Similar to the body shop

Question 1: Why would a company like the Body Shop want to forecast its financial statements?

In 1998 Anita Roddick the founder of The Body Shop, resigned from her position, after the ineffective attempts to reaffirm the company. Patrick Gournay was placed as a new CEO with a slight of management change. Moreover, the company was able to increase its revenue by 13% in 2001 while the pretax profit declined by over 21%. Gournay stated, "This is below our expectations, and we are disappointed with the outcome." Gournay had high expectations of implementing a new strategy to improve the company's results. This strategy contained three major basic objectives, which are, to enhance The Body Shop Brand through a focused product strategy and increased investment in stores, and to achieve operational efficiencies in the company's supply chain by reducing product and inventory costs, and to reinforce the company's stakeholder culture. To implement this new strategy efficiently, it was essentially required for Gournay to forecast the company's financial statements. Doing so will lead to an increase in operational efficiencies and lower product and inventory costs.

Question 1 (b): How did you prepare your forecast and what numbers did you get?

I used two different methods of financial forecasting when preparing the financial forecast for the next three years for The Body Shop. The first method is the percentage-of-sales forecasting which is forecasting the sales at first then estimating other financial statement accounts based on some acknowledged association between sales and that account. While the second method is T-accounting forecasting, which requires us to start with a base year of financial statements, such as final years. While knowing that the most used approach of financial forecasting is a hybrid of both methods, as T-accounts are used to predict shareholders' equity and fixed assets, whereas, percent-of-sales forecasting method is used to estimate the income statements, current assets, and current liabilities.

My forecasting for The Body Shop over the next three years (2002-2004) is listed below.

Income Statement

2002

2003

2004

Growth

13%

422.73

477.7

539.8

COGS

40%

169.1

191.1

215.9

Gross- Profit

253.64

286.6

323.9

Operating- Expenses

52%

219.8

248.4

280.7

Fixed

0%

0

0

0

Fixed

0%

0

0

0

Interest

6%

3.79

4.39

5.1

PBT

30.03

33.8

38.0

Tax

30%

9.01

10.15

11.41

NI

21.02

23.7

26.62

Dividends

10.9

10.9

10.9

Retained Earnings

10.12

12.78

15.72

Balance Sheet

2002

2003

2004

0.2

10

10

Accounts Rec

8%

33.8

38.2

43.2

Inventory

13.70%

57.9

65.4

74.0

CA

4.70%

19.9

22.5

25.4

FA

30.00%

126.8

143.3

161.9

OA

1.80%

7.6

8.6

9.7

TA

246.2

288.0

324.2

Accounts Payable

3%

12.7

14.3

16.2

Taxes

2%

8.5

9.6

10.8

Accruals

3.5%

14.8

16.7

18.9

Plug

0.0

22.1

34.8

CL

4%

16.9

19.1

21.6

LTL

Fixed

61.20

61.2

61.2

OL

0.1%

0.4

0.5

0.5

Equity

131.720

144.5

160.22

TL&E

246.2

288.0

314.2

Trial Assets

246

278

314.2

Trial Liabilities

246.2

265.9

298.4

Trial Plug

-0.2

12.1

24.8

Minimum Cash

10

10

10

Plug

9.8

22.1

34.8

Question 2: How much debt financing will the Body Shop need over this forecast period? What are the key drivers of this need, and how much do debt needs vary as the assumptions vary?

The Body Shop's income statement and balance sheet from 2001 prove that the company has zero debt. To put it differently, the company has $13.7 million cash, which can be used to achieve the company's desired cash balance for 2002-2004.

In 2003 the company would need to finance $22.1 million and $32.8 million if the company desires to stabilizes and maintains its desired level of cash as well as, achieve the estimated level of growth. To compute the plug account, the difference between trial assets and liabilities was calculated as well as, the desired amount of cash. Then, added all together. As shown above, the body shop will need to continue to increase its cash to finance its operations.

Question 3: What issues does this analysis raise for Roddick?

When calculating the forecast for the upcoming three years (2002, 2003, 2004) we concluded that the cost of sales and gross profits would continue to increase for the company. As well as, the company's gross profit is forecasted to be almost $324 million, which is almost over 43% from the 2001 gross profit. Not to mention, the severe decrease in cash in 1999-2004, which can also give us a good sign because as mentioned earlier, The Body Shop wanted to begin to invest in other companies, in the hope of growing their company. Having too much cash can be an indicator of having it not used efficiently. The extra cash generated should be used in further potential investment opportunities as well as, from 1999-2004 overdrafts increased significantly as well. Moreover, The Body Shop needs to be aware of its debt financing. As from 2001 to 2004, total assets increased from $320.1 million to $324.2 million. From what we have seen, we advise Roddick to continue with his plan of growing the company. By emphasizing the management of the company's expenses, continually taking opportunities in safe investments while keeping in mind that the company's account payables don't increase rapidly, which can eventually lead The Body Shop to a terrible financial position.

