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 factors below explain their behaviour with respect to the AFN.
Dividend Payout Ratio (DPR)
By formula, increase in DPR will mean reduction of retained earnings and increase in AFN. Paying dividends will reduce the available funds of the company but is a way to increase shareholder value. Increasing or decreasing of DPR spells out the standing of the company to its shareholders. Reduction or not giving dividends for a period will reduce AFN but will mean that the company is struggling to provide enough profit. Shareholders may see this as a signal that further investments for the company are riskier.
Profit margin and AFN have inverse relationship. As profit margin increases, AFN will decrease. This is true, however, only when volume of sales remains constant. More often the not when profit margin increases due to increase in prices, volume of sales will suffer, which may or may not increase the net profit itself. If increase in profit margin is caused by operational efficiency or simply reduction of costs, it is safe to say that volume of sales will not be affected. With this, AFN will decrease accordingly.
Capital Intensity Ratio (CIR)
CIR is a measure of how much money is invested to produce a dollar of sales revenue. Having a low CIR is favorable for a company. Assuming level of sales is increasing and assets are increasing at a slower rate, CIR will decrease and vice versa. This means that assets required to produce same amount of income is decreasing. If this is the condition, decreasing of CIR will reduce AFN. However, when decrease in CIR is caused by lowering of prices, depending on the effect on profit, it may post lower, higher, or no retained earnings. Despite having decreased CIR, under this condition, the effect on AFN will depend on the resulting effect on retained earnings.
NWC Lengthen purchases credit terms
Permission to pay after 60 days instead of 30 days will increase short term liabilities in general. In formula, average accounts payable will increase and have a direct impact on AFN. Increase on this kind of liability will reduce AFN and is favorable for the company in terms of cash flow. If the prices of the goods and interest rates remain the same, there will be no other way that the effect on AFN will change.
Cash Flow Interpretation
On the other hand, free cash flow for NWC is computed as shown in figure 4.
Figure 5: Free Cash Flow
Free cash flows represent the cash the company is able to generate after spending on its fixed assets. Having a negative free cash flow for NWC is not entirely bad. It just shows that the company is investing in expanding its asset base.
Figure 6: Level of Sales vs. Operating Capacity
The expected sales growth will require additional fixed assets.
Most companies producing specialized chemicals operate in an investment heavy industry. Thus, the purchase of fixed assets should be well planned. Otherwise, company’s money will be tied up with unused equipment. In New World Chemical’s (NWC) case, planning for 25% increase in sales for the coming year will mean additional fixed assets needed to be financed.
With the information given above, the company should pursue on buying fixed assets to reach the target increase in sales. If the NWC wants to close the gap of its financials to that of the industry average, investment for the new fixed assets should be debt financed.
The increase in fixed assets will at first not be able to be utilized fully but will open up excess capacity, which can be utilized by company to expand its products. A new product that has a lower variable cost is favourable for the company in terms of increasing its basic earning power. This covers up for their weakness, which is evidenced as their worst ratio in comparison to the industry.