Financial Forecasting

NWC (New Word Chemicals Inc.) is a California-base producer of specialized chemicals for use in fruit orchards.

Sue Wilson, the financial manager is asked to prepare a financial forecast for 2009.

The assumptions and data forecasts are as follow:

A 25% increase in sales for 2009.

Key ratios would remain unchanged.

FINANCIAL POSITION
(millions of dollar) Cash and cash equivalents Accounts receivable Inventories Total Current assets 2008 $20 240 240 500 2009E $25 300 300 625

Net fixed assets

Total assets Accounts payable and accrued liabilities Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

500
$1,000 $100 100 200 100 500 200 $1,000

625
$1,250 $125 190 315 190 500 245 $1250

FINANCIAL PERFORMANCE
(millions of dollar) Sales Less: Variable costs Fixed Costs Earnings before interest and taxes (EBIT) Interest Earnings before taxes (EBT) Taxes (40%) 2008
$2,000.00 1,200.00 700.00 $100.00 16.00 $84.00 33.60

2009E
$2,500.00 1,500.00 875.00 $125.00 16.00 $109.00 43.60

Net income

$50.40

$65.40

Dividends (30%) Addition to retained earnings

$15.12 $35.28

$19.62 $45.78

KEY RATIOS
NWC-2008
Basic earnings power Profit margin ROE DSO (365 days) 10.00% 2.52% 7.20% 43.80days

NWC-2009E
10.00% 2.62% 8.77 43.80days

Industry
20.00% 4.00% 15.60% 32.00days

Inventory turnover
Fixed assets turnover Total assets turnover Debt/Assets Times interest earned

8.33x
4.00x 2.00x 30.00% 6.25x

8.33x
4.00x 2.00x 40.34% 7.81x

11.00x
5.00x 2.50x 36.00% 9.40x

Current ratio
Payout ratio

2.50x
30.00%

1.99x
30.00%

3.00x
30.00%

TERMS A0 L0 S0 S1 g RR M
Current years Total Assets Current years Accounts payable and Accrual Current Sales Forecasted sales computed by (0 )(1 + g) Growth Rate Retention rate computed by (1 Payout Ratio) or (1 - )

Profit Margin
Increase in sales, computed by 1 - 0

Formal Financial Forecast Preparation

Assume 1. NWC was operating at full capacity in 2008 with respect to all assets 2. All assets must grow at the same rate as sales 3. The Accounts payable and accrued liabilities will also grow at the same rate as sales 4. The 2008 profit margin and dividend payout will be maintained. Requirement #1: What would the AFN equation predict the companys financial requirements to be for the coming year?

Formal Financial Forecast Preparation

A0 L0 AFN = S S M(S1 )(RR) S0 S0 $1,000 $100 AFN = 500 500 0.0252($2,500)(.70) $2,000 $2,000

AFN = $250 $25 $44.1

AFN = $180.9

Formal Financial Forecast Preparation

The high DSO is largely due to one customer who battled through some hardships the past 2 years. Now, he is in a stable position. DSO is predicted to be equal to 34 days without adversely affecting sales. NWC was operating a little below capacity, but its forecasted growth will require a new facility, which is expected to increase NWCs net fixed assets to $700 million.

A new inventory management system was installed thus expecting improvement as inventories decrease and turnover is expected to rise to 10x.
Incorporate this information into the 2009 initial forecast results, as these adjustments to the initial forecast represent the final forecast for 2009. Note: Total Assets did not change.

Formal Financial Forecast Preparation

Accounts Receivable Sales 365 Accounts Receivable 34 days = $2,500 365 Accounts Receivable 34 days = 6.8493 DSO =
Inventory turnover = Sales Inventory 2,500 10 = Inventory 10 = Inventory = 2,500 Inventory

$ .

2,500 10 = $

Formal Financial Forecast Preparation

Accounts Receivable Sales 365 Accounts Receivable 34 days = $2,500 365 Accounts Receivable 34 days = 6.8493 DSO =
Inventory turnover = Sales Inventory 2,500 10 = Inventory 2,500 Inventory = 10 = $

$ .

