDS NEEDED Allied's financial staff will raise the needed funds based on several factors, including the firm's target capital structure (target capital structure reflects management’s goal of what proportion of capital should be equity and what proportion debt over the longer term), the effect of short-term borrowing on the current ratio, conditions in the debt and equity markets, and restrictions imposed by existing debt agreements. The financial staff, after considering all of the relevant factors, decided on the following financing mix to raise the needed $112 million: Table 3. Amount of New Capital Per cent Dollars Interest rate Notes Payable 25 % $ 28 8% Long-term bonds 25 28 10 Common stock 50 56 -- Total 100% $112 These amounts, which are shown in Column 4 of Table 2, are added to the initially forecasted account totals as shown in Column 3 to generate the second-pass balance sheet. Thus, in Column 5 the notes payable account increases to $110 + $28 = $138 million, long-term bonds rise to $754 + $28 = $782 million, and common stock increases to $130 + $56 = $186 million. Then, the balance sheet is in balance. A COMPLICATION: FINANCING FEEDBACKS Our projected financial statements are incomplete in one sense - they do not reflect the fact that interest must be paid on the debt used to help finance the AFN, and that dividends will be paid on the shares issued to raise the common stock portion of the AFN. Those payments would lower net income and retained earnings shown in the projected statements. One could take account of these financing feedback effects by adding columns to Tables 1 and 2 and then making further adjustments. The adjustments are not difficult, but they do involve a good bit of arithmetic. But since all of the data are based on forecasts, and since the adjustments add substantially to the work but relatively little to the accuracy of the forecasts, they are not 8
  9. 9. discussed here. ANALYSIS OF THE FORECAST The 2002 forecast as developed above is only the first part of Allied's total forecasting process. We must go on to analyze the projected statements to determine whether the forecast meets the firm's financial targets as set forth in the five-year financial plan. If the statements do not meet the targets, then elements of the forecast must be changed. Table 4 shows Allied's actual ratios for 2001, its projected 2002 ratios, and the latest industry average ratios. These other ratios are used as a basis of comparison between Allied and others in the same industry, as well as Allied’s current situation versus its situation in the future. (The table also shows a "Revised Forecast for 2002" column, which we will discuss later. Disregard the revised data for now.) The firm's financial condition at the close of 2001 was weak, with many ratios well below the industry averages. For example, Allied's current ratio, based on Column 1 of Table 4, was only 3.2 versus 4.2 for an average food processor. The "Inputs" section shown on the top three rows of the table provides data on three of the model's key drivers: (1) costs (excluding depreciation) as a percentage of sales, (2) accounts receivable as a percentage of sales, and (3) inventories as a percentage of sales. The preliminary forecast in Column 2 assumes these variables remain constant. While Allied's cost-to-sales ratio is only slightly worse than the industry average, its ratios of accounts receivable to sales and inventories to sales are significantly higher than those of its competitors. Its investment in inventories and receivables is too high, causing its returns on assets, equity, and invested capital as shown in the lower part of the table to be too low. Therefore, Allied should make operational changes designed to reduce its current assets. 9
  10. 10. Table 4. Inputs, AFN, Ratios PRELIMINARY REVISED INDUSTRY ACTUAL FORECAST FOR FORECAST FOR AVERAGE 2001 2002 2002(a) 2001 (1) (2) (3) (4) INPUTS 87.2% 87.2% 86.0% 87.1% Costs (excluding depreciation) as percentage of sales Accounts receivable: as percentage of sales 12.5 12.5 11.8 10.0 Inventories as percentage of sales 20.5 20.5 16.7 11.1 OUTPUTS NOPAT (net operating profit after tax) $170.3 $187.3 $211.2 Net operating working capital $800.0 $880.0 $731.5 Total operating capital $1,800.0 $1,980.0 $1,831.5 Free cash flow (FCF) ($109.7) $7.3 $179.7 AFN $112 ($60) KEY RATIOS Current ratio 3.2X 3.1X 3.5x 4.2x Inventory turnover 4.9X 4.9x 6.0x 9.0x Days sales outstanding (365 days/year) 45.6 45.6 43.1 36.0 Total asset turnover 1.5 x 1.5 X 1.6X 1.8x Debt ratio 53.2% 51.8% 49.9% 40.0% Profit margin 3.8% 4.0% 4.7% 5.0% Return on assets 5.7% 5.9% 7.5% 9.0% Return on equity 12.7% 12.8% 15.6% 15.0% Return on invested capital (b) 9.5% 9.5% 11.5% 11.4% (a) 1re "'Revised" data show ratios after policy changes related to asset levels, as discussed later, have been incorporated into the forecast. All of the surplus AFN is used to pay off notes payable. (b) Return on invested capital = NOPAT/total operating capital The "Key Ratios" section of Table 4 for the forecast period provides more details regarding the firm's weaknesses. Allied's asset management ratios are much worse than the industry averages. For example, its total assets turnover ratio is 1.5 versus an industry average of 1.8. Its poor asset management ratios drag down the return on invested capital (9.5 percent for Allied versus 11.4 percent for the industry average). Furthermore, Allied must carry more than the average amount of debt to support its excessive assets, and the extra interest expense reduces its profit margin to 4.0 percent versus 5.0 percent for the industry. Much of the debt is short term, and this results in a current ratio of 3.1 versus the 4.2 industry