Financial Analysis and Planning
George Cluesson, Chief Financial Officer for Pocono Home Electronics, received a phone call in early January, 2000, from Pops Olsen, a commercial loan officer at Cluesson's bank, Captain’s Bank of Scranton, PA. Mr. Olsen explained that the bank was asking all of its major customers to estimate their loan needs for the next five years. He explained that this forecast was necessary for bank planning purposes and for insuring that the bank's best customers' loan needs would be satisfied. Specifically, he asked Mr. Cluesson to prepare quarterly estimates of bank
borrowing requirements for 2000 and annual projections thereafter. Since Mr. Cluesson
earlier had decided to extend Pocono's financial planning period beyond the current three-year projection horizon, he agreed to meet with Mr. Olsen the following week to discuss the firm's longer-range loan needs. Pocono's management considers the bank line to be the firm's residual financing source.
Currently, Pocono has a $150,000 credit line 信用额度 with Pioneer National. Terms of the
credit line require that Pocono maintain a current ratio of at least 1.50 and a total debt-to-equity ratio of less than 0.60. In addition, the bank preferred that Pocono "clean up" the credit line for at least one quarter each year, i.e., have a credit line balance of zero for at least three months. This latter requirement was an attempt to insure that the credit line was not being used for long-term funding needs. If any of the covenants契约are violated, Pioneer has the right, but not the
obligation, to "call in" the outstanding loan balance and terminate the credit line agreement if corrections are not made within one quarter.
Pocono's preliminary (unaudited) December 31, 1999 balance sheet is attached as Exhibit I.
The ending cash balance of $70,000 is the minimum level of cash Mr. Cluesson feels Pocono
should maintain. Cash surpluses over this amount are used to reduce any existing bank loan balances. If no bank loan is outstanding, cash balances over $70,000 are invested in short-term treasury securities. Pocono's current borrowing rate is prime plus two percent, or 10-3/4 percent per year. Mr. Cluesson intends to use this rate throughout the five-year planning horizon. For projection purposes, Mr. Cluesson will use the closing quarterly loan balances for 2000 and the
closing annual balances for subsequent years as a proxy for the actual loan balance during the 1preceding period. Given other estimation errors involved in forecasting, this procedure had proven adequate in past projections.
Mr. Cluesson obtained a quarterly sales forecast for 2000 from his financial analysis and planning group. See Exhibit II. This forecast was derived from feedback from sales representatives based upon discussions with customers about their inventory levels and production plans. These data supplemented aggregate industry sales level projections from an industry trade source to which Pocono subscribed. All of these data were analyzed using a
1st In other words the closing balance for the 1 quarter of 2000 will be used as an approximation for the loan balance for that
quarter. Realistically, interest would be computed and accrued daily based on daily balances for such an account.
forecasting model designed by Mr. Cluesson's staff. The projections based upon this model had proven accurate for one-year forecasts. Beyond one year, however, variations in projected-from-actual sales ranged from plus-to-minus 15 percent. As can be observed in Exhibit II, some seasonality exists in Pocono's quarterly sales levels. This same relative seasonal variation is expected to reoccur in subsequent years. Beyond 2000, the most likely scenario is for real sales
growth (increases in volume sold) to be eight percent per year through 2004.
Pocono's credit personnel estimate that 30 percent of each quarter's sales will be collected during the quarter of the sale with the remainder collected during the following quarter. This collection pattern has been remarkably stable in the past. Pocono's credit terms were set to match the competition.
Pocono purchases raw materials in advance of projected needs using a simple ordering algorithm. Specifically, every quarter they purchase materials necessary to satisfy the estimated sales need for the upcoming quarter. Raw materials average 45 percent of sales. Therefore, Pocono acquires raw materials in a given quarter equal to 45 percent of the coming quarter's estimated sales. Pocono typically pays for one-half of these purchases in the quarter ordered and the remaining balance the following quarter. In addition, direct labor expenses run at 10 percent of sales and are paid as realized. Cost of goods sold consists solely of raw materials and direct labor. No overhead items are included in cost of goods sold. Production runs typically are completed in one or two days. Finished goods are shipped shortly after completion. Accordingly, no significant work-in-progress or finished goods inventory exists.
