1

CORPORATE FINANCIAL MANAGEMENT

Expert Systems, Inc. Financial Analysis and Forecasting Case

Svetlana Svetlichnaya Anzella Afroze Xiaoqing Zhang

Brandon Schuldt

10/25/2013

2

1. AFN = (28.08/56.16)([56.16(1.2)]-56.16) - ([1.63-.8]/56.16)([56.16(1.2)]-56.16) -

[(.061)[56.16(1.2)](1-[.3/.86])]=2.77

2. The AFN that was calculated using the percentage-of-sales method was 2.86 for 1996 (See

Appendix I). There is a difference between the AFNs calculated because the percentages that

were used to determine the needed components were different. The formula used just the 20%

increase in sales as part of the calculation. The percentage-sales-method estimated the percent of

sales for every item on the income statement and balance sheet.

3.

a. The Proportionality assumption says that Total Assets; as well as each Asset account will

increase proportionally with Expert Systems’ sales. As can be seen in the following table and

charts A, B and C, the proportionality assumption has been true over the previous 5 years of the

company’s operation (See Appendix II). Chart A shows the growth of each account in dollar

amounts and, which shows each account increasing. Than Chart B and C show the growth

percentage of Sales, Total Assets, Inventory and Fixed Assets and all have very clearly

experienced the same rate of growth.

b. Under the conditions given containing the new Total Asset figures, it can be easily seen in

Table D and Chart D below that the proportionality assumption does not hold true at all (See

Appendix II). The Total assets do not grow proportionally with sale. It also seems that the Total

assets do not have any sort of consistent relationship with the company’s sales Growth.

c. In order to get an idea of which of the two situations presented in part (b), please refer to

charts F, G and H for Microsoft, Oracle and CA, Inc. respectively (See Appendix II). The charts

show the relationship between each company’s Sales Growth compared to the growth of their

Total assets (TA Growth). Each company seems to have a different relationship between the two.

For Microsoft, the two seem to follow a similar pattern; however, their growth rates are quite

different. CA, Inc., a smaller software company, has a quite different relationship between its

sales and assets. Most notably, in 2010 and 2011, both seem consistent with each other, but then

in 2012, their sales growth grew from 2% to 9% while its asset went down from 5% to less than

zero% growth. In chart G, Oracle’s fixed asset growth decreased consistently over the previous 5

years, while its sales increased significantly from 2010 to 2011 and then decreased significantly

in 2012 and 2013. Since all four companies are likely to have lumpy assets, they should both

experience periods of significant asset growth with more slowly growing sales. When companies

like these reach the capacity of their production operations, they will need to invest significantly

into new assets in order to maintain their sales growth. For this reason, the situations shown in

part (b); as well as Charts F-H, seem to be more likely than the percentage-of-sales method.

3

This has significant implications for use of the percentage-of-sales method as it applies to the

financial planning of Expert Systems, Inc. While historically it has been true that the company’s

asset accounts have grown proportionally with its sales, as its production draws closer to full

capacity, it will have to invest significantly in new assets, especially its fixed assets and

inventory in order to realize further sales growth. In coming years, Expert Systems, Inc’s assets

are likely to grow much faster than its sales.

4. Because the vice-president feels that the fixed assets were being operated at 80% capacity

instead of 100%, the projected external capital requirements should be recalculated. First, the full

capacity sales have to be calculated taking the actual sales from 1995 and dividing them by the

percentage of capacity, 80% (56.16/.8). The calculation suggests that if the fixed assets had been

used to full capacity, 1996 sales could have been as high as $70.2 million. The this amount is

used to estimate the target fixed asset to sales ratio by taking the 1995 fixed asset amount and

dividing it by the full capacity sales (18.24/70.2) resulting in 25.98%. Lastly the required level of

fixed assets is calculated by multiplying the above ratio with the projected 1996 sales

(25.98%*67.39); resulting in a required fixed asset level of $17.52 million. The calculated

amount is lower than the 1995 fixed asset amount meaning that no new assets are needed.

5. With 80% capacity there are excess funds generated. The excess funds can be used to increase

dividends, for growth opportunities, or pay down debt. Our suggestion would be to use it for

growth opportunities because they are already increasing their dividends by $0.10 and they want

to continue using their specific capital structure.

