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Introduction
The Pro – forma financial statements are often prepared in advance of major transactions. Some of the transactions that require Pro – forma financial statements are starting of a business, capital investment projects, alteration of the capital structure of the business, acquisition, and merger among other transactions. The Pro – forma financial statements are quite similar to financial projections since they have similar objectives. The Pro – forma financial statements should be prepared based on well stated objective and reliable information. This enables the company owners to come up with accurate estimates of profits and the financial needs a company during the period of forecasting (Bangs 23).
Objectives of the paper
The work aims at preparing Pro – forma statement of financial position and income statement for ALFIN Mills Inc. The Pro – forma financial statements will be prepared using percentage of sales method. The Pro – forma financial statements will aid the management of the company in estimating the external funding needs (EFN) required for a 20% sales expansion. The results obtained will later be compared with the amount that the management intends to borrow ($40 million). Further, a scenario analysis will be carried out on EFN of the company. Finally, a cash budget will be prepared to ascertain if the loan that the management intends to take will adequately cover all the operating expenses of the company.
Pro – forma income statement and pro – forma balance sheet
The financial projections in the Pro – forma statements are based on a number of assumptions. First, the statements are prepared based on an assumption about the financial and operating features of the business under different scenarios. Secondly, the projections are based on the objectives of the owners and what they intend to achieve within a given period of time. For instance, in this case, the management of the company intends to increase sales volume in the following year of operation. Thirdly, the financial projections are often based on the historical financial results of the business and results of other companies in the same industry because such data provide a good basis for preparing the Pro – forma statements (Bangs 22). The Pro – forma statements are commonly prepared using a number of methods. For ALFIN Mills Inc., the percentage of sales method will be used. The percentage of sales method is based on the basis that the values in the statement of financial position and the income statement change depending on the sales level. Thus, the anticipated changes in the income statement and balance sheet are adjusted based on the expected change in the value of sales. Thereafter, the Pro-Forma financial statements are prepared based on the adjusted values (Bangs 29).
Step one
In this part, the items in the financial statements of the company are expressed as a percentage of sales. The calculations of the percentages of sales are shown in the tables presented below.
Income statement for ALFIN Mills Inc
For the year ending December 31, 2005 (000USD)
Balance sheet for ALFIN Mills Inc
As of December 31, 2005 (000 USD)
Step two
Computation of the new sales level
2006 sales = $2,025,000 * (20% + 100%) = $2,430,000
Step three
This stage entails preparing the Pro – forma statements of the company. The new sales level calculated in stage two is multiplied by the percentages computed in stage one so as to obtain the values to be used in the balance sheet for the year 2006. The subsequent tables presented below shows the Pro – forma income statement.
Pro – Forma income statement for ALFIN Mills Inc
For the year ending December 31, 2006 (000USD)
Balance sheet for ALFIN Mills Inc
As of December 31, 2005 (000 USD)
Continuation of the table
The decision on whether ALFIN can manage to finance the 20% increase in sales levels
The increase in sales by 20%, that is from $2,025,000 thousand in 2005 to $2,430,000 thousand in 2006 results in an increase in the amount of net income from $182,250 thousand in 2005 to $236,700 thousand in 2006. The increase in net income is $54,450 thousand. This also leads to an increase in the amount of the retained earnings. Further, it can be observed that the value of total assets ($923,400 thousand) in 2006 exceeds the amount of total liabilities and equity ($889,650 thousand). The difference is an indication that the company will require additional funding to finance the 20% increase in sales. The computations of the external financing needs for the 20% increase in sales are illustrated in the table presented below.
Based on the table above, it can be observed that ALFINS mills Inc. will require $33,750 million to finance the increase in sales. The value is less than the $40 million loan that the management of the company requested from the bank. This implies that the management of the company will be able to manage to finance the 20% increase in the sale with a loan of $40 million.
