4) The capital intensity ratio increases
The capital intensity ratio is defined as the ratio of required assets to total sales, which is the amount of assets required per dollar of sales. It has a major effect on capital requirements. Companies with higher assets-to-sales ratios require more assets for a given increase in sales. The higher the capital intensity ratio, the more money will be required to support an additional dollar of sales. Therefore, holding other ratios constant, the higher the capital intensity ratio, the greater is the AFN.
5) SEC begins paying its suppliers sooner
If SEC begins paying its suppliers sooner, the account payable amount will be reduced, which decreases the current and total liabilities of the company. With a lower current liability amount as the working capital to support the company’s sales, this would increase the need for external financing. Notes and long-term debt would be increased together to pay for short-term creditors. The amount of AFN needed, thus, increases.
(e)
Percent of sales is a method that begins with the sales forecast, expressed as an annual growth rate in dollar sales revenues. Many items on the income statement and balance sheets are assumed to increase proportionally with sales, with their values estimated as percentages of the forecasted sales for the year. The remaining items that are not tied directly to sales depend on the company’s dividend policy and its relative use of debt and equity financing. There are four steps by using the percent of sales method:
1) Analyses the historical ratios – The objective of this step is to forecast the future, or pro forma, financial statements. The percent of sales method assumes that costs in a given year will be some specified percentage of that year’s sales. The analysis started by calculating the ratio of costs of sales for several past years. And a thorough analysis should have at least five years of historical data.
2) Forecast income statement – To forecast the income statement, we should use the actual data times the forecast basis that the company had determined. Firstly, we should forecast the sales (Actual sales*Growth rate). After that, we can use the forecast sales times other basis to forecast other expense such as the administrative expense.
Secondly, we forecast the earnings before interest and taxes (EBIT), assuming that the cost structure will remain unchanged. Thirdly, we should forecast the interest expense; however, two assumptions are needed.
Assumption 1: Specifying the balance of debt for computing interest expense – Interest on loans and debts is calculated base on the amount of debt at the beginning of the year. If the debt remained constant during the year, the balance used for forecasting interest expense would be the amount of debt at the beginning. Besides, we can also us the amount of debts at the end or use the average amount of debts at the beginning and at the ending of the year.
Assumption 2: Specify interest rates – As different debts have different interest rate, for forecasting, a single interest rate is applied.
The forecasted interest expense is the net interest expense paid on short-term financing plus the interest on long-term bonds. We estimate the net interest on short-term financing by first finding the interest expense on notes payable and subtracting any interest income from short-term investments.
At last, after we forecast the earning before taxes (EBT), we forecast the dividend paid and calculate the addition to retained earning to see how much the company should transfer its income from income statement (addition to retained earnings) to balance sheet (retained earnings).
3) Forecast the balance sheet – For the assets side, these consist of operating current assets plus operating long-term assets. Assuming that each class of assets is proportional to sales, we can determine the amount of new assets needed to support the forecasted sales.
For the liability, the percent of sales method assumes that accounts payable and accruals are both proportional to sales, so given the sales forecast we can forecast operating current liabilities.
Most mature companies rarely issue new common stock, so the forecast for common stock is usually the previous year’s common stock. Assuming that there is no preferred stock, by adding the addition to retained earnings, we can arrive at the total of common equity.
The remaining difference between the assets and liabilities and equity side would be the long-term bonds and short-term banks loans to finance the company’s operations. The exact amount would depend on the individual company’s financing policy.
4) Raising the additional Funds Needed – By subtracting the amount of specified sources of financing from the required assets, the AFN required amount is calculated. If the AFN is positive, it means that the company needs to have additional financing and they need to consider how the additional fund should be raised
5) Analysis of the Forecast – This is the last step which is used to examine the projected statement and determine whether the forecast meets the financial targets as was set in the previous years’ financial plan.
(g)
The reasons why the two approaches produce a somewhat different result are that the equation approach assumes everything including the assets, accounts payable and accruals grow proportionally with sales. The profit margin and dividend payout ratios are maintained whereas the sales approach allows the profit margin and all other ratios to fluctuate. The two approaches, therefore, produce different AFN.
