Financial Statement Forecasting: The Percent of Sales Method 423percent for MicroDrive versus 11.4 percent for the industry average). Furthermore,
MicroDrive must carry more than the average amount of debt to support its excessive
assets, and the extra interest expense reduces its profit margin to 3.9 percent versus 5.0
percent for the industry. Much of the debt is short term, and this results in a current ra-
tio of 2.5 versus the 4.2 industry average. These problems will persist unless manage-
ment takes action to improve things.
After reviewing its preliminary forecast, management decided to take three steps
to improve its financial condition: (1) It decided to lay off some workers and close
certain operations. It forecasted that these steps would lower operating costs (exclud-
ing depreciation) from the current 87.2 to 86 percent of sales as shown in Column 3 of
Table 11-4. (2) By screening credit customers more closely and being more aggressive
in collecting past-due accounts, the company believes it can reduce the ratio of
accounts receivable to sales from 12.5 to 11.8 percent. (3) Finally, management thinks
it can reduce the inventory-to-sales ratio from 20.5 to 16.7 percent through the use of
tighter inventory controls.^4
These projected operational changes were then used to create a revised set of fore-
casted statements for 2003. We do not show the new financial statements, but the re-
vised ratios are shown in the third column of Table 11-4. You can see the details in the
chapter spreadsheet model, Ch 11 Tool Kit.xls.Here are the highlights of the revised
forecast:- The reduction in operating costs improved the 2003 NOPAT ,or net operating
profit after taxes ,by $23.8 million. Even more impressive ,the improvements in the
receivables policy and in inventory management reduced receivables and inventories
by $148.5 million. The net result of the increase in NOPAT and the reduction of op-
erating current assets was a very large increase in free cash flow for 2003 ,from a pre-
viously estimated $7.5 million to $179.7 million. - The profit margin improved to 4.6 percent. However, the firm’s profit margin
still lagged the industry average because its high debt ratio results in higher-than-
average interest payments. - The increase in the profit margin resulted in an increase in projected retained
earnings. More importantly, by tightening inventory controls and reducing the
days sales outstanding, MicroDrive projected a reduction in inventories and receiv-
ables. Taken together, these actions resulted in a negativeAFN of $57.5 million,
which means that MicroDrive would actually generate $57.5 million more from in-
ternal operations and its financing plan than it needs for new assets. Under its cur-
rent financial policy, MicroDrive would have $110 million in notes payable (the
amount it carried over from the previous year) and $57.5 million in short-term in-
vestments. (Note: MicroDrive’s managers considered using the $57.5 million to
pay down some of the debt but decided instead to keep it as a liquid asset, which
gives them the flexibility to quickly fund any new projects created by their R&D
department.) The net effect is a significant reduction in MicroDrive’s debt ratio, al-
though it is still above the industry average. - These actions would also raise the rate of return on assets from 5.8 to 7.2 percent,
and they would boost the return on equity from 12.5 to 15.4 percent, which is even
higher than the industry average.
Although MicroDrive’s managers believed that the revised forecast is achievable,
they were not sure of this. Accordingly, they wanted to know how variations in sales
would affect the forecast. Therefore, they ran a spreadsheet model using several(^4) We will discuss receivables and inventory management in detail in Chapter 16.