Question 4: How did you derive your forecast? Why did you choose the base case assumptions that you did?

We derived the forecast from the sales; we used the percentage of sales method through growth rate. Then after that, we forecasted the rest of the financial statement elements such as expenses, cost of sales, etc. The sales were the key factor for all other calculations.

· Sales: for the sales, we assumed 13% growth rate it is a reasonable growth rate to apply because it is near from the growth rates percentages of the previous historical data.

· COGS: the cost of goods sold or cost of sales for the previous historical years was between 39% and 42%, so we chose an assumption of 40% to forecast. The result was increasing to 169.1 in 2002 to 191.08 in 2003 to 215.92 in 2004.

· Operating Expense: operating expenses have a high effect on the percentage of sales for the historical data, and it was around 49% and 52% so we used the 52% in the assumption 52% and we got in the forecasting 2002 in 219.8 and 248.4 in 2003 and 280.7 in 2004

· Restructuring Cost Rate: first, the incensement of the Restructuring costs is expected and then decrease at a rate ____ This happened because a plan of restructuring the company has been made Nevertheless, costs will start to decrease when the restructuring is done. The costs will drop faster than the COGS and Operating expenses because the rate of ___ was chosen. Since restructuring costs are one of the amounts that have meager future costs.

· Tax expense: The percentage of profit in our assumption was 30% where it resulted in 9.05 in 2002 then increased to 10.14 in 2003 then 11.41 in 2004.

· Dividend: From the historical data we have noticed that the dividend is the same for every year 10.9 that's why we assumed the same dividend was paid each year even for our forecasting.

· All other assets: The rate of percentages of rated we took is fixed at 0.1% for the other liabilities, same as the ones for the historical data that's why for the forecasting period it was 0.4% at 2002 then it remained constant at 0.5 for 2003 and 2004

· All other liabilities: The rate of percentages of rated we took is fixed at 0.1% for the other liabilities, same as the ones for the historical data that's why for the forecasting period it was 0.4% at 2002 then it remained constant at 0.5 for 2003 and 2004

· Shareholder Equity: The shareholder equity increased in the projection years from 131.806 in 2002 then to 144.6 in 2003 then 160.30 in 2004

Question 5: Based on your pro forma projection how much additional financing will the body shop need during the period?

The amount of additional financing, the Body Shop will need to be exemplified by the overdraft method (plug method) it works by covering the minimum cash balance with the excess cash they have. The Body Shop will need additional and extra financing on the three periods we're projecting; with 6% of debt assumption the Body Shop will need 3.66 million of debt in 2002 and 4.40 million in 2003 and 4.2 million in 2004

Question 6: What are the three or four most important assumptions or key drivers in the forecast? What is the effect on the financing need of varying each of these assumptions up or down from the base case? Intuitively, why are these assumptions so important?

Sensitivity analysis

Sensitivity analysis has been undertaken by evaluating the changes in a number of important inputs such as growth rates in sales, cost of sales percentage, operating costs percentage, and cost of debt.

Growth in sales

One of the significant factors that have an impact on the business is the rate of growth in sales. Currently, sales are expected to increase by 13 percent. This level could either be surpassed or even not realized. It is important to note that in the events that actual growth in sales increases by a rate lower than 13 percent, the company will generate retained profits below the budgeted level. However, the pressure on additional investments and thereby the financial plug required will decrease. On the other hand, an increase in sales beyond the forecasted rate of 13 percent will yield an increase in profits retained whereas the plug in required will be higher.

It is important for the Body Shop’s management to ensure that the estimated sales forecast is achieved so as to achieve the expected growth in profits. However, it is important to note that growth in sales beyond the expected rate of 13 percent will require additional financing and thus the plug needed will increase. Therefore, the management should ensure that adequate lines of financing are arranged in case there is an upsurge in demand. To achieve a high growth rate in sales, the company could choose to adopt aggressive marketing campaign or adopt diversification of product offering.

