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Forecasting and Pro Forma Financial Statements

It is strongly advised that the student use the assigned case, construct an Exce
l worksheet with the various financial data included, and input the data from th
e case in the worksheet. Then using the Allied example as a guide, he/she should
determine what needs to be done.

For success, the work needs to be done with patience and care. Keep you eyes on
every financial statement, and examine every item on these statements to make su
re all items are consistent across all statements. In the Allied example some it
ems are “plugs” – see Table 2, in the column “AFN”; these are items used to bala
nce things out. For example, the firm may be short of funds and these must come
from somewhere – e.g., borrowing from the bank or selling new common stocks. The
borrowing can be short-term (notes) or long-term (bonds).

This is an individual effort. But you may consult other students on “concepts” o
r developing a worksheet. While I encourage all of you to become proficient in c
onstructing the various Financial reports in a worksheet format, you may get hel
p from colleague or even use their worksheets – as long as their worksheets are
cleared of their own work on this case.

Forecasted Financial Statements

In planning, one must make forecasts. In making forecasts, you consider a number
of possibilities (called “states” of the world). One possibility is that busine
ss conditions will be “normal”, another that the economy will go into a mild rec
ession and business suffers a little, and so on. To each possibility one associa
tes a likelihood (or “probability”). If we have taken into account all possible
outcomes, then these probabilities must sum to unity.

Each possible “outcome” implies certain things about your business – e.g., if th
e economy experiences a mild recession your sales may drop. When all these outco
mes are considered some average (“expected value”) of your future sales is obtai
ned. This approach requires elaborate analyses. For the purpose of your case, us
e a simple growth based on the company’s recent past sales.

Once sales are forecasted, you must also forecast income statements, balance she
ets and cash flow statements for the entire forecast period. This provides an es
timate of your profits, your need for plan and equipment, and your need for cash
and capital. Without this information you are likely to run a great business in
to the ground: lose customers, lose suppliers, go bankrupt.

The forecasted financial statements are referred to as “pro forma” statements. B


ut be warned that these days companies often manipulate their financial reports
to highlight or hide certain information; because of this the reports do not con
form to GAAP (generally accepted accounting practices) and they have to give the
m a name – thus they call these pro forma statements as well; but these are NOT
forecasted financial reports – they are whatever the reporting company wants the
m to be.

Sales Forecast
A forecast of a firm s unit and dollar sales for some future period; it is gener
ally based on recent sales trends plus forecasts of the economic prospects for t
he nation, region, industry, and so forth.

The sales forecast generally starts with a review of sales during the past five
to ten years, expressed in a graph such as that in the Figure below. The graph c
ould have contained 10 years of sales data, but Allied focuses on sales figures
for the latest five years because the firm s studies have shown that its future
growth is more closely related to recent events than to the distant past. Sales
for 2002 are forecasted to rise 10% above the 2001 level; the 10% growth is the
(approximate) average growth between 1997 and 2001.

Allied had its ups and downs during the period from 1997 to 2001. In 1999, poo
r weather in California s fruit-producing regions resulted in low production, wh
ich caused 1999 sales to fall below the 1998 level. Then, a bumper crop in 2000
pushed sales up by 15 percent, an unusually high growth rate for a mature food p
rocessor. Based on a simple growth analysis, Allied s forecasters determined tha
t the average annual growth rate in sales over the past five years was 9.1 perce
nt. On the basis of this historical sales trend, on planned new-product introduc
tions, and on Allied s forecast for the economy, the firm s planning committee p
rojects a 10 percent sales growth rate during 2002, to sales of $3,300 million.
Here are some of the factors Allied considered in developing its sales forecast:

1. Allied Food Products is divided into three divisions: canned foods, frozen fo
ods, and packaged foods such as dried fruits. Sales growth is seldom the same fo
r each of the divisions, so to begin the forecasting process, divisional project
ions are made on the basis of historical growth, and then the divisional forecas
ts are combined to produce a "first approximation" corporate sales forecast.
2. Next, the level of economic activity in each of the company s marketing areas
is forecasted-for example, how strong will the economies be in each of Allied s
six domestic and two foreign distribution territories, and what population chan
ges are forecasted in each area?
3. Allied s planning committee also looks at the firm s probable market share in
each distribution territory. Consideration is given to such factors as the firm
s production and distribution capacity, its competitors capacities, new-produc
t introductions that are planned by Allied or its competitors, and potential cha
nges in shelf-space allocations, which are vital for food sales. Pricing strateg
ies are also considered-for example, does the company have plans to raise prices
to boost margins, or to lower prices to increase market share and take advantag
e of economies of scale? Obviously, such factors could greatly affect future sal
es.
4. Allied s foreign sales present unique forecasting problems. In particular, it
s planners must consider how exchange rate fluctuations would affect sales. Alli
ed must also consider the effects of trade agreements, governmental policies, an
d the like.
5. Allied s planners must also consider the effects of inflation on prices. Over
the next five years, the inflation rate for food products is assumed by Allied
to average 3 to 4 percent, and Allied plans to increase prices, on average, by a
like amount. In addition, the firm expects to expand its market share in certai
n products, resulting in a 4 percent growth rate in unit sales. The combination
of unit sales growth and increases in sales prices has resulted in historical re
venue growth rates in the 8 to 10 percent range, and this same situation is expe
cted in the future.
6. Advertising campaigns, promotional discounts, credit terms, and the like also
affect sales, so probable developments for these items are also factored in.
7. Forecasts are made for each division, both in the aggregate and on an individ
ual product basis. The individual product sales forecasts are summed, and this s
um is compared with the aggregated division/ forecasts. Differences are reconcil
ed, and the end result is a sales forecast for the company as a whole but with b
reakdowns by the three divisions and by individual products.

If the sales forecast is off, the consequences can be serious. First, if the mar
ket expands more than Allied has geared up for, the company will not be able to
meet demand. Its customers will end up buying competitors products, and Allied
will lose market share. On the other hand, if its projections are overly optimis
tic, Allied could end up with too much plant, equipment, and inventory. This wou
ld mean low turnover ratios, high costs for depreciation and storage, and write-
offs of spoiled inventory. All of this would result in low profits, a low rate o
f return on equity, and a depressed stock price. If Allied had financed an unnec
essary expansion with debt, high interest charges would compound its problems. T
hus, an accurate sales forecast is critical to the firm s well-being.

FINANCIAL STATEMENT FORECASTING:

Percent of Sales Method: A method of forecasting future financial statements tha


t expresses each account as a percentage of sales. These percentages can be cons
tant, or they can change over time.

Once sales have been forecasted, we must forecast future balance sheets and inco
me statements (called pro forma reports). The most commonly used technique is th
e percent of sales method, which begins with the sales forecast, expressed as an
annual growth rate in dollar sales revenues. Although only one year is shown in
our earlier example, Allied s managers actually forecasted sales for eight year
s, with these results: 10% in each of the years 2002-2005, 9% in 2006, 8% in 200
7, and 7% in 2008 and 2009.

This eight-year period is called the explicit forecast period, with the eighth y
ear being the forecast horizon

Note: A sales forecast is actually the expected value of a probability distribut


ion, so there are many possible levels of sales. Because any sales forecast is s
ubject to uncertainty, financial planners are just as interested in the degree o
f uncertainty inherent in the sales forecast, as measured by the standard deviat
ion, as in the expected level of sales.

