New World Chemicals Inc

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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 affect 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? h. 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...
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