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Financial Management Financial Forecasting Aug 6, 2010

Table of Contents FINANCIAL FORECASTING...........................................................................................2 Usefulness of Financial Forecasting.........................................................................2 II. Limitations of Financial Forecasting.................................................................2 III. Cases when a company may not find forecasting a justifiable investment......2 IV. Financial Forecasting Techniques .....................................................................2 Subjective Forecasting (Judgmental Approach)...................................................2 Trend Analysis ........................................................................................................3 Correlation Forecasting...........................................................................................7 FORECAST FINANCIAL STATEMENTS...........................................................................8 FORECAST INCOME STATEMENT..............................................................................9 FORECAST BALANCE SHEET..................................................................................10 ASSETS...............................................................................................................11 LIABILITES..........................................................................................................11 CAPITAL..............................................................................................................11 PERCENTAGE OF SALES METHOD ......................................................................13 CASH FORECAST.................................................................................................14 PROBLEM: PROFORMA BALANCE SHEET WITH CHOICE OF FINANCING...................16 Required:...............................................................................................................16 Answers: ...............................................................................................................16 CASE ANALYSIS: CHAMPION CATTLE FARMS, INC. (A)...............................................20 COMPANY BACKGROUND.......................................................................................20 GUIDE QUESTIONS:................................................................................................22 I. Time Context.................................................................................................22 II. Viewpoint.......................................................................................................22 III. Statement of the Problem..............................................................................22 IV. Objectives......................................................................................................22 V. Areas of Consideration.....................................................................................22 VI. Alternative Courses of Actions.........................................................................23 VII. Recommendation...........................................................................................24 VIII. Detailed Plan of Actions..................................................................................24

Divine Grace Kuan

8/06/2010

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Financial Management Financial Forecasting FINANCIAL FORECASTING  Estimates of the overall impact of the management strategy and program of action;  Provide a comprehensive picture of a company’s future financial status and 

   

performance and guide managerial decision making; Estimates of bottom line effect; Improve the quality of planning at all levels of the organization; Makes clarity in communicating targets to stockholders; Enables lower management to determine the level of efforts it should exert to attain forecast results; Support plans, integrate the views of managers and communicate goal throughout the company;

Usefulness of Financial Forecasting • • •

They support short- term and long-term managerial plans; They provide a comprehensive view of the intended results of the investment and financing decisions of management; They improve the planning process throughout the organization;

II. • •

Limitations of Financial Forecasting Inherent uncertainty of future events and the judgmental nature of forecasts Takes time and is costly

III. Cases when a company may not find forecasting a justifiable investment • •

When companies does not incur substantial cost for being caught unprepared; When the company can insure itself against adverse situations;

IV. Financial Forecasting Techniques Subjective Forecasting (Judgmental Approach)  A method of forecasting that uses the forecaster’s experience and opinion about the future business conditions and capability of the company

Advantage: a) A manager assimilates his awareness of operating conditions into the forecast. b) A manager is more committed to achieving the objectives of plans that are based on his own forecasts. c) Subjective forecasts only require an expert.

Disadvantage: a) When managers realize that top management uses forecasts as standards of performance, managers might not reveal the actual operating conditions to the top management.

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Financial Management Financial Forecasting Trend Analysis  A quantitative trend predict financial variables using past data. This are prediction methods that derive patterns from past data.

3 Methods: ABC COMPANY: INVENTORY AND SALES OVER TIME (in million pesos)

Year 1 2 3 4 5 6 7 8 9 10 11 12 13

Sales 53 35 63 83 127 132 140 179 190 228 303 476 525

Inventory 14 15 22 19 39 36 29 25 29 44 57 80 71

14 532 87 Table above shows future sales inventory based on past performance trends 1. One-Period Forecasting Method

-

Forecasts the next period’s value based only on the last period’s value. This method is also useful for very short forecast periods while chances that sales will increase next year are very good, tomorrow’s sales may be more or may be less than yesterday’s sales. Yesterdays sales would be the best predictor of tomorrow’s sales.  Useful for very short forecast periods  It is not a preferred forecasting technique because it is all that can be done by a forecaster who could not find any sound basis for his forecast.

