Tipton Ice Cream: Financial Forecasting

Summary
Tipton Ice Cream, a retail based company, is going to forecast its financial condition
adopting debt financing for the first time after doing business for 25 years with equity
financing. This is a strong case for borrowing made by Brenda Hood, the chief financial
officer of Tipton expecting strong growth in the coming year 1996. The CFO of Tipton
estimates some clear assumptions mentioning some constraints to achieve the expected
goal. Based on these, the case can be summarized as follow:

Planning for Business expansion

Making new accounting & financial statements
Analyzing relevant ratios
Comparing the causes and effects of Debt and Equity financing

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Measuring the risk of borrowing

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After answering all the questions of this case, we’ve concluded some findings regarding the

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financial forecasting of Tipton Ice Cream.

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Questions and Answers

Ques-1: Tipton’s 1996 income statement with the estimations assuming no

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borrowings:
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Answer:
1995 1996
in '000 in % in '000 in %
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Net sales 100,000.00 100.00% 125,000.00 100.00%

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COGS 79,000.00 79.00% 93,750.00 75.00%

Gross Profit 21,000.00 21.00% 31,250.00 25.00%
Admin & Selling
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Expense 10,000.00 10.00% 12,000.00 9.60%

Depreciation 600.00 0.60% 600.00 0.48%
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Miscellaneous 200.00 0.20% 220.00 0.18%

10,800.00 10.80% 12,820.00 10.26%
EBT 10,200.00 10.20% 18,430.00 14.74%
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Tax Provision 5,100.00 5.10% 9,215.00 7.37%

Net Income 5,100.00 5.10% 9,215.00 7.37%
Dividends 2,550.00 2.55% 4,607.00 3.69%
Retain Earnings 2,550.00 2.55% 4,607.00 3.69%

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 Ques-2: Tipton’s 1996 balance sheet with the estimations assuming no borrowings:
Answer:
1995 1996
in '000 in % in '000 in %
Assets
Cash &Mkt Sec 3,000.00 7.06% 3,200.00 6.81%
A/C receivable 8,000.00 18.82% 11,250.00 23.95%
Inventory 11,500.00 27.06% 8,130.00 17.31%
Current Assets 22,500.00 52.94% 22,580.00 48.06%
Fixed Assets 24,000.00 56.47% 29,000.00 61.73%
Depreciation 4,000.00 9.41% 4,600.00 9.79%
Net Fixed Assets 20,000.00 47.06% 24,400.00 51.94%
Total Assets 42,500.00 100.00% 46,980.00 100.00%

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Liabilities & payables

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Notes Payable - 0.00% 450.00 0.96%

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A/C Payable 9,500.00 22.35% 7,590.00 16.16%

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Accrual 3,000.00 7.06% 3,190.00 6.79%
Current Liabilities
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Non-current liability

Bond - - - -
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Common Stock 20,000.00 47.06% 28,200.00 60.03%

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Retain Earning 10,000.00 23.53% 7,550.00 16.07%

Total Liability and
Shareholder’s Equity 42,500.00 100.00% 46,980.00 100.00%
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Ques-3: Explain how the $93.75 million cost of goods sold estimate for 1996 was
obtained?
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Answer: The Cost of goods sold or COGS was estimated to be $93.75 million in 1996. Hood
enlisted Frank Davis, a recent MBA who reminded her that 1996 is expected to be a big
year for the company and sale are predicted to increase by 25%. Due to the strong demand,
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marketing feels any cost increases can easily be passed on. Consequently, the gross margin
should exceed the current level of 21%. Hood notes that the sales-to-inventory ratio will be
lowered to 6.5%, and that purchase should total $101,481,000. Thus suggests COGS for
1996 would be $93.75 million.

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 Purchase $101,481,000.00
Opening Inventory $11,500,000.00
Balance $112,981,000.00
COGS $93,750,000.00
Direct Costs $11,101,000.00
Closing Stock $8,130,000.00

Ques-4: How much money will Tipton need to raise in 1996?

Answer: Tipton will need to raise:

$9,400,000+$2,000,000
= $11,400,000
It is 26% of the total capital. It indicates that Tipton is not using debt financing

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aggressively, which is a better for future growth.

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Ques-5: (a) How much of money can Tipton borrow long term without violating the

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constrains imposed by Hood?

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Answer:
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Constraints by Hood:
Tipton’s debt ratio remains below 0.5
Current and quick ratios mustn’t fall below 2 to 1
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Ratios Calculation:
Quick ratio= (18,830,000-8130,000)/ 9400,000=1.14
Current ratio=18,830,000/9400,000=2.00
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Debt ratio= Total Debt/ Total Asset

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0.49= Total Debt/ $43,230,000; Here,

So, Total Debt= 21,182,700 0.49= Assuming the maximum portion
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of debt ratio, which is below 0.5

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$21,182,700 - $9,400,000 =$11,782,700 $43,230,000= Total Asset in 1996

with Debt Financing
So, long term borrowing should not exceed $11,782,700 whereas Tipton has forecasted
their long term borrowing to be 2 million.
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 Ques-5: (b) How much of this money can be raised using note payable without
violating the constrains?