The initially forecasted growth rate is 10 percent, but high growth attracts c
ompetitors, and eventually the market becomes saturated. Therefore, population g
rowth and inflation determine the long-term sales growth rate for most companies
. Reasonable values for the long-term sales growth rate are from 5 to 7 percent
for companies in mature industries. Allied s managers believe that a long-term s
ales growth rate of 7 percent is reasonable. Its managers also believe that comp
etition will drive their growth rate down to this level within seven or eight ye
ars, so they have chosen an eight-year forecast period.
Companies often have what is called a competitive advantage period, during whi
ch they can grow at rates higher than the long-term growth rate. For companies w
ith proprietary technology or strong brand identities, such as Microsoft or Coca
-Cola, the competitive advantage period might be as long as 20 years. For compan
ies that produce commodities or that are in highly competitive industries, the c
ompetitive advantage period might be as short as two or three years, or even be
nonexistent.
To summarize, most financial plans have a forecast period of at least 5 years,
with 5 to 15 years, depending on the expected length of the competitive advanta
ge period, being most common.
Many items on the income statement and balance sheet are often assumed to incr
ease proportionally with sales. For example, the inventories-to-sales ratio migh
t increase 20 percent, receivables/sales might increase 15 percent, variable cos
ts might increase 60 percent of sales, and so forth. Then, as sales increase, it
ems that are tied to sales also increase, and the values of those items for a pa
rticular year are estimated as percentages of the forecasted sales for that year
. The remaining items on the forecasted statements - items that are not tied dir
ectly to sales - are set at "reasonable" levels.
Note that if the forecasted percentage of sales for each item is the same as t
he percentage for the prior year, then each item will grow at the same rate as s
ales. While the financial statement forecasting method often begins by assuming
that many key items will grow at the same rate as projected sales, it is importa
nt to recognize that this method can be easily adjusted to allow different incom
e statement and balance sheet items to grow at different rates. This process is
particularly straightforward whenever a spreadsheet is used to develop the forec
ast. With this understanding in mind, we explain in the following section how to
use this method to forecast Allied s financial statements.

STEP 1. FORECASTED INCOME STATEMENT

First, we forecast the income statement for the coming year. This statement is n
eeded to estimate both income and the addition to retained earnings. Table 1 sho
ws the forecast for 2002. Sales are forecasted to grow by 10 percent. The foreca
st of sales for 2002, shown in Row 1 of Column 3, is calculated by multiplying t
he 2001 sales, shown in Column 1, by (1 + growth rate) = 1.10. The result is a 2
002 forecast of $3,300 million.

Table 1. Allied Food Products: Actual 2001 and Projected 2002 Income Statements
(Millions of Dollars)

2001, Actual (1) Forecast Basis (2) 2002, Forecast (3)


Sales 3,000 1.10x 2001 Sales = 3,300
Costs, except Depreciation 2616 .872x2002 Sales = 2878
Depreciation 100 0.1x2002 Net plant = 110
Total operating costs 2716 2988
EBIT 284 312
Interest 88 88 (a)
Earnings before tax 196 224
Tax at 40% 78 89
Net income before preferred dividends 118 135
Dividends to preferred 4 4 (a)
Net income for common 114 131
Dividends to common 58 63
Addition to retained earnings 56 68
Same as prior year

The percent of sales method assumes initially that all costs except depreciati
on are a specified percentage of sales. For 2001, Allied s ratio of costs to sal
es is 87.2 percent ($2,616/$3,000 = 0.872). Thus, for each dollar of sales in 20
01, Allied incurred 87.2 cents of costs. Initially, the company s managers assum
e that the cost structure will remain unchanged in 2002. We can explore the impa
ct of an improvement in the cost structure, but for now we assume that costs wil
l equal 87.2 percent of sales. See Column 3, Row 2.
Allied s managers assume that depreciation will be a fixed percentage of net pl
ant and equipment. For 2001, the ratio of depreciation to net plant and equipmen
t is 10 percent ($100/$1,000 = 0.10), and Allied s managers believe that this is
a good estimate of future depreciation. The forecasted net plant and equipment
for 2002 is $1,100. Therefore, the forecasted depreciation for 2002 is 0.10($1,1
00) = $110.
Total operating costs, shown in Row 4, are the sum of costs and depreciation.
EBIT is found by subtraction, while the interest charges in Column 3 are simply
carried over from Column 1.
Earnings before taxes (EBT) is then calculated, as is net income before prefer
red dividends. Preferred dividends are carried over from the 2001 column, and th
ey will remain constant unless Allied decides to issue additional preferred stoc
k. Net income available to common is then calculated, after which the 2002 divid
ends are forecasted as follows. The 2001 dividend per share is $1.15, and this d
ividend is expected to increase by about 8 percent, to $1.25. Since there are 50
million shares outstanding, the projected dividends are $1.25(50) = $62.5 milli
on, rounded to $63 million.
To complete the forecasted income statement, the $63 million of projected divi
dends are subtracted from the $131 million projected net income, and the result
is the first-pass projection of the addition to retained earnings, $131 - $6 = $
68 million. We call it “first-pass” because we may make errors in ensuring that
all the financial statements are consistent so we go back and correct them