2. Forecasts Based on Average Growth Rates

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Financial Management Financial Forecasting 

Simple Growth Rate Relates the change in the variable over the number of periods that have elapsed. Variable

t+n

= Variable t + g x Variable t

where g = (variable t+n – variable t ) (variable t ) x n ABC Company would like to forecast its sales for year15 using the past average annual growth rate. g = (P532M – P53M) = 64.6% P53 x 14 Sales (Year 15) = Sales (Year 14) + Growth rate x Sales (Year 14) = P 532M + (0.646 x P532M) = P 875.7M 

Average Compound Growth Rate Uses the compounding formula in future value analysis. The base period is the starting point of calculation of the growth rate

Future value = Present value x (1 + g)n g = (Future Value/Present value) 1/n - 1 Variable

t+n

where g =

= Variable t + g x Variable t 1/n

variablet+n variablet

___

1

ABC Company wants to determine the compound growth rates of its sales and inventory for the past 13years and to forecast for year15 on this basis . g (Sales) = (P532M/P53M) 1/13 - 1 = 0.194 or 19.4% g (inventory) = (P87M/P14M) 1/13 - 1 = 0.151 or 15.1% Sales

Year 15

Inventory

= Sales

Year 15

+ Growth rate x Sales Year 14 = P 532M + (19.4% x P532M) = P 635.2M

Year 14

= Inventory Year 14 + Growth rate x Inventory = P 87M + (15.1% x P87M) = P 100.14M

Year 14

 A method that does ignore other information in deriving the prediction model is not likely to be a very powerful forecasting model.

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Financial Management Financial Forecasting 800 700 600 500 400 300 200 100 0 1

2

3

4

5

6

7

8

9

10

11

12

13

14

This graph compares the two growth rate methods 3. Forecasts Based on Financial Data in Time Series Time series forecast reveal patterns from past data. An example of time series model is a Linear Regression with time as dependent variable. This responds to the limitations of the two growth rate techniques. The time series analysis assumes that the dependent variable changes in a linear pattern over time Variable = a + b x t where t = (1,2,….,n) corresponds to n time periods, with t=1 representing Year 1

 

Coefficient of determination (R-squared/ r2) – the summary measure of the degree fit of the regression line. The higher the R-squared, the higher is the degree of reliability of the regression equation as a tool.

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Financial Management Financial Forecasting ABC Company wants to develop the regression forecast models using the time series regression approach for sales and inventory. Then the company wants to apply these models To forecast sales for year 15. X Year

Y Sales

1

53

xy

x2

5 3

2

35

7

63

18

83

33

127

63

132

79

140

98

179

2

16,129

3

17,424

4

19,600

6

32,041

8

36,100

10

51,984

12

91,809

6

0 8

6,889

5

2 7

1 6

5 6

3,969 9

2 5

1,225 4

9 4

2,809 1

0 3

y2

9 1,432 4

9

190

1,710 1

10

228

2,280 0

11

303

3,333 1

12

476

5,712

14

226,576

16

275,625

19

283,024

1,

1,065,20 4

4 13

525

6,825 9

14

532

7,448 6

105

3,066

91

31,7

015

Linear Regression table for the first 14 years of the company b=

n (∑xy) - (∑x) (∑y) n (∑x2) - (∑x) 2 = 14 (31,791) – (105)(3,066) 14 (1,015) – (105) 2 = 445,074 – 321,930 14,210 – 11,025 = 123,144/3,185 = 38.66

a=y–bx = 219 – 38.66 (7.5) = 70.98

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Financial Management Financial Forecasting Sales (Year 15) = P70.98M + (38.66M x 15) = P70.98M + P579.9M = P 650.88 M  The regression technique is a better predictor of long-term trends. The regression model calculates one growth (or decline) rate using all past data.  Growth trend techniques are more suited for short-term projections.

Correlation Forecasting 1. Ratio Technique – assumes a constant relationship between two variables. The relationship must be established from past experience and management policy. ABC Company forecasts sales next year at P 540M. The company wants to control inventory at 15% of sales. Forecast Inventory = Planned Ratio x Forecast Sales = 0.15 X P540M = P81M 2. Regression Analysis Establishes the relationship between actual levels of inventory and sales. ABC company wants to estimate the regression equation that relates inventory to sales based on its performance and to forecast inventory given the sales forecast of P540M. x