Financial Position
(millions of dollars) Cash and cash equivalents Accounts receivable Inventories Total Current assets 2008 $20 240 240 500 2009E $25 300 300 625 234 2009F

Net fixed assets

Total assets Accounts payable and accrued liabilities Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

500
$1,000 $100 100 200 100 500 200 $1,000

625
$1,250 $125 190 315 190 500 245 $1,250 $125 190 315 190 500 245 $1,250

Financial Position
(millions of dollars) Cash and cash equivalents Accounts receivable Inventories Total Current assets 2008 $20 240 240 500 2009E $25 300 300 625 234 2009F

Net fixed assets

Total assets Accounts payable and accrued liabilities Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

500
$1,000 $100 100 200 100 500 200 $1,000

625
$1,250 $125 190 315 190 500 245 $1,250

700

$125 190 315 190 500 245 $1,250

Financial Position
(millions of dollars) Cash and cash equivalents Accounts receivable Inventories Total Current assets 2008 $20 240 240 500 2009E $25 300 300 625 234 250 2009F

Net fixed assets

Total assets Accounts payable and accrued liabilities Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

500
$1,000 $100 100 200 100 500 200 $1,000

625
$1,250 $125 190 315 190 500 245 $1,250

700

$125 190 315 190 500 245 $1,250

Financial Position
(millions of dollars) Cash and cash equivalents Accounts receivable Inventories Total Current assets 2008 $20 240 240 500 2009E $25 300 300 625 2009F 66 234 250 550

Net fixed assets

Total assets Accounts payable and accrued liabilities Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

500
$1,000 $100 100 200 100 500 200 $1,000

625
$1,250 $125 190 315 190 500 245 $1,250

700
$1,250 $125 190 315 190 500 245 $1,250

Formal Financial Forecast Preparation

C. Calculate NWCs forecasted ratios based on its final forecast, and compare them with the companys

2008 historical ratios, the 2009 initial forecast ratios, and with the industry averages. How does NWC compare with the average firm in its industry, and is the companys financial position expected to improve during the coming year?

Formal Financial Forecast Preparation

Receivables DSO = Sales 365 $234 DSO = $2,500 365 Sales Inventory turnover = Inventory $2,500 Inventory turnover = 250 =

Formal Financial Forecast Preparation

Fixed Assets Turnover Fixed Assets Turnover Sales = Fixed Assets $2,500 = $700

= 3.57x Current Ratio Current Ratio Current Assets = Current Liabilities $550 = $315 = .

KEY RATIOS
NWC2008
Basic earnings power
Profit margin ROE DSO (365 days) Inventory turnover

NWC2009E
10.00%
2.62% 8.77% 43.80days 8.33x

NWC2009F
10.00%
2.62% 8.77% 34.00days

Industry
20.00%
4.00% 15.60% 32.00days 11.00x

Comment
Low
Low Low OK Slightly Low

10.00%
2.52% 7.20% 43.80days 8.33x

Fixed assets turnover

Total assets turnover Debt/Assets Times interest earned Current ratio

4.00x
2.00x 30.00% 6.25x 2.50x

4.00x
2.00x 40.34% 7.81x 1.99x 2.00x 40.34% 7.81x

5.00x
2.50x 36.00% 9.40x 3.00x

Low
Slightly Low High Low Low

Payout ratio

30.00%

30.00%

30.00%

30.00%

OK

KEY RATIOS
NWC2008
Basic earnings power
Profit margin ROE DSO (365 days) Inventory turnover

