Reading 42: Financial Statement Analysis: Applications L 2010, net, technology, company, border

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LOS b: Prepare a basic projection of a company’s future net income and cash flow.

Sterling Company is a start-up technology firm that has been experiencing super-normal growth over the past two years. Selected common-size financial information follows:

	2007 Actual % of Sales	2008 Forecast % of Sales
Sales	100%	100%
Cost of goods sold	60%	55%
Selling and administration expenses	25%	20%
Depreciation expense	10%	10%
Net income	5%	15%
Non-cash operating working capital a	20%	25%
a Non-cash operating working capital = Receivables + Inventory – Payables

For the year ended 2007, Sterling reported sales of $20 million. Sterling expects that sales will increase 50% in 2008. Ignoring income taxes, what is Sterling’s forecast operating cash flow for the year ended 2008, and is this forecast likely to be as reliable as a forecast for a large, well diversified, firm operating in mature industries?

Operating cash flow

Reliable forecast

A) $4.0 million No

B) $4.5 million No

C) $4.0 million Yes

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2008 sales are expected to be $30 million ($20 million 2007 sales × 1.5) and 2008 net income is expected to be $4.5 million ($30 million 2008 sales × 15%). 2007 non-cash operating working capital was $4 million ($20 million 2007 sales × 20%) and 2008 non-cash operating working capital is expected to be $7.5 million ($30 million 2008 sales × 25%). 2008 operating cash flow is expected to be $4 million ($4.5 million 2008 net income + $3 million 2008 depreciation – $3.5 million increase in non-cash operating working capital). Forecasts for small firms, start-ups, or firms operating in volatile industries may be less reliable than a forecast for a large, well diversified, firm operating in mature industries.

 

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For 2007, Morris Company had 73 days of inventory on hand. Morris would like to decrease its days of inventory on hand to 50. Morris’ cost of goods sold for 2007 was $100 million. Morris expects cost of goods sold to be $124.1 million in 2008. Assuming a 365 day year, compute the impact on Morris’ operating cash flow of the change in average inventory for 2008.

A) $6.3 million source of cash.

B) $3.0 million use of cash.

C) $3.0 million source of cash.

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2007 inventory turnover was 5 (365 / 73 days in inventory). Given inventory turnover and COGS, 2007 average inventory was $20 million ($100 million COGS / 5 inventory turnover). 2008 inventory turnover is expected to be 7.3 (365 / 50 days in inventory). Given expected inventory turnover, 2008 average inventory is $17 million ($124.1 million COGS / 7.3 expected inventory turnover). To achieve 50 days of inventory on hand, average inventory must decline $3 million ($20 million 2007 average inventory – $17 million 2008 expected inventory). A decrease in inventory is a source of cash.

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Would projecting future financial performance based on past trends provide a reliable basis for valuation of the following firms?

Firm #1 – A rapidly growing company that has made numerous acquisitions and divestitures.

Firm #2 – A large, well-diversified, company operating in a number of mature industries.

Firm #1

Firm #2

A) Yes No

B) No Yes

C) No No

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Using past trends to project future financial performance would be reliable for a well-diversified firm operating in a number of mature industries. The diversified firm would likely have relatively predictable earnings. Using past trends to project future financial performance would not likely be reliable for the rapidly growing firm involved in numerous acquisitions and divestitures. Such a firm would likely have high earnings volatility.

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Baetica Company reported the following selected financial statement data for the year ended December 31, 20X7:

in millions		% of Sales
For the year ended December 31, 20X7:	$500	100%
Sales
Cost of goods sold	(300)	60%
Selling and administration expenses	(125)	25%
Depreciation	(50)	10%
Net income	$25	5%
As of December 31, 20X7:
Non-cash operating working capital a	$100	20%
Cash balance	$35	N/A

^a Non-cash operating working capital = Receivables + Inventory – Payables

Baetica expects that sales will increase 20% in 20X8. In addition, Baetica expects to make fixed capital expenditures of $75 million in 20X8. Ignoring taxes, calculate Baetica’s expected cash balance, as of December 31, 2008, assuming all of the common-size percentages remain constant.

A) $40 million.

B) $80 million.

C) $30 million.

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2008 sales are expected to be $600 million ($500 million 2007 sales × 1.2) and 20X8 net income is expected to be $30 million ($600 million 20X8 sales × 5%). 2008 non-cash operating working capital is expected to be $120 million ($600 million 20X8 sales × 20%). The change in cash is expected to be –$5 million ($30 million 20X8 net income + $60 million 20X8 depreciation – $20 million increase in non-cash operating working capital – $75 million 20X8 capital expenditures). The 20X8 ending balance of cash is expected to be $30 million ($35 million beginning cash balance – $5 million decrease in cash).