Y

53

14

xy

x2 74

2 35

52 5

63

22

32,04

5,51

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84 1

1

0

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19,60

4,47

29

1,29 6

0

5 190

17,42

4,06

25

1,52 1

4

0 179

16,12

4,75

29

36 1

9

2 140

6,88

4,95

36

48 4

9

3 132

3,96

1,57

39

22 5

9

7 127

1,22

1,38

19

19 6

5

6 83

2,80 9

15

y2

62 5

36,10 0

84 1

7

Financial Management Financial Forecasting 228

44

10,03 2

303

57

17,27 1

476

80

38,08

51,98 6

91,80 9 226,576

9

0 525

71

37,27

87

567

6,40

275,625

5,04 1

46,28

283,024

4 3,066

3,24 0

5 532

1,93

4

176,922

7,56 9

1,065,204

30,585

Computation: b = n (∑xy) - (∑x) (∑y) n (∑x2) - (∑x) 2 = 14 (176,922) – (3,066)(567) 14 (1,065,204) – (3,066) 2 = 2,476,908 – 1,738,422 14,912,856 – 9,400,356 = 738,486/14,912,856 = 0.134 a=y–bx = 40.5 – 0.134 (219) = 11.15 R2 = 0.92 Inventory

= = = =

a + b x sales P11.15M + (0.134 x P 540M) P11.15M + P 72.36M P 83.51M

 Regression analysis provides sound forecasts only if future operations expected to remain similar to those in the past.  Suppose a company has undergone major changes in its line of businesses. Then, its past data are not a valid basis for deriving correlation.  In that case, the regression method is not relevant, and the analyst would be better off with ratio and subjective methods.

FORECAST FINANCIAL STATEMENTS 1. Cash flow forecast – a summary of planned cash receipts and disbursements of a company. It predicts the future liquidity position of the company. Is valuable planning tool for managing cash collections, investment residual cash, meeting operating expense and repaying debts.

2. Forecast Balance Sheet – shows the planned levels of assets and financing of a company. It shows a company’s future asset position and solvency.

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Financial Management Financial Forecasting This facilitates the task of finding sources of funds. It also provides standards for future performance.

3. Forecast Income Statement – shows the expected future profit performance of a company and its projects. It is the basis for controlling the costs of operations and for achieving the sales targets. PREPARING FORECAST FINANCIAL STATEMENTS FORECAST INCOME STATEMENT Sales Forecast – Management prepares a sales forecast using either subjective, trend or statistical correlation methods. The other officer reviews the result then management initiates the preparation of an income statement forecast. Cost of Goods – management estimates cost of goods and other requirements and past cost levels of these items. Here they must forecast the future prices of these inputs. sales.

Expenses - analyst must derive a relationship between operating expenses and

Other income and Expense – Analyst must forecast the net income, interest expenses, tax expense to complete the income statement.

Example: 

     

XYZ Company, a shoe manufacturer and retailer, is conducting its financial planning for the next year, 19x1. Sales for the current year, 19x0, are at P100,000 (all figures in thousand pesos). Management expects sales to be 20% higher in 19x1. All goods are purchased from wholesalers. XYZ Co. adds a markup of 40% on cost. Depreciation, included in the cost of goods sold, amounts to P8,000 for the year. The company pays salesmen on commission basis. For next year, 19x1, management will increase the commission rate to 5% of sales. Fixed operating expenses are expected to remain at the same levels as in 19x0, or at 8% of sales. Interest expense for 19x1 is 10% of the beginning balance of its short-term bank loan of P36,000. The company has other income of P 2,000. XYZ COMPANY FORECAST INCOME STATEMENT, 19X1 (in thousand pesos) Actual Forecast Forecasting Method Used 19x0 19x1

Net Sales Cost of Goods Sold Gross Profit

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0

100,00 71,42 9 28,57

120,00 0 85,71 4 34,28

8/06/2010

Expected growth rate in 19x1 Ratio of CGS to Sales Mark-up of 40% on cost

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Financial Management Financial Forecasting 1 Operating Expenses: Sales Commissions

Income before Tax

4,00 0 7,00 0 8,00 0 9,57 1 2,00 0 6,30 0 5,271

Provision for Tax

1,84

Fixed Variable Income from operations Other income Interest Expense

NET INCOME

5

6

6 0

3,426

6,00 0 7,00 0 9,60 0 11,68 6 2,00 0 3,60 0 10,08

New commission rate for 19x1 Same as 19x0 At 8% of sales

Same as 19x0 Current interest cost of short-term debt

3,53 35% on income tax

6,556

FORECAST BALANCE SHEET Balance Sheets are forecast in relation to  Activity factors like sales and cost of goods  Forecast changes in policies  Planned fixed assets expansion Activities in Forecasting Balance Sheets  



Forecast balance of all assets except cash Forecast balance of all liabilities and equities except bank loan Determine the “plug” figure in a forecast balance sheet.

