Practice Case: Understanding Cash Flows and Financial Planning
FIN 3154, Easterwood
(A) Description:
KLW Products, Inc., has enjoyed strong performance during most of the past decade. Its ROA based
on net income was 4.42% in Year -1, compared to an industry average of about 4%. In prior years, its
profitability was even better. However, the economic contraction that set in during Year -1 and
throughout Year 0 has dramatically affected firm performance. KLW’s CFO, Jane Wu, has asked you
to act as a consultant and assist her with the preparation of the forecasts of financial statements and
cash flows through the period of recession and recovery. Wu and the majority of the firm’s Board of
Directors believe that sales will begin growing at 4% in Year +1 and continue to grow at that rate in
Year +2 and Year +3.
Wu has asked you to help her with two forecasts that go out to Year +3. The first, called “Quick
recovery”, predicts that the firm will experience a 4% increase in sales during each of the next three
years. [The second forecast, called “Slow recovery”, is described below.] For Quick recovery, Wu
expects that fixed asset growth will be minimal in Year +1 (say 1%) but will rebound to 4% beginning
in Year +2 and going forward. Assume that the firm’s new assets have a 20 year expected life and that
the firm uses the straight line method for both financial reporting and tax purposes. In both forecasts,
depreciation of the assets that KLW currently owns will continue at the same amount for all three years
of your forecasts. Wu does not expect the firm to sell any assets during this period. Note that in the
long-term, KLW cannot expect to meet its sales forecasts and the corresponding operating profitability
unless its fixed assets grow as described.
To forecast cash flows for the Quick recovery scenario, you will need information about costs, interest
rates, and several financial statement relationships. Cost of goods sold is composed of both fixed and
variable components. The fixed costs will be $25 million in each year. Assume that this amount
doesn’t change during the coming 3 years. The variable component of cost of goods sold is 21% of
sales for each year. Similarly, selling, general, and administrative expenses are expected to have a
fixed component of $30 million and a variable component of 10% of sales in each year. Expect that
cash (4%), accounts receivable (18%), inventory (25%), and accounts payable (8%) will all have direct
and proportional relationships with sales. The firm faces a tax rate of 40% of its taxable income. The
tax rate is expected to be the same for all 3 years. KLW is incorporated in a state that does not require
par values for firms’ common shares. The firm does not expect to issue or repurchase stock during the
next 3 years.
The firm currently has 3 categories of debt – accounts payable and other accrued expenses (described
in the prior paragraph), notes payable (short-term borrowings from a consortium of banks through a
credit line), and long-term debt. The notes payable have maturities of one year. The long-term debt is
a bond issue that matures in 10 years from now and requires retirement of $5 million of principal each
year through a sinking fund. You don’t need to “reclassify” the portion of long-term debt due in each
period as a current liability. The credit line with the banks has a limit of $45 million and has covenants
that require the firm to maintain a current ratio (CR) of 1.1 and a debt service coverage ratio (DSCR)
of 1.5. For the notes payable, Wu agrees to use the firm’s current cost of 7% for the Quick recovery
scenario. Use 9% as the rate on long-term debt for both scenarios.
In most of this decade, KLW has experienced 5% growth in dividends each year. Wu says that the
firm had to eliminate the dividend in Year 0 due to catastrophic economic conditions and to conserve
cash in the short run. KLW is anxious to resume paying dividends in Year +1 if financial conditions
permit it. Wu proposes to pay a dividend of $1 million in Year +1 and to double the dividend to $2
million in Year +2. Accordingly, if the economy experiences the quick recovery, she hopes to adopt a
dividend growth rate of 4% beginning in Year +3.
While the majority of the board agrees with Wu’s predictions, two board members have expressed
doubts that the economy will rebound quickly enough to support the projections above. Citing several
prominent economic forecasts, they argue that the economy will recover very slowly if at all in the
coming year. Using this information and a desire to plan for plausibly adverse conditions, they have
requested a second set of forecasts, called Slow recovery, based on the idea that sales grow at only
1.5% throughout the forecast horizon. They propose to undertake no capital spending in Year +1 and
Year +2 and to increase gross fixed asset to grow at a rate of 2% in Year +3. They believe the unused
capacity at the end of Year 0 will allow the firm to increase its sales without expanding its assets.
