Case 8.1

New World Chemicals Inc.

Financial Forecasting

Sue Wilson, the new financial manager of new world chemicals (NWC), a California producer of specialized chemicals for use in fruit orchards, you must prepare financial forecast for 2003. NWC's 2002 sales were $2 billion, and the marketing department is forecasting a 25 percent increase for 2003. Wilson thinks the company was operating at full capacity in 2002, but she is not sure about this. The 2002 financial statements, plus some other data, are given in Table IC9-1.

Table IC8-1. Financial Statements and Other Data on NWC

(Millions of Dollars)

A. 2002 BALANCE SHEET

Cash & Securities $ 20 Accounts Payable & Accrued Liabilities $ 100

Accounts Receivable 240 Notes Payable 100

Inventories 240 Total Current Liabilities $ 200

Total Current Assets $ 500 Long-Term Debt 100

Common Stock 500

Net Fixed Assets 500 Retained Earnings 200

Total Assets $1,000 Total Liabilities and Equity $1,000

B. 2002 INCOME STATEMENT

Sales $2,000.00

Less: Variable Costs 1,200.00

Fixed Costs 700.00

Earnings before Interest and Taxes (EBIT) $ 100.00

Interest 16.00

Earnings before Taxes (EBT) $ 84.00

Taxes (40%) 33.60

Net Income $ 50.40

Dividends (30%) $ 15.12

Addition to Retained Earnings $ 35.28

C. KEY RATIOS

NWC INDUSTRY COMMENT

Basic Earning Power 10.00% 20.00%

Profit Margin 2.52 4.00

Return on Equity 7.20 15.60

Days Sales Outstanding (365 Days) 43.80 Days 32.00 Days

Inventory Turnover 8.33 11.00

Fixed Assets Turnover 4.00 5.00

Total Assets Turnover 2.00 2.50

Debt/Assets 30.00% 36.00%

Times Interest Earned 6.25 9.40

Current Ratio 2.50 3.00

Payout Ratio 30.00% 30.00%

Assume that you were recently hired as Wilson's 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. Assume (1) that NWC was operating at full capacity in 2002 with respect to all assets, (2) that all assets must grow proportionally with sales, (3) that accounts payable and accrued liabilities will also grow in proportion to sales, and (4) that the 2002 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.

B. Now estimate the 2003 financial requirements using the projected financial statement approach. Disregard the assumptions in part a, and now assume (1) that each type of asset, as well as payables, accrued liabilities, and fixed and variable costs, grow in proportion to sales; (2) that NWC was operating at full capacity; (3) that the payout ratio is held constant at 30 percent; and (4) 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.)

C. Why do the two methods produce somewhat different AFN forecasts? Which method provides the more accurate forecast?

D. Calculate NWC's forecasted ratios, and compare them with the company's 2002 ratios and with the industry averages. How does NWC compare with the average firm in its industry, and is the company expected to improve during the coming year?

E. Calculate NWC's free cash flow for 2003.

F. Suppose you now learn that NWC's 2002 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 2002 with the available fixed assets? What would the fixed assets-to-sales ratio have been if NWC had been operating at full capacity? (2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2003?

G. Without actually working out the numbers, how would you expect the ratios to change in the situation where excess capacity in fixed assets exists? Explain your reasoning.

H. On the basis of comparisons between NWC's days' sales outstanding (DSO) and inventory turnover ratios with the industry average figures, does it appear that NWC is operating efficiently with respect to its inventories and accounts receivable? If the company were able to bring these ratios into line with the industry averages, what effect would this have on its AFN and its financial ratios?

I. How would changes in these items affect the AFN? (1) the dividend payout ratio, (2) the profit margin, (3) the capital intensity ratio, and (4) if NWC begins buying from its suppliers on terms that permit it to pay after 60 days rather than after 30 days. (Consider each item separately and hold all other things constant.)

Cyberproblem 8.1

Analyst Forecasts - Zacks

A sales forecast usually begins with a forecast of a firm's unit and dollar sales for some future period; and it is generally based on recent sales trends plus forecasts of the economic prospects for the nation, region, industry, and so forth. Analysts at investment research firms also make forecasts of companies' current and likely future financial performance. These analysts must piece together information that includes forecasts of the overall economy and the level and direction of interest rates. Moreover, they must examine economic and competitive conditions in specific industries right down to sales, costs, margins, profits, and cash flows for specific firms. In this cyberproblem, you will look at analysts' forecasts of earnings and recommendations about the investment potential of specific firms based on their forecasts of the firms' performance.

For this cyberproblem, you will be using the Zacks Investment Research Web site, which can be found at http://my.zacks.com.

a. Sun Microsystems has enjoyed a dramatic increase in sales, earnings and stock price that have made many employees and investors in the company millionaires in a very short time. What were Sun

Microsystem's actual earnings last quarter? Was there an earnings surprise? If so, what was it? What are the analysts' consensus estimates for the (a) current quarter, (b) current fiscal year, and (c) next fiscal year? What was the average broker recommendation for Sun Microsystems, and was there any change from the previous average recommendation? To answer this question, enter Sun Microsystems' stock symbol and request "All Reports". If you do not know Sun Microsystems' stock symbol, you can use Zack's "Ticker Lookup" function.

b. Access Sun Microsystem's company report as prepared by Zacks. What percentage of Sun Microsystems' shareholders are institutional investors and insiders? What was the stock's 52-week high and low? What was the stock's price change during the last year?

c. Access Sun Microsystems' "Annual Ratios & Turnover Rates" and comment on any recent trends that you observe in the company's different types of ratios (liquidity, asset management, debt management, and profitability ratios).

d. Examine analysts' predictions about future earnings and investment potential for software companies Oracle and Microsoft. How do analysts generate earnings predictions and make recommendations