CORPORATE FINANCIAL MANAGEMENT

Expert Systems, Inc.

Financial Analysis and Forecasting Case
Svetlana Svetlichnaya Anzella Afroze Xiaoqing Zhang Brandon Schuldt 10/25/2013

1. AFN = (28.08/56.16)([56.16(1.2)]-56.16) [(.061)[56.16(1.2)](1-[.3/.86])]=2.77

([1.63-.8]/56.16)([56.16(1.2)]-56.16)

2. The AFN that was calculated using the percentage-of-sales method was 2.86 for 1996 (See Appendix I). There is a difference between the AFNs calculated because the percentages that were used to determine the needed components were different. The formula used just the 20% increase in sales as part of the calculation. The percentage-sales-method estimated the percent of sales for every item on the income statement and balance sheet. 3. a. The Proportionality assumption says that Total Assets; as well as each Asset account will increase proportionally with Expert Systems sales. As can be seen in the following table and charts A, B and C, the proportionality assumption has been true over the previous 5 years of the companys operation (See Appendix II). Chart A shows the growth of each account in dollar amounts and, which shows each account increasing. Than Chart B and C show the growth percentage of Sales, Total Assets, Inventory and Fixed Assets and all have very clearly experienced the same rate of growth. b. Under the conditions given containing the new Total Asset figures, it can be easily seen in Table D and Chart D below that the proportionality assumption does not hold true at all (See Appendix II). The Total assets do not grow proportionally with sale. It also seems that the Total assets do not have any sort of consistent relationship with the companys sales Growth. c. In order to get an idea of which of the two situations presented in part (b), please refer to charts F, G and H for Microsoft, Oracle and CA, Inc. respectively (See Appendix II). The charts show the relationship between each companys Sales Growth compared to the growth of their Total assets (TA Growth). Each company seems to have a different relationship between the two. For Microsoft, the two seem to follow a similar pattern; however, their growth rates are quite different. CA, Inc., a smaller software company, has a quite different relationship between its sales and assets. Most notably, in 2010 and 2011, both seem consistent with each other, but then in 2012, their sales growth grew from 2% to 9% while its asset went down from 5% to less than zero% growth. In chart G, Oracles fixed asset growth decreased consistently over the previous 5 years, while its sales increased significantly from 2010 to 2011 and then decreased significantly in 2012 and 2013. Since all four companies are likely to have lumpy assets, they should both experience periods of significant asset growth with more slowly growing sales. When companies like these reach the capacity of their production operations, they will need to invest significantly into new assets in order to maintain their sales growth. For this reason, the situations shown in part (b); as well as Charts F-H, seem to be more likely than the percentage-of-sales method.