Based on the poor overall economic climate, they expect credit spreads (the rate borrowers with default
risk pay minus the rate the US Treasury pays) to increase in the very near future. To reflect this, use
8% as the short-term rate for KLW for your slow recovery forecasts. Continue to use 9% for the longterm debt since that is an already issued liability. These board members have also suggested that the
firm should expect credit customers to pay more slowly. To reflect this, they suggest that forecasts
show accounts receivable rising to 23% of sales. They also suggest that the firm could economize on
its inventory in the current economic climate. Wu asks that you plan on inventory also being 23% of
sales. Finally, these board members say that returning to pay a dividend at this time is not prudent.
They suggest paying no dividend in Year +1 and resuming a $1 million dividend in Year +2 and then
allowing for 4% growth thereafter. Assume other variables are the same as the Quick recovery
forecast.
(B) Instructions:
Prepare forecasts of income statements and balance sheets for Years +1 thru +3 using the Year 0 data
and the information above. Year -1 data is also available for use in the analysis below. Using these
statements (both past and forecasted), prepare a cash flow statement using the financial framework for
each year. Use the notes payable as your balancing item in forecasting your balance sheets for each
scenario. If the balancing figure violates a requirement of the loan, you can discuss that while
answering the questions below, but don’t force the numbers to correspond to the loan terms. In
constructing your cash flow statement, treat the bank loan as an operating liability, but think about how
your cash flow analysis would be affected if you assumed instead that the bank loan is discretionary
financing. You should begin with Year -1 for the variables that can be computed using one year’s
worth of data. If two year’s data is needed to calculate a change in a balance sheet item, then begin
with Year 0. Also, compute the following ratios for each year Years -1 thru +3: Debt Ratio (total
liabilities/total assets), Current Ratio, Debt Service Coverage Ratio (operating cash flow from your
cash flow statement/the sum of interest and principal due in each year), Asset turnover, Net ROA (net
income/total assets), and Cash Flow ROA (operating cash flow from your cash flow statement/total
assets). In the interest of simplicity, all ratios can use end of year figures.
Organize your Excel file as follows. First, include an “Assumptions” sheet with a column for the
Quick recovery assumptions and a column for the Slow recovery assumptions. Some figures will be
the same in both columns while other variables will be different. Next, using the Year 0 data and your
assumptions, forecast your statements in one sheet for the Quick recovery scenario and in another sheet
for the Slow Recovery scenario. Finally, prepare a “Summary” sheet/page that lists the ratios and other
relevant variables used in answering the questions below. This sheet/page should be extensive enough
so that you don’t need to go back to the models to answer the questions. There is no single format for
the summary page, but make sure that you have a visually attractive and easily readable page which
contains all of the important data and presents it in a professional manner. While this is not an “art
class”, having a professional appearance is important.
(C) Questions:
1. Based on the general description of the problem in this assignment, what would you expect to
happen to a firm’s performance as reflected in its income statement, balance sheet, and cash flow
statement in response to a sharp economic decline. This answer should be prepared before you have
completed the forecasts and answered the questions below. Your answer shouldn’t be especially long,
but you should give a clear indication of what you think a firm in this position should experience.
2. Look at the 3 parts of your statements of cash flow. Look first at the free cash flow figures and the
calculations that went into them. How do the free cash flows and its components compare between the
two recovery scenarios? Explain your observations. Next, repeat the analysis for the cash flow to
creditors and the cash flow to stockholders. What, if any, differences or similarities exist? Explain
briefly but thoroughly.
3. Look first at the three $ profit measures (EBIT, Net Income, and Operating Cash Flow from the
statement of cash flows) and the two % profit measures. How do these profit measures respond to the
predicted recession and recovery? Do profits respond the same way or differently for the Quick
Recovery and Slow Recovery scenarios? Explain your answer. Are these responses as you expected or
different? Explain your answer.
4. (a) Look at the level of notes payable, the debt ratios, the current ratios, and the debt service
coverage ratios through time under each recession scenario. Describe the patterns and the relationship
between your predictions and the common sense critical values (100% for the DR, and 1 for the CR
and DSCR) and your analysis of cash flow to creditors. For a given scenario, what is the relationship
between the three ratios? Explain. Compare the two scenarios for each ratio. Does the firm experience
difficulties equally or differentially under the two scenarios? Explain.
4. (b) Wu plans to meet with her bank creditors soon. What issues should she discuss? What issues
are the bankers likely to bring up? How would you recommend responding to any criticism and
concerns the bankers might express about KLW?