Discussion Questions

1. What are the basic benefits and purposes of developing pro forma statements and a cash budget?

2. Explain how the collections and purchases schedules are related to the borrowing needs of the corporation.

3. With inflation, what are the implications of using LIFO and FIFO inventory methods? How do they affect the cost of goods sold?

4. Explain the relationship between inventory turnover and purchasing needs.

5. Rapid corporate growth in sales and profits can cause financing problems. Elaborate on this statement.

6. Rapid corporate growth in sales and profits can cause financing problems. Elaborate on this statement.

7. What conditions would help make a percent-of-sales forecast almost as accurate as pro forma financial statements and cash budgets?

Problems

1. Eli Lilly is very excited because sales for his nursery and plant company are expected to double from $600,000 to $1,200,000 next year. Eli notes that net assets (Assets - Liabilities) will remain at 50 percent of sales. His firm will enjoy an 8 percent return on total sales. He will start the year with $120,000 in the bank and is bragging about the Jaguar and luxury townhouse he will buy. Does his optimistic outlook for his cash position appear to be correct? Compute his likely cash balance or deficit for the end of the year. Start with beginning cash and subtract the asset buildup (equal to 50 percent of the sales increase) and add in profit.

2. In problem 1 if there had been no increase in sales and all other facts were the same, what would Eli's ending cash balance be? What lesson do the examples in problems 1 and 2 illustrate?

3. Gibson Manufacturing Corp. expects to sell the following number of units of steel cables at the prices indicated under three different scenarios in the economy. The probability of each outcome is indicated. What is the expected value of the total sales projection?

4. The Alliance Corp. expects to sell the following number of units of copper cables at the prices indicated, under three different scenarios in the economy. The probability of each outcome is indicated. What is the expected value of the total sales projection?

5. ER Medical Supplies had sales of 2,000 units at $160 per unit last year. The marketing manager projects a 25 percent increase in unit volume this year with a 10 percent price increase. Returned merchandise will represent 5 percent of total sales. What is your net dollar sales projection for this year?

6. Cyber Security Systems had sales of 3,000 units at $50 per unit last year. The marketing manager projects a 20 percent increase in unit volume sales this year with a 10 percent price increase. Returned merchandise will represent 6 percent of total sales. What is your net dollar sales projection for this year?

7. Sales for Ross Pro's Sports Equipment are expected to be 4,800 units for the coming month. The company likes to maintain 10 percent of unit sales for each month in ending inventory. Beginning inventory is 300 units. How many units should the firm produce for the coming month?

8. Digitex, Inc., had sales of 6,000 units in March. A 50 percent increase is expected in April. The company will maintain 5 percent of expected unit sales for April in ending inventory. Beginning inventory for April was 200 units. How many units should the company produce in April?

9. Hoover Electronics has beginning inventory of 22,000 units, will sell 60,000 units for the coming month, and desires to reduce ending inventory to 30 percent of beginning inventory. How many units should Hoover produce?

10. On December 31 of last year, Barton Air Filters had in inventory 600 units of its product, which costs $28 per unit to produce. During January, the company produced 1,200 units at a cost of $32 per unit. Assuming Barton Air Filters sold 1,500 units in January, what was the cost of goods sold (assume FIFO inventory accounting)?

11. On December 31 of last year, Wolfson Corporation had in inventory 400 units of its product, which cost $21 per unit to produce. During January, the company produced 800 units at a cost of $24 per unit. Assuming that Wolfson Corporation sold 700 units in January, what was the cost of goods sold (assume FIFO inventory accounting)?

12. At the end of January, Lemon Auto Parts had an inventory of 825 units, which cost $12 per unit to produce. During February the company produced 750 units at a cost of $16 per unit. If the firm sold 1,050 units in February, what was its cost of goods sold?
a. Assume LIFO inventory accounting.
b. Assume FIFO inventory accounting.

13. Convex Mechanical Supplies produces a product with the following costs as of July 1, 2009:

Beginning inventory at these costs on July 1 was 5,000 units. From July 1 to December 1, Convex produced 15,000 units. These units had a material cost of $10 per unit. The costs for labor and overhead were the same. Convex uses FIFO inventory accounting.
Assuming that Convex sold 17,000 units during the last six months of the year at $20 each, what would gross profit be? What is the value of ending inventory?