STEP 2. FORECAST THE BALANCE SHEET

The assets shown on Allied s balance sheet must increase if sales are to increas
e. For example, companies such as Allied write and deposit checks every day. Bec
ause they don t know exactly when all of these checks will clear, they can t pre
dict exactly what the balance in their checking accounts will be on any given da
y. Therefore, they must maintain a balance of cash and marketable securities to
avoid overdrawing their accounts. For now we simply assume that the cash require
d to support the company s operations is proportional to its sales. Allied s 200
1 ratio of cash to sales was approximately 0.33 percent ($10/$3,000 = 0.003333),
and its managers believe this ratio will remain constant in 2002. Therefore, th
e forecasted cash balance for 2002, shown in Column 3 of Table 2, is 0.003333($3
,300) = $11 million.
Unless a company changes its credit policy or has a change in its types of cus
tomers, accounts receivable will increase proportionately with sales. Allied s 2
001 ratio of accounts receivable to sales was $375/$3,000 = 0.125 = 12.5%. One c
ould examine the effect of a change in credit policy, but for now we assume a co
nstant credit policy and customer base. Therefore, the forecasted accounts recei
vable for 2002 is 0.125($3,300) = $412.5 million, rounded to $412 million as sho
wn in Column 3 of Table 2.
As sales increase, companies generally need more inventory. For Allied, the 20
01 ratio of inventory to sales is $615/$3,000 = 20.5%. Assuming no change in All
ied s inventory management, the forecasted inventory for 2002 is 0.205($3,300) =
$676.5 million, rounded to $677 million as shown in Column 3 of Table 2.
It might be reasonable to assume that cash, accounts receivable, and inventory
grow proportionally with sales, but will the amount of net plant and equipment
go up and down as sales go up and down? The correct answer could be yes or no. W
hen companies acquire plant and equipment, they often install greater capacity t
han they currently need, due to economies of scale. For example, it was economic
ally better for GM to build the Saturn automobile plant with a capacity of about
320,000 cars per year than to build the plant with a capacity of only 50,000 ca
rs per year and then add capacity each year. Saturn s sales were far below 320,0
00 units for the first few years of production, so it was possible to increase s
ales during those years without also increasing plant and equipment. Even if a f
actory is at its maximum rated capacity, most companies can produce additional u
nits by reducing the amount of downtime due to scheduled maintenance, by running
machinery at a higher than optimal speed, or by running a second (or third) shi
ft. Therefore, there is not necessarily a close relationship between sales and n
et plant and equipment in the short term.
However, for some companies there is a fixed relationship between sales and pl
ant and equipment, even in the short term. For example, new stores in many retai
l chains achieve the same sales during their first year as the chain s existing
stores. The only way these retailers can grow is by adding new stores, which res
ults in a strong proportional relationship between fixed assets and sales.
In the long run, there is a relatively close relationship between sales and fi
xed assets for all companies: No company can continue to increase sales unless i
t eventually adds capacity. Therefore, as a first approximation it is reasonable
to assume that the long-term ratio of net plant and equipment to sales will be
constant.
For the first years of a forecast, managers generally use the actual planned d
ollars of investment in plant

