TIPTON ICE CREAM

FINANCIAL FORECASTING

George Tipton began the Tipton 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. Tipton was fond of saying. The company was an immediate success and sales quickly reached seven figures.

DEBT AVERSION

The firm expects strong growth in the coming year (1996) and Brenda Hood, Tiptons 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 Tipton family. George Tipton, perhaps unduly influenced by the Great Depression of the 1930s, detested borrowing money and his motto

was Never a lander nor borrower be. For nearly 25 years all the companys stock was owned by the Tipton family, but due to expansion new shares have been sold during the last 15 years to individuals outside the family. By 1995 the Tipton family owns 60 percent of all shares, and although the family tradition: Never a lender nor borrower be. To this day Tipton has never owed anything

beyond its accounts payable and accruals.

Hood knows this is an exterme case of debt aversion and the policy has hurt the owners profits. For example, historically Tipton has been slightly above the industry average in return on total assets but consistently below in return on owners equity. At each annual meeting she has tried unsuccessfully to convince the Tipton clan to use more debt. And each year Hood 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 non financial executives of Tipton. Some members of the Tipton family had attended these session. She explained that when sales increase, then inventory, cash and accounts receivable must also increase. Further, if the firms existing operating capacity was insufficient to support the increased sales, additional fixed assets would be required. She had also stressed the need for pro forma statement to determine the magnitude of the funds needed. It was the first time members of the Tipton family had received any formal financial exposure, and she recalls they seemed interested and attentive.

At the previous annual meetings Hood had avoided using any technical financial analysis to make her case for borrowing. But now she thinks, why not?'

FORECASTING ASSUMPTIONS

She decides to estimate (1) the amount of funds Tipton will have to obtain in 1996; (2) the 1996 income statement assuming all of the financing is done through borrowing; and (3) another income statement assuming all new stock is issued. To help in the estimates Hood enlists Frank Davis, a recent MBA. Davis reminds her that 1996 is expected to be a big year for the company; sales are predicted to increase by 25 percent. Hood 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 for 1996 would be $93,750,000. What about administrative and selling expenses? Hood asks Davis. He informs her that management salaries would have to rise sharply because these salaries had increased very slightly over the past three years. Davis believes a 20 percent increase in administrative and selling expenses is reasonable. Fixed assets are likely to change sharply in the coming year. Currently, Tipton 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 in 1996, it is clear that the company cannot grow beyond 1996 without them. In any event, it is urgent that the financing question be resolved as soon as possible. A reasonable estimate is that Tipton will purchase $5 million of new plant and equipment in 1996.

During the past year we have been a bit slow in paying our suppliers, Hood remarks. We definitely will have to pay more promptly or we are going to have some annoyed creditors; plus we will pick up cash discounts by paying earlier. See if you can come with an estimate of our payables using past information. Hood and Davis also feel that over the last few years factors ( other than sales) affecting accruals and receivables have been relatively constant. For example, the company has not altered its credit policy in the last three years. Nor can they think of any reason why items should change significantly in the coming year. Of course, an exact relationship between each of these and sales is unlikely yo exist, Hood cautions. We can expect some yearly random fluctuation. And keep in mind the big/little mix will be changing since we will be selling to smaller food chains. This has implications for our receivables since these firms are relatively slow to pay. This shouldnt be major factor, Frank, but it is some thing you should be aware of when you make your estimate.'

Hood and Davis 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. Davis suggest he assume a level of 2 percent of sales, which is the approximate industry average, and Hood agrees. What about dividends? Davis asks Hood. 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 Hood believes the company should use more debt, she recognizes that the final decision rests with the Tipton 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. Hood, therefore, instructs Davis to work within the following constraints when doing the forecast. As working hypotheses she wants Tiptons debt ratio to remain below 0.5, and the current and quick ratios must not fall below 2 and 1, respectively. In order 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, Hood tells Davis.

QUESTION Project the 1996 income statement assuming no borrowing.

Exhibit 1

Selected Financial Informaiton for Previous Three Years (000s)

1993 1994 1995

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

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

Exhibit 2

Balance Sheet (000s)

Equity Debt

1995 1996 1996

Assets

Cash & Marketable securities $3,000

Accounts receivable 8,000

Inventory 11,500 _____ _____

Current assets 22,500

Gross fixed assets 24,000

Accumulated depreciation (4,000) $(4,600) $(4,600)

Net fixed assets 20,000 _____ _____

Total assets $42,500 _____ _____

Liabilities and Equity

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 and equity $42,500 _____ _____