14. Assume in problem 13 that Convex used LIFO accounting instead of FIFO. What would gross profit be? What is the value of ending inventory?

15. Jerrico Wallboard Co. had a beginning inventory of 7,000 units on January 1, 2008. The costs associated with the inventory were:
Material ......................... $9.00 unit
Labor ............................. 5.00 unit
Overhead ....................... 4.10 unit

During 2008, Jerrico produced 28,500 units with the following costs:

Material ......................... $11.50 unit
Labor ............................. 4.80 unit
Overhead ....................... 6.20 unit
Sales for the year were 31,500 units at $29.60 each. Jerrico uses LIFO accounting. What was the gross profit? What was the value of ending inventory?

16. J. Lo's Clothiers has forecast credit sales for the fourth quarter of the year as:

September (actual)............................. $70,000
Fourth Quarter
October ..............................................
$60,000
November .......................................... 55,000
December .......................................... 80,000

Experience has shown that 30 percent of sales are collected in the month of sale, 60 percent in the following month, and 10 percent are never collected.
Prepare a schedule of cash receipts for J. Lo's Clothiers covering the fourth quarter (October through December).

17. Victoria's Apparel has forecast credit sales for the fourth quarter of the year as:

September (actual)............................. $50,000
Fourth Quarter
October ..............................................
$40,000
November .......................................... 35,000
December .......................................... 60,000

Experience has shown that 20 percent of sales are collected in the month of sale, 70 percent in the following month, and 10 percent are never collected.

Prepare a schedule of cash receipts for Victoria's Apparel covering the fourth quarter (October through December).

18. Pirate Video Company has made the following sales projections for the next six months. All sales are credit sales.

Sales in January and February were $27,000 and $26,000, respectively.

Experience has shown that of total sales, 10 percent are uncollectible, 30 percent are collected in the month of sale, 40 percent are collected in the following month, and 20 percent are collected two months after sale.

Prepare a monthly cash receipts schedule for the firm for March through August.

Of the sales expected to be made during the six months from March through August, how much will still be uncollected at the end of August? How much of this is expected to be collected later?

19. The Elliot Corporation has forecast the following sales for the first seven months of the year:

Monthly material purchases are set equal to 20 percent of forecasted sales for the next month. Of the total material costs, 40 percent are paid in the month of purchase and 60 percent in the following month. Labor costs will run $6,000 per month, and fixed overhead is $3,000 per month. Interest payments on the debt will be $4,500 for both March and June. Finally, Elliot's salesforce will receive a 3 percent commission on total sales for the first six months of the year, to be paid on June 30.

Prepare a monthly summary of cash payments for the six-month period from January through June. (Note: Compute prior December purchases to help get total material payments for January.)

20. Wright Lighting Fixtures forecasts its sales in units for the next four months as follows:

Wright maintains an ending inventory for each month in the amount of one and one-half times the expected sales in the following month. The ending inventory for February (March's beginning inventory) reflects this policy. Materials cost $7 per unit and are paid for in the month after production. Labor cost is $3 per unit and is paid for in the month incurred. Fixed overhead is $10,000 per month. Dividends of $14,000 are to be paid in May. Eight thousand units were produced in February.

Complete a production schedule and a summary of cash payments for March, April, and May. Remember that production in any one month is equal to sales plus desired ending inventory minus beginning inventory.

21. Dina's Lamp Company has forecast its sales in units as follows:

Dina's always keeps an ending inventory equal to 120 percent of the next month's expected sales. The ending inventory for December (January's beginning inventory) is 1,200 units, which is consistent with this policy.
Materials cost $14 per unit and are paid for in the month after purchase. Labor cost is $7 per unit and is paid in the month the cost is incurred. Overhead costs are $8,000 per month. Interest of $10,000 is scheduled to be paid in March, and employee bonuses of $15,500 will be paid in June.

Prepare a monthly production schedule and a monthly summary of cash payments for January through June. Dina produced 800 units in December.

22. Graham Potato Company has projected sales of $6,000 in September, $10,000 in October, $16,000 in November, and $12,000 in December. Of the company's sales, 20 percent are paid for by cash and 80 percent are sold on credit. Experience, shows that 40 percent of accounts receivable are paid in the month after the sale, while the remaining 60 percent are paid two months after. Determine collections for November and December.