Table 2. Allied, Balance Sheet: 2001-Actual and 2002-Forecast


2001, Actual
(1)
Forecast
Basis, (2)
First Pass
(3)
AFN
(4)
Second
Pass (5)
Cash and near cash 10 .33% x 2002 sales 11 11
Accounts Rec 375 12.5% x ’02 sales 412 412
Inventories 615 29.5% x ’02 sales 677 677
Tot current assets 1000 1100 1100
Net Plant & Equip 1000 33.33%x ’02 sales 1100 1100
Total assets 2000 2200 2200
Acc. Payable 60 2% x ’02 sales 66 66
Notes Payable 110 110 +28 138
Accruals 140 4.67% x ’02 sales 154 154
Tot Current Liab 310 330 358
Long-term bonds 754 754 +28 782
Total Debt 1064 1084 1140
Preferred Stock 40 40 40
Common stock 130 130 +56 186
Retained Earnings 766 +68 834 834
Total Equity 896 964 1020
Tot Liab and equity 2000 2088 +112 2200
AFN 112
Note: AFN stands for Additional Funds Needed. This figure is shown in the last r
ow of column (3); then column (4) shows how the required $112 of AFN is used.

and equipment. If those estimates are not available, it is reasonable to assume


an approximately constant ratio of net plant and equipment to sales. For Allied,
the ratio of net plant and equipment to sales for 2001 is $1,000/$3,000 = 33.33
%. Allied s net plant and equipment have grown fairly steadily in the past, and
its managers expect steady future growth. Therefore, they forecast net plant and
equipment for 2002 to be 0.3333($3,300) = $1,100 million.
Once the individual asset accounts have been forecasted, they can be summed to
complete the asset section of the balance sheet. For Allied, the total current
assets forecasted for 2002 are $11 + $412 + $677 = $1,100 million, and fixed ass
ets add another $1,100 million. Therefore, as Table 2 shows, Allied will need to
tal assets of $2,200 million to support $3,300 million of sales in 2002.

Note: Spontaneously Generated Funds: funds that are obtained automatically from
routine business transactions

If Allied s assets are to increase, its liabilities and equity must also increas
e-- the additional assets must be financed. Some items on the liability side can
be expected to increase spontaneously with sales, producing what are called spo
ntaneously generated funds. For example, as sales increase, so will Allied s pur
chases of raw materials, and those larger purchases will spontaneously lead to a
higher level of accounts payable. For Allied, the 2001 ratio of accounts payabl
e to sales is $60/$3,000 = 0.02 = 2%. Allied s managers assume that their payabl
es policy will not change, so the forecasted accounts payable for 2002 is 0.02($
3,300) = $66 million.
More sales will require more labor, and higher sales should also result in high
er taxable income and thus taxes. Therefore, accrued wages and taxes will both i
ncrease. For Allied, the 2001 ratio of accruals to sales is $140/$3,000 = 0.0467
= 4.67%. If this ratio does not change, then the forecasted level of accruals f
or 2002 will be 0.0467($3,300) = $154 million.
Retained earnings will also increase, but not at the same rate as sales: The n
ew balance for retained earnings will be the old level plus the addition to reta
ined earnings, which we calculated in Step 1. Also, notes payable, long-term bon
ds, preferred stock, and common stock will not rise spontaneously with sales - r
ather, the projected levels of these accounts will depend on financing decisions
, as we discuss later.
In summary, (1) higher sales must be supported by additional assets, (2) some
of the asset increases can be financed by spontaneous increases in accounts paya
ble and accruals, and by retained earnings, but (3) any shortfall must be financ
ed from external sources, using some combination of debt, preferred stock, and c
ommon stock.
The spontaneously increasing liabilities (accounts payable -and accruals) are f
orecasted and shown in Column 3 of Table 2, the first-pass forecast. Then, those
liability and equity accounts whose values reflect conscious management decisio
ns - notes payable, long-term bonds, preferred stock, and common stock - are ini
tially set at their 2001 levels. Thus, 2002 notes payable are initially set at $
110 million, the long-term bond account is forecasted at $754 million, and so on
. The 2002 value for the retained earnings (RE) account is obtained by adding th
e projected addition to retained earnings as developed in the 2002 income statem
ent (see Table 1) to the 2001 ending balance:
2002 RE = 2001 RE + 2002 forecasted addition to RE
= $766 + $68 = $834 million.

