Question

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 formal financial forecast

for 2017. NWC’s 2016 sales were $2 billion, and the marketing department is forecasting a 25% increase for

2017. Wilson thinks the company was operating at full capacity in 2016, but she is not sure. The first step in

her forecast was to assume that key ratios would remain unchanged and that it would be “business as usual”

at NWC. The 2016 financial statements, the 2017 initial forecast, and a ratio analysis for 2016 and the 2017

initial forecast are given in Table IC 16.1.

Assume that you were recently hired as Wilson’s assistant and that your first major task is to help her

develop the formal financial forecast. She asks you to begin by answering the following questions.

a. Assume (1) that NWC was operating at full capacity in 2016 with respect to all assets, (2) that all assets

must grow at the same rate as sales, (3) that accounts payable and accrued liabilities also will grow at

the same rate as sales, and (4) that the 2016 profit margin and dividend payout will be maintained.

Under those conditions, what would the AFN equation predict the company’s financial requirements to

be for the coming year?

b. Consultations with several key managers within NWC, including production, inventory, and receivable

managers, have yielded some very useful information.

1. NWC’s high DSO is largely due to one significant customer who battled through some hardships the

past 2 years but who appears to be financially healthy again and is generating strong cash flow. As a

result, NWC’s accounts receivable manager expects the firm to lower receivables enough for a

calculated DSO of 34 days without adversely affecting sales.

2. NWC was operating slightly below capacity; but its forecasted growth will require a new facility,

which is expected to increase NWC’s net fixed assets to $700 million.

3. Arelatively newinventorymanagement system(installed last year) has taken some time to catch on and

to operate efficiently.NWC’s inventory turnover improved slightly last year, but this yearNWC expects

even more improvement as inventories decrease and inventory turnover is expected to rise to 10 .

Incorporate that information into the 2017 initial forecast results, as these adjustments to the initial forecast

represent the final forecast for 2017. (Hint: Total assets do not change from the initial forecast.)

c. Calculate NWC’s forecasted ratios based on its final forecast and compare them with the company’s

2016 historical ratios, the 2017 initial forecast ratios, and the industry averages. How does NWC

compare with the average firm in its industry, and is the company’s financial position expected to

improve during the coming year? Explain.

Answer 1

Ans a.

NWC WILL NEED $180.9 MILLION. HERE IS THE AFN EQUATION:

AFN = (A^*/S₀)?S - (L^*/S₀)?S - M(S₁)(1 - d)

= (A^*/S₀)(g)(S₀) - (L^*/S₀)(g)(S₀) - M(S₀)(1 + g)(1 - PAYOUT)

= ($1,000/$2,000)(0.25)($2,000) - ($100/$2,000)(0.25)($2,000)

- 0.0252($2,000)(1.25)(0.7)

= $250 - $25 - $44.1 = $180.9 MILLION.

Ans. c.  KEY RATIOS INDUSTRY NWC

2001 2002(E) 2001

BASIC EARNINGS POWER 10.00% 10.00% 20.00%

PROFIT MARGIN 2.52% 2.27% 4.00%

ROE 7.20% 7.68% 15.60%

DAYS SALES OUTSTANDING 43.20 43.20 32.00

INVENTORY TURNOVER 8.33x 8.33x 11.00x

FIXED ASSETS TURNOVER 4.00x 4.00x 5.00x

TOTAL ASSETS TURNOVER 2.00x 2.00x 2.50x

DEBT/ASSETS 30.00% 40.34% 36.00%

TIMES INTEREST EARNED 6.25x 4.12x 9.40x

CURRENT RATIO 2.50x 1.99x 3.00x

PAYOUT RATIO 30.00% 30.00% 30.00%

OPERATING PROFIT MARGIN 3.00% 3.00% 5.00%

AFTER TAXES

(NOPAT/SALES)

OPERATING CAPITAL 45.00% 45.00% 35.00%

REQUIREMENT

(OPERATING CAPITAL/SALES)

RETURN ON INVESTED CAPITAL 6.67% 6.67% 14.00%

(NOPAT/OPERATING CAPITAL)

NWC’S BEP, PROFIT MARGIN, AND ROE ARE ONLY ABOUT HALF AS HIGH AS THE INDUSTRY AVERAGE--NWC IS NOT VERY PROFITABLE RELATIVE TO OTHER FIRMS IN ITS INDUSTRY. FURTHER, ITS DSO IS TOO HIGH, AND ITS INVENTORY TURNOVER RATIO IS TOO LOW, WHICH INDICATES THAT THE COMPANY IS CARRYING EXCESS INVENTORY AND RECEIVABLES. IN ADDITION, ITS DEBT RATIO IS FORECASTED TO MOVE ABOVE THE INDUSTRY AVERAGE, AND ITS COVERAGE RATIO IS LOW. THE COMPANY IS NOT IN GOOD SHAPE, AND THINGS DO NOT APPEAR TO BE IMPROVING.