SELF TEST (Financial Forecasting)

SELF-TEST QUESTIONS
Definitional
1. If various asset categories increase, _____________ and/or ________ must also increase.
2. Typically, certain liabilities will rise _________________ with sales. These include accounts
_________ and __________.
3. _______, ___________ stock, ________ stock, and __________ earnings are examples of
accounts that do not increase proportionately with higher levels of sales.
4. As the dividend ________ _______ is increased, the amount of earnings available to finance
new assets is ___________.
5. Retained earnings depend not only on next years sales level and dividend payout ratio but
also on the ________ ________.
6. The amount of assets that are tied directly to sales, A*/S0, is often called the _________
___________ _______.
7. A capital intensive industry will require large amounts of __________ capital to finance
increased growth.
8. The _________ ____ _______ method involves projecting the asset requirements for the
coming period, then projecting the liabilities and equity that will be generated under normal
operations, and subtracting the projected liabilities and capital from the required assets to
estimate the ____________ _______ ________.
9. The assumption of constant percentage of sales ratios may not be accurate when assets must be
added in discrete amounts, called _______ assets, or when ___________ of scale are considered.
10. Two methods can be used to estimate external funding requirements: the _________ ____
_______ and the _________ methods.
11. One complexity that arises in financial forecasting relates to ___________ ___________,
which are the effects on the income statement and balance sheet of actions taken to finance asset
increases.
12. Forecasting is a(n) ___________ process, both in the way financial statements are generated
and the way the financial plan is developed.
13. The faster a firms growth rate in sales, the _________ its need for additional financing.

14. If economies of scale, lumpy assets, or excess capacity exist, the capital intensity ratio will
not be a constant, and the percent of sales method should not be used. Other techniques such as
linear ______________ and ________ __________ adjustment should be used.
15. ______ __________ _______ is defined as actual sales divided by the percentage of capacity
at which fixed assets were operated to achieve those sales.
16. A(n) _________ ___________ is, in many ways, a condensed version of the firms strategic
plan.
17. Strategic plans usually begin with a statement of the overall ___________ _________.
18. The ___________ ____________ set forth specific goals for management to attain.
19. The most commonly used technique for forecasting future balance sheets and income
statements is the _________ ____ _______ approach.
Conceptual
20. An increase in a firms inventory will call for additional financing unless the increase is offset
by an equal or larger decrease in some other asset account.
a. True

b. False

21. If the capital intensity ratio of a firm actually decreases as sales increase, use of the formula
method will typically overstate the amount of additional funds required, other things held
constant.
a. True

b. False

22. If the dividend payout ratio is 100 percent, all ratios are held constant, and the firm is
operating at full capacity, then any increase in sales will require additional financing.
a. True

b. False

23. One of the first steps in forecasting financial statements with the percent of sales approach is
to identify those asset and liability accounts that increase spontaneously with retained earnings.
a. True

b. False

24. Which of the following would reduce the additional funds required if all other things are held
constant?
a. An increase in the dividend payout ratio.
b. A decrease in the profit margin.
c. An increase in the capital intensity ratio.
d. An increase in the expected sales growth rate.
e. A decrease in the firms tax rate.

25. Which of the following statements is most correct?

a. Suppose economies of scale exist in a firms use of assets. Under this condition, the firm
should use the regression method of forecasting asset requirements rather than assuming items
are proportional to sales.
b. If a firm must acquire assets in lumpy units, it can avoid errors in forecasts of its need for
funds by using the linear regression method of forecasting asset requirements because all the
points will lie on the regression line.
c. If economies of scale in the use of assets exist, then the AFN formula rather than the
forecasted financial statements method using the percent of sales approach should be used to
forecast additional funds requirements.
d. Notes payable to banks are included in the AFN formula, along with a projection of retained
earnings.
e. One problem with the AFN formula is that it does not take account of the firms dividend
policy.
SELF-TEST PROBLEMS
1. United Products Inc. has the following balance sheet:
Current assets

$ 5,000

Net fixed assets

5,000

Total assets

$10,000

Accounts payable
Notes payable
Long-term debt
Common equity
Total liabilities and equity