The forecast of total assets as shown in Column 3 (first-pass forecast) of Tab


le 2 is $2,200 million, which indicates that Allied must add $200 million of new
assets in 2002 to support the higher sales level. However, the forecasted liabi
lity and equity accounts as shown in the lower portion of Column 3 rise by only
$88 million, to $2,088 million. Since the balance sheet must balance, Allied mus
t raise an additional $2,200 - $2,088 = $112 million, which we define as Additio
nal Funds Needed (AFN). The AFN will be raised by some combination of borrowing
from the bank as notes payable, issuing long-term bonds, and selling new common
stock.

STEP 3. RAISING THE ADDITIONAL FUNDS NEEDED

Allied s financial staff will raise the needed funds based on several factors, i
ncluding the firm s target capital structure (target capital structure reflects
management’s goal of what proportion of capital should be equity and what propor
tion debt over the longer term), the effect of short-term borrowing on the curre
nt ratio, conditions in the debt and equity markets, and restrictions imposed by
existing debt agreements. The financial staff, after considering all of the rel
evant factors, decided on the following financing mix to raise the needed $112 m
illion:
Table 3. Amount of New Capital
Per cent Dollars Interest rate
Notes Payable 25 % $ 28 8%
Long-term bonds 25 28 10
Common stock 50 56 --
Total 100% $112

These amounts, which are shown in Column 4 of Table 2, are added to the initiall
y forecasted account totals as shown in Column 3 to generate the second-pass bal
ance sheet. Thus, in Column 5 the notes payable account increases to $110 + $28
= $138 million, long-term bonds rise to $754 + $28 = $782 million, and common st
ock increases to $130 + $56 = $186 million. Then, the balance sheet is in balanc
e.

A COMPLICATION: FINANCING FEEDBACKS

Our projected financial statements are incomplete in one sense - they do not ref
lect the fact that interest must be paid on the debt used to help finance the AF
N, and that dividends will be paid on the shares issued to raise the common stoc
k portion of the AFN. Those payments would lower net income and retained earning
s shown in the projected statements. One could take account of these financing f
eedback effects by adding columns to Tables 1 and 2 and then making further adju
stments. The adjustments are not difficult, but they do involve a good bit of ar
ithmetic. But since all of the data are based on forecasts, and since the adjust
ments add substantially to the work but relatively little to the accuracy of the
forecasts, they are not discussed here.

ANALYSIS OF THE FORECAST

The 2002 forecast as developed above is only the first part of Allied s total fo
recasting process. We must go on to analyze the projected statements to determin
e whether the forecast meets the firm s financial targets as set forth in the fi
ve-year financial plan. If the statements do not meet the targets, then elements
of the forecast must be changed.
Table 4 shows Allied s actual ratios for 2001, its projected 2002 ratios, and th
e latest industry average ratios. These other ratios are used as a basis of comp
arison between Allied and others in the same industry, as well as Allied’s curre
nt situation versus its situation in the future. (The table also shows a "Revise
d Forecast for 2002" column, which we will discuss later. Disregard the revised
data for now.) The firm s financial condition at the close of 2001 was weak, wit
h many ratios well below the industry averages. For example, Allied s current ra
tio, based on Column 1 of Table 4, was only 3.2 versus 4.2 for an average food p
rocessor.
The "Inputs" section shown on the top three rows of the table provides data on
three of the model s key drivers: (1) costs (excluding depreciation) as a percen
tage of sales, (2) accounts receivable as a percentage of sales, and (3) invento
ries as a percentage of sales. The preliminary forecast in Column 2 assumes thes
e variables remain constant. While Allied s cost-to-sales ratio is only slightly
worse than the industry average, its ratios of accounts receivable to sales and
inventories to sales are significantly higher than those of its competitors. It
s investment in inventories and receivables is too high, causing its returns on
assets, equity, and invested capital as shown in the lower part of the table to
be too low. Therefore, Allied should make operational changes designed to reduce
its current assets.

