The assignment is all about projected financial statements. I am having a lot of trouble on the balance sheet. I can't seem to understand working capital management.

\fBackground Paper: Projected Financial Statements and Financing Requirements College of Business and Economics Master of Business Administration MBA C604 Accounting and Finance Concepts for Managers Contents Introduction and Purpose Process for Preparing Projected Financial Statements Initial Steps in Preparing Projected Financial Statements Sales Projections Projected Income Statement Operating expenses Depreciation and amortization Interest expense Other losses and expenses Interest and other income or gains Income taxes Projected Balance Sheet Evaluating the Reasonableness of Projected Financial Statements Times interest earned (interest coverage) ratio Return on total common stockholders' equity ratio Projected Statement of Cash Flows Relationships between balance sheet and income statement elements Relationships among balance sheet items Projecting External Funds Needed Sustainable Sales Growth 1 Topic 9 Introduction and Purpose To help them meet their responsibility for planning and controlling a business' strategy, operations, investments, and finances, managers prepare several forward-looking documents. These include: Annual operating budgets (such as so-called \"master\" (static) budgets, \"flexible\" budgets, and production plans, as examined in undergraduate managerial accounting courses) Capital budgets, examined in the Topic 6 background paper, Short-term cash flow forecasts, examined in the Topic 7 background paper, Long-range strategic plans (examined in management and strategy courses), and Projected financial statements, examined in this background paper This background paper describes the application of concepts and methods examined in the Topic 3-4 background paper and the Topic 8 background paper in connection with preparing projected financial statements of a business.1 Managers use projected financial statements of a business to determine the amount of any additional external financial capital needed to finance the planned operating and investing activities of the business during the projected period. In addition, managers use projected financial statements of other businesses to support their decisions to acquire such businesses; enter into a supplier or joint venture arrangement with these businesses; and make trade (customer) credit available to these businesses. 1 The Topic 3-4 background paper examines the interpretation of general-purpose financial statements and reviewed the methods for preparing them, which you originally learned in a financial accounting principles course. The Topic 8 background paper examines financial ratio analysis. 2 Learning Objective 1 Process for Preparing Projected Financial Statements Managers routinely prepare projected financial statements to assist them with their planning and control of a business' activities. The typical projection period is one year. Of course, one year corresponds to the planning period of businesses' operating and capital budgets. However, managers frequently prepare \"next twelve month\" financial projections at various points during a business' on-going fiscal year in order to anticipate needs, challenges, and opportunities before beginning the process of preparing the operating or capital budget for the business' subsequent fiscal year. One of the primary objectives of preparing projected financial statements is to assist managers with estimating the amount of additional debt or equity capital the business will need to finance plans for expanding the business during the projection period. Managers may use this estimate to reevaluate their capital structure and dividend policies and to plan their capital-raising activities, such as obtaining bank loans, issuing bonds or additional shares of common stock, or revising existing dividend policies. Capital-raising activities often require a significant amount of time to complete. This background paper describes a generalized method for preparing projected financial statements. Managers adapt this method to the characteristics of their particular business and industry. They typically prepare projected financial statements for periods up to one year into the future. Projected financial statements include a: Projected income statement, Projected balance sheet, and Projected cash flow statement.2 Typically, managers first prepare the projected income statement. Next, they prepare the projected balance sheet, and finally they prepare the projected cash flow statement. Initial Steps in Preparing Projected Financial Statements Examine recent financial performance trends and relationships. In anticipation of preparing projected financial statements, managers examine recent historical financial statements, including relationships among and trends in financial statement elements described by various financial ratios, examined in the Topic 8 background paper. Review existing strategic plan and current operating budget. Managers review their previous decisions and assumptions, as set forth in existing, approved long-range strategic plans and annual operating budgets. This review helps ensure that current projections are \"anchored\" to, or at least reconciled with, previously adopted business strategies and key operating decisions reached.3 Prepare sales projection. With the results of the two preceding steps in mind, managers begin their preparation of a projected income statement by developing a sales projection. Managers may use a variety of approaches to develop sales projections, depending on nature of the business' products and customers, the extent of its geographic \"reach,\" and the nature or number distribution \"channels\" used to sell its products or services: _____ 2 The Topic 3-4 background paper examines the content and preparation of historical (rather than projected) financial statements. The form and content of projected financial statements is essentially the same as that of projected financial statements. However, the process used to prepare projected financial statements reflecting events that have not yet occurred is necessarily different from that used to prepare historical financial statements that report the results of transactions and events that have already occurred and conditions that already exist. This background paper examines the process for preparing projected financial statements. 3 Courses in marketing and strategy examine strategic plans. Undergraduate managerial (or cost) accounting courses examine the process for preparing annual operating budgets (the Topic 1-2 background paper examines several key concepts used in preparing operating budgets). 3 Products (\"what?\") Project sales of each product or product line Geographic (\"where\"?) Project domestic vs. foreign sales, for each domestic region, for each country, etc. Significant customers (\"who?\") Project sales to individually large customers - such as government agencies, large manufacturers or nation-wide retailers - or categories of customers Sales channels (\"how?