External financing need
The formula for calculating external financing needs is EFN = [(A/S * (ΔS) – L/S * (ΔS)] – [(M) * (St) * (1-D)]. Adjustments will be made to the [(M) * (St) * (1-D)] because of the value of interest rate of $90,000 which does not depend on sales
30% increase in sales
The values to be used in the formula are estimated as shown below.
Assets to sales historical relationship (A/S)
= Total assets / total sales
= 769,500 / $2,025,000
= 0.38
Spontaneous liabilities to sales historical relationship (L/S)
= $141,750 / $2,025,000
= 0.07
Absolute change in sales volume (Forecast less historical sales volume) (∆S)
= $2,025,000 (30% + 100%) – $2,025,000
= $607,500
Total sales volume forecasted for the year (St)
= $2,025,000 (30% + 100%)
= $2,632,500
Forecasted profit margin (M)
= 9% (from the previous calculations of 20% increase)
Forecasted dividend payout ratio (D)
= 60% (from the previous calculations of 20% increase)
The values estimated above can be inserted in the formula to calculate the value of EFN as illustrated below.
EFN = [(A/S*(ΔS) – L/S *(ΔS)] – [(M)*(St)*(1-D)]
= [(0.38 * 607,500) – (0.07 * 607,500)] – [0.09 * 2,632,500 * (1 – 0.60)]
= (230,850 – 42,525) – 101,250
= $87,075
From the calculations, the company will require $87,075 thousand of external financing needs.
10% increase in sales
The values to be used in the formula are estimated as shown below.
Assets to sales historical relationship (A/S)
= Total assets / total sales
= 769,500 / $2,025,000
= 0.38
Spontaneous liabilities to sales historical relationship (L/S)
= $141,750 / $2,025,000
= 0.07
Absolute change in sales volume (Forecast less historical sales volume) (∆S)
= $2,025,000 (10% + 100%) – $2,025,000
= $202,500
Total sales volume forecasted for the year (St)
= $2,025,000 (10% + 100%)
= $2,227,500
Forecasted profit margin (M)
= 9% (from the previous calculations of 20% increase)
Forecasted dividend payout ratio (D)
= 60% (from the previous calculations of 20% increase)
The values estimated above can be inserted in the formula to calculate the value of EFN as illustrated below.
EFN = [(A/S*(ΔS) – L/S *(ΔS)] – [(M)*(St)*(1-D)]
= [(0.38 * 202,500) – (0.07 * 202,500)] – [0.09 * 2,227,500 * (1 – 0.60)]
= (76,950 – 14,175) – 82,350
= ($19,575)
From the calculations, the company will require ($19,575 thousand) of external financing. This implies that the management will not require any source of financing for the 10% increase in sales volume. It shows that the company has surplus capital after a 10% increase in sales.
Comparison of 30% increase and 10% increase in sales volume
Based on the calculations above, it can be observed that the external financing needs for a 30% increase in sales ($87,075 thousand) is higher than 20% increase in sales ($33,750 thousand). The higher value can be as a result of a number of reasons. First, a 30% increase in sales results in higher cost of sales than a 20% increase in sales volume. This also results in higher selling, administration and general expenses, and taxes. Apart from the increase in costs of the three assets, a 30% increase in sales volume requires a higher amount of assets than a 20% increase in sales volume. It can be observed that a 30% increase in sales requires $1,000,350 of assets while a 20% increase in sales requires $923,400 thousand of assets. The high amount of assets required also contributes to the high external funding need required. Further, it can be observed that a 30% increase in sales volume results in higher profit margin than a 20% increase in sales volume. However, the higher amount of sales is not sufficient to offset the increase in cost. This explains why a 30% increase in sales volume requires higher amounts of external financing than a 20% increase in sales volume.
As mentioned earlier, the 10% increase in sales volume does not require the external financing need. Therefore, the company can finance the 10% increase in sales internally without seeking external sources of finance.
The maximum increase in sales that ALFIN can sustain without EFN
Based on the calculations and analysis above, it can be observed that the management of the company can increase the sales volume up to a certain level without the need to seek for external sources of finance. The estimation of the percentage increase of sales volume that the company can achieve without EFN is shown below. Interpolation method will be used to estimate the value.