The sale approach actually provides the more accurate forecast since the AFN will be more accurate when it is in the case that everything is not increased proportionally with sales. For example, when there are economies of scale in the use of assets or lumpy assets, the ratio of assets will not be just increase in proportionally with sales. In that case, the sales approach would provide a more accurate forecast on AFN than the equation approach.
(h)
Workings for 2005 forecast:
- Profit Margin = 63 / 2500 * 100 = 2.52
- Return on Equity = 63 / 737.8*100 = 8.54
- DSO = 300 / 2500*365 = 43.80 days
- Inventory Turnover = 2500 / 300 = 8.33
- Fixed Assets Turnover = 2500 / 625 = 4.00
- Debt/Assets = 512.2 / 1250 * 100 = 40.98
- Times Interest Earned = 125 / 20 = 6.25
- Current Ratio = 625 / 318.60 = 1.96
The financial condition of the company in 2005 is weak. Its profit margin has decreased by 0.18% in compared with 2004 and it is 1.48% below the industry average. The return on equity is 0.83% higher than 2004, but it is still far below the industry average, with 7.06% in difference.
The company, on average, takes 43.8 days to collect money from its accounts receivable, with is the same as 2004, but it is 11.8 days slower than the industry average. The inventory turnover and the fixed assets turnover are the same in 2004 and in 2005, but it is still 2.67 and 1 lower than the industry averages respectively.
Its 2005’s Debt/Assets ratio becomes 10.98% higher than 2004 and 4.98% lower than the industry average. Its current ratio has decreased by 0.54% in 2005, which is 1.04% lower than the industry average. Lastly, SEC’s time interest earned has decreased by 3.75 times in compared with 2004, which is 3.15 times below the industry average.
SEC’s forecasted free cash flow:
= NOPAT – Change in NOWC – CAPEX
= NOPAT – (NOWC –NOWC) - CAPEX
= 125 (1 - 0.4) - ( (625 – 125) – (500 – 100) ) – (625 – 500)
= $ - 150
SEC’s ROIC:
= NOPAT / Operating Capital
= 125 (1 - 0.4) / (625 – 125 + 625)
= 6.67%
(i) SEC Industry average
DSO 43.80 32.00
Inventory Turnover 8.33 11.00
Based on the forecasted ratios, it takes 43.8 days for SEC to collect its revenue after a sale has been made. Compared with the industry average of 32 days in collecting revenue, SEC takes a longer period (11.8 days more) to collect money from its customers after its sale.
SEC has a lower inventory turnover ratio than the industry average of 11. By that, it means that the company is having insufficient sale and excess inventory from its operation.
Having a good operating cash flow is vital to the development of a company. A good company should collect its accounts receivables as quick as possible so that it can reinvest the money into the company. In addition, a good company should maintain its inventory level at a low level with sufficient sale so as to keep it inventory turnover at a good level near to the industry average.
Since SEC’s DSO is higher than the industry average and its inventory turnover is lower than the industry average, SEC is not operating efficiently with respect to its inventory and accounts receivable in compared with the industry average.
