Topeka SDI Expansion: Pro Forma Financial Case Study

Introduction: External Funding and Retained Earnings

While it may be true that the retained earnings of the company provide a large amount of cash for future endeavors, there are several issues with using this cash to fund the necessary expansion efforts. First, this cash might simply be inadequate to fund the entire expansion. Second, such a use would significantly impair the company's ability to operate if a supplier disruption or major payment issue arose. Third, this cash represents the only return on investment for the company's owners and stakeholders. All of these reasons make securing at least some external financing preferable.

1996 Pro Forma Income Statement

The following pro forma income statement projects SDI's financial performance for 1996, assuming a 31% gross margin on expected sales revenue and a 40% tax rate on income before taxes.

Receivables, Payables, and Purchase Estimates

It is assumed that 40% of sales will be collected on a net-30 basis with 80% on-time payment, and that 60% of sales will be made on a net-45 basis with 90% on-time payment. The average collection period for on-time payments can thus be calculated as:

(.4 × .8 × 30) + (.6 × .9 × 45) = 33.9 days

Assuming that late payments are made within thirty days of the payment due date, late payment schedules can be calculated as:

(.4 × .2 × 60) + (.6 × .1 × 75) = 9.3 days

This brings the total average expected accounts receivable period to 43.2 days. With an expected average receivables period of 43.2 days on $1,933,100 in receivables at the end of a 360-day year, total receivables at the end of the year can be estimated at $214,789.

The purchase estimate for 1996 is based on the cost of goods ($1,333,839) plus beginning inventory ($149,500) less ending inventory — which has been a fairly consistent 13.9% of cost of goods and can be estimated at $185,404 — for a total of $1,297,935.

Assuming one-third of all payments are made on a 2/10 net-30 basis and the remaining two-thirds are made on a net-30 basis, the average payment period will be:

(.33 × 10) + (.66 × 30) = 23.1 days

In a 360-day year with $1,333,839 in purchases and an average payment period of 23.1 days, the average level of payables would be $57,742.

1996 Pro Forma Balance Sheet and Cash Flow

The following pro forma balance sheet presents SDI's projected financial position at the end of 1996.

It is possible that no additional funds from external sources will be necessary in 1996, as projected sales are not hugely different from 1995's actual sales. It is in 1997 and 1998 that funds will be required to expand operations. Funding that equals the cost of goods sold, other operational costs, and debt payments — in the neighborhood of $1,600,000 — should be sufficient.

While reducing the cost of goods sold/inventory ratio would provide for a freer cash flow and thus ease concerns regarding operating capital, it would not present a significant cost savings and is thus not a point of essential consideration in the projection of these pro forma documents.

In 1995, approximately 95% of sales revenue was needed to cover all operating expenses and debt payments. Ninety-five percent of 1996's expected sales revenue ($1,933,100) is $1,836,445. The answers derived from the balance sheet analysis and this operating-expense estimate are fairly similar; some discrepancy exists because it was not possible to adequately project administrative costs with the information given, and this expense is therefore excluded from the pro forma cash flow statement for 1996.

Saving money tends to make sound financial sense in the long run for any company, and as long as operational expenses can be met with early payments the discount received is certainly worthwhile. If the company has to borrow at a rate higher than 2% on a regular basis in order to make payments within ten days to its suppliers, however, then early payment does not make financial sense during the growth period. For 1996, continuing to make ten-day payments and receive the discount is definitely sensible.

Extending fifteen days of extra credit makes sense at the current time. After expanding — when a sale of this size will make up a smaller percentage of total revenue — establishing a stricter credit scheme would be advantageous.

A review of SDI's key financial ratios against contractual obligations reveals the following:

The bank's analysis of SDI's current position is quite accurate, and the very high debt ratio is especially concerning. If the company can secure financing for its expansion project and meet projected sales increases and cost savings, sales revenue will increase to $330,386 in 1996 at a cost of goods of $274,200, and in 1997 to $371,684 at a cost of $297,347. The rise in short-term interest rates will not significantly affect earnings figures as long as administrative and selling expenses are kept in check over this period; there is not much room for these to grow proportionately with sales if the company wishes to achieve a stronger financial position.