External financing need at 30% = $93,555
External financing needs at 10% = ($17,415)
Interpolation will be used to estimate the balance
= 10% + (30% – 10%) * 17,415 / (93,555 + 17,415)
= 10% + 20% (17,415 / 110,970)
= 13.14%
Based on the interpolation calculations shown above, the company can increase the sales volume by 13.14% without the need to seek for external sources of financing. This implies that the surplus capital available can support a maximum of 13.14 % increase in sales volume without the need for EFN.
Discussion on external financing needs
Impact of a reduction of accounts receivable collection period on EFN
The accounts receivable collection period denotes the period of time that it takes the business to collect the debts arising from the sale of goods on credit to customers. The collection period may not affect the current sales volume of the company. However, it may have a significant impact on the balance of accounts receivable reported in the statement of financial position. According information provided for the company, the current policy on accounts receivable collection is that fifty five percent of the sales is collected within the month sale is made and the remaining fourty five percent is collected in the subsequent month. A reduction in the collection period would mean for instance, reducing the period of time that debtors should take before they pay the amount they owe the company. The reduction of the period will result in a lower balance of accounts receivable reported in the statement of financial position. This results in a reduction of the amount of current assets and the total assets of the company. A reduction in the amount of total assets, for instance, from $769,500 to $700,000 will result in a reduction of the amount of external funding needs required.
The impact of reducing the accounts payable period on EFN
Just like the company can reduce the accounts receivables collection period, suppliers can also reduce the period of time it takes their customers to pay for goods they supplied on credit. Such an action by the supplier affects the accounts payable in the books of account of the company. According to the information provided about the company, the current policy on accounts payable period is that seventy percent to be paid in the first month and thirty percent in the second month. A reduction in the accounts payable period would mean for instance, reducing the period of time that the company pays suppliers the amount owing for the inventory bought on credit. This action will have an impact on reducing the balance of accounts payable reported in the statement of financial position. This results in a reduction in the amount of current liabilities and the total shareholders’ equity and liabilities of the company. A reduction in the amount of total shareholders equity and liabilities, for instance, from $769,500 to $700,000 will have an impact of increasing the amount of external funding needs required.
The impact of an increase in sales volume without increasing the fixed asset on EFN
The basic knowledge of accounting requires that an increase in sales should be supported by a corresponding increase in the amount of fixed assets when a company has reached full capacity in production. However, when the company has not exploited the available capacity and there is room for production of additional sales, then it may not be necessary to increase the asset balance reported in the statement of financial position. However, from the calculations computed above, it is observed that an increase in sales volume results in a corresponding increase in the working capital which is the difference between current assets and current liabilities. This mainly will affect the items that are directly related to sales such as cash, accounts receivable, inventory, and accounts payable among others.
The impact of increasing sales volume in such as scenario will depend on the resulting difference between current assets and current liabilities. When the amount of current assets exceeds the amount of current liabilities, then the increase in sales volume will result in an increase in the amount of additional funds needed. On the other hand, when the amount of current liabilities exceeds the amount of current assets, and then the increase in sales volume will also result in an increase in the amount of additional funds needed. Also, this will depend on the whether the additional sales revenue will cover the increase in expenses associated with an increase in sales such as cost of sales, selling, administration and general expenses. If an increase in the sales revenue cannot cover the increase in expenses, then the increase in sales volume will affect the external financing need negatively. On the other hand, if an increase in the sales revenue can cover the increase in expenses, then the increase in sales volume will affect the external financing need positively.
