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Percent of

Sales

2007 Balance Sheet (in millions)


Cash and Securities
Accounts Receivable
Inventories
Total Current Assets
Net Fixed Assets
Total Assets

$20.0
$240.0
$240.0
$500.0
$500.0
$1,000.0

1%
12%
12%

Accounts Payable and Accruals


Notes Payable
Total Current Liabilities
Long Term Debt
Common Stock
Retained Earnings
Total Liabilities and Equity

$100.0
$100.0
$200.0
$100.0
$500.0
$200.0
$1,000.0

5%

Percent of
Sales

2007 Income Statement (in millions)


Sales
Variable Costs
Fixed Costs
EBIT
Interest
EBT
Taxes(40%)
Net Income
Dividends(40%)
Additions to Retained Earnings

25%

$2,000.0
$1,200.0
$700.0
$100.0
$10.0
$90.0
$36.0
$54.0
$21.6
$32.4
2007

60%
35%

Key Ratios
Profit margin
ROE
DSO
Inventory turnover
Fixed asset turnover
Debt/Assets
TIE
Current ratio
NOPAT/Sales
Operating Capital / Sales
Return on Invested Capital (NOPAT/Capital)

SEC

Industry

2.70%
7.71%
43.80
8.33
4.00
30.00%
10.00
2.50
3.00%
45.00%
6.67%

4.00%
15.60%
32.00
11.00
5.00
36.00%
9.40
3.00
5.00%
35.00%
14.00%

Assume that you were recently hired as Simmons' 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. Describe three ways that pro forma statements are used in financial planning.
b. Explain the steps in financial forecasting.
c. Assume (1) that SEC was operating at full capacity in 2007 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 2007 profit margin and dividend payout will be maintained. Under these conditions, what will the
company's financial requirements be for the coming year? Use the AFN equation to answer this question.
USING THE AFN EQUATION
Additional Data
Sales Increase =
2007 Profit Margin=
Payout Ratio=

AFN=

25%
2.70%
40%

D Required
Assets

D
Spontaneou
s Liabilities

D Retained
Earnings

D Required
Assets

Asset to
Sales Ratio

D Sales

=
=

0.500
$250.00

$500.00

D Sales

D
Spontaneo
us
Liabilities

Spontaneou
s Liab. to
Sales Ratio

D Retained
Earnings

AFN=

D Required
Assets
= $250.00
AFN= $184.50

=
=

0.050
$25.00

Profit
Margin

=
=

0.027
$40.50

D
Spontaneou
s Liabilities
$25.00

$500.00

Sales

Retention
Ratio

$ 2,500.0

0.600

D Retained
Earnings
$40.50

d. How would changes in these items affect the AFN? (1) Sales increase, (2) the dividend payout ratio increases,
(3) the profit margin increases, (4) the capital intensity ratio increases, and (5) SEC begins paying its suppliers
sooner. (Consider each item separately and hold all other things constant.)
e. Briefly explain how to forecast financial statements using the percent of sales approach. Be sure to explain
how to forecast interest expenses.
f. Now estimate the 2008 financial requirements using the percent of sales approach. Assume (1) that each type
of asset, as well as payables, accruals, and fixed and variable costs, will be the same percent of sales in 2008 as in
2007; (2) that the payout ratio is held constant at 40 percent; (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); (4) that all
debt carries an interest rate of 10 percent; and (5) interest expenses should be based on the balance of debt at the

Percent of Sales Inputs


COGS/Sales
SGA/Sales
Cash/Sales
Accounts Rec./Sales
Inv./Sales
Net Fixed Assets/Sales
AP & Accruals/Sales

Actual
2007
60.0%
35.0%
1.0%
12.0%
12.0%
25.0%
5.0%

Projected
2008
60.0%
35.0%
1.0%
12.0%
12.0%
25.0%
5.0%

Other Inputs
Percent growth in sales
Growth factor in sales
Interest rate on debt
Tax rate
Dividend Payout Ratio

25%
1.25
10%
40%
40%

Funds will be generated through:


Notes Payable =

50%

Long Term Debt =


INCOME STATEMENT
(in millions of dollars)
Sales
COGS
SGA Expenses
EBIT
Less Interest

50%

Actual
2007
$ 2,000.0
$ 1,200.0
$
700.0
$
100.0
$
10.0

EBT
$
Taxes (40%)
$
Net Income
$
Dividends
$
Add. To retained earnings$

Forecast basis
Growth
1.25
% of Sales
60.00%
% of Sales
35.00%
Interest rate x Debt07

90.0
36.0
54.0
21.6
32.4

$
$
$
$
$

BALANCE SHEET
(in millions of dollars)
2007
Assets
Cash
Accounts receivable
Inventories
Total current assets
Net plant and equipment
Total assets