\") Project sales for each channel, including business-owned \"brick-and-mortar\" stores, Internet or catalog operations, independent retailers or agents, wholesalers, and exporters, or business customers such as assemblers and processors Sales Projections Factors affecting sales growth. In developing sales projections (as well as detailed annual operating budgets and short-term cash flow forecasts, examined in the Topic 7 background paper), managers consider a variety of factors that affect the level and growth of sales, such as: Planned introduction of new products or services by the business or its competitors Managers' plans and programs for sales promotion and advertising Recent or expected changes in the industry and the nature or extent of competition Expected changes in technology and regulation related to the business' products or operations Expected changes in consumer tastes and preferences Current and expected general economic conditions, including the outlook for price inflation, business and consumer spending, and government fiscal and monetary policy The Topic 6 background paper illustrates a model for projecting sales of a new product. In that illustration, managers began with a projection of the overall size of the market for the new product, expected product selling prices, and an estimate of the business' realizable market share. In contrast to that approach, managers of a mature retail business may develop a projection of sales for its coming fiscal year by examining its recent historical sales and managers' plans for new stores and existing stores.4 To illustrate, at the end of its most recent fiscal year, December 31, 20X5 a retail business operated 100 stores located throughout the Pacific Southwest region of the U.S. All of these stores were in operation throughout 20X5. Managers' plans for the coming fiscal year of the business, 20X6, call for the opening of 10 additional stores on or around July 1. During 20X5, average per-store sales (for the existing 100 stores) were $500,000. During the past five years, average per-store sales grew as follows: Per-store average annual Sales Sales growth (1) 20X0 20X1 20X2 20X3 20X4 20X5 $375,000 $395,000 $423,000 $447,000 $474,000 $500,000 - 5.3% 7.1% 5.7% 6.0% 5.5% (1) Computed based only on stores opened throughout the entire preceding fiscal year. (Compound five-year growth rate of per-store sales is about 5.9 percent, computed as ($500,000 / $375,000)1/5 - 1.) Managers' previous analysis indicated that price increases are responsible for about 3.0 percent annual sales growth, with general price inflation responsible for nearly all price increases. Management expects inflationrelated price increases in 20X6 to approximate this recent experience. According to managers' sales and marketing plan, the business will introduce changes in product mix and store layout that are expected to yield a 4.0 percent increase in average per-store sales volume (quantity or units) in 20X6. _____ 4 Courses in marketing and strategy examine methods for preparing sales projections in further detail. 4 The business' previous experience indicates that, on average, during the first 12 months of operation, sales of new stores is about 80 percent of total sales achieved in the stores' second year of operation, once promotional efforts achieve \"market awareness.\" Furthermore, previous experience indicates that new stores realize about 40 percent of their first-twelve-months sales during their first six months of operation. Based on this information, managers projected the business' total 20X6 sales as follows; (B) (C) (D) (E) (F) (G) Existing stores Per-store sales of existing stores in 20X5 Projected percent growth in per-store sales: Due to inflation-related price increases Due to planned changes in product mix and store layout Total projected percent growth in per-store sales Projected per-store sales in 20X6 Number of existing stores Projected total sales of existing stores in 20X6 (H) (I) (J) (K) (L) (M) (N) New stores Projected per-store sales in 20X6 Percent of per-store sales expected in first 12 months Projected sales for new stores in first 12 months of operation Percent of first-12-months sales expected in first 6 months Projected 20X6 sales in new stores opening around July 1 Planned number of new stores opening around July 1 Projected total sales of new stores in 20X6 (L) x (M) 535,000 80.0% $ 428,000 40.0% $ 171,200 10 $ 1,712,000 (O) Projected total 20X6 sales of retail stores (G) + (N) $55,212,000 (A) $ 500,000 3.0% 4.0% (B) + (C) 7.0% (A) x [1 + (D)] $ 535,000 100 (E) x (F) $53,500,000 (E) (H) x (I) (J) x (K) $ Once they have developed a sales projection, managers typically prepare the remainder of the projected income statement using the method described below. 5 Projected Income Statement Operating expenses. In preparing the projected income statement of a business, managers usually project the amounts of operating expenses (except as described immediately below) based on their expected relationship to sales. Managers determine these relationships by examining the historical values of certain financial ratios (examined in the Topic 8 background paper) and the current operating budget of the business. Depreciation and amortization. Managers usually project future depreciation and amortization expense using (a) previously developed depreciation or amortization schedules for existing property, plant, and equipment (PP&E), intangible property, and other long-lived assets, and (b) estimated amounts of depreciation expense for planned investments (examined in the Topic 6 background paper) during the projection period. Interest expense. Managers project the future amount of interest expense as the product of (a) the projected average outstanding balance of (current and noncurrent) debt, computed using the business' most recent historical balance sheet and projected balance sheet (examined below) and (b) the expected nominal interest rates corresponding to those borrowings. Other losses and expenses. Managers project the amounts of any other future losses or expenses based on information available to them at the time they prepare the projected income statement. These estimated losses or expenses may arise from (for example): Planned disposals of long-lived operating assets (such as PP&E), operating business units or product lines, and investment securities Anticipated write-downs of inventory or long-lived operating assets in order to recognize \"other-thantemporary impairment\" in their recoverable values Expected adverse outcomes of pending litigation against the business Interest and other income or gains. Similarly, managers project the amounts of any other future income or gains based on information available to them at the time they prepare the projected income statement. Expected gains or other income include (for example): Interest from investments in debt securities and dividends from certain marketable equity securities, and Gains on planned disposals of investment securities or PP&E Income taxes. Managers project the amount of income taxes as the product of (a) projected income before income taxes and (b) the business' projected combined effective income tax rate, examined in the Topic 1-2 background paper and Topic 6 background paper. To illustrate, presented below is the projected income statement for a company's fiscal year (FY) 20X5, prepared by managers using the method described above. Before preparing the projected income