Also assume Graham's cash payments for November and December are $13,000 and $6,000, respectively. The beginning cash balance in November is $5,000, which is the desired minimum balance.

Prepare a cash budget with borrowing needed or repayments for November and December. (You will need to prepare a cash receipts schedule first.)

23. Juan's Taco Company has restaurants in five college towns. Juan wants to expand into Austin and College Station and needs a bank loan to do this. Mr. Bryan, the banker, will finance construction if Juan can present an acceptable three-month financial plan for January through March. Following are actual and forecasted sales figures:

Of Juan's sales, 30 percent are for cash and the remaining 70 percent are on credit. Of credit sales, 40 percent are paid in the month after sale and 60 percent are paid in the second month after the sale. Materials cost 20 percent of sales and are paid for in cash. Labor expense is 50 percent of sales and is also paid in the month of sales. Selling and administrative expense is 5 percent of sales and is also paid in the month of sales.

Overhead expense is $12,000 in cash per month; depreciation expense is $25,000 per month. Taxes of $20,000 and dividends of $16,000 will be paid in March. Cash at the beginning of January is $70,000, and the minimum desired cash balance is $65,000.

For January, February, and March, prepare a schedule of monthly cash receipts, monthly cash payments, and a complete monthly cash budget with borrowings and repayments.

24. Hickman Avionics's actual sales and purchases for April and May are shown here along with forecasted sales and purchases for June through September.

The company makes 10 percent of its sales for cash and 90 percent on credit. Of the credit sales, 20 percent are collected in the month after the sale and 80 percent are collected two months later. Hickman pays for 40 percent of its purchases in the month after purchase and 60 percent two months after.

Labor expense equals 10 percent of the current month's sales. Overhead expense equals $15,000 per month. Interest payments of $40,000 are due in June and September. A cash dividend of $20,000 is scheduled to be paid in June. Tax payments of $35,000 are due in June and September. There is a scheduled capital outlay of $300,000 in September.

Hickman Avionics's ending cash balance in May is $20,000. The minimum desired cash balance is $15,000. Prepare a schedule of monthly cash receipts, monthly cash payments, and a complete monthly cash budget with borrowing and repayments for June through September. The maximum desired cash balance is $50,000. Excess cash (above $50,000) is used to buy marketable securities. Marketable securities are sold before borrowing funds in case of a cash shortfall (less than $15,000).

25. Carter Paint Company has plants in nine midwestern states. Sales for last year were $100 million, and the balance sheet at year-end is similar in percentage of sales to that of previous years (and this will continue in the future). All assets (including fixed assets) and current liabilities will vary directly with sales.

BALANCE SHEET
(in $ millions)

Carter Paint has an aftertax profit margin of 5 percent and a dividend payout ratio of 30 percent.

If sales grow by 10 percent next year, determine how many dollars of new funds are needed to finance the expansion. (Assume Carter Paint is already using assets at full capacity and that plant must be added.)

26. Jordan Aluminum Supplies has the following financial statements, which are representative of the company's historical average.

Income Statement
Sales ...................................................... $300,000
Expenses ............................................... 247,000
Earnings before interest and taxes ........ $ 53,000
Interest .................................................. 3,000
Earnings before taxes............................ $ 50,000
Taxes..................................................... 20,000
Earnings after taxes............................... $ 30,000
Dividends .............................................. $ 18,000

Balance Sheet

Jordan is expecting a 20 percent increase in sales next year, and management is concerned about the company's need for external funds. The increase in sales is expected to be carried out without any expansion of fixed assets, but rather through more efficient asset utilization in the existing stores. Among liabilities, only current liabilities vary directly with sales.

Using the percent-of-sales method, determine whether Jordan Aluminum has external financing needs. (Hint: A profit margin and payout ratio must be found from the income statement.)

27. Cambridge Prep Shops, a national clothing chain, had sales of $200 million last year. The business has a steady net profit margin of 12 percent and a dividend payout ratio of 40 percent. The balance sheet for the end of last year is shown below.

Balance Sheet End of Year (in $ millions)                          

Cambridge's marketing staff tells the president that in this coming year there will be a large increase in the demand for tweed sport coats and various shoes. A sales increase of 15 percent is forecast for the Prep Shop.

