Running head: A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.

A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.

California Baptist University

BUS539-BE Financial Management

Dr. John Obradovich

June 21, 2020

Abstract
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
New World Chemicals (NWC) is a producer of specialized chemicals. Sue Wilson, the new

financial manager, and her assistant must prepare a formal forecast for the next year. This paper

analyzes the process of preparing a financial forecast by evaluating the operating capacity, sales,

accounts payable and accrued liabilities, the profit margin and dividend payout. All these factors

will be used to calculate company’s financials for the following year and compared to their

effect on the Additional Funds Needed (AFN) equation’s predictions.

Introduction
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
New World Chemicals (NWC) is a producer of specialized chemicals. Sue Wilson, the

new financial manager, and her assistant must prepare a formal forecast for 2019 using the

numbers from 2018 as a baseline. This paper assumes that the company was operating at full

capacity in 2018. As sales increase, assets, payables and accruals also increase proportionally.

The 2018 profit margin of 2.52% along with a 30% payout will be maintained in 2019. Most

notable, sales are expected to increase by $500 million in 2019. This is a 25% change in sales

(%∆S = 25%).

The process of preparing a financial forecast includes evaluating the operating capacity,

sales, accounts payable and accrued liabilities, the profit margin and dividend payout. All these

factors will be used to calculate company’s financials for 2019. Analyzing the Additional Funds

Needed (AFN) equation will help predict the company’s financial requirements for 2019.

Tables A, B, and C below, were used to formulate the following responses to Ms. Wilson’s

questions, in preparing the 2019 financial forecast.

Responses to Ms. Wilson Questions

a. The AFN equation would predict that the company’s financial requirement for the

coming year are $180.9 millions dollars. This is calculated by solving the AFN equation as

follows:

AFN = (A0*/S0) ∆S – (L0*/S0) ∆S – (M(S1)(1 – Payout)

= ($1,000/$2,000)($500) – ($100/$2,000)($500)

– 0.0252($2,500)(0.7)

= $180.9 million
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
b. By incorporating NWC’s accounts receivable’s DSO to 34 days, increasing NWC’s net

fixed assets to $700 million, decrease its inventories and increases its inventory turnover rate ten

times, will result in adjustments to the firm’s assets. However, these changes will no effect on

the firm’s equity section and liabilities of its balance sheet or its income statement.

c. NWC’s ratios when compared to the average firm in its industry shows that for 2018 it

was performing under than the industry’s averages, as Table C shows. For basic earning power

is was at half at 10% compared to the industry average of 20%. It was only at 63% of the 4.00

industry average of profit margin. Its return on equity was less than half, at 7.20 compared to

15.60. Its DSO was 11.8 days higher than that of 32 for the industry average. The company’s

DSO along with its inventory turnover, total assets turnover, and payout ratio were performing

close or at the industry average. Other categories that were below the industry average were

fixed assets turnover, liabilities/assets, times interest earned and current ratio.

For 2019, the company’s financial position is expected to improve during the coming

year in bring down its DSO’s from 43.8 days to 34 days, only 2 more days than the industry

average. Its inventory turnover will also improve from 8.33x in 2018 to 10.00x in 2019, only

1.00 more than the industry average. The company’s basic earning power, total assets turnover

and payout ratio are expected to stay the same in 2019 as in 2018. While profit margin, return

on equity, and times interest earned will also see an improvement in 2019 but not near the

industry average. Fixed assets turnover and current ratio are expected to decline in 2019 from

their 2018 levels. Overall the company is headed in the right direction but needs more time to

improve and meet or exceed the industry averages.

d. In order to calculate NWC’s cash flow for 2019, it is first necessary to solve what the net

investment in capital is for 2019 is forecasted at. The equation to solve is:
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
Capital2019 = Net Operating Working Capital (NOWC) + Net Fixed Assets (NetFA)

= $625 - ($315 - $190) + $625

= $625 - $125 + $625

= $1,125

Capital2018 = $900

Net Investment in Capital = $1,125-$900

= $225

It is important to note that all cash is being used for operations. Knowing that the net

investment in Capital is $225 million, now the free cash flow (FCF) that is expected to be

generated in 2019 can be determined. The equal to solve for FCF is:

FCF = EBIT (1-T) – Net Investment in Capital

= $125(0.6) - $225

= $75 - $225

= -$150

This FCF differs from the FCF forecasted by NWC’s initial “business as usual” forecast

by -$150 million. Therefore, NWC’s forecasted financials shows that the company’s financial

position will not improve in 2019.

e. If NWC’s fixed assets were only operating at 85% of capacity, sales could have

increased by $353 million, a 17.65% increase, before reaching its full capacity. This is

calculated by:

Capacity Sales = Actual Sales/% of Capacity

= $2,000/.85

= $2,353
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
If company was operating at full capacity in 2018, sales would have been $2,353

compared to $2,000 at 85% capacity. The difference being the $353 million noted above. This

$353 million represents a 17.65% increase over the $2,000 million actual sales for 2018. In

order to support the 2019 forecasted sales of $2,500, new fixed assets are required, since at full

capacity the company would only be able to handle $2,353 in sales.