statement, managers analyzed historical income statements for the previous five FYs, 20X0 - 20X4 (included below) and prepared a detailed sales projection for 20X5 (not reproduced in this illustration). Below the projected income statement, managers summarized their important assumptions and method used. 6 Krugman & Stiglitz Company Fiscal year income statements Actual (historical) 20X0 (A) Sales revenue 20X1 20X2 Projected 20X3 20X4 20X5 $ 99,000,000 105,000,000 110,000,000 117,000,000 125,000,000 $ 135,000,000 See Notes below Less Cost of goods sold: (B) Depreciation of manufacturing PP&E 13,500,000 14,500,000 15,000,000 15,500,000 16,500,000 17,300,000 (C) All other cost of goods sold 55,700,000 60,565,000 62,450,000 65,130,000 70,375,000 77,260,000 (D) - (B) 69,200,000 75,065,000 77,450,000 80,630,000 86,875,000 94,560,000 (A) - (E) $ 29,800,000 29,935,000 32,550,000 36,370,000 38,125,000 40,440,000 (A) x (F) 30.1% 28.5% 29.6% 31.1% 30.5% 480,000 540,000 580,000 660,000 750,000 13,200,000 14,300,000 14,500,000 15,600,000 16,400,000 17,955,000 2,800,000 3,200,000 3,800,000 4,100,000 5,100,000 4,700,000 375,000 395,000 470,000 210,000 275,000 345,000 16,855,000 18,435,000 19,350,000 20,570,000 22,525,000 23,800,000 12,945,000 11,500,000 13,200,000 15,800,000 15,600,000 16,640,000 (2,311,000) (2,385,000) (2,420,000) (2,309,000) (2,243,000) (2,285,000) 16,000 28,000 46,000 42,000 26,000 15,000 - (75,000) 50,000 - - (150,000) 10,650,000 9,068,000 10,876,000 13,533,000 13,383,000 14,220,000 (L) + (M) + (N) + (O) 4,260,000 3,627,000 4,350,000 5,413,000 5,353,000 5,688,000 (P) x 0.40 6,390,000 5,441,000 6,526,000 8,120,000 8,030,000 8,532,000 (P) - (Q) (D) Total cost of goods sold (COGS) (E) Gross profit (F) Gross margin (gross profit divide sales revenue) $ 30.0% Operating expenses : Selling and adm inistrative expenses : (G) Depreciation of non-manufacturing PP&E (H) All other S&A expenses (I) Research and development (R&D) expenses (J) Other operating expenses (K) (L) $ Total operating expenses Operating income $ 800,000 (A) x 0.133% (E) - (K) Add (less) Non-operating item s : (M) Interest on debt (N) Interest and dividends on short-term investments (O) Gain (loss) on disposal of PP&E (P) Income before income taxes (Q) Less Provision for income taxes (R) Net income $ $ 7 Notes - Managers' assumptions and methods used in projecting 20X5 amounts (A) Based on managers' separate sales projection. (B) Projected depreciation expense is based on existing depreciation schedules for manufacturing PP&E held at FYE 20X4, plus estimated depreciation of planned 20X5 PP&E purchases. (F) The average gross margin during the 20X0-20X4 period, 30.0 percent, is a reasonable basis for projecting gross profit. (G) Projected depreciation expense is based on existing depreciation schedules for non-manufacturing PP&E held at FYE 20X4, plus estimated depreciation of planned 20X5 PP&E purchases. (H) The average ratio of "all other S&A-to-sales revenue" during the 20X0-20X4 period, 13.3 percent, is a reasonable basis for projecting "all other S&A." (I) The projected amount of R&D expense is based on managers' tentative proposal, developed in connection with the long-term strategic plan. (J) The average amount of "other operating expense" during the 20X0-20X4 period, $345,000, is an adequate basis for projecting this expense. (M) Interest expense is computed as: interest rate on debt, 8.0 percent, times projected average debt outstanding in 20X5 of: $ 28,560,000 (N) Interest and dividend income is computed as: projected rate of return on short-term investments, 4.0 percent, times the projected average balance of investments held during FY 20X5 of: $375,000 (O) Managers expect to incur a loss on disposal of existing PP&E of about $150,000, based on a tentative capital budget for 20X5. (Q) The income tax provision is computed using an estimated combined effective income tax rate of 40.0 percent in 20X5. 8 Projected Balance Sheet Relationships between balance sheet and income statement elements. In anticipation of preparing a business' projected balance sheet, managers examine the relationship between income statement elements and balance sheet elements. As examined in the Topic 3-4 background paper, these relationships exist because of accrual accounting. For example, because of accrual accounting, there exists a relationship between sales and trade accounts receivable. Certain financial ratios, examined in the Topic 8 background paper, describe these income statement-to-balance sheet relationships. In the case of sales and accounts receivable, for example, the average collection period and accounts receivable turnover ratios describe this relationship. Managers will typically review the historical values of financial ratios in several preceding years and consider any expected changes in the business' policies, industry characteristics, and economic conditions that would affect the expected value of these ratios during the period of the projection. Then, they will use the projected values of these ratios for the projected period, together with the projected income statement, to develop the projected amounts of related balance sheet elements. Following the generalized method examined in this background paper, managers use the following ratios to project the identified elements of the balance sheet: Ratio Definition Average collection period (days) (1) Average accounts receivable (AR), net Average daily sales Average days to sell inventory (1) Average accounts payable payment period (days) Accrued income taxes payable-toprovision for income taxes ratio Projected balance sheet element Computation in projected balance sheet Accounts receivable = Projected sales 360 = Projected COGS 360 Accounts payable = Projected \"cash costs\" 360 Accrued income taxes payable = where, Average daily sales = Sales / Number of days in period (assume 360-day year) Average inventory Average daily cost of goods sold (COGS) Inventory where, Average daily COGS = Total cost of goods sold (COGS) / Number of days in period (assume 360-day year) Average accounts payable (AP) Average daily \"cash costs\" where, Average daily \"cash costs\" = (COGS + Total operating expenses, excluding depreciation) / Number of days in period (assume 360-day year) Accrued income taxes payable Provision for income taxes where, Provision for income taxes (i.e., income tax expense) is from the income statement Projected provision for income taxes x x x x Projected average collection period (days) Projected average days to sell inventory Projected average AP payment period (days) Projected accrued income taxes payableto-provision for income taxes ratio (1) The Topic 7 background paper examines the average collection period ratio and average days to sell inventory ratio. 