This has significant implications for use of the percentage-of-sales method as it applies to the financial planning of Expert Systems, Inc. While historically it has been true that the companys asset accounts have grown proportionally with its sales, as its production draws closer to full capacity, it will have to invest significantly in new assets, especially its fixed assets and inventory in order to realize further sales growth. In coming years, Expert Systems, Incs assets are likely to grow much faster than its sales. 4. Because the vice-president feels that the fixed assets were being operated at 80% capacity instead of 100%, the projected external capital requirements should be recalculated. First, the full capacity sales have to be calculated taking the actual sales from 1995 and dividing them by the percentage of capacity, 80% (56.16/.8). The calculation suggests that if the fixed assets had been used to full capacity, 1996 sales could have been as high as $70.2 million. The this amount is used to estimate the target fixed asset to sales ratio by taking the 1995 fixed asset amount and dividing it by the full capacity sales (18.24/70.2) resulting in 25.98%. Lastly the required level of fixed assets is calculated by multiplying the above ratio with the projected 1996 sales (25.98%*67.39); resulting in a required fixed asset level of $17.52 million. The calculated amount is lower than the 1995 fixed asset amount meaning that no new assets are needed. 5. With 80% capacity there are excess funds generated. The excess funds can be used to increase dividends, for growth opportunities, or pay down debt. Our suggestion would be to use it for growth opportunities because they are already increasing their dividends by $0.10 and they want to continue using their specific capital structure. 6. a. If ESI was operating at 90% capacity in 1995, then the actual sale in 1995 would have to be divided by .9, equaling $62.4 million sales. Then this amount is used to estimate the target fixed asset to sales ratio by taking the 1995 fixed asset amount and dividing it by the full capacity sales (18.24/62.4) resulting in 29.23%. Finally, the required level of fixed assets calculated by multiplying the above ratio with the projected 1996 sales (29.23%*67.39); resulting in a required fixed asset level of $19.70 million. The fixed assets would need to increase by 1.46 million in 1996. b. In many industries, technological considerations show that adding fixed assets in large, discrete units play an important role if a firm wants to be more competitive. These assets are referred to as lumpy assets. When lumpy assets occur, the firms capital intensity ratio will change. At that point where the assets must be increased in a large amount, the capital intensity ratio will be high, so required external financing will be high. Lumpy assets have a major effect on the fixed assets/sales ratio at different sales levels as well as on financial statements. When a firm is operating at full capacity a small increase in sales would require a large increase in fixed assets, therefore a small increase in projected sales would result in a very large financial outlay.
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Having accurate estimates in the percentage of sales method is extremely important to future success. If assets are not lumpy which means they can be purchased in smaller quantities over a long period of time, which is not capital intensive in the short term. Knowing the capacity utilization in this case is not as crucial as in the case with lumpy assets. 7. When a company pays higher dividends, it increases the dividend payout ratio, which in turn reduces the funds available internally and increases additional funds needed. A higher profit margin means that there are more funds available internally and there is no need for additional funds needed. Higher capital intensity ratio such as ROA increase asset requirements therefore increasing additional funds needed. 8. Financial planning is both important and highly useful for allocating resources as well as anticipating the firms future financing needs. One type of financial planning method is the percent-of-sales method. This method is used for developing pro forma financial statements to create reasonable projections. The percentage of sales method shows how a financial statement account item is related to historically sales figures by calculating a percentage. Then the percentage is used to project the value of those financial statement account items based on future sales estimates. For example, after examining and analyzing historical financial statement data, an analyst determines that inventory levels are typically at 10% of sales, and the sales forecast for the coming year is for $100,000 dollars in sales, then, according to the percent-of-sales method of forecasting, the analyst can estimate inventory of approximately $10,000, or 10% of the estimated sales figure. There are three steps in the percent-of-sales forecasting process. The first step is to analyze historical financial statement data to determine which items are correlated with the sales figures and which are not. Only the items which are correlated with sales figures can accurately be predicted or forecast using the percent-of-sales method. Items that have no concrete relation to sales figures must be estimated using a different technique. The next step is to forecast sales for the fiscal period in question. Because all the projections in the percent-of-sales method are dependent on relationship the between financial statement items and sales figures, it is very important to get an accurate sales forecasts. The third step in this method is to forecast the values of certain appropriate financial statement items using the sales forecast from the previous step in combination with the percentages calculated between the financial statement item and the sales figure. 9. There are a few other types of methods that could be used besides the percentage-of-sales method, which include the additional funds needed formula, quantitative forecast, time series forecast and the casual forecast. If there were a need to incorporate these methods in the financial forecasts that are available already it would take several more weeks to complete the financial
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forecasts. The information that would be needed for these forecasts methods includes historical financial data. 10. In the case, it is stated that John, the companys CFO, assumes that the companys capital structure is made up of 25% long-term debt and 75% common equity, which is measured at market value. For planning purposes, it seems like measuring common equity by book value would be much easier to use since market value can be difficult to predict and is always changing. The companys balance sheet for 1995 shows the companys Long-term debt to Total permanent Capital, which is Long-term Debt plus Common Stock and Retained Earnings to be 29%. It is difficult to gauge whether or not this figure indicates an unbalanced capital structure, since this number uses the book value of the equity. As a result, looking at the companys historical figures for this ratio is helpful. The companys Long-term debt to total permanent capital percentage has been 14.6%, 22%, 29%, 30.76% and 29% for 1991, 92, 93, 94 and 95 respectively. The current percentage of 29% has been the capital structure for the company over the last 3 years. Also, the companys current Debt-to-assets ratio of 33.2% is lower than its rate of 36% of the previous two years. The figures indicate that the company is using about the appropriate level of debt and in order to maintain the same level of risk, they should not modify the mix of debt and equity at this time. We also believe that the company should use this long-term debt to total permanent capital percentage as opposed to the long-term debt to the market value of common stock percentage. It presents a more reliable prediction of the companys capital structure; as well as a better way to predict its Additional Fund Needed in the next year. 11. If there is an increase in debt in the capital structure the rate will be higher. Lending companies would consider them more risky and would require a higher rate. When interest increases, stockholders do not like that and EPS decreases which in turn lowers the stock price. The stockholders would get nervous when company takes on more debt because if it goes bankrupt, they would be the last ones to get paid. If the amount of debt is decrease, interest rate decreases as well. EPS would increase and stock price would increase because there is less financial risk and that would attract more investors. 12. Years Current ratio Profit Margin ROE 1995 1996 6.04 6.06 6.13% 6.20% EPS

