Assume that you have recently been hired as Simmons's assistant and that your first major task is to help her develop the forecast. She has asked you to begin by answering the following set of questions.

a. Describe three ways that pro forma statements are used in financial planning. 

b. Explain the steps in financial forecasting.

c. Assume (1) that OCL was operating at full capacity in 2015 with respect to all assets, (2) that all assets must grow proportionally with sales, (3) that accounts payable and accruals will also grow in proportion to sales, and (4) that the 2015 profit margin and dividend payout will be maintained. Under these conditions, what will the company's financial requirements be for the coming year? Use the AFN equation to answer this question.

d. How would changes in the following items affect the AFN? (1) Sales increase; (2) the dividend payout ratio increases; (3) the profit margin increases; (4) the capital intensity ratio increases; (5) OCL begins paying its suppliers sooner. (Consider each item separately and hold all other things constant.)

e. Briefly explain how to forecast financial statements using the forecast financial statements approach. Be sure to explain how to forecast interest expenses.

f. Now estimate the 2016 financial requirements using the forecast financial statements approach. Assume (1) that each type of asset, as well as payables, accruals, and fixed and variable costs, will be the same percentage of sales in 2016 as in 2015; (2) that the payout ratio is held constant at 40%; (3) that external funds needed are financed 50% by notes payable and 50% by long-term debt (no new common stock will be issued); (4) that all debt carries an interest rate of 10%; and (5) that interest expenses should be based on the balance of debt at the beginning of the year.

g. Why does the forecast financial statements approach produce somewhat different AFN than the equation approach? Which method provides the more accurate forecast?

h. Calculate OCL's forecasted ratios, and compare them with the company's 2015 ratios and with the industry averages. Calculate OCL's forecast free cash flow and return on invested capital (ROIC).

i. Based on comparisons between OCL's days sales outstanding (DSO) and inventory turnover ratios with the industry average figures, does it appear that OCL is operating efficiently with respect to its inventory and accounts receivable? Suppose OCL were able to bring these ratios into line with the industry averages and reduce its SGA/Sales ratio to 33%. What effect would this have on its AFN and its financial ratios? What effect would this have on free cash flow and ROIC?

j. Suppose you now learn that OCL's 2015 receivables and inventories were in line with required levels, given the firm's credit and inventory policies, but that excess capacity existed with regard to fixed assets. Specifically, fixed assets were operated at only 75%
of capacity. 

(1) What level of sales could have existed in 2015 with the available fixed assets?

(2) How would the existence of excess capacity in fixed assets affect the additional funds needed during 2016?

k. The relationship between sales and the various types of assets is important in financial forecasting. The forecasted financial statements approach, under the assumption that each asset item grows at the same rate as sales, leads to an AFN forecast that is reasonably close to the forecast using the AFN equation. Explain how each of the following factors would affect the accuracy of financial forecasts based on the AFN equation: (1) economies of scale in the use of assets and (2) lumpy assets.

Betty Simmons, the new financial manager of Okanagan Chemicals Ltd. (OCL), a B.C. producer of specialized chemicals for use in fruit orchards, must prepare a financial forecast for 2016. OCL's 2015 sales were $2 billion, and the marketing department is forecasting a 25% increase for 2016. Simmons thinks the company was operating at full capacity in 2015, but she is not sure about this. The 2015 financial statements, plus some other data, are shown below. 

A. 2015 Balance Sheet (Millions of Dollars)

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Percent Percent of Sales of Sales $ 20 Accounts payable and accruals Notes payable Cash and securities $ 100 1% 5% Accounts receivable 240 12% 100 Inventories Total current liabilities 240 12% 200 Total current assets Long-term debt 500 100 Net fixed assets 500 25% Common stock 500 Retained earnings 200 Total liabilities and equity Total assets $1,000 $1,000 B. 2015 Income Statement (Millions of Dollars) Percent of Sales Sales $2,000.00 Cost of goods sold (COGS) Sales, general, and administrative costs (SGA) 1,200.00 60% 700.00 35% 100.00 Earnings before interest and taxes 10.00 Interest Earnings before taxes 90.00 Taxes (40%) 36.00 54.00 Net income Dividends (40%) 21.60 Addition to retained earnings 32.40 C. Key Ratios OCL Industry Profit margin 2.70% 4.00% Return on equity 7.71% 15.60% Days sales outstanding (365 days) Inventory turnover 43.80 days 32.00 days 5.00x 6.60X Fixed assets turnover 4.00x 5.00X Debt/assets 20.00% 24.00% Times interest earned 10.00X 9.40X Current ratio 2.50X 3.00X Return on invested capital (NOPAT/Operating capital) 6.67% 14.00%