9 Relationships among balance sheet items. The graphic below describes structural relationships among certain balance items that managers use in preparing the projected balance sheet. (Parenthetical letter references are to the illustrative projected balance sheet, further below.) Balance sheet item Projection method Assets (A) Cash and cash equivalents Projected as: Projected total current assets, (E) Less balances of AR and inventory, separately projected as described above, and short-term investments (E) Total current assets Projected as: Total assets, (J) Less projected balances of PP&E and other noncurrent assets, separately projected as illustrated below (J) Total assets Relying on the \"basic accounting equation,\" examined in the Topic 3-4 background paper, total assets are projected as: Total liabilities and stockholders' equity, (W) projected below Liabilities and shareholders' equity (Q) Noncurrent debt, including notes, bonds, and mortgages payable Projected as: Total liabilities, (R) Less current liabilities, separately projected as illustrated below (R) Total liabilities Projected as: Total liabilities and stockholders' equity, (W) Less total stockholders' (or other owners') equity, (V) (V) Total stockholders' (or other owners') equity, including common stock, (S), additional paid-in capital, (T) and retained earnings, (U) Projected based on expected changes during the period, as: Historical balances of (S), (T), and (U) at the beginning of projected period, Plus projected net issuances (or, less net repurchases), if any, of common stock (or other equity interests) during the projected period, reflected as increases (or decreases) in (S) and (T) Plus projected net income (from the projected income statement), reflected as an increase in (U), Less any projected dividends, reflected as a decrease in (U) Projected based on total stockholders' equity, (V) and the business' targeted \"debt-versus-equity\" capital structure, as: Projected total stockholders' equity, (V) projected above Plus \"targeted\" total liabilities In turn, targeted total liabilities is projected as: Total stockholders' equity, (V) projected above Times targeted total debt ratio (ratio of total liabilities-to-total stockholders' equity) Stated differently, total liabilities and stockholders' equity is projected as: (W) Total liabilities and stockholders' equity Projected total stockholders' equity + Projected total stockholders' equity x Projected total liabilities Projected total stockholders' equity 10 Close examination of the graphic above reveals that this generalized method \"begins at the bottom\" of the balance sheet and works its way upward, ending with cash and cash equivalents. Using computerized spreadsheets to prepare projected balance sheets, managers use spreadsheet formulas to establish the structural relationships defined above and in the illustrative balance sheet, below. This generalized method for projecting a business' balance sheet requires managers to: Project the changes in its shareholders' (or other owners') equity capital balance Establish a targeted total debt ratio that reflects its capital structure policy.5 That policy states the relative percentages of equity capital and total liabilities (including debt in the form of loans, bonds, mortgages, and other borrowings) that will comprise the business' total financial capital, as examined in the Topic 6 background paper (in connection with estimating a business' weighted average cost of capital) Establish a desired current (working capital) ratio in connection with adopting a working capital management policy, as examined in the Topic 7 background paper6 Use cash and cash equivalents as the residual \"balancing item\" in the projected balance sheet, the balance of which managers examine for reasonableness by (a) comparing the resulting balance of cash and cash equivalents to its historical levels and (b) comparing the resulting (projected) current ratio to its desired and historical values To illustrate, presented below is the projected balance sheet for FY 20X5 of the same company whose projected income statement managers already prepared (above). Managers prepared the projected balance sheet using the method just described. Before preparing the projected balance sheet, managers analyzed historical balance sheets for the previous five FYs, 20X0 - 20X4 (included below) and the relationships between these historical balance sheets and the corresponding FYs' income statements (presented in comparative fashion with the projected income statement, above). Below the projected balance sheet, managers summarized their important assumptions and method used. In preparing its projected balance sheet, managers were mindful of the company's working capital management policy and capital structure strategy: The company's working capital management policy provides guidelines for investments in short-term, highly liquid investment securities. That policy also requires managers to take steps to maintain a current (working capital) ratio of about 1.0. Historically, managers have relied on bank lines of credit (examined in the Topic 7 background paper) to help meet this requirement. According to the terms of its bank loan agreements, the company must pay interest quarterly on its outstanding loans; these interest payments are due immediately after the end of each fiscal quarter. The company's capital structure strategy, adopted in 20X0, calls for annual reductions in the total debt ratio, from 1.2 in 20X0 to 0.75 by the end of 20X6. In its projected 20X5 balance sheet, managers' targeted total debt ratio is 0.81. According to its long-standing dividend policy, the company pays dividends early each FY amounting to 0.40 (40.0 percent) of net income for the FY just ended (i.e., a dividend \"payout\" ratio of 40 percent). _____ 5 6 The Topic 8 background paper defines the total debt-to-equity (total debt) ratio as: Total (current AND noncurrent) liabilities Total stockholders' equity The Topic 8 background paper defines the current (working capital) ratio as: Total current assets Total current liabilities 11 Krugman & Stiglitz Company Fiscal yearend balance sheets Actual (historical) 20X0 Assets: 20X1 20X2 Projected 20X3 20X4 20X5 See Notes below Current assets : (A) Cash and cash equivalents (B) Investment securities available for sale (C) $ 692,000 589,000 727,000 537,000 556,000 400,000 1,000,000 1,300,000 800,000 500,000 250,000 Accounts receivable 12,375,000 13,125,000 13,750,000 14,625,000 15,625,000 16,875,000 Sales / 360 x 45 (D) Inventory 11,533,000 12,511,000 12,908,000 13,438,000 14,479,000 15,760,000 COGS / 360 x 60 (E) Total current assets 25,000,000 27,225,000 28,685,000 29,400,000 31,160,000 33,390,000 (J) - (H) - (I) 1.1 1.1 1.1 1.0 1.0 1.0 70,700,000 86,620,000 101,290,000 116,320,000 131,790,000 147,960,000 (G) Less Accumulated depreciation 21,200,000 34,120,000 46,290,000 57,820,000 69,290,000 80,460,000 (H) Property, plant, and equipment, net 49,500,000 52,500,000 55,000,000 58,500,000 62,500,000 67,500,000 (I) Other assets 850,000 925,000 825,000 990,000 910,000 900,000 (J) Total assets $ 75,350,000 80,650,000 84,510,000 88,890,000 94,570,000 $ 101,790,000 8,010,000 8,720,000 9,020,000 9,450,000 10,240,000 $ Current ratio (ratio of current assets to current liab .) (F) Property, plant, and equipment, at cost $ 505,000 (E) - (B) - (C) - (D) (E) / (P) (F) - (G) From (W), below Liabilities: Current liabilities : (K) Accounts payable 11,140,000 "Cash costs" / 360 x 40 (L) Accrued income taxes payable 1,070,000 910,000 1,090,000 1,350,000 1,340,000 1,420,000 Tax provision x 0.25 (M) Dividends payable on common stock 2,560,000 2,180,000 2,610,000 3,250,000 3,210,000 3,410,000 (N) Bank notes payable - current portion 10,000,000 11,300,000 12,600,000 13,900,000 15,200,000 16,500,000 (O) Accrued interest payable 