18.33% $0.86 17.91% $1.05

The sales growth rate, the payout ratio, the capital structure, and the profit margin change do affect these above ratios. For example, if the sales growth rate fell while interest expense
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increased sharply, the net income available to common stockholders would undoubtedly decline, so do the profit margin and EPS. Senior executives at the retreat would be interested in this type of data because it may tell them how different business actions would affect the companys operation and the investors profits. This data can also make it easier to compare the company to its peers or industry averages. It is possible to provide the senior executives with the data on a real time basis. If we can monitor and track the changes of whole inputs timely, then we can rectify our financial forecasting and decide whether and how extra capital is needed and raised.

Appendix I TABLE 3 Historical 1995 and Projected Financial Statements (Millions of Dollars) Balance Sheet: 1996 Projected 1995 Cash and securities Accounts receivable Inventories Current assets Net fixed assets Total assets Accounts payable Notes payable Accrued wages & taxes Current liabilities Long-term debt Total liabilities Common stock Retained earnings Total common equity Total liabilities & equity Corrections: Should be 0.57 Should be 1.96 Should be 8.40 4 Should be 31.04 Additional funds needed (AFN) Cumulative AFN $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1.64 4.00 4.20 9.84 18.24 28.08 0.47 0.80 0.36 1.63 7.68 9.31 13.04 5.73 18.77 28.08 Percentage of sales 1st Pass 2.92% 7.12% 8% NA 32.48% NA 0.84% 1.42% 0.64% NA NA. NA NA. NA. NA. NA. $ 1.97 $ 4.80 $ 5.04 $ 11.81 $ 21.89 $ 33.70 $ 0.57 $ 0.96 $ 0.43 $ 1.952 $ 7.68 $ 9.64 $ 13.04 $ 8.36 $ 21.40 $ 31.034 2nd Pass $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1.97 4.80 5.04 11.81 21.89 33.70 0.57 0.96 0.43 1.952 8.35 10.305 15.04 8.16 23.20 33.506 3rd Pass $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1.97 4.80 5.04 11.81 21.89 33.70 0.56 0.96 0.43 1.96 8.39 10.357 15.18 8.15 23.33 33.688 4th Pass $ 1.97 $ 4.80 $ 5.04 $ 11.81 $ 21.89 $ 33.70 $ $ $ $ $ $ $ $ $ $ 0.57 0.96 0.43 1.96 8.40 10.36 15.19 8.15 23.34 33.70

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Should be 10.31 Should be 33.51 7 Should be 10.36 8 Should be 33.69 $2.66 2.66 $ 0.19 $2.85 $ 0.01 $2.86 $ $2.86

TABLE 3 (Continued) Income Statements: 1996 Projected 1995 $ 56.16 $ 49.60 $ 6.56 $ 0.83 $ 5.73 $ 2.29 $ 3.44 $ 1.20 $ 2.24 Percentage of sales 1st Pass 100.00% $ 67.39 88.32% $ 59.52 11.68% $ 7.87 N.A. $ 0.83 N.A. $ 7.04 N.A. $ 2.82 N.A. $ 4.22 N.A. $ 1.60 N.A. $ 2.62 80% 90%

Sales Cost of goods sold EB1T Interest expense Taxable income Taxes Net income Dividends Additions to R.E. Corrections: * Should be 2.78 ** Should be 4.18 *** Should be 2.43 Additional Funds Needed (AFN) Assumed additional LT debt Assumed additional stock Additional interest (ST and LT) Additional dividends Selected Ratios: Current Profit margin ROE EPS