6.

a. If ESI was operating at 90% capacity in 1995, then the actual sale in 1995 would have to be

divided by .9, equaling $62.4 million sales. Then this amount is used to estimate the target fixed

asset to sales ratio by taking the 1995 fixed asset amount and dividing it by the full capacity sales

(18.24/62.4) resulting in 29.23%. Finally, the required level of fixed assets calculated by

multiplying the above ratio with the projected 1996 sales (29.23%*67.39); resulting in a required

fixed asset level of $19.70 million. The fixed assets would need to increase by 1.46 million in

1996.

b. In many industries, technological considerations show that adding fixed assets in large,

discrete units play an important role if a firm wants to be more competitive. These assets are

referred to as lumpy assets. When lumpy assets occur, the firm’s capital intensity ratio will

change. At that point where the assets must be increased in a large amount, the capital intensity

ratio will be high, so required external financing will be high. Lumpy assets have a major effect

on the fixed assets/sales ratio at different sales levels as well as on financial statements. When a

firm is operating at full capacity a small increase in sales would require a large increase in fixed

assets, therefore a small increase in projected sales would result in a very large financial outlay.

4

Having accurate estimates in the percentage of sales method is extremely important to future

success. If assets are not “lumpy” which means they can be purchased in smaller quantities over

a long period of time, which is not capital intensive in the short term. Knowing the capacity

utilization in this case is not as crucial as in the case with “lumpy” assets.

7. When a company pays higher dividends, it increases the dividend payout ratio, which in turn

reduces the funds available internally and increases additional funds needed. A higher profit

margin means that there are more funds available internally and there is no need for additional

funds needed. Higher capital intensity ratio such as ROA increase asset requirements therefore

increasing additional funds needed.

8. Financial planning is both important and highly useful for allocating resources as well as

anticipating the firm’s future financing needs. One type of financial planning method is the

percent-of-sales method. This method is used for developing pro forma financial statements to

create reasonable projections.

The percentage of sales method shows how a financial statement account item is related to

historically sales figures by calculating a percentage. Then the percentage is used to project the

value of those financial statement account items based on future sales estimates. For example,

after examining and analyzing historical financial statement data, an analyst determines that

inventory levels are typically at 10% of sales, and the sales forecast for the coming year is for

$100,000 dollars in sales, then, according to the percent-of-sales method of forecasting, the

analyst can estimate inventory of approximately $10,000, or 10% of the estimated sales figure.

There are three steps in the percent-of-sales forecasting process. The first step is to analyze

historical financial statement data to determine which items are correlated with the sales figures

and which are not. Only the items which are correlated with sales figures can accurately be

predicted or forecast using the percent-of-sales method. Items that have no concrete relation to

sales figures must be estimated using a different technique. The next step is to forecast sales for

the fiscal period in question. Because all the projections in the percent-of-sales method are

dependent on relationship the between financial statement items and sales figures, it is very

important to get an accurate sales forecasts. The third step in this method is to forecast the

values of certain appropriate financial statement items using the sales forecast from the previous

step in combination with the percentages calculated between the financial statement item and the

sales figure.

9. There are a few other types of methods that could be used besides the percentage-of-sales

method, which include the additional funds needed formula, quantitative forecast, time series

forecast and the casual forecast. If there were a need to incorporate these methods in the financial

forecasts that are available already it would take several more weeks to complete the financial

5

forecasts. The information that would be needed for these forecasts methods includes historical

financial data.

10. In the case, it is stated that John, the company’s CFO, assumes that the company’s capital

structure is made up of 25% long-term debt and 75% common equity, which is measured at

market value. For planning purposes, it seems like measuring common equity by book value

would be much easier to use since market value can be difficult to predict and is always

changing. The company’s balance sheet for 1995 shows the company’s Long-term debt to Total

permanent Capital, which is Long-term Debt plus Common Stock and Retained Earnings to be

29%. It is difficult to gauge whether or not this figure indicates an unbalanced capital structure,

since this number uses the book value of the equity. As a result, looking at the company’s

historical figures for this ratio is helpful.

The company’s Long-term debt to total permanent capital percentage has been 14.6%, 22%,

29%, 30.76% and 29% for 1991, 92, 93, 94 and 95 respectively. The current percentage of 29%

has been the capital structure for the company over the last 3 years. Also, the company’s current

Debt-to-assets ratio of 33.2% is lower than its rate of 36% of the previous two years. The figures

indicate that the company is using about the appropriate level of debt and in order to maintain the

same level of risk, they should not modify the mix of debt and equity at this time. We also

believe that the company should use this ‘long-term debt to total permanent capital’ percentage

as opposed to the ‘long-term debt to the market value of common stock’ percentage. It presents a

more reliable prediction of the company’s capital structure; as well as a better way to predict its

Additional Fund Needed in the next year.