578,000 596,000 605,000 577,000 561,000 571,000 (P) Total current liabilities 22,218,000 23,706,000 25,925,000 28,527,000 30,551,000 33,041,000 Sum (K) through (O) (Q) Bank notes payable - noncurrent portion 18,882,000 19,433,000 17,158,000 14,066,000 12,902,000 12,510,000 (R) - (P) (R) Total liabilities 41,100,000 43,139,000 43,083,000 42,593,000 43,453,000 45,551,000 (W) - (V) 1.20 1.15 1.04 0.92 0.85 0.81 (R) / (V) 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000 20,000,000 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000 Total deb t ratio (ratio of total liab ilities to total equity ) $ Interest exp./ 360 x 90 Stockholders' equity: (S) Common stock, at par (T) Additional paid-in capital (U) Retained earnings 10,250,000 13,511,000 17,427,000 22,297,000 27,117,000 32,239,000 (V) Total stockholders' equity 34,250,000 37,511,000 41,427,000 46,297,000 51,117,000 56,239,000 (S) + (T) + (U) $ 75,350,000 80,650,000 84,510,000 88,890,000 94,570,000 $ 101,790,000 (V) + (V) x 0.81 (W) Total liabilities and stockholders' equity 12 Notes - Managers' assumptions and methods used in projecting 20X5 amounts (A) The projected balance of cash and cash equivalents is computed as a residual amount: Total current assets less the projected balance of all other current asset elements. (B) The projected balance of short-term, highly liquid investment securities is based on management' working capital management policy (examined in the Topic 7 background paper). (C) The projected balance of accounts receivable (AR) is computed using projected sales and the projected AR collection period ratio, 45 days. The average collection period during the 20X0-20X4 period (45 days) is a reasonable basis for projecting AR. (D) The projected balance of inventory is computed using projected cost of goods sold (COGS) and the projected average days to sell inventory ratio, 60 days. The average days to sell inventory ratio during the 20X0-20X4 period (60 days) is a reasonable basis for projecting inventory. (E) Total current assets is computed as a residual amount: Total assets less PP&E and other assets. (F) The projected balance of property, plant, and equipment (PP&E) is computed as: 20X4 balance of PP&E, $131,790,000, plus projected 20X5 acquisitions (net of any projected disposals of PP&E), $16,170,000, obtained from a tentative capital budget. (G) The projected balance of accumulated depreciation (AD) is computed as: 20X4 balance of AD, $69,290,000 plus projected depreciation expense of $17,300,000 (manufacturing PP&E) and $800,000 (non-manufacturing PP&E), from the projected income statement less AD of PP&E management tentatively expects to dispose of in 20X5, $6,930,000. (I) (J) The average amount of other assets during the 20X0-20X4 period, $900,000, is a reasonable basis for projecting the 20X5 balance. The projected balance of total assets is determined from the projected balance of total liabilities and shareholders' equity, at (W). (K) The projected balance of accounts payable (AP) is computed using projected "cash costs" and projected average AP payment period , 40 days. The average payment period of "cash costs" during the 20X0-20X4 period (40 days) is a reasonable basis for projecting AP. For this purpose, "cash costs" include projected cost of goods sold (COGS) and operating expenses, excluding depreciation (which does not use cash). (L) The projected balance of accrued income taxes payable is computed as the projected provision for income taxes (from the projected income statement) times 0.25, the average ratio of accrued income taxes payable-to -provision for income taxes during the 20X0-20X4 period. (M) The projected balance of dividends payable is equal to dividends that the company expects to declare during the final week of 20X5 and pay early in FY 20X6. The company's long-standing policy is to declare annual yearend dividends equal to 0.40 (40 percent) of the FY's net income. (N) The projected balance of bank notes payable - current portion is that amount which results in a current ratio of about 1.0, consistent with management's working capital management policy (examined in the Topic 7 background paper). (O) The projected balance of accrued interest payable is computed as: Projected interest expense (from the projected income statement) divide 360 days times 90 days, based on the requirement (in its loan agreement) that company pay interest on its borrowings at the beginning of each fiscal quarter. (Q) The projected balance of bank notes payable - noncurrent is computed as: Projected total liabilities at (R) less total current liabilities at (P). (R) The projected balance of total liabilities (or, targeted total liabilities) is computed as described at (W), below. (S) Managers plan no repurchases (or issuances) of common stock based on an on-going plan to reduce the company's financial leverage, as measured by the total debt-to-equity (total debt) ratio (refer to Note (W), below). This note also applies to additional paid-in capital, at (T). (U) The projected balance of retained earnings (RE) is computed as: 20X4 balance of RE, $27,117,000 plus projected net income (from the projected income statement) less projected dividends, $3,410,000, at (M). (W) The projected balance of total liabilities and stockholders' equity is computed as: Total stockholders' equity, at (V), plus targeted total liabilities. In turn, the targeted balance of total liabilities is computed as: Total stockholders' equity times the targeted total debt ratio (ratio of total liabilities-to-total stockholders' equity ). The targeted total debt ratio for 20X5 is 0.81 (81 percent), based on managers' previously established targeted capital structure (examined in the Topic 6 background paper). The company's capital structure strategy, adopted in 20X0, calls for reductions in the total debt ratio , from 1.20 in 20X0 to 0.75 by end of FY 20X6. 13 Evaluating the Reasonableness of Projected Financial Statements As indicated above, managers test the reasonableness of projected balance sheets they prepare by comparing the projected balance of cash and cash equivalents (the residual \"balancing item\") to historical levels of cash and cash equivalents and by comparing the projected current ratio to the desired and historical values of this ratio. In addition, managers typically compute historical and projected values for other financial ratios (examined in the Topic 8 background paper) in order to test the reasonableness of the overall financial projection, including the reasonableness of the projected balance sheet in relation to the projected income statement. In particular, managers compute and evaluate the following ratios: Times interest earned (interest coverage) ratio. The amount of interest expense (in the projected income statement) depends in part on the projected amount of debt (in the projected balance sheet). Therefore, managers examine the projected value of the TIE (interest coverage) ratio by comparing it to (a) its historical values and to (b) the minimum requirements for this ratio set forth in the business' capital structure policy and debt agreements (i.e., financial covenants) governing the business' borrowings, as examined in the Topic 7 and Topic 8 background papers. Return on total common stockholders' equity ratio. The ROCE ratio compares