PLUG Figure  A forecast cash surplus if the company’s total liabilities and capital exceed total assets

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Financial Management Financial Forecasting  A forecast short-term bank loan if the company’s total assets including an assumed minimum cash balance, exceed total liabilities and capital

ASSETS •

Cash – equal to the ending balance of a cash flow forecast. It is assumed at the minimum balance.

•

Accounts Receivable – considers the forecast sales level, credit policy and expected bad debts. Example: If accounts receivable were 8.33% of sales corresponding to a 30day collection period: Forecast A/R = 8.33% of forecast sales = 30 days x forecast sales/360

•

Inventory – uses the past relationship between costs of goods sold and inventory level, and considers the desired stock level in the future. Forecast Inventory = Days’ Inventory x Forecast Purchases/360

 Estimates of net fixed assets are made by adding the amount of planned additional

capital expenditures and deducting the planned disposition of fixed assets and depreciation to the previous balance of this account.

 Other minor items remain at the previous year’s level.

LIABILITES •

Accounts Payable – relate past balances of this account and purchases and company payment policies Forecast A/P = (Credit Period/360) x Purchases for the year

•

Income Tax Payable – corresponds to the taxes due for the following year.

•

Long-term debt – relies on the forecasts of future financing.

•

Accruals and other liabilities – rely on prior years’ patterns.

•

Short-term bank loan – the PLUG or balancing figure. If assets exceed liabilities without the loan: Bank Loan = Total Assets – Liabilities (except bank loan) + Stockholders’

Equity

CAPITAL •

Capital – takes into account the beginning balance of capital plus planned new stock issues for the next period.

•

Revaluation capital - any other capital accounts

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Financial Management Financial Forecasting •

Retained Earnings – increase due to forecast net income and decrease due to future dividends

Example:

• • • • • • •

XYZ Company wants to prepare a forecast balance sheet to determine whether it should request for more bank loan. Management plans to maintain the present cash balance of P5(all figures in millions). It intends to control inventory to 60 days of stocks and hold customer accounts at 30 days. Investments and prepaid accounts will be maintained at the previous balances. A major expansion in several stores will increase net fixed assets to P56 from the previous balance of P46. Depreciation for the year amounted to P8. Suppliers have just tightened their credit terms from 60 to 45 days due to unusually large export orders. No capital stock issues are being considered, nor is there any appraisal of properties contemplated in the future. Dividends of P3 will be paid in the following year.

Assets Cash & temporary investments Accounts Receivable Merchandise Inventory

XYZ COMPANY FORECAST BALANCE SHEET, 19X1 (in thousand pesos) Actual Forecast Forecasting Method Used 19x0 19x1 5,000 5,000 Same as 19x0 8,000 11,161

10,000 14,286

Prepayments Investments Fixed Assets

3,000 7,500 46,000

3,000 7,500 56,000

Total Assets

80,661

95,786

Liabilities & Stockholders' Equity Accounts Payable 11,000

10,714

Notes Payable Income Tax Payable

36,000 2,161

PLUG 3,530

Total Liabilities

49,161

60,730

Capital Stock

12,000

12,000

Other capital accounts Retained Earnings

7,000 12,500

7,000 12,500

Total Stockholders' Equity

31,500

31,500

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Turnover of 12 times sales Turnover of 60 days' cost of sales No change over 19x0 No change over 19x0 Plant expansion for 19x1, net of depreciation

Supplier credit reduced to 45 days Balancing amount 19x1 income tax payable

No new capital stock issue in 19x1 19x0 balance plus net income net of dividends

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Financial Management Financial Forecasting Total Liabilities & SHE

80,661

92,230

PERCENTAGE OF SALES METHOD  Useful for external analysts who do not have access to management’s plans.  Assets are proportionate to sales under the principle of turnover or capital intensity. Asset Turnover = Sales Assets Capital Intensity = Assets Sales  Under this principle, every asset that supports sales should likewise increase by a reasonably stable, if not constant, proportion. Exceptions are assets that are not directly related to the business of a company, for example, investments, other assets and intangibles.

