Module 3 Exercises

1. Pro forma income statements: Scenario analysis

Smyth Inc. has decided to do a scenario analysis for the year 2018. Their pessimistic prediction
for sales is $360,000, the most likely amount of sale is $450,000 and the optimistic sales
prediction is $520,000. Smyth’s income statement for the latest year follows:

Smyth Inc. Income Statement

For the Year Ended December 31, 2017
Sales 370,000
Less: Cost of goods sold 168,000
Gross profits 202,000
Less: Operating expenses 92,000
Operating profits 110,000
Less: Interest expense 12,500
Net profits before taxes 97,500
Less: Taxes (rate = 30%) 29,250
Net profits after taxes 68,250

a. Refer the income statement for December 31, 2017, and using the percent of sales
method, develop the pessimistic, most likely, and optimistic pro forma income statement
for the coming year ending December 31, 2018

Smyth Inc.
Pro forma Income Statements (in $)
For the Year Ended December 31, 2017
Pessimistic Most Likely Optimistic
Sales 360,000 450,000 520,000
Less: Cost of goods sold
(0.4541 of sales) 163,459.46 204,324.32 236,108.11
Gross profits 196,540.54 245,675.68 283,891.89
Less: Operating expenses
(0.2486 of sales) 89,513.51 111,891.89 129,297.30
Operating profits 107,027.03 133,783.78 154,594.59
Less: Interest expense
(0.03378 of sales) 121,62.16 152,02.70 175,67.57
Net profits before taxes 94,864.86 118,581.08 137,027.03
Less: Taxes (rate = 30%) 28,459.46 35,574.32 41,108.11
Net profits after taxes 66,405.41 83,006.76 95,918.92

The values presented in the statements were computed using Microsoft Excel. No rounding was
done between calculations, but many of the values presented in the statement were rounded off.
 b. The percent-of-sales method may result in an overstatement of profits for the pessimistic
case and an understatement of profit for the most likely and optimistic cases. Explain
why.

In all three cases, the percent-of-sales method varies the fixed components of cost of goods
sold and other expenses depending on the volume of sales.
On one hand, this may overstate profits in the pessimistic case because a fixed cost would be
larger in magnitude than the product of the variable cost and a low level of sales. Since costs
reduce profits, having variable costs only would reduce the profits to a lesser extent than having
fixed costs as well.
On the other hand, this may understate profits in the optimistic and most likely cases because
a fixed cost would be smaller in magnitude than the product of the variable cost and a high level
of sales. Having variable costs only would reduce the profits to a greater extent than having fixed
costs as well.

c. Restate the pro forma income statement in part to accommodate the following
information about the 2018 costs:
a. $75,000 of the cost of goods sold is fixed, rest is variable
b. $40,000 of operating expenses is fixed, rest is variable
c. All the interest expense is fixed

Smyth Inc.
Pro forma Income Statements (in $)
For the Year Ended December 31, 2017
Pessimistic Most Likely Optimistic
Sales 360,000 450,000 520,000
Less: Cost of goods sold 16,5486.49 18,8108.11 205,702.70
Fixed component 75,000 75,000 75,000
Variable component
(0.2514 of sales) 90,486.49 113,108.11 130,702.70
Gross profits 194,513.51 261,891.89 314,297.30
Less: Operating expenses 90,594.59 103,243.24 113,081.08
Fixed component 40,000 40,000 40,000
Variable component
(0.1405 of sales) 50,594.59 63,243.24 73,081.08
Operating profits 103,918.92 158,648.65 201,216.22
Less: Interest Expense (fixed) 12,500 12,500 12,500
Net profits before taxes 91,418.92 146,148.65 188,716.22
Less: Taxes (rate = 30%) 27,425.68 43,844.59 56,614.86
Net profits after taxes 63,993.24 102,304.05 132,101.35

The values presented in the statements were computed using Microsoft Excel. No rounding was
done between calculations, but many of the values presented in the statement were rounded off.

d. Compare your results in part a. to the results in part c. Do your observations confirm your
explanation in part b.?
 First, profits of the pessimistic case are higher in part a than in part c. Second, the profits
of the most likely case are higher in part c than in part a. Third, profits of the optimistic case
are higher in part c than in part a. These observations confirm my explanation in part b
because the first observation shows the percent-of-sales method overstating the profits, and
the third observation shows the same method understating the profits.