Cash Budget
Cash budget is prepared by managers of companies to ascertain if the amount of cash receipts will fully cover the amount of cash payment. It is prepared for internal use and not for external use like the other key financial statements. This helps the management to ascertain whether the amount of cash receipts expected during the year will adequately finance the operating expenses of the company. This helps the management to estimate the line of credit that is required to finance the operations of a business in advance so that the company can seek external financing in good time. Cash budget is quite significant for liquidity and working capital management in an organization. Cash budget is often prepared after preparing the budget for capital expenditure and operating expenses. In this scenario, it will be important to first compute the total collections from customers and payment for expenses. The cash outflows are deducted from the cash inflows to arrive at the value of line of credit that is required by an entity. The section of the paper focuses on coming up with the cash budget of ALFINS Mills Inc. It also seeks to ascertain if the amount of the loan borrowed will be adequate to cover the financial needs of the company in 2006.
Step one
The first step when coming up with a cash budget is to compute the amount of the total collection that the company expects to receive from the customers. This will be based on the policy of the company on account receivable collection period. Based on the information provided, the collects fifty five percent of the credit sales in the month of sale and the remaining fourty five percent in the following month after the sale is made. The table presented below shows the total projected receipts from customers in the first quarter of 2006.
ALFIN Mills Inc.
Total collections from customers
For a four month period (January to April) 2006
Step two
The second step entails computing the total monthly payment the company will pay suppliers for the inventories purchased. This will be based on the policy of the company on account payable period. Based on the information provided, the company pays seventy percent in the first month and thirty percent in the second month after credit purchase. The table presented below shows the total projected payment to suppliers in the first quarter of 2006.
ALFIN Mills Inc.
Total payment to suppliers
For a four month period (January to April) 2006
Step three
After estimating the values of total receipts from sales and payment to suppliers, the cash budget can then be prepared since the other values can be obtained from the financial key projections for the year 2006. The table presented below gives the cash budget for the first quarter of 2006.
ALFIN Mills Inc.
Cash budget
For a four month period (January to April) 2006
The cash budget prepared in the table presented above shows that the company will have a deficit in the first and the second month. In January, the total cash inflows amounted to $167,670 thousand while the cash outflow amounted to $270,760. This created a negative cash balance amounting to $103,000 thousand. This will be the financial need required by the company in the month of January. In February, the total cash inflows amounted to $302,455 thousand while the cash outflow amounted to $389,950. This created a negative cash balance amounting to $87,495 thousand. This will be the financing need required by the company in the month of January. The remaining two moths the company had positive cash balance amounting to $38,110 thousand in the month of March and $82,295 thousand in the month of April. Therefore, the financial need of the company in the first quarter of 2006 will amount to $190,496 thousand. The amount of the loan that the management intends to borrow is $40 million. This implies that in the first quarter of operation, the amount of loan that the company intends to take will not adequately cover the operating costs. The amount of the loan is less than the financial needs by $150,496 thousand.
Conclusion
The paper focused on the preparation of the Pro – forma statement of financial position and income statement for ALFIN Mills Inc. The Pro – forma statements were prepared using percentage of sales method. The results of the Pro – forma financial statements were used to compute the EFN required for a 20% sales expansion. Finally, a cash budget is prepared for the first quarter of 2006 to ascertain if the amount of the loan will be adequate for the financing needs of the company. From the calculation and the discussion above, it is established that the loan of $40 million will adequately finance the 20% increase in sales volume. Also, the cash budget prepared reveals that the loan will not adequately finance the operating expenses of the company in the month of January and February.
The Pro – forma financial statements and cash budgets aids the management of businesses in a number of ways. First, companies need the Pro – forma financial statements for decision making. Specifically, the statements aid in planning for available resources. It aids the management in allocating the resources available to different functions within the organization. Further, Pro – forma financial statements is used as a control tool for a company. An organization will be able to measure the results of performance of the business against the estimates in the Pro – forma statements. This enables the organization to identify variances that may arise and their causes. Hence, the organization will be able to correct the cause of the variances in good time (Siddiqui 109). Finally, the statements provide a means for analysts carry out comparative reporting of the financial statements.
Works Cited
Bangs, David. Business Planning Guide, New York: Kaplan Publishing, 2002. Print.
Siddiqui, Ashiq. Managerial Economics and Financial Analysis, New Delhi: New age international (P) Limited, 2005. Print.
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