XYZ COMPANY FORECAST BALANCE SHEET, 19X1 (in thousand pesos) Actual Percent of 19x0 Sales Assets Cash & temporary investments Accounts Receivable Merchandise Inventory Prepayments Investments Fixed Assets

Total Assets

Liabilities & Stockholders' Equity Accounts Payable Notes Payable Income Tax Payable

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5,0 00 8,0 00 11,1 61 3,0 00 7,5 00 46,0 00

0. 05 0. 08 0. 11 0. 03

0. 46

80, 661

11,0 00 36,0 00 2,1 61

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Forecast 19x1

9,6 00 9,6 00 13,2 00 3,6 00 7,5 00 55,2 00 98, 700

0. 11 PLUG 0. 02

13,2 00 48,0 44 2,4 00

13

Financial Management Financial Forecasting Total Liabilities

49, 161

63, 644

Capital Stock

12,0 00 7,0 00 12,5 00

12,0 00 7,0 00 16,0 56

Total Stockholders' Equity

31, 500

35, 056

Total Liabilities & SHE

80, 661

98, 700

Other capital accounts Retained Earnings

CASH FORECAST Cash Receipts a) b) c) d) e)

Cash sales Collections of accounts receivables Proceeds of new loans Proceeds from sales of capital stock Proceeds from sale of fixed assets or investments

Cash Disbursements a) b) c) d) e) f) 

Payments of accounts payable Cash purchases Loan amortization Payment of other liabilities Capital expenditure and other acquisitions Dividends

Cash Receipts from Sales: = Beginning Balance of A/R + Sales on account – Ending balance of A/R  Payment of Purchases: = Beginning Balance of A/P + Purchases on account – Ending balance of A/P XYZ COMPANY CASH FLOW FORECAST, 19X1 (in thousand pesos) Souces of Information Cash balance, December 31, 5,000 Previous year's balance sheet 19x0 Cash inflow from sales 118,000 Total sales and other income, net of increase in accounts Cash inflow from other 2,000 income

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Financial Management Financial Forecasting Total operating cash inflows

125,000

Cash outflow from purchases

81,125

Cash expenses Payment of taxes

22,600 2,161

Total operating cash outflows Net Operating Cash Flows

105,886 19,114

Cash Flow from Investing Activities Acquisition of new fixed 18,000 assets Total Investing Cash Flows 18,000 Cash Flow from Financing Activities Dividends Paid (3,000) Interest Paid (3,600) Additional Bank Loan 10,486 Total Financing Cash Flows 3,886 Cash Balance, December 31, 19x1

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Cost of goods net of depreciation plus increase in accounts payable and inventory Total fixed and variable expenses Operating balance + tax due - closing balance

Increase in fixed assets + depreciation

Net income - change in retained earnings From income statement Increase in bank loans

5,000

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Financial Management Financial Forecasting PROBLEM: PROFORMA BALANCE SHEET WITH FINANCING

CHOICE OF

The balance sheet of Havalari, Inc. as of December 31, 19x1 is shown below (figures in thousand pesos): Cash Accounts Receivable Inventory Total current assets Net fixed assets Total assets

500

300 650 400 1,350

Accounts Payable Accrued Expenses Bank Loan Total current liabilities

300 50 150

4,200 5,550

Long-term debt Common Stock

1,000 3,000

Retained Earnings Total Equities

1,050 5,550

Sales during 19x1 were P8million. Havalari expected sales to increase to P12million in 19x2. Existing agreements with its long-term creditors required the company to maintain a longterm debt to equity ratio of 0.25. Havalari expected to maintain its net profit margin of 5% in 19x2. The company paid 30% of its net income as dividends. Flor Havalari, president of the company, knew that the company had to increase its inventories and customer credit and to expand its cheese-making plant to meet the large increase in sales for 19x2. She believed that these should increase in the same proportion as sales. Havalari did not want to issue in new common stocks in 19x2.

Required: a.) Prepare a forecast balance sheet for 19x2 using the percentage-of-sales method. b.) Evaluate the financial position of Havalari, Inc., as of December 31, 19x1 compared to the previous year. What risk does the company face in 19x2 assuming that it achieves its sales target?