Cost of sales percentage

The company has a forecasted cost of sales percentage of 40 percent and therefore it is expecting that the business will earn a gross margin of 60 percent. Actual cost margins are however likely to vary from this level. For instance, in case the inflation level rises beyond the expected levels, there might be an upsurge of input prices thus trouble the company’s margins. Such a situation will cause the business to record significant decrease in margins even to the point of causing the business to suffer losses and thus require a significant financial plug. Conversely, a decrease in cost will help the business earn better margins and thus report higher retained profits. Consequently, the amount of financial plug required will be minimal and if the decrease in cost of sales percentage is significant, there will be no need for any financial plug. Decrease in cost of sales percentage could be achieved through adoption of efficient production techniques, reduction of wastage and idle time, among others.

It is important to note that the profitability of the business is very sensitive to changes in cost of sales and thus in the events there is an increase in costs, Body Shop will actually suffer losses throughout the forecasting period. This will also increase the financial plug in required due to increased financial deficit. The need for effective cost management can therefore not be overemphasized given its significant on the results of the business. Some of the modern cost management techniques such as the use of just-in-time inventory management system and Kaizen philosophy could be adopted by the business towards achieving efficiency in operations.

Operating costs percentage

Similar to cost of sales, the results of the business are very sensitive to changes in operating costs. The projected percentage of operating costs to sales is 52 percent for years 2002 to 2004. Actual operating costs might however differ from the budgeted level owing to market dynamics. For instance, increase in establishment costs could increase say as a result of new collective agreements signed that will push salaries and wages expenses. Similarly, other costs such as rent could rise beyond the levels budgeted for.

As indicated above, increase in operating costs beyond the forecasted level has the potential to cause the business to incur losses and therefore the level of financial plug required will increase significantly. Similarly, decrease in operating costs percentage for instance as a result of cost saving will help the business to realize better returns to shareholders. Therefore, the company will be in a position to generate sufficient operating cash flows to a level where no financial plug will be required.

Cost of debt

Cost of debt is subject to changes in market variables and thereby could either increase or decrease. A decrease in debt cost will of course result to an improvement in the amount of retained earnings and thereby the financial plug required will be minimal. It is however important to note that the level of change in retained earnings as well as the amount of financial plug required will be insignificant. Likewise, an increase in debt cost from will yield an increase in interest costs and thereby causing a reduction in retained earnings. Moreover, this will cause a marginal increase in the financial plug required and therefore changes in price of debt is not likely to hurt the business significantly. The business has the capacity to borrow additional funds to finance its operations and given the minimal cost to the company, management should ensure that growth opportunities are exploited.

Question 7: Why are your findings relevant to a general manager like Roddick? What are the implications of these findings for her? What action should she take based on your analysis?

The review of the impact of various inputs is very critical to the management of The Body Shop. The following is a discussion of these findings including a recommendation of the actions that should be taken based on this analysis.

The company is forecasting to achieve growth in sales by 13 percent, and there is the likelihood for the growth forecast either to be over or underachieved. It was noted from this analysis that a slump in sales would cause a reduction in the amount of profit that is retained. However, this will reduce the level of financing needed given the minimal investment in working capital that is required. On the other hand, an increase in sales beyond the forecast rate of 13 percent will not only yield increased retained earnings but also require an additional level of financing. The management should note the need to arrange a variety of funding that might be necessary.

Changes in the cost of sales and operating costs were noted to pose the significant impact on the company's profitability. Increase in the percentage of the cost of sales to sales, for instance, was seen to cause the business to suffer losses similar to the rise in the percentage of operating expenses to sales. Consequently, these scenarios will necessitate significant borrowing in the form of overdrafts given the increased financial gap. Management should note the need to adopt effective cost management practices since any reduction in costs will help to boost the results of the business.

Cost of financing was noted to have an insignificant influence on the company's profitability. Whereas increased debt cost caused a decrease in the level of profit that is retained and an increase in the level of financing required, the subsequent change was insignificant. This was also the cause of a decrease in the cost of debt that resulted in a marginal increase in retained profit and a slight decrease in financing required. Thereby, management should not be overly worried regarding the interest risk of the business since this is marginal.

Conclusion

There are some variables that impact on the forecast financial performance of a business. A review of the sensitivity of each of these factors is very critical to isolate those external factors that are likely to pose a significant impact on the business. In this case, cost management was found to be a critical area of focus for the business. Effective cost management will enable The Body Shop to meet its performance forecasts. This, therefore, indicates that cost management should be the mainstay of the company's strategy.