By reducing the SGA/Sales ratio to 33% and bringing the DSO and inventory turnover ratio to the industry average:
The AFN decreased by (187.2 – 15.7) = $171.5
Financial Ratios:
Forecasted Revised forecasted
2004 2005 2005
Workings:
- Profit Margin = 93 / 2500 * 100 = 3.72
- Return on Equity = 93 / 755.8*100 = 12.30
- DSO = 219.25 / 2500*365 = 32.01 days
- Inventory Turnover = 2500 / 227.25 = 11.00
- Fixed Assets Turnover = 2500 / 625 = 4.00
- Debt/Assets = 340.7 / 1096.5 * 100 = 31.07
- Times Interest Earned = 175 / 20 = 8.75
- Current Ratio = 471.5 / 232.85 = 2.02
Changes in Financial Ratios in compared with the original forecast in 2005:
- Change in Profit Margin = 3.72 – 2.52 = 1.20
- Change in Return on Equity = 12.30 – 8.54 = 3.77
- Change in DSO = 32.01 – 43.80 days = 11.79 days
- Change in Inventory Turnover = 11.00 – 8.33 = 2.67
- Change in Fixed Assets Turnover = 4.00 – 4.00 = 0
- Change in Debt/Assets = 31.07 – 40.98 = -9.90
- Change in Times Interest Earned = 8.75 – 6.25 = 2.50
- Change in Current Ratio = 2.02 – 1.96 = 0.06
Original Free Cash Flow 2005:
= 2005’s NOPAT – (2005’s NOWC – 2004’s NOWC) - CAPEX
= 125 (1 - 0.4) - ( (625 – 125) – (500 – 100) ) – (625 – 500)
= - $ 150
Revised Free Cash Flow 2005 after the change in ratios:
= 175 (1-0.4) – ( (471.5 – 125) – (500 – 100) ) - (625 – 500)
= $ 33.5
The new FCF increased by (33 - (-150) ) = $183
Original ROIC for 2005:
= 125 (1 - 0.4) / (625 – 125 + 625)
= 6.67%
Revised ROIC after the change in ratios:
= 175 (1-0.4) / (471.5 – 125 + 625)
= 10.81%
The new ROIC increased by (10.81%-6.67%) = 4.14%
(j)
1. If fixed assets had been used to full capacity, 2004 sales could have been existed as high as $2667 versus the $2000 in actual sales:
Full capacity sales = Actual sales / % of capacity at which fixed assets were operated
= $2,000 / 0.75
= $2667
2. As the company started with excess fixed asset capacity, it will not have to use as much fixed assets as was originally forecasted in 2005. SEC‘s target fixed assets/sales ratio should be 18.75 % rather than 25 %:
Target fixed assets / sales = $500 / $2667
= 0.1875
= 18.75%
The additional fixed assets required is 0.1875 per dollar of sale if the forecasted sales exceed full capacity. Otherwise, no new fixed assets are needed. Since SEC’s forecasted sales is $2500 (i.e. $2000*1.25), which is less than the capacity sales, it does not require any additional fixed assets.
According to section (f), an additional fund needed using the percent of sales approach was $187.2 while the increase in fixed assets was $125 (i.e. $500*0.25). Therefore, the additional fund needed will decline by $125 (i.e. New with excess capacity: $187.2-125 = $62.2).
(k)
1. Economies of scale in the use of assets
There are economies of scale in the use of many assets. When economies occur, the ratios are less likely to change over time as the size of the firm increases. Under the economies of scale, the assets should increase at a decreasing rate to sales. In other words, it will rise slower than the increase in sales. For example for cash, as sales expand, very large increases in sales would require very little additional inventory, a curved line with decreasing slope, therefore, was formed:
For inventories, retailers often need to maintain base stocks of different inventory items, even if current sales are quite low. As sales expand, inventories may then grow less rapidly than sales, so the ratio of inventory to sales declines as the situation shown above. A similar curve with a base stock was formed:
In the above cases, since the assets to sales ratio is ever changing at different sales levels, the AFN equation which requires the asset increases at the same rate as sales, therefore, cannot be applied. The AFN equation will, then, provide an inaccurate forecast for the future AFN.
2. Lumpy assets
In many industries, technological considerations dictate that if a firm is to be competitive, it must add fixed assets in large, discrete units, which are often referred to as lumpy assets. Lumpy assets have major effect on the fixed assets/sales ratio at different sales levels, and consequently, on financial requirements. If the firm is operating at a sales level with excess capacity on fixed assets, a small increase in sales does not require an expansion in the fixed assets. However if the firm is already operating at capacity, even a small little increase in sales would require a large financial requirement on fixed assets.
In that case, the AFN equation cannot provide an accurate forecast for future since there will be a great effect on the fixed assets/sales ratio at different sales levels. The AFN equation, thus, cannot be easily applied.
