New World Chemicals, Inc. (NWC) hired Sue Wilson as its new financial manager and consequently, Ms. Wilson has to produce a sound financial forecast for the company.
In producing the financial forecast for NWC, Ms. Wilson has to determine the following:
Additional funds needed (AFN)
Free cash flow
In relation to the above, Ms. Wilson has to consider effects on the following items:
Operational capacity against sales projections
Assumptions in receivables management
Forecasted growth in fixed assets
Expected improvement in inventory handling
Methodology used in analysing the case is as follows:
Determine the initial forecast based on the following assumptions:
Operations is at full capacity
Sales to increase by 25% in 2009
All assets will grow at the same rate as sales
Accounts payable (AP) and accrued liabilities will also grow at the same rate as sales Profit margin of 2.52% and dividend pay-out of 30% will be sustained in 2009
Integrate the following useful information in the initial forecast:
Days sales outstanding will improve from 43.8 days in 2008 to about 34 days in 2009 Fixed assets will increase to $700 million in 2009
Improvement in inventory turnover from 8.33 times in 2008 to 10 times in 2009
Determine the final forecast and compute for AFN.
Determine the free cash flow in 2009. Compare the initial scenario with the final forecast. Determine the full capacity sales based on 85% operating capacity of fixed assets. Compute for the increase in fixed assets in order to compensate the projected increase in sales. Analyse the effects of the following to AFN:
Dividend payout ratio
Capital intensity ratio
Lengthen purchases credit terms
Additional Funds Needed Determination
The financial requirement based on the initial forecast considering the following assumptions yielded a positive AFN of $180.90 million.
Sales increase by 25% in 2009
All assets, AP and accrued liabilities will grow at 25% in 2009 Profit margin of 2.52% and dividend pay-out of 30% will be sustained in 2009
The AFN was determined by using the AFN formula:
AFN = Projected increase in assets
(less) spontaneous increase in liabilities
(less) increase in retained earnings
Figure 1 illustrates the step-by-step computation of the AFN.
Figure 1: Initial Forecast AFN
The same AFN, determined at $180.90 million, can also be derived using the balance sheet approach as shown in figure 2.
After consulting with different departments, Ms. Wilson determined the following items to be relevant and incorporated all the information in the computation of AFN. Using the balance sheet approach, the following assumptions were combined with the initial forecast and yielded the final 2009 projected amounts.
Figure 3 shows that the AFN is still at $180.90 million because the changes offset each other.
Figure 3: 2009 Final Projected Balance Sheet, Income Statement and AFN
Understanding Financial Ratios
In comparing key ratios with 2008 data and 2009 projection (see figure 4), the following can be concluded:
Basic earnings power, profit margin and return on equity indicate that the company is not that profitable because its numbers show that it is roughly performing only at 50% of the industry.
Days sales outstanding is higher than industry average. The projected increase will post a significant improvement in receivables management.
Inventory turnover is lower signifying that the company is carrying too much inventory.
Coverage ratio is lower than industry average.
Figure 4: Key Ratios
Having determined and interpreted the appropriate ratios as illustrated in figure 4, it is of great value for NWC to determine the nature of several ratios with regards to the AFN. The selected ratios and other...