The excess capacity would affect the forecasted ratios by improving turnover ratios.

Since sales wouldn’t change, but the company’s assets would be lower, therefore the turnover

ratios would improvement. Since the company would incur less new debt, it would be less in

interest and show higher profits. Also, earnings per share (EPS), return on equity (ROE),

liabilities-to-assets ratio and times interest earned (TIE) would also show improvement.

f. If the dividend payout ratio changed, a higher dividend payout ratio would increase AFN

and the company would have less retained earnings. A lower dividend payout ratio would

decrease AFN and the company would have higher retained earnings.

If the profit margin changed, a higher profit margin would decrease AFN, and the

company would have higher profits and more retained earnings. If there was a lower profit

margin, AFN would increase, and the company would have lower profits and less retained

earnings.

If the capital intensity ratio changed, a higher capital intensity ratio would increase AFN

and the company would need more assets to maintain a given level of sales. If the capital

intensity ratio would decrease, the AFN would decrease, and the company would need less

assets to maintain a given level of sales.

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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
If NWC was permitted to pay its suppliers after 60 days instead of 30 days, this would

decrease AFN. The company’s trade creditor would supply it with more capital (i.e. L0*/S0

increases).

Conclusion

The process of preparing a financial forecast includes evaluating the operating capacity,

sales, accounts payable and accrued liabilities, the profit margin and dividend payout. All these

factors were used to calculate NWC’s financials for 2019. Analyzing the AFN equation helped

predict the company’s financial requirements for 2019. Although there are areas in which the

company will improve slightly for 2019 over the 2018 figures, it is still necessary for the

company to improve its ratios even further in the years ago to be at or better than the industry

average ratios.
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
Financial Statements and Other Data on NWC (Millions of Dollars)
Table A. Balance Sheets 2018 2019E
Cash & Equivalents $ 20 $ 25
Accounts Receivable $ 240 $ 300
Inventories $ 240 $ 300
Total Current Assets $ 500 $ 625
Net fixed Assets $ 500 $ 625
Total Assets $ 1,000 $ 1,250

Accounts Payable & Accrued Liabilities $ 100 $ 125

Notes Payable $ 100 $ 190
Total Current Liabilities $ 200 $ 315
Long-Term Debt $ 100 $ 190
Common Stock $ 500 $ 500
Retained Earnings $ 200 $ 245
Total Liabilites & Equity $ 1,000 $ 1,250

Table B. Income Statements 2018 2019E

Sales $ 2,000.00 $ 2,500.00
Variable Costs $ 1,200.00 $ 1,500.00
Fixed Costs $ 700.00 $ 875.00
Earnings Before Interest & Taxes (EBIT) $ 100.00 $ 125.00
Interest $ 16.00 $ 16.00
Earning Before Taxes (EBT) $ 84.00 $ 109.00
Taxes (40%) $ 33.60 $ 43.60
Net Income $ 50.40 $ 65.40
Dividends (30%) $ 15.12 $ 19.62
Addition To Retained Earnings $ 35.28 $ 45.78

Table C. Key Ratios NWC (2018) NWC (2019E) Industry Comment

Basic Earning Power 10.00% 10.00% 20.00% Poor
Profit Margin 2.52 2.62 4.00 Poor
Return on Equity 7.20 8.77 15.60 Poor
Days Sales Outstanding (DSO 365 Days) 43.80 days 43.80 days 32.00 days OK
Inventory Turnover 8.33X 8.33X 11.00X OK
Fixed Assets Turnover 4.00 4.00 5.00 Poor
Total Assets Turnover 2.00 2.00 2.50 OK
Total Liabilites/Assets 30.00% 40.40% 36.00% Por
Times Interest Earned 6.25X 7.81X 9.40X Poor
Current Ratio 2.50 1.99 3.00 Poor
Payout Ratio 30.00% 30.00% 30.00% OK
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A FINANCIAL FORECAST FOR NEW WORLD CHEMICALS INC.
References

Brigham, E.F., & Houston, J.F. (2018). Fundamentals of financial management. Mason, OH.

Cengage Learning.