0.49= Total Debt/ $43,230,000;

So, Total Debt= 21,182,700
$21,182,700- ($2,000,000 +$6,700,000+$2,300,000)
= $11,982,700
So, notes payable should not exceed $11,982,700 whereas Tipton has forecasted their note
payable to be $400,000.

Ques-6: The 1996 income statement with the estimations assuming all of fund
needed are borrowed as long-term bonds at 8% keeping the retained earning same
as estimated without borrowings:

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With Debt financing

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1995 1996

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in '000 in % in '000 in %

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Net sales 100,000.00 100.00% 125,000.00 100.00%

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COGS 79,000.00 79.00% 93,750.00 75.00%
Gross Profit rs e 21,000.00 21.00% 31,250.00 25.00%
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Admin & Selling Expense 10,000.00 10.00% 12,000.00 9.60%
Depreciation 600.00 0.60% 600.00 0.48%
Miscellaneous 200.00 0.20% 220.00 0.18%
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10,800.00 10.80% 12,820.00 10.26%

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EBIT 10,200.00 10.20% 18,430.00 14.74%

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Interest (8% on Long term

borrowings of 5 million) - 0.00% 160.00 .13%
EBT 10,200.00 10.20% 18,270.00 14.26%
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Tax Provision 5,100.00 5.10% 9,135.00 7.31%

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Net Income 5,100.00 5.10% 9,135.00 7.31%

Dividends 2,550.00 2.55% 4,528.00 3.62%
Retain Earnings 2,550.00 2.55% 4,607.00 3.62%
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Ques-7: Will Tipton family own less than 50 percent of the firm’s stock if no funds are
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borrowed?

Answer:
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Tipton Firm Stock =2000000

Tipton Family members own 60% of 20 million= 1200000 stocks
Non family members own 40% of 20 million=800000 stocks
Half of the firm stock is= 1000000

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 To collect $2million without borrowing, Tipton needs to sell 190,476 stocks (of 1200000
family stocks), assuming $10.50 per share.

So, Tipton owns 1200000- 190,476 =1,009,524 stocks, which is higher than 50% (1000000
stocks) of the firm’s stocks.

No. Tipton owns more than 50%.

Ques-8: Calculate the dividend per share and earnings per share if the expansion is:
a)Financed by new equity
b) Financed by borrowing

Answer:
a) Financed by new equity 1996 b) Financed by borrowing 1996

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DPS= EPS= DPS= EPS=

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DPS= EPS= DPS= EPS=
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DPS= 0.16 EPS= 0.16 DPS=0.27 EPS=0.28

Ques-9: Use the percentage of sales method to forecast the amount of financing. Why
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does this estimate differ from your answer in question 4?

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Answer: First, determine the forecasted Sales level. This is done my multiplying Sales for
the current year (1995) by one plus the forecasted growth rate in Sales.
S1= S0(1 + g) = $100,000,000(1 + .25) = $125,000,000
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Forecasted Net Income= $5100,000*125%= $6375,000

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Partial Pro-forma Financial Statements:

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Pro Forma Income Statement 1996 (000s)

1995 1996
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in '000 in % in '000
Net sales 100,000.00 100.00% 125,000.00
COGS 79,000.00 79.00% 98,750.00
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Gross Profit 21,000.00 21% 26,250.00

Admin & Selling
Expense 10,000.00 10,000.00
Depreciation 600.00 600.00
Miscellaneous 200.00 200.00

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 10,800.00 10,800.00
EBIT 10,200.00 15,450.00
Interest -
EBT 10,200.00 15,450.00
Tax Provision 5,100.00 50.00% 9,075.00
Net Income 5,100.00 5.10% 6,375.00
Dividends 2,550.00 50.00% 3,187.50
Retain Earnings 2,550.00 50.00% 3,187.50

Pro Forma Balance Sheet of 1996 (000s)

1995 1996
% in
in '000 Sales in '000
Assets

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Cash &Mkt Sec 3000 3.00% 3,750.00

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A/C receivable 8000 8.00% 10,000.00

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Inventory 11500 11.50% 14,375.00

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Current Assets 22,500.00 23% 28,125.00

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Fixed Assets 24,000.00
Depreciation rs e 4,000.00
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Net Fixed Assets 20,000.00 20.00% 25,000.00
Total Assets 42,500.00 43% 53,125.00
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Liabilities & payables

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Notes Payable -
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A/C Payable 9,500.00 9.50% 11,875.00

Accrual 3,000.00 3,000.00
Current Liabilities 12,500.00 10% 14,875.00
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Non-current liability
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Bond
Common Stock (@10) 20,000.00 20,000.00
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Retain Earning 10,000.00 13,187.50

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42,500.00 10% 48,062.50

External Financial Needed (EFN)= $53,125,000-$48,062,500= $5,062,500

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Tipton can choose to raise the EFN by borrowing on short-term basis (Notes Payable),
borrowing on a long-term basis (Long-Term Debt), issuing equity (Common Stock), or
some combination of the above.