Answers: a. Prepare a forecast balance sheet Projected Net Income = Expected Sales X Expected Net Profit = P12,000 x 0.05 = P 600 Projected Returned Earnings = Net Income x 30% = P 600 x 0.30 = P 180 Retained Earnings, 19x2 = Beginning Retained Earnings + Net Income – Retained Earnings = P 1,050 + P600 – P180 = P 1,470 Long-Term Debt, 19x2 = Equity x Long-term debt-to-equity ratio = P 4,470 x 0.25 = P 1,117.50

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Financial Management Financial Forecasting

Bank Loan (PLUG) = Total Assets – (Liab. (except bank loan) + Stockholders’ Equity) = P 8,325 – (P 1,642.5 + P 4,470) = P 2,212.50 Percentage of Sales Method Calculations to determine percentage Cash = Cash / Sales = 300 / 8,000 = 3.75 % Accounts Receivable = Accounts Receivable / Sales = 650 / 8,000 = 8.12% Inventory = Inventory / Sales = 400 / 8,000 = 5% Net Fixed Assets = Net Fixed Assets / Sales = 4,200 / 8,000 = 52.50% Accounts Payable = Accounts Payable / Sales = 300 / 8,000 = 3.75% Accrued Expense = Accrued Expense / Sales = 50 / 8,000 = .625% Calculation to determine forecast amount Cash = Cash % ( Sales Forecast) = 3.75 % (12,000) = P450 Accounts Receivable = Accounts Receivable % ( Sales Forecast) = 8.12% (12,000) = P975 Inventory = Inventory % ( Sales Forecast) = 5% (12,000) = P600 Net Fixed Assets = Net Fixed Assets % ( Sales Forecast) = 52.50% (12,000) = P6,300 Accounts Payable = Accounts Payable % ( Sales Forecast) = 3.75% (12,000) = P450 Accrued Expense = Accrued Expense % ( Sales Forecast) = .625% (12,000) = P75

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Financial Management Financial Forecasting HAVALARI, INC. FORECAST BALANCE SHEET AS OF DECEMBER 31, 19X2 (in thousand pesos) Actual Percent 19x0 of Sales Assets Cash Accounts Receivable Inventory

Total current assets

Net Fixed Assets

Total Assets

Liabilities & Stockholders' Equity Accounts Payable Accrued expenses Bank Loan Total current liabilities Long-term debt Total Liabilities Capital Stock Retained Earnings

Total Liabilities & SHE

300. 00 650. 00 400. 00

3.75% 8.125% 5.00%

1,35 0.00 4,200. 00

5,55 0.00

Evaluation of Financial Performance Actual 19x0 Profitability Ratios: Net Profit Margin 5%

450. 00 975. 00 600. 00 2,025 .00

52.50%

5,55 0.00

300. 00 50. 00 150. 00 50 0.00 1,000. 00 1,50 0.00 3,000. 00 1,050. 00

Forecast 19x1

6,300. 00 8,325 .00

3.75% 0.625%

450. 00 75. 00 2,212. 50 2,737 .50 1,117. 50 3,855 .00 3,000. 00 1,470. 00 8,32 5.00

b.

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Forecast 19x1 5%

18

Financial Management Financial Forecasting * The company will have a net profit margin of 5% in two years. 600, Return on equity (ROE) Inventory /

400,000

000

Retained Earning

4,050,000 4,470,000 9.88% 13.42% * The company has the capacity to generate returns since there is a 35.83% ROE Return on assets (ROA)

600, 000 2,025, 000 29.63%

400,000

Inventory / Current Assets

1,350,000 29.63% * The company has a stable return on assets.

Turnover Ratios: 8,000,00 0 1,350,00 Sales / Current Assets 0 6 times 8,000,00 Fixed Assets Turnover 0 4,200,00 Sales /Fixed Assets 0 2 times * The company will decrease its fixed assets turnover by half

12,000, 000 2,025, 000 6 times 12,000, 000 6,300, 000 1 time

Total Assets Turnover

Accounts Receivable Turnover Sales / Account Receivables

12,000, 000 975,000 12 times

8,000,000 650,000 12 times

Days' Receivables 30 * The company has a good and stable collection terms on its receivables. Liquidity Ratios: Current Ratio Current Assets / Current Liabilities

Quick Ratio Assets/ Current Liability

30

1,350,000

2,025,000

500,000 2.7

2,737,500 0.74 1,425,

000 500,000 1.90

950,

000 2,737,500 0.52

* The company has a low liquidity ration which means they may have a hard time paying their debts Leverage Ratios:

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Financial Management Financial Forecasting 3,855, 1,500,000 000 1,350,000 2,025,000 1.11 1.90 * The company may exceed the company’s debt-to-asset ratio by 1 for the two years based on the forecast which means that debts exceed the company's resources 3,855, Debt-to-equity ratio 1,500,000 000 Total Liability/Retained Earnings 4,050,000 4,470,000 Debt-to-asset ratio Total Liabilities/Total Assets

0.37 0.86 * The debt-to-asset ratio will increase by more than 100% and this might create great financial exposure for the creditors.