All balance sheet items are expected to maintain the same percent-of-sales relationships as last year*, except for common stock and retained earnings. No change is scheduled in the number of common stock shares outstanding, and retained earnings will change as dictated by the profits and dividend policy of the firm. (Remember the net profit margin is 12 percent.)

a. Will external financing be required for the Prep Shop during the coming year?
b. What would be the need for external financing if the net profit margin went up to 14 percent and the dividend payout ratio was increased to 70 percent? Explain.
* This included fixed assets as the firm is at full capacity.

COMPREHENSIVE PROBLEM

Comprehensive Problem 1.

The Landis Corporation had 2008 sales of $100 million. The balance sheet items that vary directly with sales and the profit margin are as follows:

Percent
Cash....................................................................... 5%
Accounts receivable .............................................. 15
Inventory ............................................................... 25
Net fixed assets ..................................................... 40
Accounts payable .................................................. 15
Accruals ................................................................ 10
Profit margin after taxes........................................ 6%

The dividend payout rate is 50 percent of earnings, and the balance in retained earnings at the end of 2009 was $33 million. Common stock and the company's long-term bonds are constant at $10 million and $5 million, respectively. Notes payable are currently $12 million.
a. How much additional external capital will be required for next year if sales increase 15 percent? (Assume that the company is already operating at full capacity.)
b. What will happen to external fund requirements if Landis Corporation reduces the payout ratio, grows at a slower rate, or suffers a decline in its profit margin? Discuss each of these separately.
c. Prepare a pro forma balance sheet for 2009 assuming that any external funds being acquired will be in the form of notes payable. Disregard the information in part b in answering this question (that is, use the original information and part a in constructing your pro forma balance sheet).

Comprehensive Problem 2

The difficult part of solving a problem of this nature is to know what to do with the information contained within a story problem. Therefore, this problem will be easier to complete if you rely on Chapter 4 for the format of all required schedules.

The Adams Corporation makes standard-size 2-inch fasteners, which it sells for $155 per thousand. Mr. Adams is the majority owner and manages the inventory and finances of the company. He estimates sales for the following months to be:

January ................................... $263,500 (1,700,000 fasteners)
February ................................. $186,000 (1,200,000 fasteners)
March ..................................... $217,000 (1,400,000 fasteners)
April ....................................... $310,000 (2,000,000 fasteners)
May ........................................ $387,500 (2,500,000 fasteners)

Last year Adams Corporation's sales were $175,000 in November and $232,500 in December (1,500,000 fasteners).
Mr. Adams is preparing for a meeting with his banker to arrange the financing for the first quarter. Based on his sales forecast and the following information he has provided, your job as his new financial analyst is to prepare a monthly cash budget, monthly and quarterly pro forma income statements, a pro forma quarterly balance sheet, and all necessary supporting schedules for the first quarter.

Past history shows that Adams Corporation collects 50 percent of its accounts receivable in the normal 30-day credit period (the month after the sale) and the other 50 percent in 60 days (two months after the sale). It pays for its materials 30 days after receipt. In general, Mr. Adams likes to keep a two-month supply of inventory in anticipation of sales. Inventory at the beginning of December was 2,600,000 units. (This was not equal to his desired two-month supply.)

The major cost of production is the purchase of raw materials in the form of steel rods, which are cut, threaded, and finished. Last year raw material costs were $52 per 1,000 fasteners, but Mr. Adams has just been notified that material costs have risen, effective January 1, to $60 per 1,000 fasteners. The Adams Corporation uses FIFO inventory accounting. Labor costs are relatively constant at $20 per thousand fasteners, since workers are paid on a piecework basis. Overhead is allocated at $10 per thousand units, and selling and administrative expense is 20 percent of sales. Labor expense and overhead are direct cash outflows paid in the month incurred, while interest and taxes are paid quarterly.

The corporation usually maintains a minimum cash balance of $25,000, and it puts its excess cash into marketable securities. The average tax rate is 40 percent, and Mr. Adams usually pays out 50 percent of net income in dividends to stockholders. Marketable securities are sold before funds are borrowed when a cash shortage is faced. Ignore the interest on any short- term borrowings. Interest on the long-term debt is paid in March, as are taxes and dividends.