EMBA 7015 Assignment Solutions on Strategic Financial Management
Topic: Financial Management
Document Type: Coursework
Subject: Finance
Citation/Referencing Style: APA
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Guidelines and Suggestions for Case 1
The “Toys For You” case provides several opportunities. First, you will be able to sharpen your skills in developing pro forma documents that will assist an organization’s strategic planning process. Second you will be able to sharpen your managerial skills by analyzing the planning documents to determine the likely effects on financial health and goals if suggested policy changes are implemented. In other words, “Toys For You” has technical aspects and policy aspects. Should the contemplated policy changes be implemented, and what might happen to the organization if they are implemented?
Without losing sight of the policy recommendations you are required to consider, the technical challenges of developing the forecast are considerable. This complex planning forecast requires the preparation and interpretation of several planning statements:
- Pro forma monthly cash budget for July through December, 2016
- Pro forma quarterly income statement for period ending Sep 2016 and period ending Dec 2016
- Pro forma balance sheets as of Sep 30, 2016 and as of Dec 31, 2016.
1. Pro Forma Quarterly Income Statements
These statements pose the least difficulties. For the Q3 Statement, start with the estimated sales for Jul-Sep; for the Q4 Statement, start with the estimated sales for Oct-Dec. For each statement, determine COGS using the information given, Selling and Administrative Expense using the information given, and amortization using the information given. Show Interest Expense in the Q4 Statement. Calculate taxes for each quarter using the information given. After determining Net Income for each quarter, allocate that income to Dividends and to Addition to Retained Earnings, using the information provided (it appears that dividends are declared quarterly).
2. Pro Forma Monthly Cash Budget
This budget should show the effects of the proposed level production schedule and the proposed change in collections. In addition, the payments for production and the collections on sales will impact the balance sheet entries for Accounts Payable, Inventory and Accounts Receivable.
Many of the payments are easily determined. There is information for projected payments on labour expense, other expenses, and selling and administrative expense for example. There is additional information for other cash flows including payment of interest, taxes, dividends and payments to reduce notes payable.
Monthly Payments on Purchases. Payments on purchases of materials are more problematical. Information is provided for purchases made in May and June and for the forecast period with level production. Further, these purchases are paid in 40 days. So how are payments against these purchases to be allocated month by month in the cash budget? For ease of calculation, assume that each month has 30 days. Then recognize that a 40-day payment plan extends over two months (60 days). Further assume any payments are made at the end of the month. Then set up a model to solve for x, where x is the proportion of purchases that are paid at the end of 30 days, leaving (1 – x) as the proportion that are paid at the end of 60 days: x*30 + (1 – x)*60 = 40. Solving this model results in x = 2/3, indicating that 2/3 of monthly purchases are paid at the end of the next month and 1/3 of those monthly purchases are paid at the end of the second month after the purchase. Beginning with May purchases, allocate 20/30 = 2/3 to be paid in June. The remaining 1/3 of the May purchases will be paid in July, the first month of the planning period. But in the meantime, purchases were made in June. Allocate 2/3 of the June purchases also to be paid in July. So total payments in July consist of a 1/3 payment for May purchases, plus a 2/3 payment for June purchases. Now continue this allocation process for the rest of the planning period.
How does a 2/3 payment one month after purchase plus a 1/3 payment two months after purchase represent a 40-day payment schedule? This is shown by a process of weighted averaging: (2/3 x 30 days) plus (1/3 x 60 days) = 20 + 20 = 40 days.
Monthly Collections on Sales. The same process used for allocating payments over two months can be used for allocating collections over two months. However, the process is complicated because policy changes during the planning period. The plan begins with a 60-day collection experience for May and June sales. Then plans call for tighter accounts receivable control beginning with July sales such that sales are collected in 50 days. Additional controls result in planned collections in 42 days beginning with September sales and planned collections in 35 days beginning with November sales.
This means that all of May sales are collected in July and all of June sales are collected in August. Beginning in July, sales are collected in 50 days. As with purchases, set up a model where sales are collected over a two-month period, averaging 50 days: x*30 + (1 – x)*60 = 50. Solving this model results in x = 1/3. This means that 1/3 of July sales are collected in August. These month-of-July sales collections must be added to the previous month-of-June collections also received in August to obtain total collections for the month of August. Allocate the remaining 2/3 of July sales to September. Do the same allocation for month-of-August sales, realizing that total collections in September consist of some of July sales and some of August sales. (Note: this allocation system averages to 50 days as: 1/3 x 30 + 2/3 x 60 = 10 + 40 = 50 days.)
Beginning in September, planned collections are reduced to 42 days, so the model becomes x*30 + (1 – x)*60 = 42. This results in x = 3/5, meaning that 3/5 of September sales are collected in October and must be added to the remaining August sales also collected in October. Then 2/5 of September sales are allocated to November collections. Do the same allocation for October sales. (Note: this allocation system averages to 42 days as: 3/5 x 30 + 2/5 x 60 = 18 + 24 = 42 days.)