$
20.0
$
240.0
$
240.0
$
500.0
$
500.0
$ 1,000.0

Forecast
2008
$ 2,500.0
$ 1,500.0
$
875.0
$
125.0
$
20.0
105.0
42.0
63.0
25.2
37.8

2008
Forecast
Without AFN

Forecast basis
% of Sales
% of Sales
% of Sales

1.00%
12.00%
12.00%

% of Sales

25.00%

$
25.0
$
300.0
$
300.0
$
625.0
$
625.0
$ 1,250.0

AFN

2008
Forecast
With AFN
0
$
25.0
$
300.0
$
300.0
$
625.0
$
625.0
$ 1,250.0

Liabilities and equity


Accounts payable & Accruals
$
100.0
Notes payable
$
100.0
Total current liabilities $
200.0
Long-term bonds
$
100.0
Total liabilities
$
300.0
Common stock
$
500.0
Retained earnings
$
200.0
Total common equity
$
700.0
Total liabilities and equity$ 1,000.0

% of Sales
Carry-over

5.00%

Carry-over
Carry-over
RE07 + DRE08

Required assets =
Specified sources of financing =
Additional funds needed (AFN)

$
125.0
$
100.0
$
225.0
$
100.0
$
325.0
$
500.0
$
237.8
$
737.8
$ 1,062.8

93.6

93.6

$
125.0
$
193.6
$
318.6
$
193.6
$
512.2
$
500.0
$
237.8
$
737.8
$ 1,250.0

$ 1,250.0
$ 1,062.8
$ 187.20

g. Why does the forecasted financial statement approach produce a somewhat different AFN than the equation
approach? Which method provides the more accurate forecast?
h. Calculate SEC's forecasted ratios, and compare them with the company's 2007 ratios and with the industry
averages. Calculate SECs forecasted free cash flow and return on invested capital (ROIC).
MEASURING OPERATING PERFORMANCE: FREE CASH FLOW AND RATIOS

Free Cash Flow

2007

Net operating working capital (NOWC)$


400.0
Total Operating Capital
$
900.0
NOPAT
$
60.0
Investment in Capital
FCF
Return on Invested Capital (NOPAT/Capital)
Key Ratios
Profit margin
ROE
DSO
Inventory turnover
Fixed asset turnover
Debt/Assets
TIE
Current ratio

2007
2.70%
7.71%
43.80
8.33
4.00
30.00%
10.00
2.50

Forecast
2008
$
500.0
$ 1,125.0
$
75.0
$
225.0
$ (150.0)
6.67%

14.00%

2008

Industry

2.52%
8.54%
43.80
8.33
4.00
40.98%
6.25
1.96

4.00%
15.60%
32.00
11.00
5.00
36.00%
9.40
3.00

i. (1.) Based on comparisons between SEC's days sales outstanding (DSO) and inventory turnover ratios with the
industry average figures, does it appear that SEC is operating efficiently with respect to its inventory and
accounts receivable? (2.) Suppose SEC were able to bring these ratios into line with the industry averages and
reduce its SGA/Sales ratio to 33%. What effect would this have on its AFN and its financial ratios? What effect
would this have on free cash flow and ROIC?

i. (1.) Based on comparisons between SEC's days sales outstanding (DSO) and inventory turnover ratios with the
industry average figures, does it appear that SEC is operating efficiently with respect to its inventory and
accounts receivable? (2.) Suppose SEC were able to bring these ratios into line with the industry averages and
reduce its SGA/Sales ratio to 33%. What effect would this have on its AFN and its financial ratios? What effect
would this have on free cash flow and ROIC?
PROPOSED IMPROVEMENTS
Inputs
DSO
Accounts receivable/sales
Inventory turnover
Inventory/sales
SGA/sales

Before
43.80
12.00%
8.33
12.00%
35.0%

After
32.01
8.77% Note: we used Scenario
11.00 Manager to find the
9.09%
after-improvement
33.0%

Outputs
AFN
FCF
ROIC
ROE

$187.2
-$150.0
6.7%
8.5%

$15.7
$33.5
10.8%
12.3%

j. Suppose you now learn that SEC's 2007 receivables and inventories 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 2007 with the available fixed assets?
EFFECT OF EXCESS CAPACITY
Suppose in 2007 fixed assets had been operated at only 75% of capacity?
Capacity Sales
Actual
= Sales
= $2,000
Capacity Sales$2,666.67
=

/
/

% of Capacity
0.75

(2.) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2008?
Forecasted sales are less than this, so no new fixed assets are needed.
Previously forecasted AFN =
$187
Previously forecasted addition to fixed assets$125
=
AFN if there is excess capacity =
$62.20
If Sales went up to $3,000, not $2500, what would the F.A. requirement be?
Target RatioFixed
=
Assets
= $500
Target Ratio = 0.1875

/
/

Capacity Sales
$2,666.67

Change in FA = 0.1875

$333.33

Change in FA = $62.50

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