Table 4. Inputs, AFN, Ratios


PRELIMINARY REVISED INDUSTRY
ACTUAL FORECAST FOR FORECAST FOR AVERAGE
2001 2002 2002(a) 2001
(1) (2) (3) (4)
INPUTS
Costs (excluding depreciation) as percentage of sales 87.2% 87.2% 86.0% 87.1%
Accounts receivable: as percentage of sales 12.5 12.5 11.8 10.0
Inventories as percentage of sales 20.5 20.5 16.7 11.1
OUTPUTS
NOPAT (net operating profit after tax) $170.3 $187.3 $211.2
Net operating working capital $800.0 $880.0 $731.5
Total operating capital $1,800.0 $1,980.0 $1,831.5
Free cash flow (FCF) ($109.7) $7.3 $179.7
AFN $112 ($60)
KEY RATIOS
Current ratio 3.2X 3.1X 3.5x 4.2x
Inventory turnover 4.9X 4.9x 6.0x 9.0x
Days sales outstanding (365 days/year) 45.6 45.6 43.1 36.0
Total asset turnover 1.5 x 1.5 X 1.6X 1.8x
Debt ratio 53.2% 51.8% 49.9% 40.0%
Profit margin 3.8% 4.0% 4.7% 5.0%
Return on assets 5.7% 5.9% 7.5% 9.0%
Return on equity 12.7% 12.8% 15.6% 15.0%
Return on invested capital (b) 9.5% 9.5% 11.5% 11.4%

(a) 1\re " Revised" data show ratios after policy changes related to asset level
s, as discussed later, have been incorporated into the forecast. All of the surp
lus AFN is used to pay off notes payable.
(b) Return on invested capital = NOPAT/total operating capital

The "Key Ratios" section of Table 4 for the forecast period provides more detail
s regarding the firm s weaknesses. Allied s asset management ratios are much wor
se than the industry averages. For example, its total assets turnover ratio is 1
.5 versus an industry average of 1.8. Its poor asset management ratios drag down
the return on invested capital (9.5 percent for Allied versus 11.4 percent for
the industry average). Furthermore, Allied must carry more than the average amou
nt of debt to support its excessive assets, and the extra interest expense reduc
es its profit margin to 4.0 percent versus 5.0 percent for the industry. Much of
the debt is short term, and this results in a current ratio of 3.1 versus the 4
.2 industry average. These problems will persist unless management takes action
to improve things.
After reviewing its preliminary forecast, management decided to take three ste
ps to improve its financial condition: (1) It decided to layoff some workers and
close certain operations. It forecasted that these steps would lower operating
costs (excluding depreciation) from the current 87.2 to 86 percent of sales as s
hown in Column 3 of Table 4. (2) By screening credit customers more closely and
by being more aggressive in collecting past-due accounts, the company believes i
t can reduce the ratio of accounts receivable-to-sales from 12.5 to 11.8 percent
. (3) Finally, management thinks it can reduce the inventories-to-sales ratio fr
om 20.5 to 16.7 percent through the use of tighter inventory controls.6
These projected operational changes were then used to create a revised set of
forecasted statements for 2002. We do not show the new financial statements, but
the revised ratios are shown in the third column of Table 4. Here are the highl
ights of the revised forecast:

1. The reduction in operating costs improved the 2002 NOPAT, or net operating pr
ofit after taxes, by $23.9 million. Even more impressive, the improvements in th
e receivables policy and in inventory management reduced receivables and invento
ries by $148.5 million. The net result of the increase in NOPAT and the reductio
n of current assets was a very large increase in free cash flow for 2002, from a
previously estimated $7.3 million to $179.7 million. Although not shown, the im
provements in operations will lead to significantly higher free cash flow for ea
ch year in the whole forecast period.
2. The profit margin improved to 4.7 percent. However, the firm s profit margin
still lagged the industry average because its high debt ratio results in higher-
than-average interest payments.
3. The increase in the profit margin resulted in an increase in projected retain
ed earnings. More importantly, by tightening inventory controls and reducing the
days sales outstanding, Allied projected a reduction in inventories and receiva
bles. Taken together, these actions resulted in a negative AFN of $60 million, w
hich means that Allied would actually generate $60 million more from internal op
erations during 2002 than it needs for new assets. All of this $60 million of su
rplus funds would be used to reduce short-term debt, which would lead to a decre
ase in the forecasted debt ratio from 51.8 to 49.9 percent. The debt ratio would
still be well above the industry average, but this is a step in the right direc
tion.
4. The indicated changes would also affect Allied s current ratio, which would i
mprove from 3.1 to 3.5.
5. These actions would also raise the rate of return on assets from 5.9 to 7.5 p
ercent, and they would boost the return on equity from 12.8 to 15.6 percent, whi
ch is even higher than the industry average.

Although Allied s managers believe that the revised forecast is achievable, th


ey are not sure of this. Accordingly, they wanted to know how variations in sale
s would affect the forecast. Therefore, a spreadsheet model was run using severa
l different sales growth rates, and the results were analyzed to see how the rat
ios would change under different growth scenarios. To illustrate, if the sales g
rowth rate increased from 10 to 20 percent, the additional funding requirement w
ould change dramatically, from a $60 million surplus to an $87 million shortfall
.
The spreadsheet model can also used to evaluate dividend policy. If Allied dec
ided to reduce its dividend growth rate, then additional funds would be generate
d, and those funds could be invested in plant, equipment, and inventories; used
to reduce debt; or used to repurchase stock.
The model can also used to evaluate financing alternatives. For example, Allie
d could use the forecasted $60 million of surplus funds to retire long-term bond
s rather than to reduce short-term debt. Under this financing alternative, the c
urrent ratio would drop from 3.5 to 2.9, but the firm s interest coverage ratio
would rise, assuming that the firm s long-term debt carries a higher interest ra
te than its notes payable.
We see, then, that forecasting is an iterative process, both in the way the fi
nancial statements are generated and the way the financial plan is developed. Fo
r planning purposes, the financial staff develops a preliminary forecast based o
n a continuation of past policies and trends. This provides a starting point, or
"baseline" forecast. Next, the projections are modified to see what effects alt
ernative operating plans would have on the firm s earnings and financial conditi
on. This results in a revised forecast. Then alternative operating plans are exa
mined under different sales growth scenarios, and the model is used to evaluate
both dividend policy and capital structure decisions.
The spreadsheet model can be used to analyze alternative working capital polic
ies-that is, to see the effects of changes in cash management, credit policy, in
ventory policy, and the use of different types of short-term credit. We can also
examine Allied s working capital policy within the framework of the company s f
inancial model financial forecasting process.

Finally, The spreadsheet model can also be used to estimate Allied s free cash f
low. Free cash flow is calculated as follows: FCF = Operating cash flow - Gross
investment in operating capital.
This FCF is the cash that is available to investors (equity as well as creditors
) to take out of the firm while making sure that it has thee resources to contin
ue to prosper. If one forecasts FCF and takes the present value of all these fut
ure FCF, that provides a good measure of how much the business is worth.

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