2. Pro forma balance sheet

Leonard Industries wishes to prepare a pro forma balance sheet for December 31, 2020. The firm
expects 2020 sales to total $3,000,000. The following information has been gathered:

a. A minimum cash balance of $50,000 is desired

b. Marketable securities are expected to remain unchanged
c. Accounts receivable represent 10% of sales
d. Inventories represent 12% of sales
e. A new machine costing $90,000 will be acquired in 2020. Total depreciation for
the year will be $32,000.
f. Accounts payable represent 14% of sales.
g. Accruals, other current liabilities, long-term debt and common stock are expected
to remain unchanged.
h. The firm’s net profit margin is 4% and it expects to pay out $70,000 in cash
dividends during 2020
i. The December 31, 2019 balance sheet follows:

Leonard Industries Balance Sheet

As of December 31, 2019
Assets 2019
Cash 45,000
Marketable securities 15,000
Accounts receivable 255,000
Inventories 340,000
Total current assets 655,000
Net fixed assets 600,000
Total assets 1,255,000

Liabilities and stockholder's equity  

Accounts payable 395,000
Notes payable 60,000
Accruals 30,000
Total current liabilities 485,000
Long-term debt 350,000
Total liabilities 835,000
Common stock 200,000
Retained earnings 220,000
Total stockholder's equity 420,000
 Total liabilities and stockholder's equity 1,255,000

a. Use the judgmental approach to prepare a pro forma balance sheet dated December 31,
2020 for Leonard Industries.

Leonard Industries
Pro forma Balance Sheet (in $)
As of December 31, 2020
Assets
Cash 50,000
Marketable securities 15,000
Accounts receivable 300,000
Inventories 360,000
Total current assets 725,000
Net fixed assets 658,000
Total assets 1,383,000

Liabilities and stockholder's equity  

Accounts payable 420,000
Notes payable 60,000
Accruals 30,000
Total current liabilities 510,000
Long-term debt 350,000
Total liabilities 860,000
Common stock 200,000
Retained earnings 270,000
Total stockholder's equity 470,000
Additional financing required 53,000
Total liabilities and stockholder's equity 1,383,000

b. How much, if any, additional financing will Leonard Industries require in 2020? Discuss.

Leonard Industries will require $ 53,000 additional financing in 2020. This is because each
account in the balance sheet was independently derived according to the policies and conditions
expected in 2020. No regards were made to debits and credits, and to balancing sources and uses.
Therefore, total assets more often than not exceed total liabilities and equity in the first attempt
to create a pro forma balance sheet. The additional financing ‘plug’ account is one way to
balance the totals.

c. Could Leonard Industries adjust its planned 2020 to avoid the situation described in part
b? Explain how.

Leonard Industries could to avoid the situation described in part b by working towards the
following adjustment plans for 2020:
 1. Decrease the planned minimum cash required. However, a large decrease is not
recommended because cash is king/queen.
2. Plan for a faster collection system to decrease the percentage of sales of accounts
receivables.
3. Minimize the planned leftover inventory to decrease its percentage of sales.
4. Plan for a slower the payment system within the credit terms of the suppliers to increase
the percentage of sales of accounts payables.
5. Cut on production costs or operating expenses to increase net profit margin.
6. Reduce the planned amount of cash dividends.