11. If there is an increase in debt in the capital structure the rate will be higher. Lending

companies would consider them more risky and would require a higher rate. When interest

increases, stockholders do not like that and EPS decreases which in turn lowers the stock price.

The stockholders would get nervous when company takes on more debt because if it goes

bankrupt, they would be the last ones to get paid. If the amount of debt is decrease, interest rate

decreases as well. EPS would increase and stock price would increase because there is less

financial risk and that would attract more investors.

12.

Years Current ratio Profit Margin ROE EPS

1995 6.04 6.13% 18.33% $0.86

1996 6.06 6.20% 17.91% $1.05

The sales growth rate, the payout ratio, the capital structure, and the profit margin change do

affect these above ratios. For example, if the sales growth rate fell while interest expense

6

increased sharply, the net income available to common stockholders would undoubtedly decline,

so do the profit margin and EPS. Senior executives at the retreat would be interested in this type

of data because it may tell them how different business actions would affect the company’s

operation and the investors’ profits. This data can also make it easier to compare the company to

its peers or industry averages.

It is possible to provide the senior executives with the data on a real time basis. If we can

monitor and track the changes of whole inputs timely, then we can rectify our financial

forecasting and decide whether and how extra capital is needed and raised.

7

Appendix I

TABLE 3

Historical 1995 and Projected Financial Statements

(Millions of Dollars)

Balance Sheet:

1996 Projected

1995

Percentage

of sales 1st Pass 2nd Pass 3rd Pass 4th Pass

Cash and securities $ 1.64 2.92% $ 1.97 $ 1.97 $ 1.97 $ 1.97

Accounts receivable $ 4.00 7.12% $ 4.80 $ 4.80 $ 4.80 $ 4.80

Inventories $ 4.20 8% $ 5.04 $ 5.04 $ 5.04 $ 5.04

Current assets $ 9.84 NA $ 11.81 $ 11.81 $ 11.81 $ 11.81

Net fixed assets $ 18.24 32.48% $ 21.89 $ 21.89 $ 21.89 $ 21.89

Total assets $ 28.08 NA $ 33.70 $ 33.70 $ 33.70 $ 33.70

Accounts payable $ 0.47 0.84% $ 0.57 $ 0.57 $ 0.56¹ $ 0.57

Notes payable $ 0.80 1.42% $ 0.96 $ 0.96 $ 0.96 $ 0.96

Accrued wages & taxes $ 0.36 0.64% $ 0.43 $ 0.43 $ 0.43 $ 0.43

Current liabilities $ 1.63 NA $ 1.952 $ 1.95

2 $ 1.96 $ 1.96

Long-term debt $ 7.68 NA. $ 7.68 $ 8.35 $ 8.39³ $ 8.40

Total liabilities $ 9.31 NA $ 9.64 $ 10.305 $ 10.35

7 $ 10.36

Common stock $ 13.04 NA. $ 13.04 $ 15.04 $ 15.18 $ 15.19

Retained earnings $ 5.73 NA. $ 8.36 $ 8.16 $ 8.15 $ 8.15

Total common equity $ 18.77 NA. $ 21.40 $ 23.20 $ 23.33 $ 23.34

Total liabilities & equity $ 28.08 NA. $ 31.034 $ 33.50

6 $ 33.68

8 $ 33.70

Corrections:

¹Should be 0.57 5Should be 10.31

²Should be 1.96 6Should be 33.51

³Should be 8.40 7Should be 10.36

4Should be 31.04

8Should be 33.69

Additional funds needed (AFN) $2.66 $ 0.19 $ 0.01 $ -

Cumulative AFN 2.66 $2.85 $2.86 $2.86

8

TABLE 3 (Continued)

Income Statements:

1996 Projected 80% 90%

1995

Percentage

of sales 1st Pass 2st Pass 3rd Pass 4th Pass 1995 1995

Sales $ 56.16 100.00% $ 67.39 $ 67.39 $ 67.39 $ 67.39 $70.20 $67.20

Cost of goods sold $ 49.60 88.32% $ 59.52 $ 59.52 $ 59.52 $ 59.52

EB1T $ 6.56 11.68% $ 7.87 $ 7.87 $ 7.87 $ 7.87

Interest expense $ 0.83 N.A. $ 0.83 $ 0.91 $ 0.91 $ 0.91

Taxable income $ 5.73 N.A. $ 7.04 $ 6.96 $ 6.96 $ 6.96

Taxes $ 2.29 N.A. $ 2.82 $ 2.79* $ 2.78 $ 2.78

Net income $ 3.44 N.A. $ 4.22 $ 4.17**

$ 4.18 $ 4.18

Dividends $ 1.20 N.A. $ 1.60 $ 1.75 $ 1.76 $ 1.76

Additions to R.E. $ 2.24 N.A. $ 2.62 $ 2.42***

$ 2.42 $ 2.42

Corrections:

*Should be 2.78

**Should be 4.18

***Should be 2.43

1st Pass 2nd Pass 3rd Pass 4th Pass Totals

Additional Funds Needed (AFN)

$2.66 $0.19 $0.01 $0.00 2.86

Assumed additional LT debt

$0.67 $0.05 $0.00 $0.00 0.72

Assumed additional stock

$2.00 $0.14 $0.01 $0.00 2.15

Additional interest (ST and LT)

$0.08 $0.00 $0.00 $0.00 0.08

Additional dividends

$0.15 $0.01 $0.00 $0.00 0.16

Selected Ratios:

1996 Projected

1995 1st Pass 2nd Pass 3rd Pass 4th Pass

Current

6.04 6.04 6.04 6.04 6.03

Profit margin

6.10% 6.30% 6.20% 6.20% 6.2

ROE

15.70% 17.90% 17.90% 17.90% 17.90%

EPS

$0.86 $0.97 $0.95 $0.95 $1.05

9

Appendix II

TABLE FOR CHARTS A, B, C

Chart A

Chart B

Year ES, Inc.

Sales

ES, Inc. Sales

Growth ES, Inc.

Total Assets

ES Inc. Assets

Growth ES, Inc.

Inventories ES, Inc. Inv

Growth ES, Inc.

Fixed Assets ES, Inc. FA

Growth

1991 $ 24.00

$12.00

$1.80

$ 7.80 1992 $ 28.80 20% $14.40 20% $2.16 20% $ 9.36 20%

1993 $ 36.00 25% $18.00 25% $2.70 25% $ 11.70 25%

1994 $ 43.20 20% $21.60 20% $3.24 20% $ 14.04 20%

1995 $ 56.16 30% $28.08 30% $4.20 30% $ 18.24 30%

$-

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

1991 1992 1993 1994 1995 1996

ES, Inc. Sales

ES, Inc. Total Assets

ES, Inc. Inventories

ES, Inc. Fixed Assets

15%

20%

25%

30%

35%

1991.5 1992 1992.5 1993 1993.5 1994 1994.5 1995 1995.5

ES, Inc. Inv Growth

ES, Inc. FA Growth

10

Chart C

TABLE FOR CHART D

Chart D

TABLE FOR CHART F

15%

20%

25%

30%

35%

1991 1992 1993 1994 1995

ES, Inc. Sales Growth

ES Inc. Assets Growth

Year Sales Sales Growth Total Assets TA Growth

1991 $ 24.00

$ 22.80 1992 $ 28.80 20% $ 24.27 6%

1993 $ 36.00 25% $ 27.20 12%

1994 $ 43.20 20% $ 30.56 12%

1995 $ 56.16 30% $ 31.25 2%

0%

10%

20%

30%

40%

1992 1993 1994 1995

Sales Growth

TA Growth

Microsoft

Microsoft Sales Growth Microsoft TA Growth

2009 58.4

77.9 2010 62.5 7% 86.1 11%

2011 69.9 12% 108.7 26%

2012 73.7 5% 121.3 12%

2013 77.8 6% 142.4 17%

11

Chart F

TABLE FOR CHART G

Chart G

Oracle

Oracle Sales Growth

Oracle TA Growth

2009 23.2

47.4 2010 26.8 16% 61.5 30%

2011 35.6 33% 73.5 20%

2012 37.1 4% 78.3 7%

2013 37.2 0% 81.8 4%

0%

10%

20%

30%

40%

2009 2010 2011 2012 2013

Oracle Sales Growth

Oracle TA Growth

0%

10%

20%

30%

2009 2010 2011 2012 2013

Microsoft Sales Growth

MicrosoftTA Growth

12

TABLE FOR CHART H

Chart H

-5%

0%

5%

10%

2009 2010 2011 2012 2013

CA, Inc Sale Growth

CA, Inc TA Growth

CA, Inc.

CA, Inc Sale Growth

CA, Inc TA Growth

2009 4.2

11.2 2010 4.3 2% 11.8 5%

2011 4.4 2% 12.4 5%

2012 4.8 9% 12 -3%

2013 4.6 -4% 11.8 -2%