Fundamentals of Financial Management (Concise 6th Edition)

524 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management

This is $49 million less than the $627 million forecast used in the projected! nancial

statements. Note also that although our graph shows a linear relationship, we could

have used a nonlinear regression model had we believed that such a relationship

was more appropriate. Also, we could have used a multiple regression equation,

which would have brought other factors that affect inventories into the picture.

SEL

F^ TEST Examine the following statement: Using regression to predict items such

as inventories is better than basing such predictions on last year’s

Inventory/Sales ratio because regression helps smooth out the effects of

random fluctuations. Do you agree or disagree? Explain.

16-6 ANALYZING THE EFFECTS OF CHANGING RATIOS

When we forecasted the 2009! nancial statements, we assumed that the 2009 oper-

ating ratios would move closer to the industry averages and we based asset levels

on those assumptions. However, it is often preferable to base forecasted assets on

a regression analysis. Also, it is often useful to examine speci! c asset ratios to get

a better idea of the effects on the! rm’s! nancial position given various changes to

these ratios. In this section, we explore the effects of modifying receivable and

inventory ratios.

16-6a Modifying Accounts Receivable

In Table 16-2, Allied’s DSO is projected to be 40.15 days versus an industry average

36 days. Its sales per day are projected to be $3,300/365 = $9.04 million. If Allied

could operate at the industry-average DSO, its receivables would be reduced by

Receivables at 40.15 days! 40.15($9.04)! $363.0 million

Receivables at 36.00 days! 36.00($9.04)! $325.5 million

Receivables reduction! Additional 2009 FCF! $ 37.5 million

Thus, receivables could be reduced by another $37.5 million if Allied’s credit man-

ager could achieve the industry-average DSO. That would mean $37.5 million of

additional free cash " ow to the! rm in 2009, plus additional FCF going forward as

Allied grows. The CFO could use this example in a discussion with Allied’s credit

manager.

16-6b Modifying Inventories

Inventories can be analyzed in a similar manner. First, note that Allied’s forecasted

inventory turnover is 5.26 times versus 10.9 times for the industry. Moreover, in

Table 16-2 Allied’s forecasted 2009 inventory is $627 million versus $3,300 million

of sales. Given this information, we can! nd Allied’s inventories if Allied is able to

achieve the industry-average inventory turnover:

Currently forecasted inventory turnover! $3,300/5.26! $627 million

Inventory at industry-average turnover! $3,300/10.9! $303 million

Inventory reduction! Additional 2009 FCF! $324 million