The Expert Systems case focuses around a business that develops computer programs for firms in the banking industry. John Grady, CFO for ESI, needs help in creating a detailed forecast for the executive meeting and to present it to the group. Using the information given in John’s memos, his questions must be answered to help show the top managers how certain assumptions affect various outcomes. One of John’s memos includes the percentage-of-sales formula to calculate the additional funds needed (AFN) to support the projected increased level of sales. John explains that AFN is calculated by subtracting spontaneous liability increase and increase in retained earnings from the required asset increase. This formula is shown below: AFN = (A*/S)DS – (L*/S)DS – MS1(1-d)
We calculate the AFN as $2.76 million. Please see the attached spreadsheet for full calculations.
Once we complete Table 3, provided by John, we can also calculate the AFN with the financial statements by taking the difference between the total assets and the total liabilities and equity. AFN calculated in this form equals 2.89. Please see attached spreadsheet for completed financial statements and cumulative AFN.
Since the vice-president feels that the fixed assets were actually being operated at only 80% of capacity the projected external capital requirements must be recalculated. We must first calculate what full capacity sales would be by taking the actual sales from 1995 and dividing them by the percentage of capacity, in this case 80%. This suggests that if the fixed assets had been used to full capacity, 1996 sales could have been as high as $70.2 million. We then use this amount to estimate the target fixed asset to sales ratio by taking the 1995 fixed asset amount and dividing it by the full capacity sales; this results in 26%. Finally, we calculate the required level of fixed assets by multiplying the above ratio with the projected 1996 sales; resulting in a required fixed asset level of $17.52 million. Since this amount is lower than the 1995 fixed asset amount it concludes that no new assets are needed. The excess funds can be used to increase dividends, use for growth opportunities, or pay down debt. Our suggestion would be to use it for growth opportunities because they are already increasing their dividends by $0.10 and they want to continue using their specific capital structure. Also, the case mentions that they had “other products in the pipeline” so the excess funds could be used for those products. If the assumption was made that ESI was operating at 90% capacity in 1995, then we would re-work the previous mentioned calculations, fully shown on the attached spreadsheet, and conclude that fixed assets would need to be increased in 1996 by $1.3 million. This would change the AFN to $0.54 million. In many industries, technological considerations dictate that if a firm is to be competitive, it must add fixed assets in large, discrete units; known as lumpy assets. Lumpy assets have a major effect on the fixed assets/sales ratio at different sales levels and, consequently, on financial statements. When a firm is operating at full capacity even a small increase in sales would require a doubling of fixed assets, so a small projected sales increase would bring with it a very large financial requirement. Being certain about the percentage of capacity a business is working at is crucial to future success. Higher dividend payout ratio reduces funds available internally, and increases additional funds needed. Higher profit margins increase funds available internally, and decrease additional funds needed. Higher capital intensity ratios increase asset requirements, and it also increases additional funds needed. The percent-of-sales method is a technique for forecasting financial data. When forecasting financial data for strategic planning, budgeting, or for developing pro forma financial statements, analysts can use the percent-of-sales method of...
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