Topeka Adhesives Financial Forecasting

Two sisters are in the process of negotiating a number of large contracts for the coming year (1996) and product inquires are markedly higher. Sales are expected to increase in the next three years, more than doubling by the end of 1998. Partners estimate sales of $1,933,100 in 1996, $2,609,700 in 1997 and $3,131,600 in 1998. The downside to this growth is that such large growth will require external financing and could cause managerial difficulties.

Forecasting considerations

The table below shows the 1996 pro forma balance sheet and indicates $226,100 needs to be raised.

Topekas 1996 Pro Forma Balance Sheet (000s)

	Assets			Liabilities & Equity
Current Assets		$485.2		Payables & Accruals		$141.1
Net Fixed		267.5		Debt Due		20.0
		$752.7		Long Term Debt		60.0
				Equity		305.5
				Funds Needed		226.1
						$752.7

Partners need to develop forecasts for 1997 and 1998, though they are confident that 1996 will be the year of the largest need for external funds.

They do not intend to declare any dividends and expect the net profit margin (NI/sales) to equal 3.5 percent. The net profit margin estimate is a bit conservative since it considers the possibility that new funds may be borrowed, which would increase interest expense. They also believe that there will be little if any economies of scale in working capital requirements, and consequently it is reasonable to assume that current assets will increase proportionately with sales in 1997 and 1998, as will accruals and accounts payable, that is, spontaneous liabilities.

Net fixed assets are expected to increase by $140,000 in 1997 and $50,000 in 1998. Topeka has one loan outstanding and the amount due each year is $20,000.

One partner wants to borrow all the necessary funds for a number of reasons. First, we have very limited capital of our own implying any equity beyond retained earnings will have to be raised from new investors. The partner has been told private companies with sales under ten million have sold at 4 to 6 times EBDIT. During the five previous years, the multiple was seven to ten. They also believe that profits are going to explode and she doesnt like the idea of sharing them with outsiders. They also want to borrow as much short term debt as possible in part because of its relatively low interest rate. Realizes that much of the external financing will be used to expand receivables and inventory. They consider these to be short-term assets and believes that it is appropriate to finance them using a short-term debt instrument.

The companys current ratio must exceed 2 and its debt to equity ratio (debt divided by equity (at book value)) cant fall below 1. So forecasts must be made incorporating these limits.

QUESTIONS

1. Use the format of the table in the case and develop Topeka's 1997 and 1998 pro forma balance sheets.
2. How much of the funds needed in 1996-1998 can be borrowed each year without violating the debt-to-equity constraint given in the case?
3. How much of the funds needed in 1996-1998 can be borrowed each year as short-term debt without violating the current ratio constraint given in the case?
4. Carefully evaluate the partner's arguments for using short-term debt.
5. How do you recommend the partners proceed? Defend your advice.