Wooster Adhesives Financial Forecasting

Meg and Beth Smith are twins and the owners of Wooster Adhesives, a company they started seven years ago. The technical expertise of the firm is unsurpassed, and Wooster has developed a number of adhesives like tapes and glues that are popular with industrial users as well as hardware stores, and on-line vendors.

About twelve months ago the partners concluded that Woosters products were underappreciated and that sales could, and should, be substantially higher. They fired an unproductive salesperson and, more importantly, made a key marketing decision. They decided to reduce advertising in trade journals and increase the funds spent on attending trade shows and pay-per-click ads on-line. The marketing changes worked. The firms exhibits were impressive, and the Smiths made important contacts with some major industrial users and even one large retailer, Walstore. The sisters are in the process of negotiating a number of large contracts for the coming year (2016) and product inquiries are markedly higher.

As a result of all this, Woosters sales are expected to increase sharply in the next three years, more than doubling by the end of 2018. The partners estimate sales of $1,933,100 in 2016, $2,609,700 in 2017, and $3,131,600 in 2018. On one hand the twins are extremely pleased with the forecast because it is evidence of what they have long believed: The Company manufactures quality products at a reasonable price. The downside of such large growth will undoubtedly require external financing and could cause managerial difficulties.

Forecasting Considerations

The partners have met with Leo D. Capria, Woosters accountant, and Kirk Shatner, the firms general manager, in order to compile a forecast for 2016-2018 and to discuss the financing options. Table 1 (see excel file) shows the 2016 pro forma balance sheet resulting from the meetings, and indicates that $226,100 needs to be raised. The partners need to develop forecasts for 2017 and 2018, though they are confident that 2016 will be the year of the largest need for external funds.

The Smiths do not intend to declare any dividends and expect the net profit margin (NI/Sales) to equal 3.5%. 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 2017 and 2018, as will accruals and accounts payable, that is, Spontaneous Liabilities.

Net Fixed Assets are expected to increase by $140,000 in 2017 and $50,000 in 2018. Wooster has one loan outstanding and the amount due each year is $20,000 (principal payment).

Financing Differences

Meg Smith wants to borrow all the necessary funds for a number of reasons. First, she argues that they have limited personal capital to invest. This implies that any equity beyond Retained Earnings will have to be raised from new investors. She is loath to do this because she has been told that during the past twelve months privately held companies with sales under $10 million have sold at four to six times EBIDT. During the 5 previous years the multiple was 7 to 10 times. In short, Meg is convinced that any new share of stock would be sold at relatively low prices.

In addition, she really believes that profits are going to explode and she doesnt like the idea of sharing with outsiders. Further, Meg wants to borrow as much short-term debt as possible in part because of its relatively low interest rate. And she realizes that much of the external financial will be used to expand receivables and inventory. She considers these to be short-term assets and believes that it is appropriate to finance them using a short-term debt instrument.

The possibility of borrowing makes Beth a bit uneasy. Frankly, she doesnt believe that her sister thinks enough about consequences of a down-side disaster. Beth doesnt want to worry about a cash crunch, that is, in bad times the firm may have to scramble to raise the funds necessary to meet debt payments.

Beth agrees with Meg that this is not a good time to sell new equity. Still, she is not convinced that new equity could not be raised at an acceptable price. True, it appears that is a buyers market for small firms. Yet Wooster has an extremely strong customer and product base, and unusual growth prospects. Thus, Beth reasons, an equity interest in Wooster might well be sold at a very attractive price.

She does admit, though, that borrowing at least some of the necessary funds is a good idea. Still, she is not willing to concede that she and her sister will be unable to supply additional capital. For example, the s own land that could be sold to raise needed funds.

After further input from Capria and Shatner, the twins decide on two things. First, the forecast needs to be completed to see the results of their expansion. Second, the forecast should consider prudent liquidity and debt ratios. And the decision about what constitutes prudent was made for them. Woosters bank, Key Bank, said it would strongly consider a loan request but that any loan agreement would likely contain the following provisions: Woosters current ratio must exceed 2 and its Total Liabilities-to-equity ratio (at book values) cannot fall below 1.0. These are numbers that Beth is comfortable with, so the forecast will be made incorporating these constraints.