net income available to common stockholders (determined using the projected income statement) to the average balance of the business' total common stockholders equity (determined from the projected and most recent historical balance sheets). Managers examine the projected ROCE ratio by comparing it to (a) historical values for this ratio and (b) the business' estimated cost of equity capital, rE, as examined in the Topic 6 background paper (in connection with the discussion of business' cost of capital). The Topic 6 background paper explains that, if the rate of return from an investment equals or exceeds the business' required rate of return (cost of capital), the investment will increase the value of a business to its owners. However, if the rate of return from an investment is less than the business' cost of capital), the investment will destroy business value. This conclusion applies to the overall business, as well. Accordingly, if managers' financial projections for a business indicate that the ROCE ratio for the projected period is less than the business' estimated cost of equity capital, rE, managers should review: The reasonableness of their projections, The business' capital structure policy and plans, and Elements of the business' strategy and operations, such as product pricing and manufacturing costs in order to identify the underlying causes of this indication To illustrate, managers computed these selected ratios for the projected FY 20X5 and, for comparison, the five preceding FYs, 20X0 - 20X4, using the income statements and balance sheets presented above, as set forth below. Based on these computations, managers concluded that: 1. The company's projected TIE (interest coverage) ratio, 7.3, will comfortably meet the minimum requirements of its existing loan agreements, 4.5, in FY 20X5, and 2. The company's projected return on average common stockholders' equity (ROCE) of 15.9 percent for FY 20X5 will surpass its cost of equity capital, estimated to be about 14.2 percent. 14 Krugman & Stiglitz Company Fiscal year selected financial ratios Actual (historical) 20X0 (A) 20X1 20X2 Projected 20X3 20X4 20X5 5.6 4.8 5.6 7.0 (B) Earnings before interest and income taxes (EBIT) $ 12,945,000 11,425,000 13,250,000 15,800,000 (C) Interest expense, net of any interest income $ 2,295,000 2,357,000 2,374,000 2,267,000 2,217,000 $ 2,270,000 (D) Return on average common equity (ROCE) ratio (E) Net income NA 15.2% $ 5,441,000 16.5% 6,526,000 18.5% 8,120,000 16.5% 8,030,000 $ 15.9% 8,532,000 - - - - - 5,441,000 34,250,000 6,526,000 37,511,000 8,120,000 41,427,000 8,030,000 46,297,000 8,532,000 51,117,000 37,511,000 41,427,000 46,297,000 51,117,000 56,239,000 $ 35,880,500 39,469,000 43,862,000 48,707,000 $ 53,678,000 Times interest earned (TIE) (interest coverage) ratio (F) Dividends on preferred stock (G) Income available to common stockholders (H) Total stockholders' equity, beginning of FY (I) Total stockholders' equity, end of FY (J) Average total stockholders' equity NA 7.0 See Notes below 7.3 (B) / (C) 15,600,000 $ 16,490,000 (G) / (J) (E) - (F) (H) + (I) / 2 Notes - Managers' assumptions and methods used in projecting 20X5 amounts (A) Minimum TIE (interest coverage) ratio set forth in company's loan agreement (financial covenants) is 4.5 (B) - (C) EBIT and net interest expense determined from projected income statement. (D) Current estimate of company's cost of equity capital, r E is 0.142 (14.2 percent), computed using CAPM as r E = r F + x (r M - r F) = 0.04 + 1.2 x (0.125 - 0.04) (E) Net income determined from projected income statement. (F) The company has no preferred stock outstanding. (H) Balance of total stockholders' equity at beginning of FY is from the FY 20X4 balance sheet. (I) Balance of total stockholders' equity at end of FY is from the projected balance sheet. 15 Projected Statement of Cash Flows The method for preparing a projected statement of cash flows (SCF) is (mercifully) essentially identical to and somewhat simpler than that used to prepare a historical (actual) SCF. The Topic 3-4 background paper examines the preparation of a historical SCF is detail. In order to prepare a projected SCF, managers first prepare the projected income statement and projected balance sheet for the corresponding period, as examined above. In addition to these projected statements, managers will use the historical (actual) balance sheet of the business as of the beginning of the projected period (i.e., the end of the most recent historical period) to prepare the projected SCF. As described in the Topic 3-4 background paper, an important step in preparing a historical SCF is the examination of changes (increases and decreases) in non-working capital asset and liability accounts - such as PP&E, other assets or investments, and notes (or bonds) payable - that effect the presentation of investing cash flow and financing cash flow information within the SCF. In contrast, when preparing a projected SCF, managers generally simplify the projection of investing and financing cash flows by presenting only the net changes in related balance sheet elements.7 To illustrate, presented below is the projected SCF for FY 20X5 of the same company whose projected income statement and balance sheet managers already prepared (above). Managers prepared the projected SCF using the projected FY 20X5 income statement, projected 20X5 balance sheet, and actual (historical) FY 20X4 balance sheet. Included for comparative purposes are the historical SCFs for the company's FYs 20X1 - 20X4. Below the projected income statement, managers summarized their important assumptions and certain supporting computations. _____ 7 Of course, the nature and amount of changes in these accounts is largely undeterminable at the time managers prepare financial projections. 16 Krugman & Stiglitz Company Fiscal year statements of cash flows Actual (historical) Operating cash flow s OCF) (A) Net income $ Projected 20X1 20X2 20X3 20X4 20X5 5,441,000 6,526,000 8,120,000 8,030,000 14,500,000 15,000,000 15,500,000 16,500,000 17,300,000 540,000 580,000 660,000 750,000 800,000 75,000 (50,000) - - 150,000 $ See Notes below 8,532,000 Adjustm ents to reconcile net incom e to OCF (B) Depreciation of manufacturing PP&E (C) Depreciation of non-manufacturing PP&E (D) Loss (gain) on disposal of PP&E Changes in w orking capital accounts : (E) Decrease (increase) in accounts receivable (750,000) (625,000) (875,000) (1,000,000) (1,250,000) (F) Decrease (increase) in inventory (978,000) (397,000) (530,000) (1,041,000) (1,281,000) (G) Increase (decrease) in accounts payable 710,000 300,000 430,000 790,000 900,000 (H) Increase (decrease) in accrued inc. taxes payable (160,000) 180,000 260,000 (10,000) 80,000 (I) Increase (decrease) in accrued interest payable 18,000 9,000 (28,000) (16,000) 10,000 (J) Net cash provided by (used in) operating activities 19,396,000 21,523,000 23,537,000 24,003,000 25,241,000 (600,000) (300,000) 500,000 300,000 250,000 (18,115,000) (18,030,000) (19,660,000) (21,250,000) (23,250,000) (75,000) 100,000 (165,000) 80,000 10,000 (18,790,000) (18,230,000) (19,325,000) (20,870,000) - - - - - (2,560,000) (2,180,000) (2,610,000) (3,250,000) (3,210,000) 1,851,000 (975,000) (1,792,000) 136,000 908,000 Sum of (A) through (I) Cash flow s from investing activities : (K) Net (acquisitions) disposals or maturities of investment securities (L) Net acquisitions of PP&E (M) Net (acquisitions) disposals of other assets (N) Net cash provided by (used in) investing activities (22,990,000) Sum of (K) through (M) Cash flow s from financing activities : (O) Net proceeds from issuances (repurchases) of common stock (P) Payment of dividends on common stock (Q) Net proceeds from (repayments of) bank notes payable (R) Net cash provided by (used in) financing activities (709,000) (3,155,000) (4,402,000) (3,114,000) (S) Net increase (decrease) in cash and cash equivalents (103,000) 138,000 (190,000) 19,000 (51,000) (T) Cash and cash equivalents at beginning of FY 692,000 589,000 727,000 537,000 556,000 (U) Cash and cash equivalents at end of FY 589,000 727,000 537,000 556,000 $ (2,302,000) Sum of (O) through (Q) $ (J) + (N) + (R) 505,000 17 Notes - Managers' assumptions and methods used in projecting 20X5 amounts No FY 20X0 SCF is presented because the balance sheet for the preceding year is not available for use in preparing the SCF (A) - (D) Projected net income, depreciation, and loss (gain) on disposal of PPE obtained from the projected income statement. (E) - (I) Projected changes in the balances of working capital accounts are computed using the projected and FY 20X4 balance sheets. (K) Projected net (acquisitions) disposals or maturities of investment securities is computed using the projected and FY 20X4 balance sheets. (L) Projected net acquisitions of PP&E is computed as: Projected balance of net PP&E (from the projected balance sheet) $ 67,500,000 17,300,000 Add projected depreciation of manufacturing PP&E (from the projected income statement) Add projected depreciation of non-manufacturing PP&E (from the projected income statement) 800,000 Add projected loss (or deduct projected gain ) on disposal of PPE (from the projected income statement) 150,000 (62,500,000) Less beginning-of-year balance of net PP&E (from the FY 20X4 balance sheet) Net acquisitions of PP&E $ 23,250,000 (M) Projected net (acquisitions) disposals of other assets is computed using the projected and FY 20X4 balance sheets. (O) Projected net proceeds from issuances (repurchases) of common stock is computed using balances of common stock, at par and additional paid-in capital from the projected and FY 20X4 balance sheets. (P) Projected payment of dividends on common stock is equal to dividends that the company declared during the final week of 20X4 and will pay early in FY 20X5, the projected period (also reflected as accrued dividends payable in the FY 20X4 balance sheet). (Q) Projected net proceeds from (repayments of) bank notes payable is computed as the net change in total current and noncurrent balances of bank notes payable, obtained from projected and FY 20X4 balance sheets - i.e., $29,010,000 less $28,102,000 represents "external funds needed." (T) Balance of cash and cash equivalents at beginning of FY is from the FY 20X4 balance sheet. (U) Balance of cash and cash equivalents at end of FY is from the projected balance sheet. 18 Learning Objective 2 Projecting External Funds Needed The projected SCF is useful for focusing managers' attention on the need for any additional external financing necessary to support their plans for the business' operating and investing activities during the projected period. The illustrative projected SCF above indicates managers' plans to finance the company's projected net investment cash outflows, totaling about $23.0 million with projected operating cash inflows (OCF) of about $25.2 million. In addition, the company will pay dividends on its common stock totaling about $3.2 million while projecting net additional borrowings under its bank loan agreement of less than $1.0 million. This relatively modest projected increase in bank notes payable is consistent with managers' previously adopted plan to reduce the company's total financial leverage (as measured by the total debt ratio), described earlier. Learning Objective 3 Sustainable Sales Growth Managers typically present their long-run strategic and annual operating plans for a business (and subsequently evaluate its financial performance) in terms of sales growth. Implicit in this \"sales growth\" orientation is the assumption that the profitability accompanying sales growth is adequate to meet or surpass the business' cost of capital, as examined in the Topic 6 background paper. After all, history records the decline or failure of many businesses that achieved remarkable growth in sales. As the Topic 6 background paper explains, managers' proper focus is the pursuit of investments that promise positive net present values (NPV) because the rate of return on (profitability of) positive-NPV investments exceeds the business' cost of capital, thereby increasing the value of the business to its owners. By following this \"growth in value\" orientation, sales growth generally \"takes care of itself,\" accompanying growth in a business' value. To help finance their growth, incorporated businesses may raise additional equity capital from external sources by issuing additional shares of the corporation's common stock. However, managers are usually averse to issuing additional common stock.8 Managers who are unwilling to raise additional equity capital from external sources may use the following equation to compute a business' sustainable growth rate of sales: _____ 8 Managers are reluctant to raise additional common equity capital from existing stockholders or prospective investors for several reasons. First, the direct costs of issuing common stock are usually significant and include \"flotation\" costs (investment bankers' underwriting fees), attorneys' fees, auditors' fees, securities registration fees. Second, the indirect costs of issuing additional common stock include the considerable diversion of managers' time and attention from other activities to the process of issuing additional common stock. Finally, depending on investors' assessment of the timing and profitability of managers' planned investment of the new common equity capital, existing stockholders (which may include managers) may experience immediate dilution in the value of their proportionate ownership interests in the corporation. 