$ 1,000
1,000
4,000
4,000
$10,000

Business has been slow; therefore, fixed assets are vastly underutilized. Management believes it
can double sales next year with the introduction of a new product. No new fixed assets will be
required, and management expects that there will be no earnings retained next year. What is next
years additional financing requirement?
a. $0

b. $4,000

c. $6,000

d. $13,000

e. $19,000

2. The balance sheet for last year for American Pulp and Paper is shown below (in millions of
dollars):
Cash
$3.0
Accounts receivable 3.0
Inventory
5.0
Current assets
$11.0

Accounts payable
Notes payable

$2.0
1.5

Current liabilities

$3.5

Fixed assets

3.0

Total assets

$14.0

Long-term debt
Common equity
Total liabilities and equity

3.0
7.5
$14.0

For last year, sales were $60 million. This year, management believes that sales will increase by
20 percent to a total of $72 million. The profit margin is expected to be 5 percent, and the
dividend payout ratio is targeted at 40 percent. No excess capacity exists. What is the additional
financing requirement (in millions) for this year using the formula method?
a. $0.36

b. $0.24

c. $0

d. -$0.24

e. -$0.36

3. Refer to Self-Test Problem 2. How much can sales grow above the last years level of $60
million without requiring any additional funds?
a. 12.28%

b. 14.63%

c. 15.75%

d. 17.65%

e. 18.14%

4. Smith Machines Inc. has a net income this year of $500 on sales of $2,000 and is operating its
fixed assets at full capacity. Management expects sales to increase by 25 percent next year and is
forecasting a dividend payout ratio of 30 percent. The profit margin is not expected to change.
If spontaneous liabilities are $500 this year and no excess funds are expected next year, what are
Smiths total assets this year?
a. $1,000

b. $1,500

c. $2,250

d. $3,000

e. $3,500

(The following data apply to the next three Self-Test Problems.)

Crossley Products Companys last years financial statements are shown below:
Crossley Products Company
Balance Sheet as of December 31, last year
(Thousands of Dollars)
Cash
Receivables
Inventory
Total current assets

$600
3,600
4,200
$8,400

Net Fixed assets

Total assets

7,200
$15,600

Accounts payable
Notes payable
New line of credit
Accruals
Total current liabilities
Long-term bonds
Common stock
Retained earnings
Total liabilities and equity

Crossley Products Company

Income Statement for December 31, last year
(Thousands of Dollars)
Sales
Operating costs
Earnings
Interest
Earnings before taxes

$12,000
10,261
$1,739
239
$1,500

$2,400
1,157
0
840
$4,397
1,667
667
8,869
$15,600

Taxes (40%)
Net income

600
$900

Dividends (60%)
$540
Addition to retained earnings $360
5. Assume that last year the company was operating at full capacity with regard to all items
except fixed assets; fixed assets last year were utilized to only 75 percent of capacity. By what
percentage could this years sales increase over last years sales without the need for an increase
in fixed assets?
a. 33%

b. 25%

c. 20%

d. 44%

e. 50%

6. Now suppose this year sales increase by 25 percent over last year sales. Assume that Crossley
cannot sell any fixed assets. Use the forecasted financial statements method to develop a pro
forma balance sheet and income statement. Assume no new notes payable, long-term debt, or
common stock will be issued and that that any required financing is borrowed as a new line of
credit on the last day of the year (because the line of credit is drawn on the last day of the year, it
will not accrue any interest expense). The interest rate on all notes payable and long-term debt is
12 percent. Base the forecasted interest expense for notes payable and long-term debt on the
average amount in the year. Cash is used for operations and earns no interest. Use a pro forma
income statement to determine the addition to retained earnings. How much additional external
capital (in thousands) will be required?
a. $825

$925

c. $750

d. $900

e. $850

7. Refer to Self-Test Problem 6. After the required financing is borrowed as a new line of credit,
what are the firms current and debt ratios?
a. 1.73; 38.84%
b. 2.02; 38.84%
c. 1.73; 44.06%

d. 1.73; 15.95%
e. 2.02; 43.64%

(The following data apply to the next two Self-Test Problems.)