3. Free Cash Flows

Consider the following balance sheets and selected data from the income statement of Keith
Corporation:

Keith Corporation Balance Sheet

December 31
Assets 2019 2018
Cash 1,500 1,000
Marketable securities 1,800 1,200
Accounts receivable 2,000 1,800
Inventories 2,900 2,800
Total current assets 8,200 6,800
Gross fixed assets 29,500 28,100
Less: Accumulated depreciation 14,700 13,100
Net fixed assets 14,800 15,000
Total assets 23,000 21,800

Liabilities and stockholder's equity    

Accounts payable 1,600 1,500
Notes payable 2,800 2,200
Accruals 200 300
Total current liabilities 4,600 4,000
Long-term debt 5,000 5,000
Total liabilities 9,600 9,000
Common stock 10,000 10,000
Retained earnings 3,400 2,800
Total stockholder's equity 13,400 12,800
Total liabilities and stockholder's equity 23,000 21,800

Selected income statement data (2019)

Depreciation expense 1,600
 Earnings before interest and taxes (EBIT) 2,700
Interest expense 367
Net profits after taxes 1,400
Tax rate 21%

a. Calculate the firm’s net operating profit after taxes (NOPAT) for the year ended
December 31, 2019

NOPAT = EBIT * (1 – Tax rate) = 2,700 * (1 – 0.21) = 2,133

b. Calculate the firm’s operating cash flow (OCF) for the year ended December 31, 2019

OCF = NOPAT + Depreciation expense = 2,133 + 1,600 = 3,733

c. Calculate the firm’s free cash flow (FCF) for the year ended December 31, 2019

FCF = OCF – Net fixed asset investment – Net current asset investment
Net fixed asset investment = Change in net fixed assets + Depreciation expense
= -200 + 1,600 = 1,400
Net current asset investment = Change in current assets – Change in (accounts payable +
accruals) = 1,400 – (100 – 100) = 1,400
FCF = 3,733 – 1,400 – 1,400 = 933

d. Interpret, compare and contrast your cash flow estimates in parts b. and c.

Dividends = Net profits in 2019 - Change in retained earnings from 2018 to 2019
= 1,400 - (3,400 - 2,800) = 800
FCF - Interest expense = 933 - 367 = 566 < 800

The OCF estimate in part B tells us that the firm generates a net cash gain of
3,733 from its operations. The FCF estimate in part C tells us that the firm generates a
net cash gain of 933 after meeting all its operation needs and paying for investments in
fixed assets and current assets. The firm’s OCF is higher than its FCF because it accounts
for less expenses than the latter. The FCF, however, is not enough to pay for both the
interest expense and dividends if more than 566 of the dividends are in cash. Therefore,
the company should generate more FCF.

4. Cash Conversion Cycle

Metal Supplies is concerned about its cash management. On average, the days’ sales in inventory
(duration of inventory on shelf) is 90 days. Accounts receivable are collected in 90 days, while
accounts payable are paid in 60 days. Metal Supplies has annual sales of $14 million; cost of
goods sold total $9.5 million and purchases are $5 million. (Note: Use a 365 year).

a. Calculate Metal Supplies’ operating cycle

Operating cycle = Days’ sales in inventory + Days’ receivables = 90 + 90 = 180 days

b. What is Metal supplies cash conversion cycle?

Cash conversion cycle = Operating cycle – Average payment period = 180 - 60 = 120 days

c. Calculate the amount of resources needed to support Metal supplies’ cash conversion
cycle

Resources needed = Working capital needed = Inventory + Accounts receivable – Accounts

payable
Inventory = Days’ sales in inventory * Cost of goods sold / 365 = 90 * $ 9.5 million / 365
= $ 2,342,465.75 (approximation)
Accounts receivable = Days’ receivable * Annual Sales / 365 = 90 * $ 14 million / 365
= $ 3,452,054.79 (approximation)
Accounts payable = Average payment period * Purchases / 365 = 60 * $ 5 million / 365
= $ 821,917.81 (approximation)
Resources needed = $ 4,972,602.74 (approximation)

d. Discuss how Metal Supplies might be able to reduce its cash conversion cycle.

The firm could reduce its cash conversion cycle by (1) decreasing its average age of
inventory or average collection period, or by (2) increasing its average payment period. It
could decrease its average age of inventory by increasing the stock of products that sell
frequently and limiting or getting rid of the stock of products that do not sell frequently
relative to the average selling frequency in its industry. It could decrease its average
collection period by sending invoices immediately and providing incentives to customers
who pay early. It could increase its average payment period by negotiating cheaper deals or
those with longer deadlines with suppliers.