NWC2009E
10.00%
2.62% 8.77% 43.80days 8.33x

NWC2009F
10.00%
2.62% 8.77% 34.00days 10.00x

Industry
20.00%
4.00% 15.60% 32.00days 11.00x

Comment
Low
Low Low OK Slightly Low

10.00%
2.52% 7.20% 43.80days 8.33x

Fixed assets turnover

Total assets turnover Debt/Assets Times interest earned Current ratio

4.00x
2.00x 30.00% 6.25x 2.50x

4.00x
2.00x 40.34% 7.81x 1.99x 2.00x 40.34% 7.81x

5.00x
2.50x 36.00% 9.40x 3.00x

Low
Slightly Low High Low Low

Payout ratio

30.00%

30.00%

30.00%

30.00%

OK

KEY RATIOS
NWC2008
Basic earnings power
Profit margin ROE DSO (365 days) Inventory turnover

NWC2009E
10.00%
2.62% 8.77% 43.80days 8.33x

NWC2009F
10.00%
2.62% 8.77% 34.00days 10.00x

Industry
20.00%
4.00% 15.60% 32.00days 11.00x

Comment
Low
Low Low OK Slightly Low

10.00%
2.52% 7.20% 43.80days 8.33x

Fixed assets turnover

Total assets turnover Debt/Assets Times interest earned Current ratio

4.00x
2.00x 30.00% 6.25x 2.50x

4.00x
2.00x 40.34% 7.81x 1.99x

3.57x
2.00x 40.34% 7.81x

5.00x
2.50x 36.00% 9.40x 3.00x

Low
Slightly Low High Low Low

Payout ratio

30.00%

30.00%

30.00%

30.00%

OK

KEY RATIOS
NWC2008
Basic earnings power
Profit margin ROE DSO (365 days) Inventory turnover

NWC2009E
10.00%
2.62% 8.77% 43.80days 8.33x

NWC2009F
10.00%
2.62% 8.77% 34.00days 10.00x

Industry
20.00%
4.00% 15.60% 32.00days 11.00x

Comment
Low
Low Low OK Slightly Low

10.00%
2.52% 7.20% 43.80days 8.33x

Fixed assets turnover

Total assets turnover Debt/Assets Times interest earned Current ratio

4.00x
2.00x 30.00% 6.25x 2.50x

4.00x
2.00x 40.34% 7.81x 1.99x

3.57x
2.00x 40.34% 7.81x 1.75x

5.00x
2.50x 36.00% 9.40x 3.00x

Low
Slightly Low High Low Low

Payout ratio

30.00%

30.00%

30.00%

30.00%

OK

Formal Financial Forecast Preparation

FCF2008 = EBIT 1 T + Depreciation CAPEX NWC
FCFInitial = 125 1 .4 + 875 625 500 + 875 + [ 625 500 125 100 ] FCFInitial = 75 + 875 (1,000 + 100) FCFInitial = 950 1,100 = $-150 FCFFinal = EBIT 1 T + Depreciation CAPEX NWC FCFFinal = 125 1 .4 + 875 700 500 + 875 + [ 550 500 125 100 ] FCFFinal = 75 + 875 ( 1,075 + 25 ) = -150

Formal Financial Forecast Preparation

Initially, some NWC managers questioned whether the new facility expansion was necessary, especially since it results in increasing net fixed assets from $500 million to $700 million (a 40% increase). However, after extensive discussions about NWC needing to position itself for future growth and being flexible and competitive in todays marketplace, NWCs top managers agreed the expansion was necessary. Among the issues raised by opponents was that NWCs fixed assets were being operated at only 85% of capacity. Assuming that its fixed assets were operating at only 85% of capacity, by how much could sales have increased, both in dollar terms and in percentage terms, before NWC reached full capacity?

Formal Financial Forecast Preparation

Actual Sales Full Capacity Sales = % of capacity at which Fixed Assets were opearted $2,000 Full Capacity Sales = 84% = $, . $, Increase in sales $ = $2,353 $2,000 $ = $ Increase in sales % = Full Capacity Sales Actual Sales Actual Sales 2,353 2,000 Increase in sales % = 2,000 % = 17.65%

Formal Financial Forecast Preparation

How would changes in these items affect the AFN? (Consider each

item separately and hold all other things constant.) Dividend Payout Ratio Profit Margin
Capital Intensity Ratio If NWC begins buying from its suppliers on terms that permit it to pay after 60 days rather than after 30 days.