Taylor Technologies Inc.s financial statements for last year are shown below:
Taylor Technologies Inc.
Balance Sheet as of December 31, last year
Cash $
Receivables
Inventory
Total current assets

90,000
180,000
360,000
$630,000

Net fixed assets

720,000

Accounts payable
Notes payable
Line of credit
Accruals
Total current liabilities
Common stock
Retained earnings

$180,000
78,000
0
90,000
$348,000
900,000
102,000

Total assets

$1,350,000

Total liabilities and equity

$1,350,000

Taylor Technologies Inc.

Income Statement for December 31, last year
Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income
Dividends (60%)
Addition to retained earnings

$1,800,000
1,639,860
$160,140
9,140
$151,000
60,400
$90,600
$54,360
$36,240

8. Suppose that this years sales increase by 10 percent over last years sales. Construct the pro
forma financial statements using the percent of sales approach. The preliminary plan does not
add any new notes payable or common stock. The interest rate on notes payable is 13 percent.
Cash is used in operations and earns no interest. Any required financing is borrowed as a new
line of credit on the last day of the year (because the line of credit is drawn on the last day of the
year, it will not accrue any interest expense). Assume the firm operated at full capacity last year.
How much additional capital will be required?
a. $72,459

b. $70,211 c. $68,157

d. $66,445

e. $63,989

9. Refer to Self-Test Problem 8. Assume now that fixed assets are only being operated at 95
percent of capacity. Construct the pro forma financial statements using the forecasted financial
statement approach. How much additional capital will be required?
a. $28,557

b. $32,400

c. $39,843

d. $45,400

e. $50,000

10. Your companys sales were $2,000 last year, and they are forecasted to rise by 50 percent
during the coming year. Here is the latest balance sheet:
Cash
Receivables
Inventory
Total current assets

$100
300
800
$1,200

Net Fixed Assets

Total assets

800
$2,000

Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and equity

$200
200
20
$420
780
400
400
$2,000

Fixed assets were used to only 80 percent of capacity last year, and year-end inventory holdings
were $100 greater than were needed to support the $2,000 of sales. The other current assets
(cash and receivables) were at their proper levels. All assets would be a constant percentage of
sales if excess capacity did not exist; that is, all assets would increase at the same rate as sales if

no excess capacity existed. The companys after-tax profit margin will be 3 percent, and its
payout ratio will be 80 percent. If all additional funds needed (AFN) are raised as notes payable
and financing feedbacks are ignored, what will the current ratio be at the end of the coming year?
a.2.47

b. 1.44

c. 1.21

d. 1.00

e. 1.63

11. The Bouchard Companys sales are forecasted to increase from $500 in last year to $1,000 in
this year. Here is the December 31, balance sheet for last year:
Cash
Receivables
Inventory
Total current assets

$50
100
100
$250

Net fixed assets

Total assets $

250
500

Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and equity

$25
75
25
$125
200
50
125
$500

Bouchards fixed assets were used to only 50 percent of capacity during last year, but its current
assets were at their proper levels. All assets except fixed assets should be a constant percentage
of sales, and fixed assets would also increase at the same rate if the current excess capacity did
not exist. Bouchards after-tax profit margin is forecasted to be 8 percent, and its payout ratio
will be 40 percent. What is Bouchards additional funds needed (AFN) for the coming year?
a. $102

b. $152

c. $197

d. $167

e. $183

ANSWERS TO SELF-TEST QUESTIONS

1. liabilities; equity
2. spontaneously; payable; accruals
3. Bonds; preferred; common; retained
4. payout ratio; decreased
5. profit margin
6. capital intensity ratio
7. external
8. forecasted financial statement; additional funds needed
9. lumpy; economies
10. forecasted financial statements; formula
11. financing feedbacks
12. iterative
13. greater
14. regression; excess capacity
15. Full capacity sales
16. mission statement
17. corporate purpose
18. corporate objectives
19. percent of sales