Managerial Control

The partners are convinced that one reason Wooster has been and is successful is because theyve been involved in all phases of the business: production, research, marketing, finance, and so on. The sisters believe they can keep on top of the business through 2018, they are concerned, though, and that large growth beyond that time may cause them to lose managerial effectiveness, and think it may be a good idea to limit sales growth beyond 2018. I wonder, muses Meg, whether we should cap our growth after 2018 at an amount we can internally finance.

Questions:

Using information supplied, develop Woosters pro forma Balance Sheet for 2017 and 2018.

How much of the funds needed in 2016-2018 can be borrowed each year without violating the total liabilities-to-equity constraint?

How much of the funds needed in 2016-2018 can be borrowed each year ad short-term debt without violating the current ratio constraint?

Consider Megs arguments for using short-term debt.

How do you recommend the partners proceed? Defend your answer.

Consider the following formula for estimate the maximum annual sales growth rate, g, which can be financed out of retained earnings.

g= ROA*b/(1-TL/A-ROA*b)

Where b = retained earnings ratio, ROA = [NI/S]*[S/TA] and ROA = return on assets, NI/S = net profit margin, S/TA = total asset turnover, and TL/A = total liabilities-asset ratio.

The Smiths are interested in estimating the maximum annual sales growth after 2018 that can be financed out of Retained Earnings. Estimate this assuming the Smiths maintain a TL/A ratio of .5, pay no Dividends, and use the 2018 total asset turnover and net profit margin.

There is some possibility that the s will decide not to use any additional interest-bearing debt after 2018. Re-estimate your answer to part a) assuming that this occurs. Continue to assume no dividends, and use the 2018 Total Asset Turnover Ratio and Net Profit Margin. (Hint: after TL/A ratio would only consider those spontaneous liabilities.)

The partners are worried that large growth after 2018 may reduce their ability to effectively manage Wooster. Is it reasonable to believe that the sales growth rate that can be internally financed is also the growth rate that the Smiths can effectively manage? Defend your answer.

The Smiths have worked hard at firming up the estimates of the financial forecast. Shown in Table 2 is the set of estimates that they feel most comfortable about, and they call it the Base-case Scenario.

Meg has convinced Beth that selling new equity is not a good idea, and both sisters would like to raise any needed funds by borrowing and/or using their own capital. They feel they could raise $200,000 of equity over the next three years (2016-2018).

Beth is also concerned about the debt-equity constraint and would like it to be set at .75 instead of 1. Neither sister has difficulty using the current ratio constraint of 2.

The other scenario reflects a pessimistic set of estimates from a funds needed standpoint. That is, if this scenario materializes, then the Smiths will undoubtedly need more cash than if the Base case occurs. Though they agree that the Pessimistic scenarios is unlikely, no one, of course, knows exactly what the future will bring.

If the Total Liabilities-Equity constraint is 1, will the capital of $200,000 be sufficient to cover the firms equity needs? What if the constraint is .75?

Estimate funds needed for the next three years under the Pessimistic scenario. If the Debt-Equity constraint is 1, will the s capital of $200,000 cover the firms equity needs? What if the constraint is .75?

Based on your answers in a) and b), how reasonable is it to impose a Total Liabilities-Equity constraint of .75? Defend your position.

Wooster Adhesives
Wooster's 2016 Pro Forma Balance Sheet ($000)
Assets		Liabilities and Equity
Current Assets	$485.2	Payables and Accruals	$141.1
Net Fixed Assets	267.5	Current portion of LT Debt	20.0
		Long-term Debt	60.0
		Equity	305.5
		Funds needed	226.1
Total Asset	$752.7	Total Liabilites and Equity	$752.7

Wooster Adhesives
Base Case Scenario
2016 Sales	$2,000
2017 Sales Growth	0.30
2018 Sales Growth	0.25
CA/Sales	0.26
SL/Sales	0.07
NI/Sales	0.035
Debt due	$20 Each year
2017 P&E	$200
2018 P&E	$75
Pessimistic Scenario
2016 Sales	$2,100
2017 Sales Growth	0.35
2018 Sales Growth	0.30
CA/Sales	0.285
SL/Sales	0.07
NI/Sales	0.03
Debt due	$20
2017 P&E	$200
2018 P&E	$75
All dollars in ($000)