Sales personnel are paid on a straight commission basis which averages 15 percent of sales.
Administrative expenses are expected to run at $18,000 per quarter for 2000 and are forecast to grow at $2,000 per quarter per year, i.e., $20,000 per quarter in 2001, etc. Commissions and administrative expenses are paid as incurred.
Depreciation currently amounted to $10,000 per quarter and will continue at this level on existing equipment over the planning horizon. New equipment costing $250,000 is scheduled to come "on line" April 1, 2000. This equipment will provide the firm much needed capacity increases. In early January 2003, another addition of $300,000 to capacity is planned to meet demand requirements. Both of these capitalized expenditures will be depreciated quarterly to an estimated zero salvage value over 10 years via straight line depreciation. For each of these additions, the equipment manufacturer will be paid at $25,000 per quarter beginning the quarter
installation. No interest will be paid on these loans as an inducement to Pocono to deal following
with this manufacturer.
Over the next five years, approximately $5,000 will be expended per quarter to keep existing equipment (as of January 1, 2000) operational. This maintenance expense will increase to $7,000 per quarter after the new equipment comes on line in 2000 and to $9,000 per quarter once the 2003 expansion is in place. These maintenance outlays will be expensed and are paid as incurred.
Miscellaneous cash expenses are estimated to run about $5,000 per quarter and are paid as they arise. Mr. Cluesson estimates that these expenses will increase by $1,000 per quarter per year.
The mortgage loan is being amortized at $9,000 per quarter plus interest on the unpaid
balance. This loan carried a fixed rate of nine percent. Other assets and miscellaneous accruals seldom vary by significant amounts.
Federal tax payments are made quarterly in March, June, September, and December based upon estimated taxable income for that quarter. Penalties are attached to underestimates, which must be paid in-full the following January. The December payment is adjusted downward for any over-payments. Pocono is taxed at 35 percent.
In 1999 Pocono paid a $100,000 dividend in equal quarterly installments of $25,000. Mr. Cluesson plans to use a 10 percent per year increase in annual dividends for forecasting purposes, i.e., in 2000 dividends would be $27,500, also payable quarterly.
As he reviews the task before him, Mr. Cluesson has hired you to perform the following tasks:
1) Prepare quarterly pro forma income statements and balance sheets for 2000. He wants you to construct the
balance sheet assuming that the bank is the residual financing source using the "plug" approach.
2) Prepare annual pro forma income statements and balance sheets for 2001 through 2004, to complete the five-2year planning horizon that Mr. Olsen requested.
3) Perform ratio analysis on the pro forma statements to evaluate compliance with the bank covenants. If out of
compliance, Mr. Cluesson wants you to make specific recommendations on how to correct the deficiency. He
specifies that you must justify any recommendations that you may make!
4) As an aside, Mr. Cluesson wonders how you would build expected inflation into your analysis. Again, the
expected real annual growth rate is eight percent. He wants you to just briefly discuss the procedure that you
would follow without doing the actual analysis.
5) Finally, use the pro forma financial statements to forecast the free cash flow that is expected for the firm over the
2 Given the difficulty in estimating sales levels beyond 2000, Mr. Cluesson is also interested in the bank loan and ratio variations
if sales vary +/- 15 percent from the "base case" forecast, or the historical sales forecast error margin. However, given your time
constraints, he is not asking you to perform these analyses.
Pro Forma Balance Sheet
December 31, 1999
Cash $ 70,000 Materials Payable $ 74,250
Accounts Receivable 194,000 Taxes Payable 0 Raw Material Inventory 148,500 Miscellaneous Accruals 10,000 Treasury Securities 0 Bank Loan 31,000 Net Plant & Equipment 504,000 Mortgage Loan (Current) 36,000 Other Assets 285,000 Mortgage Loan (Long-Term) 208,000
Common Stock ($1 par) 75,000
Retained Earnings 767,250
2000 SALES FORECAST
of Annual Sales
First Quarter $330,000 22%
Second Quarter 480,000 32%
Third Quarter 400,000 26%
Forth Quarter 300,000 20%
TOTAL $1,510,000 100%