20. a. When an increase in one asset account is not offset by an equivalent decrease in another
asset account, then financing is needed to reestablish equilibrium on the balance sheet. Note,
though, that this additional financing may come from a spontaneous increase in accounts payable
or from retained earnings.
21. a. A decreasing capital intensity ratio, A*/S 0, means that fewer assets are required,
proportionately, as sales increase. Thus, the external funding requirement is overstated. Always
keep in mind that the formula method assumes that the asset / sales ratio is constant regardless of
the level of sales.
22. a. With a 100 percent payout ratio, there will be no retained earnings. When operating at full
capacity, all assets are spontaneous, but all liabilities cannot be spontaneous since a firm must
have common equity. Thus, the growth in assets cannot be matched by a growth in spontaneous
liabilities, so additional financing will be required in order to keep the financial ratios (the debt
ratio in particular) constant.
23. b. The first step is to identify those accounts, which increase spontaneously with sales.
24. e. Answers a through d would increase the additional funds required, but a decrease in the tax
rate would raise the profit margin and thus increase the amount of available retained earnings.
25. a. Statement a is correct; economies of scale cause the ratios to change over time, which
violates the assumption that items are proportional to sales. Statement b is false; the points will
not all lie on the regression line. Statement c is false; the AFN formula requires a constant
percentage of sales over time. Statement d is false; the AFN formula includes only spontaneous
liabilities, and notes payable do not spontaneously increase with sales. Statement e is false; the
AFN formula includes the dividend payout, so dividend policy is included.
SOLUTIONS TO SELF-TEST PROBLEMS
1. b. Look at next years balance sheet:
Current assets
Net fixed assets

Total assets

$10,000
5,000

$15,000

Accounts payable
Notes payable
Current liabilities
Long-Term debt
Common equity
AFN
Total liabilities and equity

$2,000
1,000
$3,000
$4,000
4,000
$11,000
4,000
$15,000

With no retained earnings next year, the common equity account remains at $4,000. Thus, the
additional financing requirement is $15,000 $11,000 = $4,000.
2. b. None of the items on the right side of the balance sheet rises spontaneously with sales
except accounts payable. Therefore,

AFN = (A*/S0)(S) (L*/S0)(S) MS1(1 d)

= ($14/$60)($12) ($2/$60)($12) (0.05)($72)(0.6)
= $2.8 $0.4 $2.16 = $0.24 million.
The firm will need $240,000 in additional funds to support the increase in sales.
3. d. Note that g = Sales growth = S/S0 and S1 = S0(1 + g). Then,
AFN = A*g L*g M[(S0)(1 + g)](1 d) = 0
$14g $2g 0.05[($60)(1 + g)](0.6) = 0
$12g [($3 + $3g)(0.60)] = 0
$12g $1.8 $1.8g = 0
$10.20g = $1.80
g = 0.1765 = 17.65%.
4. c.
0 = (A*/S0)(S) - (L*/S0)(S) - MS1(1 - d)
0 = (A*/$2,000)($500) - ($500/$2,000)($500) - ($500/$2,000)($2,500)(1 - 0.3)
0 = ($500A*/$2,000) - $125 - $437.50
0 = ($500A*/$2,000) - $562.50
$562.50 = 0.25A*
A* = $2,250.
5. a.

Therefore, sales could expand by 33 percent before Crossley Products would need to add fixed
assets.
6. e.
Crossley Products Company
Pro Forma Income Statement
December 31, this year
(Thousands of Dollars)
Last year
Sales

$12,000

Forecast
Basisa
1.25

This year
Forecast
$15,000

Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income

10,261
$1,739
239
$1,500
600
$900

Dividends (60%)
Addition to RE

$540
$360

0.8551
12% of debt

12,826
$2,174
339
$1,835
734
$1,101
$661
$440

Crossley Products Company

Pro Forma Balance Sheet
December 31, this year
(Thousands of Dollars)
Last year

Forecast
Basisa

Cash
Receivables
Inventory
Total current assets
Net fixed assets
Total assets

$600
3,600
4,200
$8,400
7,200
$15,600

0.05
0.30
0.35

Accts. payable
Notes payable
Line of credit
Accruals
Total current liab.
Mortgage bonds
Common stock
Retained earnings
Total liabilities
and equity

