Case 2 JENSEN ICE CREAM

Financial Forecasting

Larry Jensen began the Jensen Ice Cream Company nearly five decades ago. He patented a soft ice cream and right from the outset paid special attention to quality. We only make one product, but we make it in many flavors and we make it well, Jensen was fond of saying. It was an immediate success and sales quickly reached seven figures.

DEBT AVERSION

The firm expects strong growth in the coming year and Vickie Seiler, Jensens chief financial officer, hopes she can make a strong case for borrowing to finance the companys expansion. She realizes, however, that she is likely to face stiff opposition from the Jensen family. Larry Jensen, perhaps unduly influenced by the industry-wide liquidity crunch during the recent recession, detested borrowing money and his motto was, Never a lender nor borrower be. At the beginning all the companys stock was owned by the Jensen family, but due to expansion new shares have been sold during the last 20 years to individuals outside the family. By the end of last year the Jensen family owned 60 percent of all shares. Although the family has not been very active in running the firm, it does insist on one family tradition: Never a lender nor borrower be. To this day Jensen has never owed anything beyond its accounts payable and accruals.

Seiler knows this is an extreme case of debt aversion and the policy has hurt the owners profits. For example, historically Jensen has been slightly above the industry average in return on total assets but consistently below the return on owners equity. At each annual meeting she has tried unsuccessfully to convince the Jensen clan to use debt. Each year Seiler heard a chorus of Never a lender But perhaps this year would be different.

She recalls two sessions on financial management that she held for the nonfinancial executives of Jensen. Some members of the Jensen family had attended these sessions. She explained that when sales increase, then inventory, cash, and accounts receivable must also increase. Further, if the firms existing operating capacity were insufficient to support the increased sales, additional fixed assets would be required. She had also stressed the need for pro forma statements to determine the magnitude of the funds needed. It was the first time members of the Jensen family had received any formal financial exposure, and she recalls they seemed interested and attentive. At the previous annual meetings Seiler had avoided using any technical financial analysis to make her case for borrowing. But now she thinks, Why not?

FORECASTING ASSUMPTIONS

Vickie Seiler decides to estimate (1) the amount of funds Jensen will have to obtain next year; (2) the next years projected income statement assuming all of the financing is done through borrowing; and (3) another income statement projection assuming all new stock is issued. To help in the estimates Seiler enlists Warren Hubbard, a recent MBA. Hubbard reminds her that the next year is expected to be a big year for the company; sales are predicted to increase by 25 percent. Due to the strong demand, marketing feels any cost increases can easily be passed on. Consequently, the gross margin should exceed the current level of 21 percent. Seiler notes that the sales-to-inventory ratio will be lowered to 6.5, and that purchases should total $101,481,000. This suggests cost of goods would be $93,750,000 next year.

What about administrative and selling expenses? Seiler asks Hubbard. He informs her that management salaries would have to rise sharply because these salaries had increased very slightly over the past three years. Hubbard believes a 20 percent increase in administrative and selling expenses is reasonable for the next year.

Fixed assets are likely to change sharply in the coming year. Currently, Jensen is operating virtually near capacity, demand is expected to remain high, and thus extra capacity will be needed. In addition, some major improvements to existing equipment will have to be made in order for the company to remain competitive. The planning for these changes has been anticipated for some time, and though all of these changes do not have to be made by next year, it is clear that the company cannot grow in the future without them. In any event, it is urgent that the financing question be resolved as soon as possible. A reasonable estimate is that Jensen will purchase $5 million of new plant and equipment next year.

During the past year we have been a bit slow in paying our suppliers, Seiler remarks. We definitely will have to pay more promptly or were going to have some annoyed creditors, plus starting next year well pick up cash discounts by paying earlier. See if you can come up with an estimate of our payables using past information.

Seiler and Hubbard also feel that over the last few years, factors (other than sales) affecting accruals have been relatively constant and will remain constant. Seiler cautions, however, that the company may experience some yearly fluctuation in receivables. Lets keep in mind that next year the big/little mix will change since well be selling our product to smaller food chains. This has implications for our receivables since these firms are relatively slow to pay. It is something we should be aware of when we make our estimate of receivables for the coming year.

Seiler and Hubbard think the cash management of the firm has been a bit sloppy over the past few years, and both agree the company could make do with a lower level of liquidity. Hubbard suggests he assume a level of 2 percent of sales, which is the approximate industry average, and Seiler agrees. What about dividends? Hubbard asks Seiler. Our payout ratio is usually around 50 percent. However, if we borrow all the extra money, lets work backwards on the dividends; that is, out of net income subtract the amount of the retained earnings we would obtain if we used all-equity financing.

FORECASTING RESTRICTIONS

There are two final problems. While Seiler believes the company should use more debt, she recognizes that the final decision rests with the Jensen family. Given their debt aversion, it is important that any projections not appear too debt-heavy. She also wonders how much flexibility she would have to use short-term debt, assuming the decision to borrow is made. Seiler, therefore, instructs Hubbard to work within the following constraints when doing the forecast. As working hypotheses she wants Jensens debt ratio to remain below 0.5, and the current and quick ratios must not fall below 2 and 1, respectively. In other words, the financial projection cannot violate any one of these restrictions. Given these limitations, see how much flexibility we have in raising any funds needed, Seiler tells Hubbard.

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TABLE 1

Selected Financial Information for Previous Three Years (000s)

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Present

Two Years Ago A Year Ago Year

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Sales $88,500 $96,000 $100,000

Receivables $7,432 $8,533 $8,000

Average Collection Period (days) 30.2 32 28.8

Accounts Payable $5,700 $6,000 $9,500

Accruals $2,400 $1,800 $3,000

TABLE 2

Balance Sheets (000s)

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Present Next Year Projection

Year With Equity Financing (No Debt)

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Assets

Cash & Securities $3,000

Receivables 8,000

Inventory 11,500 ________

Current Assets 22,500

Gross Fixed Assets 24,000

Accumulated Depreciation (4,000) (4,600)

Net Fixed Assets 20,000 ________

Total Assets $42,500 ________

Liabilities

Notes Payable $ 0

Accounts Payable 9,500

Accruals 3,000 ________

Current Liabilities 12,500

Bonds 0

Common Stock ($10 par) 20,000

Retained Earnings 10,000 ________

Total Liabilities & Equity $42,500 ________

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TABLE 2

(Continued)

Income Statements (000s)

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Present Next Year Projection

Year With Equity Financing (No Debt)

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Net Sales $100,000

Cost of Goods Sold _79,000 _______

Gross Profit 21,000

Administrative and Selling 10,000

Depreciation 600 600

Miscellaneous Expenses __200 _220

EBIT 10,200

Interest Expense ____0 _______

EBT 10,200

Taxes (50%) _5,100 _______

Net Income 5,100

Dividends 2,550

To Retained Earnings 2,550

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TABLE 3

Selected Financial Ratio Comparison

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Industry Jensen*

Current Ratio 1.8 2.98

Quick Ratio 0.8 1.23

Debt Ratio (%) 50.0 40.0

Times Interest Earned 6.0 19.86

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* Ratios are calculated under the debt financing scenario.

1) Calculate Jensens FN (funds needed) using the Percent-of-Sales FN formula:

FN = (A/S)S - (SL/S)S - S'mb

Show all the relevant numbers and calculations.

2) Your calculation should show A/S=.425 and SL/S=.125. Explain what these numbers specifically mean.