Finally, beginning in November, planned collections are reduced to 35 days, so the model becomes x*30 + (1-x)*60 = 35. This results in x = 5/6,meaning that 5/6 of November sales are collected in December and must be added to the remaining October sales also collected in December. The remaining November sales and the December sales can be ignored because they would be collected beyond this six-month planning period. (Note: this allocation system averages to 35 days as 5/6 x 30 + 1/6 x 60 = 25 + 10 = 35 days.)
As a final part of the analysis, you should rework the cash flows showing the current collection experience of 60 days, meaning the collection policy reforms are not implemented.
3. Pro Forma Quarterly Balance Sheets
Balance Sheet Effects of Purchases and Payments. Now we need to determine how the payments affect Accounts Payable on the Balance Sheet. The level of A/P is shown on the June 30 Balance Sheet, and this is the starting point. The June 30 level of A/P includes purchases made in May and in June that are yet to be paid, so it is current. The level of A/P for July is determined as June A/P plus Purchases made in July less Payments made in July. Use the running total of A/P in September for the September Balance Sheet and the running total of A/P in December for the December Balance Sheet.
Balance Sheet Effects of Sales and Collections. We need to determine how the collections affect Accounts Receivable on the Balance Sheet. The level of A/R shown on the June 30 Balance Sheet is 3,578. This consists of all of the uncollected sales from May and June and is more precisely depicted as 1732.5 + 1845 = 3577.5. This is the starting point. The level of A/R for July is determined as June A/R plus Sales made in July less collections received in July. Use the running total of A/R in September for the September Balance Sheet and the running total of A/R in December for the December Balance Sheet.
More Balance Sheet Effects. This is a good place to determine how Purchases and Sales affect Inventory levels shown on the Balance Sheet. Toys For You is a manufacturing firm and we will assume only a finished goods inventory for simplicity. Purchases are part of “cost of goods produced.” Additional components of this cost are labor and other manufacturing costs. Recall that the firm plans to adopt level production in July. Information about monthly purchases, labor expense, and manufacturing expense is provided.
The level of Inventory on the Balance Sheet as of June 30 is the starting point. The level of Inventory for July is determined as June Inventory plus “cost of goods produced” in July less COGS sold in July. This “cost of goods produced” is not a ledger account that appears on the Income Statement, but it does reflect the value of goods manufactured during July that are added to inventory. The COGS for July is based on July sales and the COGS relationship explained in the exercise. Use the running total of Inventory in September for the September Balance Sheet and the running total of Inventory in December for the December Balance Sheet.
There is also a connection between the income statement and the balance sheet through retained earnings. The income statement is the starting point. Net income is either paid out in the form of dividends or retained within the firm. Periodic retentions (additions to retained earnings) are reflected by adjustments to the Retained Earnings account as shown in the equity section of the balance sheet. The equity section shows partially as Common Stock and partially as Retained Earnings. Changes in the common stock account derive from sales of additional shares, or repurchase of shares. Additions to the retained earnings account derive from Net Income that is not distributed in the form of dividends. And any losses (negative net income) shown in the Income Statement are reflected as reductions to the balance of retained earnings shown in the Balance Sheet.
4. Additional Notes
It is suggested that you show May sales at 1733.0. Then the May sales plus the June sales, none of which are collected through June, will be consistent with the Accounts Receivable of 3578.0 as shown on the June Balance Sheet.
Some groups may choose to use the author-provided template. The provided template is more of a worksheet than a cash budget, because it contains several entries that normally are not on the cash budget, but are needed for the other pro forma statements. For this reason, use of the template is not encouraged except as a guideline. If you use this worksheet, please present a separate cash budget in the customary format: first show cash receipts, then cash payments, then net cash flow, and finally an ending cash position for the month.
TOYS FOR YOU
Balance Sheet (estimated)
June 30, 20XY ($ thousands)
Assets
Current assets:
Cash $ 666
Accounts receivable 3,578
Inventory 8,231
Total current assets 12,475
Capital assets:
Plant and equipment 11,273
Less: Accumulated amortization 4,784 6,489
Total assets $18,964
Liabilities and Shareholders’ Equity
Current liabilities
Accounts payable $ 945
Notes payable 3,700
Accrued liabilities 2,596
Total current liabilities 7,241
Long-term debt 4,725
Common stock 4,500
Retained earnings 2,498
Total liabilities and shareholders’ equity $18,964
Using the information above, prepare pro forma statements for Toys for You for the three months ending September and December 20XY. Also construct a cash budget for the six‐month period and identify any need for short‐term financing. There are no changes in accounts not mentioned above. Comment on the policy changes and examine the consequences if the collection period remains at 60 days. Assume capital assets are sufficient for increased sales.
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