$2,400
1,157
0
840
$4,397
1,667
667
8,869

0.20

$15,600

0.07

440c

This year
Forecast
$750
4,500
5,250
$10,500
7,200b
$17,700
$3,000
1,157
0
1,050
$5,207
1,667
667
9,309

After LOC
$750
4,500
5,250
$10,500
7,200
$17,700

$3,000
1,157
+850 850
1,050
$6,057
1,667
667
9,309

$16,850

Explanations:
Increase in accounts payable and accruals:
Increase in notes payable, long-term debt, and common stock:
Increase in retained earnings:
Total increase in financing:
Increase in total assets:
Amount of deficit or surplus:
Line of credit:
Special dividend:

LOC

$810
$0
$440
$1,250
$2,100
$850
$850
$0

$17,700

Notes:
a

Sales are increased by 25%. Operating costs, all assets except fixed assets, accruals, and
accounts payable are divided by last years sales to determine the appropriate ratios to apply to
next years sales to calculate next years account balances.
b

From Self-Test Problem 5 we know that sales can increase by 33 percent before additions to
fixed assets are needed.
c

See income statement.

7. d.

Current ratio = CA/CL

= $10,500/$6,057
= 1.73.
Debt/Asset ratio = ($1,157 + $1,667)/$17,700
= 15.95%.

8. c. The projected balance sheet indicates that the AFN = $68,157.

Taylor Technologies Inc.
Pro Forma Income Statement
December 31, Coming Year
Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income

Last Year
$1,800,000
1,639,860
$160,140
9,140
$151,000
60,400
$90,600

Dividends (60%)
Addition to RE

$54,360
$36,240

Forecast
Basisa
1.10
0.9110
13% debt

Coming Year
Forecast
$1,980,000
1,803,846
$176,154
10,140
$66,014
66,406
$99,608
$59,765
$39,843

Taylor Technologies Inc.

Pro Forma Balance Sheet
December 31, Coming Year

Cash
Receivables
Inventory
Total current assets

Last Year
$90,000
180,000
360,000
$630,000

Forecast
Basisa
0.05
0.10
0.20

Coming Year
Forecast
$99,000
198,000
396,000
$693,000

Fixed assets
Total assets

720,000
$1,350,000

0.40

Accts. payable
Notes payable
Line of credit
Accruals
Total current liabilities
Common stock
Ret. earnings
Total liabilities and equity

$180,000
78,000

0.10

90,000
$348,000
900,000
102,000
$1,350,000

792,000
$1,485,000

$198,000
78,000
68,157
68,157
0.05
99,000
$443,157
900,000
39,843b
141,843
$1,485,000

Increase in accounts payable and accruals:

Increase in notes payable, long-term debt, and common stock:
Increase in retained earnings:
Total increase in financing:
Increase in total assets:
Amount of deficit or surplus:
Line of credit:
Special dividend:

$27,000
$0
$39,843
$66,843
$135,000
$68,157
$68,157
$0

Notes:
a

Sales are increased by 10%. Operating costs, all assets, accruals, and accounts payable are
divided by last years sales to determine the appropriate ratios to apply to the next years sales to
calculate next years account balances.
b

See income statement.

9. a. $28,557
Taylor Technologies Inc.
Pro Forma Income Statement
December 31, Coming Year
Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income

Last Year
$1,800,000
1,639,860
$160,140
9,140
$151,000
60,400
$90,600

Dividends (60%)
Addition to RE

$54,360
$36,240

Forecast
Basisa
1.10
0.9110
13% debt

Coming Year
Forecast
$1,980,000
1,803,846
$176,154
10,140
$166,014
66,406
$99,608
$59,765
$39,843

Taylor Technologies Inc.

