PART III FINANCIAL PLANNING contacts with some industrial users and even one national retailer, Spears. The sis- ters are in the process of negotiating a number of large contracts for the year (1996) and product inquiries are markedly higher. coming the next three years, and sales are estimated to more than double by the end of As a result of all this, Topeka's sales growth is expected to increase sharply in 1998. The Whatleys predict sales of $1,933,100 in 1996, $2,609,700 in 1997, and $3,131,600 in 1998. On one hand, the twins are extremely pleased with the fore- I) 23 cast because it is evidence of what they have long believed: The company man- ufactures quality products at a reasonable price. The downside is that such large growth will undoubtedly require external financing and could cause manager- ial difficulties. While the partners will explore a number of financing alternatives, they rec- ognize that the first step is to estimate the external funds needed for the 1996-1998 period. After all, before they decide on a financing option, they want a reasonable projection of what needs to be raised. And it is even possible that most of the expected growth can be internally financed. FORECASTING CONSIDERATIONS In order to develop the forecast the partners decided to meet with Fred Lanzi, All the firm's accountant, and Karl Shatner, Topeka's general manager. agree that the sales projections are "quite reasonable" in view of the activity resulting from the trade shows and may even be a bit low. They also decide to concentrate on the 1996 forecast at the initial meeting. A few months ago Shatner began implementing a number of cost-cutting measures that are expected to generate a 32 percent gross margin each year of the forecast. Due to economies of scale administrative expenses are expected to increase less than proportionately with sales, and the group estimates a 20 per- cent increase in 1996. The relevant tax rate is 40 percent. Lanzi pointed out that the financial forecast needs to consider the tighter credit terms offered by many of the firm's suppliers. Company records show that two years ago about 80 percent of Topeka's purchases were on terms of 2/10, net 30. That is, most suppliers offered a 2 percent discount to customers who paid within ten days but, in any event, full payment was expected by day course," noted Lanzi, "always took the discount when it was offered." thirty. Roughly 20 percent of the purchases were on terms of net 30. "We, of firm's suppliers offered the above discount. Lanzi strongly believes that even Company records also show that during the past year only about half of the be made on terms of 2/10, net 30. In addition, he recommends that Shatner's sume-and the Whatley's concur-that only a third of all future purchases will fewer vendors will offer a discount in the future, and thinks that it is wise to as- gross margin estimate be reduced to 31 percent, in part because of fewer trade discounts. After some discussion, Shatner agrees that Lanzi's points "are well made and my estimate of gross margin is probably a bit high." CASE 12 TOPEKA ADHESIVES (I) 77 The discussion then turns to working capital management. Inventory control has been a problem for Topeka at times. Elizabeth Whatley believes that inven- tory turnover (CGS/inventory) can be increased to 7.7 mainly by using suppli- ers with shorter delivery time. Karen Whatley, however, is skeptical. She thinks that it is unrealistic to think that the firm's inventory management can be im- proved and believes that some type of estimate based on historical inventory patterns is appropriate. Despite her objections, however, the group decides use Elizabeth's estimate. It is clear that the firm's historical experience with its accounts receivable will be of little help in predicting future receivables. In the past, Topeka has offered terms of net 30; 1/10, net 30; and 2/10, net 30. Quite frankly, which one Topeka offered depended on the bargaining power and importance of the customer. And many of Topeka's new clients are quite large firms who have insisted on a longer payment period. For the purpose of this forecast, the Whatleys decide to assume that they will offer credit terms of net 30 and net 45. They estimate that 40 percent of all sales will be on terms of net 30, and that 80 percent of this group will pay on time, though taking the full 30 days. The 20 percent who pay late are expected to take an extra 10 days, or 40 days in all. Sixty percent of all sales are estimated to be made on terms of net 45. The Whatleys believe that these customers will tend to be "more reliable and stable" and, thus, expect that 90 percent of these sales will be paid on time, that is, on day 45. The 10 percent who will be late are predicted to take an extra ten days. The Whatleys expect that "virtually all" sales will be collected and they esti- mate that bad debt expense will be "insignificant" and can be ignored. The group also thinks that cash should be 3 percent of sales, "other cur- rent" assets will be .6 percent of sales, and accruals are best estimated using past information. The firm's predicted 1996 spending on plant, land, and equipment is $175,000. These expenditures partly reflect the replacement of existing equip- ment but mainly result from the new facilities necessary to accommodate the growth in sales. FINANCIAL ISSUES Topeka will pay no dividends during 1996. The firm has one loan outstanding and the amount due is $20,000 each year. Assuming no additional borrowing, annual interest expense will decline since the loan's balance also declines and be borrowed. For the time being, however, the forecasters decide to ignore the rate is fixed. Still, it is likely that some if not most of any new funds would possibility of any new debt except for the assumption that interest expense will remain constant over the forecasting period. the Lanzi says he has enough information to develop an estimate for 1996 and then, as the meeting is about to break up, Karen Whatley raises an issue that EXHIBIT 1 Income Statements of Topeka Adhesives: 1993-1995 (000s) 1993 1994 1995 Sales $1,347.0 $1,448.0 $1,546.5 Cost of goods Gross margin 956.4 1,010.7 1,076.4 390.6 437.3 470.1 Administrative Depreciation 323.3 350.4 368.1 29.6 31.9 34.0 EBIT 37.7 55.0 68.0 Interest 14.0 12.0 10.0 EBT 23.7 43.0 58.0 Taxes 9.5 17.2 23.2 Net income $14.2 $25.8 $34.8 EXHIBIT 2 Balance Sheets of Topeka Adhesives: 1993-1995 (0000s) 1993 1994 1995 Assets Cash $47.6 $56.6 $47.0 Receivables 97.3 88.5 110.8 Inventory 134.7 138.5 149.5 Other current 8.1 8.7 9.3 Current assets 287.7 292.2 316.6 Gross fixed assets 194.3 232.1 266.1 Accumulated depreciation (59.6) (91.5) (125.5) Net fixed assets 134.7 140.6 140.6 Total assets $422.4 $432.8 $457.2 Liabilities and equity Accounts payable $39.8 39.5 $48.3 Debt due 20.0 20.0 20.0 Accruals 28.3 33.3 34.0 Current liabilities 88.1 92.8 102.4 Long-term debt 120.0 100.0 80.0 Common stock 110.0 110.0 110.0 Retained earnings 104.2 130.0 164.9 Total liabilities and equity $422.4 $432.8 $457.2