CASE ANALYSIS: CHAMPION CATTLE FARMS, INC. (A) “This is a critical time for my cattle farm. I need a bank loan to run my cattle-fattening farm to full capacity.“ explain Albert Lim to the branch manager of the Development Bank if Batangas(DBB), Gloria Santos. Today, March 6, 1998, Lim, Owner-manager of Champion Cattle Farms Inc. requested an P8 million loan from DBB. “I promise to look closely into your request” replied Santos. “But may I request for a detailed estimate of the amount and timing of your financing requirements? Send in your latest financial statements as well” Lim left the bank’s office and began to prepare a letter to DBB explaining Champion Cattle Farms financial situation. COMPANY BACKGROUND Champion Cattle Farms, Inc. was set up in South Batangas Province by Albert Lim in January 1998. Its operation involved buying yearling cattle (about 12-18 months old) from the cattle raising areas of Masbate Province and intensively farmfeeding them for about six month until they weighed about 100-120 kilograms. The cattle were then sold to traders who in turn sold them to meat dealers in Manila. Terms of purchase and sale of live cattle were on cash. The farm was initially financed by an inheritance of Lim amounting to P 8.5 million. When he received this inheritance, he immediately purchased the farm and built facilities for a feed-lot operation on a site in Calatagan, South Batangas. He chose the location because of good access to the port for easy transport of cattle, the availability to feed supply, and good workers to tend and feed lot. The few pieces of equipment needed for his operation, mainly feeding and cleaning equipment, were acquired using Lim’s capital. When the first batch of yearlings were purchased in January, Lim thought about spreading out his feed-lot operation into monthly batches of about 200-300 head of cattle. His farm and equipment could handle 1,8000 head of fully-grown cattle. By June, an inventory of 1,200 to 1,800 head of cattle in six weight category would be achieved. While Lim could determine that range of inventory to be kept at

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Financial Management Financial Forecasting all times (which he called “regular” level of inventory), the exact number would depend on the availability of yearlings from Masbate ranchers, purchase price, and his own financial resources. In the past, there were lean months of supply when there were failures in foaling, bad weather and other problems. In other periods, there were surplus supply of yearlings when small cattle ranchers wanted to raise cash for town fiestas or for financial support of their families or children attending school in Manila Champion Farms could only obtain credit for a minor portion of its feeds and veterinary supply. Many suppliers of feeds in the Batangas area were small business operators and traders supplied by companies based in Manila. Initial purchases of yearling is January and February were made using available cash. By the end of February, Lim realized that he did not have sufficient cash to purchase stocks in six monthly batches. At this point, he decided to request for bank financing at the DBB. Lim personally knew its branch manager. DBB was known for its lending program to cattle farmers in Batangas. Cattle Feed Lot Operations Champion Farms purchased yearlings at an average price of P3,000 per head “on-the-hoof” and these were delivered to the farm. The average weight of these yearlings was 40kg. Estimated costs over a six-month feeding period for each head of cattle are shown in Table 1. Feed Operation Table1. Cost Per Head of Culture Item Cost(in Pesos) Purchased Feeds 3,740 Wages of Farm Labor 320 Veterinary Supplies 105 Farm Overhead Costs 35 Total P 4,200 A fully Frown cattle weighed an average of 100kg. and could be sold “on-thehoof” for P80kg in nearby cattle market auctions. Marketing cost were not incurred. Lim kept other overhead cost under control. Expenses which were not associated with feed-lot operation were limited to the salary of a farm manager. Ely Tio, who kept cost records and facilities cost like insurance, office supplies, etc. He estimated monthly overhead expenses at P10,000. Tio purchased feeds on cash-on-delivery basis except from a dealer of a Manila company which sold on 21-day credit term. Champion Farms had a credit limit from this dealer of P150,000. Lim noted that his cash balance reached dangerously low levels in late February. He requested Tio to prepare a balance sheet as of February 28 as shown in Exhibit 1. CHAMPION CATTLE FARMS, INC.(A) Balance Sheet As of February 28, 1998 (in Thousand Pesos) Assets Cash Feeds inventory Cattle stock inventory Equipment

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456 134 2,950 460

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Financial Management Financial Forecasting Land and building Total Assets

4,550 8,550

Liabilities and stockholder’s equity Accounts payable Common Stock Total Liability and Stockholder’s Equity