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 According to question-4, the forecasted total debt was $11,400,000. This is $11,400,000-
$5,062,500) = $15,737,500 more than the amount estimated through Percentage of Sales
method. The relevant causesare-

 We’ve used forecasted net income which is 125% of the current net income.
 The current and Quick ratio falls below 2 and 1, which violates the constrains stated
by Brenda Hood.
 Tipton’s needs financing around $21,330,000 for account receivables, purchasing
money of inventory and fixed assets; where the forecasted debt is $11,400,000.
Ques-10:
a) When making a financial forecast, which one of the item that must be estimated is
the most important? Why?
b) Which item do you think is typically most difficult to forecast?

Answer:

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10. a) When making a financial forecast, which one of the item that must be estimated is the

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most important? Why?

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Answer: Analyzing the availability of fund and estimating the fund the company needs to
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raise are the most important items to be estimated. Because the objective of the forecasting
is to increase sales as well as increase the business growth.
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10. b) Which item do you think is typically most difficult to forecast?

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Answer: Company’s systematic risk is the most difficult item to forecast. Systematic risk,
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also known as “un-diversifiable risk” “volatility” or “market risk,” affects the overall market,
not just a particular stock or industry. So the firm has literally no control over this risk.
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Ques-11: a) What are some ratios you would calculate to help determine the risk of
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using debt?

Answer: The risk determining ratios using debt are:

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The risk determining ratios using debt are:

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Debt to Capital Ratio=Total Debt/ Total Capital

= (Short-term+ Long-term)/(All Debt+ Shareholders equity)
=$11,400,000/ ($11,400,000+ $31,830,000)
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= 0.2637
Debt to Equity Ratio= Total Debt/ Total Equity
= $11,400,000/ $31,830,000
= 0.3581
The ratio is less than 1 means Tipton would have enough money to pay off its debt.

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 Debt ratio= Total Debt/ Total Asset
=$11,400,000/$43,230,000
=0.2637

It means the debt finance is less than half of the assets. Tipton should be able to make its
debt payments even during economic downturns.

b) Play the role of a consultant. Industry averages for all categories of ratios are
given in Exhibit 3. Based on yourprevious answers, the ratios calculated in part (a)
and these industry averages, would you endorse the debt financing if you were a
member of the Tipton family? Explain.

Answer:

Ratios Industry Tipton Company

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Averages
Debt Remark Equity Remark

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Financing Financing

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Current (%) 1.8 2.09 Better 2.01 Better

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Quick (%) 0.8 1.19 Better 1.29 Better
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Debt (%) 50.0 26.0 Better 47.81 Good
Times Interest Earned 6.0 27.50 Better - -
(EBIT/Interest)
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Inventory Turnover 6.0 6.50 Good 21.0 Not good

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Average Collection Period 26.0 24 Better 32 Not good

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Total Asset Turnover 2.1 2.91 Better 2.67 Better

Gross Profit Margin (%) 18.0 25.0 Better 25.0 Better
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Return on Total Asset(%) 8.5 20.20% Better 19.60% Better

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Net Profit on Sales (%) 3.9 7.21% Better 7.40% Better

Return on Net Worth (%) 17.0 28.32% Better 32.9% Better
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Based on the ratios calculated in part (a) and the industry averages, I would endorse the
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debt financing if I were a member of the Tipton family.

Because as we can see from the ratios in part (a) that Tipton’s financial leverage is in a
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good condition, Tipton would have enough money to pay off its debt and the Debt ratio
indicates debt finance is less than half of the assets. Tipton should be able to make its debt
payments even during economic downturns.

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 Almost all the ratios are better than Industry Averages except inventory turnover ratio
which increased to 6.5. The Equity financing also seems promising but the Inventory
Turnover and Average Collection Period is at an alarming position in Equity Financing. Also
there is not much room for growth in Equity Financing whereas Debt Financing promises
to help the company grow more so Debt Financing would be recommended.

Major Findings
Total fund needed for the expansion is estimated $20,800,000. Of this, long-term
borrowing is $2,000,000
The current and quick ratios are 2.00 and 1.14 at debt financing and 2.01 and 1.29
at equity financing; the required range was more than 2 to 1

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The debt ratio is 0.48; Tipton’s debt finance is less than half of the assets

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The debt-equity ratio is 0.65; Debt financing for Tipton is not riskier

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DPS and EPS are 0.16 in equity financing and are 0.27 in debt financing (at 50%

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payout ratio)

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The estimated ROA is 20.20% where industry average is 8.5%
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The estimated ROE is 28.32% where industry average is 17.0%
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After the study, it is clear that Tipton would not face high risk being borrower. The
forecasting gives a clear figure of an improved growth in debt financing comparing with
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equity financing. So, Tipton can accept the proposed financing method by its financial
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officer.
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………………….
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