19 Sustainable growth rate of sales9 = ROCEBeginning x (1 - Payout ratio) = Net income Common equityBeginning x (1 - Payout ratio) where, ROCEBeginning is the return on the beginning-of-year balance of the business' common equity, computed as net income for the year divide total common stockholders' equity at the beginning of the year Payout ratio is the percentage of the business' net income that a business distributes to its owners in the form of cash dividends. In the illustration above, the company's projected net income for FY 20X5 is $8,532,000 and, accordingly, it expects to distribute about $3,410,000 in cash dividends to its shareholders in early FY 20X6, based on its dividend payout policy of 0.40 (40.0 percent). Management computed the company's sustainable growth rate of sales using the above equation, as: Sustainable growth rate of sales $8,532,000 = = $51,117,000 x (1 - 0.40) 0.10 (or, 10.0 percent) _____ 9 Managers may also use either of the following variations of the sustainable growth of sales equation: Sustainable growth rate of sales = = ROCEEnding x (1 - Payout ratio) 1 - ROCEEnding x (1 - Payout ratio) Net income / Common equityEnding x (1 - Payout ratio) 1 - Net income / Common equityEnding x (1 - Payout ratio) In the illustration, above: = = $8,532,000 / $56,239,000 x (1 - 0.40) 1 - $8,532,000 / $56,239,000 x (1 - 0.40)) 0.10 (or, 10.0 percent) Alternatively, Sustainable growth rate of sales = = Net margin ratio x (1 - Payout ratio) x (1 + Total debt ratio) Total assetsEnding / Sales - Net margin ratio x (1 - Payout ratio) x (1 + Total debt ratio) Net income / Sales x (1 - Payout ratio) x (1 + Total liabilitiesEnding / Common equityEnding) Total assetsEnding / Sales - Net income / Sales x (1 - Payout ratio) x (1 + Total liabilitiesEnding / Common equityEnding) In the illustration, above: = = $8,532,000 / $135,000,000 x (1 - 0.40) x (1 + $45,551,000 / $56,239,000) $101,790,000 / $135,000,000 - $8,532,000 / $135,000,000 x (1 - 0.40) x (1 + $45,551,000 / $56,239,000) 0.10 (or, 10.0 percent) 20 This deceptively simple equation operates properly only if the following four factors remain constant: Factor Financial ratio Ratio definition Explanation Financial leverage (capital structure policy) Total debt ratio (1) Total liabilities Total common equity The business' total liabilities grow only in proportion to any growth in its total common equity capital (i.e., retained net income) Asset utilization (productivity) Total asset turnover ratio Sales Total assets The business' total assets grow only in proportion to the growth in its sales Profitability (operating performance) Net margin ratio (1) Net income Sales The business' net income grows in proportion to its sales Payout ratio Dividends Net income The business consistently pays dividends limited to a specified, constant payout ratio Dividend policy (1) Above, this background paper (and the Topic 8 background paper) examines the total debt ratio and net margin ratio. Careful examination of this equation reveals that, under the constraints set forth above, a business may sustain a rate of growth in its sales proportional to its \"retained\" return on beginning-of-period common equity. For example, a business that maintains a policy of paying no dividends (its payout ratio is zero), may sustain a rate of sales growth equal to its ROCEBeginning. When managers examine a business' potential sales growth rate from this \"ROCE perspective,\" they typically begin their investigation into opportunities to improve the business' operating performance, asset utilization, and capital structure by performing traditional \"DuPont analysis,\" which analyses ROCE as: ROCEEnding = ROCEEnding = Operating performance Asset utilization Capital structure (Profitability) (Efficiency) (Leverage) Net margin Net income Sales x x Asset turnover Sales Total assetsEnding x x Equity multiplier Total assetsEnding Common equityEnding In the illustration above, management subjected the company's ROCEEnding to the following analysis: ROCEEnding = $8,532,000 $135,000,000 = 0.0632 = 0.1517 (or, 15.2 percent) x x $135,000,000 $101,790,000 x $101,790,000 $56,239,000 1.32626 1.81 \"Ending\" indicates that managers use the end-of-period balances of common equity and total assets The sustainable growth rate of sales equation establishes a maximum rate of sales growth for a business that relies solely on internally generated equity capital (i.e., undistributed net income). If a business' actual sales growth surpasses its sustainable growth rate of sales, managers may consider raising additional (external) equity capital. However, in the absence of additional external equity capital, a business may increase its sustainable growth rate of sales only if it relaxes one or more of the constraints described above by: Permitting increased financial leverage, Achieving increased asset utilization (productivity), Accomplishing greater profitability relative to sales (for example, by reducing manufacturing costs), or Retaining and reinvesting in the business more of its net income (reducing the payout ratio) 21 If a business' actual sales growth rate is persistently below its sustainable growth rate of sales, managers' proper focus is on improving the business' asset utilization (efficiency) or revisiting its financial strategy (for example by reducing the extent of its financial leverage or increasing its dividend payout ratio). In the illustration above, the company's projected sales growth rate for 20X5 is 8.0 percent and its five-year compound growth of sales during the 20X1 - 20X5 period is 6.4 percent [i.e., ($135,000,000 / $99,000,000)1/5 - 1]. Both of these sales growth rates are below the company's sustainable growth rate of sales, 10.0 percent (computed earlier). As the illustration indicates, managers implemented a plan to reduce the company's financial leverage to a total debt ratio to 0.75 by the end of fiscal year 20X6. ***** Course developer's note on content of and sources used in preparing course background papers: In selecting the content and determining the organization of material for this course, the developer considered a number of factors, including the university's MBA program outcomes, material examined in the program's accounting and finance foundation courses, and material examined in subsequent MBA accounting and finance courses, in particular MBA A602 (Interpreting Accounting Information) and MBA F602 (Financial Decision-making), which, in turn, are prerequisites for other MBA accounting and finance courses. The course developer reviewed several accounting and finance texts, listed below, to ensure that the examination of models, concepts, methods, and terminology in the background papers is generally consistent with a variety of such texts over time. The course developer noticed that, on the one hand, there is substantial similarity among texts in the material (models, concepts, methods, and terminology) examined. The developer also noticed that, on the other hand, in spite of this similarity, none of these texts appears to include references to other texts (just original research articles, authoritative accounting literature, and the occasional federal statute, internal revenue code section, or IRS regulation). In addition, much of the material examined in the texts and the background papers is the subject of articles on several unrestricted Websites, such as Wikipedia.com. As such, the material contained in the background papers represents both essential and common knowledge for business managers. Atkinson, A. A., Banker, R. D., Kaplan, R. S. & Young, S. M. (1995). Management accounting. Englewood Cliffs, New Jersey: Simon & Schuster Co./Prentice-Hall. Horngren, Charles T. (1977). Cost accounting: A managerial emphasis. (4th ed.). Englewood Cliffs, NJ: Prentice-Hall. Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2004). Intermediate accounting. (11th ed.). New York: Wiley & Sons. Ross, S. A., Westerfield, R. W. & Jaffe, J. E. (1993). Corporate finance. (3rd ed.). Burr Ridge, IL: Richard D. Irwin. Wild, J. J., Subramanyam, K. R. & Halsey, R. F. (2004). Financial statement analysis. (10th ed.). New York: McGraw-Hill/Irwin. Wolk, H. I., Dodd, J. L. & Tearney, M. G. (2004). Accounting theory: Conceptual issues in a political and economic environment. (6th ed.). Mason, OH: Thomson Learning/South-Western. 22