Pro Forma Balance Sheet
December 31, Coming Year
Last Year
$90,000
180,000
360,000
$630,000
720,000
$1,350,000

Cash
Receivables
Inventory
Total current assets
Fixed assets
Total assets
Accts. payable
Notes payable
Line of credit
Accruals
Total current liabilities
Common stock
Ret. earnings
Total liabilities and equity

$180,000
78,000
90,000
$348,000
900,000
102,000
$1,350,000

Forecast
Basisa
0.05
0.10
0.20
32,400b

Coming Year
Forecast
$99,000
198,000
396,000
$693,000
752,400
$1,445,400

0.10

$198,000
78,000
28,557
28,557
0.05
99,000
$403,557
900,000
39,843b
141,843
$1,445,400

Increase in accounts payable and accruals:

Increase in notes payable, long-term debt, and common stock:
Increase in retained earnings:
Total increase in financing:
Increase in total assets:
Amount of deficit or surplus:
Line of credit:
Special dividend:

$27,000
$0
$39,843
$66,843
$95,400
$28,557
$28,557
$0

Notes:
a

Sales are increased by 10%. Operating costs, all assets except fixed assets, accruals, and
accounts payable are divided by last years sales to determine the appropriate ratios to apply to
next years sales to calculate next years account balances.
b

Full capacity sales = $1,800,000/0.95 = $1,894,737.

Target fixed assets/ Sales ratio = $720,000/$1,894,737 = 38%.

Required level of fixed assets = (0.38)($1,980,000) = $752,400.
Necessary FA increase = $752,400 - $720,000 = $32,400.
c

See income statement.

10. e.

Current

Forecast

1st

2nd

Cash
Receivables
Inventory
Total curr. assets
Net fixed assets
Total assets

Year
$100
300
800
$1,200
800
$2,000

Basisa
0.05
0.15
+250b

Accts. payable
Notes payable
Accruals
Total curr. liab.
Long-term debt
Common stock
Ret. earnings
Total liab./equity

$200
200
20
$420
780
400
400
$2,000

0.10

+160c

0.01

+18d

Pass
$150
450
1,050
$1,650
960
$2,610
$300
200
30
$530
780
400
418
$2,128

AFN

+ 482

Pass
$150
450
1,050
$1,650
960
$2,610
$300
682
30
$1,012
780
400
418
$2,610

AFN = $482
Notes:
a

Cash, receivables, accounts payable, and accruals are divided by current years sales to
determine the appropriate ratios to apply to next years sales to calculate next years account
balances.
b

Target inventory/assets = ($800 $100)/$2,000 = 35%.

Target inventory level = 0.35($3,000) = $1,050.
Since we already have $800 of inventories, we need:
Additional inventories = $1,050 $800 = $250.

Capacity sales = Sales/Capacity factor = $2,000/0.8 = $2,500.

Target FA/S ratio = FA/Capacity sales = $800/$2,500 = 32%.
Required FA = (Target ratio)(Forecasted sales) = 0.32($3,000) = $960.
Since we already have $800 of fixed assets, we need:
Additional fixed assets = $960 $800 = $160.

Additions to RE = M(S1)(1 Payout ratio) = 0.03($3,000)(0.2) = $18.

The problem asks for the forecasted current ratio, which is calculated as:
Forecasted current ratio = $1,650/$1,012 = 1.6304.

11. b.
Cash
Receivables
Inventory
Total current assets

Last Year
$50
100
100
$250

Forecast
Basisa
0.10
0.20
0.20

1st Pass
Next Year
$100
200
200
$500

Net fixed assets

Total assets

250
$500

+0b

250
$750

Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total claims

$25
75
25
$125
200
50
125
$500

0.05

$50
75
50
$175
200
50
173
$598

0.05

+48c

AFN = $152
Notes:
a

Cash, receivables, inventory, accounts payable, an accruals are divided by last years sales to
determine the appropriate ratios to apply to next years sales to calculate next years account
balances.
b

Capacity sales = Actual sales/Capacity factor = $500/0.5 = $1,000.

Target FA/S ratio = $250/$1,000 = 0.25.
Target FA = 0.25($1,000) = $250 = Required fixed assets.
Since Bouchard currently has $250 of FA, no new FA will be required.

Addition to RE = M(S1)(1 Payout ratio) = 0.08($1,000)(0.6) = $48.