2st Pass 3rd Pass 4th Pass 1995 1995 $ 67.39 $ 67.39 $ 67.39 $70.20 $67.20 $ 59.52 $ 59.52 $ 59.52 $ 7.87 $ 7.87 $ 7.87 $ 0.91 $ 0.91 $ 0.91 $ 6.96 $ 6.96 $ 6.96 $ 2.79* $ 2.78 $ 2.78 ** $ 4.17 $ 4.18 $ 4.18 $ 1.75 $ 1.76 $ 1.76 *** $ 2.42 $ 2.42 $ 2.42

1st Pass $2.66 $0.67 $2.00 $0.08 $0.15

2nd Pass $0.19 $0.05 $0.14 $0.00 $0.01

3rd Pass $0.01 $0.00 $0.01 $0.00 $0.00

4th Pass $0.00 $0.00 $0.00 $0.00 $0.00

Totals 2.86 0.72 2.15 0.08 0.16

1995 6.04 6.10% 15.70% $0.86

1st Pass 6.04 6.30% 17.90% $0.97

1996 Projected 2nd Pass 3rd Pass 6.04 6.04 6.20% 6.20% 17.90% 17.90% $0.95 $0.95

4th Pass 6.03 6.2 17.90% $1.05

Appendix II TABLE FOR CHARTS A, B, C ES, Inc. Sales $ 24.00 $ 28.80 $ 36.00 $ 43.20 $ 56.16 ES, Inc. Sales Growth 20% 25% 20% 30% ES, Inc. Total Assets $12.00 $14.40 $18.00 $21.60 $28.08 ES Inc. Assets Growth 20% 25% 20% 30% ES, Inc. Inventories $1.80 $2.16 $2.70 $3.24 $4.20 ES, Inc. Inv Growth 20% 25% 20% 30% ES, Inc. Fixed Assets $ 7.80 $ 9.36 $ 11.70 $ 14.04 $ 18.24 ES, Inc. FA Growth 20% 25% 20% 30%

Year 1991 1992 1993 1994 1995

Chart A
$60.00 $50.00 $40.00 $30.00 $20.00 $10.00 $1991 1992 1993 1994 1995 1996 ES, Inc. Sales ES, Inc. Total Assets ES, Inc. Inventories ES, Inc. Fixed Assets

Chart B
35%

30%

25%

ES, Inc. Inv Growth ES, Inc. FA Growth

20%

15% 1991.5 1992 1992.5 1993 1993.5 1994 1994.5 1995 1995.5

Chart C
35% 30% ES, Inc. Sales Growth 25% 20% 15% 1991 ES Inc. Assets Growth

1992

1993

1994

1995

TABLE FOR CHART D Year 1991 1992 1993 1994 1995 $ $ $ $ $ Sales 24.00 28.80 36.00 43.20 56.16 Sales Growth 20% 25% 20% 30% $ $ $ $ $ Total Assets 22.80 24.27 27.20 30.56 31.25 TA Growth 6% 12% 12% 2%

Chart D
40% 30% 20% 10% 0% 1992 1993 1994 1995 Sales Growth TA Growth

TABLE FOR CHART F Microsoft 2009 2010 2011 2012 2013 58.4 62.5 69.9 73.7 77.8 Microsoft Sales Growth Microsoft TA Growth 77.9 7% 86.1 11% 12% 108.7 26% 5% 121.3 12% 6% 142.4 17%

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Chart F
30%

20% Microsoft Sales Growth 10% MicrosoftTA Growth

0% 2009

2010

2011

2012

2013

TABLE FOR CHART G Oracle Oracle Sales Growth 2009 2010 2011 2012 2013 Chart G
40% 30% 20% 10% 0% 2009 Oracle Sales Growth Oracle TA Growth

Oracle TA Growth 47.4 61.5 73.5 78.3 81.8 30% 20% 7% 4%

23.2 26.8 35.6 37.1 37.2

16% 33% 4% 0%

2010

2011

2012

2013

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TABLE FOR CHART H CA, Inc. CA, Inc Sale Growth 2009 2010 2011 2012 2013 4.2 4.3 4.4 4.8 4.6 2% 2% 9% -4% 11.2 11.8 12.4 12 11.8 CA, Inc TA Growth 5% 5% -3% -2%

Chart H
10% 5% CA, Inc Sale Growth 0% -5% 2009 CA, Inc TA Growth

2010

2011

2012

2013

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