150 8,400 8,550

On the first week of March, lim made his usual trip to Masbate and came back with 90 heads of yearling cattle. Immediately, he went to Santos of DBB to explain Champion Farms Problem “ We need the bank load because we shall sell our January batch only in July. Please give us a one-year loan of at least P8 Million.”, he said as he presented his cost estimates and balance sheet to Santos,

GUIDE QUESTIONS: a. Why does Champion Farms need financing? What possible sources of funds can be accessed by Champion Farms? b. Prepare a cash budget. Estimate the amount and timing of financing needed by Champion Farms. c. What funding source is most suitable for the financial need and condition of Champion Farms? If DBB grants a bank loan, what are Champion Farms sources of repayment of the loan? Will these sources be sufficient to pay off the loan at the end of the year?

I.

Time Context

March 6, 1998

II.

Viewpoint

Albert Lim, owner-manager of Champion Cattle Farms

III.

Statement of the Problem

Albert Lim does not have enough funds to maximize his farm capacity due to lack of funding.

IV. • • •

Objectives

To be able to maximize the resources and profitability of the farm To have enough cash to attain his goal of having 1,200 – 1,800 heads of cattle in hid farm. To have other source of funds that will fit his needs.

V. Areas of Consideration Divine Grace Kuan

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Financial Management Financial Forecasting A. Internal Environment 1. Strengths •

The farm and equipment could handle 1,800 head of fully-grown cattle. Lim kept overhead cost under control. Expenses which were not associated with feed-lot operations were limited to the salary of a farm manager, The estimated monthly overhead expenses at P 10,000. • Terms of sale of live cattle were on cash. • They have control over funding and other direct costs because they have their loyal small feed suppliers and Tio’s many years of experience in livestock farms. 2. Weakness

•

•

He can only sell the cattle after six months until they weighed 100-120 kilograms. • The farm was initially financed by Albert Lim’s inheritance, He had no other source of financial support. • Gross Margin Percentage: 10% (P800/P8,000) Selling Price 8,000 Cost of Cattle 7,200 Gross Profit 800 B. External Environment

1. Opportunities • Development Bank of Batangas (DBB) was known for its lending program to cattle farmers in Batangas. • Lim personally knew DBB’s branch manager, Gloria Santos. • Champion Farms had a credit limit from the dealer of feeds in Manila of P 150,000. The credit term is 21 days. • A fully grown cattle weighed an average of 100kg and could be sold on-thehoof for P80.kilo in the nearby cattle market auction, here market cost is not incurred • The Batangas location has good access to the port for easy transport of cattle, feed supply and food workers to tend the feed lot. 2. Threats • There were lean months of supply when there were failures in foaling, bad weather and other problems. • Champion Farms could only obtain credit for minor portion of its feeds and veterinary supply. • Terms of purchase of yearling cattle were on cash basis. • There were surplus supply of yearlings when small cattle ranchers wanted to raise cash for town fiestas or for financial support of their families or children attending schools in Manila. • The number of yearlings will depend on the yearlings of Masbate ranchers, purchase prices.

VI. Alternative Courses of Actions Divine Grace Kuan

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Financial Management Financial Forecasting ACA 1: Unsecured bank loan of up to three years Advantages:

Can be easily given/approved less risky since there is no other assets at stake Can solve their funding problems immediately

Disadvantages: May result to additional cost for the company due to its higher interest

ACA 2: Secured bank loan payable in nine years using the existing inventories, equipment and real estate as collateral Advantages:

Can be easily given/approved He can request for a higher amount of loan Payment terms can be more flexible favorable interest and payment terms.

Disadvantages: May be more risky when there is default on payment. ACA 3: Offer stocks to possible shareholders. Advantages:

There is a possibility to have bigger investment

Disadvantages: It will be a difficult to find investors who is willing to invest in a starting business.

VII. Recommendation ACA 2: Secured bank loan payable in nine years using the existing inventories, equipment and real estate as collateral

VIII. Detailed Plan of Actions NATURE OF ACTIVITY Submit all the needed requirements to DBB Review submitted documents Meet with Albert Lim and discuss terms Approve requested loan Open and maintain regular account in DBB Assess monthly Cash and ensure that the monthly

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PERSON RESPONSIBLE Albert Lim

DURATION Immediately

Gloria Santos Gloria Santos Gloria Santos Albert Lim

2 weeks 1 day 1 day 1 day

Albert Lim

Regularly

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