average. These problems will persist unless management takes action to improve things. After reviewing its preliminary forecast, management decided to take three steps to improve its financial condition: (1) It decided to layoff some workers and close certain operations. It forecasted that these steps would lower operating costs (excluding depreciation) from the current 87.2 to 86 percent of sales as shown in Column 3 of Table 4. (2) By screening credit customers more closely and by being more aggressive in collecting past-due accounts, the company believes it can reduce the ratio of accounts receivable-to-sales from 12.5 to 11.8 percent. (3) Finally, management thinks it can reduce the inventories-to-sales ratio from 20.5 to 16.7 percent through the use of tighter inventory controls.6 These projected operational changes were then used to create a revised set of forecasted statements for 10
  11. 11. 2002. We do not show the new financial statements, but the revised ratios are shown in the third column of Table 4. Here are the highlights of the revised forecast: 1. The reduction in operating costs improved the 2002 NOPAT, or net operating profit after taxes, by $23.9 million. Even more impressive, the improvements in the receivables policy and in inventory management reduced receivables and inventories by $148.5 million. The net result of the increase in NOPAT and the reduction of current assets was a very large increase in free cash flow for 2002, from a previously estimated $7.3 million to $179.7 million. Although not shown, the improvements in operations will lead to significantly higher free cash flow for each year in the whole forecast period. 2. The profit margin improved to 4.7 percent. However, the firm's profit margin still lagged the industry average because its high debt ratio results in higher-than-average interest payments. 3. The increase in the profit margin resulted in an increase in projected retained earnings. More importantly, by tightening inventory controls and reducing the days sales outstanding, Allied projected a reduction in inventories and receivables. Taken together, these actions resulted in a negative AFN of $60 million, which means that Allied would actually generate $60 million more from internal operations during 2002 than it needs for new assets. All of this $60 million of surplus funds would be used to reduce short-term debt, which would lead to a decrease in the forecasted debt ratio from 51.8 to 49.9 percent. The debt ratio would still be well above the industry average, but this is a step in the right direction. 4. The indicated changes would also affect Allied's current ratio, which would improve from 3.1 to 3.5. 5. These actions would also raise the rate of return on assets from 5.9 to 7.5 percent, and they would boost the return on equity from 12.8 to 15.6 percent, which is even higher than the industry average. Although Allied's managers believe that the revised forecast is achievable, they are not sure of this. Accordingly, they wanted to know how variations in sales would affect the forecast. Therefore, a spreadsheet model was run using several different sales growth rates, and the results were analyzed to see how the ratios would change under different growth scenarios. To illustrate, if the sales growth rate increased from 10 to 20 percent, the additional funding requirement would change dramatically, from a $60 million surplus to an $87 million shortfall. The spreadsheet model can also used to evaluate dividend policy. If Allied decided to reduce its dividend growth rate, then additional funds would be generated, and those funds could be invested in plant, equipment, and inventories; used to reduce debt; or used to repurchase stock. The model can also used to evaluate financing alternatives. For example, Allied could use the forecasted $60 million of surplus funds to retire long-term bonds rather than to reduce short-term debt. Under this financing alternative, the current ratio would drop from 3.5 to 2.9, but the firm's interest coverage ratio would rise, assuming that the firm's long-term debt carries a higher interest rate than its notes payable. We see, then, that forecasting is an iterative process, both in the way the financial statements are generated and the way the financial plan is developed. For planning purposes, the financial staff develops a preliminary forecast based on a continuation of past policies and trends. This provides a starting point, or "baseline" forecast. Next, the projections are modified to see what effects alternative operating plans would have on the firm's earnings and financial condition. This results in a revised forecast. Then alternative operating plans are examined under different sales growth scenarios, and the model is used to evaluate both dividend policy and capital structure decisions. The spreadsheet model can be used to analyze alternative working capital policies-that is, to see the effects of changes in cash management, credit policy, inventory policy, and the use of different types of short-term credit. We can also examine Allied's working capital policy within the framework of the company's financial model financial forecasting process. Finally, The spreadsheet model can also be used to estimate Allied's free cash flow. Free cash flow is calculated as follows: FCF = Operating cash flow - Gross investment in operating capital. This FCF is the cash that is available to investors (equity as well as creditors) to take out of the firm while making sure that it has thee resources to continue to prosper. If one forecasts FCF and takes the present value of all these future FCF, that provides a good measure of how much the business is worth. 11
  12. 12. 12